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” (see “Howey Test” page 1), 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.
James M. Falvey is a consultant with Bovill, a specialist financial services regulatory consultancy with offices throughout the world.