In an op-ed published in the Wall Street Journal on January 24, 2018, Jay Clayton, the Chair of the US Securities and Exchange Commission (SEC), and J. Christopher Giancarlo, the Chair of the US Commodity Futures Trading Commission (CFTC), warned that while some market participants may make a fortune by investing in initial coin offerings (ICOs), the risks are high and that “[c]aution is merited.” They described the challenges of monitoring and regulating cryptocurrency activities. For example, they note that federal authority to apply anti-money laundering rules to these activities is clear, but the ability to regulate other aspects of this market is “murkier.” Acknowledging that distributed ledger technology “may in fact be the next great disruptive and productivity-enhancing economic development,” the regulators made it clear that they “will not allow it or any other advancement to disrupt our commitment to fair and sound markets.” The SEC’s website published excerpts of the op-ed article.
The op-ed by Chairman Clayton and Chairman Giancarlo followed closely on the heels of a joint statement by the enforcement divisions of the two agencies, issued just days earlier, that they will aggressively pursue fraud cases involving digital assets. The joint statement succinctly stated that, “When market participants engage in fraud under the guise of offering digital instruments – whether characterized as virtual currencies, coins, tokens, or the like – the SEC and the CFTC will look beyond form, examine the substance of the activity and prosecute violations of federal securities and commodities laws.”
Federal and State Enforcement
It was certainly no mere coincidence that at the same time the CFTC announced enforcement actions involving cryptocurrency fraud.
One complaint charged a cryptocurrency sponsor with fraud and misappropriation in connection with purchases and trading of Bitcoin and Litecoin. The CFTC alleged that the promotor induced customers to send money and virtual currencies, purportedly for trading advice and virtual currency purchases, but instead simply misappropriated the money.
Another complaint charged the defendants with fraudulently soliciting Bitcoin from customers, misrepresenting that customers’ funds would be pooled and invested in products including binary options, making Ponzi-style payments to commodity pool participants from other participants’ funds, misappropriating pool participants’ funds, and failing to register with the CFTC as a commodity pool operator and associated person of a CPO.
The states are taking an interest as well. On January 17, 2018, the Enforcement Section of the Securities Division of the Secretary of the Commonwealth of Massachusetts filed a complaint against a Cayman Islands entity and a Massachusetts resident for allegedly offering the sale of so-called “Caviar tokens” that were allegedly unregistered securities. The complaint suggests that the token sponsor, when questioned, claimed there had been no U.S. sales of the tokens. But the complaint quickly added that such sales had in fact taken place and that the screening process was so inadequate that a Securities Division investigator was able to apply “using the name of a popular cartoon character” and an uploaded photo of a government-issued photo ID obtained using a Google Image Search showing a name and address different from that given in the application. The complaint claims the investigator’s identification was “verified” and approved to participate in the ICO within 29 minutes of producing the false ID.
SEC Staff Letter on Fund Innovation and Cryptocurrency-Related Holdings
The SEC Division of Investment Management meanwhile entered the cryptocurrency regulatory fray in a letter dated January 18, 2017. In a careful two-step, the Division (a) acknowledged that cryptocurrencies, and financial markets innovation more generally, can provide market benefits, but (b) then basically said that cryptocurrency products are not ready for the primetime exposure that would come from including them in regulated funds or exchange-traded structures.
The Division staff went on to say, that until certain regulatory and structural questions are resolved, it has asked sponsors of funds that would invest substantially in cryptocurrencies or related instruments to hold off and not seek to register their fund shares with the agency. (Those with already filed registration statements were asked to withdraw them.) In the meantime, the letter invites “interested sponsors to engage” with the agency as the staff ponders its approach to regulation of cryptocurrencies.
The staff guidance, which addresses investment management regulation, follows other SEC actions that address whether cryptocurrencies are “securities” as defined under federal law and should be regulated under the Securities Act of 1933.
Among other things, the letter addressed the following issues:
- Valuation. Valuation of digital assets can present challenges when the markets for those assets are thin or non-existent. The staff questioned whether funds have information necessary to adequately value cryptocurrencies and related products, given their volatility, fragmentation and overall lack of regulation of the underlying markets. For example, the staff questioned how funds would develop and implement policies and procedures to value assets that can change in nature (such as cryptocurrency “forks”).
- Liquidity. The SEC’s liquidity risk management rules, which will phase in over the coming months, will require, among other things, most registered investment companies to classify the liquidity of each portfolio investment based on the number of days within which it determined that it reasonably expects an investment would be convertible to cash without the conversion significantly changing the market value of the investment. In addition, funds must limit their investments in illiquid assets to 15 percent of their net assets. Funds and their directors may face challenges in assessing the liquidity of tokens, which may be considered illiquid for these purposes. The staff questioned what steps funds investing in cryptocurrencies take to assure that they have sufficient liquidity, and how they would classify these assets under the fund liquidity rule. Moreover, the staff asks, if a fund’s investment in cryptocurrency-related futures grows to represent a substantial portion of the futures market for that instrument, how would that growth affect its portfolio management and liquidity analysis?
- Custody. Investment company custodians must satisfy statutory requirements, and traditional fund custodians must be capable of holding digital assets with adequate protections. The staff questioned how funds would satisfy these requirements, and, in particular, how funds would “validate existence, exclusive ownership and software functionality of private cryptocurrencies keys and other ownership records.” The staff raised the issue of how funds would address potential cybersecurity threats or potential hacks on “digital wallets” that could affect the safekeeping of digital assets. The staff also asked under what circumstances funds would hold these digital assets directly.
- Arbitrage for ETFs. ETFs are able to narrow the spread between the net asset value and market price of the shares when “authorized persons,” who buy and sell “creation units” use arbitrage in their principal transactions. The staff questions whether funds have engaged with market makers and authorized participants to understand the feasibility of arbitrage when the ETF invests in volatile cryptocurrencies. The staff suggested that volatility-driven trading halts could hinder the ability of authorized participants to arbitrage, which, in turn, could result in the inability of ETFs to comply with their exemptive orders that require them to minimize spreads.
- Potential manipulation and other risks. The staff noted that SEC Chair Jay Clayton raised concerns that the cryptocurrency markets “feature less investor protection than traditional securities markets.” It also expressed concern that retail investors may not fully understand the risks presented by this asset class. (The Chair’s remarks cited here were part of a burst of Commission-level cryptocurrency statements released over the past month, all preceding the Wall Street Journal editorial covered above, first by the SEC Chair and then the full Commission: See Jay Clayton's statement on cryptocurrencies and ICOs and Clayton's and Commissioners' statements on cryptocurrencies).
Until these questions can be addressed to its satisfaction, the staff said that it does “not believe that it is appropriate for fund sponsors to initiate registration of funds that intend to invest substantially in cryptocurrency and related products.”
These various actions – taken within a matter of days of each other – paint a picture. The period of watching and waiting is ending; regulators are ready to devote significant time and resources to cryptocurrency issues.