Synthetic or simulated trading has become increasingly popular in the crypto industry as a means for aspiring traders to learn the mechanics of (ideally) becoming profitable traders. While neither the Securities Act or Commodities Act specifically regulate the providers of synthetic trading environments, as with nearly all regulation concerning crypto, one must look to past enforcement actions to understand the potential pitfalls of marketing such a business.
The two “flash points” when conducting an analysis of whether or not a synthetic trading platform is viable are:
- Does the synthetic trading platform allow for the virtual trading of cryptocurrencies that could be considered securities?; and
- Does the synthetic trading platform allow traders to earn a percentage profit based on virtual trading performance?
A security-based swap (SBS) is a type of financial derivative that is based on the price or value of one or more securities. It is a hybrid financial instrument that combines features of both securities and swaps. Unlike traditional security swaps that involve non-securities assets like commodities or currencies, security-based swaps are directly linked to securities, such as stocks, bonds, or other investment instruments. These swaps allow investors to gain exposure to the price movements or performance of the underlying securities without owning the actual securities themselves.
There are two (2) relevant regulations governing security-based swaps in the Securities Act:
- Section 5(e) of the Securities Act, which makes it unlawful for any person to offer to sell, offer to buy or purchase or sell a security-based swap to any person who is not an eligible contract participant without an effective registration statement. 15 U.S.C.§ 77e(e). This requirement is intended to ensure that persons who are not eligible contract participants receive financial and other significant information to allow them to properly evaluate a transaction involving security-based swaps.
- Section 6(l) of the Exchange Act, which makes it unlawful for any person to effect transactions in security-based swaps to any person who is not an eligible contract participant unless the transaction is effected on a registered national securities exchange. 5 U.S.C. § 78f(l).
Synthetic Trading & Security-Based Swaps
If the synthetic trading platform allows traders to virtually trade security tokens together with providing for a “reward” tied to the profits earned on the virtual platform, the provider may unknowingly be creating and issuing a security-based swap. That is, a funded synthetic trading account constitutes a swap because it could provide payments based on the value or level of securities while assuming the financial risk associated with a future change in such value or level. The trading platform provider has now, arguably and perhaps unintentionally, violated Section 5(e) and Section 6(I).
First, providers of synthetic crypto trading platforms can allay most, if not all, regulatory concern by not allowing trading in security tokens. This is, of course, a herculean task given the current regulatory environment which seemingly reclassifies tokens every other day.
Second, “gamify” the synthetic crypto trading platform. In lieu of providing for a return equal to a percentage of virtual profits, reward traders on a milestone basis. Or, alternatively, reward traders on a peer-to-peer contest basis.
A great real world example of this is https://emberfund.io
Running a trading education platform can be wildly profitable and the most profitable among them offer synthetic trading environments – whether it be in crypto, equity, forex, etc. But doing so is not without its regulatory hurdles, albeit perhaps not a major enforcement priority for regulators.
My company offers services related to structuring synthetic trading environments. Be sure to reach out should you have any questions.
Otherwise, you can book a meeting here.
About Adam Tracy
Adam Tracy is a payments expert and entrepreneur who specializes in payment systems, blockchain technology, digital currencies, and other emerging technologies. He is the founder of Blockrunner, LLC that provides consulting services to clients in the blockchain, payments and cryptocurrency arenas.
Tracy has been involved in the payments industry as an attorney, consultant and entrepreneur since 2005, while he was become an expert in blockchain and cryptocurrency since its advent in 2013. Tracy has worked with a wide range of clients, including startups, established businesses, and investor – both in the United States and worldwide. He has advised clients on a wide range of compliance, legal and operational issues related to payment transfer systems, crypto token generation and architecture, cryptocurrency exchanges, regulatory licensing, smart contracts, and other blockchain applications.
In addition to his consulting work, Tracy has founded several companies in the payments, blockchain and cryptocurrency space, including a digital asset hedge fund, licensed electronic money institution and a blockchain-based tokenization platform. He is also a proponent of decentralized finance (DeFi) and has been involved in various DeFi projects.
Tracy is also a frequent speaker and writer on blockchain and cryptocurrency topics. He has been featured in a wide range of publications, including Forbes, Hollywood Reporters, CNBC, Reuters, CoinDesk, and Bitcoin.com.
Find Adam: https://linktr.ee/adamtracy
Blockrunner, LLC., is a financial services match-making marketplace and consulting company. We are not a bank, FI/NBFI, Payment Service Provider, deposit taking institution, trust, or money services business of any kind. We are not regulated by any financial regulator. Banking, Payment, Processing, and Licensing services are provided by our participating members. This website is for informational purposes only and does not constitute legal advice. If you need legal advice, please consult a licensed attorney in your jurisdiction.