Regulators Catching Up with the Crypto Craze

The Risk to Investors

Despite the proliferation of Bitcoin and other cryptocurrencies, financial regulators have been slow to introduce rules to govern them. Cordium’s Jesse Brown surveys the current state of regulation regarding investment in cryptocurrencies and ICOs and discusses the compliance considerations investors should make before pursuing investments in the crypto space.

Cryptocurrency and its applications within the financial industry are now mainstream news, and new instruments, products and price fluctuations capture the headlines daily. Many investors are eager to jump in, but the speed with which the underlying technology has developed means that regulatory bodies are working from behind, rushing to create rules governing the new types of investments that cryptocurrencies have given rise to. While some major markets, such as China, have banned digital currency exchanges entirely, developments in the United States suggest that regulators are pursuing less drastic measures, working to apply rules and oversight to the industry rather than imposing an outright prohibition.

The SEC Office of Compliance Inspections and Examinations recently announced that cryptocurrencies, initial coin offerings (ICOs), secondary market trading and blockchain are on its list of exam priorities for 2018. Given the mounting popularity and intense media attention directed at these issues, the SEC is under pressure to address possible regulation. Until they do so comprehensively, investors will be forced to navigate a patchwork regulatory structure based on isolated individual decisions and oblique signals. International rules create an entire additional set of issues.

To make sure they stay compliant, investors should take a cautious approach as they wait for additional signals from governing bodies about the classifications of these new instruments. And of course, it’s always important to be well-versed in the definitions and current regulatory status of the technologies and processes involved.

Cryptocurrencies

So what are cryptocurrencies, and are they regulated? Simply put, cryptocurrencies are a digital form of currency which can be used as a unit of exchange. Cryptocurrencies are currently being examined by regulators throughout the world to determine if they fall within their respective jurisdictions. While the SEC has yet to apply any of its existing regulatory guidelines to cryptocurrencies, they have stated that certain cryptocurrencies are within their jurisdiction depending on their uses and characteristics, which has led to the announcement of a focus on ICOs. The Internal Revenue Service (IRS) treats cryptocurrencies as a unit of account, meaning they do not have legal tender status. If an investor were to hold Bitcoin as an investment, it would be taxed as a capital asset, meaning capital gains and losses can apply.

Initial Coin Offerings

An initial coin offering is similar to an initial public offering (IPO). An ICO is a project in which raising capital is completed through issuing a cryptocurrency or token, which investors can purchase. These tokens are generally used as a form of currency within the company for products or services. If an ICO markets its tokens as having the ability to increase in value, those tokens can be considered securities by the SEC. As of December, no ICOs had been registered with the agency. This process is unregulated and may pose a threat to retail investors. Although many ICOs are legitimate business functions, the SEC warns that ICOs can defraud investors through misinformation and lack of transparency, aided by a lack of oversight from regulators. Ernst & Young has reported that 10 percent of the $3.7 billion raised in initial coin offerings has been lost or stolen.

In January, the SEC sued AriseBank for alleged fraud. AriseBank launched an ICO that promised investors the company was purchasing an FDIC-insured bank. The marketing campaign touted that the bank purchase would enable customers to have FDIC-insured accounts within a cryptocurrency-focused banking firm. The SEC claims that the token sale and nature of the ICO implied that the tokens will increase in value, making them fall under the SEC definition of a security. This action corresponds directly with the 2018 exam priorities announced by the SEC, and enforcement actions seem likely to continue. On February 28, news emerged of a sweeping SEC probe in which dozens of subpoenas and information requests were issued to companies involved in the cryptocurrencies market.

Regulatory Trends

Cryptocurrency speculation by retail investors is largely based on regulatory and media announcements. Recent extreme volatility in cryptocurrency markets has focused attention on what regulators will do to protect and inform everyday investors.

United States regulators have so far been open to the inclusion of cryptocurrencies in the financial system. However, the SEC has denied all cryptocurrency exchange-traded fund applications to date. Citing the number of unknowns in the space, the SEC is still examining its regulations to see if and how they apply to cryptocurrency products. Some foreign regulators, such as the China Securities Regulatory Commission (CSRC), have banned all cryptocurrency exchanges. This effectively prohibits cryptocurrencies in what would be their largest market. In South Korea, where the Won is one of the most common currencies used to trade Bitcoin, the Financial Services Commission has announced a focus on creating higher levels of transparency. It has taken this course rather than implementing a ban, as they had previously suggested. In the case of cryptocurrency products, the major financial regulators throughout the world are keeping close eyes on each other. Overall, we expect the SEC to continue engaging in enforcement actions against illegitimate cryptocurrency exchanges and ICOs in the near future, as they continue to act upon Chairman Jay Clayton’s assertion that “many promoters of ICOs and cryptocurrencies are not complying with our securities laws.”

In the meantime, it will be up to investors to use their best judgment and carefully vet incoming opportunities to ensure they are legitimate and in alignment with the investor’s objectives. As in most cases where new technology is accompanied by a media frenzy, the market is rife with get-rich-quick schemes and potential traps for investors. For those looking to remain safe and compliant, a healthy dose of caution is needed.