Introduction to the legal and regulatory framework
In the United States, multiple regulators have asserted overlapping, and often conflicting, jurisdiction for market participants transacting in virtual currencies or other digital assets. Market participants in this space must consider legal and regulatory regimes overseen at the federal level by the US Securities and Exchange Commission (SEC), the US Commodity Futures Trading Commission (CFTC), the Financial Crimes Enforcement Network (FinCEN), the Office of Foreign Asset Control (OFAC) of the US Treasury Department and federal banking regulators. In addition, US, the District of Columbia and potentially even US overseas territories states have legal and regulatory regimes that should be considered when undertaking virtual currency activities. These include state money transmitter requirements, state virtual currency licensing regimes and state 'blue sky' laws applicable to digital asset securities transactions, as well as generally applicable state laws related to fraud. Market participants should also consider commercial, tax and bankruptcy laws before engaging in virtual currency transactions. There is nothing simple or straightforward about the US regulatory regime for virtual currency.
At the time of writing, El Salvador has just announced that it will recognise Bitcoin as legal tender. The El Salvador development could impact how various US regulators view Bitcoin. Certain US laws and regulations do distinguish between transactions in money and other transactions or between transactions in currency (or foreign currency) and other transactions. Does the fact that a single country now recognises Bitcoin as legal tender push Bitcoin from one category into another in the United States? It is too soon to say definitively.
Securities and investment laws
In this section, we discuss securities and commodities laws and regulations that apply to digital assets. See Section V (Regulation of miners), Section VI (Regulation of issuers and sponsors) and Section VII (Criminal and civil fraud and enforcement) for discussions that also implicate securities and commodities laws as they relate to digital assets.i Digital asset securities
The SEC regulates digital asset transactions if they are offered or traded as securities or if they are offered through a collective investment fund. The SEC has published reports and guidance related to the offering of secondary trading in and investing in digital asset securities.
A threshold consideration in trading or investing in digital assets is whether the particular digital asset is a security and therefore subject to the federal securities laws. Section 5 of the Securities Act of 1933 9 (the Securities Act) makes it unlawful for any person to make use of the means or instrumentalities of interstate commerce to offer or sell a security unless the security is registered with the SEC or there is an applicable exemption from the registration requirements.2 In July 2017, the SEC issued a Report of Investigation (the DAO Report) analysing whether the offer and sale of a digital asset was subject to the federal securities laws.3 The digital asset in question was a token issued by an entity known as the Decentralized Autonomous Organisation (DAO), an unincorporated organisation. The DAO was created by a German corporation named Slock.it UG, and by the time the DAO Report was issued, the DAO had offered and sold approximately 1.15 billion DAO tokens in exchange for a total of approximately 12 million Ether, a virtual currency used on the Ethereum blockchain, which had a value, at the time the offering closed, of approximately US$150 million.
The SEC analysed whether the DAO token was an investment contract, and therefore a security, as defined by the Supreme Court of the United States (the Court) in the seminal case, SEC v. WJ Howey Co,4 which involved the offer and sale of interests in an orange grove. The Court defined an investment contract as an investment of money in a collective enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. In the DAO Report, the SEC approvingly quoted from the Court's observation that this definition embodies a 'flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits'.5 Presented with the facts and circumstances surrounding the DAO token, the SEC concluded that the DAO token was an investment contract. There was (1) an investment of money (in this case Ether) in (2) a common enterprise (the DAO platform), with the (3) expectation of profits (promotional materials informed investors that the DAO was a for-profit entity whose objective was to fund projects in exchange for a return on investment) (4) derived from the efforts of others (Slock.it and the curators). Although the DAO token holders did have voting rights, the SEC concluded that the voting rights were limited and that the holders were substantially reliant on the managerial efforts of Slock.it and the curators. As an investment contract, the DAO Report noted that the offer and sale of the DAO token was required to be registered under the Securities Act (unless a valid exemption from registration applied) and that platforms trading DAO tokens that met the definition of an exchange would need to register as such under the Securities Exchange Act of 1934 (the Exchange Act).
Since issuing the DAO Report, the SEC has instituted a number of enforcement actions against a mix of individuals and firms for alleged Section 5 violations for conducting unregistered securities offerings based on the Howey test, with many of these enforcement actions, but not all, also involving allegations of fraud. Through these enforcement actions, the SEC provided further clarity that notwithstanding the fact that a digital asset may have 'a practical use at the time of the offering, it would not preclude the token from being a security. Determining whether a transaction involves a security does not turn on labelling . . . but instead requires an assessment of the economic realities underlying the transaction'. In assessing those economic realities, the SEC considers the manner of sale and statements made by the token promoter and whether 'investors' are primed by marketing efforts to reasonably expect that their 'investments' would increase in value.
In June 2018, the SEC's Director of the Division of Corporation Finance, William Hinman, made an important speech in which he provided further guidance refining the SEC's approach to analysing when a digital asset is offered as an investment contract and therefore is a security.6 He framed the question differently by focusing not on the digital asset itself, but rather on the circumstances surrounding the digital asset and the manner in which it is sold. He conceded that the token, or 'whatever the digital information packet is called', is not a security all by itself, just as the interests in the orange grove in Howey were not. The token is 'simply code'. Instead, 'the way it is sold – as part of an investment; to non-users; by promoters to develop the enterprise – can be, and, in that context, most often is, a security – because it evidences an investment contract. And regulating these transactions as securities transactions makes sense'. When there is information asymmetry between promoters or founders and investors, then the protections of the Securities Act – namely, disclosure and liability for material misstatements and omissions – are necessary and appropriate.
On the other hand, Hinman noted that '[i]f the network on which the token or coin is to function is sufficiently decentralised – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise's success, material information asymmetries recede'. Hinman put both Bitcoin and Ether into this latter category – as digital assets where there is no central third party whose efforts are a key determining factor in the common enterprise and where it would seem that the disclosure regime of the federal securities laws would provide little value to the holders of Bitcoin and Ether.
In other words, as has always been the case, an investment contract can be made out of virtually any asset, including digital assets, so long as the investor is reasonably expecting profits from the promoter's efforts. As Hinman reiterated, 'the economic substance of [a] transaction determines the analysis, not the label'. Similarly, an investment contract can also be unwound or undone. The management contract for the orange grove can be terminated. With regard to digital assets, it is a novel idea that this transition or change would or could occur as a result of changes to the facts and circumstances associated with the token, without necessarily any action taken or to be taken by the holder. In response to Hinman's speech, many market participants sought clarity as to the precise mix of facts that would distinguish the sale of digital assets from a securities transaction.
In April 2019, the SEC's Strategic Hub for Innovation and Financial Technology (FinHub)7 released a framework (the Framework) for applying the investment contract analysis set out in Howey and its progeny to digital assets to 'help market participants assess whether the federal securities laws apply to the offer, sale, or release of a particular digital asset'.8 While the Framework does not create new law, it provides the SEC staff's view as to whether specific facts commonly present in the digital asset context make it more or less likely that specific elements of the Howey test are met. In addition, the Framework provides additional factors to consider that may be indicative of whether a digital asset is offered with 'consumptive' intent (as opposed to investment intent) and highlights particular facts that may change over time to be considered in determining whether and when a subsequent offering and sale of a digital asset previously sold as a security may no longer be considered an offering and sale of a security. Specifically with respect to 'virtual currency', the Framework notes that the ability to use the virtual currency immediately to make payments for goods and services without having to convert it to another digital asset or real currency may make it less likely that the Howey test is met.
To date, the SEC Division of Corporation Finance has issued three no-action letters relating to the offer and sale of a digital asset,9 providing relief that the relevant tokens would not be required to be registered under the Securities Act or the Exchange Act. In the first no-action letter, issued in April 2019, the Division of Corporation Finance particularly noted that: (1) the issuer would not use funds from the token sale to develop the related application and that the application would be fully developed and operational at the time tokens are sold; (2) the tokens would be immediately usable for their intended functionality (purchasing air charter services) at the time they are sold; (3) the tokens could not be transferred external to the application; and (4) the tokens would always be sold at a fixed price and redeemable for services valued at that price.
In July 2019, the SEC Division of Corporation Finance issued its second no-action letter to a company seeking to distribute digital assets. In providing relief that the particular tokens would not be required to register under the Securities Act or the Exchange Act, the SEC noted that: (1) the issuer would not use any funds from the token sale to build the related application, which was fully developed and would be fully functional and operational immediately upon its launch and before any of the tokens were sold; (2) the tokens would be immediately usable for their intended functionality (gaming) at the time they were sold; (3) the issuer would implement technological and contractual provisions governing the tokens and the related application restricting the transfer of the tokens to the issuer or to wallets on the related application; (4) gamers would only be able to transfer the tokens from their on-platform wallets for gameplay to addresses of developers with approved accounts or to the issuer in connection with participation in e-sports tournaments; (5) only developers and influencers with approved accounts would be capable of exchanging tokens for Ethereum at predetermined exchange rates by transferring their tokens to the token smart contract; (6) to create an approved account, developers and influencers would be subject to know-your-customer (KYC) and anti-money laundering (AML) checks at account initiation as well as on an ongoing basis; (7) tokens would be made continuously available to the most common type of user (gamers) in unlimited quantities at a fixed price; (8) there would be a correlation between the purchase price of the tokens and the market price of accessing and interacting with participating games; and (9) the issuer would market and sell the tokens to gamers solely for consumptive use as a means of accessing and interacting with participating games.
The Division of Corporation Finance issued the third no-action letter in November 2020 to another game developer. In its incoming letter requesting relief, the developer explained that tokens are intended for consumptive use on the platform and will be sold and repurchased at a fixed price that the issuer will maintain, and that the issuer would take certain steps to deter speculation. In providing relief, the Division of Corporation Finance took note of the foregoing and the facts that (1) profits from the sale of the tokens will not be used to finance the network ecosystem; (2) the tokens will be immediately usable; (3) the issuer will impose limits on token transactions; and (4) users will be required to affirm they are acquiring the assets for consumptive purposes and will be subject to KYC and AML checks.
In October 2019, the SEC sued Telegram Group Inc and its wholly owned subsidiary TON Issuer Inc (together, Telegram), alleging that Telegram failed to register the offers and sales of digital assets called 'Grams', which were made in the United States and overseas and raised more than US$1.7 billion of investor funds. The SEC obtained a temporary restraining order preventing the delivery of Grams to purchasers. Opposing the SEC's motion for a preliminary injunction further preventing the delivery of Grams, Telegram argued that the prior sales to investors and transaction in Grams after the Telegram blockchain was launched should be considered separately. According to Telegram, the sale of Grams to investors was an offering of securities, which Telegram conducted relying on an exemption from registration under the Securities Act (Rule 506(c) under Regulation D); however, transactions in Grams once the blockchain was launched would constitute spot transactions in commodities, not securities transactions. In an important decision, in March 2020, the US District Court for Southern District of New York (SDNY) ruled in favour of the SEC, finding that the sales to investors and any subsequent transactions after the blockchain had launched comprised a single scheme (but notably, not the Grams themselves) constituting an investment contract by application of the Howey test.10
Another highly publicised and contested suit brought by the SEC for an unregistered securities offering of tokens, against Kik Interactive Inc, was similarly decided in favour of the SEC in October 2020. The defendant had sold its digital token, Kin, in two rounds: first, a private sale of agreements for future delivery of tokens to sophisticated investors; and second, a public sale. Between the two rounds the defendant earned approximately US$100 million. The defendant argued that while the first round did constitute the sale of a security, it qualified for a registration exemption under SEC Rule 506(c), and that the second round failed Howey's final prongs because the scheme did not constitute a common enterprise with an expectation of profits derived from the efforts of others. In siding with the SEC, the SDNY held that the offering involved a common enterprise because the defendant pooled all investor cash and used it to develop the token's ecosystem, meaning the fortunes of all investors were tied together and, further, that the defendant advertised the tokens as investments, making it clear that the defendant would increase the value of the tokens by developing the token's ecosystem. Having established that the tokens constitute a security, the court held that the first round of sales did not qualify for an exemption because it must be integrated with the second round, which patently did not qualify under Rule 506(c) as it was not limited to accredited investors as required by the rule.
In December 2020, the SEC filed a complaint against Ripple Labs (Ripple) for conducting a continuous unregistered securities offering related to the digital asset XRP. The SEC's complaint alleges that Ripple and two of its executives sold approximately US$1.4 billion worth of XRP without registering the offering nor qualifying for an exemption. The SEC argues that XRP constitutes an investment contract under Howey and is therefore a security because purchasers of XRP invested in a common enterprise, expecting to derive profits from Ripple's 'entrepreneurial' and 'managerial' efforts. In support of its claims, the SEC argued the defendants 'repeatedly and publicly' pledged to develop uses for XRP and promote the market for trading in XRP. In their answer to the complaint, the defendants argue that XRP is a virtual currency and therefore not subject to securities laws. In support of this theory, they claim that XRP is a 'bridge currency', allowing users to effect cross-border transactions. Ripple further argues that XRP's value is dependent not on their efforts, but on the value of other virtual currencies, and that the ledger system through which XRP is distributed is open, decentralised and beyond Ripple's control. At the time of writing, the litigation remains ongoing.
In February 2020, SEC Commissioner Hester Peirce gave a speech explaining the need for clarity on the application of federal securities law to the offer and sale of digital assets, describing a proposal for a safe harbour from the registration requirements of the Securities Act.11 The safe harbour, if adopted, is intended to provide development teams with a three-year period within which they can facilitate participation in a functional or decentralised network, exempt from the registration provisions of the federal securities laws.12 To rely on the safe harbour, a development team would need to disclose certain information on a freely accessible public website, and the token must be offered and sold for the purpose of facilitating access to, participation on or the development of the network. The company must undertake good faith and reasonable efforts to create liquidity through listing the token on trading platforms, exempt from the definition of 'exchange', 'broker' or 'dealer' under the Exchange Act. Furthermore, the issuer would have to file a notice of reliance with the SEC. The following year, in April 2021, Commissioner Peirce proposed an updated version of the safe harbour, reflecting feedback from the digital asset community, securities lawyers and members of the public. The updated safe harbour reflects three principal changes: (1) the proposal now requires the development team to make semi-annual updates to the plan of development disclosure and release a block explorer (e.g., web-based software that draws various data from a blockchain and presents the data to users in a searchable format); (2) at the end of the three-year period, the development team must file an 'exit report' setting out either an analysis by outside counsel explaining why the network is decentralised or functional or an announcement that the tokens will be registered under the Exchange Act; and (3) the specifications for the required exit report provide further guidance on what outside counsel's analysis should address when explaining why the network is decentralised, including, among other things, examples of material engagement on network development and governance matters by parties unaffiliated with the initial development team and the extent to which the initial development team's continuing activities are more limited in nature and cannot reasonably be expected uniquely to drive an increase in the value of the tokens. The safe harbour is currently a draft proposal; an actual safe harbour proposal will require formal rule-making by the entire Commission and will be subject to a public comment period. Further, the proposed safe harbour is not expected to change the SEC's approach in pending enforcement actions.ii Certain market participants
In planning to negotiate, effect, clear or settle transactions in virtual currencies that are securities,13 market participants should also evaluate whether their activities may trigger registration and related requirements under the framework of the Exchange Act, which is administered by the SEC. In particular, market participants should be aware of the definitions of broker,14 dealer,15 exchange,16 alternative trading system (ATS),17 clearing agency18 and transfer agent.19 The SEC has increasingly made clear that it intends to regulate virtual currencies to the extent of its existing authority in these areas.
For example, the SEC's Division of Trading and Markets and Division of Enforcement published a joint statement in which they noted that trading venues on which individuals buy tokens that are securities as part of an ICO (or in secondary transactions) may be required to register with the SEC as a national securities exchange or otherwise avail themselves of an exemption from registration, such as by filing as an ATS.20 The SEC addressed this same point in its July 2017 issuance of the DAO Report.21 There, it found that certain platforms that facilitated trading of certain DAO tokens that constituted securities appeared to violate Section 5 of the Exchange Act by engaging in activities that met the definition of an exchange (i.e., matching the orders of multiple buyers and sellers for execution using non-discretionary methods) without being registered as such or relying on an available exemption from registration.
Below is a general overview of some of the most common registration types and related requirements under the Exchange Act that may be triggered by transacting in or otherwise facilitating transactions in virtual currencies that are securities.Broker-dealers
Registration with the SEC is generally required for any entity that meets the statutory definition of a broker or dealer, including with respect to their activities in virtual currencies that are securities. A securities broker includes any person who is engaged in the business of effecting transactions in securities for the accounts of others.22 Exceptions from the broker definition are also available to a bank,23 as defined under the Exchange Act, that only engages in certain securities activities (e.g., third-party brokerage arrangements, trust activities, stock purchase plans and sweep accounts).24 A securities dealer includes any person engaged in the business of buying and selling securities for that person's own account, regardless of whether through a broker or otherwise. However, the definition also includes an exception for persons who are not in the business of dealing in securities. Specifically, the dealer-trader exception states that a person is generally not acting as a dealer when that person trades for his or her own account but not as part of a regular business. The SEC Division of Trading and Markets has also published a significant volume of guidance in the form of no-action letters that further address when a person may be engaged in broker or dealer activities, but SEC staff would not recommend enforcement action by the agency if the person engages in the specified activities without becoming registered. Consideration of that guidance is therefore also relevant to a market participant's own evaluation of whether it is acting as broker or dealer and must register.
Section 15(a)(1) of the Exchange Act generally requires registration of any person who acts as a broker or dealer, as described above, and who uses instrumentalities of interstate commerce25 'to effect any transaction in, or to induce or attempt to induce the purchase or sale of, any security (other than an exempted security or commercial paper, bankers acceptances or commercial bills)'.26 Registration with the SEC requires the submission of Form BD (Uniform Application for Broker-Dealer Registration) through the Central Registration Depository, which is currently the central licensing and registration system operated by the Financial Industry Regulatory Authority, Inc (FINRA). Unless a broker-dealer is a member of a US national securities exchange and generally limits its securities activities to trading on that exchange, it must also become a member of FINRA, which is the national securities association in the United States for broker-dealers that, among other things, has surveillance and enforcement authority over its members. To apply to become a member of FINRA, broker-dealers must complete a detailed new membership application that requires an applicant to provide FINRA with, among other things, detailed written supervisory and compliance procedures. Since 2018, FINRA has sought to engage in an ongoing dialogue with member firms regarding their current and planned activities relating to digital assets by issuing annual notices to members, the most recent of which being Regulatory Notice 20-23. The notices request member firms to notify FINRA if 'it, or its associated persons or affiliates, currently engages, or intends to engage, in any activities related to digital assets'.27 The notice also reminds FINRA members of the requirement to submit a Continuing Membership Application pursuant to FINRA Rule 1017 and receive approval from FINRA before engaging in a material change in business operations, but does not state that activities related to digital assets would per se be a material change.
In 2021, FINRA published its inaugural Report on FINRA's Examination and Risk Monitoring Program, highlighting considerations FINRA believes firms should take into account with respect to their compliance programmes. FINRA advised firms to consider (1) how they address digital assets in their review of outside business activities of registered persons (OBAs) and private securities transactions of associated persons (PSTs); (2) whether public communications regarding digital assets are 'fair and balanced' and contain adequate risk disclosures; and (3) whether they are considering and addressing application of the Customer Protection Rule to dealings in digital assets. The report also identified a number of effective and ineffective practices relating to digital asset communications, and OBA and PST compliance programmes.
Among other considerations regarding acting as a broker-dealer in respect of virtual currencies that are securities, market participants should consider the compatibility of their planned activities with the existing requirements of the SEC's financial responsibility rules.28 For example, broker-dealers are generally required by SEC Rule 15c3-3(b)(1) to promptly obtain and thereafter maintain control of all fully paid and excess margin securities that are carried for the account of a customer.29 The terms 'fully paid securities'30 and 'excess margin securities'31 are separately defined in Rule 15c3-3, and broker-dealers frequently satisfy this obligation through custody of the securities at a clearing agency (e.g., the Depository Trust Company (DTC) or a custodian bank) because those locations are recognised in Rule 15c3-3(c) as being under the control of the broker-dealer. In terms of virtual currencies that are securities, however, the same recognised good control locations may not be practicable depending on the characteristics of the financial instruments and how they are issued and maintained. Accordingly, a broker-dealer should evaluate its planned activities against the SEC's control requirement, including whether it may need to apply to the SEC for the recognition of a new control location pursuant to Rule 15c3-3(c)(7). On 8 July 2019, the SEC's Division of Trading and Markets and FINRA's Office of General Counsel issued a joint statement on broker-dealer custody of digital asset securities that contained regulatory considerations applicable to various market participants, including those related to noncustodial broker-dealer models, the application of SEC Rule 15c3-3 to broker-dealer custody and books and records and financial reporting rules.32 On 23 December 2020, the SEC issued a statement and request for comment relating to broker-dealer custody of digital assets pursuant to Rule 15c3-3. Recognising the complexity of the application of Rule 15c3-3 to digital assets and the need to address the risks digital asset custody issues pose to investors and market participants, the SEC issued this statement, simultaneously (1) soliciting comment on best practices and standards relating to custody of digital assets; and (2) implementing temporary standards relating to custody.
According to these temporary standards, which are set to expire in April 2026, the SEC will not bring an enforcement action against a broker-dealer that 'deems itself to have obtained and maintained physical possession or control of customer fully paid and excess margin digital asset securities' pursuant to Rule 15c3-3(b)(1) under certain listed circumstances. The standards are intended to safeguard broker-dealers and their clients while the SEC seeks 'to gain [the] additional insight into the evolving standards and best practices with respect to custody of digital asset securities' that will inform potential future regulation. Notably, the SEC's statement does not opine on whether a broker-dealer may satisfy Rule 15c3-3 by relying on one of the locations recognised in Rule 15c3-3(c) as being under the control of the broker-dealer.Exchanges and ATSs
In general under the Exchange Act, an exchange is defined to mean a system that brings together the orders for securities of multiple buyers and sellers, and uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other.33 As noted above, the SEC and its staff have emphasised recently that market participants who facilitate transactions in virtual currencies that are securities may come within the definition of an exchange, and that any entity or group of persons that performs the functions typically provided by a securities exchange must either register as a national securities exchange, pursue an exemption from the definition of an exchange34 or become an ATS that is operated by a broker-dealer. Under the regulatory framework administered by the SEC, an ATS is a national securities exchange; however, it is exempt from this registration, provided that it complies with the requirements of the SEC's Regulation ATS.35
The regulatory burdens associated with registering and operating as a national securities exchange are significantly greater than those associated with an ATS. For example, the registration process for an exchange involves completing and submitting Form 1 to the SEC, which is published for public notice and comment. By contrast, the submission of Form ATS to the SEC is not subject to the same public notice and comment process. Additionally, under Section 6(b)(2) of the Exchange Act,36 a national securities exchange is generally required to permit any broker-dealer or natural person associated with a broker-dealer to become a member of the exchange. An ATS is not subject to this obligation, and therefore it has more discretion over who it allows to participate. The rules of an exchange also generally cannot be amended without the advance submission of rule changes to the SEC pursuant to Section 19(b)(1) of the Exchange Act, which are published for public notice and comment and may take up to 240 calendar days for the SEC to approve or disapprove.37 No such rule filing requirement currently applies to an ATS that wishes to change its operating procedures. Changes to the operating procedures of an ATS made pursuant to an amendment to Form ATS or Form ATS-N are not approved by the SEC and need only be submitted to the SEC 30 days (at most) in advance of implementation of the change.38 Exchanges are also subject to the SEC's Regulation Systems Compliance and Integrity (Regulation SCI),39 which requires detailed policies, procedures and monitoring to ensure the integrity and resiliency of most exchange systems. ATSs are generally not subject to these same requirements, unless they exceed certain volume thresholds in a given security.40
In the SEC's Division of Trading and Markets and FINRA's Office of General Counsel 8 July 2019 joint statement, the SEC and FINRA staff identified a potential non-custodial business model for broker-dealers wishing to operate an ATS for digital asset securities whereby 'the buyer and seller send their respective orders to the ATS; the ATS matches the orders; the ATS notifies the buyer and seller of the matched trade; and the buyer and seller settle the transaction'. On 25 September 2020, the SEC's Division of Trading and Markets published a no-action letter providing for an alternative non-custodial ATS for digital asset securities allowing for an abbreviated model whereby 'the buyer and seller send their respective orders to the ATS, notify their respective custodians of their respective orders submitted to the ATS, and instruct their respective custodians to settle transactions in accordance with the terms of their orders when the ATS notifies the custodians of a match on the ATS; the ATS matches the orders; and the ATS notifies the buyer and seller and their respective custodians of the matched trade and the custodians carry out the conditional instructions'. Significantly, the broker-dealer does not exercise control over the digital assets at issue nor guarantee trade settlement.Clearing agencies
Market participants who plan to engage in post-trade activities related to transactions in virtual currencies that are securities should closely examine whether their activities may rise to the level of performing clearing agency functions. The term clearing agency under Section 3(a)(23)(A)41 of the Exchange Act is defined broadly to generally include any person who:
- acts as an intermediary in making payments or deliveries, or both, in connection with transactions in securities;
- provides facilities for the comparison of data regarding the terms of settlement of securities transactions to reduce the number of settlements of securities transactions or for the allocation of securities settlement responsibilities;
- acts as a custodian of securities in connection with a system for the central handling of securities whereby all securities of a particular class or series of any issuer deposited within the system are treated as fungible and may be transferred, loaned or pledged by bookkeeping entry, without physical delivery of securities certificates; or
- otherwise permits or facilitates the settlement of securities transactions or the hypothecation or lending of securities without physical delivery of certificates.
In practice, this reaches firms that operate as a central counterparty to novate, net and guarantee securities settlement obligations or that operate as a central securities depository (e.g., DTC) to transfer ownership by book entry. However, the SEC has also recognised in guidance that it may capture firms performing other common types of functions in the securities markets. These include, but are not limited to, collateral management activities – involving calculating collateral requirements and facilitating the transfer of collateral between counterparties and trade matching services – whereby an intermediary compares trade data to reduce the number of settlements or to allocate settlement responsibilities.42
Like the registration and operation of a national securities exchange, the registration and operation of a registered clearing agency involves significant regulatory requirements that include, but are not limited to, the submission of proposed rule changes to the SEC and compliance with Regulation SCI. Accordingly, market participants who believe that their activities may come within the clearing agency definition may wish to consider whether they nonetheless qualify for certain exclusions from the clearing agency definition in Section 3(a)(23)(B) of the Exchange Act,43 or whether it would be appropriate to pursue an exemption from registration. The SEC has authority to provide conditional or unconditional exemptions from registration pursuant to Section 17A(b)(1) of the Exchange Act.44
In October 2019, the SEC issued a no-action letter to Paxos Trust Company, LLC (Paxos) providing relief from clearing agency registration under Section 17A(b)(1) of the Exchange Act.45 The no-action letter was issued on the basis that Paxos would operate, for no more than 24 months, a private permissioned distributed ledger system to conduct a feasibility study of the system.46 The system records changes in ownership of securities and cash resulting from the settlement of securities transactions between participants in the service.47 The system is designed to conduct simultaneous delivery versus payment settlement of securities and cash for trades submitted to the system for clearance and settlement.48Transfer agents
Where a market participant provides services to the issuer of a virtual currency that is a security, it should consider the implications of the transfer agent definition. The definition of a transfer agent in Section 3(a)(25) of the Exchange Act49 includes any person who engages on behalf of a securities issuer in:
- countersigning such securities upon issuance;
- monitoring the issuance of such securities with a view to preventing unauthorised issuance;
- registering the transfer of the issuer's securities of the issuer;
- exchanging or converting the securities; or
- transferring record ownership of the securities by bookkeeping entry without physical issuance of securities certificates.
In turn, Section 17A(c)(1) of the Exchange Act requires that, except as otherwise provided in the Exchange Act, it is unlawful for any transfer agent, unless registered, to use US instrumentalities of interstate commerce 'to perform the function of a transfer agent with respect to any security registered under Section 12 [of the Exchange Act] or which would be required to be registered except for the exemption from registration provided by subsections (g)(2)(B) or (g)(2)(G) of that section'.50 Therefore, transfer agent registration is not required unless a person acts as a transfer agent in respect of such securities. The SEC also has authority pursuant to Section 17A(c)(1) of the Exchange Act51 to provide conditional or unconditional exemptions from transfer agent registration.iii Commodities laws
To the extent that a virtual currency is deemed to be a commodity, the Commodity Futures Trading Commission (CFTC) has regulatory jurisdiction over derivatives transactions with respect to the virtual currency and has anti-fraud and manipulation authority with respect to transactions in the virtual currency itself. The CFTC has brought civil enforcement cases against virtual currency derivatives trading facilities alleging failure to comply with the CFTC's requirements for regulated derivatives exchanges. The CFTC also has broad authority to bring civil enforcement actions where there is fraud or manipulation with respect to any commodity transaction in interstate commerce, even if the transaction is not a derivatives transaction (i.e., even if it is not a futures contract, swap or option). Because certain virtual currencies are commodities as the term is defined in the Commodity Exchange Act (CEA), the CFTC maintains that it can police any fraudulent, deceptive or manipulative activity involving virtual currency spot, cash and forward transactions, making the CFTC a key player in the US regulatory regime for virtual currencies.
In 2014, the then current CFTC chair advised Congress that derivatives contracts based on virtual currencies fell within the CFTC's regulatory jurisdiction. Beginning in 2015, the CFTC commenced several administrative enforcement actions involving virtual currencies. In settling certain of these enforcement cases, the CFTC determined that Bitcoin and all virtual currencies were commodities, Bitcoin was not a fiat currency, Bitcoin options were commodity options (and therefore within the definition of swaps), and trading facilities that list Bitcoin derivatives were therefore required to be registered with the CFTC as either swap execution facilities (SEFs) or designated contracts markets (DCMs). The CFTC has since reaffirmed its view that all virtual currencies fall within the CEA definition of a commodity, regardless of whether futures contracts on a particular virtual currency may not yet exist. It remains unclear whether all courts will agree with the CFTC's broad view of its jurisdiction; however, at least one district court has upheld the CFTC's jurisdiction over virtual currency transactions. In March 2018, in the enforcement case CFTC v. McDonnell, a federal district court judge confirmed the CFTC's view that all virtual currencies are commodities under the CEA definition, and that spot transactions in virtual currencies are subject to the CFTC's anti-fraud and anti-manipulation enforcement authority.52 Pursuant to the CFTC's enforcement authority over spot commodity transactions, in March 2021, the CFTC brought and settled an enforcement action against Coinbase Inc, for false, misleading or inaccurate reporting of spot virtual currency transactions executed on its platform, as well as wash trading by a former employee, notwithstanding that none of the transactions involved derivatives.
Certain provisions of the CEA and CFTC regulations differ for commodities that are foreign currency (i.e., fiat currency) and for other commodities. It is clear from public statements by CFTC commissioners and the CFTC staff, as well as from several rule-makings and enforcement cases, that the CFTC does not view virtual currency as being the regulatory equivalent of foreign currency – to date, virtual currencies have not been legal tender and they have not been issued by a sovereign government. Notwithstanding the clear view within the CFTC that virtual currencies are not fiat currency, in March 2020, the CFTC stated that virtual currency is 'a digital asset that encompasses any digital representation of value or unit of account that is or can be used as form of currency (i.e., transferred from one party to another as a medium of exchange)'.53
Active markets in Bitcoin futures contracts now exist in the United States and there is increasing acceptance of virtual currency derivatives in the marketplace. In June 2020, a market survey indicated that 22 per cent of US survey respondents invested in digital assets had exposure via futures, up from nine per cent the prior year.54
One way in which the CFTC has asserted its jurisdiction over the virtual currency markets is in connection with 'retail commodity transactions'. The CEA gives the CFTC regulatory jurisdiction over transactions with the retail public in any commodity to the extent that the transaction is leveraged, margined or financed by the offeror or a person acting in concert with the offeror. The retail commodity transaction provisions do not apply to transactions that result in 'actual delivery' within 28 days. The meaning of the term 'actual delivery' in the context of purely digital representations of value, such as virtual currencies, has been subject to heated debate. In March 2020, the CFTC issued final interpretive guidance on the meaning of the term in the context of retail transactions in virtual currencies. The CFTC advised that while the test for whether actual delivery has occurred would be determined by facts and circumstances, it will look to whether, no later than 28 days after the transaction, the retail customer is able to take possession and control of the entire quantity of the virtual currency purchased (including the margined, leveraged or financed portion) and use it freely in commerce at all times thereafter without the seller, the trading platform or the financing provider (or any of their affiliates or agents) retaining any interest in, legal right or control over the virtual currency. The CFTC indicated that it would generally consider customer possession and control to have been demonstrated when (1) there is a transfer of the virtual currency away from the seller or trading platform and receipt by a separate blockchain address over which the retail customer maintains sole possession and control or a separate, independent and appropriately licensed depository chosen by the retail customer, (2) the retail customer has the ability to use the virtual currency freely in commerce as soon as technologically practicable and (3) none of the seller, the trading platform or the financing provider (or any of their affiliates or agents) retain any interest in, legal right or control over the transferred virtual currency. The CFTC recognised that actual delivery could be achieved even if a trading platform has relationships or affiliations with its customers' depositories so long as the depository is completely separated from the trading platform and the depository has certain other safeguards in place to ensure the customer receives actual possession and control over the virtual currency.55 The CFTC also advised that a book-out, cash settlement, netting or offset mechanism, or where the virtual currency is retained in an omnibus wallet where the trading platform operator retains the private keys, will not constitute actual delivery.
The CFTC has a separate source of jurisdiction that is not tied to the definition of a commodity. The CFTC has regulatory jurisdiction over swaps. The definition of a swap is broad. It includes a number of different types of transactions in which the underlier is a commodity but also includes transactions in which the underlier is an interest or other rate, currency, security, instrument of indebtedness, index, quantitative measure or other financial or economic interest or property of any kind. The definition also includes certain executory contracts in which performance is contingent on 'the occurrence, non-occurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic or commercial consequence'. Because the swap definition is so broad, the CFTC may have jurisdiction over certain types of transactions in virtual currency, regardless of whether the particular virtual currency is ultimately determined to be a commodity.
In the United States, in October 2020, the CFTC filed a civil enforcement action in New York federal court against the owners of a virtual currency trading platform, BitMEX, that was reportedly the world's largest such platform, accusing the owners of operating an unregistered trading platform, alleging that they received more than US$11 billion in Bitcoin deposits and made more than US$1 billion in fees, while conducting significant aspects of the business from the United States and accepting orders and funds from US customers. The CFTC alleged that, from 2014 to 2020, BitMEX illegally offered leveraged retail commodity transactions, futures, options and swaps on cryptocurrencies, including Bitcoin, Ether and Litecoin, allowing traders to use leverage of up to 100 to 1 when entering into transactions on its platform, facilitating cryptocurrency derivatives transactions with an aggregate notional value of trillions of dollars without having CFTC approval as a futures exchange or swap execution facility and operating as an unregistered futures commission merchant by soliciting orders for and accepting Bitcoin to margin digital asset derivatives transactions, and by acting as a counterparty to leveraged retail commodity transactions.
On the same day that the CFTC filed its civil complaint, the US Department of Justice (DOJ) criminally indicted the three owners and an officer of BitMEX for allegedly intentionally failing to maintain an adequate anti-money laundering programme, failing to file suspicious activity reports and failing to implement an appropriate KYC programme. The government alleged that BitMEX engaged in significant activities from within the United States, had US customers, allowed non-US individuals who were subject to US Treasury Department sanctions to trade on its platform, and attempted to evade US regulations by incorporating in the Seychelles. In announcing the indictment, the DOJ stated: 'As alleged, these defendants . . . undertook to operate a purportedly “off-shore” crypto exchange while wilfully failing to implement and maintain even basic anti-money laundering policies. In so doing, they allegedly allowed BitMEX to operate as a platform in the shadows of the financial markets.'
Because virtual currency is novel and poorly understood by many, and some virtual currencies have vacillated in value over very short periods, fraud has become a common occurrence. As the CFTC has broad anti-fraud jurisdiction with respect to transactions in virtual currency, the CFTC has brought a number of cases related to virtual currency – Ponzi schemes, failure to register cases, pump-and-dump schemes, wash trading violations, etc. In many cases, the facts are only novel in that they involve virtual currency. The wrongdoing itself is fairly straightforward. The victims are often senior citizens.