With the rise of cryptocurrency as a popular investment, cryptocurrency wallets and exchanges have proliferated, offering platforms that allow investors to hold and trade cryptocurrency. Because these platforms hold cryptocurrency on their customers’ behalf, they present problems associated with custody. Namely, how do investors ensure that these platforms do not misuse or mishandle their assets? And how will customer assets be treated if a platform enters bankruptcy?

To answer these questions, this Note looks to the experience of broker-dealers, exploring the similarities between the problems con­fronting cryptocurrency platforms today and the problems that broker-dealers faced in the late 1960s. Widespread broker-dealer failures during the late 1960s revealed problems with mishandled client assets, insufficient capital, and inadequate protection of cus­tomer assets in bankruptcy. Similar problems plague cryptocurrency platforms today.

This Note therefore points to the regulation of broker-dealers as a template for how to approach the regulation of cryptocurrency platforms. Looking to the regulatory responses to broker-dealer failures in the late 1960s—including the customer protection rule, net capital rule, and alternative bankruptcy regime created by the Securities Investor Protection Act—this Note proposes that a similar regulatory framework could be applied to cryptocurrency platforms.


Investors piled into cryptocurrencies 1 Cryptocurrencies are digital assets recorded on a decentralized, public ledger. See infra section I.A.1 for a description of cryptocurrencies.  in 2017, 2 Companies raised over $2 billion in the first nine months of 2017 by issuing new cryptocurrency through a process known as an initial coin offering (ICO). See Paul Vigna, What’s an Initial Coin Offering? ICOs Explained in 11 Questions, Wall St. J. (Oct. 2, 2017), (on file with the Columbia Law Review) [hereinafter Vigna, What’s an ICO].  fueling a surge in cryptocurrency prices. 3 See CRIX, [] (last visited Aug. 14, 2018) (showing a significant rise in the CRIX, an index of cryptocurrencies weighted by market value, through 2017).  The price of Bitcoin, the most well-known crypto­currency, increased over 1,000% in 2017. 4 Paul Vigna, For Bitcoin, a Year Like No Other, Wall St. J. (Dec. 31, 2017), (on file with the Columbia Law Review).  As a sign of the mania surrounding these new investments, celebrities from Paris Hilton to Floyd Mayweather have endorsed cryptocurrencies. 5 See Richard Waters, To Coin a Craze: Silicon Valley’s Cryptocurrency Boom, Fin. Times (Sept. 13, 2017), (on file with the Columbia Law Review).  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. 6 This Note uses the term “cryptocurrency platform” to refer to online cryptocurrency wallets and centralized cryptocurrency exchanges. See infra section I.A.2 for a discussion of cryptocurrency wallets and exchanges.  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, 7 See infra section II.B.4.  and customers have lost hundreds of millions of dollars as a result. 8 See infra section II.B.2 (discussing the collapse of Mt. Gox, formerly one of the largest Bitcoin exchanges).  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, 9 See infra section II.A (discussing briefly how broker-dealers are defined under the securities laws).  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. 10 See infra section I.B.  During the 1960s, there was a significant rise in the stock market, drawing new investors who had previously eschewed stocks. 11 Wyatt Wells, Certificates and Computers: The Remaking of Wall Street, 1967 to 1971, 74 Bus. Hist. Rev. 193, 194 (2000).  In 1952, only 6.5 million Americans owned stocks; by 1965, that number was over 20 million. 12 Id. at 194–95.  In the late 1960s, markets experienced a downturn, and broker-dealers failed en masse, leading to severe customer losses. 13 See infra section I.B.1.  In response, Congress enacted the Securities Investor Protection Act of 1970 (SIPA), 14 Securities Investor Protection Act of 1970, Pub. L. No. 91-598, 84 Stat. 1636 (codified as amended at 15 U.S.C. §§ 78aaa–78lll (2012)).  and the SEC promulgated rules intended to address many of the perceived weaknesses leading to broker-dealers’ failures in the late 1960s. 15 See infra sections I.B.2–.3 (discussing the customer protection and net capital rules).

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. 16 See Omri Marian, A Conceptual Framework for the Regulation of Cryptocurrencies, 82 U. Chi. L. Rev. Dialogue 53, 55 (2015),​viewcontent.cgi?article=1035&context=uclrev_online (on file with the Columbia Law Review). The ledger, known as a blockchain, 17 See V. Gerard Comizio, Virtual Currencies: Growing Regulatory Framework and Challenges in the Emerging Fintech Ecosystem, 21 N.C. Banking Inst. 131, 133–35 (2017) (describing the blockchain for Bitcoin).  serves as a record of asset ownership and transfers, much like a land registry. 18 See Marian, supra note 16, at 55. Of course, unlike with land, there is no physical possession of property. As such, records on the blockchain serve as the only proof of ownership.  Owning cryptocurrency involves having a private key. 19 See id. at 56.  This private key, when matched with the public blockchain, allows owners to access their cryptocurrency and transfer it to another person. 20 See id. at 55.  A transfer occurs when it is recorded on the blockchain. 21 The recording is done through a decentralized process known as “mining.” See id. (describing the process through which miners update 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. 22 See Lam Pak Nian & David Lee Kuo Chuen, Introduction to Bitcoin, in Handbook of Digital Currency: Bitcoin, Innovation, Financial Instruments, and Big Data 5, 19–20 (David Lee Kuo Chuen ed., 2015) [hereinafter Handbook of Digital Currency] (describing how the blockchain is updated by miners who employ high-powered computers to solve computationally intensive problems and how the mining process makes it “exponentially difficult to reverse previous transactions”).  This prevents someone from “double-spending,” or transferring the same cryptocurrency twice. 23 See id. at 15–16 (discussing how the technology behind Bitcoin solves the “double-spending” problem); François R. Velde, Bitcoin: A Primer, Chi. Fed Letter (Fed. Reserve Bank of Chi., Chi., Ill.), Dec. 2013, at 2, (on file with the Columbia Law Review) (“[T]he [B]itcoin protocol provides an elegant solution to the problem of creating a digital currency—i.e., how to regulate its issue, defeat counterfeiting and double-spending, and ensure that it can be conveyed safely—without relying on a single authority.”).

While the best-known cryptocurrency may be Bitcoin, there are numer­ous other types, often referred to as “altcoins.” 24 See Sarah Jane Hughes & Stephen T. Middlebrook, Advancing a Framework for Regulating Cryptocurrency Payments Intermediaries, 32 Yale J. on Reg. 495, 505 (2015) (describing Bitcoin and altcoins). The term “altcoin” means alternative to Bitcoin. What Is an Altcoin?, Bitcoin Mag., [] (last visited Aug. 11, 2018).  As new coins are constantly launched in the market, the list of altcoins grows. 25 These launches are typically done through an ICO. See Vigna, What’s an ICO, supra note 2.  New altcoins raised over $2 billion in the first nine months of 2017. 26 See id.  By one count, there are over 800 cryptocurrencies, though the largest ones make up a disproportionate share of the aggregate market capitalization of cryptocurrencies. 27 Market capitalization is the number of coins in circulation multiplied by the price per coin. See All Coins, CoinMarketCap, [] (last visited Aug. 12, 2018) (listing various types of cryptocurrencies in descending order of dollar market capitalization).  Because more altcoins are entering the market and each altcoin is different, it is dif­ficult to provide a definition that encompasses them all. 28 See Hughes & Middlebrook, supra note 24, at 505 (“‘[E]stablishing firm definitions [for altcoins] is a challenge’ as these new altcoin variations continue to emerge.” (quoting The Clearing House & Indep. Cmty. of Bankers of Am., Virtual Currency: Risks and Regulation 2 (2014), [])).  Nevertheless, they generally follow the structure described above: digital assets recorded on a decentralized blockchain. 29 Julie Verhage, Camila Russo & Lily Katz, What’s an ICO? Like an IPO but with Digital Coins, Bloomberg (Sept. 18, 2017), (on file with the Columbia Law Review) (last updated Oct. 23, 2017) (“Transactions [for cryptocurrency] will take place on a blockchain, the digital ledger technology first developed for [B]itcoin . . . .”).  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. 30 See Hughes & Middlebrook, supra note 24, at 506.

2. Cryptocurrency Wallets and Exchanges. — An online cryptocurrency wallet is a service that stores and safeguards cryptocurrency on behalf of customers. 31 See Nian & Chuen, supra note 22, at 18–19. Instead of entrusting private keys to an online wallet, some people choose to manage their own wallets. These personal wallets can be hosted on computers, mobile devices, or specialized hardware. See How to Store Your Bitcoin, Coindesk, [] (last updated Jan. 20, 2018) (describing various types of cryptocurrency wallets). Recall, owning cryptocurrency simply involves having a private key, which allows owners to transfer their cryptocurrency. 32 See supra notes 19–20 and accompanying text.  Wallet providers hold private keys on behalf of their customers, acting as their custodians. 33 See Nian & Chuen, supra note 22, at 18–19.  In fact, when customers hold cryptocurrency in an online wallet, they do not have access to their private keys; 34 See, e.g., Where Can I Find the Private Keys for My Wallet?, Coinbase, [] (last visited Aug. 12, 2018) (telling Coinbase customers that they do not have access to the private keys for their cryptocurrency). For a discussion of how online wallets typically hold their customers’ cryptocurrency, see infra notes 212–217 and accompanying text.  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. 35 See Nirupama Devi Bhaskar & David Lee Kuo Chuen, Bitcoin Exchanges, in Handbook of Digital Currency, supra note 22, at 559, 559–60.  These exchanges differ in the currency pairs they offer and their fees. 36 See Best Cryptocurrency Exchanges: The Ultimate Guide, Blockgeeks, [] (last visited Aug. 11, 2018) (listing several cryptocurrency exchanges and how they differ).  Fees typically include a commission for each trade and withdrawal fees for transferring cryptocurrency out of the exchange. 37 See, e.g., Coinbase Pricing & Fees Disclosures, Coinbase, https://support. [] (last visited Aug. 11, 2018) (describing a “transfer” fee for withdrawing cryptocurrency and a commission of “0 to 50 basis points [0.00% to 0.50%]” for buying or selling cryptocurrency); Digital Assets/Cryptocurrency Withdrawal Fees, Kraken, [] (last visited Aug. 11, 2018) (describing withdrawal fees based on the currency being withdrawn); Fee Schedule, Kraken, [] (last visited Aug. 11, 2018) (outlining per-trade fees for various currency pairs); What Fees Does Bittrex Charge?, Bittrex (May 11, 2017), [] (describing a 0.25% commission and a transfer fee for withdrawal of cryptocurrency).  Because the industry is still nascent, cryptocurrency markets are quite fragmented; by one count, there are almost eighty exchanges. 38 See Cryptocurrency Exchanges/Markets List, CryptoCoinCharts, [] (last visited Aug. 11, 2018).  They are also located in various jurisdictions. 39 See, e.g., Samuel Gibbs, Bitcoin Worth $78m Stolen from Bitfinex Exchange in Hong Kong, Guardian (Aug. 3, 2016),​bitcoin-stolen-bitfinex-exchange-hong-kong []; Cynthia Kim & Heekyong Yang, Uproar over Crackdown on Cryptocurrencies Divides South Korea, Reuters (Jan. 12, 2018), []; Rachel Rose O’Leary, Japan Issues Licenses for 11 Bitcoin Exchanges, Coindesk (Sept. 29, 2017), []. The fact that so many cryptocurrency exchanges are international presents a potential problem of regulatory jurisdiction that is beyond the scope of this Note.

Exchanges combine both wallet and exchange services. 40 See Bhaskar & Chuen, supra note 35, at 560 (“At a Bitcoin exchange, a client can buy, sell, or store [B]itcoins at the exchange rate and in the currency supported by that particular Bitcoin exchange.”).  In order to trade on an exchange, customers must hold cryptocurrency in the exchange’s wallet. 41 See id. (“When a client wants to sell [B]itcoins through an exchange, he or she has to transfer those [B]itcoins to the wallet of the exchange. An exchange creates a wallet for every user in their system and one can trade [B]itcoins with this 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. 42 These exchanges, in which the platform provides both wallet and exchange services, are known as centralized exchanges. By contrast, decentralized exchanges do not require traders to hold cryptocurrency on the exchange’s wallet. Instead, traders manage their own wallets, and the decentralized exchange merely facilitates direct, peer-to-peer transactions. See Loi Luu, Solving the Liquidity Challenge of Decentralized Exchanges, Coindesk (Aug. 13, 2017), [] (last updated Aug. 14, 2017) (“[F]unds are held by the user in a personal wallet, rather than with a third party.”); Antonio Madeira, What Is a Decentralized Exchange, CryptoCompare (July 23, 2018),​guides/what-is-a-decentralized-exchange/ [] (“A decentralized exchange is an exchange market that does not rely on a third party service to hold the customer’s funds.”). Because this Note addresses issues that arise when customers entrust their assets to a custodian, this Note deals only with centralized exchanges and online wallets. In decentralized exchanges and personally managed wallets, cryptocurrency is never entrusted to a custodian.  Most cryptocurrency trading is done on these exchanges. 43 See Arvind Narayanan et al., Bitcoin and Cryptocurrency Technologies: A Comprehensive Introduction 259 (2016). Centralized exchanges make up the majority of trading activity in large part because it is difficult to facilitate sufficient liquidity on decentralized exchanges. See Luu, supra note 42 (describing the liquidity challenge faced by decentralized exchanges); see also supra note 42 (describing the distinction between centralized and decentralized 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. 44 See infra section I.B.1.  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. 45 See Abe Mastbaum, A Practical Guide to U.S. Capital Markets ch. 11, Westlaw (database updated July 2016). The decade before these failures featured a sustained bull market, 46 Bull markets are periods of general increases in share prices. See, e.g., Wells, supra note 11, at 194 (discussing the bull market during the 1960s). Bear markets are the inverse: periods of general decreases in share prices. See, e.g., id. at 216 (discussing the bear market during the late 1960s and early 1970s).  with more and more investors speculating in stocks. 47 See id. at 194–95 (“Whereas only about six and a half million Americans owned equities in 1952, over twenty million did so in 1965, and that number had climbed to almost thirty-two million by 1970.”).  Trading volume increased over 180% from 1963 to 1968, 48 Harold S. Bloomenthal & Donald Salcito, Customer Protection from Brokerage Failures: The Securities Investor Protection Corporation and the SEC, 54 U. Colo. L. Rev. 161, 164 (1983).  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. 49 See Neal L. Wolkoff & Jason B. Werner, The History of Regulation of Clearing in the Securities and Futures Markets, and Its Impact on Competition, 30 Rev. Banking & Fin. L. 313, 317 (2010).  Broker-dealers had to deliver physical securities with each transaction. Often, each transaction required dozens of paper documents. 50 See id.

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. 51 See Mastbaum, supra note 45 (“[I]t became common to register securities in ‘street name,’ that is in the name of the broker-dealer . . . handling the settlements.”).  Broker-dealers would simply note on their own books that they were holding these securities for a customer. 52 Michael E. Don & Josephine Wang, Stockbroker Liquidations Under the Securities Investor Protection Act and Their Impact on Security Transfers, 12 Cardozo L. Rev. 509, 529 (1990).  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. 53 Id. at 530.  As a result, many broker-dealers began financing themselves with customers’ assets. That is, some would borrow money secured by customers’ securities. 54 See SEC, Study of Unsafe and Unsound Practices of Brokers and Dealers, H.R. Doc. No. 92-231, at 134 (1st Sess. 1971) (describing improper hypothecation of customer 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. 55 Id. at 75.

Even still, broker-dealers faced a paperwork crisis. 56 See Wells, supra note 11, at 201–02.  There was an insufficient number of back-office employees to process the volume of trading. 57 Id. at 204–06.  Exchanges had to close early so that broker-dealers could work through the backlog of paperwork. 58 Bloomenthal & Salcito, supra note 48, at 165.  Trades often failed or took extremely long to settle. 59 See Wells, supra note 11, at 203.  Losses caused by failure to receive or deliver securities reached four billion dollars. 60 Wolkoff & Werner, supra note 49, at 317–18.  Theft was also rampant: Because of the back­log, broker-dealers often lost track of where their securities were, inviting theft. 61 See SEC, supra note 54, at 145–46.  Then-U.S. Attorney General John Mitchell testified that more than $400 million worth of securities had been stolen between 1969 and 1970. 62 Marjorie Hunter, Big Board Too Busy to Stop 1968–69 Thefts, N.Y. Times (June 24, 1971), (on file with the Columbia Law Review).

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. 63 See Wells, supra note 11, at 216.  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. 64 See Bloomenthal & Salcito, supra note 48, at 165; see also SEC, supra note 54, at 14.  Approxi­mately 160 NYSE broker-dealers closed, merged, or filed for bankruptcy during this period. 65 Wolkoff & Werner, supra note 49, at 318.  Customer losses were significant. 66 Bloomenthal & Salcito, supra note 48, at 166.  In response, Congress enacted SIPA in 1970 to protect customers from losses in the event of subsequent broker-dealer failures, 67 See 69 Am. Jur. 2d Securities Regulation—Federal § 834, Westlaw (database updated Aug. 2018).  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, 68 See supra notes 51–53and accompanying text.  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. 69 See Michael P. Jamroz, The Customer Protection Rule, 57 Bus. Law. 1069, 1071 (2002).  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. 70 See id. at 1070.

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.” 71 17 C.F.R. § 240.15c3-3(b)(1) (2018).  “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. 72 See Bloomenthal & Salcito, supra note 48, at 168.  If there is a shortfall, then the broker-dealer must take steps to make up any differ­ence. 73 17 C.F.R. § 240.15c3-3(d).  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. 74 See id. § 240.15c3-3(c)(2), (5).  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. 75 See id. § 240.15c3-3(e).  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. 76 See id. § 240.15c3-3(e)(3)(i).  However, the customer protection rule also limits broker-dealers’ ability to use such cash in risky operations, 77 See Bloomenthal & Salcito, supra note 48, at 173 (“The formula prescribed for determining the amount of the deposit is designed to protect customers’ cash balances by allowing brokers to deploy customers’ cash only in relatively safe areas of the brokerage business.”).  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. 78 This was done pursuant to the 1975 amendments to the Exchange Act, which directed the SEC to “establish minimum financial responsibility requirements for all brokers and dealers.” See Steven L. Molinari & Nelson S. Kibler, Broker-Dealers’ Financial Responsibility Under the Uniform Net Capital Rule—A Case for Liquidity, 72 Geo. L.J. 1, 15–16 (1983) (internal quotation marks omitted) (quoting 15 U.S.C. § 78o(c)(3) (1976)). Though broker-dealers had been subject to capital requirements since the 1940s, the rules were inadequate. 79 See id. at 5–8 (describing the net capital rule promulgated by the SEC in 1942 and NYSE Rule 325, and how these rules were inadequate).  By 1970, broker-dealers had become leveraged ten to one, 80 Ten-to-one leverage means that, for every $100 worth of assets a broker-dealer holds, it has only $10 of equity. The higher a broker-dealer’s leverage, the higher the risk of insolvency. For instance, if the broker-dealer’s assets drop in value from $100 to $90 in the above example, then its equity will drop from $10 to $0, leading to insolvency. See SEC, supra note 54, at 74–75 (“[A]t year end 1970, NYSE member firms had $1.9 billion in equity capital and $18.6 billion in assets. . . . [T]otal liabilities (including subordinated borrowings) were 90 percent of total assets for NYSE member firms.”).  with the largest firms exhibiting even higher leverage. 81 See id. at 75–76 (describing how the thirteen largest broker-dealers made up approximately 52% of all NYSE members’ assets but just 37% of their equity).  Observing the number of broker-dealer failures during the late 1960s and early 1970s, the SEC concluded that broker-dealers were undercapitalized. 82 Id.

The net capital rule ensures that broker-dealers maintain adequate liquidity to satisfy their customers’ claims. 83 See Molinari & Kibler, supra note 78, at 18.  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. 84 Michael P. Jamroz, The Net Capital Rule, 47 Bus. Law. 863, 863–64 (1992) [hereinafter Jamroz, Net Capital Rule]; see also Net Capital Rule, Exchange Act Release No. 34-31511, 52 SEC Docket 2694, 2697–98 (Nov. 24, 1992) (“A supervised self-liquidation can avoid the delays that might arise in the context of a court-imposed liquidation.”).  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. 85 Jamroz, Net Capital Rule, supra note 84, at 865.  Self-liquidations are usually preferred to formal liquidations because they are less costly and result in fewer delays for customers. 86 Id.  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. 87 Id.

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. 88 See id. at 867 (“[T]he [net capital] [r]ule . . . assumes the firm will liquidate.”).  It is calculated as net worth under Generally Accepted Accounting Principles (GAAP), with various adjustments to reflect a liquida­tion. 89 Id. at 866–67.  For example, assets that cannot be easily converted into cash, such as real estate or furniture, are excluded from net capital. 90 17 C.F.R. § 240.15c3-1(c)(2)(iv) (2018) (“Deducting fixed assets and assets which cannot be readily converted into cash . . . including . . . [r]eal estate; furniture and fixtures . . . .”).  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. 91 See Jamroz, Net Capital Rule, supra note 84, at 867.  Riskier securities—whose values are more volatile—have a higher haircut whereas safer securities have a lower hair­cut. 92 See Molinari & Kibler, supra note 78, at 19.  For example, equity securities are subject to a 15% haircut whereas short-dated Treasury bills are not discounted at all. 93 Compare 17 C.F.R. § 240.15c3-1(c)(2)(vi)(J) (applying a 15% haircut to equities), with id. § 240.15c3-1(c)(2)(vi)(A)(1) (applying a 0% haircut to U.S. government debt with less than three months to maturity).

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, 94 U.S. Gen. Accounting Office, GAO/GGD-98-153, Risk-Based Capital: Regulatory and Industry Approaches to Capital and Risk 133–34 (1998), [].  the broker-dealer’s “aggregate indebtedness” cannot exceed 1,500% of its net capital, 95 17 C.F.R. § 240.15c3-1(a)(1)(i).  with aggregate indebtedness defined as the “total money liabilities of a broker or dealer arising in connection with any transaction whatsoever.” 96 Id. § 240.15c3-1(c)(1). Some liabilities are excluded from “aggregate indebtedness.” See id. § 240.15c3-1(c)(1)(i)–(xv).  Essentially, under the basic method, broker-dealers cannot have liabilities exceeding fifteen times their net capital.

The alternative method, which most large firms use, 97 See Jerry W. Markham & Thomas Lee Hazen, Broker-Dealer Operations Under Securities and Commodities Law § 4:2, Westlaw (database updated Nov. 2017) (“[A]pproximately 90 percent of all customer funds in securities held by broker-dealers were covered by the alternate net capital method.”).  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. 98 See Molinari & Kibler, supra note 78, 16–17 (describing the net capital requirement as “two percent of customer-related receivables”); see also 17 C.F.R. § 240.15c3-1(a)(1)(ii).  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. 99 See supra note 84 and accompanying text. Broker-dealers must resort to liquidation in bankruptcy; they have no recourse to Chapter 11 bankruptcy, which permits the debtor to reorganize itself rather than liquidating. See Richard Lieb, The Bankrupt Stockbroker, 1980 Ann. Surv. Bankr. L. 353, 355 (“[A] stockbroker is ineligible for Chapter 11 relief.”).

Because the broker-dealer is supposed to have sufficient securities and cash to satisfy all of its customers’ claims under the customer protection rule, 100 See supra section I.B.2.  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. 101 See Jamroz, Net Capital Rule, supra note 84, at 2698 (“While requiring additional amounts of capital will not prevent firms from failing, the additional capital serves as a fund from which the expenses associated with a liquidation can be paid.”).  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. 102 Lieb, supra note 99, at 355–56 (“When a SIPA protective decree application is filed . . . that filing by itself automatically stays any stockbroker liquidation proceeding pending under Chapter 7 of the Code . . . .”); A. Michael Sabino, Failed Stockbrokerages and the Bankruptcy Courts in the 21st Century: Bringing Order to Chaos, 2002 Ann. Surv. Bankr. L. 131, 140–41 (describing how SIPA “prevails over” the bankruptcy code for stockbroker liquidations). Chapter 7 bankruptcy is a type of bankruptcy proceeding that involves liquidation of the debtor’s assets. This is in contrast to Chapter 11 bankruptcy, which allows the debtor to reorganize itself instead of liquidation. Cf. Lieb, supra note 99, at 356 (“Under the [bankruptcy] [c]ode, . . . both stockbrokers and commodity brokers are specifically excluded from eligibility for reorganization under Chapter 11.”). In both Chapter 7 bankruptcy proceedings and liquidation under SIPA, broker-dealer customers are preferred to general creditors in bankruptcy. 103 See Thomas W. Joo, Who Watches the Watchers? The Securities Investor Protection Act, Investor Confidence, and the Subsidization of Failure, 72 S. Cal. L. Rev. 1071, 1119 (1999) (“[M]ost of the business of a liquidation [under SIPA] has great importance to the industry and its customers, and very little to do with the interests of general creditors.”); Lieb, supra note 99, at 353 (“Since . . . 1938, the Bankruptcy Act has granted certain priorities to a bankrupt stockbroker’s customers over the claims of noncustomer general creditors . . . .”).  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. 104 See Joo, supra note 103, at 1095. There is another category of assets known as “customer name securities”—securities that are registered in the customer’s name. These securities are returned to the customer whose name the security is registered in. However, because securities are typically registered in the broker-dealer’s name (that is, “street name”), there are typically few customer name securities. See id.; see also supra note 51 and accompanying text.  General creditors do not have a claim on customer property; instead, customer property is used only to satisfy customers’ claims. 105 See Don & Wang, supra note 52, at 542 (describing how customer property is distributed among customers); Lieb, supra note 99, at 362–63 (same).  Because brokers typically have relatively few assets other than their customers’ property, 106 See Joo, supra note 103, at 1095–96 (describing the division of a broker-dealer’s estate into three categories—customer name securities, customer property, and a general estate—of which customer property is the largest).  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. 107 Id. at 1074.  In any broker-dealer bankruptcy proceeding, SIPC can step in to manage the liquidation of the broker-dealer. 108 See 11 U.S.C. § 742 (2012) (“SIPC may file an application for a protective decree under [SIPA]. The filing of such application stays all proceedings in the case under [the bankruptcy code] . . . . If SIPC completes the liquidation of the debtor, then the court shall dismiss the case.”).  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. 109 Compare id. § 750 (“The trustee may not distribute a security . . . .”), with 15 U.S.C. § 78fff-2(b) (2012) (“[T]he court shall[,] . . . with respect to claims relating to . . . securities[,] . . . authorize the trustee to deliver securities . . . .”).  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, 110 See 11 U.S.C. § 741(6)(A)(i) (describing how net equity is calculated “at the time of the filing of the petition”). Net equity is the basis upon which customer property is distributed. See id. § 752(a) (“The trustee shall distribute customer property ratably to customers on the basis and to the extent of such customers’ allowed net equity claims and in priority to all other claims . . . .”).  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. 111 To be sure, if Amazon shares decrease in value, then the customer may prefer receiving cash. But, in general, if customers are holding securities for investment purposes, then they would likely prefer to receive the securities in kind, preserving their investment, rather than being forced to effectively sell their securities on the filing date.  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. 112 See 15 U.S.C. § 78fff-2(d) (“The trustee shall . . . purchase securities as necessary for the delivery of securities to customers in satisfaction of their claims . . . in order to restore the accounts of such customers as of the filing date.”); Don & Wang, supra note 52, at 542–43 (highlighting the “adoption of a provision authorizing SIPC trustees to purchase securities in satisfaction of customer claims”).  Specifically, SIPC insures up to $500,000 per customer, of which a maximum of $250,000 can be cash. 113 What SIPC Protects, SIPC, [] (last visited Aug. 12, 2018).  The insurance protects only the broker-dealer’s customers, not its general creditors. 114 See Joo, supra note 103, at 1097.  SIPC itself is funded by assessments on broker-dealers. 115 Alexander C. Dill, Broker-Dealer Regulation Under the Securities Exchange Act of 1934: The Case of Independent Contracting, 1994 Colum. Bus. L. Rev. 189, 221.  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. 116 A complete statutory analysis of whether cryptocurrency platforms are broker-dealers for purposes of the federal securities laws is beyond the scope of this Note. However, SEC Chairman Jay Clayton has suggested that some cryptocurrency platforms may be operating as broker-dealers. See Public Statement, Jay Clayton, Chairman, SEC, Statement on Cryptocurrencies and Initial Coin Offerings (Dec. 11, 2017),​public-statement/statement-clayton-2017-12-11/ [] (“I also caution those who operate systems and platforms that effect or facilitate transactions in [cryptocurrencies] that they may be operating . . . broker-dealers that are in violation of the Securities Exchange Act of 1934.”).  Specifically, like broker-dealers, they provide two key functions: (1) acting as custodians for customer assets 117 See supra section I.A.2.  and (2) executing trades for their customers. 118 See supra notes 35–37 and accompanying text.

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.” 119 15 U.S.C. § 78c(a)(4)(A) (2012).  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. 120 See supra notes 35–37 and accompanying text.  However, to meet the Exchange Act definition of a broker, cryptocurrencies would need to be considered “securities” for purposes of the federal securities laws. 121 15 U.S.C. § 78c(a)(4)(A) (“The term ‘broker’ means any person engaged in the business of effecting transactions in securities for the account of others.” (emphasis added)).  The SEC, in a report published in July 2017, endorsed a case-by-case determination of whether cryptocurrencies are securities. 122 Specifically, the SEC endorsed the Howey test in determining whether a cryptocurrency is a security for purposes of the federal securities laws. See Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Exchange Act Release No. 81207, at 1, 11–15 (July 25, 2017),​investreport/34-81207.pdf [] (applying the Howey test to DAO tokens, a type of cryptocurrency). The Howey test was originally developed in SEC v. W.J. Howey Co., in which the Supreme Court defined “investment contract,” a type of security defined in the Securities Act of 1933. 328 U.S. 293, 298–99 (1946) (“[A]n investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party . . . .”).  Given this case-by-case approach, the regulatory landscape is uncertain as to which cryptocurren­cies are securities and which are not. 123 See Paul Vigna, Digital-Coin Companies Shrug Off SEC Scrutiny, Wall St. J. (July 26, 2017), (on file with the Columbia Law Review) (highlighting the uncertainty around how the Howey test might be applied to other cryptocurrencies). But cf. William Hinman, Dir. of the Div. of Corp. Fin., SEC, Digital Asset Transactions: When Howey Met Gary (Plastic) (June 14, 2018), [] (concluding that Bitcoin and Ether, another popular cryptocurrency, do not appear to be securities under the Howey test).

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. 124 It is worth noting that futures commission merchants (FCMs), who execute futures contracts (but not securities transactions) on behalf of customers, are subject to similar regulation as broker-dealers: They are also required to segregate customer assets and are subject to capital requirements. See Futures Commission Merchants (FCMs): Segregation of Customer Funds, CFTC,​fcmsegregationfunds [] (last visited Aug. 12, 2018) (describing how FCMs are required to segregate customer funds from their own funds); see also Futures Commission Merchants (FCMs): Minimum Adjusted Net Capital Requirements for Futures Commission Merchants and Introducing Brokers, CFTC, [] (last visited Aug. 12, 2018) (describing capital requirements for FCMs). As such, even if cryptocurrencies are considered currencies or commodities (as opposed to securities), regulation of FCMs suggests that the same regulatory principles—protection of customer funds and capital requirements—would apply.

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. 125 See supra notes 33–34and accompanying text (explaining how cryptocurrency wallets act as custodians of customer assets).  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. 126 See supra notes 49–53 and accompanying text (outlining the transition from paper to “street name” stock ownership).  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. 127 See supra notes 56–62 and accompanying text (describing the paperwork crisis and resulting problems).  They also used customer securities for their own purposes. For example, broker-dealers used customer assets to fund their own trading activities. 128 See supra notes 54–55 and accompanying text.

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. 129 See supra notes 31–33 and accompanying text.  Because customers do not even have access to these private keys, 130 See supra note 34 and accompanying text.  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. 131 Samuel Gibbs, Head of Mt Gox Bitcoin Exchange on Trial for Embezzlement and Loss of Millions, Guardian (July 11, 2017),
2017/jul/​11/gox-bitcoin-exchange-mark-karpeles-on-trial-japan-embezzlement-loss-of-millions [].
In 2013, customers began expe­riencing months-long delays in withdrawals. 132 Robert McMillan, The Inside Story of Mt. Gox, Bitcoin’s $460 Million Disaster, Wired (Mar. 3, 2014), [].  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. 133 See Robin Sidel, Eleanor Warnock & Takashi Mochizuki, Almost Half a Billion Worth of Bitcoins Vanish, Wall St. J. (Feb. 28, 2014), (on file with the Columbia Law Review). As of August 15, 2018, those 750,000 lost Bitcoin are worth over $4.6 billion dollars based on a Bitcoin price of approximately $6,200 (750,000 Bitcoin x $6,200). See Bitcoin (USD) Price, Coindesk, (on file with the Columbia Law Review) (last visited Aug. 15, 2018).  Because it failed under somewhat mysterious circumstances, it is unclear what exactly led to Mt. Gox’s demise. 134 See Comizio, supra note 17, at 140 (speculating about possible reasons for Mt. Gox’s collapse, including theft, fraud, and mismanagement).  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. 135 See, e.g., Eric Mu, Why There Should Be a Bitcoin Central Bank, Forbes (Aug. 24, 2014), [] (speculating that Mt. Gox was operating on a fractional reserve basis, resulting in its collapse); Jon Southurst, Most Mt Gox Bitcoins Were Gone by May 2013, Report Claims, Coindesk (Apr. 19, 2015),​most-mt-gox-bitcoins-were-gone-by-may-2013-report-claims [] (last updated Apr. 21, 2015) (citing a report concluding that Mt. Gox had been “operating on a fractional reserve basis”).  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. 136 See Nathaniel Popper, Mt. Gox Creditors Seek Trillions Where There Are Only Millions, N.Y. Times: Dealbook (May 25, 2016),​business/dealbook/mt-gox-creditors-seek-trillions-where-there-are-only-millions.html (on file with the Columbia Law Review) (“The Japanese trustee overseeing the case said . . . that only $91 million in assets has been tracked down to distribute to claimants . . . [which represents] a tiny portion of the amount that claimants have requested.”).

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, 137 See supra notes 56–62 and accompanying text.  Mt. Gox lost most of its Bitcoin by the summer of 2013, months before it declared bankruptcy in February 2014. 138 Ben McLannahan, MtGox ‘Lost Coins’ Long Before Collapse, Fin. Times (Apr. 19, 2015), (on file with the Columbia Law Review).  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.” 139 Does Coinbase Use Customer Deposits for Anything?, Coinbase, [] (last visited Aug. 11, 2018).  Another platform tried to use technolog­ical solutions to prove that it had adequate reserves to back up client deposits. 140 This is known as proof of reserves. See Nermin Hajdarbegovic, Kraken Bitcoin Exchange Passes ‘Proof of Reserves’ Cryptographic Audit, Coindesk (Mar. 24, 2014), https://​ [] (last updated Jan. 6, 2015) (describing how Kraken, a cryptocurrency exchange, implemented and passed a proof-of-reserves audit).  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. 141 See infra notes 142–146and accompanying text.  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. 142 See Press Release, N.Y. State Dep’t of Fin. Servs., NYDFS Announces Approval of First BitLicense Application from a Virtual Currency Firm (Sept. 22, 2015), http://​about/press/pr1509221.htm [].
 In addition to anti–money laundering and cybersecurity provisions, 143 While cryptocurrency raises novel anti–money laundering issues, they are beyond the scope of this Note.  BitLicense addresses the issue of safeguarding customer assets. 144 See Press Release, N.Y. State Dep’t of Fin. Servs., supra note 142.  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. 145 N.Y. Comp. Codes R. & Regs. tit. 23, § 200.9(b) (2017).  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].” 146 Id. § 200.9(c).  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. 147 Kevin Helms, Coinbase Exits as Hawaii Requires Bitcoin Companies to Hold Fiat Reserves, Coindesk (Feb. 28, 2017), [] (describing Hawaii’s money transmitter license requirements as applied to cryptocurrency platforms); see also Haw. Rev. Stat. § 489D-8 (2018) (“A licensee, at all times, shall possess permissible investments having an aggregate market value . . . of not less than the aggregate amount of all outstanding payment obligations.”). “Permissible investments” are generally cash or cash-like instruments. See id. § 489D-4.  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 148 N.Y. Comp. Codes R. & Regs. tit. 23, § 200.9(b). ) 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. 149 See Helms, supra note 147.  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. 150 N.Y. Comp. Codes R. & Regs. tit. 23, § 200.2(q). Kraken, a cryptocurrency exchange, decided to stop operating in New York to avoid New York’s BitLicense regime. See David Floyd, Kraken CEO: Crypto Exchange Won’t Answer New York AG’s Inquiry, Coindesk (Apr. 18, 2018), [] (last updated Apr. 19, 2018). But cf. Hughes & Middlebrook, supra note 24, at 540–41 (discussing how, as a practical matter, it may be difficult for cryptocurrency platforms “to avoid engaging in activity that involves New York”).  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. 151 See Tyler Moore & Nicolas Christin, Beware the Middleman: Empirical Analysis of Bitcoin-Exchange Risk, in Financial Cryptography and Data Security 25, 28 (Ahmad-Reza Sadeghi ed., 2013). By another count, thirty-six exchanges had failed as of 2015. See Luke Parker, 36 Bitcoin Exchanges that Are No Longer with Us, Brave New Coin (Oct. 23, 2015), []. 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. 152 See Moore & Christin, supra note 151, at 27–28.

To date, hacking has been the most common reason behind cryptocur­rency platform failure. 153 See id. at 26–27 (identifying breaches in nine out of forty exchanges examined).  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. 154 See Cade Metz, The Next Big Thing You Missed: There’s a Sure-Fire Way to Control the Price of Bitcoin, Wired (Jan. 14, 2014),
bitcoin-derivatives/ [] (“Coinbase holds an awful lot of [B]itcoin in its own digital wallets.”).
 While the company “runs complex software that monitors price fluctuations and responds almost instantly in an effort to avoid serious losses,” 155 Id.  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, 156 See supra notes 63–64 and accompanying text.  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. 157 SIPC-managed liquidations are available only to SIPC members, who are broker-dealers registered under the Securities Exchange Act. See 15 U.S.C. § 78ccc(2)(A) (2012) (“SIPC shall be a membership corporation the members of which shall be all persons registered as brokers or dealers under [the Securities Exchange Act] . . . .”). Cryptocurrency platforms are not registered as broker-dealers under the Securities Act. See supra notes 119–123 and accompanying text (discussing whether cryptocurrency platforms might be considered broker-dealers).  As such, in bankruptcy, customers receive the value of their liquidated cryptocurrency in cash instead of receiving their cryptocurrency in kind. 158 See, e.g., Order Granting Receiver’s Motion for Authorization to Liquidate Certain Cryptocurrencies Secured by the Receiver at 1–2, Leidel v. Project Inv’rs, Inc., No. 9:16-cv-80060-MARRA (S.D. Fla. Oct. 5, 2016),​uploads/2016/06/Oct-5-2016-Order-to-Liquidate-Certain-Cryptocurrencies.pdf [] (ordering the receiver to liquidate cryptocurrencies).

However, many customers, especially those holding cryptocurrency as an investment, likely prefer to receive cryptocurrency rather than a forced liquidation of their investments. 159 See supra notes 109–111 and accompanying text.  First and foremost, empirical analysis suggests that cryptocurrency is “primarily held for investment purposes,” not as a medium of exchange. 160 See Dirk G. Baur et al., Bitcoin: Medium of Exchange or Speculative Assets? 15–16 (Sept. 26, 2017) (unpublished manuscript), (on file with the Columbia Law Review) (concluding that Bitcoin is primarily “held for investment purposes” based on analysis of Bitcoin transaction data).  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.” 161 11 U.S.C. § 741(6)(A)(i) (2012).  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. 162 See, e.g., supra note 133 and accompanying text (illustrating the dramatic change in value of Bitcoin since Mt. Gox’s bankruptcy).  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. 163 Ben McLannahan, Mt Gox Creditors Want Payouts in Bitcoins, Fin. Times (July 23, 2014), (on file with the Columbia Law Review).  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. 164 Alexandra Harney & Steve Stecklow, Twice Burned—How Mt. Gox’s Bitcoin Customers Could Lose Again (Nov. 16, 2017), []. While Mt. Gox is being liquidated under Japanese bankruptcy law, U.S. Chapter 7 bankruptcy has the same general principle. See supra note 110 and accompanying text (noting that, under Chapter 7 of the bankruptcy code, the values of claims are fixed as of the bankruptcy filing date).  At the time, Bitcoin was worth approximately $483. 165 Harney & Stecklow, supra note 164.  As of August 2018, it is worth over $6,200, 166 See Bitcoin Price, supra note 133.  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. 167 See Harney & Stecklow, supra note 164.

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. 168 See supra note 157 and accompanying text.  The bankruptcy code has special provisions for stockbroker liquidations that generally benefit the stockbroker’s customers over other creditors. 169 See 11 U.S.C. § 752 (2012) (describing how “customer property” is first distributed to customers, not general creditors).  Specifically, customer assets are used only to satisfy custom­ers’ claims; general creditors do not have claims to customer property. 170 See supra notes 103–106 and accompanying text.

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.” 171 11 U.S.C. § 101(53A)(B).  Given the SEC’s case-by-case approach to determining whether cryptocurrency is a security, 172 See supra note 122 and accompanying text.  there is at least some uncertainty as to whether cryptocurrency platforms are “effecting transactions in securities” for purposes of the bankruptcy code. 173 11 U.S.C. § 101(53A)(B) (emphasis added).  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. 174 See supra section II.B.1. As the Mt. Gox example suggests, mismanagement of customer cryptocurrency can result in serious customer losses. 175 See supra notes 133–138 and accompanying text.  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. 176 See supra section I.B.2.  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. 177 See Xavier Freixas et al., Lender of Last Resort: What Have We Learned Since Bagehot?, 18 J. Fin. Servs. Res. 63, 64 & 80 n.2 (2000).  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, 178 See id. at 64 (“A distinguishing characteristic of banks is that their assets are largely illiquid term loans while their liabilities predominantly are unsecured short-term deposits.”).  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. 179 See Markham & Hazen, supra note 97, § 3:1 (noting that receiving compensation for facilitating transactions is a hallmark of the broker-dealer).  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. 180 See Freixas et al., supra note 177, at 64 (discussing the central bank’s lender of last resort function as a response to bank runs).  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. 181 See, e.g., What to Expect When You Open a Brokerage Account, FINRA, http://​ [] (last visited Aug. 12, 2018) (advising customers to ask brokerages about “[f]ees for not maintaining a minimum balance”).  Similarly, cryptocurrency platforms often charge their customers withdrawal fees for transferring cryptocurrency out of the platform’s wallet. 182 See supra note 37 and accompanying text.  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. 183 See, e.g., Press Release, Consumer Fin. Prot. Bureau, CFPB Takes Action Against M&T Bank for Deceptively Advertising Free Checking (Oct. 9, 2014), https://www.consumerfinance​.gov/about-us/newsroom/cfpb-takes-action-against-mt-bank-for-deceptively-advertising-free-checking [] (describing a CFPB enforcement action against a bank for deceptively advertising free checking).  Nevertheless, because cryptocurrency platforms hold themselves out as custodians of customer assets, 184 See supra notes 33–34 and accompanying text.  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. 185 See supra notes 139–140 and accompanying text.  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, 186 See supra section II.B.4. 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 187 See supra notes 83–84 and accompanying text. —appears appropriate for cryptocurrency platforms. Unlike in the case of banks or other highly interconnected financial institutions that pose sys­temic risk, 188 Systemic risk refers to the risk of harm to the financial system as a whole. For example, the failure of a large bank may have follow-on effects that adversely affect the entire financial system. See Freixas et al., supra note 177, at 68–70 (describing how banks 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. 189 Steven Russolillo, Paul Vigna & Akane Otani, Cryptocurrency Market Plumbs New Depths in 2018, Wall St. J. (Aug. 14, 2018), (on file with the Columbia Law Review).  By comparison, the U.S. equity market is approximately $32 trillion. 190 Sec. Indus. & Fin. Mkts. Ass’n, 2018 Fact Book 30 (2018),​wp-content/uploads/2017/08/US-Fact-Book-2018-SIFMA.pdf []. U.S. bond markets are even larger at $41 trillion. See Bonds Outstanding, SIFMA, http://​ [] (last visited Aug. 12, 2018).  Second, to date, cryptocur­rency platforms have been standalone entities instead of interconnected financial institutions. 191 This may change, as traditional financial players consider entering cryptocurrency markets. See, e.g., Paul Vigna, Telis Demos & Liz Hoffman, Goldman Sachs Explores a New World: Trading Bitcoin, Wall St. J. (Oct. 2, 2017), (on file with the Columbia Law Review) (“Goldman Sachs . . . is weighing a new trading operation dedicated to [B]itcoin and other digital currencies, the first blue-chip Wall Street firm preparing to deal directly in this burgeoning yet controversial market . . . .”).  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. 192 See supra note 109and accompanying text.  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; 193 See supra notes 159–162 and accompanying text.  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. 194 See supra notes 168–173 and accompanying text (describing the uncertainty around whether customers of cryptocurrency platforms are prioritized over general creditors under current law).  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. 195 See supra notes 103–106 and accompanying text (describing how customers are prioritized over general creditors in a SIPC-managed liquidation).  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. 196 See Norman S. Poser, James A. Fanto & Jill I. Gross, Broker-Dealer Law and Regulation § 12.03[C], at 12-41 (4th ed. Supp. 2018).  Finally, SIPC’s funding model, based on assessments on broker-dealers, 197 See supra note 115 and accompanying text.  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 198 See Emily Hammond, Double Deference in Administrative Law, 116 Colum. L. Rev. 1705, 1714–17 (2016) (describing the structure of self-regulatory organizations). —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. 199 See William A. Birdthistle & M. Todd Henderson, Becoming a Fifth Branch, 99 Cornell L. Rev. 1, 13–24 (2013) (describing the evolution of SROs in the securities industry since before the New Deal).  For example, before the advent of the net capital rule, the NYSE required its members to hold a minimum amount of capital. 200 See Molinari & Kibler, supra note 78, at 7–8. The NYSE’s rule proved inadequate during the late 1960s in part due to inadequate enforcement by the NYSE. Id. This raises the natural question whether private actors have adequate incentives to regulate themselves. For a comparison of the differing enforcement incentives of SROs versus government actors in the context of securities laws, see James J. Park, Rules, Principles, and the Competition to Enforce the Securities Laws, 100 Calif. L. Rev. 115, 143–62 (2012). Whether government regulators or private actors such as SROs are best suited to regulate cryptocurrency platforms is beyond the scope of this Note.  Today, the Financial Industry Regulatory Authority (FINRA), an SRO that governs broker-dealers, 201 See FINRA, About FINRA, [] (last visited Aug. 24, 2018) (“FINRA is dedicated to investor protection and market integrity through effective and efficient regulation of broker-dealers.”). The SEC oversees FINRA’s rulemaking and enforcement activities. See Hammond, supra note 198, at 1734–39 (describing the SEC’s oversight of FINRA).  enforces, among other things, the net capital rule and customer protection rule. 202 See Markham & Hazen, supra note 97, § 4.40 n.4 (“FINRA may, where a firm is in violation of the net capital rule, direct it to cease operations, or it may impose other restrictions.”); see also, e.g., Press Release, FINRA, FINRA Fines Wedbush Securities Inc. $1.5 Million for Customer Protection, Net Capital Rule Violations and Related Failures (Feb. 5, 2018), [] (describing fines by FINRA for violations of the customer protection and net capital rules).  It is at least conceivable that an SRO could play a similar role in the nascent cryptocurrency industry. 203 For a discussion of the viability of a cryptocurrency SRO, see Ryan Clements, Can a Cryptocurrency Self-Regulatory Organization Work? Assessing Its Promise and Likely Challenges, The FinReg Blog (June 21, 2018),​can-a-cryptocurrency-self-regulatory-organization-work-assessing-its-promise-and-likely-challenges/ [].

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. 204 See Paul Vigna, Winklevoss Effort to Self-Regulate Cryptocurrency Gets Members, Wall St. J. (Aug. 20, 2018), (on file with the Columbia Law Review) (describing the founding of the Virtual Commodity Association); see also Press Release, Virtual Commodity Ass’n, The Virtual Commodity Association Working Group Has Formed and Is Planning Inaugural Meeting (Aug. 20, 2018),​20180820005066/en/Virtual-Commodity-Association-Working-Group-Formed-Planning []; Virtual Commodity Ass’n, [] (last visited Aug. 25, 2018).  The VCA hopes to establish “[a] thoughtful SRO framework that provides a virtual commodity regulatory program for the virtual commodity industry.” 205 Cameron Winklevoss, Joining the Virtual Commodity Association, Medium (Aug. 20, 2018), [].  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. 206 See Asia Sec. Indus. & Fin. Mkts. Ass’n, ASIFMA Best Practices for Digital Asset Exchanges 24 (2018),​20practices%20for%20digital%20asset%20exchanges%20june%202018.pdf [] (“Digital asset exchanges that . . . maintain custody or control of digital assets . . . on behalf of a person must hold that same type and amount of digital assets . . . owed to the person. Digital asset exchanges should not create a right of lien, offset or encumbrance . . . with respect to user digital 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. 207 17 C.F.R. § 240.15c3-3(b)(1) (2018).  Separately, platforms would also have to maintain a cash reserve account in an amount equal to the net amount of cash owed to customers. 208 See supra notes 75–77 and accompanying text.

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. 209 Cryptocurrency exists only on the blockchain, a digital ledger. See supra section I.A.1 (discussing how cryptocurrency is held and transferred). “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. 210 See 17 C.F.R. § 240.15c3-3(c) (defining the control locations where broker-dealers can hold securities and satisfy the control requirement); Markham & Hazen, supra note 97, § 5:4 (“The possession or control requirement means that broker-dealers must have securities in physical possession or at one of several ‘central locations’ . . . .” (quoting 17 C.F.R. § 240.15c3-3)).  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. 211 See supra notes 33–34 and accompanying text.

Platforms typically split their cryptocurrency between “hot wallets” and “cold storage.” 212 See, e.g., Security, Gemini, [] (last visited Aug. 12, 2018) (describing how assets are split between a “hot wallet” and “cold storage”); Security Practices, Kraken, [] (last visited Aug. 12, 2018) (“[N]ew deposits go directly to cold wallets . . . . [C]oins that are needed to maintain operational liquidity are stored in hot (online) wallets.”).  Hot wallets are connected to the internet and therefore easy to access and use. 213 See Joseph Young, Storing Bitcoin in Exchanges and Hot Wallets Is Risky—What to Do Instead, Cointelegraph (Aug. 4, 2016), [] (describing how hot wallets allow instantaneous sending and receiving of cryptocurrency).  Unfortunately, this also leaves them vulnerable to hacks. 214 See id.  As such, platforms keep the majority of their crypto­currency in cold storage. 215 See, e.g., Security, Coinbase, [
Z82W-WY55] [hereinafter Coinbase: Security] (last visited Aug. 12, 2018) (“98% of customer funds are stored offline.”).
 Cold storage refers to cryptocurrency stored in a manner that is unconnected to the internet, such as on flash drives or even physical paper. 216 Immaculate Dadiso Motsi-Omoijiade, Financial Intermediation in Cryptocurrency Markets—Regulation, Gaps and Bridges, in 1 Handbook of Blockchain, Digital Finance, and Inclusion 207, 215 (David Lee Kuo Chuen & Robert Deng eds., 2018) (“Cold storage services store client’s cryptocurrencies in a manner that is not connected to the Internet through various techniques such as the provision of paper wallets, flash drives and bespoke hardware devices . . . .”).  Cold storage mitigates the risk of hacking by storing cryp­tocurrency in an unhackable medium. 217 See id. However, cryptocurrency stored in cold storage is costlier to retrieve. For example, Coinbase’s cold storage is kept in safety deposit boxes and vaults, which could prove costly and time consuming to retrieve. See Coinbase: Security, supra note 215 (“We distribute [B]itcoin geographically in safe deposit boxes and vaults around the world.”).  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. 218 See supra notes 19–20 and accompanying text.  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, 219 For a brief discussion of the SEC’s current case-by-case approach to the question of whether cryptocurrencies are securities for purposes of the federal securities laws, see supra notes 122–123and accompanying text.  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. 220 See supra note 76 and accompanying text.  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. 221 Cryptocurrency is relatively illiquid compared to most financial assets, meaning it is comparatively difficult or costly to purchase or sell. See Simon Trimborn et al., Investing with Cryptocurrencies—A Liquidity Constrained Investment Approach 9 (SFB 649 Discussion Paper No. 2017-014, 2017),​SFB649DP2017-014.pdf [] (“[C]ryptocurrencies have far lower daily trading amount than traditional financial assets, causing a liquidity problem . . . .”).  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. 222 Broker-dealers are permitted, with their customers’ consent, to sweep customer funds into money-market funds or Federal Deposit Insurance Corporation (FDIC)-insured bank deposits. Customers receive a higher rate of return from the money-market fund or enjoy FDIC insurance on the bank deposit while the broker-dealer typically receives a fee from the money-market fund or bank for sweeping customer cash to them. See 17 C.F.R. § 240.15c3-3(a)(17) (2018) (“Sweep Program means a service provided by a broker or dealer . . . offer[ing] to its customer the option to . . . transfer free credit balances in the securities account of the customer to either a money market mutual fund . . . or an account at a bank whose deposits are insured by the [FDIC].”). See generally George Tepe, Note, Broker-Dealer Use of “Idle” Customer Assets: Customer Protection with Sweep Programs and Securities Lending, 2016 Colum. Bus. L. Rev. 823, 830–35 (discussing how broker-dealer sweep programs make use of idle customer cash).  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. 223 See supra notes 88–89 and accompanying text.  First, net capital would exclude illiquid assets. 224 See supra note 90 and accompanying text.  Then, platforms would apply predetermined haircuts—discounts to market value—to their assets based upon the riskiness of those assets. 225 See supra note 91 and accompanying text.  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, 226 See, e.g., Jeffrey Chu et al., GARCH Modelling of Cryptocurrencies, J. Risk & Fin. Mgmt., Oct. 1, 2017, at 1, 13 (“Our results show that cryptocurrencies such as Bitcoin, Ethereum, Litecoin and many others exhibit extreme volatility especially when we look at their inter-daily prices.”); Cameron Harwick, Cryptocurrency and the Problem of Intermediation, 20 Indep. Rev. 569, 574 (2016) (“On stability of value, however, cryptocurrencies reveal their inadequacy as day-to-day currency. . . . [T]he primary impediment is purchasing-power volatility. Bitcoin, for example, . . . has suffered from frequent and severe jumps and crashes since its inception in 2010.”).  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. 227 Compare 17 C.F.R. § 240.15c3-1(c)(2)(vi)(J) (applying a 15% haircut to equities), with id. § 240.15c3-1(c)(2)(vi)(A)–(K) (listing haircuts for various fixed-income securities).  The haircut for cryptocurrencies would likely have to be higher than even the haircut for equity securities, reflecting their higher volatility. 228 See David Lee Kuo Chuen et al., Cryptocurrency: A New Investment Opportunity?, J. Alternative Inv., Winter 2018, at 16, 21 (“CRIX [an index of cryptocurrencies] tends to have a high return volatility compared to the S&P 500 [an index of large-capitalization U.S. stocks].”).  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 229 See All Coins, supra note 27 (listing many cryptocurrencies with relatively small dollar market capitalizations). —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. 230 See Trimborn et al., supra note 221, at 9.

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. 231 See 17 C.F.R. § 240.15c3-1(c)(2)(vi) (listing the applicable haircuts for various types of securities). For bonds, haircuts also vary by maturity. See, e.g., id. § 240.15c3-1(c)(2)(vi)(F)(1) (providing different haircuts for fixed rate nonconvertible debt securities based on maturity). There are also further adjustments for undue concentration and illiquid securities. See id. § 240.15c3-1(c)(2)(vi)(K), (M) (defining haircuts for securities with a limited market or securities in which the broker-dealer has an undue concentration).  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. 232 See John C. Coffee, Jr. & Hillary A. Sale, Redesigning the SEC: Does the Treasury Have a Better Idea?, 95 Va. L. Rev. 707, 742 (2009) (“[T]he investment bank generates a mathematical model that crunches historical data to evaluate how risky its portfolio assets were and how much capital it needed to maintain . . . .”).  For these models to work, there must, at a minimum, be sufficient, representative historical data to adequately calibrate the models. 233 See Erik F. Gerding, Law, Bubbles, and Financial Regulation 510–11 (2013) (“Like every model . . . those used by regulators are only as good as their simplifying assumptions. Moreover, models do not forecast risks adequately when the data on financial institutions being inputted are shoddy. This is encapsulated by the old phrase ‘garbage in, garbage out.’”).  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. 234 See, e.g., Robert F. Weber, New Governance, Financial Regulation, and Challenges to Legitimacy: The Example of the Internal Models Approach to Capital Adequacy Regulation, 62 Admin. L. Rev. 783, 863 (2010) (describing a large bank’s inadequate modelling of risks in its mortgage securitization business).  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. 235 Comizio, supra note 17, at 133.

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. 236 See Weber, supra note 234, at 830 (describing the CSE program); see also Coffee & Sale, supra note 232, at 735 (discussing how the five major investment banks at the time opted into the CSE program).  By 2008, all five broker-dealers had either failed or converted themselves into bank holding companies. 237 See Coffee & Sale, supra note 232, at 735.  This foray into risk-based capital requirements has been criticized for being inadequate in the lead-up to the financial crisis. 238 See, e.g., id. at 740–41 (positing three reasons why the CSE program was inadequate); Norman S. Poser, Why the SEC Failed: Regulators Against Regulation, 3 Brook. J. Corp. Fin. & Com. L. 289, 299 (2009) (criticizing the CSE program for allowing investment banks to take on “extreme leverage”); Weber, supra note 234, at 834 (noting that each of the major investment banks was adequately capitalized under the CSE program despite facing mounting financial distress). Apart from broker-dealers, there is similar criticism of the overreliance on internal risk models in determining capital requirements for banks. See, e.g., Andrew G. Haldane & Vasileios Madouros, The Dog and the Frisbee, in The Changing Policy Landscape: A Symposium Sponsored by the Federal Reserve Bank of Kansas City 109, 126–31 (Richard A. Babson ed., 2013) (arguing that simple leverage ratios—equity divided by total assets—were superior to risk-based capital in predicting bank distress during the financial crisis of 2007–2008).  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. 239 See supra notes 164–167 and accompanying text.  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. 240 See supra note 153 and accompanying text; see also Steven Russolillo & Eun-Young Jeong, Cryptocurrency Exchanges Are Getting Hacked Because It’s Easy, Wall St. J. (July 16, 2018), (on file with the Columbia Law Review) (detailing cyberattacks on cryptocurrency exchanges and their increasing frequency).  Multiple platforms have failed or suffered losses as a result. 241 See Steve Stecklow et al., Chaos and Hackers Stalk Investors on Cryptocurrency Exchanges, Reuters (Sept. 29, 2017),​bitcoin-exchanges-risks [] (listing various cryptocurrency hacks and associated losses).  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.