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Good afternoon and welcome everyone to the second installment of the Crypto Task Force’s Roundtables.
Today, we focus on crypto trading. This topic is of particular interest to me because it wades into some of the practical implications, questions, challenges, and risks that impact actual investors who own – and, therefore, trade – crypto of all varieties. Any conversation about crypto trading quickly reveals the immense complexity and unique nature of these transactions.
In thinking about these complexities, I can’t help but consider them from the perspective of a retail investor. What is a retail investor’s expectation for how their crypto investments move through a trading platform? What protections do they naturally assume they have based on crypto companies’ marketing and their experience with more traditional investments? Do they actually have the benefit of those protections in practice? In my view, they should. But… do they? And if they don’t, how are they warned of that?
In addition to investor expectations, we, of course, have to consider how crypto trading platforms may (or may not) fit into our existing regulatory regime for national securities exchanges and alternative trading systems. Crypto trading platforms are unique because, among other reasons, they often perform multiple services under one roof, sometimes including brokerage, clearing, and custody. Each of these functions is vitally important to maintaining the safety and integrity of assets entrusted by investors to such entities. In traditional finance, they are typically performed by separate registered entities. That’s because of the high risk of conflicts of interest and risks for investors. Because many of these entities are not registered with any regulator (not the SEC, not the states, and not an SRO), they do not comply with laws designed to minimize these risks and potential conflicts. Though the SEC has urged investors to exercise caution,[1] in some instances, we have seen those risks materialize in a way that has caused significant market disruption and harm to investors.
After those instances, we become painfully aware of the mismatch between investor expectations and reality.[2] Investors didn’t realize that their crypto may be held in a single wallet controlled solely by the exchange.[3] Investors didn’t realize that custodially held crypto would be treated as property of the exchange in a bankruptcy proceeding.[4] Investors didn’t realize that their investments were not covered by any FDIC or SIPC insurance.[5] Beyond the consequences to individual investors, these ongoing, unmitigated risks pose a larger threat to orderly functioning of the crypto markets and potentially also to the banking system and traditional finance.
So, where do we go from here? That’s where you and this roundtable come in. How do we approach the question of crypto exchange registration? How do on- and off-chain transactions comply with broker-dealers’ best execution obligations? How can we address and minimize custody risks and conflicts of interest?
Together, let’s explore answers to these difficult questions that can both protect investors and markets.
Thank you all for your continued participation in these roundtables.
[1] See S.E.C. Office of Investor Education and Advocacy, Exercise Caution with Crypto Asset Securities: Investor Alert (Mar. 23, 2023).
[2] See Adam Levitin, Not Your Keys, Not Your Coins: Unpriced Credit Risk in Cryptocurrency, 101 Tex. L. Rev. 877 (2023) (arguing that the risks cryptocurrency exchanges and similar platforms pose for their customers are both substantial and poorly appreciated by many cryptocurrency investors).
[3] Id. at 3.
[4] Id. at 4.
[5] Id. at 5.
