Bates Research | 12-06-17
Did BitCoin Just Go Mainstream? The Challenge for U.S. Regulators is Getting Real
Only a few weeks ago, SEC Chair Jay Clayton made clear that trading in virtual currencies can present a significant risk to investors and poses unique regulatory challenges. He warned that investors are vulnerable to price manipulation and fraud because they may lack information about online platforms that list and trade virtual coins or tokens offered and sold in initial coin offerings (“ICOs”). He pledged to provide more clarity and transparency about the risks, and he promised the SEC would publish guidance for investors on standards, process, value and existing protections.
In the weeks since Mr. Clayton’s public commitment, bitcoin prices have soared, several CFTC regulated exchanges have announced that they will offer futures products based on the virtual currency, and a United States District Court issued an emergency injunction preventing a "recidivist securities law violator" from raising funds through an ICO.
Soaring BitCoin Market
According to a Wall Street Journal report, bitcoin prices have soared over 900% this year with swings of over 40% during short periods. This startling volatility presents both an allure and a danger for uninformed investors. Commenting on recent developments, an investment bank analyst recently lauded bitcoin as representing the emergence of a new asset class whose value is a “function of the breadth of its acceptance as a store of wealth and as a means of payment.”
Such enthusiasm could mask the significant differences between bitcoin and other traditional commodities. The bitcoin worldwide network is not managed by a central repository or administration. Transactions are intermediary-free and take place between users directly. Most distinguishing is the fact that the virtual network is reliant on advanced cryptography for identification, and distributed ledger technology (“blockchain”) for transaction verification. Such reliance carries substantial and unique cyber risk. (See Finra Primer on Bitcoin and Finra Report on Blockchain).
A Futures Market for Crypto-Currencies Emerges
For investors, the run-up in price belies the uncertainty of the legal and regulatory treatment associated with crypto-currencies. This week, some of that uncertainty may have abated as the Chicago Mercantile Exchange Inc. (“CME”) and the Chicago Board Options Exchange (”CBOE”) “self-certified” new contracts for bitcoin futures products. Self-certification is the first step in the process toward offering such products on the exchanges. CBOE will offer contracts referencing the auction price of bitcoin on a single exchange, CME will offer contracts referencing the weighted auction price across four exchanges, and the Cantor Exchange (Cantor) self-certified a new contract for bitcoin binary options. (See also, Bloomberg’s report on NASDAQ’s likely entry into the bitcoin futures trading market.) Upon the self-certification announcement, the CFTC published a fact sheet which discusses the nature of these complex products, and the agency’s role and limitations in oversight. Acknowledging legal limitations, CFTC Chairman J. Christopher Giancarlo stated:
“We have had extensive discussions with the exchanges regarding the proposed contracts, and CME, CFE and Cantor have agreed to significant enhancements to protect customers and maintain orderly markets. In working with the Commission, CME, CFE and Cantor have set an appropriate standard for oversight over these bitcoin contracts given the CFTC’s limited statutory ability to oversee the cash market for bitcoin.”
That said, the CFTC emphasized that the exchanges had committed to coordinating and sharing surveillance activities with the Commission. Further, the CFTC stated that it will monitor and analyze the development of the market, conduct reviews of designated contract markets (“DCMs”), derivatives clearing organizations (DCOs), clearing firms and individual traders involved in trading and clearing bitcoin futures. The CFTC also committed to working with the National Futures Association (NFA) member firms, merchants and introducing brokers who are involved in the trading of any virtual currency futures product. It is noteworthy that the CFTC offered an important disclaimer:
“the completion of the [self-certification processes]…is not a Commission approval. It does not constitute a Commission endorsement of the use or value of virtual currency products or derivatives. It is incumbent on market participants to conduct appropriate due diligence to determine the particular appropriateness of these products, which at times have exhibited extreme volatility and unique risks.”
As if to underscore the point, the NFA issued a contemporaneous Investor Advisory on crypto-currencies. (The SEC's Office of Investor Education and Advocacy issued an Investor Alert in August 2017 concerning fraud and initial coin offerings.)
SEC Cyber Unit Prosecutes First ICO Fraud Case
The timing may be coincidental, but an emergency injunction issued by the U.S. District Court for the Eastern District of New York shows that the regulators are serious about prosecuting investor fraud in crypto-currency. The new SEC Cyber Unit (see Bates report here) succeeded in securing an Order that prevents a "recidivist securities law violator" and his business partner from continuing to raise funds through an ICO. The defendants allegedly raised over $15 million by fraudulently marketing and selling securities as digital tokens, promising investors a 13-fold profit through listing the token on digital asset exchanges. The Complaint charges the defendants with violating SEC anti-fraud provisions, registration provisions, and other federal securities laws. The Cyber unit seeks permanent injunctions, disgorgement plus interest and penalties, and an officer-and-director bar from offering digital securities.
The development of the cyber currency marketplace is proceeding rapidly. It is clear that the CFTC Chair and the SEC Chair both understand the significance and are concerned about the limitations of their oversight over the new technology. They will, no doubt, test their authority with aggressive enforcement as the market continues to develop. Bates will keep you apprised.