The Evolving Regulatory Framework: Are Virtual Currencies Securities or Commodities?
Regulators continue to grapple with how to oversee high-profile products using blockchain technology, particularly cryptocurrencies and initial coin offerings (“ICOs”). The marketplace for these products has grown significantly over the past few years through rapid technological change, and cryptocurrencies have increased as a source of capital raising. Such growth carries significant risks, such as fraudulent actors and failure to comply with established financial services regulations. The SEC and the Commodity Futures Trading Commission (“CFTC”) have been at the forefront of this scrutiny with several statements and enforcement cases over the past year.
Regarding securities law, the SEC has naturally raised the question as to whether virtual currency products and services are subject to those laws. The Commission has reviewed the use of virtual currencies on a case-by-case basis through established and traditional approaches to securities regulation. In a recent investigative report, the SEC stated unequivocally that “foundational principles of the securities laws” apply to virtual currency firms and those making use of distributed ledger technologies, such as blockchain1. Under a four-part test (known as the “Howey test”)2, ICOs will be deemed securities by the Commission if the transactions are:
- An investment of money;
- In a common enterprise;
- With a reasonable expectation of profits; and
- Profits are derived from the entrepreneurial or managerial efforts of others.
As noted, the SEC has found ICOs or token sales to meet each element of the Howey test through some key factual findings. First, an “investment of money” is not limited to cash, therefore digital currencies, such as Etherium or Bitcoin, meet the first element. Second, the content of promotional materials will be decisive in determining whether the investment occurs in a “common enterprise with a reasonable expectation of profits.” Key factors to consider include whether the investment included funding of projects in exchange for a return on investment. Finally, when determining if profits are derived from managerial efforts of third parties other than the investors, the Investigative Report cites the central issue is whether these efforts “are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.”3
The SEC is also concerned that investors, especially in retail, have a limited understanding of the risks involved in cryptocurrency products. The Commission has noted that cryptocurrency products are promoted in a similar manner as traditional financial services products, but contain unique risks such as4:
- Lack of government backing and support, unlike fiat currencies;
- No federal deposit insurance for cryptocurrency accounts (or wallets);
- Higher than usual volatility;
- Reliance on cryptocurrency companies that lack adequate internal controls; and
- Heightened cybersecurity or money laundering risk.
As for commodities regulations, the CFTC has taken a more direct approach by declaring virtual currencies, such as Bitcoin, commodities under the Commodity Exchange Act.5 The use of virtual currencies in derivative contracts invokes the CFTC’s jurisdiction, where firms may be required to register as swap execution facilities (“SEFs”), designated contracts markets (“DCMs”) or derivative clearing organizations (“DCOs”)6. Very recently, the CFTC also announced it will be mandating notification of transactions in virtual currencies or virtual currency derivatives7.
New and existing market participants in virtual currencies are urged to be diligent in exploring these regulatory issues. New sell-side market participants may be required to register as broker-dealers with the SEC and become members of the Financial Industry Regulatory Authority (“FINRA”). Buy-side firms managing cryptocurrency assets may be required to register with the CFTC as CPOs (fund managers of pools executing cryptocurrency transactions) and/or CTAs (trading programs including cryptocurrencies for managed accounts). Existing market participants will need to observe regulatory guidance and watch for additional registration and reporting requirements.
What’s the upshot of these pronouncements? Simply put, if you are a financial firm subject to these laws and regulations, you must properly register your firms with the SEC and/or CFTC and become members of FINRA and/or the NFA. Registration processes can take several months, and firms must have detailed business plans explaining the use of cryptocurrency products. The business plan is particularly important to fit virtual currency products within regulatory constructs dating back decades when technology was far less advanced. Policies and procedures must be created and implemented to cover various topics, including but not limited to codes of ethics, marketing and advertising, anti-money laundering, cybersecurity, business continuity planning and operations/ trading requirements. As regulators increase scrutiny, existing and new market participants can expect greater reporting requirements.
No doubt, financial services firms will need to consult legal counsel to determine whether their cryptocurrency activities implicate securities laws. More importantly, firms must consider the scope of their business activities and plan for potential regulatory scrutiny.
1. Securities and Exchange Commission, Securities Exchange Act of 1934, Release No. 81207/July 25, 2017. Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (“Investigative Report”).
2. See SEC v. Howey Co., 328 U.S. 293 (1946). The Supreme Court interpreted the meaning of an “investment contract” under the Securities Act of 1933.
3. See Investigative Report, citing SEC v. Glenn W. Turner Enters., Inc., 474 F.2d 476, 482 (9th Cir. 1973). The SEC cites limitations on voting rights as indicative of relying on management by third parties.
4. See North American Securities Administrators Association (“NASAA”), January 4, 2018, NASAA Reminds Investors to Approach Cryptocurrencies, Initial Coin Offerings and Other Cryptocurrency-Related Investment Products with Caution.
5. In the Matter of Coinflip, Inc. d/b/a Derivabit, and Francisco Riordan, CFTC Docket No. 15-29, September 17, 2015.
6. See A CFTC Primer on Virtual Currencies, October 17, 2017, where permitted activities under commodities law may require firms to register with the CFTC as SEFs, DCMs or DCOs.
7. See National Futures Association (“NFA”) Notice to Member I-17-28, December 14, 2017. Additional reporting requirements for Commodity Pool Operators (“CPOs”) and Commodity Trading Advisers (“CTAs”) that trade virtual currency products.
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