What the DAO Report of Investigation by the SEC Means for Digital Token Exchanges

Less than a month ago, the SEC issued its Report of Investigation, finding that a particular digital token, The DAO, is a security under U.S. law. In reaching its conclusion, the SEC used the Howey Test and noted that whether a token will be characterized as a security will depend on the facts and circumstances of that particular token. In the days that followed, significant attention was paid to how this guidance might impact existing digital tokens, as well as future ones and ICOs. Much less attention was paid to how this guidance might affect the exchanges that facilitate the purchase, sale and transfer of digital tokens.

Section 5 of the Securities Exchange Act of 1934 makes it unlawful for an exchange to affect any transaction in a security unless it is registered as a national securities exchange or is otherwise exempted from such registration. An exchange will likely be deemed to have affected such a transaction if it (1) brings together orders for securities from multiple buyers and sellers and (2) uses established, non-discretionary methods to match buyers and sellers. In its report, the SEC noted that “the Platforms that traded DAO Tokens appear to have satisfied the criteria [because they] provided users with an electronic system that matched orders from multiple parties to buy and sell DAO Tokens for execution based on non-discretionary methods.”

In its Report, the SEC noted that it does not intend to pursue enforcement action against any of the parties involved with the DAO. Nonetheless, exchanges are on notice that they may be liable under the U.S. securities laws if they facilitate the trade of security tokens without being registered. This leaves exchanges with several options, including, without limitation: (1) registering as a securities exchange; (2) delisting tokens at risk of being considered securities; and (3) stop serving or limiting services to U.S. customers.

Until recently, it was unclear whether the Report prompted exchanges to take any action. However, on August 11, 2017, Bitfinex, one of the largest digital token exchanges by volume, announced that it was changing the services it provides U.S. customers. Certain services were discontinued immediately, while others are being discontinued over the next 90 days. These include changes to the verification process and trading of certain tokens and beginning on Wednesday, August 16, U.S. customers will be barred from trading ERC-20 tokens issued through ICOs. If you are a U.S. citizen with holdings at Bitfinex, you should consider the implications of this announcement on your particular situation.

Although Bitfinex’s announcement noted that nothing in it “should be taken as fact or opinion that any such ERC20 tokens are a security pursuant to U.S. law or require regulation under U.S. law”, the timing suggests that the Report may have had an impact on the decision. Now that Bitfinex has acted, it will be interesting to see whether, and if so how, other exchanges will respond to the Report. If you have digital token holdings on other exchanges, it is important that you track any announcements from that exchange so that you are best prepared for any future developments in this area.