The last two weeks have seen important regulatory movement on Initial Coin Offerings (ICO’s) and online digital trading platforms, which not only have important implications for historical offerings and existing trading platforms, but also for token-driven blockchain startups. These go to the heart of the ICO and blockchain enterprise, and could present considerable financial and regulatory hurdles to the blockchain industry.

The last several months has produced a flurry of ICO’s looking to capitalize on the increasing popularity, and speculation in virtual currencies, including Bitcoin and Ether. Some ICO issuers have in this process appeared to flout existing securities laws by publicly offering tokens in sales and pre-sales without registration or exemption from registration under Securities and Exchange Commission (SEC) rules.

To further cultivate liquidity in ICO tokens, which tend to be securities, unregulated platforms have emerged to trade these tokens. This is despite the tokens being ‘restricted securities’ incapable (other than in defined circumstances) of transfer, and there being long standing securities laws prohibiting unregulated securities exchanges. Some ICO issuers, while claiming that their tokens are not ‘securities’, nevertheless sought to benefit from these unregulated exchanges and the speculation in their tokens that this would entail, while using ICO proceeds to fund startup or existing business operations.

The SEC has previously come out strongly against the attempt to classify ICO tokens as ‘utility’ tokens and not securities. Given existing securities law definitions of what constitutes a security, it is hard to envisage a circumstance in which ICO tokens would not be a security. The current environment of increased SEC and other regulatory enforcement bears this out.

Now, in this environment of heightened enforcement, the SEC in its March 7th, 2018 Public Statement, has come out expressly to warn investors to take care in using online cryptocurrency or other digital asset trading platforms and to ensure that the platform, or persons effecting trades in the digital assets are approved or registered with the SEC.

The SEC, in the statement, notes that there are a number of online trading platforms which appear to be regulated and registered with the SEC, but in fact do not have the benefit of SEC review, oversight and trading protocols afforded to regulated national securities exchanges, alternative trading systems (ATS) or licensed brokers. The SEC points out that there are considerable pitfalls in trading on these unregulated and illegal platforms, including in relation to the quality and standard of the digital assets traded, inequality in access to trading services and disparity in, and lack of information integrity. The SEC also listed a number of questions which investors should ask for their protection before trading digital assets on online trading platforms, including specifically asking whether the platform operates as a national securities exchange or ATS. The SEC maintains lists of current national securities exchanges and ATS.

Securities regulation is only one aspect of the legal and regulatory matrix impacting virtual currencies, and it is not only the SEC that is sharpening its regulatory focus. Other agencies, including FinCEN and the Commodities Futures Trading Commission (CFTC) are actively expanding enforcement action, and cryptocurrencies are receiving considerable congressional attention.

This is reflected in the second recent important development, which came in the form of a letter addressed by Drew Maloney, Assistant Secretary for Legislative Affairs with the Department of the Treasury, to US Senator Ron Wyden, dated February 13th, 2018 (DOT Letter), but only recently published. Mirroring the now keen interest of legislators in cryptocurrencies, particularly in combatting money laundering and other criminal and terrorist activity, the DOT Letter focusses on the steps being taken by the Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN) in administering the Bank Secrecy Act (BSA) in so far as it relates to virtual currencies.

The DOT Letter, while not, in itself, a formal ruling or guidance, for the most part repeats previous FinCEN rules and guidance regarding the treatment of virtual currency issuers as Money Services Businesses (MSB’s), and, more particularly within that classification, money transmitters. MSB’s are required to comply with the BSA’s strict registration and reporting requirements, including filing suspicious activity, currency transaction and other reports, preparing written anti-money laundering compliance programs and obtaining customer identification information required under anti-money laundering and combatting-the-financing-of-terrorism programs and rules.

The DOT Letter further repeats the distinction used in previous guidance between virtual currency ‘exchangers’ and ‘administrators’. An ‘exchanger’, in accordance with FinCEN’s March 18, 2013 interpretive guidance, is “…a person engaged as a business in the exchange of virtual currency for real currency, funds or other virtual currency”. The guidance also defines ‘administrator’ as a person “…engaged as a business in issuing (putting into circulation) a virtual currency, and who has the authority to redeem (to withdraw from circulation) such virtual currency.” The guidance further goes on to say that “…[a]n administrator or an exchanger that (1) accepts and transmits a convertible virtual currency; or (2) buys or sells convertible currency for any reason is a money transmitter…” and accordingly an MSB subject to the compliance requirements.

Nevertheless, the Code of Federal Regulations (CFR) definition of ‘money transmitters’ expressly states that “…[w]hether a person is a money transmitter as described in this section is a matter of facts and circumstances. The term “money transmitter” shall not include a person that only …[a]ccepts and transmits funds only integral to the sale of goods or the provision of services… by the person who is accepting and transmitting the funds.” (Goods and Services Exception).

Despite this exception, the DOT Letter goes on to state that : “[g]enerally, under existing regulations and interpretations, a developer that sells convertible virtual currency, including in the form of ICO coins or tokens, in exchange for another type of value that substitutes for currency is a money transmitter and must comply with AML/CFT requirements that apply to this type of MSB. An exchange that sells ICO coins or tokens, or exchanges them for other virtual currency, fiat currency, or other value that substitutes for currency, would typically also be a money transmitter” .

While this statement demonstrates the separate enforcement perspectives that the SEC and FinCEN have when it comes to virtual currency exchanges, the question here is how this relates to the Goods and Services Exception. While ICO issuers may well be money transmitters (as, for instance, administrators), it is not clear whether this broad brush should apply to any “developer” of virtual currencies “ …that sells convertible currency,... in the form of ICO coins or tokens” (our emphasis). Does this go beyond the essence of the pure ‘currency’ nature of tokens in an ICO sale, to extend to blockchain businesses which use tokens to drive the sale of their goods and services?

Left unclarified, this could potentially present a challenge for blockchain startups and innovators who rely on ‘Minimum Viable Product’, and whose very ethos is lean technology and product development. To these businesses, the need to comply with FinCEN MSB requirements would be daunting and could serve to stifle innovation in what the DOT Letter itself recognizes as “…positive financial innovations associated with this technology…”.

This last week has further brought to light the disparate views in Congress on virtual currencies, which, reportedly, range from outright condemnation of cryptocurrencies as a “crock” and “popular with guys who want to sit in their pyjamas and tell their wives they’re going to be millionaires” to others praising the technological advances that have been made, and are promised with blockchain and emphasizing the need to fine tune regulation with a clear understanding of the technology and its promise.

J. Christopher Giancarlo, Chairman of the CFTC, reportedly said recently, “[i]t is important to remember that if there was [sic] no Bitcoin, there would be no blockchain.”. It remains to be seen whether virtual currency regulation will take a separate path to pure blockchain regulation. The months ahead may give us an idea of how the regulatory landscape will develop.

There is a real need now not to throw the baby out with the bathwater and insure that innovation is not overwhelmed by regulation.