In the world of finance, one of the first signs of success is when regulators fight over oversight. In that regard, cryptocurrencies have arrived.
At a recent panel in London regarding cryptocurrencies, Blockchain, and Initial Coin Offerings (ICOs), the experience from individuals (and/or their organizations) that had completed ICOs was that confusion reigned supreme around the regulatory and legal requirements of the ICO process and, generally, around the nascent “cryptoverse”.
They stated that great sums of money had been spent on expensive attorneys to receive confusing and often contradictory advice about how to conduct an ICO and not end up in jail. Furthermore, as the only American on the panel (other than the moderator), I was pressed as to why the regulatory landscape in the United States was particularly challenging.
The answer to the U.S. regulatory question lies, at least partially, with the multiple regulator system that we have in the United States. Each regulator has carved up the regulatory crypto pie based on its respective mandate (i.e., securities vs. derivatives) and issued rulings, opinions and/or guidance from its unique perspective and precedents. Unfortunately, while correct legally, this approach does not always yield perfectly clear regulation. Market participants are sometimes left to struggle with contradictory and confusing rules. So, they do what most rational people do and avoid the jurisdiction while looking for countries that have either favorable, or at least not confusing, regulations. In the meantime, the United States loses out on potential business as market participants seek shelter away from the Land of Confusion.
Dual Regulation Strikes Again
Two of the most powerful financial regulators in the United States (actually, one could persuasively argue that their power extends to the world), the Commodity Futures Trading Commission (CFTC) and the Securities & Exchange Commission (SEC) have been going back-and-forth since 2014 with rulings and guidance on the cryptoverse. For example, in September 2014, the CFTC granted TeraExchange, a swap execution facility (SEF), approval of a Bitcoin Swap. Around this time, various CFTC Commissioners, as well as former Chairman Tim Massad, stated that because bitcoin and all digital currencies were commodities, the CFTC had jurisdiction over these products.
Chairman Massad, in testimony before the Senate Agriculture Committee in December 2014 said that, “Derivative contracts based on a virtual currency represent one area within our responsibility.”
He went on to say that the CFTC defines commodities “very broadly,” which is consistent with the Commodity Exchange Act (CEA) – the CFTC’s guiding statute.
When the calendar rolled over to 2015, the CFTC’s docket was still busy with issues arising from the cryptoverse. Among other things, a new crypto-entity, LedgerX, submitted a SEF and an adjoining Derivatives Clearing Organization (DCO) application. LedgerX touted itself as “a new derivatives exchange and clearinghouse that will serve the digital currency market by offering physically settled swaps and options contracts.” LedgerX went on to point out that it would be the first exchange to offer physically settled bitcoin derivatives in the United States.
While the CFTC issued a few straight-forward Orders in connection with crypto-businesses during 2015 and 2016 (e.g., TaraExchange agreed to cease and desist failing to enforce its wash trading and prearranged trading rules on the SEF platform), the bulk of the interaction between the CFTC and the SEC began in the summer of 2017. After a two-year application process, the CFTC granted SEF status to LedgerX on July 6, 2017 and, a couple of weeks later, DCO status on July 24, 2017.
Additionally, the futures exchange associated with the Cboe Global Markets known as CBOE Futures Exchange (CFE) issued a statement around this time stating that it had entered into an agreement with the Gemini cryptocurrency exchange, owned and operated in part by the Winklevoss twins of Facebook fame, to launch cryptocurrency derivatives trading CFE has targeted a Q4 or early 2018 launch, but is waiting on CFTC approval.
The Summer of 2017
On July 25 2017, the SEC weighed in on the cryptoverse debate in a significant way. Through its Divisions of Corporation Finance and Enforcement, the SEC issued a Statement on the Report of Investigation related to the DAO (the DAO Statement). “DAO” was the name of the entity under investigation by the SEC and, to make matters more confusing, it is a descriptive title given to organizations that engage in and/or issue ICOs, to wit: “decentralized autonomous organizations” that use distributed ledger or Blockchain technology to operate as a “virtual” entity.
The SEC held that tokens issued from ICOs may be securities and subject to the securities laws and regulations of the United States. In the specific case of the DAO, the SEC stated that the tokens issued were securities. Also, the SEC stated that any secondary trading of tokens would likely have to occur on a National Securities Exchange or find an exemption, such as being traded on an Alternative Trading System (ATS). However, for reasons not made clear by the SEC, the regulator did not pursue an enforcement action against the DAO.
A quick word about tokens and cryptocurrencies. Tokens and cryptocurrencies are the same, but different. Tokens are more flexible than cryptocurrencies. Tokens can take on unique characteristics depending on how the issuer creates the token. So, for example, a token could be issued that primarily has the characteristics of cryptocurrency and/or a security in that it provides a return, is traded on a secondary market and fits the legal definition for security under the age-old “Howey test” , as well as currency (it’s defined as a commodity under the CEA). Are you beginning to see where some of the confusion begins?
A token can also be designated as a “utility” and, as such, not a security under the prevailing securities laws. For example, a token could provide services of some kind to the purchaser. Some tokens offer governance rights in the issuing entity. Knowing that there is no one-size-fits-all of tokens, the SEC indicated that it would have to decide whether a token is a security on a case-by-case basis. It is not clear at this time if a utility token is a “commodity” under the CEA.
An additional point to consider is that the CFTC’s jurisdiction is over the derivatives markets, so it shouldn’t bump into the SEC’s securities analysis. However, in conversations with former high-level CFTC officials, as well as based on CFTC precedent, the CFTC believes that it has jurisdiction over the cash markets of derivatives that it oversees. In 2008, for instance, the CFTC opened an investigation because of alleged manipulation in the silver market. In its five-year investigation, the CFTC reviewed not only derivatives trading, but analyzed the cash market, as well. It is not an unreasonable position to take that in order to properly regulate the derivatives market, the CFTC must be able to examine and potentially take action in the cash markets.
More recently, as if trying to one-up each other, both the CFTC and the SEC have filed enforcement actions in the cryptoverse. On Sept. 21, 2017, the CFTC filed a federal civil enforcement action against Nicholas Gelfman and Gelfman Blueprint Inc. alleging that the defendants operated a bitcoin Ponzi scheme. The defendants were charged with fraud, misappropriation and issuing false account statements in connection with solicited investments in bitcoin.
The SEC, on Sept. 29, 2017, filed an action against two companies, REcoin Group Foundation and Diamond Reserve Club (DRC World) alleging that they defrauded investors in a pair of ICOs that were supposedly backed by real estate (REcoin) and diamonds (DRC). The SEC stated that there was no real estate or diamonds within these companies and their advertisements were therefore fraudulent. Further, the SEC, via U.S. District Court Order, froze the accounts of these entities as they were continuing to solicit investors and receive funds.
Where Do We Go From Here?
Despite the confusion that exists in U.S. markets as to the cryptoverse, the bellwether currency, bitcoin, has performed quite well (worldwide). When viewing the most significant announcement by the U.S. regulators over the past three to four months, the SEC’s DAO Statement on July 25, 2017, it hasn’t negatively affected bitcoin in the least. At that time, bitcoin was trading at $2,591.22/per coin. On Oct. 12, 2017, bitcoin crossed the $5,000/per coin threshold and remained in that territory, closing on the popular CoinDesk Platform at $5,439.13 on Oct. 12, for the first time in its roughly nine-year history. So, in a mere 13 weeks – since the SEC issued what many at the time believed was bad news – bitcoin more than doubled in value.
That said, at least as to ICOs and yet-to-be-introduced inventions in the cryptoverse, the regulators in the United States need to work together with market participants in order to alleviate the confusion and encourage growth of the cryptoverse. Regulation, in and of itself, is not a bad thing for these markets despite the fact that the group given credit for the creation of bitcoin and blockchain, the cypherpunks, and their notoriously publicity-shy leader, Satoshi Nakamoto, who were by most accounts Anarchists or Libertarians, would vehemently disagree with my assertion (even though some degree of regulation has arguably helped boost bitcoin prices into the stratosphere making the cypherpunks multimillionaires).
The CFTC and the SEC (and other financial services regulators in the U.S. and around the world) must work together to embrace this amazing new invention with endless possibilities to improve not only the financial system, but the world.
The Howey Test
The “Howey test” is a test created by the Supreme Court for determining whether certain transactions qualify as “investment contracts”. If so, then under the Securities Act of 1933 and the Securities Exchange Act of 1934, those transactions are considered securities and therefore subject to certain disclosure and registration requirements.
These high level definitions are a combination of my thought process and experience along with descriptions provided on Dictionary.com
- Bitcoin is a type of digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank. Bitcoin is one of the most significant cryptocurrencies in the world at the moment and has the largest market capitalization at $93 billion as of Oct.13, 2017.
- Blockchain is a digital ledger in which transactions made in bitcoin or another cryptocurrency are recorded chronologically and publicly. Additionally, transactions or other items, such as birth certificates patent applications or land deeds, can be stored cryptographically on a blockchain. While the Bitcoin Blockchain is, perhaps, the most well-known blockchain, there are many blockchains in existence – some are public and others are private. The Bitcoin Blockchain is updated with new transactions approximately every 10 minutes. Whenever the Bitcoin Blackchain is updated the veracity of all of the previous transactions is re-confirmed.
- Cryptocurrencies, also referred to as “digital money”, “virtual currency” or “magic internet money” are digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, typically operating independently of a central bank.
- Cryptoverse is the name of a podcast adopted by industry players to describe the world of cryptocurrencies, blockchain and initial coin offerings, as well as anything else that is developed or invented in this space.
- Initial Coin Offering (ICO) is a means of crowdfunding via use of cryptocurrency or tokens, which are issued during a company’s ICO and is a source of capital for a start-up company. Many ICOs resemble the combination of Kick-starter and a traditional initial public offering. In an ICO, a percentage of the newly issued cryptocurrency or tokens (from the start-up company) is sold to investors in exchange for fiat currency (such as U.S. dollars or British Pounds) and/or other cryptocurrencies such as Bitcoin or Ethereum.
- Tokens are issued by companies, usually in connection with an ICO, as a form of currency to trade for fiat currency and/or other cryptocurrencies. Tokens can be created in several different forms – they can be securities or they can provide services to the buyer. These “service” coins are to as “utility tokens”.