Who’s on First, What’s on Second – Who is Regulating ICOs, Cryptocurrencies and Exchange Platforms?
Abbott and Costello’s famous routine — Who’s on First, What’s on Second — puts cryptocurrency regulation and enforcement risks in perspective. Here is the classic comedy routine.
When new technologies appear on the scene, Washington regulation is sure to follow. The exact configuration can take years to sort out, especially when it comes to financial products, given the labyrinth of regulatory bodies seeking to lay claim to regulatory jurisdiction over new technologies.
With the advent of virtual currencies and blockchain, there is no question that these new technologies will have (and already are) a significant impact on our economy. To explain the simplicity of the idea, consider this – when we conduct financial transactions, historically these transactions occur with the assistance of a financial intermediary, such as a bank, savings and loan, or other institution that we use to transfer money from one individual or entity to another individual or entity. (Paypal, Venmo and other payment platforms have developed as well, but again serve as an intermediary). The transactions are recorded and maintained by the intermediary financial institution or platform.
In a blockchain world, financial transactions are recorded using a decentralized, distributed ledger technology, meaning that everyone will have access to that blockchain ledger for a particular function. Individual transactions can be arranged and recorded on the blockchain. The security of the blockchain is purportedly immutable and protected from alteration. Real-time recording of transactions will occur on this format.
Luckily, we are not facing a world of blockchain immediately since it’s still not completely understood and the last few kinks are being worked out. So, we are not facing a world where regulation of blockchain has to be resolved as soon as possible.
In the meantime, we are facing a world where regulatory jurisdiction is being crafted for ICOs, cryptocurrencies and trading platforms. Let’s take a look at these three categories.
Initial Coin Offerings – The Securities and Exchange Commission has entered the ICO market to regulate the initial offerings of virtual currencies. From my perspective, this was just in the nick of time. I would never condemn an entire market for fraudsters and Ponzi schemers, but the ICO market was quickly attracting some brazen and greedy actors. The SEC realized this, provided some strong public statements defining most, if not all, ICOs as a “securities” offering and subjecting the industry to much-needed regulation. The SEC has now pushed the industry to define what it is they are selling and to disclose the relevant risks. At the same time, the SEC launched a number of separate investigations and enforcement actions against ICO operators to subject them to federal securities laws.
Once defined as a “security,” market participants who sell coins and other cryptocurrencies will have to comply with applicable broker-dealer registration requirements and regulations. The SEC has asserted jurisdiction over ICO coin offerings as a way to aise capital and will treat them as securities offerings or apply exemptions from securities registration requirements (e.g. Regulation D offering).
Exchanges and Trading Platforms – Bitcoin and other cryptocurrencies have experienced rapid growth. These markets – whether local, national or global – are rapidly attracting investors. In regulatory parlance, the term “cryptocurrencies” is used to describe “a substitute or replacement for dollar currency.” As a digital asset, one must generally rely on an online service or marketplace to facilitate trades.
The SEC has begun to pull cryptocurrency exchanges and trading platforms under its ambit. In a March 7, 2018 memo, the SEC very clearly stated:
A number of these platforms provide a mechanism for trading assets that meet the definition of a “security” under the federal securities laws. If a platform offers trading of digital assets that are securities and operates as an “exchange,” as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration.
This memo follows its recent enforcement action against the BitFunder platform. This platform was unique in that it didn’t directly trade cryptocurrency, but rather allowed users to contribute Bitcoin to a central fund and then invest in various “assets.” A series of cybersecurity breaches and a variety of other criminal missteps contributed significantly to this action. However, it brought the Commission’s focus onto the area and note that many of these services may actually be operating as an “exchange” as defined by federal security laws.
The CFTC’s history with virtual currencies has been consistent – in 2015, the CFTC determined that virtual currencies such as Bitcoin is a “commodity” for purposes of the Commodity Exchange Act. The CFTC, however, does not have regulatory jurisdiction over markets or platforms conducting cash or “spot” transactions in virtual currencies. No federal regulator has jurisdiction over these trading platforms.
Notwithstanding this limitation, the CFTC has enforcement authority to investigate and bring civil enforcement actions against fraud and manipulation in virtual currency derivatives and in underlying virtual currency spot markets.
In the derivatives market, the CFTC has regulatory and enforcement jurisdiction in the United States. The CFTC can impose registration requirements and compliance with market surveillance requirements, as well as reporting and monitoring and standards for conduct, capital requirements and platform and system safeguards.
The CFTC already has exercised its enforcement authority – in 2015, it took action to prohibit wash trading (when an investor simultaneously sells and buys the same financial instrument to create misleading, artificial activity in the market) and prearranged trades on a virtual currency derivatives platform; in 2016, the CFTC took action against a Bitcoin futures exchange that failed to register with the CFTC. In 2017, the CFTC brought enforcement actions against perpetrators of fraud, market manipulation and disruptive trading, including My Big Coin Pay (here), The Entrepreneurs Headquarters Limited (here), and Coin Drop Markets (here)