SEC Charges EtherDelta founder with first enforcement action for operating an unregistered exchange

Following a summer of enforcement activity related to cryptos which we recently reported on, the Securities and Exchange Commission has announced settled charges against Zachary Coburn,  founder of the EtherDelta digital token trading platform. The charges demonstrate that a “decentralized exchange” can be considered an unregistered national securities exchange and that trading cryptoassets on such a platform in violation of US securities law can attract serious penalties for individuals.

Exchanges for secondary trading of cryptoassets

EtherDelta is an online platform for secondary market trading of ERC20 tokens, a type of blockchain-based token commonly issued in Initial Coin Offerings (ICOs). It operates as a marketplace for buyers and sellers of digital assets which offers users an order book, a website with orders displayed and a “smart contract” run on the Ethereum blockchain. 

EtherDelta's smart contract was coded to validate order messages, confirm the terms and conditions of orders, execute paired orders, and direct the distributed ledger to be updated to reflect a trade.

Trading of certain digital asset securities regulated

Over a period of 18 months, 3.6 million orders for ERC20 tokens were placed using EtherDelta. 

Many of these tokens were traded after the Commission issued its 2017 DAO Report, which concluded that:

  • certain digital assets, such as Decentralized Autonomous Organization (DAO) tokens, were securities; and
  • platforms that offered trading of these digital asset securities would be subject to the SEC's requirement that exchanges register or operate pursuant to an exemption. 
Warning to the market

Coburn settled the charges for $388,000, without admitting to or denying the SEC findings. Coburn’s cooperation is noted as the reason he did not face a stiffer penalty.

The SEC also indicated that this the “first enforcement action” against a platform found to be operating an “unregistered national securities exchange” which seems to be a warning to the market that further enforcement is likely in relation to unregistered exchanges.

Additional enforcement action?

Even though the SEC’s order specifically finds that EtherDelta violated Section 5 of the Exchange Act, Coburn was charged as an individual and EtherDelta’s remains operational.  Thus, the enforcement action may be a preview of other potential enforcement actions including:

  • by the SEC against EtherDelta’s current owners (Coburn sold the site to a Chinese acquirer at the end of 2017). 
  • by the SEC against other “decentralized” trading systems on the basis that they have been facilitating securities trading without registration and oversight.
  • by the SEC against issuers of other tokens traded on EtherDelta that may be deemed securities (particularly issuers who actively sought the listing of their tokens with a view to creating a secondary market to drive up token prices generally).
  • by foreign regulators against EtherDelta’s current owners or similar decentralized “trading systems” (since enforcement authorities in other jurisdictions with similar regulatory frameworks governing exchanges may be prompted by this Order to examine or re-examine their treatment of systems facilitating trades in cryptocurrency).
Decentralized exchange?

EtherDelta promoted itself as a decentralized exchange, but the order notes that open orders were maintained, not on the Ethereum blockchain, but on a centralized server that was apparently owned and maintained by Coburn. 

This factual finding importantly shows how EtherDelta was operating as an exchange. The order book available on the centralized server played a key role in bringing together buyers and sellers and in facilitating trades. 

Further, the Order notes that Coburn had exclusive control over the EtherDelta smart contract that facilitated order execution.  Given these facts, it is hard to classify EtherDelta as a decentralized exchange.

Significant outstanding issues

While the order provides a significant amount of insight into how the SEC may handle similar cases in the future, many questions still remain unanswered:

  • Which of the more than 500 tokens that traded on EtherDelta were legally-designated securities?
  • Could a "fully decentralized" exchange self-run by smart contracts on a blockchain ever fit the SEC definition of exchange?  To be considered an exchange, the platform must "maintain, or provide a market place.”  Coburn, through his maintenance of the site and the smart contract, clearly fits this definition.  A truly autonomous, decentralized exchange would, theoretically, require no maintenance and would not be “provided” by any single person or group of persons.
  • Even if the SEC has the authority to regulate a "fully decentralized" exchange, who would be liable for possible violations?
  • Will exchanges that facilitate cryptocurrency trading continue to move away from the US due to the heightened possibility of enforcement actions
What happens next?

We will be monitoring developments closely and will report on any updates.