Bates Research - 05-10-18
Inching Toward A Common Approach to Cryptocurrency Regulation?
Movement toward a common approach by U.S. regulators on digital currency may be slow (sometimes imperceptible), but new developments are keeping up the momentum. Treasury, CFTC and SEC regulators are speaking about the need to coordinate, courts are recognizing authorities and state attorneys are exerting pressure. Here are some developments.
Is FSOC the Answer?
Last week, CFTC Commissioner Rostin Behnam became the latest regulator to propose a way forward during the FIA Conference, stating that the Financial Stability Oversight Council (FSOC) was the right body to focus on “cryptocurrencies, but also examine financial technology’s impact on payment systems, artificial intelligence, blockchain, and identity verification.” In prepared remarks, he argued: “the interests of regulators, the markets, and market participants should be aligned when it comes to building legal certainty…Anything less than decisive action by policymakers in the short term will leave us all scratching heads, pointing fingers, and asking who, what, when, and how.”
The Commissioner’s statement follows on the heels of Treasury Secretary Steve Mnuchin’s announcement of an FSOC working group on these issues. (See Bates’ coverage here). The FSOC is led by the Treasury Secretary and includes, among others, the CFTC, the SEC, the Federal Reserve and the Comptroller of the Currency.
SEC and CFTC: You Say Security, I Say Commodity
In late January, SEC Chair Jay Clayton and CFTC Chair J. Christopher Giancarlo penned a joint op-ed in which they declared that “[m]any of the internet-based cryptocurrency-trading platforms … are not subject to direct oversight by the SEC or the CFTC” and pledged to “work together to bring transparency and integrity to these markets and, importantly, to deter and prosecute fraud and abuse.” Over the past few months, that focus has been evident in the robust enforcement actions taken by both regulators.
In a widely reported move, the SEC issued subpoenas and requests for information to over eighty technology companies and advisers. On March 7, only a few weeks later, the SEC issued a statement on “Potentially Unlawful Online Platforms for Trading Digital Assets." By these actions, the SEC sent a signal that it was asserting authority over the cryptocurrency marketplace.
These and other SEC enforcement efforts ultimately hinge on whether tokens and cryptocurrency are classified as securities and thus subject to regulation by the SEC. That determination could be made relatively soon, as it is a central question in a much publicized matter involving the second-most valuable cryptocurrency after Bitcoin, Ethereum. Regulators from the CFTC and the SEC are said to be working together to determine whether Ethereum’s cryptocurrency, Ether, should be considered a security. (For an additional discussion of the underlying issues in the Etherium probe see here).
Cryptocurrency venture capitalists and others are bracing for the possibility that cryptocurrency will be regulated as securities, but they may be surprised. A more conciliatory SEC approach may have been revealed at an April 26 House Financial Services oversight hearing. The SEC’s Division of Corporation Finance head William Hinman “assured listeners that [SEC] representatives are trying to view the situation openly and see which [cybercurrency] entities might exhibit utility-based behaviors.” He called for a “balanced approach” to cryptocurrency regulation in which a token that is bought for its utility would not be treated the same way as a token bought as an investment.
Federal Court Says Cryptocurrency Is A Commodity, but…
Meanwhile, in early March, the United States District Court for the Eastern District of New York weighed in on whether cryptocurrency should be considered a commodity or a security for purposes of applying anti-fraud regulations. The Court concluded that “virtual currencies can be regulated by CFTC as a commodity.” (Decision on pp. 24-26)
This first-time judicial finding establishes that the CFTC has “standing to police fraud in virtual currency spot markets.” However, the Court acknowledged that “some products that are labeled cryptocurrencies have characteristics that make them securities.” In a determination that has implications in the SEC matter above, the Court stated that “the jurisdictional authority of CFTC to regulate virtual currencies as commodities does not preclude other agencies from exercising their regulatory power when virtual currencies function differently than derivative commodities.” Presumably, this means that other federal and state regulatory authorities (i.e. SEC, FinCEN, state regulators) have concurrent jurisdiction over different aspects of cryptocurrency.
OFAC Issues FAQs
Compliance questions concerning virtual currency transactions were addressed in a set of FAQs published by the U.S. Treasury Department's Office of Foreign Assets Control (OFAC). The FAQs define terms (e.g., digital currency wallet, digital currency address, etc.), require compliance with the Specially Designated Nationals and Blocked Persons (SDN) lists (which may now include digital currency addresses) and set forth sanctions for illicit digital currency transactions. The National Futures Association (NFA) recently counseled member firms “to ensure that their AML programs address OFAC regulatory obligations as they relate to virtual currency transactions and the use of digital currency wallets.” Most of the industry concerns about these FAQs center on the implications of requiring firms to self-police the illicit activity on the blockchain and whether the level of diligence currently being conducted on digital currency addresses by firms and U.S. persons subject to the Bank Secrecy Act is sufficient.
New York Does It Again
On April 17, the New York Attorney General stepped into the cryptocurrency fray by launching a “Virtual Markets Integrity Initiative,” a “fact-finding inquiry into the policies and practices” of platforms that trade cryptocurrencies. The Attorney General sent a questionnaire to thirteen major virtual currency trading platforms requesting information on their operations, internal controls, and safeguards to protect customer assets. The purpose of the initiative, he said, was to “better inform enforcement agencies, investors, and consumers,” and the compiled responses will be published. The Initiative follows on the heels of new New York Department of Financial Services guidance that requires virtual currency exchanges to have comprehensive policies to identify, stop and report fraud, such as market manipulation. It is not clear at this time whether the Attorney General’s recent departure will affect the initiative.
Another state development worth noting is in Wyoming. Legislators there are engaged in efforts to “ease regulatory burdens at the state level for blockchain and digital asset ventures.”
Federal regulatory actors, the SEC and the CFTC, have been publicly expressing their intention to collaborate on a common approach to cyber currency regulation that embraces innovation and protects investors. Matters affecting key players like Ethereum will indicate whether they can work together. Commissioner Benham’s proposal to make FSOC the lead could be a step toward creating an approach that could work for federal agencies and the states.
All of this, however, may simply be wishful thinking. “The regulatory landscape surrounding digital assets is very much still a work in progress, and while the competition among regulators will ultimately help stabilize and legitimize these markets, it places a large burden on firms not only to comply with regulations, but to guess where those regulations might be headed,” said Bates Group Director Alex Russell, “Until the day arrives when there is a consistent and coordinated approach, Bates will continue to support our clients in managing the potential risk associated with this new class of assets.”
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