Powers On Broker disintermediation and unregulated crypto exchanges

Powers On... is a monthly opinion column from Marc Powers, who spent much of his 40-year legal career working with complex securities-related cases in the United States after a stint with the SEC. He is now an adjunct professor at Florida International University College of Law, where he teaches the course “Blockchain, Crypto and Regulatory Considerations.”More and more, governments are fearing that they will lose control over aspects of their respective legitimate financial systems, including capital raising and trading, to the hundreds of unlicensed, unregulated centralized and decentralized crypto exchanges worldwide. There is a clear rising chorus of alarm in statements by government regulators in the United States, England, China, Southeast Asia and elsewhere, which are focused now more than ever on the unregulated exchanges that offer trading of derivatives and spot markets in numerous cryptocurrencies. These efforts follow regulators having tamped down on the rampant initial public offering of cryptocurrencies in the form of initial coin offerings, simple agreements for token contracts, and security token offerings during the 2016–2020 period. Some of the cryptocurrencies trading on exchanges such as Binance, Poloniex, Coinbase, KuCoin and Kraken — to name a few — are, indeed, currencies in the form of stablecoins. Others are likely securities as defined by United States federal securities laws, under the expansive interpretation of “investment contracts” by U. S. courts and the SEC. Other cryptocurrencies are commodities, such as Bitcoin ( BTC ) and Ether ( ETH ). Their futures are one of the few cryptocurrencies traded on licensed U. S. exchanges such as the Chicago Mercantile Exchange and Bakkt. Related: It is time for the US to create a ‘Ripple test’ for cryptoIn some measure, these fears are justified — to the extent that investor protection is compromised by allowing unacceptable risks to investors who may not understand or appreciate the downside of their trading activities. An example of this is margin trading that allows significant leverage based upon only a small deposit of funds or tokens in an account. Binance, until recently, allowed 125x leverage on futures purchases of Bitcoin. (It reportedly  reduced leverage down to 20x in July, presumably due to pressure from various international regulators.) In other words, if you had $10,000 in assets in your account, you could purchase up to $1.25 million worth of cryptocurrencies! That is insane leverage, filled with potential problems for both the exchange and the customer. Given the extreme volatility in the prices of various cryptocurrencies, this could be a major problem for the customer if prices drop and they are forced to come up with adequate reserves for their account. If they do not have the funds, their positions will be liquidated by the exchange, which will likely result in substantial losses for the account. There might be a large debit balance created in the account. The exchange has to fulfill the trades ordered by customers, and even with liquidations, it might be stuck with the customer’s losses if they do not have the funds. In periods of market disarray, this can have a cascading effect on various exchanges worldwide. All one has to do is remember the 2008–2009 financial crisis, which was brought about in part by the failure of Lehman Brothers. Here in the U. S., most retail customers can not leverage more than 60% to 75% of their account’s value. That’s not even 1x. The U. S. Federal Reserve’s Regulation T and Financial Industry Regulatory Authority’s margin rules require licensed brokers to monitor the extent of customer leverage to ensure it does not exceed a certain level. Related: Broker licensing for US blockchain developers threatens jobs and diversityThere are also net capital rules for brokers, known technically as “broker-dealers” under securities laws, which require them to maintain a certain level of capital representative of the asset value of their customer account. These rules seek to ensure that they maintain minimum levels of liquid assets and are set forth in Rule 15c3-1 promulgated under the Securities Exchange Act of 1934. If the SEC-registered broker-dealer holding the customer’s assets in an account goes out of business, there is up to $500,000 in Securities Investor Protection Corporation, or SIPC, insurance to protect the customer’s account. Worse, there are continuous efforts by criminals to hack these platforms and steal investor funds. Moreover, some exchanges — not likely the ones mentioned above — may unknowingly allow market participants to engage in trading patterns or activities that are manipulative. Many such manipulative practices are defined and prohibited by statute, in Sections 9(a)(2) and 10(b) of the Exchange Act. These include spoofing, front-running and insider trading. What is fascinating to me about all this is the fact that blockchain “disintermediation,” the ma