Last week, a second private lawsuit was filed against the promoters of a highly successful initial coin offering earlier this year to support development of the Tezos Blockchain project. The prospective class action lawsuit, filed in a Florida federal court, alleged the unlawful sale of securities and securities fraud, among other offenses. Generally, the allegations paralleled claims made in another purported class action lawsuit against the Tezos ICO promoters filed in October in a California state court. (Click here for background on the first private action in the article “Backers of Tezos Initial Coin Offering Named in Prospective Class Action Litigation” in the November 12, 2017 edition of Bridging the Week.)

In other cryptocurrency developments last week:

  1. CME Group announced that it would begin testing its proposed Bitcoin futures contract on November 20. The daily settlement price of the proposed futures contract will be based on prices derived from trading on four-spot Bitcoin exchanges not affiliated with CME Group (click here for details).
  2. The European Securities and Markets Authority became the latest in a string of regulators warning about the risks of initial coin offerings. (Click here for background in the article “Singapore Regulator Joins Other Regulators in Warning Initial Coin Offerings May Impact Local Laws” in the October 8, 2017 edition of Bridging the Week.) According to ESMA, ICOs are “highly speculative investments” that may not be regulated. ESMA said that some ICOs may be used for fraudulent or illicit purposes; may involve a “high risk” of losing all invested capital; may not have exit options because investors may not be able to trade their digital tokens or exchange them for other currencies; may have offering documents that are “unaudited, incomplete, unbalanced or even misleading”; and may involve investments in technology that is flawed.
  3. The UK Financial Conduct Authority warned investors about investing in contracts for differences involving cryptocurrencies. Among other things, FCA said that issues regarding the volatility and transparency of cryptocurrency prices, as well as charges and funding costs, make CFDs based on cryptocurrencies more risky. FCA asserted that it regulates CFDs based on cryptocurrencies but “these protections will not compensate you for any losses from trading.”
  4. REcoin Group Foundation, LLC and DRC World Inc. (known as Diamond Reserve Club), and Maksim Zaslavskiy, their sole owner, consented to the entry of a preliminary injunction and asset freeze in response to a Securities Exchange Commission enforcement action alleging that they engaged in a fraudulent initial coin offering from July 2017 through at least September 2017. The enforcement action was filed in September in a federal court in Brooklyn, NY. (Click here for details in the article “SEC Files Lawsuit Against Companies and Backer for Purportedly Fake Initial Coin Offerings” in the October 1, 2017 edition of Bridging the Week.)

My View: As I have written previously, it is hard for me to imagine that blockchain technology, including the use of smart contracts, will not increasingly play a pivotal role in finance as well as other fields. As Commodity Futures Trading Commission Chairman J. Christopher Giancarlo said last week in Singapore, “Shared ledger technology, which holds promise in increasing operational efficiencies, may also help facilitate real-time, standardized, and lower-cost regulatory reporting… And related application of contracts … could result in the potential decrease of execution risk, more efficient use of trade-related margin and collateral, and the incorporation of automated regulatory compliance provisions into the contract code.” (Click here for Mr. Giancarlo’s full speech before the Singapore FinTech Festival.)

Moreover, as long as a blockchain’s protocol is widely distributed and decentralized, its network will likely be dependent on the use of a digital coin of some type to provide incentives to miners or other persons who maintain the system’s integrity. At least some of these digital coins will continue to grow in popularity as a medium of exchange, much as Bitcoin and Ether have already attracted a widespread following.

However, while there have been increasing regulatory pronouncements that cryptocurrencies issued as part of initial coin offerings may be securities subject to local regulations – including by the US Securities and Exchange Commission – less is clear about cryptocurrencies later in their life when they principally serve as a medium of exchange.

The CFTC has declared that such cryptocurrencies are commodities, and asserted its right to impose requirements on any purveyor of such commodities for future delivery and spot cryptocurrencies sold to retail persons where there is financing and actual delivery does not occur within 28 days. Relying on this authority, the CFTC designated LedgerX as a swap execution facility and derivatives clearing organization for fully collateralized digital currency swaps in July 2017. Moreover, the CFTC has said that it has jurisdiction over purveyors of cryptocurrencies who engage in deceptive activities or contrivances in connection with purchases and sales of such commodities, even where there is no futurity or financing involved. (Click here for a general background of CFTC regulation of cryptocurrencies in the article “LedgerX Approved by CFTC as First Derivatives Clearing Organization for Fully Collateralized Swap Contracts Potentially Settling in Bitcoin” in the July 30, 2017 edition of Bridging the Week.)

However, other than the CFTC’s potential oversight, most spot transactions in cryptocurrencies are essentially unregulated. Persons holding cryptocurrencies for others or engaging in a business of exchanging cryptocurrencies for other cryptocurrencies or fiat currencies likely have to register with the Financial Crimes Enforcement Network of the US Department of Treasury, as well as possibly one or more state agencies. There is also a heightened regulatory structure for persons engaged in certain cryptocurrency business activities involving New York or a NY resident under NY's BitLicense scheme, and a model code promoting equivalent oversight may be rolled out to other states in the near future. However, FinCEN's and the states' regulation is mostly focused on promoting sound anti-money laundering practices and customer funds protection, not trading oversight. (Click here for background regarding the Uniform Regulation of Virtual Currency Business Act, FinCEN regulation and NY BitLicense requirements in the article “Model State Law Regarding Virtual Currency Businesses Virtually Finalized” in the August 20, 2017 edition of Bridging the Week.)

As a result, there is no effective functional regulation of cryptocurrency businesses (other than of regulated CFTC entities), including spot exchanges, that helps ensure on an ongoing basis that prices are derived through ordinary market forces and are not manipulated or otherwise artificially distorted. This is among the reasons why the SEC refused earlier this year to approve a proposed rule change by the Bats BZX Exchange, Inc. to list and trade shares of the Winklevoss Bitcoin Trust – whose pricing was to be based on the prices of a spot Bitcoin exchange related to the Trust (click here for details).

The attraction of a decentralized distributed ledger system to some is to exist outside of government control and oversight. However, smart government regulation or proactive self-regulation (with mandatory third-party verifications) could further promote the credibility of a still nascent technology and help ensure that unintended consequences don’t derail what should be highly useful applications in the future. Uncoordinated government regulation, however, should be avoided at all costs.