Build a compliant crypto exchange after blockchain.

I gained a reputation for being skeptical about the legality of selling cryptocurrency tokens in the United States. I used to write extensively about this, especially in 2017 when I was studying for my master’s in law, which gave me more free time and flexibility to express my opinions.

Furthermore, I held this position when it was unpopular and not obvious, unlike current crypto critics like former government lawyer John Reed Stark (who seems to enjoy kicking the industry while it’s down). For example, on July 9th, 2014, my friend Tim Swanson and I were quoted in a CoinTelegraph article, “Mitigating the Legal Risks of Issuing Securities on a Cryptoledger,” where I said that “[Virtually] nobody has done this correctly. To date, I have not seen a single crypto-security that has been properly structured.”

Preston Byrne is a lawyer and partner of Brown Rudnick’s Digital Commerce Group.

At the time, people thought I was crazy, and others probably thought I was just a jerk. The truth probably falls somewhere in between. However, in 2014, the idea of an “initial coin offering” (ICO) did not exist; entrepreneurs like Joel Dietz marketed his “Swarm” crowdfunding token as “crypto-equity,” a term that fell out of favor with more sophisticated projects like Ethereum, which launched its ICO only a month after I was quoted in the CoinTelegraph article. But even that was not called an ICO. That, presumably per whatever advice was given to Joe Lubin by his lawyers, was a “sale of crypto fuel for the Ethereum network.” Or, as the New York Attorney General alleged in its recent lawsuit against KuCoin, a security.

Ethereum subsequently exploded in 2017, and with it came a thousand imitators and other variations just like it. U.S. regulators were slow to respond. Then-SEC Director Bill Hinman added fuel to the ICO fire when he made his famous “Hinman Speech,” which set out the (now-discredited) “sufficiently decentralized” exception to the Howey test. Considering that Hinman was based out of San Francisco, the general assumption among those of us who were not in the cool SF venture-capitalist crowd was that they had successfully convinced that office that Ethereum – a popular investment out there – was the next Internet, and the best thing for the government to do would be to get out of the way and let Ethereum prove it.

I think it is safe to say, five years later, that Ethereum has not cracked a lot of the scaling issues it would have needed to do to become the next Internet. With those broken promises on one side, perhaps it is not surprising that the government has decided to restore the status quo ante, with the NYAG’s lawsuit against KuCoin.

Confusion and weird settlements

What followed the Hinman speech can only be described as confusing. Until the Hinman speech, the SEC really had only gotten involved in the crypto business in cases of obvious and notorious fraud. The first such case that I can recall was the case of SEC vs. Trendon Shavers and Bitcoin Savings and Trust (a Ponzi scheme) and SEC v. GAW Miners, Joshua Homero Garza et al. (another Ponzi scheme involving the sale of “mining contracts” and a $20 stablecoin called “paycoin”).

In terms of non-fraud enforcement, the SEC started to bring its first set of enforcement actions, announced by way of settlements, with a number of coin-related projects in late 2018, only months after the Hinman Speech was published. The first such settlement, with a founder of early decentralized exchange, or “DEX,” EtherDelta, was announced on Nov. 8th, 2018; the SEC claimed that the DEX operator was operating an unregistered exchange, which necessarily implied that the SEC took the view that some of the assets on EtherDelta – being Ether and ERC-20s – were securities. Ten days later, the SEC announced its first settlements with two otherwise completely unmemorable ICO issues, Airfox and Paragon; both respondents agreed to register their tokens as securities (which does not appear to have happened as far as I can tell).

What followed over the next year was a range of weird settlements which failed to serve as a deterrent to further ICO issuance being conducted at the same time as a bunch of weird transactions which tried to pretzel their way into compliance with the non-guidance guidance issued by Bill Hinman. EOS, for example, which advertised its product on a giant Times Square billboard during Consensus 2017 and raised north of $4 billion in crypto (as valued at the time), was somehow allowed to skate by paying a $24 million fine – and not even a requirement to register!

Some cryptocurrency projects have not had good luck with the Securities and Exchange Commission (SEC). Kik Interactive, Telegram, Ripple Labs, and LBRY have all faced legal challenges from the SEC. LBRY did not receive a settlement offer, which may be because the SEC’s Boston office wanted to make an example of a crypto startup in New Hampshire. The SEC has now filed a complaint against Blockchain for violating securities registration requirements and operating as an unregistered broker-dealer and clearing agency.

The SEC is seeking a permanent injunction against Blockchain from operating an unlicensed exchange. If the SEC can win at trial, they may be able to shut down Blockchain’s core business completely. This is not surprising, as it was predicted that law enforcement would crack down on major exchanges and ICO promoters.

The question now is what comes next. Cryptocurrency is not going away, but new exchanges may be needed to avoid regulatory issues. Compliance may now be cheaper than non-compliance. Companies that want to succeed will need a growth strategy that does not rely solely on the United States. The UK may be a good launch point to access English-speaking Africa and India.

Therefore, cryptocurrency is not dead, but it requires some legal adjustments. Let the best and most compliant startup emerge victorious.