BROKER-DEALERS FOR VIRTUAL CURRENCY

Author(s): Dennis Chu

Source: Columbia Law Review , DECEMBER 2018, Vol. 118, No. 8 (DECEMBER 2018), pp.
2323-2360
Published by: Columbia Law Review Association, Inc.

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 NOTES

BROKER-DEALERS FOR VIRTUAL CURRENCY:

REGULATING CRYPTOCURRENCY WALLETS AND
EXCHANGES

Dennis Chu *

With the rise of cryptocurrency as a popular investment,

cryptocurrency wallets and exchanges have proliferated, offering
platforms that allow investors to hold and trade cryptocurrency.
Because these platforms hold cryptocurrency on their customers’ behalf,
they present problems associated with custody. Namely, how do investors
ensure that these platforms do not misuse or mishandle their assets?
And how will customer assets be treated if a platform enters bankruptcy?
To answer these questions, this Note looks to the experience of
broker-dealers, exploring the similarities between the problems con-
fronting cryptocurrency platforms today and the problems that broker-
dealers faced in the late 1960s. Widespread broker-dealer failures
during the late 1960s revealed problems with mishandled client assets,
insufficient capital, and inadequate protection of customer assets in
bankruptcy. Similar problems plague cryptocurrency platforms today.
This Note therefore points to the regulation of broker-dealers as a
template for how to approach the regulation of cryptocurrency platforms.
Looking to the regulatory responses to broker-dealer failures in the late
1960s—including the customer protection rule, net capital rule, and
alternative bankruptcy regime created by the Securities Investor
Protection Act—this Note proposes that a similar regulatory framework
could be applied to cryptocurrency platforms.

* J.D. Candidate 2019, Columbia Law School. The author would like to thank
Kathryn Judge and the editorial staff of the Columbia Law Review for their helpful
comments and feedback.

2323

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2324 COLUMBIA LAW REVIEW [Vol. 118:2323

INTRODUCTION
Investors piled into cryptocurrencies1 in 2017,2 fueling a surge in
cryptocurrency prices.3 The price of Bitcoin, the most well-known crypto-
currency, increased over 1,000% in 2017.4 As a sign of the mania
surrounding these new investments, celebrities from Paris Hilton to
Floyd Mayweather have endorsed cryptocurrencies.5 This new investment
was enabled by cryptocurrency wallets and exchanges. These platforms,
akin to broker-dealers for virtual currency, are the entities through which
many investors hold and trade cryptocurrency.6 The rise of these new
cryptocurrency platforms raises questions about how they should be
regulated.
As with any custodial relationship—in which the custodian holds
assets on a customer’s behalf—there is a fundamental problem of trust
associated with these platforms. Namely, why should customers entrust
their cryptocurrency to these platforms? And if these cryptocurrency
platforms fail, will customers be able to recover their investments? These
are not idle concerns. Cryptocurrency platforms have failed at an exceed-
ingly high rate,7 and customers have lost hundreds of millions of dollars
as a result.8 To answer these questions, this Note looks to the experience
of broker-dealers, beginning with the observation that cryptocurrency
platforms function much like broker-dealers for cryptocurrency. Just as

1. Cryptocurrencies are digital assets recorded on a decentralized, public ledger.

See infra section I.A.1 for a description of cryptocurrencies.
2. Companies raised over $2 billion in the first nine months of 2017 by issuing new
cryptocurrency through a process known as an initial coin offering (ICO). See Paul Vigna,
What’s an Initial Coin Offering? ICOs Explained in 11 Questions, Wall St. J. (Oct. 2, 2017),
https://www.wsj.com/articles/whats-an-initial-coin-offering-icos-explained-in-11-questions-
1506936601 (on file with the Columbia Law Review) [hereinafter Vigna, What’s an ICO].
3. See CRIX, http://thecrix.de/ [https://perma.cc/KBE5-CY42] (last visited Aug.
14, 2018) (showing a significant rise in the CRIX, an index of cryptocurrencies weighted
by market value, through 2017).
4. Paul Vigna, For Bitcoin, a Year Like No Other, Wall St. J. (Dec. 31, 2017),
https://www.wsj.com/articles/for-bitcoin-a-year-like-no-other-1514721601 (on file with the
Columbia Law Review).
5. See Richard Waters, To Coin a Craze: Silicon Valley’s Cryptocurrency Boom, Fin.
Times (Sept. 13, 2017), http://www.ft.com/content/2b0d8926-96d9-11e7-b83c-9588e51488a0
(on file with the Columbia Law Review).
6. This Note uses the term “cryptocurrency platform” to refer to online
cryptocurrency wallets and centralized cryptocurrency exchanges. See infra section I.A.2
for a discussion of cryptocurrency wallets and exchanges.
7. See infra section II.B.4.
8. See infra section II.B.2 (discussing the collapse of Mt. Gox, formerly one of the
largest Bitcoin exchanges).

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2018] BROKER-DEALERS FOR VIRTUAL CURRENCY 2325

broker-dealers enable investors to hold and trade securities,9 cryptocur-

rency platforms allow customers to invest in cryptocurrency.
Customer protection regulation for broker-dealers changed dramati-
cally during the 1970s in response to widespread broker-dealer failures.10
During the 1960s, there was a significant rise in the stock market,
drawing new investors who had previously eschewed stocks.11 In 1952,
only 6.5 million Americans owned stocks; by 1965, that number was over
20 million.12 In the late 1960s, markets experienced a downturn, and
broker-dealers failed en masse, leading to severe customer losses.13 In
response, Congress enacted the Securities Investor Protection Act of
1970 (SIPA),14 and the SEC promulgated rules intended to address many
of the perceived weaknesses leading to broker-dealers’ failures in the late
1960s.15
This Note argues that cryptocurrency platforms face many problems
similar to those that plagued broker-dealers during the late 1960s, and,
therefore, Congress’s and the SEC’s responses to these problems provide
a potential framework from which to approach regulating cryptocurrency
platforms. Part I provides a brief background of cryptocurrency and
cryptocurrency platforms and then discusses how broker-dealers are
regulated. Part II discusses similarities between broker-dealers in the
1960s and cryptocurrency platforms today and argues that SIPA and the
SEC’s broker-dealer regulations provide a useful framework from which
to approach regulation of cryptocurrency platforms. Part III proposes
how the broker-dealer regulatory framework may be adapted to crypto-
currency platforms.

I. CRYPTOCURRENCY PLATFORMS AND REGULATION OF BROKER-DEALERS

This Part begins with a brief overview of cryptocurrency and crypto-
currency platforms and then proceeds to discuss Congress’s and the
SEC’s responses to broker-dealer failures during the late 1960s. Section
I.A considers cryptocurrency and the platforms that allow customers to
hold and trade cryptocurrencies. Section I.B describes SIPA, including

9. See infra section II.A (discussing briefly how broker-dealers are defined under
the securities laws).
10. See infra section I.B.
11. Wyatt Wells, Certificates and Computers: The Remaking of Wall Street, 1967 to
1971, 74 Bus. Hist. Rev. 193, 194 (2000).
12. Id. at 194–95.
13. See infra section I.B.1.
14. Securities Investor Protection Act of 1970, Pub. L. No. 91-598, 84 Stat. 1636
(codified as amended at 15 U.S.C. §§ 78aaa–78lll (2012)).
15. See infra sections I.B.2–.3 (discussing the customer protection and net capital
rules).

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2326 COLUMBIA LAW REVIEW [Vol. 118:2323

the historical context in which Congress enacted the law, and key broker-
dealer regulations promulgated by the SEC.

A. Cryptocurrency and Cryptocurrency Platforms

1. What Is Cryptocurrency? — Cryptocurrencies are digital assets
recorded on decentralized, public ledgers.16 The ledger, known as a
blockchain,17 serves as a record of asset ownership and transfers, much
like a land registry.18 Owning cryptocurrency involves having a private
key.19 This private key, when matched with the public blockchain, allows
owners to access their cryptocurrency and transfer it to another person.20
A transfer occurs when it is recorded on the blockchain.21 Because the
blockchain is maintained through a decentralized process, once a
transaction is recorded on the blockchain, it is virtually impossible to
reverse.22 This prevents someone from “double-spending,” or
transferring the same cryptocurrency twice.23
While the best-known cryptocurrency may be Bitcoin, there are
numerous other types, often referred to as “altcoins.”24 As new coins are

16. See Omri Marian, A Conceptual Framework for the Regulation of

Cryptocurrencies, 82 U. Chi. L. Rev. Dialogue 53, 55 (2015), https://chicagounbound.
uchicago.edu/cgi/viewcontent.cgi?article=1035&context=uclrev_online (on file with the
Columbia Law Review).
17. See V. Gerard Comizio, Virtual Currencies: Growing Regulatory Framework and
Challenges in the Emerging Fintech Ecosystem, 21 N.C. Banking Inst. 131, 133–35 (2017)
(describing the blockchain for Bitcoin).
18. See Marian, supra note 16, at 55. Of course, unlike with land, there is no physical
possession of property. As such, records on the blockchain serve as the only proof of
ownership.
19. See id. at 56.
20. See id. at 55.
21. The recording is done through a decentralized process known as “mining.” See
id. (describing the process through which miners update the blockchain).
22. See Lam Pak Nian & David Lee Kuo Chuen, Introduction to Bitcoin, in
Handbook of Digital Currency: Bitcoin, Innovation, Financial Instruments, and Big Data
5, 19–20 (David Lee Kuo Chuen ed., 2015) [hereinafter Handbook of Digital Currency]
(describing how the blockchain is updated by miners who employ high-powered
computers to solve computationally intensive problems and how the mining process makes
it “exponentially difficult to reverse previous transactions”).
23. See id. at 15–16 (discussing how the technology behind Bitcoin solves the
“double-spending” problem); François R. Velde, Bitcoin: A Primer, Chi. Fed Letter (Fed.
Reserve Bank of Chi., Chi., Ill.), Dec. 2013, at 2, https://www.chicagofed.org/
publications/chicago-fed-letter/2013/december-317 (on file with the Columbia Law Review)
(“[T]he [B]itcoin protocol provides an elegant solution to the problem of creating a digital
currency—i.e., how to regulate its issue, defeat counterfeiting and double-spending, and
ensure that it can be conveyed safely—without relying on a single authority.”).
24. See Sarah Jane Hughes & Stephen T. Middlebrook, Advancing a Framework for
Regulating Cryptocurrency Payments Intermediaries, 32 Yale J. on Reg. 495, 505 (2015)
(describing Bitcoin and altcoins). The term “altcoin” means alternative to Bitcoin. What Is

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2018] BROKER-DEALERS FOR VIRTUAL CURRENCY 2327

constantly launched in the market, the list of altcoins grows.25 New

altcoins raised over $2 billion in the first nine months of 2017.26 By one
count, there are over 800 cryptocurrencies, though the largest ones make
up a disproportionate share of the aggregate market capitalization of
cryptocurrencies.27 Because more altcoins are entering the market and
each altcoin is different, it is difficult to provide a definition that
encompasses them all.28 Nevertheless, they generally follow the structure
described above: digital assets recorded on a decentralized blockchain.29
In addition to being recorded on a decentralized blockchain, another
factor that distinguishes cryptocurrencies from other digital assets is that
they are convertible to legal tender on a cryptocurrency exchange—as
opposed to, for example, digital currencies in video games, which
generally are not convertible into cash.30
2. Cryptocurrency Wallets and Exchanges. — An online cryptocurrency
wallet is a service that stores and safeguards cryptocurrency on behalf of
customers.31 Recall, owning cryptocurrency simply involves having a
private key, which allows owners to transfer their cryptocurrency.32 Wallet
providers hold private keys on behalf of their customers, acting as their

an Altcoin?, Bitcoin Mag., https://bitcoinmagazine.com/guides/what-altcoin [https://

perma.cc/DKB9-DQZE] (last visited Aug. 11, 2018).
25. These launches are typically done through an ICO. See Vigna, What’s an ICO,
supra note 2.
26. See id.
27. Market capitalization is the number of coins in circulation multiplied by the price
per coin. See All Coins, CoinMarketCap, https://coinmarketcap.com/coins/views/all
[https://perma.cc/SPT3-F3YS] (last visited Aug. 12, 2018) (listing various types of
cryptocurrencies in descending order of dollar market capitalization).
28. See Hughes & Middlebrook, supra note 24, at 505 (“‘[E]stablishing firm
definitions [for altcoins] is a challenge’ as these new altcoin variations continue to
emerge.” (quoting The Clearing House & Indep. Cmty. of Bankers of Am., Virtual
Currency: Risks and Regulation 2 (2014), https://www.theclearinghouse.org/~/media/
Files/Research/20140623-Virtual-Currency-White-Paper.pdf [https://perma.cc/UXN9-
J8MU])).
29. Julie Verhage, Camila Russo & Lily Katz, What’s an ICO? Like an IPO but with
Digital Coins, Bloomberg (Sept. 18, 2017), https://www.bloomberg.com/news/articles/
2017-09-18/what-s-an-ico-like-an-ipo-but-with-digital-coins-quicktake-q-a (on file with the
Columbia Law Review) (last updated Oct. 23, 2017) (“Transactions [for cryptocurrency] will
take place on a blockchain, the digital ledger technology first developed for
[B]itcoin . . . .”).
30. See Hughes & Middlebrook, supra note 24, at 506.
31. See Nian & Chuen, supra note 22, at 18–19. Instead of entrusting private keys to
an online wallet, some people choose to manage their own wallets. These personal wallets
can be hosted on computers, mobile devices, or specialized hardware. See How to Store
Your Bitcoin, Coindesk, http://www.coindesk.com/information/how-to-store-your-bitcoins
[https://perma.cc/N52R-PRRS] (last updated Jan. 20, 2018) (describing various types of
cryptocurrency wallets).
32. See supra notes 19–20 and accompanying text.

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2328 COLUMBIA LAW REVIEW [Vol. 118:2323

custodians.33 In fact, when customers hold cryptocurrency in an online

wallet, they do not have access to their private keys;34 instead, they must
trust their wallet providers to hold the cryptocurrency on their behalf.
Unlike wallets, which simply hold cryptocurrency on their clients’
behalf, cryptocurrency exchanges also provide marketplaces where users
can trade one cryptocurrency for another or for government-issued
currency.35 These exchanges differ in the currency pairs they offer and
their fees.36 Fees typically include a commission for each trade and
withdrawal fees for transferring cryptocurrency out of the exchange.37
Because the industry is still nascent, cryptocurrency markets are quite
fragmented; by one count, there are almost eighty exchanges.38 They are
also located in various jurisdictions.39

33. See Nian & Chuen, supra note 22, at 18–19.

34. See, e.g., Where Can I Find the Private Keys for My Wallet?, Coinbase, https://
support.coinbase.com/customer/portal/articles/1526452-where-can-i-find-the-private-keys-
for-my-wallet [https://perma.cc/5AWR-5H3J] (last visited Aug. 12, 2018) (telling Coinbase
customers that they do not have access to the private keys for their cryptocurrency). For a
discussion of how online wallets typically hold their customers’ cryptocurrency, see infra
notes 213–218 and accompanying text.
35. See Nirupama Devi Bhaskar & David Lee Kuo Chuen, Bitcoin Exchanges, in
Handbook of Digital Currency, supra note 22, at 559, 559–60.
36. See Best Cryptocurrency Exchanges: The Ultimate Guide, Blockgeeks, http://
blockgeeks.com/guides/best-cryptocurrency-exchanges [https://perma.cc/5Z8Y-XE4G]
(last visited Aug. 11, 2018) (listing several cryptocurrency exchanges and how they differ).
37. See, e.g., Coinbase Pricing & Fees Disclosures, Coinbase, https://support.
coinbase.com/customer/portal/articles/2109597-buy-sell-bank-transfer-fees [https://
perma.cc/4A87-QU9U] (last visited Aug. 11, 2018) (describing a “transfer” fee for
withdrawing cryptocurrency and a commission of “0 to 50 basis points [0.00% to 0.50%]”
for buying or selling cryptocurrency); Digital Assets/Cryptocurrency Withdrawal Fees,
Kraken, http://support.kraken.com/hc/en-us/articles/201893608-What-are-the-withdrawal-
fees [https://perma.cc/8K3J-AVFN] (last visited Aug. 11, 2018) (describing withdrawal
fees based on the currency being withdrawn); Fee Schedule, Kraken, https://
www.kraken.com/help/fees [https://perma.cc/6TK6-ELEG] (last visited Aug. 11, 2018)
(outlining per-trade fees for various currency pairs); What Fees Does Bittrex Charge?,
Bittrex (May 11, 2017), http://support.bittrex.com/hc/en-us/articles/115000199651-What-
fees-does-Bittrex-charge [https://perma.cc/6MAP-8QXZ] (describing a 0.25% commission
and a transfer fee for withdrawal of cryptocurrency).
38. See Cryptocurrency Exchanges/Markets List, CryptoCoinCharts, https://
cryptocoincharts.info/markets/info [https://perma.cc/JB6J-GNZ8] (last visited Aug. 11,
2018).
39. See, e.g., Samuel Gibbs, Bitcoin Worth $78m Stolen from Bitfinex Exchange in
Hong Kong, Guardian (Aug. 3, 2016), https://www.theguardian.com/technology/2016/
aug/03/bitcoin-stolen-bitfinex-exchange-hong-kong [https://perma.cc/44CV-7W3R];
Cynthia Kim & Heekyong Yang, Uproar over Crackdown on Cryptocurrencies Divides
South Korea, Reuters (Jan. 12, 2018), https://www.reuters.com/article/us-southkorea-
bitcoin/idUSKBN1F10YG [https://perma.cc/5CAH-QF86]; Rachel Rose O’Leary, Japan
Issues Licenses for 11 Bitcoin Exchanges, Coindesk (Sept. 29, 2017), https://www.
coindesk.com/japans-finance-regulator-issues-licenses-for-11-bitcoin-exchanges/ [https://

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2018] BROKER-DEALERS FOR VIRTUAL CURRENCY 2329

Exchanges combine both wallet and exchange services.40 In order to

trade on an exchange, customers must hold cryptocurrency in the
exchange’s wallet.41 Exchanges execute trades only between customers
that have wallets with the exchange. By providing both wallet and
exchange services, they are one-stop shops for people who are looking to
trade and invest in cryptocurrencies.42 Most cryptocurrency trading is
done on these exchanges.43

B. Regulation of Broker-Dealers
This section turns to regulation of broker-dealers, beginning with
the historical context under which Congress and the SEC enacted and
implemented various broker-dealer reforms during the early 1970s.
Namely, many broker-dealers failed amid market and operational turmoil
during the late 1960s.44 The section goes on to describe Congress’s and
the SEC’s responses to these broker-dealer failures, including the cus-
tomer protection rule, net capital rule, and alternative bankruptcy
regime for broker-dealers.

perma.cc/SVP6-TZGY]. The fact that so many cryptocurrency exchanges are international

presents a potential problem of regulatory jurisdiction that is beyond the scope of this Note.
40. See Bhaskar & Chuen, supra note 35, at 560 (“At a Bitcoin exchange, a client can
buy, sell, or store [B]itcoins at the exchange rate and in the currency supported by that
particular Bitcoin exchange.”).
41. See id. (“When a client wants to sell [B]itcoins through an exchange, he or she
has to transfer those [B]itcoins to the wallet of the exchange. An exchange creates a wallet
for every user in their system and one can trade [B]itcoins with this wallet.”).
42. These exchanges, in which the platform provides both wallet and exchange
services, are known as centralized exchanges. By contrast, decentralized exchanges do not
require traders to hold cryptocurrency on the exchange’s wallet. Instead, traders manage
their own wallets, and the decentralized exchange merely facilitates direct, peer-to-peer
transactions. See Loi Luu, Solving the Liquidity Challenge of Decentralized Exchanges,
Coindesk (Aug. 13, 2017), http://www.coindesk.com/solving-liquidity-challenge-decentralized-
exchanges [https://perma.cc/T375-BMZT] (last updated Aug. 14, 2017) (“[F]unds are held
by the user in a personal wallet, rather than with a third party.”); Antonio Madeira, What Is
a Decentralized Exchange, CryptoCompare (July 23, 2018), https://www.cryptocompare.com/
exchanges/guides/what-is-a-decentralized-exchange/ [https://perma.cc/89SB-Z4LW] (“A
decentralized exchange is an exchange market that does not rely on a third party service
to hold the customer’s funds.”). Because this Note addresses issues that arise when
customers entrust their assets to a custodian, this Note deals only with centralized
exchanges and online wallets. In decentralized exchanges and personally managed wallets,
cryptocurrency is never entrusted to a custodian.
43. See Arvind Narayanan et al., Bitcoin and Cryptocurrency Technologies: A
Comprehensive Introduction 259 (2016). Centralized exchanges make up the majority of
trading activity in large part because it is difficult to facilitate sufficient liquidity on
decentralized exchanges. See Luu, supra note 42 (describing the liquidity challenge faced
by decentralized exchanges); see also supra note 42 (describing the distinction between
centralized and decentralized exchanges).
44. See infra section I.B.1.

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2330 COLUMBIA LAW REVIEW [Vol. 118:2323

1. Historical Background. — In order to understand broker-dealer

regulation and its potential application to cryptocurrency platforms, it is
helpful to understand its historical background. Congress enacted SIPA
in 1970 in response to a series of broker-dealer failures during the late
1960s.45 The decade before these failures featured a sustained bull
market,46 with more and more investors speculating in stocks.47 Trading
volume increased over 180% from 1963 to 1968,48 and brokerages began
having difficulty dealing with this new business, not least because
securities were still held and delivered in physical (that is, paper) form.49
Broker-dealers had to deliver physical securities with each transaction.
Often, each transaction required dozens of paper documents.50
In order to ease the administrative burden inherent in each
transaction, broker-dealers began registering securities in their own
name—a practice known as using “street names”—instead of delivering
physical securities to customers.51 Broker-dealers would simply note on
their own books that they were holding these securities for a customer.52
This blurred the line between a broker-dealer’s securities and its
customers’ securities: Instead of separating its own assets from those of its
customers, a broker-dealer would instead hold one fungible pool of
securities.53 As a result, many broker-dealers began financing themselves
with customers’ assets. That is, some would borrow money secured by
customers’ securities.54 By one estimate, 41% and 33% of broker-dealers’

45. See Abe Mastbaum, A Practical Guide to U.S. Capital Markets ch. 11, Westlaw
(database updated July 2016).
46. Bull markets are periods of general increases in share prices. See, e.g., Wells,
supra note 11, at 194 (discussing the bull market during the 1960s). Bear markets are the
inverse: periods of general decreases in share prices. See, e.g., id. at 216 (discussing the
bear market during the late 1960s and early 1970s).
47. See id. at 194–95 (“Whereas only about six and a half million Americans owned
equities in 1952, over twenty million did so in 1965, and that number had climbed to
almost thirty-two million by 1970.”).
48. Harold S. Bloomenthal & Donald Salcito, Customer Protection from Brokerage
Failures: The Securities Investor Protection Corporation and the SEC, 54 U. Colo. L. Rev.
161, 164 (1983).
49. See Neal L. Wolkoff & Jason B. Werner, The History of Regulation of Clearing in
the Securities and Futures Markets, and Its Impact on Competition, 30 Rev. Banking &
Fin. L. 313, 317 (2010).
50. See id.
51. See Mastbaum, supra note 45 (“[I]t became common to register securities in
‘street name,’ that is in the name of the broker-dealer . . . handling the settlements.”).
52. Michael E. Don & Josephine Wang, Stockbroker Liquidations Under the
Securities Investor Protection Act and Their Impact on Security Transfers, 12 Cardozo L.
Rev. 509, 529 (1990).
53. Id. at 530.
54. See SEC, Study of Unsafe and Unsound Practices of Brokers and Dealers, H.R.
Doc. No. 92-231, at 134 (1st Sess. 1971) (describing improper hypothecation of customer
securities).

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2018] BROKER-DEALERS FOR VIRTUAL CURRENCY 2331

assets on the New York Stock Exchange (NYSE) were financed by client
assets in 1969 and 1970, respectively.55
Even still, broker-dealers faced a paperwork crisis.56 There was an
insufficient number of back-office employees to process the volume of
trading.57 Exchanges had to close early so that broker-dealers could work
through the backlog of paperwork.58 Trades often failed or took
extremely long to settle.59 Losses caused by failure to receive or deliver
securities reached four billion dollars.60 Theft was also rampant: Because
of the backlog, broker-dealers often lost track of where their securities
were, inviting theft.61 Then-U.S. Attorney General John Mitchell testified
that more than $400 million worth of securities had been stolen between
1969 and 1970.62
Adding to these operational problems, a bear market in 1969 led to
a sharp drop in the value of broker-dealers’ proprietary holdings and
depressed trading volume.63 Broker-dealers, already plagued by opera-
tional issues, began failing in the face of reduced trade commissions and
severe declines in the value of their proprietary accounts.64 Approxi-
mately 160 NYSE broker-dealers closed, merged, or filed for bankruptcy
during this period.65 Customer losses were significant.66 In response,
Congress enacted SIPA in 1970 to protect customers from losses in the
event of subsequent broker-dealer failures,67 and the SEC promulgated
the customer protection rule and net capital rule, discussed below.
2. Customer Protection Rule. — Responding to problems stemming
from the commingling of a broker-dealer’s assets with those of its
customers,69 the customer protection rule is intended to separate a
broker-dealer’s own activities and assets from those of its customers,
ensuring that there are sufficient assets to satisfy customers’ claims in the

55. Id. at 75.

56. See Wells, supra note 11, at 201–02.
57. Id. at 204–06.
58. Bloomenthal & Salcito, supra note 48, at 165.
59. See Wells, supra note 11, at 203.
60. Wolkoff & Werner, supra note 49, at 317–18.
61. See SEC, supra note 54, at 145–46.
62. Marjorie Hunter, Big Board Too Busy to Stop 1968–69 Thefts, N.Y. Times (June
24, 1971), https://www.nytimes.com/1971/06/24/archives/big-board-too-busy-to-stop-196869-
thefts-haack-tells-senate-of-near.html (on file with the Columbia Law Review).
63. See Wells, supra note 11, at 216.
64. See Bloomenthal & Salcito, supra note 48, at 165; see also SEC, supra note 54, at
14.
65. Wolkoff & Werner, supra note 49, at 318.
66. Bloomenthal & Salcito, supra note 48, at 166.
67. See 69 Am. Jur. 2d Securities Regulation—Federal § 834, Westlaw (database
updated Aug. 2018).
69. See supra notes 51–53 and accompanying text.

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2332 COLUMBIA LAW REVIEW [Vol. 118:2323

event of failure.70 The rule is primarily composed of two parts: (1)

requiring broker-dealers to have possession or control of customer
securities and (2) protecting customers’ cash.71
To safeguard customers’ securities, the customer protection rule
requires a broker-dealer to “promptly obtain and . . . thereafter maintain
the physical possession or control of all . . . securities carried by a broker
or dealer for the account of customers.”72 “Promptly” generally means
the broker-dealer must assess its inventory of securities each day to
ensure that it has sufficient securities to satisfy all of its customers’
claims.73 If there is a shortfall, then the broker-dealer must take steps to
make up any difference.74 For example, if its customers collectively own
250,000 shares of IBM, a broker-dealer must have “possession or control”
of 250,000 shares of IBM to satisfy its customers’ claims. In addition, the
securities held on behalf of customers must be unencumbered—free of
any lien or other claim.75 In effect, the customer protection rule requires
that a broker-dealer have sufficient securities such that, if all of its
customers were to simultaneously withdraw their securities, the broker-
dealer would be able to deliver all of them.
In addition to securities, the customer protection rule also covers
customers’ cash holdings. Broker-dealers must maintain a deposit in a
separate account representing the net amount of funds that the broker-
dealer owes to its customers.76 The rule governing cash is somewhat more
lax than the rule governing securities. Unlike securities, which must be
inventoried daily, the net amount of funds owed to customers is
calculated only weekly.77 However, the customer protection rule also
limits broker-dealers’ ability to use such cash in risky operations,78
limiting the likelihood that there will be a significant cash shortfall.
3. Net Capital Rule. — In response to the failure of undercapitalized
broker-dealers during the late 1960s and early 1970s, the SEC also

70. See Michael P. Jamroz, The Customer Protection Rule, 57 Bus. Law. 1069, 1071
(2002).
71. See id. at 1070.
72. 17 C.F.R. § 240.15c3-3(b)(1) (2018).
73. See Bloomenthal & Salcito, supra note 48, at 168.
74. 17 C.F.R. § 240.15c3-3(d).
75. See id. § 240.15c3-3(c)(2), (5).
76. See id. § 240.15c3-3(e).
77. See id. § 240.15c3-3(e)(3)(i).
78. See Bloomenthal & Salcito, supra note 48, at 173 (“The formula prescribed for
determining the amount of the deposit is designed to protect customers’ cash balances by
allowing brokers to deploy customers’ cash only in relatively safe areas of the brokerage
business.”).

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2018] BROKER-DEALERS FOR VIRTUAL CURRENCY 2333

promulgated the net capital rule.79 Though broker-dealers had been

subject to capital requirements since the 1940s, the rules were
inadequate.80 By 1970, broker-dealers had become leveraged ten to one,81
with the largest firms exhibiting even higher leverage.82 Observing the
number of broker-dealer failures during the late 1960s and early 1970s,
the SEC concluded that broker-dealers were undercapitalized.83
The net capital rule ensures that broker-dealers maintain adequate
liquidity to satisfy their customers’ claims.84 However, the purpose of the
net capital rule is not to avoid broker-dealer failures per se. Instead, the
primary purpose of the net capital rule is to ensure that customers can
recover their assets in the event of a broker-dealer failure without resort-
ing to formal liquidation proceedings.85 In a self-liquidation, a broker-
dealer facing financial distress typically sells itself to a financially healthy
broker-dealer with relatively few disruptions for the distressed broker-
dealer’s customers.86 Self-liquidations are usually preferred to formal
liquidations because they are less costly and result in fewer delays for
customers.87 For example, during a period of market stress for broker-
dealers during the late 1980s, there were eighteen self-liquidations
compared to eight formal liquidations.88
The net capital rule requires broker-dealers to maintain net capital
in excess of certain thresholds. Net capital is essentially the value of the

79. This was done pursuant to the 1975 amendments to the Exchange Act, which
directed the SEC to “establish minimum financial responsibility requirements for all
brokers and dealers.” See Steven L. Molinari & Nelson S. Kibler, Broker-Dealers’ Financial
Responsibility Under the Uniform Net Capital Rule—A Case for Liquidity, 72 Geo. L.J. 1,
15–16 (1983) (internal quotation marks omitted) (quoting 15 U.S.C. § 78o(c)(3) (1976)).
80. See id. at 5–8 (describing the net capital rule promulgated by the SEC in 1942
and NYSE Rule 325, and how these rules were inadequate).
81. Ten-to-one leverage means that, for every $100 worth of assets a broker-dealer
holds, it has only $10 of equity. The higher a broker-dealer’s leverage, the higher the risk
of insolvency. For instance, if the broker-dealer’s assets drop in value from $100 to $90 in
the above example, then its equity will drop from $10 to $0, leading to insolvency. See
SEC, supra note 54, at 74–75 (“[A]t year end 1970, NYSE member firms had $1.9 billion in
equity capital and $18.6 billion in assets. . . . [T]otal liabilities (including subordinated
borrowings) were 90 percent of total assets for NYSE member firms.”).
82. See id. at 75–76 (describing how the thirteen largest broker-dealers made up
approximately 52% of all NYSE members’ assets but just 37% of their equity).
83. Id.
84. See Molinari & Kibler, supra note 79, at 18.
85. Michael P. Jamroz, The Net Capital Rule, 47 Bus. Law. 863, 863–64 (1992)
[hereinafter Jamroz, Net Capital Rule]; see also Net Capital Rule, Exchange Act Release
No. 34-31511, 52 SEC Docket 2694, 2697–98 (Nov. 24, 1992) (“A supervised self-
liquidation can avoid the delays that might arise in the context of a court-imposed
liquidation.”).
86. Jamroz, Net Capital Rule, supra note 85, at 865.
87. Id.
88. Id.

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2334 COLUMBIA LAW REVIEW [Vol. 118:2323

firm if it were to liquidate.89 It is calculated as net worth under Generally

Accepted Accounting Principles (GAAP), with various adjustments to
reflect a liquidation.90 For example, assets that cannot be easily converted
into cash, such as real estate or furniture, are excluded from net capital.91
Most importantly, “haircuts”—discounts to market value—are applied to
securities held by the broker-dealer, reflecting the estimated price the
broker-dealer would receive in liquidation.92 Riskier securities—whose
values are more volatile—have a higher haircut whereas safer securities
have a lower haircut.93 For example, equity securities are subject to a 15%
haircut whereas short-dated Treasury bills are not discounted at all.94
The net capital rule provides two methods to benchmark net capital:
the basic and the alternative methods. Under the basic method, which
most smaller firms use,95 the broker-dealer’s “aggregate indebtedness”
cannot exceed 1,500% of its net capital,96 with aggregate indebtedness
defined as the “total money liabilities of a broker or dealer arising in
connection with any transaction whatsoever.”97 Essentially, under the
basic method, broker-dealers cannot have liabilities exceeding fifteen
times their net capital.
The alternative method, which most large firms use,98 requires the
firm to maintain net capital in excess of the greater of $250,000 or 2% of
the amount that is owed by customers to the broker-dealer.99 The motivat-
ing principle behind the alternative method is that a broker-dealer with

89. See id. at 867 (“[T]he [net capital] [r]ule . . . assumes the firm will liquidate.”).
90. Id. at 866–67.
91. 17 C.F.R. § 240.15c3-1(c)(2)(iv) (2018) (“Deducting fixed assets and assets which
cannot be readily converted into cash . . . including . . . [r]eal estate; furniture and
fixtures . . . .”).
92. See Jamroz, Net Capital Rule, supra note 85, at 867.
93. See Molinari & Kibler, supra note 79, at 19.
94. Compare 17 C.F.R. § 240.15c3-1(c)(2)(vi)(J) (applying a 15% haircut to equities),
with id. § 240.15c3-1(c)(2)(vi)(A)(1) (applying a 0% haircut to U.S. government debt with
less than three months to maturity).
95. U.S. Gen. Accounting Office, GAO/GGD-98-153, Risk-Based Capital: Regulatory
and Industry Approaches to Capital and Risk 133–34 (1998), http://www.gao.gov/assets/
160/156259.pdf [https://perma.cc/T543-26AM].
96. 17 C.F.R. § 240.15c3-1(a)(1)(i).
97. Id. § 240.15c3-1(c)(1). Some liabilities are excluded from “aggregate indebtedness.”
See id. § 240.15c3-1(c)(1)(i)–(xv).
98. See Jerry W. Markham & Thomas Lee Hazen, Broker-Dealer Operations Under
Securities and Commodities Law § 4:2, Westlaw (database updated Nov. 2017)
(“[A]pproximately 90 percent of all customer funds in securities held by broker-dealers
were covered by the alternate net capital method.”).
99. See Molinari & Kibler, supra note 79, 16–17 (describing the net capital
requirement as “two percent of customer-related receivables”); see also 17 C.F.R.
§ 240.15c3-1(a)(1)(ii).

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2018] BROKER-DEALERS FOR VIRTUAL CURRENCY 2335

sufficient capital should be able to liquidate itself informally—without

resort to the courts.100
Because the broker-dealer is supposed to have sufficient securities
and cash to satisfy all of its customers’ claims under the customer
protection rule,101 the broker-dealer’s net capital is meant to provide an
additional cushion to cover the administrative costs of liquidation in the
event of failure.102 Under the alternative method, a broker-dealer
complying with both the customer protection and net capital rules would
thus have enough securities and cash to satisfy all of its customers’ claims
plus a sufficient cushion—its net capital—to operate until it returned all
of its customers’ securities in liquidation.
4. Broker-Dealer Bankruptcy. — In addition to the net capital rule,
which was intended to obviate the need for formal liquidation
proceedings, SIPA created a backstop in the form of an alternative
proceeding to Chapter 7 bankruptcy for broker-dealers.103 In both
Chapter 7 bankruptcy proceedings and liquidation under SIPA, broker-
dealer customers are preferred to general creditors in bankruptcy.104
Specifically, customer property—securities held by the broker for its
customers—is separated from the general estate in both Chapter 7

100. See supra note 85 and accompanying text. Broker-dealers must resort to
liquidation in bankruptcy; they have no recourse to Chapter 11 bankruptcy, which permits
the debtor to reorganize itself rather than liquidating. See Richard Lieb, The Bankrupt
Stockbroker, 1980 Ann. Surv. Bankr. L. 353, 355 (“[A] stockbroker is ineligible for Chapter
11 relief.”).
101. See supra section I.B.2.
102. See Jamroz, Net Capital Rule, supra note 85, at 2698 (“While requiring additional
amounts of capital will not prevent firms from failing, the additional capital serves as a
fund from which the expenses associated with a liquidation can be paid.”).
103. Lieb, supra note 100, at 355–56 (“When a SIPA protective decree application is
filed . . . that filing by itself automatically stays any stockbroker liquidation proceeding
pending under Chapter 7 of the Code . . . .”); A. Michael Sabino, Failed Stockbrokerages
and the Bankruptcy Courts in the 21st Century: Bringing Order to Chaos, 2002 Ann. Surv.
Bankr. L. 131, 140–41 (describing how SIPA “prevails over” the bankruptcy code for
stockbroker liquidations). Chapter 7 bankruptcy is a type of bankruptcy proceeding that
involves liquidation of the debtor’s assets. This is in contrast to Chapter 11 bankruptcy,
which allows the debtor to reorganize itself instead of liquidation. Cf. Lieb, supra note
100, at 356 (“Under the [bankruptcy] [c]ode, . . . both stockbrokers and commodity
brokers are specifically excluded from eligibility for reorganization under Chapter 11.”).
104. See Thomas W. Joo, Who Watches the Watchers? The Securities Investor
Protection Act, Investor Confidence, and the Subsidization of Failure, 72 S. Cal. L. Rev.
1071, 1119 (1999) (“[M]ost of the business of a liquidation [under SIPA] has great
importance to the industry and its customers, and very little to do with the interests of
general creditors.”); Lieb, supra note 100, at 353 (“Since . . . 1938, the Bankruptcy Act has
granted certain priorities to a bankrupt stockbroker’s customers over the claims of
noncustomer general creditors . . . .”).

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2336 COLUMBIA LAW REVIEW [Vol. 118:2323

bankruptcy and liquidation under SIPA.105 General creditors do not have

a claim on customer property; instead, customer property is used only to
satisfy customers’ claims.106 Because brokers typically have relatively few
assets other than their customers’ property,107 this feature of the
bankruptcy regime strongly favors customers.
SIPA established further protections for customers. Seeking an
alternative to the bankruptcy code, Congress established the Securities
Investor Protection Corporation (SIPC) to oversee bankruptcy proceed-
ings for broker-dealers.108 In any broker-dealer bankruptcy proceeding,
SIPC can step in to manage the liquidation of the broker-dealer.109 A key
difference between SIPC-managed liquidations and Chapter 7
bankruptcy is that the former favors distribution of securities back to
customers whereas the latter requires liquidation of securities into
cash.110 Investors typically prefer receiving securities rather than cash
because in-kind distribution of securities avoids a forced liquidation of
investors’ holdings. Because distributions under Chapter 7 bankruptcy
are based upon the value of the customer’s holdings on the date of the
bankruptcy filing,111 the value of cash distributed in Chapter 7
bankruptcy can deviate from the value of the customer’s holdings when
there are changes in the market value of the customer’s securities
between the filing and distribution dates. For example, suppose a
customer has 100 Amazon shares in her brokerage account, worth $1,000
per share as of the bankruptcy filing date. She will be entitled only to

105. See Joo, supra note 104, at 1095. There is another category of assets known as
“customer name securities”—securities that are registered in the customer’s name. These
securities are returned to the customer whose name the security is registered in. However,
because securities are typically registered in the broker-dealer’s name (that is, “street
name”), there are typically few customer name securities. See id.; see also supra note 51
and accompanying text.
106. See Don & Wang, supra note 52, at 542 (describing how customer property is
distributed among customers); Lieb, supra note 100, at 362–63 (same).
107. See Joo, supra note 104, at 1095–96 (describing the division of a broker-dealer’s
estate into three categories—customer name securities, customer property, and a general
estate—of which customer property is the largest).
108. Id. at 1074.
109. See 11 U.S.C. § 742 (2012) (“SIPC may file an application for a protective decree
under [SIPA]. The filing of such application stays all proceedings in the case under [the
bankruptcy code] . . . . If SIPC completes the liquidation of the debtor, then the court
shall dismiss the case.”).
110. Compare id. § 750 (“The trustee may not distribute a security . . . .”), with 15
U.S.C. § 78fff-2(b) (2012) (“[T]he court shall[,] . . . with respect to claims relating to . . .
securities[,] . . . authorize the trustee to deliver securities . . . .”).
111. See 11 U.S.C. § 741(6)(A)(i) (describing how net equity is calculated “at the time
of the filing of the petition”). Net equity is the basis upon which customer property is
distributed. See id. § 752(a) (“The trustee shall distribute customer property ratably to
customers on the basis and to the extent of such customers’ allowed net equity claims and
in priority to all other claims . . . .”).

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2018] BROKER-DEALERS FOR VIRTUAL CURRENCY 2337

$100,000 (100 shares multiplied by $1,000 per share) in Chapter 7

bankruptcy, even if her Amazon shares have appreciated to $1,200 by the
time of distribution.112 Distributing securities in kind avoids this problem.
The second difference between Chapter 7 bankruptcy and a SIPC-
managed liquidation is that SIPC provides insurance to cover unsatisfied
customer claims. As such, if there are insufficient securities to satisfy all
of the customers’ claims, SIPC is authorized to purchase securities to
make up the shortfall.113 Specifically, SIPC insures up to $500,000 per
customer, of which a maximum of $250,000 can be cash.114 The
insurance protects only the broker-dealer’s customers, not its general
creditors.115 SIPC itself is funded by assessments on broker-dealers.116
Through SIPC insurance and preference for in-kind distribution of
securities in bankruptcy, Congress reformed the broker-dealer
bankruptcy process to protect customers from losses.

II. PARALLELS BETWEEN BROKER-DEALERS AND

CRYPTOCURRENCY PLATFORMS
Following Part I’s description of the problems faced by broker-
dealers in the late 1960s, this Part highlights how similar problems are in
many ways arising among cryptocurrency platforms. It then argues that
SIPA and the regulatory response to broker-dealer failures described in
Part I might provide a framework from which to approach regulation of
cryptocurrency platforms.
Section II.A briefly explains how cryptocurrency platforms function
as the broker-dealers for cryptocurrencies. Sections II.B and II.C
highlight how problems that plagued broker-dealers in the late 1960s
might arise among cryptocurrency platforms. Section II.B describes the
problem of fractional reserves, which is reminiscent of how broker-
dealers commingled their own assets with those of their customers
during the 1960s, and suggests that recent state efforts to regulate

112. To be sure, if Amazon shares decrease in value, then the customer may prefer
receiving cash. But, in general, if customers are holding securities for investment
purposes, then they would likely prefer to receive the securities in kind, preserving their
investment, rather than being forced to effectively sell their securities on the filing date.
113. See 15 U.S.C. § 78fff-2(d) (“The trustee shall . . . purchase securities as necessary
for the delivery of securities to customers in satisfaction of their claims . . . in order to
restore the accounts of such customers as of the filing date.”); Don & Wang, supra note 52,
at 542–43 (highlighting the “adoption of a provision authorizing SIPC trustees to purchase
securities in satisfaction of customer claims”).
114. What SIPC Protects, SIPC, https://www.sipc.org/for-investors/what-sipc-protects
[https://perma.cc/U4TA-PBXY] (last visited Aug. 12, 2018).
115. See Joo, supra note 104, at 1097.
116. Alexander C. Dill, Broker-Dealer Regulation Under the Securities Exchange Act
of 1934: The Case of Independent Contracting, 1994 Colum. Bus. L. Rev. 189, 221.

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2338 COLUMBIA LAW REVIEW [Vol. 118:2323

cryptocurrency are likely to be insufficient. It then briefly highlights the

risk of cryptocurrency platform failures. Section II.C argues that, under
current law, there are inadequate protections for cryptocurrency
platform customers in bankruptcy. Finally, section II.D argues that the
broker-dealer reforms enacted in the early 1970s provide an effective
framework from which to approach regulation of cryptocurrency
platforms.

A. Cryptocurrency Platforms as Broker-Dealers

Cryptocurrency platforms functionally act much like broker-dealers
for cryptocurrencies.117 Specifically, like broker-dealers, they provide two
key functions: (1) acting as custodians for customer assets118 and (2)
executing trades for their customers.119
To be considered a broker under the Securities Exchange Act of
1934, an entity must be “engaged in the business of effecting transactions
in securities for the account of others.”120 Cryptocurrency platforms are
“engaged in the business of effecting transactions” on behalf of their cus-
tomers: Like brokers, they profit by receiving and executing customers’
orders, typically charging customers on a per-trade basis.121 However, to
meet the Exchange Act definition of a broker, cryptocurrencies would
need to be considered “securities” for purposes of the federal securities
laws.122 The SEC, in a report published in July 2017, endorsed a case-by-
case determination of whether cryptocurrencies are securities.123 Given

117. A complete statutory analysis of whether cryptocurrency platforms are broker-

dealers for purposes of the federal securities laws is beyond the scope of this Note.
However, SEC Chairman Jay Clayton has suggested that some cryptocurrency platforms
may be operating as broker-dealers. See Public Statement, Jay Clayton, Chairman, SEC,
Statement on Cryptocurrencies and Initial Coin Offerings (Dec. 11, 2017), https://
www.sec.gov/news/public-statement/statement-clayton-2017-12-11/ [https://perma.cc/7HKP-
C3EK] (“I also caution those who operate systems and platforms that effect or facilitate
transactions in [cryptocurrencies] that they may be operating . . . broker-dealers that are
in violation of the Securities Exchange Act of 1934.”).
118. See supra section I.A.2.
119. See supra notes 35–37 and accompanying text.
120. 15 U.S.C. § 78c(a)(4)(A) (2012).
121. See supra notes 35–37 and accompanying text.
122. 15 U.S.C. § 78c(a)(4)(A) (“The term ‘broker’ means any person engaged in the
business of effecting transactions in securities for the account of others.” (emphasis
added)).
123. Specifically, the SEC endorsed the Howey test in determining whether a
cryptocurrency is a security for purposes of the federal securities laws. See Report of
Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO,
Exchange Act Release No. 81207, at 1, 11–15 (July 25, 2017), https://www.sec.gov/
litigation/investreport/34-81207.pdf [https://perma.cc/6ZNF-XBWJ] (applying the
Howey test to DAO tokens, a type of cryptocurrency). The Howey test was originally
developed in SEC v. W.J. Howey Co., in which the Supreme Court defined “investment

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2018] BROKER-DEALERS FOR VIRTUAL CURRENCY 2339

this case-by-case approach, the regulatory landscape is uncertain as to

which cryptocurrencies are securities and which are not.124
However, a detailed analysis of whether cryptocurrency platforms are
broker-dealers for purposes of the federal securities laws is not necessary
here. Regardless of whether cryptocurrencies are considered securities,
cryptocurrency platforms face the same basic problem that plagues
broker-dealers—namely, why should customers entrust their assets to the
cryptocurrency platform? Because these platforms functionally act much
like broker-dealers for cryptocurrency, the experience of broker-dealers
provides insight into how cryptocurrency platforms might be regulated,
regardless of whether cryptocurrencies are considered securities.125

B. The Problem of “Fractional Reserves” and the Risk of Cryptocurrency

Platform Failures
1. Fractional Reserves. — Like brokers, cryptocurrency platforms hold
assets on their customers’ behalf. When customers own cryptocurrency
on a platform, what they really have is an IOU from the platform.126 This
presents the same fundamental issue of trust that broker-dealers faced in
the late 1960s as stock ownership moved from physical form to being

contract,” a type of security defined in the Securities Act of 1933. 328 U.S. 293, 298–99
(1946) (“[A]n investment contract for purposes of the Securities Act means a contract,
transaction or scheme whereby a person invests his money in a common enterprise and is
led to expect profits solely from the efforts of the promoter or a third party . . . .”).
124. See Paul Vigna, Digital-Coin Companies Shrug Off SEC Scrutiny, Wall St. J. (July 26,
2017), http://www.wsj.com/articles/digital-coin-companies-shrug-off-sec-scrutiny-1501110893
(on file with the Columbia Law Review) (highlighting the uncertainty around how the Howey
test might be applied to other cryptocurrencies). But cf. William Hinman, Dir. of the Div. of
Corp. Fin., SEC, Digital Asset Transactions: When Howey Met Gary (Plastic) (June 14, 2018),
https://www.sec.gov/news/speech/speech-hinman-061418 [https://perma.cc/P7NB-SXDJ]
(concluding that Bitcoin and Ether, another popular cryptocurrency, do not appear to be
securities under the Howey test).
125. It is worth noting that futures commission merchants (FCMs), who execute
futures contracts (but not securities transactions) on behalf of customers, are subject to
similar regulation as broker-dealers: They are also required to segregate customer assets
and are subject to capital requirements. See Futures Commission Merchants (FCMs):
Segregation of Customer Funds, CFTC, https://www.cftc.gov/IndustryOversight/
Intermediaries/FCMs/fcmsegregationfunds [https://perma.cc/Z5X5-G3BB] (last visited
Aug. 12, 2018) (describing how FCMs are required to segregate customer funds from their
own funds); see also Futures Commission Merchants (FCMs): Minimum Adjusted Net
Capital Requirements for Futures Commission Merchants and Introducing Brokers, CFTC,
http://www.cftc.gov/IndustryOversight/Intermediaries/FCMs/fcmibminimumnetcapital
[https://perma.cc/WM57-B8AE] (last visited Aug. 12, 2018) (describing capital requirements
for FCMs). As such, even if cryptocurrencies are considered currencies or commodities (as
opposed to securities), regulation of FCMs suggests that the same regulatory principles—
protection of customer funds and capital requirements—would apply.
126. See supra notes 33–34 and accompanying text (explaining how cryptocurrency
wallets act as custodians of customer assets).

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2340 COLUMBIA LAW REVIEW [Vol. 118:2323

held in the broker’s name.127 When broker-dealers held stock in paper

form, customers had physical proof of their stock ownership. Once
brokers began holding stocks in “street name,” customers had to trust
that their brokers were actually holding stock on their behalf. Indeed,
before the customer protection rule, brokers often mishandled customer
securities, leading to delayed trades or stolen securities.128 They also used
customer securities for their own purposes. For example, broker-dealers
used customer assets to fund their own trading activities.129
This same problem—misuse and mismanagement of customer
assets—could occur among cryptocurrency platforms. Just as a broker
holds customers’ assets in its own name, a cryptocurrency platform holds
its clients’ assets in its own name by managing the private keys.130 Because
customers do not even have access to these private keys,131 they must trust
that the platform will not misuse their cryptocurrency. Like broker-
dealers in the late 1960s, a cryptocurrency platform could use customer
assets to fund its own activities, and thus may not hold sufficient assets to
satisfy all of its customers’ claims—otherwise known as running a
fractional reserve.
To illustrate, suppose a platform has only two customers, each
owning ten Bitcoin. If the platform holds only fifteen Bitcoin on behalf
of customers (using the other five Bitcoin to finance its own trading),
then it has insufficient reserves to satisfy all of its customers’ claims. If
both customers withdraw or sell all of their Bitcoin simultaneously, then
the platform will face a shortfall of five Bitcoin as a result of the fractional
reserve. Because cryptocurrency platforms are largely unregulated, it is
unclear what percentage of client assets are actually held by
cryptocurrency platforms. This has led to problems, most famously in the
case of Mt. Gox, discussed in the following section.
2. Mt. Gox. — Mt. Gox was one of the largest Bitcoin exchanges,
handling around 80% of Bitcoin trades at its peak.132 In 2013, customers
began experiencing months-long delays in withdrawals.133 Finally, in

127. See supra notes 49–53 and accompanying text (outlining the transition from
paper to “street name” stock ownership).
128. See supra notes 56–62 and accompanying text (describing the paperwork crisis
and resulting problems).
129. See supra notes 54–55 and accompanying text.
130. See supra notes 31–33 and accompanying text.
131. See supra note 34 and accompanying text.
132. Samuel Gibbs, Head of Mt Gox Bitcoin Exchange on Trial for Embezzlement and
Loss of Millions, Guardian (July 11, 2017), https://www.theguardian.com/technology/
2017/jul/11/gox-bitcoin-exchange-mark-karpeles-on-trial-japan-embezzlement-loss-of-millions
[https://perma.cc/NQG5-EXUW].
133. Robert McMillan, The Inside Story of Mt. Gox, Bitcoin’s $460 Million Disaster,
Wired (Mar. 3, 2014), https://www.wired.com/2014/03/bitcoin-exchange/ [https://
perma.cc/DDG2-6KL4].

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2018] BROKER-DEALERS FOR VIRTUAL CURRENCY 2341

February 2014, Mt. Gox collapsed, announcing that it had lost over
750,000 of its customers’ Bitcoin, representing several hundred million
dollars in losses at the time.134 Because it failed under somewhat
mysterious circumstances, it is unclear what exactly led to Mt. Gox’s
demise.135 There have been persistent rumors that Mt. Gox was running
on a fractional reserve basis, meaning Mt. Gox used customer Bitcoin to
fund its own activities.136 Regardless of the ultimate cause of Mt. Gox’s
failure, it is clear that, at the time of its collapse, Mt. Gox had insufficient
Bitcoin holdings to satisfy all of its customers’ claims.137
In many ways, Mt. Gox’s collapse echoes the failures of many broker-
dealers in the late 1960s. At a minimum, Mt. Gox likely mismanaged
customer assets. Just as broker-dealers lost track of customer securities,138
Mt. Gox lost most of its Bitcoin by the summer of 2013, months before it
declared bankruptcy in February 2014.139 Whatever the cause of its
collapse—whether intentional pilfering of customer assets or negligence
in safeguarding customer deposits—Mt. Gox did not adequately protect
its customers’ cryptocurrency, leading to insolvency.
Learning from the experience of Mt. Gox, many cryptocurrency
platforms now claim that they do not use customer deposits to fund their
own activities. For example, Coinbase, a large cryptocurrency platform,

134. See Robin Sidel, Eleanor Warnock & Takashi Mochizuki, Almost Half a Billion
Worth of Bitcoins Vanish, Wall St. J. (Feb. 28, 2014), https://www.wsj.com/articles/mt-gox-
to-hold-news-conference-1393579356 (on file with the Columbia Law Review). As of August
15, 2018, those 750,000 lost Bitcoin are worth over $4.6 billion dollars based on a Bitcoin
price of approximately $6,200 (750,000 Bitcoin x $6,200). See Bitcoin (USD) Price,
Coindesk, https://www.coindesk.com/price/ (on file with the Columbia Law Review) (last
visited Aug. 15, 2018).
135. See Comizio, supra note 17, at 140 (speculating about possible reasons for Mt.
Gox’s collapse, including theft, fraud, and mismanagement).
136. See, e.g., Eric Mu, Why There Should Be a Bitcoin Central Bank, Forbes (Aug. 24,
2014), http://www.forbes.com/sites/ericxlmu/2014/08/24/why-there-should-be-a-bitcoin-
central-bank [https://perma.cc/R3VU-SCCG] (speculating that Mt. Gox was operating on
a fractional reserve basis, resulting in its collapse); Jon Southurst, Most Mt Gox Bitcoins
Were Gone by May 2013, Report Claims, Coindesk (Apr. 19, 2015), https://www.coindesk.com/
most-mt-gox-bitcoins-were-gone-by-may-2013-report-claims [https://perma.cc/LN9J-RVP2]
(last updated Apr. 21, 2015) (citing a report concluding that Mt. Gox had been “operating
on a fractional reserve basis”).
137. See Nathaniel Popper, Mt. Gox Creditors Seek Trillions Where There Are Only
Millions, N.Y. Times: Dealbook (May 25, 2016), https://www.nytimes.com/2016/05/26/
business/dealbook/mt-gox-creditors-seek-trillions-where-there-are-only-millions.html (on
file with the Columbia Law Review) (“The Japanese trustee overseeing the case said . . . that
only $91 million in assets has been tracked down to distribute to claimants . . . [which
represents] a tiny portion of the amount that claimants have requested.”).
138. See supra notes 56–62 and accompanying text.
139. Ben McLannahan, MtGox ‘Lost Coins’ Long Before Collapse, Fin. Times (Apr.
19, 2015), http://www.ft.com/content/0694b99c-e647-11e4-ab4e-00144feab7de (on file with
the Columbia Law Review).

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2342 COLUMBIA LAW REVIEW [Vol. 118:2323

tells its customers: “Customer deposits are not sent anywhere. Unlike
other financial institutions, we do not lend out customer funds. 100% of
your funds are securely stored.”140 Another platform tried to use
technological solutions to prove that it had adequate reserves to back up
client deposits.141 However, absent adequate regulatory oversight, custom-
ers who choose to invest in cryptocurrency are still left taking these
cryptocurrency platforms at their word.
3. State Regulation. — It should be noted that cryptocurrency
platforms are not entirely unregulated; several states have begun
regulating them, with some even addressing the issue of safeguarding
customer assets and the problem of fractional reserves.142 However, state
regulations are unlikely to be sufficient because they are not uniform and
are easy to sidestep. The contradictory regulatory approaches of New
York and Hawaii highlight these problems.
New York established a framework for regulating cryptocurrency
platforms, known as BitLicense, in 2015.143 In addition to anti–money
laundering and cybersecurity provisions,144 BitLicense addresses the issue
of safeguarding customer assets.145 Specifically, New York requires crypto-
currency platforms to “hold Virtual Currency of the same type and
amount as that which is owed or obligated” to customers.146 It also
prohibits platforms from “selling, transferring, assigning, lending,
hypothecating, pledging, or otherwise using or encumbering assets,
including Virtual Currency . . . except for the sale, transfer, or assign-
ment of such assets at the direction of [the customer].”147 By requiring
platforms to hold unencumbered cryptocurrency in the amount that is
owed to customers, New York’s BitLicense regulation safeguards
customer assets and effectively prevents fractional reserves.

140. Does Coinbase Use Customer Deposits for Anything?, Coinbase, https://support.
coinbase.com/customer/portal/articles/667213-does-coinbase-use-customer-deposits-for-
anything [https://perma.cc/GC2G-TTH3] (last visited Aug. 11, 2018).
141. This is known as proof of reserves. See Nermin Hajdarbegovic, Kraken Bitcoin
Exchange Passes ‘Proof of Reserves’ Cryptographic Audit, Coindesk (Mar. 24, 2014),
https://www.coindesk.com/krakens-audit-proves-holds-100-bitcoins-reserve [https://perma.cc/
GGV3-PXHW] (last updated Jan. 6, 2015) (describing how Kraken, a cryptocurrency
exchange, implemented and passed a proof-of-reserves audit).
142. See infra notes 143–147 and accompanying text.
143. See Press Release, N.Y. State Dep’t of Fin. Servs., NYDFS Announces Approval of
First BitLicense Application from a Virtual Currency Firm (Sept. 22, 2015), http://
www.dfs.ny.gov/about/press/pr1509221.htm [https://perma.cc/FUG6-XN44].
144. While cryptocurrency raises novel anti–money laundering issues, they are beyond
the scope of this Note.
145. See Press Release, N.Y. State Dep’t of Fin. Servs., supra note 143.
146. N.Y. Comp. Codes R. & Regs. tit. 23, § 200.9(b) (2017).
147. Id. § 200.9(c).

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2018] BROKER-DEALERS FOR VIRTUAL CURRENCY 2343

Hawaii, however, takes a different approach to protecting customer

assets. Hawaii’s Money Transmitters Act requires cryptocurrency
platforms to hold cash reserves, rather than cryptocurrency, against
customers’ cryptocurrency deposits.148 For example, a platform holding
100 Bitcoin on behalf of customers would have to hold the dollar
equivalent of 100 Bitcoin in cash as reserves. A cryptocurrency platform
attempting to comply with both New York and Hawaii’s regulations would
thus be required to hold both 100 Bitcoin (to satisfy New York’s
requirement to “hold Virtual Currency of the same type and amount as
that which is owed or obligated” to customers149) and the dollar
equivalent of 100 Bitcoin in cash (to satisfy Hawaii’s requirement).
Faced with precisely such a costly regulatory dilemma, Coinbase
simply decided to stop operating in Hawaii.150 This highlights yet another
shortcoming of state regulation: Because state regulation generally only
covers activity within the state or involving its residents, it can be easy to
sidestep. For example, New York’s BitLicense covers only activities
involving “New York or a New York Resident,” allowing cryptocurrency
platforms to potentially circumvent these regulations by avoiding
business with New York and its residents.151 Federal legislation, on the
other hand, would be more difficult to avoid.
4. Risk of Platform Failures. — While Mt. Gox was the largest
cryptocurrency exchange to collapse, there have been a plethora of other
failures. An early study indicates that 45% of cryptocurrency exchanges
have failed, with the median exchange lasting just 381 days.152 To be sure,

148. Kevin Helms, Coinbase Exits as Hawaii Requires Bitcoin Companies to Hold Fiat
Reserves, Coindesk (Feb. 28, 2017), https://news.bitcoin.com/coinbase-exits-as-hawaii-
requires-money-transmitter-license/ [https://perma.cc/D977-TU2K] (describing Hawaii’s
money transmitter license requirements as applied to cryptocurrency platforms); see also
Haw. Rev. Stat. § 489D-8 (2018) (“A licensee, at all times, shall possess permissible
investments having an aggregate market value . . . of not less than the aggregate amount of
all outstanding payment obligations.”). “Permissible investments” are generally cash or
cash-like instruments. See id. § 489D-4.
149. N.Y. Comp. Codes R. & Regs. tit. 23, § 200.9(b).
150. See Helms, supra note 148.
151. N.Y. Comp. Codes R. & Regs. tit. 23, § 200.2(q). Kraken, a cryptocurrency
exchange, decided to stop operating in New York to avoid New York’s BitLicense regime.
See David Floyd, Kraken CEO: Crypto Exchange Won’t Answer New York AG’s Inquiry,
Coindesk (Apr. 18, 2018), http://www.coindesk.com/kraken-ceo-crypto-exchange-wont-
comply-with-new-york-inquiry [https://perma.cc/2HGU-ESC6] (last updated Apr. 19,
2018). But cf. Hughes & Middlebrook, supra note 24, at 540–41 (discussing how, as a
practical matter, it may be difficult for cryptocurrency platforms “to avoid engaging in
activity that involves New York”).
152. See Tyler Moore & Nicolas Christin, Beware the Middleman: Empirical Analysis
of Bitcoin-Exchange Risk, in Financial Cryptography and Data Security 25, 28 (Ahmad-
Reza Sadeghi ed., 2013). By another count, thirty-six exchanges had failed as of 2015. See
Luke Parker, 36 Bitcoin Exchanges that Are No Longer with Us, Brave New Coin (Oct. 23,

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2344 COLUMBIA LAW REVIEW [Vol. 118:2323

some of these failures likely reflect the growing pains of a nascent and
fast-moving industry. Nevertheless, the prevalence of failures suggests
that more could be done to protect customer assets, since customers are
often unable to reclaim their lost cryptocurrency holdings following
exchange failures.153
To date, hacking has been the most common reason behind
cryptocurrency platform failure.154 But in addition to hacking, cryptocur-
rency platforms could fail due to inadequate risk management or
excessive risk taking. Like any broker-dealer who holds risky assets,
cryptocurrency platforms operate with the risk of insolvency. Any
cryptocurrency platform that trades or holds cryptocurrency on its own
behalf is subject to the vagaries of the cryptocurrency market. Coinbase,
for example, holds a significant inventory of cryptocurrency to facilitate
trades and payments.155 While the company “runs complex software that
monitors price fluctuations and responds almost instantly in an effort to
avoid serious losses,”156 past financial crises demonstrate that losses are
not always predictable. A market downturn would also likely dampen
trading activity, reducing commission revenue for cryptocurrency plat-
forms. Just as the market downturn in the late 1960s led to widespread
broker-dealer failures,157 an unforeseen downturn could render some
cryptocurrency platforms insolvent.

C. Cryptocurrency Platform Bankruptcy

Given the problem of fractional reserves and the risk of platform
failures, the bankruptcy procedure for cryptocurrency platforms may
prove to be important. Unfortunately, the current procedure is
potentially deficient. Instead of a SIPC-managed liquidation, which is
available only for registered broker-dealers, cryptocurrency platforms are
subject to Chapter 7 bankruptcy.158 As such, in bankruptcy, customers

2015), https://bravenewcoin.com/news/36-bitcoin-exchanges-that-are-no-longer-with-us/
[https://perma.cc/77YP-DJWS].
153. See Moore & Christin, supra note 152, at 27–28.
154. See id. at 26–27 (identifying breaches in nine out of forty exchanges examined).
155. See Cade Metz, The Next Big Thing You Missed: There’s a Sure-Fire Way to
Control the Price of Bitcoin, Wired (Jan. 14, 2014), https://www.wired.com/2014/01/
bitcoin-derivatives/ [https://perma.cc/7KRH-L2NG] (“Coinbase holds an awful lot of
[B]itcoin in its own digital wallets.”).
156. Id.
157. See supra notes 63–64 and accompanying text.
158. SIPC-managed liquidations are available only to SIPC members, who are broker-
dealers registered under the Securities Exchange Act. See 15 U.S.C. § 78ccc(2)(A) (2012)
(“SIPC shall be a membership corporation the members of which shall be all persons
registered as brokers or dealers under [the Securities Exchange Act] . . . .”).
Cryptocurrency platforms are not registered as broker-dealers under the Securities Act.

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2018] BROKER-DEALERS FOR VIRTUAL CURRENCY 2345

receive the value of their liquidated cryptocurrency in cash instead of

receiving their cryptocurrency in kind.159
However, many customers, especially those holding cryptocurrency
as an investment, likely prefer to receive cryptocurrency rather than a
forced liquidation of their investments.160 First and foremost, empirical
analysis suggests that cryptocurrency is “primarily held for investment
purposes,” not as a medium of exchange.161 Moreover, in bankruptcy, the
value of a customer’s claim is determined by the value of her holdings “at
the time of the filing of the [bankruptcy] petition.”162 As such, changes in
value between filing date and ultimate recovery are ignored. Given the
volatility of cryptocurrencies, the value of what customers receive in cash
might diverge substantially from the value of their cryptocurrency.163
Finally, returning cryptocurrency to customers is likely faster and less
costly than liquidation into cash.
Mt. Gox’s bankruptcy proceedings illustrate this preference for in-
kind distribution over distribution of cash. A group of Mt. Gox’s former
customers requested that their bankruptcy payouts be done in Bitcoin
rather than cash in part because they believe Bitcoin is “superior” to
cash.164 Further, pending ongoing bankruptcy proceedings, Mt. Gox’s
customers appear to be entitled only to the market price of their Bitcoin
holdings as of April 2014, when the court ordered liquidation of the
exchange.165 At the time, Bitcoin was worth approximately $483.166 As of

See supra notes 120–124 and accompanying text (discussing whether cryptocurrency
platforms might be considered broker-dealers).
159. See, e.g., Order Granting Receiver’s Motion for Authorization to Liquidate
Certain Cryptocurrencies Secured by the Receiver at 1–2, Leidel v. Project Inv’rs, Inc., No.
9:16-cv-80060-MARRA (S.D. Fla. Oct. 5, 2016), http://cryptsyreceivership.com/v1/wp-
content/uploads/2016/06/Oct-5-2016-Order-to-Liquidate-Certain-Cryptocurrencies.pdf
[https://perma.cc/7BYG-9PEX] (ordering the receiver to liquidate cryptocurrencies).
160. See supra notes 110–112 and accompanying text.
161. See Dirk G. Baur et al., Bitcoin: Medium of Exchange or Speculative Assets? 15–
16 (Sept. 26, 2017) (unpublished manuscript), https://ssrn.com/abstract=2561183 (on file
with the Columbia Law Review) (concluding that Bitcoin is primarily “held for investment
purposes” based on analysis of Bitcoin transaction data).
162. 11 U.S.C. § 741(6)(A)(i) (2012).
163. See, e.g., supra note 134 and accompanying text (illustrating the dramatic
change in value of Bitcoin since Mt. Gox’s bankruptcy).
164. Ben McLannahan, Mt Gox Creditors Want Payouts in Bitcoins, Fin. Times (July
23, 2014), http://www.ft.com/content/ed3b578e-1258-11e4-a581-00144feabdc0 (on file with
the Columbia Law Review).
165. Alexandra Harney & Steve Stecklow, Twice Burned—How Mt. Gox’s Bitcoin
Customers Could Lose Again (Nov. 16, 2017), https://www.reuters.com/investigates/
special-report/bitcoin-gox/ [https://perma.cc/SD7F-FR8L]. While Mt. Gox is being
liquidated under Japanese bankruptcy law, U.S. Chapter 7 bankruptcy has the same
general principle. See supra note 111 and accompanying text (noting that, under Chapter
7 of the bankruptcy code, the values of claims are fixed as of the bankruptcy filing date).
166. Harney & Stecklow, supra note 165.

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2346 COLUMBIA LAW REVIEW [Vol. 118:2323

August 2018, it is worth over $6,200,167 potentially leaving customers with

significant forgone gains. Furthermore, after all creditors are paid, Mt.
Gox’s shareholders will receive any surplus. Without a preference for
distribution of cryptocurrency in kind rather than liquidation to cash,
Mt. Gox could potentially reap the gain from its customers’ Bitcoin
investments.168
An additional source of uncertainty in cryptocurrency platform
bankruptcy is whether customers’ claims would be prioritized against
those of general creditors. Because cryptocurrency platforms are not
SIPC members, their liquidations are governed by the bankruptcy
code.169 The bankruptcy code has special provisions for stockbroker
liquidations that generally benefit the stockbroker’s customers over other
creditors.170 Specifically, customer assets are used only to satisfy custom-
ers’ claims; general creditors do not have claims to customer property.171
Under current law, however, it is unclear whether a cryptocurrency
platform would be considered a “stockbroker” and thus subject to these
special provisions. The bankruptcy code defines “stockbroker” as an
entity “that is engaged in the business of effecting transactions in
securities . . . for the account of others.”172 Given the SEC’s case-by-case
approach to determining whether cryptocurrency is a security,173 there is
at least some uncertainty as to whether cryptocurrency platforms are
“effecting transactions in securities” for purposes of the bankruptcy
code.174 Without these special provisions, customers’ assets might be used
to satisfy the claims of general creditors in bankruptcy.

D. Broker-Dealer Regulation as a Framework for Regulating Cryptocurrency

Platforms
In light of the similarities between the problems faced by cryptocur-
rency platforms and broker-dealers, this section argues that broker-dealer
regulation provides a robust framework with which to approach
regulation of cryptocurrency platforms. This section assesses the three
elements of the broker-dealer regulatory framework described in section
I.B—the customer protection rule, net capital rule, and broker-dealer
bankruptcy regime—in the context of cryptocurrency platforms. It

167. See Bitcoin Price, supra note 134.

168. See Harney & Stecklow, supra note 165.
169. See supra note 158 and accompanying text.
170. See 11 U.S.C. § 752 (2012) (describing how “customer property” is first
distributed to customers, not general creditors).
171. See supra notes 104–107 and accompanying text.
172. 11 U.S.C. § 101(53A)(B).
173. See supra note 123 and accompanying text.
174. 11 U.S.C. § 101(53A)(B) (emphasis added).

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2018] BROKER-DEALERS FOR VIRTUAL CURRENCY 2347

argues that this framework could address many of the problems

identified in sections II.B and II.C. The section concludes with a brief
discussion of the potential for private solutions to these problems.
1. Customer Protection Rule. — As illustrated in section II.B.1, crypto-
currency platforms face the same problem that broker-dealers did in the
late 1960s: the potential for these platforms to misuse their customers’
assets.175 As the Mt. Gox example suggests, mismanagement of customer
cryptocurrency can result in serious customer losses.176 A customer
protection rule would ensure that cryptocurrency platforms act as
custodians for customer assets by requiring that the platforms take stock
of their cryptocurrency on a daily basis to ensure that they keep sufficient
assets to satisfy all of their customers’ claims.177 Such a rule would have
likely alerted Mt. Gox to the fact that it had lost its customers’
cryptocurrency long before it declared bankruptcy, potentially avoiding
such a catastrophic collapse.
A customer protection rule would effectively prevent cryptocurrency
platforms from running fractional reserves. To understand why fractional
reserves are not appropriate for cryptocurrency platforms, it is worth
considering how broker-dealers differ from banks. Banks run fractional
reserves as a matter of course.178 However, broker-dealers have a funda-
mentally different business model than banks. Whereas banks pay
customers interest for their deposits and then use those deposits to fund
other activities such as loans,179 broker-dealers do not pay customers
interest on their assets or use customer assets to fund other activities;
instead, they typically profit by charging their clients for trades.180
Moreover, because banks engage in maturity transformation—borrowing
short-term from depositors and lending longer term (such as a thirty-year
mortgage)—they have access to the central bank, which provides
liquidity to the bank if it has insufficient cash to meet its short-term
obligations.181 Unlike banks, broker-dealers do not have recourse to the
central bank because they do not engage in maturity transformation. On
the spectrum between broker-dealers and banks, cryptocurrency

175. See supra section II.B.1.

176. See supra notes 134–139 and accompanying text.
177. See supra section I.B.2.
178. See Xavier Freixas et al., Lender of Last Resort: What Have We Learned Since
Bagehot?, 18 J. Fin. Servs. Res. 63, 64 & 80 n.2 (2000).
179. See id. at 64 (“A distinguishing characteristic of banks is that their assets are
largely illiquid term loans while their liabilities predominantly are unsecured short-term
deposits.”).
180. See Markham & Hazen, supra note 98, § 3:1 (noting that receiving compensation
for facilitating transactions is a hallmark of the broker-dealer).
181. See Freixas et al., supra note 178, at 64 (discussing the central bank’s lender of
last resort function as a response to bank runs).

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2348 COLUMBIA LAW REVIEW [Vol. 118:2323

platforms fall on the side of broker-dealers. Like broker-dealers, they are

in the business of effecting transactions for customers and do not have
access to the central bank. As such, cryptocurrency platforms, like
broker-dealers, should not be allowed to run fractional reserves.
To be sure, a customer protection rule could impose higher costs
upon customers relative to a world in which cryptocurrency platforms
could run fractional reserves, since it is economically costly to have assets
sitting idle that could otherwise be used to fund productive ventures.
These costs are passed on to customers. For example, in addition to per-
trade fees, broker-dealers often impose minimum-balance requirements
on their customers.182 Similarly, cryptocurrency platforms often charge
their customers withdrawal fees for transferring cryptocurrency out of
the platform’s wallet.183 Contrast these fee structures with that of banks:
Because they run fractional reserves, banks not only pay interest on
customer deposits, they also often offer their customers “free” services,
such as free checking.184 Nevertheless, because cryptocurrency platforms
hold themselves out as custodians of customer assets,185 it is appropriate
to treat them as such.
In addition, a customer protection rule would not drastically affect
most cryptocurrency platforms. Many cryptocurrency platforms claim
that they do not run fractional reserves, suggesting that they already hold
sufficient assets to satisfy all of their customers’ claims.186 A customer
protection rule would simply apply a regulatory approach consistent with
how these cryptocurrency platforms claim to operate.
2. Net Capital Rule. — In light of a slew of cryptocurrency platform
failures,187 capital requirements for these platforms may also be prudent.
Ensuring that platforms retain sufficient capital would help cushion
them against adverse movements in the market and ensure that, in the
event of their failure, customers could still receive their cryptocurrency
holdings. Just like broker-dealers during the late 1960s, inadequately
capitalized platforms with significant proprietary holdings of risky assets

182. See, e.g., What to Expect When You Open a Brokerage Account, FINRA, http://
www.finra.org/investors/what-expect-when-you-open-brokerage-account [https://perma.cc/
5VPG-CUV9] (last visited Aug. 12, 2018) (advising customers to ask brokerages about
“[f]ees for not maintaining a minimum balance”).
183. See supra note 37 and accompanying text.
184. See, e.g., Press Release, Consumer Fin. Prot. Bureau, CFPB Takes Action Against
M&T Bank for Deceptively Advertising Free Checking (Oct. 9, 2014), https://www.
consumerfinance.gov/about-us/newsroom/cfpb-takes-action-against-mt-bank-for-deceptively-
advertising-free-checking [https://perma.cc/3Z7E-DQL4] (describing a CFPB enforcement
action against a bank for deceptively advertising free checking).
185. See supra notes 33–34 and accompanying text.
186. See supra notes 140–141 and accompanying text.
187. See supra section II.B.4.

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2018] BROKER-DEALERS FOR VIRTUAL CURRENCY 2349

may become insolvent during a severe downturn, resulting in customer

losses.
Moreover, the goal of the net capital rule—to ensure that customers
can recover their assets in the event of a broker-dealer failure188—
appears appropriate for cryptocurrency platforms. Unlike in the case of
banks or other highly interconnected financial institutions that pose sys-
temic risk,189 the goal for cryptocurrency platforms need not be to avoid
failures per se. First, cryptocurrencies, despite their significant growth,
are still a relatively small portion of the financial markets. In aggregate,
cryptocurrency market capitalization is approximately $200 billion.190 By
comparison, the U.S. equity market is approximately $32 trillion.191
Second, to date, cryptocurrency platforms have been standalone entities
instead of interconnected financial institutions.192 As such, it is unlikely
that the bankruptcy of a single cryptocurrency platform would trigger
cascading failures and pose systemic risk. Given cryptocurrency plat-
forms’ relatively small size and independence from other financial
institutions, the goal of capital requirements, like in the broker-dealer
context, need not be to avoid failures altogether but rather should be to
avoid significant customer losses in the event of a platform failure.
3. Bankruptcy and Insurance. — The bankruptcy regime for broker-
dealers also provides a strong framework for resolving failing cryptocur-
rency platforms. A SIPC-like liquidation procedure, in which customers
could receive their cryptocurrency rather than the dollar value of their
liquidated investments, would be an improvement over the traditional

188. See supra notes 84–85 and accompanying text.

189. Systemic risk refers to the risk of harm to the financial system as a whole. For
example, the failure of a large bank may have follow-on effects that adversely affect the
entire financial system. See Freixas et al., supra note 178, at 68–70 (describing how banks
pose systemic risk).
190. Steven Russolillo, Paul Vigna & Akane Otani, Cryptocurrency Market Plumbs
New Depths in 2018, Wall St. J. (Aug. 14, 2018), https://www.wsj.com/articles/
cryptocurrency-market-plumbs-new-depths-in-2018-1534241274 (on file with the Columbia
Law Review).
191. Sec. Indus. & Fin. Mkts. Ass’n, 2018 Fact Book 30 (2018), https://www.sifma.org/
wp-content/uploads/2017/08/US-Fact-Book-2018-SIFMA.pdf [https://perma.cc/W4WZ-
SLEA]. U.S. bond markets are even larger at $41 trillion. See Bonds Outstanding, SIFMA,
http://www.sifma.org/resources/research/bond-chart [https://perma.cc/P2FT-6F88] (last
visited Aug. 12, 2018).
192. This may change, as traditional financial players consider entering cryptocurrency
markets. See, e.g., Paul Vigna, Telis Demos & Liz Hoffman, Goldman Sachs Explores a
New World: Trading Bitcoin, Wall St. J. (Oct. 2, 2017), https://www.wsj.com/articles/
goldman-sachs-explores-a-new-world-trading-bitcoin-1506959128 (on file with the Columbia
Law Review) (“Goldman Sachs . . . is weighing a new trading operation dedicated to
[B]itcoin and other digital currencies, the first blue-chip Wall Street firm preparing to
deal directly in this burgeoning yet controversial market . . . .”).

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2350 COLUMBIA LAW REVIEW [Vol. 118:2323

bankruptcy process, which requires liquidation to cash.193 As discussed in

section II.C, customers holding cryptocurrency for investment purposes
would likely prefer to receive cryptocurrency in kind rather than the
dollar equivalent;194 a SIPC-like proceeding would enable this result.
In addition, a SIPC-like bankruptcy regime would help resolve any
uncertainty about whether customers’ claims are prioritized to those of
general creditors.195 Unlike debt or equity claimants in bankruptcy,
customers of cryptocurrency platforms are not “investing” in the
platform. Instead, they are entrusting their assets to the platform for
safekeeping. As such, their assets should be segregated from the general
estate in bankruptcy. A SIPC-like bankruptcy regime would achieve this
goal.196 Moreover, it would be incongruous to protect customers of
broker-dealers but not customers of cryptocurrency platforms because
investors may expect to receive similar protection in both contexts.
Finally, insurance akin to that provided by SIPC could help further
protect customers from losses. SIPC has been remarkably successful in
fulfilling its mandate to protect customer funds. From 1971 to 2016, only
356 out of 767,300 customer claims were unsatisfied; these 356 unsatis-
fied claims exceeded the dollar limits under SIPA.197 Finally, SIPC’s
funding model, based on assessments on broker-dealers,198 would ensure
that cryptocurrency platforms collectively bear the risk of their failures.
4. Potential for Private Solutions. — Some of the issues highlighted
above do not preclude the possibility of private solutions. While prob-
lems with the bankruptcy process for cryptocurrency platforms may
require changes to the bankruptcy code, problems regarding custody of
customer assets or inadequate capital do not necessarily require
governmental solutions. For example, a self-regulatory organization
(SRO)—a private organization that regulates its own industry199—could
set custody and capital requirements for member platforms and punish
members who violate those standards.

193. See supra note 110 and accompanying text.

194. See supra notes 160–163 and accompanying text.
195. See supra notes 169–174 and accompanying text (describing the uncertainty
around whether customers of cryptocurrency platforms are prioritized over general
creditors under current law).
196. See supra notes 104–107 and accompanying text (describing how customers are
prioritized over general creditors in a SIPC-managed liquidation).
197. See Norman S. Poser, James A. Fanto & Jill I. Gross, Broker-Dealer Law and
Regulation § 12.03[C], at 12-41 (4th ed. Supp. 2018).
198. See supra note 116 and accompanying text.
199. See Emily Hammond, Double Deference in Administrative Law, 116 Colum. L.
Rev. 1705, 1714–17 (2016) (describing the structure of self-regulatory organizations).

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2018] BROKER-DEALERS FOR VIRTUAL CURRENCY 2351

In fact, SROs have been prevalent in the securities industry for many
years.200 For example, before the advent of the net capital rule, the NYSE
required its members to hold a minimum amount of capital.201 Today,
the Financial Industry Regulatory Authority (FINRA), an SRO that
governs broker-dealers,202 enforces, among other things, the net capital
rule and customer protection rule.203 It is at least conceivable that an
SRO could play a similar role in the nascent cryptocurrency industry.204
There is some early evidence that cryptocurrency platforms may
privately establish industry standards. Several cryptocurrency exchanges
recently formed an SRO, the Virtual Commodity Association (VCA), to
oversee cryptocurrency marketplaces.205 The VCA hopes to establish “[a]
thoughtful SRO framework that provides a virtual commodity regulatory

200. See William A. Birdthistle & M. Todd Henderson, Becoming a Fifth Branch, 99
Cornell L. Rev. 1, 13–24 (2013) (describing the evolution of SROs in the securities
industry since before the New Deal).
201. See Molinari & Kibler, supra note 79, at 7–8. The NYSE’s rule proved inadequate
during the late 1960s in part due to inadequate enforcement by the NYSE. Id. This raises
the natural question whether private actors have adequate incentives to regulate
themselves. For a comparison of the differing enforcement incentives of SROs versus
government actors in the context of securities laws, see James J. Park, Rules, Principles,
and the Competition to Enforce the Securities Laws, 100 Calif. L. Rev. 115, 143–62 (2012).
Whether government regulators or private actors such as SROs are best suited to regulate
cryptocurrency platforms is beyond the scope of this Note.
202. See FINRA, About FINRA, http://www.finra.org/about [https://perma.cc/
TB2H-5SVU] (last visited Aug. 24, 2018) (“FINRA is dedicated to investor protection and
market integrity through effective and efficient regulation of broker-dealers.”). The SEC
oversees FINRA’s rulemaking and enforcement activities. See Hammond, supra note 199,
at 1734–39 (describing the SEC’s oversight of FINRA).
203. See Markham & Hazen, supra note 98, § 4.40 n.4 (“FINRA may, where a firm is in
violation of the net capital rule, direct it to cease operations, or it may impose other
restrictions.”); see also, e.g., Press Release, FINRA, FINRA Fines Wedbush Securities Inc.
$1.5 Million for Customer Protection, Net Capital Rule Violations and Related Failures
(Feb. 5, 2018), http://www.finra.org/newsroom/2018/wedbush-securities-fined-15-million-
customer-protection-net-capital-violations [https://perma.cc/Y87G-PWMJ] (describing fines
by FINRA for violations of the customer protection and net capital rules).
204. For a discussion of the viability of a cryptocurrency SRO, see Ryan Clements, Can
a Cryptocurrency Self-Regulatory Organization Work? Assessing Its Promise and Likely
Challenges, The FinReg Blog ( June 21, 2018), https://sites.duke.edu/thefinregblog/
2018/06/21/can-a-cryptocurrency-self-regulatory-organization-work-assessing-its-promise-
and-likely-challenges/ [https://perma.cc/C3E7-QHMF].
205. See Paul Vigna, Winklevoss Effort to Self-Regulate Cryptocurrency Gets Members,
Wall St. J. (Aug. 20, 2018), https://www.wsj.com/articles/winklevoss-effort-to-self-regulate-
cryptocurrency-gets-members-1534804308 (on file with the Columbia Law Review)
(describing the founding of the Virtual Commodity Association); see also Press Release,
Virtual Commodity Ass’n, The Virtual Commodity Association Working Group Has Formed
and Is Planning Inaugural Meeting (Aug. 20, 2018), http://www.businesswire.com/news/
home/20180820005066/en/Virtual-Commodity-Association-Working-Group-Formed-Planning
[https://perma.cc/HD6X-3KUL]; Virtual Commodity Ass’n, http://virtualcommodities.org
[https://perma.cc/6TYM-SGFX] (last visited Aug. 25, 2018).

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2352 COLUMBIA LAW REVIEW [Vol. 118:2323

program for the virtual commodity industry.”206 Along similar lines, a

trade group published industry best practices for digital asset exchanges,
including principles akin to those that animate the customer protection
rule—requiring cryptocurrency platforms to maintain unencumbered
custody of customer assets.207 Though it is too early to tell how these
private efforts will fare, they suggest that some cryptocurrency platforms
recognize the need for industry-wide rules and standards.

III. A FRAMEWORK FOR REGULATING CRYPTOCURRENCY PLATFORMS

In light of the parallels between broker-dealers and cryptocurrency
platforms described in Part II, this Part explores how the broker-dealer
regulatory framework could be applied to cryptocurrency platforms.
While a complete analysis of the intricacies of broker-dealer regulation is
beyond the scope of this Note, this Part argues that the broker-dealer
regulatory framework—as embodied by the customer protection rule, net
capital rule, and SIPC-managed liquidation process—can be applied to
cryptocurrency platforms with some caveats and modifications. The
sections consider each rule in turn.

A. Customer Protection Rule

The regulatory framework provided by the customer protection rule
can be applied to cryptocurrency platforms. Under such a rule, plat-
forms, like broker-dealers, would have to effectively segregate their own
assets from those of their customers. On a daily basis, cryptocurrency
platforms would have to obtain “physical possession or control” of
sufficient cryptocurrency to satisfy all of their customers’ claims.208
Separately, platforms would also have to maintain a cash reserve account
in an amount equal to the net amount of cash owed to customers.209
Cryptocurrency, however, poses two unique challenges to the
customer protection rule. First, as a digital asset, cryptocurrency does not
fit neatly within the “physical possession or control” requirement.
Second, as a “currency,” cryptocurrency is at least arguably subject to the

206. Cameron Winklevoss, Joining the Virtual Commodity Association, Medium (Aug. 20,
2018), http://medium.com/gemini/joining-the-virtual-commodity-association-8bdf3b2f803e
[https://perma.cc/HXV9-AK2L].
207. See Asia Sec. Indus. & Fin. Mkts. Ass’n, ASIFMA Best Practices for Digital Asset
Exchanges 24 (2018), http://www.asifma.org/uploadedfiles/resources/asifma%20best%
20practices%20for%20digital%20asset%20exchanges%20june%202018.pdf [https://perma.cc/
TY84-2XZE] (“Digital asset exchanges that . . . maintain custody or control of digital
assets . . . on behalf of a person must hold that same type and amount of digital assets . . .
owed to the person. Digital asset exchanges should not create a right of lien, offset or
encumbrance . . . with respect to user digital assets . . . .”).
208. 17 C.F.R. § 240.15c3-3(b)(1) (2018).
209. See supra notes 76–78 and accompanying text.

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2018] BROKER-DEALERS FOR VIRTUAL CURRENCY 2353

less stringent rules for cash, as opposed to securities, under the customer
protection rule.
1. Physical Possession or Control. — For a customer protection rule to
apply to cryptocurrency, the physical possession or control requirement
would have to encapsulate how cryptocurrency is held and stored.
“Physical possession,” literally construed, does not make sense in the
context of an asset that exists only in digital format.210 “Control,”
however, could potentially encompass how cryptocurrency platforms
hold virtual currency. Currently, control is statutorily defined: Broker-
dealers are deemed to be in control of securities when they hold
unencumbered securities in certain control locations, such as a clearing
corporation or bank.211 However, unlike broker-dealers, which hold
securities in control locations, cryptocurrency platforms typically manage
their own currency—that is, they store their own private keys.212
Platforms typically split their cryptocurrency between “hot wallets”
and “cold storage.”213 Hot wallets are connected to the internet and
therefore easy to access and use.214 Unfortunately, this also leaves them
vulnerable to hacks.215 As such, platforms keep the majority of their
cryptocurrency in cold storage.216 Cold storage refers to cryptocurrency
stored in a manner that is unconnected to the internet, such as on flash
drives or even physical paper.217 Cold storage mitigates the risk of

210. Cryptocurrency exists only on the blockchain, a digital ledger. See supra section
I.A.1 (discussing how cryptocurrency is held and transferred).
211. See 17 C.F.R. § 240.15c3-3(c) (defining the control locations where broker-
dealers can hold securities and satisfy the control requirement); Markham & Hazen, supra
note 98, § 5:4 (“The possession or control requirement means that broker-dealers must
have securities in physical possession or at one of several ‘central locations’ . . . .” (quoting
17 C.F.R. § 240.15c3-3)).
212. See supra notes 33–34 and accompanying text.
213. See, e.g., Security, Gemini, https://gemini.com/security/ [https://perma.cc/
K4EH-2XLX] (last visited Aug. 12, 2018) (describing how assets are split between a “hot
wallet” and “cold storage”); Security Practices, Kraken, https://www.kraken.com/
security/practices [https://perma.cc/KH9U-B8WW] (last visited Aug. 12, 2018) (“[N]ew
deposits go directly to cold wallets . . . . [C]oins that are needed to maintain operational
liquidity are stored in hot (online) wallets.”).
214. See Joseph Young, Storing Bitcoin in Exchanges and Hot Wallets Is Risky—What to
Do Instead, Cointelegraph (Aug. 4, 2016), https://cointelegraph.com/news/storing-bitcoin-
in-exchanges-and-hot-wallets-is-risky-what-to-do-instead/ [https://perma.cc/E3PF-AF8P]
(describing how hot wallets allow instantaneous sending and receiving of cryptocurrency).
215. See id.
216. See, e.g., Security, Coinbase, http://www.coinbase.com/security [https://perma.cc/
Z82W-WY55] [hereinafter Coinbase: Security] (last visited Aug. 12, 2018) (“98% of
customer funds are stored offline.”).
217. Immaculate Dadiso Motsi-Omoijiade, Financial Intermediation in Cryptocurrency
Markets—Regulation, Gaps and Bridges, in 1 Handbook of Blockchain, Digital Finance,
and Inclusion 207, 215 (David Lee Kuo Chuen & Robert Deng eds., 2018) (“Cold storage
services store client’s cryptocurrencies in a manner that is not connected to the Internet

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2354 COLUMBIA LAW REVIEW [Vol. 118:2323

hacking by storing cryptocurrency in an unhackable medium.218 In the

case of both hot wallets and cold storage, cryptocurrency platforms are
handling their own private keys, meaning they have access to and control
of their cryptocurrency.219 As such, the possession or control
requirement—if platforms are to be regulated similarly to broker-
dealers—should be interpreted so as to encompass both hot wallets and
cold storage. Perhaps “control” could be defined to include any form of
storage in which cryptocurrency platforms are managing their own
private keys and are therefore in control of their cryptocurrency.
2. Cash or Security? — A customer protection rule for cryptocurrency
platforms should not treat cryptocurrencies as cash. Given that the cur-
rent customer protection rule has separate regulations for securities and
cash, a potential issue is whether cryptocurrency might be considered
currency and therefore subject to the rules for cash as opposed to the
rules for securities. Setting aside the thorny issue of whether
cryptocurrencies are securities for purposes of federal securities laws,220 it
is clear that the customer protection rules for cash are inapposite for
cryptocurrency. First, calculations of how much cash broker-dealers are
required to set aside for customers are done on a weekly basis, as
opposed to a daily basis for securities.221 Weekly determinations could
expose platforms to serious shortfalls in cryptocurrency that could prove
difficult to make up during times of market turmoil. Compared to cash,
cryptocurrency is much more difficult to locate in a crunch.222 In
addition, the customer protection rule allows broker-dealers to indirectly
profit from their customers’ idle cash by sweeping customer cash into
money-market funds or bank deposits in return for a fee.223 The same

through various techniques such as the provision of paper wallets, flash drives and bespoke
hardware devices . . . .”).
218. See id. However, cryptocurrency stored in cold storage is costlier to retrieve. For
example, Coinbase’s cold storage is kept in safety deposit boxes and vaults, which could
prove costly and time consuming to retrieve. See Coinbase: Security, supra note 216 (“We
distribute [B]itcoin geographically in safe deposit boxes and vaults around the world.”).
219. See supra notes 19–20 and accompanying text.
220. For a brief discussion of the SEC’s current case-by-case approach to the question
of whether cryptocurrencies are securities for purposes of the federal securities laws, see
supra notes 123–124 and accompanying text.
221. See supra note 77 and accompanying text.
222. Cryptocurrency is relatively illiquid compared to most financial assets, meaning it
is comparatively difficult or costly to purchase or sell. See Simon Trimborn et al., Investing
with Cryptocurrencies—A Liquidity Constrained Investment Approach 9 (SFB 649
Discussion Paper No. 2017-014, 2017), https://www.econstor.eu/bitstream/10419/
169204/1/SFB649DP2017-014.pdf [https://perma.cc/AN2R-BVHX] (“[C]ryptocurrencies
have far lower daily trading amount than traditional financial assets, causing a liquidity
problem . . . .”).
223. Broker-dealers are permitted, with their customers’ consent, to sweep customer
funds into money-market funds or Federal Deposit Insurance Corporation (FDIC)-insured

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2018] BROKER-DEALERS FOR VIRTUAL CURRENCY 2355

principles, if applied to cryptocurrency, could prove problematic because

platforms may be incentivized to sweep customer cryptocurrency into
risky or illiquid investment vehicles in return for high fees. Because daily,
rather than weekly, determinations are more appropriate for illiquid
assets such as cryptocurrency, the stricter customer protection rule for
securities should apply to cryptocurrency.

B. Net Capital Rule

The basic framework for the net capital rule can be applied to
cryptocurrency platforms. As with broker-dealers, net capital for
cryptocurrency platforms would be net worth under GAAP with various
adjustments.224 First, net capital would exclude illiquid assets.225 Then,
platforms would apply predetermined haircuts—discounts to market
value—to their assets based upon the riskiness of those assets.226 The net
capital rule already supplies haircuts for securities, but there would need
to be a new haircut, approximating the price the broker-dealer would
receive for the asset during liquidation in distress, applicable to
cryptocurrencies.
Because the prices of cryptocurrencies are extremely volatile,227 the
haircut for cryptocurrencies would likely have to be quite high, reflecting
the potential for lower prices when cryptocurrency platforms seek to
liquidate their holdings. Currently, equity securities have the highest
haircut.228 The haircut for cryptocurrencies would likely have to be

bank deposits. Customers receive a higher rate of return from the money-market fund or
enjoy FDIC insurance on the bank deposit while the broker-dealer typically receives a fee
from the money-market fund or bank for sweeping customer cash to them. See 17 C.F.R.
§ 240.15c3-3(a)(17) (2018) (“Sweep Program means a service provided by a broker or
dealer . . . offer[ing] to its customer the option to . . . transfer free credit balances in the
securities account of the customer to either a money market mutual fund . . . or an
account at a bank whose deposits are insured by the [FDIC].”). See generally George
Tepe, Note, Broker-Dealer Use of “Idle” Customer Assets: Customer Protection with
Sweep Programs and Securities Lending, 2016 Colum. Bus. L. Rev. 823, 830–35 (discussing
how broker-dealer sweep programs make use of idle customer cash).
224. See supra notes 89–90 and accompanying text.
225. See supra note 91 and accompanying text.
226. See supra note 92 and accompanying text.
227. See, e.g., Jeffrey Chu et al., GARCH Modelling of Cryptocurrencies, J. Risk & Fin.
Mgmt., Oct. 1, 2017, at 1, 13 (“Our results show that cryptocurrencies such as Bitcoin,
Ethereum, Litecoin and many others exhibit extreme volatility especially when we look at
their inter-daily prices.”); Cameron Harwick, Cryptocurrency and the Problem of
Intermediation, 20 Indep. Rev. 569, 574 (2016) (“On stability of value, however,
cryptocurrencies reveal their inadequacy as day-to-day currency. . . . [T]he primary
impediment is purchasing-power volatility. Bitcoin, for example, . . . has suffered from
frequent and severe jumps and crashes since its inception in 2010.”).
228. Compare 17 C.F.R. § 240.15c3-1(c)(2)(vi)(J) (applying a 15% haircut to equities),
with id. § 240.15c3-1(c)(2)(vi)(A)–(K) (listing haircuts for various fixed-income securities).

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2356 COLUMBIA LAW REVIEW [Vol. 118:2323

higher than even the haircut for equity securities, reflecting their higher
volatility.229 In addition to a higher haircut for cryptocurrency, it also
makes sense to apply larger haircuts for undue concentration in certain
cryptocurrencies. With the proliferation of so many altcoins—some
individually quite small230—cryptocurrency platforms may hold a
significant portion of a given altcoin. Lack of liquidity when selling
concentrated positions is a potential concern, especially considering that
even the markets for larger cryptocurrencies can be relatively illiquid.231
A related issue is whether to apply a uniform haircut for all
cryptocurrencies or haircuts that vary by currency, reflecting the fact that
some cryptocurrencies may be less risky than others. Given the short
history of cryptocurrencies, a uniform haircut would likely be more
appropriate. Admittedly, the current net capital rule has crude risk
sensitivities: With minor exceptions, haircuts are set at the asset class
level, meaning there is no distinguishing between, say, stock of a high-risk
biotech startup and stock of a large utility company.232 Similarly, a
uniform haircut for cryptocurrencies would mean there would be no
distinguishing between different types of cryptocurrencies.
A more risk-based approach would adjust for riskiness within asset
classes. However, such an approach presents several problems. First, risk-
based capital requirements typically rely on models to determine the
amount of risk associated with an asset.233 For these models to work,
there must, at a minimum, be sufficient, representative historical data to
adequately calibrate the models.234 For example, in the prelude to the

229. See David Lee Kuo Chuen et al., Cryptocurrency: A New Investment Opportunity?,
J. Alternative Inv., Winter 2018, at 16, 21 (“CRIX [an index of cryptocurrencies] tends to
have a high return volatility compared to the S&P 500 [an index of large-capitalization
U.S. stocks].”).
230. See All Coins, supra note 27 (listing many cryptocurrencies with relatively small
dollar market capitalizations).
231. See Trimborn et al., supra note 222, at 9.
232. See 17 C.F.R. § 240.15c3-1(c)(2)(vi) (listing the applicable haircuts for various
types of securities). For bonds, haircuts also vary by maturity. See, e.g., id. § 240.15c3-
1(c)(2)(vi)(F)(1) (providing different haircuts for fixed rate nonconvertible debt
securities based on maturity). There are also further adjustments for undue concentration
and illiquid securities. See id. § 240.15c3-1(c)(2)(vi)(K), (M) (defining haircuts for
securities with a limited market or securities in which the broker-dealer has an undue
concentration).
233. See John C. Coffee, Jr. & Hillary A. Sale, Redesigning the SEC: Does the Treasury
Have a Better Idea?, 95 Va. L. Rev. 707, 742 (2009) (“[T]he investment bank generates a
mathematical model that crunches historical data to evaluate how risky its portfolio assets
were and how much capital it needed to maintain . . . .”).
234. See Erik F. Gerding, Law, Bubbles, and Financial Regulation 510–11 (2013)
(“Like every model . . . those used by regulators are only as good as their simplifying
assumptions. Moreover, models do not forecast risks adequately when the data on financial

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2018] BROKER-DEALERS FOR VIRTUAL CURRENCY 2357

financial crisis, banks likely misjudged the risk of mortgage-backed

securities in part because of poorly calibrated models.235 At this relatively
early stage of cryptocurrency’s development, risk-based capital require-
ments are unlikely to be effective because there are insufficient data with
which to adequately estimate risk. Bitcoin, the oldest cryptocurrency, has
been around only since 2009.236
Second, even if regulators could come up with different haircuts for
different types of cryptocurrency, risk-based capital requirements for
broker-dealers have seen mixed results at best. In 2004, the SEC
established the Consolidated Supervised Entity (CSE) program which
allowed the five largest broker-dealers at the time, including Bear Stearns
and Lehman Brothers, to use internal models to assess the amount of
risk associated with, and therefore the amount of capital required for,
each of the broker-dealers’ assets.237 By 2008, all five broker-dealers had
either failed or converted themselves into bank holding companies.238
This foray into risk-based capital requirements has been criticized for
being inadequate in the lead-up to the financial crisis.239 Given the poor
track record of risk-based capital requirements for broker-dealers and
the lack of adequate, representative price data for cryptocurrencies, a
uniform haircut for cryptocurrency is likely most appropriate.

institutions being inputted are shoddy. This is encapsulated by the old phrase ‘garbage in,
garbage out.’”).
235. See, e.g., Robert F. Weber, New Governance, Financial Regulation, and
Challenges to Legitimacy: The Example of the Internal Models Approach to Capital
Adequacy Regulation, 62 Admin. L. Rev. 783, 863 (2010) (describing a large bank’s
inadequate modelling of risks in its mortgage securitization business).
236. Comizio, supra note 17, at 133.
237. See Weber, supra note 235, at 830 (describing the CSE program); see also Coffee
& Sale, supra note 233, at 735 (discussing how the five major investment banks at the time
opted into the CSE program).
238. See Coffee & Sale, supra note 233, at 735.
239. See, e.g., id. at 740–41 (positing three reasons why the CSE program was
inadequate); Norman S. Poser, Why the SEC Failed: Regulators Against Regulation, 3
Brook. J. Corp. Fin. & Com. L. 289, 299 (2009) (criticizing the CSE program for allowing
investment banks to take on “extreme leverage”); Weber, supra note 235, at 834 (noting
that each of the major investment banks was adequately capitalized under the CSE
program despite facing mounting financial distress). Apart from broker-dealers, there is
similar criticism of the overreliance on internal risk models in determining capital
requirements for banks. See, e.g., Andrew G. Haldane & Vasileios Madouros, The Dog and
the Frisbee, in The Changing Policy Landscape: A Symposium Sponsored by the Federal
Reserve Bank of Kansas City 109, 126–31 (Richard A. Babson ed., 2013) (arguing that
simple leverage ratios—equity divided by total assets—were superior to risk-based capital
in predicting bank distress during the financial crisis of 2007–2008).

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2358 COLUMBIA LAW REVIEW [Vol. 118:2323

C. Bankruptcy and Insurance

Cryptocurrency platforms facing bankruptcy can be subject to a
SIPC-like liquidation scheme. In bankruptcy, the trustee would favor in-
kind distribution of cryptocurrency to customers as opposed to
liquidation to cash. This would avoid a scenario like the pending Mt. Gox
bankruptcy proceeding, in which customers might be deprived of the
appreciation of their Bitcoin investments because their claims are valued
as of the bankruptcy filing date.240 In addition, customers under a SIPC-
like liquidation scheme would be preferred to general creditors in
bankruptcy. Namely, cryptocurrency held on behalf of customers would
be used to satisfy customers only, not general creditors.
A SIPC-like insurance scheme could also be applied to cryptocur-
rency platforms. A potential problem, however, is the cost of such
insurance. Hacking is a significant and unique source of risk for
cryptocurrency platforms.241 Multiple platforms have failed or suffered
losses as a result.242 The cost of insurance might therefore be quite high.
Given the unique cost and risk of hacking, it would not be appropriate to
include cryptocurrency platforms under the jurisdiction of SIPC because
it would impose the cost and risk of hacking—unique to
cryptocurrency—upon traditional broker-dealers. Instead, an insurance
scheme for cryptocurrency platforms should be separate from SIPC and
funded by assessments on these platforms alone.

CONCLUSION
Cryptocurrencies have become one of the hottest new investments
in the past year. While cryptocurrency returns have been eye-popping,
cryptocurrency platforms have proved to be a significant source of risk
for investors: Platforms have failed at a high rate, and, in some cases,
customer losses have been significant. As more investors begin to trade
and hold cryptocurrencies through cryptocurrency platforms, so too
must regulation begin to address these new broker-dealers for virtual
currency. Left unaddressed, existing problems may fester.

240. See supra notes 165–168 and accompanying text.

241. See supra note 154 and accompanying text; see also Steven Russolillo & Eun-
Young Jeong, Cryptocurrency Exchanges Are Getting Hacked Because It’s Easy, Wall St. J.
(July 16, 2018), http://www.wsj.com/articles/why-cryptocurrency-exchange-hacks-keep-
happening-1531656000 (on file with the Columbia Law Review) (detailing cyberattacks on
cryptocurrency exchanges and their increasing frequency).
242. See Steve Stecklow et al., Chaos and Hackers Stalk Investors on Cryptocurrency
Exchanges, Reuters (Sept. 29, 2017), https://www.reuters.com/investigates/special-report/
bitcoin-exchanges-risks [https://perma.cc/EDY7-CCCN] (listing various cryptocurrency
hacks and associated losses).

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2018] BROKER-DEALERS FOR VIRTUAL CURRENCY 2359

Fortunately, history provides a useful guide for how to regulate these

entities. Broker-dealers in the 1960s faced many of the same problems
that are now arising among cryptocurrency platforms: high failure rates
and inadequate protection of customer assets. This Note argues that the
regulatory response to broker-dealer failures in the late 1960s—namely,
the customer protection rule, net capital rule, and SIPC bankruptcy
scheme—provides a strong regulatory framework for cryptocurrency
platforms.

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2360 COLUMBIA LAW REVIEW [Vol. 118:2323

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