Investors piled into cryptocurrencies
fueling a surge in cryptocurrency prices.
The price of Bitcoin, the most well-known cryptocurrency, increased over 1,000% in 2017.
As a sign of the mania surrounding these new investments, celebrities from Paris Hilton to Floyd Mayweather have endorsed cryptocurrencies.
This new investment was enabled by cryptocurrency wallets and exchanges. These platforms, akin to broker-dealers for virtual currency, are the entities through which many investors hold and trade cryptocurrency.
The rise of these new cryptocurrency platforms raises questions about how they should be regulated.
As with any custodial relationship—in which the custodian holds assets on a customer’s behalf—there is a fundamental problem of trust associated with these platforms. Namely, why should customers entrust their cryptocurrency to these platforms? And if these cryptocurrency platforms fail, will customers be able to recover their investments? These are not idle concerns. Cryptocurrency platforms have failed at an exceedingly high rate,
and customers have lost hundreds of millions of dollars as a result.
To answer these questions, this Note looks to the experience of broker-dealers, beginning with the observation that cryptocurrency platforms function much like broker-dealers for cryptocurrency. Just as broker-dealers enable investors to hold and trade securities,
cryptocurrency platforms allow customers to invest in cryptocurrency.
Customer protection regulation for broker-dealers changed dramatically during the 1970s in response to widespread broker-dealer failures.
During the 1960s, there was a significant rise in the stock market, drawing new investors who had previously eschewed stocks.
In 1952, only 6.5 million Americans owned stocks; by 1965, that number was over 20 million.
In the late 1960s, markets experienced a downturn, and broker-dealers failed en masse, leading to severe customer losses.
In response, Congress enacted the Securities Investor Protection Act of 1970 (SIPA),
and the SEC promulgated rules intended to address many of the perceived weaknesses leading to broker-dealers’ failures in the late 1960s.
This Note argues that cryptocurrency platforms face many problems similar to those that plagued broker-dealers during the late 1960s, and, therefore, Congress’s and the SEC’s responses to these problems provide a potential framework from which to approach regulating cryptocurrency platforms. Part I provides a brief background of cryptocurrency and cryptocurrency platforms and then discusses how broker-dealers are regulated. Part II discusses similarities between broker-dealers in the 1960s and cryptocurrency platforms today and argues that SIPA and the SEC’s broker-dealer regulations provide a useful framework from which to approach regulation of cryptocurrency platforms. Part III proposes how the broker-dealer regulatory framework may be adapted to cryptocurrency platforms.
I. Cryptocurrency Platforms and Regulation of Broker-Dealers
This Part begins with a brief overview of cryptocurrency and cryptocurrency platforms and then proceeds to discuss Congress’s and the SEC’s responses to broker-dealer failures during the late 1960s. Section I.A considers cryptocurrency and the platforms that allow customers to hold and trade cryptocurrencies. Section I.B describes SIPA, including the historical context in which Congress enacted the law, and key broker-dealer regulations promulgated by the SEC.
A. Cryptocurrency and Cryptocurrency Platforms
1. What Is Cryptocurrency? — Cryptocurrencies are digital assets recorded on decentralized, public ledgers.
The ledger, known as a blockchain,
serves as a record of asset ownership and transfers, much like a land registry.
Owning cryptocurrency involves having a private key.
This private key, when matched with the public blockchain, allows owners to access their cryptocurrency and transfer it to another person.
A transfer occurs when it is recorded on the blockchain.
Because the blockchain is maintained through a decentralized process, once a transaction is recorded on the blockchain, it is virtually impossible to reverse.
This prevents someone from “double-spending,” or transferring the same cryptocurrency twice.
While the best-known cryptocurrency may be Bitcoin, there are numerous other types, often referred to as “altcoins.”
As new coins are constantly launched in the market, the list of altcoins grows.
New altcoins raised over $2 billion in the first nine months of 2017.
By one count, there are over 800 cryptocurrencies, though the largest ones make up a disproportionate share of the aggregate market capitalization of cryptocurrencies.
Because more altcoins are entering the market and each altcoin is different, it is difficult to provide a definition that encompasses them all.
Nevertheless, they generally follow the structure described above: digital assets recorded on a decentralized blockchain.
In addition to being recorded on a decentralized blockchain, another factor that distinguishes cryptocurrencies from other digital assets is that they are convertible to legal tender on a cryptocurrency exchange—as opposed to, for example, digital currencies in video games, which generally are not convertible into cash.
2. Cryptocurrency Wallets and Exchanges. — An online cryptocurrency wallet is a service that stores and safeguards cryptocurrency on behalf of customers.
Recall, owning cryptocurrency simply involves having a private key, which allows owners to transfer their cryptocurrency.
Wallet providers hold private keys on behalf of their customers, acting as their custodians.
In fact, when customers hold cryptocurrency in an online wallet, they do not have access to their private keys;
instead, they must trust their wallet providers to hold the cryptocurrency on their behalf.
Unlike wallets, which simply hold cryptocurrency on their clients’ behalf, cryptocurrency exchanges also provide marketplaces where users can trade one cryptocurrency for another or for government-issued currency.
These exchanges differ in the currency pairs they offer and their fees.
Fees typically include a commission for each trade and withdrawal fees for transferring cryptocurrency out of the exchange.
Because the industry is still nascent, cryptocurrency markets are quite fragmented; by one count, there are almost eighty exchanges.
They are also located in various jurisdictions.
Exchanges combine both wallet and exchange services.
In order to trade on an exchange, customers must hold cryptocurrency in the exchange’s wallet.
Exchanges execute trades only between customers that have wallets with the exchange. By providing both wallet and exchange services, they are one-stop shops for people who are looking to trade and invest in cryptocurrencies.
Most cryptocurrency trading is done on these exchanges.
B. Regulation of Broker-Dealers
This section turns to regulation of broker-dealers, beginning with the historical context under which Congress and the SEC enacted and implemented various broker-dealer reforms during the early 1970s. Namely, many broker-dealers failed amid market and operational turmoil during the late 1960s.
The section goes on to describe Congress’s and the SEC’s responses to these broker-dealer failures, including the customer protection rule, net capital rule, and alternative bankruptcy regime for broker-dealers.
1. Historical Background. — In order to understand broker-dealer regulation and its potential application to cryptocurrency platforms, it is helpful to understand its historical background. Congress enacted SIPA in 1970 in response to a series of broker-dealer failures during the late 1960s.
The decade before these failures featured a sustained bull market,
with more and more investors speculating in stocks.
Trading volume increased over 180% from 1963 to 1968,
and brokerages began having difficulty dealing with this new business, not least because securities were still held and delivered in physical (that is, paper) form.
Broker-dealers had to deliver physical securities with each transaction. Often, each transaction required dozens of paper documents.
In order to ease the administrative burden inherent in each transaction, broker-dealers began registering securities in their own name—a practice known as using “street names”—instead of delivering physical securities to customers.
Broker-dealers would simply note on their own books that they were holding these securities for a customer.
This blurred the line between a broker-dealer’s securities and its customers’ securities: Instead of separating its own assets from those of its customers, a broker-dealer would instead hold one fungible pool of securities.
As a result, many broker-dealers began financing themselves with customers’ assets. That is, some would borrow money secured by customers’ securities.
By one estimate, 41% and 33% of broker-dealers’ assets on the New York Stock Exchange (NYSE) were financed by client assets in 1969 and 1970, respectively.
Even still, broker-dealers faced a paperwork crisis.
There was an insufficient number of back-office employees to process the volume of trading.
Exchanges had to close early so that broker-dealers could work through the backlog of paperwork.
Trades often failed or took extremely long to settle.
Losses caused by failure to receive or deliver securities reached four billion dollars.
Theft was also rampant: Because of the backlog, broker-dealers often lost track of where their securities were, inviting theft.
Then-U.S. Attorney General John Mitchell testified that more than $400 million worth of securities had been stolen between 1969 and 1970.
Adding to these operational problems, a bear market in 1969 led to a sharp drop in the value of broker-dealers’ proprietary holdings and depressed trading volume.
Broker-dealers, already plagued by operational issues, began failing in the face of reduced trade commissions and severe declines in the value of their proprietary accounts.
Approximately 160 NYSE broker-dealers closed, merged, or filed for bankruptcy during this period.
Customer losses were significant.
In response, Congress enacted SIPA in 1970 to protect customers from losses in the event of subsequent broker-dealer failures,
and the SEC promulgated the customer protection rule and net capital rule, discussed below.
2. Customer Protection Rule. — Responding to problems stemming from the commingling of a broker-dealer’s assets with those of its customers,
the customer protection rule is intended to separate a broker-dealer’s own activities and assets from those of its customers, ensuring that there are sufficient assets to satisfy customers’ claims in the event of failure.
The rule is primarily composed of two parts: (1) requiring broker-dealers to have possession or control of customer securities and (2) protecting customers’ cash.
To safeguard customers’ securities, the customer protection rule requires a broker-dealer to “promptly obtain and . . . thereafter maintain the physical possession or control of all . . . securities carried by a broker or dealer for the account of customers.”
“Promptly” generally means the broker-dealer must assess its inventory of securities each day to ensure that it has sufficient securities to satisfy all of its customers’ claims.
If there is a shortfall, then the broker-dealer must take steps to make up any difference.
For example, if its customers collectively own 250,000 shares of IBM, a broker-dealer must have “possession or control” of 250,000 shares of IBM to satisfy its customers’ claims. In addition, the securities held on behalf of customers must be unencumbered—free of any lien or other claim.
In effect, the customer protection rule requires that a broker-dealer have sufficient securities such that, if all of its customers were to simultaneously withdraw their securities, the broker-dealer would be able to deliver all of them.
In addition to securities, the customer protection rule also covers customers’ cash holdings. Broker-dealers must maintain a deposit in a separate account representing the net amount of funds that the broker-dealer owes to its customers.
The rule governing cash is somewhat more lax than the rule governing securities. Unlike securities, which must be inventoried daily, the net amount of funds owed to customers is calculated only weekly.
However, the customer protection rule also limits broker-dealers’ ability to use such cash in risky operations,
limiting the likelihood that there will be a significant cash shortfall.
3. Net Capital Rule. — In response to the failure of undercapitalized broker-dealers during the late 1960s and early 1970s, the SEC also promulgated the net capital rule.
Though broker-dealers had been subject to capital requirements since the 1940s, the rules were inadequate.
By 1970, broker-dealers had become leveraged ten to one,
with the largest firms exhibiting even higher leverage.
Observing the number of broker-dealer failures during the late 1960s and early 1970s, the SEC concluded that broker-dealers were undercapitalized.
The net capital rule ensures that broker-dealers maintain adequate liquidity to satisfy their customers’ claims.
However, the purpose of the net capital rule is not to avoid broker-dealer failures per se. Instead, the primary purpose of the net capital rule is to ensure that customers can recover their assets in the event of a broker-dealer failure without resorting to formal liquidation proceedings.
In a self-liquidation, a broker-dealer facing financial distress typically sells itself to a financially healthy broker-dealer with relatively few disruptions for the distressed broker-dealer’s customers.
Self-liquidations are usually preferred to formal liquidations because they are less costly and result in fewer delays for customers.
For example, during a period of market stress for broker-dealers during the late 1980s, there were eighteen self-liquidations compared to eight formal liquidations.
The net capital rule requires broker-dealers to maintain net capital in excess of certain thresholds. Net capital is essentially the value of the firm if it were to liquidate.
It is calculated as net worth under Generally Accepted Accounting Principles (GAAP), with various adjustments to reflect a liquidation.
For example, assets that cannot be easily converted into cash, such as real estate or furniture, are excluded from net capital.
Most importantly, “haircuts”—discounts to market value—are applied to securities held by the broker-dealer, reflecting the estimated price the broker-dealer would receive in liquidation.
Riskier securities—whose values are more volatile—have a higher haircut whereas safer securities have a lower haircut.
For example, equity securities are subject to a 15% haircut whereas short-dated Treasury bills are not discounted at all.
The net capital rule provides two methods to benchmark net capital: the basic and the alternative methods. Under the basic method, which most smaller firms use,
the broker-dealer’s “aggregate indebtedness” cannot exceed 1,500% of its net capital,
with aggregate indebtedness defined as the “total money liabilities of a broker or dealer arising in connection with any transaction whatsoever.”
Essentially, under the basic method, broker-dealers cannot have liabilities exceeding fifteen times their net capital.
The alternative method, which most large firms use,
requires the firm to maintain net capital in excess of the greater of $250,000 or 2% of the amount that is owed by customers to the broker-dealer.
The motivating principle behind the alternative method is that a broker-dealer with sufficient capital should be able to liquidate itself informally—without resort to the courts.
Because the broker-dealer is supposed to have sufficient securities and cash to satisfy all of its customers’ claims under the customer protection rule,
the broker-dealer’s net capital is meant to provide an additional cushion to cover the administrative costs of liquidation in the event of failure.
Under the alternative method, a broker-dealer complying with both the customer protection and net capital rules would thus have enough securities and cash to satisfy all of its customers’ claims plus a sufficient cushion—its net capital—to operate until it returned all of its customers’ securities in liquidation.
4. Broker-Dealer Bankruptcy. — In addition to the net capital rule, which was intended to obviate the need for formal liquidation proceedings, SIPA created a backstop in the form of an alternative proceeding to Chapter 7 bankruptcy for broker-dealers.
In both Chapter 7 bankruptcy proceedings and liquidation under SIPA, broker-dealer customers are preferred to general creditors in bankruptcy.
Specifically, customer property—securities held by the broker for its customers—is separated from the general estate in both Chapter 7 bankruptcy and liquidation under SIPA.
General creditors do not have a claim on customer property; instead, customer property is used only to satisfy customers’ claims.
Because brokers typically have relatively few assets other than their customers’ property,
this feature of the bankruptcy regime strongly favors customers.
SIPA established further protections for customers. Seeking an alternative to the bankruptcy code, Congress established the Securities Investor Protection Corporation (SIPC) to oversee bankruptcy proceedings for broker-dealers.
In any broker-dealer bankruptcy proceeding, SIPC can step in to manage the liquidation of the broker-dealer.
A key difference between SIPC-managed liquidations and Chapter 7 bankruptcy is that the former favors distribution of securities back to customers whereas the latter requires liquidation of securities into cash.
Investors typically prefer receiving securities rather than cash because in-kind distribution of securities avoids a forced liquidation of investors’ holdings. Because distributions under Chapter 7 bankruptcy are based upon the value of the customer’s holdings on the date of the bankruptcy filing,
the value of cash distributed in Chapter 7 bankruptcy can deviate from the value of the customer’s holdings when there are changes in the market value of the customer’s securities between the filing and distribution dates. For example, suppose a customer has 100 Amazon shares in her brokerage account, worth $1,000 per share as of the bankruptcy filing date. She will be entitled only to $100,000 (100 shares multiplied by $1,000 per share) in Chapter 7 bankruptcy, even if her Amazon shares have appreciated to $1,200 by the time of distribution.
Distributing securities in kind avoids this problem.
The second difference between Chapter 7 bankruptcy and a SIPC-managed liquidation is that SIPC provides insurance to cover unsatisfied customer claims. As such, if there are insufficient securities to satisfy all of the customers’ claims, SIPC is authorized to purchase securities to make up the shortfall.
Specifically, SIPC insures up to $500,000 per customer, of which a maximum of $250,000 can be cash.
The insurance protects only the broker-dealer’s customers, not its general creditors.
SIPC itself is funded by assessments on broker-dealers.
Through SIPC insurance and preference for in-kind distribution of securities in bankruptcy, Congress reformed the broker-dealer bankruptcy process to protect customers from losses.
II. Parallels Between Broker-Dealers and Cryptocurrency Platforms
Following Part I’s description of the problems faced by broker-dealers in the late 1960s, this Part highlights how similar problems are in many ways arising among cryptocurrency platforms. It then argues that SIPA and the regulatory response to broker-dealer failures described in Part I might provide a framework from which to approach regulation of cryptocurrency platforms.
Section II.A briefly explains how cryptocurrency platforms function as the broker-dealers for cryptocurrencies. Sections II.B and II.C highlight how problems that plagued broker-dealers in the late 1960s might arise among cryptocurrency platforms. Section II.B describes the problem of fractional reserves, which is reminiscent of how broker-dealers commingled their own assets with those of their customers during the 1960s, and suggests that recent state efforts to regulate cryptocurrency are likely to be insufficient. It then briefly highlights the risk of cryptocurrency platform failures. Section II.C argues that, under current law, there are inadequate protections for cryptocurrency platform customers in bankruptcy. Finally, section II.D argues that the broker-dealer reforms enacted in the early 1970s provide an effective framework from which to approach regulation of cryptocurrency platforms.
A. Cryptocurrency Platforms as Broker-Dealers
Cryptocurrency platforms functionally act much like broker-dealers for cryptocurrencies.
Specifically, like broker-dealers, they provide two key functions: (1) acting as custodians for customer assets
and (2) executing trades for their customers.
To be considered a broker under the Securities Exchange Act of 1934, an entity must be “engaged in the business of effecting transactions in securities for the account of others.”
Cryptocurrency platforms are “engaged in the business of effecting transactions” on behalf of their customers: Like brokers, they profit by receiving and executing customers’ orders, typically charging customers on a per-trade basis.
However, to meet the Exchange Act definition of a broker, cryptocurrencies would need to be considered “securities” for purposes of the federal securities laws.
The SEC, in a report published in July 2017, endorsed a case-by-case determination of whether cryptocurrencies are securities.
Given this case-by-case approach, the regulatory landscape is uncertain as to which cryptocurrencies are securities and which are not.
However, a detailed analysis of whether cryptocurrency platforms are broker-dealers for purposes of the federal securities laws is not necessary here. Regardless of whether cryptocurrencies are considered securities, cryptocurrency platforms face the same basic problem that plagues broker-dealers—namely, why should customers entrust their assets to the cryptocurrency platform? Because these platforms functionally act much like broker-dealers for cryptocurrency, the experience of broker-dealers provides insight into how cryptocurrency platforms might be regulated, regardless of whether cryptocurrencies are considered securities.
B. The Problem of “Fractional Reserves” and the Risk of Cryptocurrency Platform Failures
1. Fractional Reserves. — Like brokers, cryptocurrency platforms hold assets on their customers’ behalf. When customers own cryptocurrency on a platform, what they really have is an IOU from the platform.
This presents the same fundamental issue of trust that broker-dealers faced in the late 1960s as stock ownership moved from physical form to being held in the broker’s name.
When broker-dealers held stock in paper form, customers had physical proof of their stock ownership. Once brokers began holding stocks in “street name,” customers had to trust that their brokers were actually holding stock on their behalf. Indeed, before the customer protection rule, brokers often mishandled customer securities, leading to delayed trades or stolen securities.
They also used customer securities for their own purposes. For example, broker-dealers used customer assets to fund their own trading activities.
This same problem—misuse and mismanagement of customer assets—could occur among cryptocurrency platforms. Just as a broker holds customers’ assets in its own name, a cryptocurrency platform holds its clients’ assets in its own name by managing the private keys.
Because customers do not even have access to these private keys,
they must trust that the platform will not misuse their cryptocurrency. Like broker-dealers in the late 1960s, a cryptocurrency platform could use customer assets to fund its own activities, and thus may not hold sufficient assets to satisfy all of its customers’ claims—otherwise known as running a fractional reserve.
To illustrate, suppose a platform has only two customers, each owning ten Bitcoin. If the platform holds only fifteen Bitcoin on behalf of customers (using the other five Bitcoin to finance its own trading), then it has insufficient reserves to satisfy all of its customers’ claims. If both customers withdraw or sell all of their Bitcoin simultaneously, then the platform will face a shortfall of five Bitcoin as a result of the fractional reserve. Because cryptocurrency platforms are largely unregulated, it is unclear what percentage of client assets are actually held by cryptocurrency platforms. This has led to problems, most famously in the case of Mt. Gox, discussed in the following section.
2. Mt. Gox. — Mt. Gox was one of the largest Bitcoin exchanges, handling around 80% of Bitcoin trades at its peak.
In 2013, customers began experiencing months-long delays in withdrawals.
Finally, in February 2014, Mt. Gox collapsed, announcing that it had lost over 750,000 of its customers’ Bitcoin, representing several hundred million dollars in losses at the time.
Because it failed under somewhat mysterious circumstances, it is unclear what exactly led to Mt. Gox’s demise.
There have been persistent rumors that Mt. Gox was running on a fractional reserve basis, meaning Mt. Gox used customer Bitcoin to fund its own activities.
Regardless of the ultimate cause of Mt. Gox’s failure, it is clear that, at the time of its collapse, Mt. Gox had insufficient Bitcoin holdings to satisfy all of its customers’ claims.
In many ways, Mt. Gox’s collapse echoes the failures of many broker-dealers in the late 1960s. At a minimum, Mt. Gox likely mismanaged customer assets. Just as broker-dealers lost track of customer securities,
Mt. Gox lost most of its Bitcoin by the summer of 2013, months before it declared bankruptcy in February 2014.
Whatever the cause of its collapse—whether intentional pilfering of customer assets or negligence in safeguarding customer deposits—Mt. Gox did not adequately protect its customers’ cryptocurrency, leading to insolvency.
Learning from the experience of Mt. Gox, many cryptocurrency platforms now claim that they do not use customer deposits to fund their own activities. For example, Coinbase, a large cryptocurrency platform, tells its customers: “Customer deposits are not sent anywhere. Unlike other financial institutions, we do not lend out customer funds. 100% of your funds are securely stored.”
Another platform tried to use technological solutions to prove that it had adequate reserves to back up client deposits.
However, absent adequate regulatory oversight, customers who choose to invest in cryptocurrency are still left taking these cryptocurrency platforms at their word.
3. State Regulation. — It should be noted that cryptocurrency platforms are not entirely unregulated; several states have begun regulating them, with some even addressing the issue of safeguarding customer assets and the problem of fractional reserves.
However, state regulations are unlikely to be sufficient because they are not uniform and are easy to sidestep. The contradictory regulatory approaches of New York and Hawaii highlight these problems.
New York established a framework for regulating cryptocurrency platforms, known as BitLicense, in 2015.
In addition to anti–money laundering and cybersecurity provisions,
BitLicense addresses the issue of safeguarding customer assets.
Specifically, New York requires cryptocurrency platforms to “hold Virtual Currency of the same type and amount as that which is owed or obligated” to customers.
It also prohibits platforms from “selling, transferring, assigning, lending, hypothecating, pledging, or otherwise using or encumbering assets, including Virtual Currency . . . except for the sale, transfer, or assignment of such assets at the direction of [the customer].”
By requiring platforms to hold unencumbered cryptocurrency in the amount that is owed to customers, New York’s BitLicense regulation safeguards customer assets and effectively prevents fractional reserves.
Hawaii, however, takes a different approach to protecting customer assets. Hawaii’s Money Transmitters Act requires cryptocurrency platforms to hold cash reserves, rather than cryptocurrency, against customers’ cryptocurrency deposits.
For example, a platform holding 100 Bitcoin on behalf of customers would have to hold the dollar equivalent of 100 Bitcoin in cash as reserves. A cryptocurrency platform attempting to comply with both New York and Hawaii’s regulations would thus be required to hold both 100 Bitcoin (to satisfy New York’s requirement to “hold Virtual Currency of the same type and amount as that which is owed or obligated” to customers
) and the dollar equivalent of 100 Bitcoin in cash (to satisfy Hawaii’s requirement).
Faced with precisely such a costly regulatory dilemma, Coinbase simply decided to stop operating in Hawaii.
This highlights yet another shortcoming of state regulation: Because state regulation generally only covers activity within the state or involving its residents, it can be easy to sidestep. For example, New York’s BitLicense covers only activities involving “New York or a New York Resident,” allowing cryptocurrency platforms to potentially circumvent these regulations by avoiding business with New York and its residents.
Federal legislation, on the other hand, would be more difficult to avoid.
4. Risk of Platform Failures. — While Mt. Gox was the largest cryptocurrency exchange to collapse, there have been a plethora of other failures. An early study indicates that 45% of cryptocurrency exchanges have failed, with the median exchange lasting just 381 days.
To be sure, some of these failures likely reflect the growing pains of a nascent and fast-moving industry. Nevertheless, the prevalence of failures suggests that more could be done to protect customer assets, since customers are often unable to reclaim their lost cryptocurrency holdings following exchange failures.
To date, hacking has been the most common reason behind cryptocurrency platform failure.
But in addition to hacking, cryptocurrency platforms could fail due to inadequate risk management or excessive risk taking. Like any broker-dealer who holds risky assets, cryptocurrency platforms operate with the risk of insolvency. Any cryptocurrency platform that trades or holds cryptocurrency on its own behalf is subject to the vagaries of the cryptocurrency market. Coinbase, for example, holds a significant inventory of cryptocurrency to facilitate trades and payments.
While the company “runs complex software that monitors price fluctuations and responds almost instantly in an effort to avoid serious losses,”
past financial crises demonstrate that losses are not always predictable. A market downturn would also likely dampen trading activity, reducing commission revenue for cryptocurrency platforms. Just as the market downturn in the late 1960s led to widespread broker-dealer failures,
an unforeseen downturn could render some cryptocurrency platforms insolvent.
C. Cryptocurrency Platform Bankruptcy
Given the problem of fractional reserves and the risk of platform failures, the bankruptcy procedure for cryptocurrency platforms may prove to be important. Unfortunately, the current procedure is potentially deficient. Instead of a SIPC-managed liquidation, which is available only for registered broker-dealers, cryptocurrency platforms are subject to Chapter 7 bankruptcy.
As such, in bankruptcy, customers receive the value of their liquidated cryptocurrency in cash instead of receiving their cryptocurrency in kind.
However, many customers, especially those holding cryptocurrency as an investment, likely prefer to receive cryptocurrency rather than a forced liquidation of their investments.
First and foremost, empirical analysis suggests that cryptocurrency is “primarily held for investment purposes,” not as a medium of exchange.
Moreover, in bankruptcy, the value of a customer’s claim is determined by the value of her holdings “at the time of the filing of the [bankruptcy] petition.”
As such, changes in value between filing date and ultimate recovery are ignored. Given the volatility of cryptocurrencies, the value of what customers receive in cash might diverge substantially from the value of their cryptocurrency.
Finally, returning cryptocurrency to customers is likely faster and less costly than liquidation into cash.
Mt. Gox’s bankruptcy proceedings illustrate this preference for in-kind distribution over distribution of cash. A group of Mt. Gox’s former customers requested that their bankruptcy payouts be done in Bitcoin rather than cash in part because they believe Bitcoin is “superior” to cash.
Further, pending ongoing bankruptcy proceedings, Mt. Gox’s customers appear to be entitled only to the market price of their Bitcoin holdings as of April 2014, when the court ordered liquidation of the exchange.
At the time, Bitcoin was worth approximately $483.
As of August 2018, it is worth over $6,200,
potentially leaving customers with significant forgone gains. Furthermore, after all creditors are paid, Mt. Gox’s shareholders will receive any surplus. Without a preference for distribution of cryptocurrency in kind rather than liquidation to cash, Mt. Gox could potentially reap the gain from its customers’ Bitcoin investments.
An additional source of uncertainty in cryptocurrency platform bankruptcy is whether customers’ claims would be prioritized against those of general creditors. Because cryptocurrency platforms are not SIPC members, their liquidations are governed by the bankruptcy code.
The bankruptcy code has special provisions for stockbroker liquidations that generally benefit the stockbroker’s customers over other creditors.
Specifically, customer assets are used only to satisfy customers’ claims; general creditors do not have claims to customer property.
Under current law, however, it is unclear whether a cryptocurrency platform would be considered a “stockbroker” and thus subject to these special provisions. The bankruptcy code defines “stockbroker” as an entity “that is engaged in the business of effecting transactions in securities . . . for the account of others.”
Given the SEC’s case-by-case approach to determining whether cryptocurrency is a security,
there is at least some uncertainty as to whether cryptocurrency platforms are “effecting transactions in securities” for purposes of the bankruptcy code.
Without these special provisions, customers’ assets might be used to satisfy the claims of general creditors in bankruptcy.
D. Broker-Dealer Regulation as a Framework for Regulating Cryptocurrency Platforms
In light of the similarities between the problems faced by cryptocurrency platforms and broker-dealers, this section argues that broker-dealer regulation provides a robust framework with which to approach regulation of cryptocurrency platforms. This section assesses the three elements of the broker-dealer regulatory framework described in section I.B—the customer protection rule, net capital rule, and broker-dealer bankruptcy regime—in the context of cryptocurrency platforms. It argues that this framework could address many of the problems identified in sections II.B and II.C. The section concludes with a brief discussion of the potential for private solutions to these problems.
1. Customer Protection Rule. — As illustrated in section II.B.1, cryptocurrency platforms face the same problem that broker-dealers did in the late 1960s: the potential for these platforms to misuse their customers’ assets.
As the Mt. Gox example suggests, mismanagement of customer cryptocurrency can result in serious customer losses.
A customer protection rule would ensure that cryptocurrency platforms act as custodians for customer assets by requiring that the platforms take stock of their cryptocurrency on a daily basis to ensure that they keep sufficient assets to satisfy all of their customers’ claims.
Such a rule would have likely alerted Mt. Gox to the fact that it had lost its customers’ cryptocurrency long before it declared bankruptcy, potentially avoiding such a catastrophic collapse.
A customer protection rule would effectively prevent cryptocurrency platforms from running fractional reserves. To understand why fractional reserves are not appropriate for cryptocurrency platforms, it is worth considering how broker-dealers differ from banks. Banks run fractional reserves as a matter of course.
However, broker-dealers have a fundamentally different business model than banks. Whereas banks pay customers interest for their deposits and then use those deposits to fund other activities such as loans,
broker-dealers do not pay customers interest on their assets or use customer assets to fund other activities; instead, they typically profit by charging their clients for trades.
Moreover, because banks engage in maturity transformation—borrowing short-term from depositors and lending longer term (such as a thirty-year mortgage)—they have access to the central bank, which provides liquidity to the bank if it has insufficient cash to meet its short-term obligations.
Unlike banks, broker-dealers do not have recourse to the central bank because they do not engage in maturity transformation. On the spectrum between broker-dealers and banks, cryptocurrency platforms fall on the side of broker-dealers. Like broker-dealers, they are in the business of effecting transactions for customers and do not have access to the central bank. As such, cryptocurrency platforms, like broker-dealers, should not be allowed to run fractional reserves.
To be sure, a customer protection rule could impose higher costs upon customers relative to a world in which cryptocurrency platforms could run fractional reserves, since it is economically costly to have assets sitting idle that could otherwise be used to fund productive ventures. These costs are passed on to customers. For example, in addition to per-trade fees, broker-dealers often impose minimum-balance requirements on their customers.
Similarly, cryptocurrency platforms often charge their customers withdrawal fees for transferring cryptocurrency out of the platform’s wallet.
Contrast these fee structures with that of banks: Because they run fractional reserves, banks not only pay interest on customer deposits, they also often offer their customers “free” services, such as free checking.
Nevertheless, because cryptocurrency platforms hold themselves out as custodians of customer assets,
it is appropriate to treat them as such.
In addition, a customer protection rule would not drastically affect most cryptocurrency platforms. Many cryptocurrency platforms claim that they do not run fractional reserves, suggesting that they already hold sufficient assets to satisfy all of their customers’ claims.
A customer protection rule would simply apply a regulatory approach consistent with how these cryptocurrency platforms claim to operate.
2. Net Capital Rule. — In light of a slew of cryptocurrency platform failures,
capital requirements for these platforms may also be prudent. Ensuring that platforms retain sufficient capital would help cushion them against adverse movements in the market and ensure that, in the event of their failure, customers could still receive their cryptocurrency holdings. Just like broker-dealers during the late 1960s, inadequately capitalized platforms with significant proprietary holdings of risky assets may become insolvent during a severe downturn, resulting in customer losses.
Moreover, the goal of the net capital rule—to ensure that customers can recover their assets in the event of a broker-dealer failure
—appears appropriate for cryptocurrency platforms. Unlike in the case of banks or other highly interconnected financial institutions that pose systemic risk,
the goal for cryptocurrency platforms need not be to avoid failures per se. First, cryptocurrencies, despite their significant growth, are still a relatively small portion of the financial markets. In aggregate, cryptocurrency market capitalization is approximately $200 billion.
By comparison, the U.S. equity market is approximately $32 trillion.
Second, to date, cryptocurrency platforms have been standalone entities instead of interconnected financial institutions.
As such, it is unlikely that the bankruptcy of a single cryptocurrency platform would trigger cascading failures and pose systemic risk. Given cryptocurrency platforms’ relatively small size and independence from other financial institutions, the goal of capital requirements, like in the broker-dealer context, need not be to avoid failures altogether but rather should be to avoid significant customer losses in the event of a platform failure.
3. Bankruptcy and Insurance. — The bankruptcy regime for broker-dealers also provides a strong framework for resolving failing cryptocurrency platforms. A SIPC-like liquidation procedure, in which customers could receive their cryptocurrency rather than the dollar value of their liquidated investments, would be an improvement over the traditional bankruptcy process, which requires liquidation to cash.
As discussed in section II.C, customers holding cryptocurrency for investment purposes would likely prefer to receive cryptocurrency in kind rather than the dollar equivalent;
a SIPC-like proceeding would enable this result.
In addition, a SIPC-like bankruptcy regime would help resolve any uncertainty about whether customers’ claims are prioritized to those of general creditors.
Unlike debt or equity claimants in bankruptcy, customers of cryptocurrency platforms are not “investing” in the platform. Instead, they are entrusting their assets to the platform for safekeeping. As such, their assets should be segregated from the general estate in bankruptcy. A SIPC-like bankruptcy regime would achieve this goal.
Moreover, it would be incongruous to protect customers of broker-dealers but not customers of cryptocurrency platforms because investors may expect to receive similar protection in both contexts.
Finally, insurance akin to that provided by SIPC could help further protect customers from losses. SIPC has been remarkably successful in fulfilling its mandate to protect customer funds. From 1971 to 2016, only 356 out of 767,300 customer claims were unsatisfied; these 356 unsatisfied claims exceeded the dollar limits under SIPA.
Finally, SIPC’s funding model, based on assessments on broker-dealers,
would ensure that cryptocurrency platforms collectively bear the risk of their failures.
4. Potential for Private Solutions. — Some of the issues highlighted above do not preclude the possibility of private solutions. While problems with the bankruptcy process for cryptocurrency platforms may require changes to the bankruptcy code, problems regarding custody of customer assets or inadequate capital do not necessarily require governmental solutions. For example, a self-regulatory organization (SRO)—a private organization that regulates its own industry
—could set custody and capital requirements for member platforms and punish members who violate those standards.
In fact, SROs have been prevalent in the securities industry for many years.
For example, before the advent of the net capital rule, the NYSE required its members to hold a minimum amount of capital.
Today, the Financial Industry Regulatory Authority (FINRA), an SRO that governs broker-dealers,
enforces, among other things, the net capital rule and customer protection rule.
It is at least conceivable that an SRO could play a similar role in the nascent cryptocurrency industry.
There is some early evidence that cryptocurrency platforms may privately establish industry standards. Several cryptocurrency exchanges recently formed an SRO, the Virtual Commodity Association (VCA), to oversee cryptocurrency marketplaces.
The VCA hopes to establish “[a] thoughtful SRO framework that provides a virtual commodity regulatory program for the virtual commodity industry.”
Along similar lines, a trade group published industry best practices for digital asset exchanges, including principles akin to those that animate the customer protection rule—requiring cryptocurrency platforms to maintain unencumbered custody of customer assets.
Though it is too early to tell how these private efforts will fare, they suggest that some cryptocurrency platforms recognize the need for industry-wide rules and standards.
III. A Framework for Regulating Cryptocurrency Platforms
In light of the parallels between broker-dealers and cryptocurrency platforms described in Part II, this Part explores how the broker-dealer regulatory framework could be applied to cryptocurrency platforms. While a complete analysis of the intricacies of broker-dealer regulation is beyond the scope of this Note, this Part argues that the broker-dealer regulatory framework—as embodied by the customer protection rule, net capital rule, and SIPC-managed liquidation process—can be applied to cryptocurrency platforms with some caveats and modifications. The sections consider each rule in turn.
A. Customer Protection Rule
The regulatory framework provided by the customer protection rule can be applied to cryptocurrency platforms. Under such a rule, platforms, like broker-dealers, would have to effectively segregate their own assets from those of their customers. On a daily basis, cryptocurrency platforms would have to obtain “physical possession or control” of sufficient cryptocurrency to satisfy all of their customers’ claims.
Separately, platforms would also have to maintain a cash reserve account in an amount equal to the net amount of cash owed to customers.
Cryptocurrency, however, poses two unique challenges to the customer protection rule. First, as a digital asset, cryptocurrency does not fit neatly within the “physical possession or control” requirement. Second, as a “currency,” cryptocurrency is at least arguably subject to the less stringent rules for cash, as opposed to securities, under the customer protection rule.
1. Physical Possession or Control. — For a customer protection rule to apply to cryptocurrency, the physical possession or control requirement would have to encapsulate how cryptocurrency is held and stored. “Physical possession,” literally construed, does not make sense in the context of an asset that exists only in digital format.
“Control,” however, could potentially encompass how cryptocurrency platforms hold virtual currency. Currently, control is statutorily defined: Broker-dealers are deemed to be in control of securities when they hold unencumbered securities in certain control locations, such as a clearing corporation or bank.
However, unlike broker-dealers, which hold securities in control locations, cryptocurrency platforms typically manage their own currency—that is, they store their own private keys.
Platforms typically split their cryptocurrency between “hot wallets” and “cold storage.”
Hot wallets are connected to the internet and therefore easy to access and use.
Unfortunately, this also leaves them vulnerable to hacks.
As such, platforms keep the majority of their cryptocurrency in cold storage.
Cold storage refers to cryptocurrency stored in a manner that is unconnected to the internet, such as on flash drives or even physical paper.
Cold storage mitigates the risk of hacking by storing cryptocurrency in an unhackable medium.
In the case of both hot wallets and cold storage, cryptocurrency platforms are handling their own private keys, meaning they have access to and control of their cryptocurrency.
As such, the possession or control requirement—if platforms are to be regulated similarly to broker-dealers—should be interpreted so as to encompass both hot wallets and cold storage. Perhaps “control” could be defined to include any form of storage in which cryptocurrency platforms are managing their own private keys and are therefore in control of their cryptocurrency.
2. Cash or Security? — A customer protection rule for cryptocurrency platforms should not treat cryptocurrencies as cash. Given that the current customer protection rule has separate regulations for securities and cash, a potential issue is whether cryptocurrency might be considered currency and therefore subject to the rules for cash as opposed to the rules for securities. Setting aside the thorny issue of whether cryptocurrencies are securities for purposes of federal securities laws,
it is clear that the customer protection rules for cash are inapposite for cryptocurrency. First, calculations of how much cash broker-dealers are required to set aside for customers are done on a weekly basis, as opposed to a daily basis for securities.
Weekly determinations could expose platforms to serious shortfalls in cryptocurrency that could prove difficult to make up during times of market turmoil. Compared to cash, cryptocurrency is much more difficult to locate in a crunch.
In addition, the customer protection rule allows broker-dealers to indirectly profit from their customers’ idle cash by sweeping customer cash into money-market funds or bank deposits in return for a fee.
The same principles, if applied to cryptocurrency, could prove problematic because platforms may be incentivized to sweep customer cryptocurrency into risky or illiquid investment vehicles in return for high fees. Because daily, rather than weekly, determinations are more appropriate for illiquid assets such as cryptocurrency, the stricter customer protection rule for securities should apply to cryptocurrency.
B. Net Capital Rule
The basic framework for the net capital rule can be applied to cryptocurrency platforms. As with broker-dealers, net capital for cryptocurrency platforms would be net worth under GAAP with various adjustments.
First, net capital would exclude illiquid assets.
Then, platforms would apply predetermined haircuts—discounts to market value—to their assets based upon the riskiness of those assets.
The net capital rule already supplies haircuts for securities, but there would need to be a new haircut, approximating the price the broker-dealer would receive for the asset during liquidation in distress, applicable to cryptocurrencies.
Because the prices of cryptocurrencies are extremely volatile,
the haircut for cryptocurrencies would likely have to be quite high, reflecting the potential for lower prices when cryptocurrency platforms seek to liquidate their holdings. Currently, equity securities have the highest haircut.
The haircut for cryptocurrencies would likely have to be higher than even the haircut for equity securities, reflecting their higher volatility.
In addition to a higher haircut for cryptocurrency, it also makes sense to apply larger haircuts for undue concentration in certain cryptocurrencies. With the proliferation of so many altcoins—some individually quite small
—cryptocurrency platforms may hold a significant portion of a given altcoin. Lack of liquidity when selling concentrated positions is a potential concern, especially considering that even the markets for larger cryptocurrencies can be relatively illiquid.
A related issue is whether to apply a uniform haircut for all cryptocurrencies or haircuts that vary by currency, reflecting the fact that some cryptocurrencies may be less risky than others. Given the short history of cryptocurrencies, a uniform haircut would likely be more appropriate. Admittedly, the current net capital rule has crude risk sensitivities: With minor exceptions, haircuts are set at the asset class level, meaning there is no distinguishing between, say, stock of a high-risk biotech startup and stock of a large utility company.
Similarly, a uniform haircut for cryptocurrencies would mean there would be no distinguishing between different types of cryptocurrencies.
A more risk-based approach would adjust for riskiness within asset classes. However, such an approach presents several problems. First, risk-based capital requirements typically rely on models to determine the amount of risk associated with an asset.
For these models to work, there must, at a minimum, be sufficient, representative historical data to adequately calibrate the models.
For example, in the prelude to the financial crisis, banks likely misjudged the risk of mortgage-backed securities in part because of poorly calibrated models.
At this relatively early stage of cryptocurrency’s development, risk-based capital requirements are unlikely to be effective because there are insufficient data with which to adequately estimate risk. Bitcoin, the oldest cryptocurrency, has been around only since 2009.
Second, even if regulators could come up with different haircuts for different types of cryptocurrency, risk-based capital requirements for broker-dealers have seen mixed results at best. In 2004, the SEC established the Consolidated Supervised Entity (CSE) program which allowed the five largest broker-dealers at the time, including Bear Stearns and Lehman Brothers, to use internal models to assess the amount of risk associated with, and therefore the amount of capital required for, each of the broker-dealers’ assets.
By 2008, all five broker-dealers had either failed or converted themselves into bank holding companies.
This foray into risk-based capital requirements has been criticized for being inadequate in the lead-up to the financial crisis.
Given the poor track record of risk-based capital requirements for broker-dealers and the lack of adequate, representative price data for cryptocurrencies, a uniform haircut for cryptocurrency is likely most appropriate.
C. Bankruptcy and Insurance
Cryptocurrency platforms facing bankruptcy can be subject to a SIPC-like liquidation scheme. In bankruptcy, the trustee would favor in-kind distribution of cryptocurrency to customers as opposed to liquidation to cash. This would avoid a scenario like the pending Mt. Gox bankruptcy proceeding, in which customers might be deprived of the appreciation of their Bitcoin investments because their claims are valued as of the bankruptcy filing date.
In addition, customers under a SIPC-like liquidation scheme would be preferred to general creditors in bankruptcy. Namely, cryptocurrency held on behalf of customers would be used to satisfy customers only, not general creditors.
A SIPC-like insurance scheme could also be applied to cryptocurrency platforms. A potential problem, however, is the cost of such insurance. Hacking is a significant and unique source of risk for cryptocurrency platforms.
Multiple platforms have failed or suffered losses as a result.
The cost of insurance might therefore be quite high. Given the unique cost and risk of hacking, it would not be appropriate to include cryptocurrency platforms under the jurisdiction of SIPC because it would impose the cost and risk of hacking—unique to cryptocurrency—upon traditional broker-dealers. Instead, an insurance scheme for cryptocurrency platforms should be separate from SIPC and funded by assessments on these platforms alone.
Cryptocurrencies have become one of the hottest new investments in the past year. While cryptocurrency returns have been eye-popping, cryptocurrency platforms have proved to be a significant source of risk for investors: Platforms have failed at a high rate, and, in some cases, customer losses have been significant. As more investors begin to trade and hold cryptocurrencies through cryptocurrency platforms, so too must regulation begin to address these new broker-dealers for virtual currency. Left unaddressed, existing problems may fester.
Fortunately, history provides a useful guide for how to regulate these entities. Broker-dealers in the 1960s faced many of the same problems that are now arising among cryptocurrency platforms: high failure rates and inadequate protection of customer assets. This Note argues that the regulatory response to broker-dealer failures in the late 1960s—namely, the customer protection rule, net capital rule, and SIPC bankruptcy scheme—provides a strong regulatory framework for cryptocurrency platforms.