Author Archives: Tim Sturm

Alternative Trading Systems (ATS)

ATS Registration Overview for Digital Asset Platforms

Digital asset platforms located in the U.S. that facilitate trading and exchange of digital assets (which are deemed to be securities) are generally subject to securities laws requiring such platforms to be registered as a national securities exchange (“NSE”) or fall within an exemption from NSE registration.  One exemption from registration as an NSE allows firms to conduct a platform business if such firm is registered as an alternative trading system (“ATS”).  This requirement was first highlighted by the SEC in the DAO Report released in July 2017.  We anticipate that many digital asset platforms currently facilitating trading will continue to face scrutiny as to whether they need to be registered as NSEs or an ATS and many have already begun the process to register as an ATS.

ATS Definition & Requirement to Register

The statutory definition of an ATS is:

any organization, association, person, group of persons, or system:

(1) That constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange within the meaning of § 240.3b-16 of this chapter; and

(2) That does not:

(i) Set rules governing the conduct of subscribers other than the conduct of such subscribers’ trading on such organization, association, person, group of persons, or system; or

(ii) Discipline subscribers other than by exclusion from trading.

As many digital asset platforms or exchanges technically fall within the ATS definition, these platforms will need to appropriately register with the SEC.  To register as an ATS, the platform will need to do the following:

  1. Register as (or buy) a broker-dealer
  2. File Form ATS
  3. Comply with Regulation ATS

1. Register as a Broker-Dealer

Registering as a broker-dealer (“BD”) is a pre-requite to becoming an ATS.  A firm may only file Form ATS with the SEC after receiving the Financial Industry Regulatory Authority’s (“FINRA”) approval of its broker-dealer application (or after purchase of a broker-dealer).  For platforms registering as a broker-dealer, at a high level the firm must:

  • Submit Form BD;
  • Comply with all applicable state requirements; and
  • Ensure all of its “associates persons” (BD representatives) have satisfied applicable qualification requirements.

The process to register as a new BD is well worn and relatively straight forward.  Firms applying to register as a BD will need to submit online through Form BD online and then submit a New Membership Application (“NMA”) to FINRA.  The NMA requires the firm to describe their business and compliance policies and controls in detail.  A firm will also be subject to an in-person new membership interview and will have to demonstrate how the ATS technology operates to FINRA staff.  As part of the BD process, the firm will need to become a member of at least one self-regulatory organization (“SRO”), which is likely to be FINRA, and become a member of the Securities Investor Protection Corporation (“SIPC”).

If a firm is already a broker-dealer (or has a broker dealer affiliate) but is not an ATS, the firm will need to submit a Continuing Membership Application (“Form CMA”) to FINRA.  For groups registering as a de novo BD, the firm should describe those parts of its business that will include the ATS function.  As with a de novo BD, an existing BD must demonstrate to FINRA staff how the ATS technology operates.

 2. File Form ATS

After a firm has registered as a BD and has discussed the ATS platform with FINRA (to FINRA’s satisfaction), the firm will need to notify the SEC that it is operating as an ATS.  Form ATS is the official SEC notification and must be submitted at least 20 days before the firm begins to operate its platform.

Form ATS is general in scope and requires information such as:

  • Certain identification information (i.e. full name, business name, address, CRD number, etc.)
  • Firm incorporation documents as attachments
  • Description of the types of users on the platform (i.e., broker-dealer, institution, or retail) and any differences in access to services between such users
  • List of the types of securities (digital assets/tokens which are deemed to be securities) that will be traded on the platform
  • Description of how the ATS will operate
  • Description of certain ATS operational procedures (i.e., entry of orders, transaction executions, reporting transactions, compliance, etc.)

It is important to note that Form ATS is a notice filing where the SEC provides no confirmation to the ATS regarding the filing status unless the form is deficient.  When a Form ATS has been filed with the SEC, it will be listed on the SEC website which will display the platform’s full name, the name(s) under which business is conducted, and the city and state of the ATS.  The reports on Form ATS are generally not published and are considered confidential.  Such reports will only be available to the SEC staff, state securities authorities, and any SRO for examination.

3. Ongoing Compliance

An ATS will be subject to numerous compliance obligations outside.  Some of the specific ATS obligations include:

  • File Form ATS-R (which summarizes the ATS’s transactions, on a quarterly basis) within 30 calendar days after the end of each quarter.
  • Amend Form ATS at least 20 calendar days before implementing a material change to the operation of the ATS.
  • Update Form ATS within 30 calendar days after the end of each quarter to correct any inaccurate or unreported information.
  • Permit the examination and inspection of its premises, systems, and records and cooperate with the examination, inspection, or investigation of subscribers by the SEC or SRO of which such subscriber is a member.

Additional BD, FINRA, and other guidelines, regulations, and obligations include:

  • Participating in the lost and stolen securities program.
  • Complying with the fingerprinting requirement.
  • Maintaining and reporting information regarding affiliates.
  • Following certain guidelines when using electronic media to deliver information.
  • Maintaining an anti-money laundering program.
  • Complying with the Department of Treasury’s Office of Foreign Assets Control (“OFAC”) programs.
  • Filing quarterly and annual financial statements to the SEC.

If an ATS is not in compliance with the above requirements it may be subject to steep penalties.  In addition, it is important to note that securities on a registered ATS platform may be subject to a wide range of holding periods which must be enforced for an ATS to remain in compliance.

Registration Timing

It is unclear exactly how long a particular ATS application will take to be approved – it will largely depend on the exact scope of activities the platform will be involved with.  In general a platform designed for trading of private placements (in a kind of closed system for accredited investors) would likely take anywhere from 6-12 months to become fully licensed after submitting the Form NMA.  Technically, FINRA is required to review and process a substantially complete NMA within 180 calendar days after receiving it.

Issues to Consider

There are a number of issues to consider with respect to an ATS application.

  1. Underlying Instruments – the securities on most current digital asset exchanges are unregistered securities which were originally offered outside of any sort of registration exemption. Essentially these are restricted securities and any person selling or reselling such securities are arguably violating US securities laws (for more background, please see our post on restricted securities and distribution structures).  In such a case, we are not sure how FINRA will view a platform which facilitates the trading of restricted instruments.  We have seen many token issuers over the last 6-12 months who have decided to offer their tokens/securities according to registration exemptions, including through SAFTs.  To the extent a digital asset platform only transacts with such tokens (or tokens which go through the S-1 IPO process, which we think will happen within the next 12 months), we believe it is likely that such a platform would be able to be registered with FINRA.
  2. Discussion with FINRA Regarding Trading System – we have not talked directly with FINRA about their review of ATS platforms.  Most ATS platforms were created to allow for “dark pool” trading in the traditional institutional securities space.  It is unclear if FINRA has the experience or technical understanding (currently) to deal with digital assets and applicable trading platforms.
  3. IRS Reporting Requirements – the IRS released a notice in 2014 regarding the tax treatment of virtual currency. Since then, the IRS has subjected exchanges to certain user reporting requirements.  It is unclear whether the IRS will extend these types of user reporting requirements to ATS platforms as well.
  4. FinCEN’s Money Services Businesses Requirements – the Department of the Treasury’s Financial Crimes Enforcement Network (“FinCEN”) released guidance in March of 2013 regarding individuals who handle virtual currencies. FinCEN determined that a person engaged as a business in the exchange of virtual currency for real currency, funds, or other virtual currency (an “exchanger”) is subject to money services business (“MSB”) registration.  Although it is unclear if an ATS qualifies as a MSB, FinCEN has taken action against virtual currency exchanges that did not register with the bureau.
  5. Anti-Money Laundering and Know Your Customer Requirements – MSBs are required by the Bank Secrecy Act to have Anti-Money Laundering (“AML”) and Know Your Customer (“KYC”) procedures. AML procedures are required to detect and report suspicious actives that may indicate money laundering and terrorist financing.  KYC procedures are identification verification actions taken to ensure that the user is truly who they claim to be in order to prevent fraud.
  6. State Regulations – many states have imposed their own laws regarding digital assets. In addition, each state has its own rules and regulations regarding ATS platforms that operate within the state.  Before beginning to operate an ATS, you will want to research what rules and regulations your state has imposed.

Conclusion

After the DAO report, there have been a number of recent comments from SEC officials regarding digital assets and trading platforms that show the need for the cryptocurrency industry to quickly begin the process of integrating into the traditional securities regulatory landscape.  We believe that the ATS structure will become the predominant structure for digital asset exchanges in the future.  We also believe that over the next 12-24 months, as regulators flesh out various issues, the process will become more streamlined and well worn.  A few cryptocurrency related platforms have already started the process to become an ATS, with more likely to follow.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP.  Cole-Frieman & Mallon LLP has been instrumental in structuring the launches of some of the first digital currency-focused hedge funds and works routinely on matters affecting the digital asset industry.  Please contact Mr. Mallon directly at 415-868-5345 if you have any questions on this post.