Virtual currency brokers: cryptocurrency platform supervision

Oct 21, 2021 By Si Gyeongmin

Cryptocurrency platforms and securities broker supervision

(1) Cryptocurrency and cryptocurrency platform

1. The concept of cryptocurrency

Cryptocurrency is a digital asset recorded on a decentralized public distributed ledger. The distributed ledger is called the blockchain and is used as asset ownership and transfer records. Owning cryptocurrency requires possessing a private key. When the private key matches the public blockchain, the owner can access its cryptocurrency and transfer it to others. When this process is recorded on the blockchain, the transfer occurs. Since the blockchain is maintained through a decentralized process, the transactions recorded on the blockchain are irreversible, preventing "double consumption" or "two transfers of the same cryptocurrency". In addition, unlike other digital assets that cannot be converted into cash, encrypted currency can be converted into legal tender.

2. Cryptocurrency wallets and exchanges

An online cryptocurrency wallet is a service that stores and protects cryptocurrency on behalf of customers. The private key allows the owner to transfer their cryptocurrency, and the wallet provider holds the private key on behalf of its client, acting as its custodian. In fact, when customers hold cryptocurrency in an online wallet, they cannot access their private keys. Instead, they must trust the wallet provider who holds the cryptocurrency on their behalf.

Unlike wallets that only hold cryptocurrency, cryptocurrency exchanges also provide a market where users can trade one cryptocurrency with another cryptocurrency or government-issued currency. The currencies and fees required by these exchanges vary. Fees usually include commissions for each transaction and withdrawal fees for transferring cryptocurrencies from exchanges. In addition, the exchange only trades between customers who have cryptocurrency wallets. In order to trade on the exchange, the customer must hold cryptocurrency in the exchange's wallet.

(2) Supervision of securities companies

1. The historical background of securities companies supervision

During the ten years of the late 1960s, the volume of securities transactions exploded, and securities companies began to find it difficult to handle this business. In particular, securities were still held and delivered in paper form. Securities companies had to provide physical securities for each transaction, and dozens of paper documents are required. For the inherent management burden, securities companies began to register securities in their own names, and they only need to indicate in their books that they hold these securities for their clients. This blurs the boundaries between securities held by securities companies and client securities: Rather than separating their own assets from those of their clients, securities companies tend to hold a pool of interchangeable securities. As a result, many securities companies began to use their clients' assets to finance themselves. Even so, securities companies still face a paperwork crisis. The number of back-office staff is insufficient, and the exchange must be closed early so that the securities companies can handle the backlog of paperwork. Transactions often fail or take a long time to settle. Failure to receive or deliver securities caused huge losses, and theft was rampant.

In addition to these operational problems, the 1969 bear market led to a sharp decline in the value of stocks held by securities companies in their proprietary business, and the trading volume was sluggish. Therefore, Congress promulgated SIPA in 1970 to protect customers from losses in the event of bankruptcy of securities companies, and the SEC promulgated customer protection rules and net capital rules.

2. Customer protection rules

In response to the problem of the mixing of securities companies’ assets and customers’ assets, the customer protection rules aim to separate the personal activities and assets of the securities companies from its customers, ensuring that there are enough assets to satisfy customer claims in the event of an accident. The rules are mainly composed of two parts: (1) require securities companies to own or control client securities; (2) protect customers’ funds.

In order to protect customers’ securities, customer protection rules require securities companies to evaluate their securities inventory every day to ensure that they have enough securities to meet all customer requirements. If there is a shortage, the securities companies must take measures to make up for it. In addition, securities held on behalf of clients must be free from control and must not be accompanied by any liens or other claims. Except for securities, securities companies must keep deposits in separate accounts, representing the net amount of funds owed to customers. Unlike securities rules, the net amount of funds owed to customers is calculated once a week.

3. Net capital rules

Although securities companies have been subject to capital requirements since the 1940s, the rules are insufficient. The SEC observed the number of bankruptcies of securities companies in the late 1960s and early 1970s and believed that securities companies were insufficiently capitalized. The main purpose of the net capital rule is to ensure that the securities company has sufficient capital so that customers can recover their assets through self-liquidation when the securities company goes bankrupt, without resorting to formal liquidation procedures. Self-clearing is usually preferable to formal clearing because of its lower cost and less delay for customers. Net capital rules require brokers to maintain net capital in excess of certain thresholds. At the time of liquidation, the company calculates net assets in accordance with Generally Accepted Accounting Principles (GAAP) and makes various adjustments to reflect the liquidation value.

The net capital rule provides two methods for benchmarking net capital: basic and alternative methods. According to the basic method, the securities company’s liabilities cannot exceed fifteen times its net capital. The alternative method requires the company to maintain net capital of more than US$250,000 or 2% of the client's amount.

4. Bankruptcy of securities companies

According to SIPA, customer property is only used to satisfy customer claims. In addition, SIPA establishes further protection for customers. Congress established the Securities Investor Protection Corporation (SIPC) to oversee the bankruptcy proceedings of securities firms. SIPC can intervene in the management and liquidation of bankruptcy proceedings in any securities company. A key difference between SIPC-managed liquidation and Chapter 7 of the Bankruptcy Law is that the former favors the redistribution of securities to customers, while the latter requires the liquidation of securities into cash. Investors generally prefer to accept securities rather than cash, because the distribution of physical securities can avoid forced liquidation of the securities held by investors. The second difference between Chapter VII of the Bankruptcy Law and SIPC’s management liquidation is that SIPC provides insurance to cover unsatisfied customer claims. Specifically, SIPC provides each customer with up to $500,000 in insurance, of which up to $250,000 is in cash.

Similarities between securities companies and cryptocurrency platforms

(1) Cryptocurrency platform as a broker

The cryptocurrency platform functions as a cryptocurrency broker. Specifically, like brokers, they provide two key functions: as a custodian of client assets and execute transactions for clients.

According to the Securities Exchange Act of 1934, entities "engaged in the securities trading business of other people's accounts" are regarded as brokers. Cryptocurrency platforms "engage in the business of conducting transactions" on behalf of their clients: like brokers, they profit by receiving and executing client orders, usually charging clients per transaction.

(2) The issue of "partial reserves" and the risk of bankruptcy of cryptocurrency platforms

1. Partial reserve

Like securities companies, cryptocurrency platforms hold assets on behalf of clients. When customers own cryptocurrency on the platform, what they really have is an "IOU" from the platform. This brings up the same trust issues faced by brokers in the late 1960s. Therefore, abuse and improper management of customer assets may also occur in cryptocurrency platforms. Just as a securities firm holds client assets in its own name, a cryptocurrency platform may hold its client assets in its own name by managing private keys. In addition, cryptocurrency platforms can also use customer assets to fund their own activities (this part of the funds is called partial reserves), so there may not be enough assets to satisfy all customer claims.

2. Mt.Gox case

Mt.Gox is one of the largest bitcoin exchanges, handling approximately 80% of bitcoin transactions in its heyday. In February 2014, Mt.Gox closed down, announcing that it had lost more than 750,000 bitcoins and lost hundreds of millions of dollars. It is said that Mt.Gox uses the customer's bitcoin to fund its activities. Drawing on the experience of Mt.Gox, many cryptocurrency platforms claim that they do not use customer deposits to fund their activities. However, in the absence of adequate supervision, customers who choose to invest in cryptocurrency still believe that this is only a verbal commitment by the cryptocurrency platform.

3. State regulations

Some states have begun to regulate cryptocurrency platforms, and some states even involve the issue of protecting customer assets and part of the reserve fund. However, state regulations are not sufficient because they are easy to circumvent. In 2015, New York established BitLicense, a framework for regulating cryptocurrency platforms. In addition to anti-money laundering and network security provisions, BitLicense also solves the problem of protecting customer assets. However, Hawaii has adopted a contradictory approach in protecting customer assets. Faced with a costly regulatory dilemma, Coinbase (Bitcoin Company) simply decided to stop operations in Hawaii.

4. Platform bankruptcy risk

So far, hackers have been the most common reason for the failure of cryptocurrency platform operations. However, in addition to hacker attacks, cryptocurrency platforms may also fail due to insufficient risk management or excessive risk-taking. Like any broker-dealer holding risky assets, the operation of cryptocurrency platforms carries a risk of bankruptcy. Any cryptocurrency platform that trades or holds cryptocurrency on its own behalf is subject to the unpredictability of the cryptocurrency market. Just as the market downturn in the late 1960s led to general bankruptcies of securities companies, unforeseen market downturns may lead to the insolvency of some cryptocurrency platforms.

(3) Bankruptcy of cryptocurrency platform

In view of the issue of partial reserves and the risk of platform bankruptcy, the bankruptcy procedures of cryptocurrency platforms are very important, but the current procedures have flaws. The bankruptcy of cryptocurrency platforms is not subject to the liquidation contract managed by SIPC, but is affected by Chapter 7 of the Bankruptcy Law. Therefore, in the event of bankruptcy, the client obtains the value of its liquidated cryptocurrency in cash. However, many customers may prefer to accept cryptocurrency rather than being forced to liquidate their investment. Another uncertain factor in the bankruptcy of cryptocurrency platforms is whether customer claims take precedence over the claims of general creditors. Since the cryptocurrency platform is not a member of SIPC, its liquidation is conducted in accordance with the bankruptcy law. The bankruptcy law has special provisions on the liquidation of securities brokers, and their clients usually benefit more than other creditors.

Specifically, customer assets are only used to satisfy customer claims, and general creditors have no claims on customer property. However, the current law does not clarify whether cryptocurrency platforms will be regarded as "securities brokers" and thus subject to these special regulations.

(4) Taking the regulatory rules of securities brokers as the framework for the supervision of cryptocurrency platforms

1. Customer protection rules

Cryptocurrency platforms face the same problem as brokers in the late 1960s: these platforms may abuse their customers’ assets. Customer protection rules will require platforms to count their cryptocurrencies every day to ensure that they retain sufficient assets to satisfy all customer claims.

2. Net capital rules

To ensure that customers can recover their assets in the event of bankruptcy of securities companies, the goal of this net capital rule is more suitable for cryptocurrency platforms. In view of the relatively small scale of the cryptocurrency platform and independence from other financial institutions, the goal of capital requirements is not to completely avoid failure, but to avoid major customer losses when the platform fails.

3. Bankruptcy and insurance

The bankruptcy system of securities companies also provides a strong framework for resolving failed cryptocurrency platforms. Customers who hold cryptocurrencies are more willing to accept physical cryptocurrencies than U.S. dollars, and procedures similar to SIPC will achieve this result. In addition, a SIPC-like bankruptcy system will help resolve the issue of whether customer claims take precedence over general creditors.

Finally, similar insurance provided by SIPC can further protect customers from losses. SIPC has been very successful in fulfilling its protection of client funds.

4. The potential of private solutions

In fact, the securities industry has been prevalent in self-regulation for many years. For example, before the advent of the net capital rule, the New York Stock Exchange required its members to hold a minimum amount of capital. Today, the Financial Industry Regulatory Authority (FINRA) is a self-regulatory organization (SRO) that manages broker-dealers and, among other things, enforces net capital rules and customer protection rules. At least it is conceivable that SRO can play a similar role in the emerging cryptocurrency industry.

Regulatory framework for cryptocurrency platforms

(1) Customer protection rules

According to customer protection rules, the platform must effectively isolate its own assets from those of its customers. A cryptocurrency platform must acquire enough "physically owned or controlled" cryptocurrency every day to satisfy all the claims of its customers. In addition, the platform must maintain a cash reserve account equal to the net amount of cash owed to customers.

However, cryptocurrency poses two unique challenges to customer protection rules. First, as a digital asset, cryptocurrency does not fully meet the requirements of "physical possession or control. Secondly, as a "currency", cryptocurrency is subject to less strict rules on cash (rather than securities).

1. Physical possession or control

"Physical possession", taken literally, has no meaning in the context of assets that exist only in digital format. However, "control" may include how cryptocurrency platforms hold virtual currencies. At present, the definition of control is: when a securities firm holds uncontrolled securities in certain controlled locations (such as a clearing company or a bank), it is regarded as controlling the securities. Unlike brokers that hold securities in a controlled location, cryptocurrency platforms usually store their own private keys.

Platforms usually divide their cryptocurrencies into "hot wallets" and "cold wallets". The hot wallet is connected to the Internet, so it is easy to access and use. Unfortunately, this also makes them vulnerable to hacker attacks. Therefore, the platform keeps most of the cryptocurrency in a cold wallet. Cold wallets refer to encrypted currencies that are stored in a way that is not connected to the Internet, such as flash drives or even physical paper. Perhaps "control" can be defined as including the cryptocurrency platform managing its own private keys and therefore controlling any form of storage of its cryptocurrency.

2. Cash rules or securities rules

The customer protection rules of cryptocurrency platforms should not treat cryptocurrencies as cash. Given that the current customer protection rules have separate regulations for securities and cash, a potential question is whether cryptocurrencies can be regarded as currencies and are therefore subject to cash rules. First, calculate how much money the cash broker-dealer needs to reserve for customers every week. This strategy may expose the platform to a serious shortage of cryptocurrencies. In addition, customer protection rules allow securities companies to indirectly profit from customers' idle cash by investing customer cash in money market funds or bank deposits. If the same principle is applied to cryptocurrency, it will be problematic, because it may incentivize customers to invest cryptocurrency into risky or insufficiently liquid investment tools to obtain high returns. Since daily (rather than weekly) determinations are more suitable for illiquid assets such as cryptocurrencies, more stringent customer protection rules should be applied to cryptocurrencies.

(2) Net capital rules

The basic framework of net capital rules can be applied to cryptocurrency platforms. Like securities companies, the net capital of cryptocurrency platforms will be adjusted under GAAP. First, net capital will exclude illiquid assets, and then the platform will apply a predetermined deduction calculation to its assets based on the risk profile of these assets. Since the price of cryptocurrency is very volatile, its haircut may be quite high.

A related question is whether to apply uniform standards to all cryptocurrencies or deductions per currency. Given the short history of cryptocurrency, a unified deduction is more appropriate. The current net capital rules are roughly risk-sensitive: with a few exceptions, deductions are based on the asset class level, which means that there is no difference between the stocks of high-risk biotech startups and the stocks of large utility companies. The same situation can also be applied to cryptocurrencies. Based on the amount of data for which risk cannot be assessed, poorly recorded capital requirements, and lack of representative price data, a unified deduction for cryptocurrencies is the most appropriate.

(3) Bankruptcy and insurance

A cryptocurrency platform facing bankruptcy may be subject to a liquidation plan similar to SIPC. In the event of bankruptcy, the trustee will favor the physical distribution of cryptocurrency to customers rather than the liquidation of cash. In addition, under the same liquidation plan as SIPC, customers have priority over ordinary creditors who are bankrupt. Insurance plans similar to SIPC can also be applied to cryptocurrency platforms. However, in view of the special costs and risks of hackers, it is not appropriate to include the cryptocurrency platform under SIPC's jurisdiction, because it will impose the costs and risks of hacker attacks on traditional securities companies.

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