The recent flurry of activity and press coverage, over the past 18 months in particular, concerning “initial coin offerings” (also referred to as a “digital token sale”) has created confusion regarding their relationship to cryptocurrencies. While certainly connected in both concept and actuation, those with an interest in this burgeoning marketplace will be wise to note that both the risk and the regulatory landscape for existing cryptocurrencies (also referred to as “virtual currencies”) differ from ICOs/tokens. Those who forge ahead, uninformed, stand to learn an expensive lesson. We hope to illuminate certain fundamental concepts here.
Cryptocurrencies are digital or virtual currencies, intended to be used as a form of payment similar to government-issued currency, that are encrypted (secured) using cryptography. Cryptography refers to the use of encryption techniques to secure and verify the cryptocurrency transactions. Bitcoin represents the first decentralized cryptocurrency, which is powered by a public ledger that records and validates all transactions chronologically; this public ledger is called the blockchain.
Blockchain generally creates a pseudonymous ledger wherein the creation and each subsequent movement of cryptocurrency is recorded and verified through a decentralized network of computers all around the world. Blockchain technology has many potential applications outside of cryptocurrencies, and with respect to cryptocurrencies, blockchain is the “operating system” on which cryptocurrencies run.
“Altcoins” refer to cryptocurrencies that are an alternative to Bitcoin. The majority of altcoins are variants of Bitcoin, built using Bitcoin’s open-sourced, original blockchain platform with changes to its underlying codes, which create a brand new coin with a different set of features. Examples of Bitcoin-variant altcoins are Namecoin, Peercoin, Litecoin, Dogecoin, and Auroracoin. Altcoins that are not Bitcoin-variants have created their own blockchain and protocol that supports their native currency, such as Ethereum, Ripple, Omni, Nxt, Waves and Counterparty. The explosion of Bitcoin created a diverse ecosystem of other cryptocurrencies. As of today there are over 1,600 cryptocurrencies with a combined total market cap of approximately $2.96B according to the data available at Coin Market Cap.
While the underlying purpose of the Bitcoin/altcoin cryptocurrencies is to serve as an alternative form of currency for payment, the true attraction for investors is speculative cryptocurrency trading. The value of these cryptocurrencies fluctuates dramatically, driven by trading – on July 17, 2018, for example, Bitcoin’s price jumped above $7,400, adding $20B in valuation in 30 minutes just from that price increase. A currency that fluctuates in such volatile manner may be great for cryptocurrency traders, but is ill-suited for conducting payment transactions, so cryptocurrency trading platforms such as Coinbase also offer exchange services to merchants who accept cryptocurrencies (like Overstock.com) to hedge against cryptocurrency valuation volatility.
The Bitcoin/altcoin regulatory issues have been developing steadily around the world since the launch of Bitcoin in 2009, and the current state-of-play in U.S. regulation and enforcement regarding of Bitcoin/altcoin can be summarized as follows:
- From 2013 – 2015, the U.S. Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN) studied use of cryptocurrencies in illegal activities (such as the now infamous “Silk Road” website). To prevent financial exchanges from being used to launder money or finance crime, including terrorism, FinCEN took the position that exchanges and administrators of cryptocurrencies are subject to the Bank Secrecy Act (BSA)/anti-money laundering laws, and must register as a federal Money Services Business (MSB). But preventing cryptocurrencies from being used for such activities continues to be an ongoing regulatory and law enforcement challenge.
- Money transmitter regulation in the U.S. is separate from federal money services business registration, and is governed on a state-by-state basis. Currently, states’ treatment of cryptocurrencies for money transmission licensing purposes varies dramatically based upon each state’s unique law and regulator interpretation. For example, effective August 08, 2015, the New York State Department of Financial Services established a regulatory framework that any virtual currency businesses would need to abide by and get licensed under (the NY “Bitlicense,” 23 N.Y.C.R.R. Section 200). By contrast, the Texas Department of Banking issued a supervisory memo on April 03, 2014, establishing that “because cryptocurrency is not money under the Money Services Act, receiving it in exchange for a promise to make it available at a later time or different location is not money transmission.”
To address this disparate treatment, the Uniform Law Commission finalized a model “Regulation of Virtual Currency Businesses Act” in 2017, and a version of that uniform law has been introduced (but not yet passed into law) in three states thus far in 2018 (Connecticut, Hawaii and Nebraska).
- In 2014, the Internal Revenue Service (IRS) described cryptocurrencies as “a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value [and] does not have legal tender status in any jurisdiction.” The IRS treats cryptocurrencies as property and requires gains or losses to be calculated upon an exchange of cryptocurrency.
- The Consumer Financial Protection Bureau (CFPB) released a consumer advisory in August 2014 to warn consumers of the risk of cryptocurrencies. The advisory warned consumers of hackers, scammers, loss of cryptocurrency funds and value if the consumer loses their private key, fewer regulations, lack of FDIC insurance coverage and an inability to make chargebacks and dispute transactions purchased with cryptocurrency. However, in a recent shift in attitude toward emerging financial technologies, including cryptocurrencies, the CFPB announced on July 18, 2018, that it is launching a new “Office of Innovation” that will provide guidance and a “regulatory sandbox” environment to create policies that might facilitate innovation, engage with entrepreneurs and regulators, and review outdated or unnecessary regulations.
- The Federal Trade Commission has brought several enforcement actions touching on cryptocurrency under the FTC’s Section 5 “Unfair and Deceptive Acts and Practices” enforcement authority, including one for deceptive sale of goods related to cryptocurrency mining (F.T.C. v. BF (Butterfly) Labs, Inc., et al., No. 4:14-cv-815 (W.D. Mo. Sept. 2014)).
- The Commodities and Futures Trading Commission (CFTC) has asserted enforcement authority over cryptocurrency due to the IRS classification as a “commodity” and has brought several enforcement actions under its enforcement authority regarding commodities trading, for example for fraud and misappropriation in connection with purchases and trading of the virtual currencies Bitcoin and Litecoin (C.F.T.C. v. Patrick K. McDonnell et al., 1:18-cv-00361 (E.D.N.Y. Mar. 2018).
- The Securities and Exchange Commission (SEC) treats cryptocurrency-related securities crimes like violations involving any other currency, and has been the most active enforcement agency on both investment in Bitcoin/altcoin type cryptocurrencies and with regard to ICO’s (discussed further below). On Bitcoin/altcoin type cryptocurrencies, it has taken enforcement actions on defrauding of Bitcoin/altcoin cryptocurrency investors, for example conducting a Ponzi scheme by offering shares in a Bitcoin mining operation that did not have enough computing power for the mining they promised to conduct (SEC v. Homero Joshua Garza, GAW Miners, LLC, et al., Civil Action No. 3:15-cv-01760 (D. Conn., Complaint filed Dec. 1, 2015)). (A “miner” of cryptocurrency essentially allows their computer or network node (a larger group of computers) to be used to download and solve complicated mathematical problems called “proof of work” in order to create a new cryptocurrency block. Every time a slew of transactions is amassed into a block, this is appended to the blockchain, and the successful miner gets rewarded with some of that blockchain’s cryptocurrency.)
Crypto-Tokens and ICOs
The continuing evolution of cryptocurrency has brought us Crypto-Tokens, created via an Initial Coin Offering (ICO) intended to operate similar to an Initial Public Offering (IPO) for stocks. A start-up entity launches an ICO by issuing crypto-tokens on the blockchain (usually the Bitcoin or the Ethereum blockchain), giving early investors the chance to acquire tokens in exchange for yet-to-be-issued new cryptocurrency. An Initial Coin Offering (ICO) is typically used as a fundraising tool that trades future cryptocoins in exchange for cryptocurrencies of immediate, liquid value (e.g. the Bitcoin/altcoin cryptocurrencies). Effectively, the derivative nature of these Crypto-Tokens create an exponential element, intensifying the risk and (an investor would hope) the potential return.
To illustrate the concept, consider investors who would give the ICO Bitcoin or Ethereum to invest in a new “Charles Mackay” coin. An investor may eventually recoup their ICO investment if the new entity platform raises enough money, and if the new entity platform successfully launches the new Charles Mackay coin as a form of payment on that new platform. That ICO investor risk pattern is different from the Bitcoin/altcoin cryptocurrency risk, which is typically tied to the volatility of the cryptocurrency’s market value. For ICO’s, investors are having to bet that the new cryptocurrency even launches at all.
ICOs are usually limited by time or a cap on the amount of funds raised. The value and number of tokens released can be static or vary based on the total investment secured. And the tokens that ICO investors receive are essentially digital coupons for a corresponding amount of the new Charles Mackay coins. Investors hope that successful projects will cause tokens’ value to rise. This potential value increase provides the basis of the current perceived appeal of ICOs.
As with any boom, bad actors lurk in the ICO space. Given Bitcoin/altcoin cryptocurrencies’ history of tolerating bad actors, it is no surprise that ICOs are attracting fraudsters looking to dupe would-be investors. But investors are becoming more sophisticated about evaluating potential ICOs, generally preferring ICOs that focus on selling digital tokens linked to a clear use case in a blockchain application (referred to as a “utility” token). The utility of the tokens in an application with a solid concept and strong potential means that there would be a demand for the tokens if the application succeeds. If a start-up entity is issuing tokens that are not tied to the underlying business or technology in any way, then the tokens are essentially meaningless.
If the tokens somehow give holders rights to some returns, dividends, or profits, then there are legal and regulatory issues to consider. The first thing for an entity seeking to offer an ICO to consider is whether the ICO or token could be characterized as a security or some other scheme which will require regulatory approvals. This will affect whether to proceed or not, where to incorporate or register the legal entity issuing the tokens and conducting the ICO, and potentially who to prohibit from being involved in the ICO. Second, regardless of the legal characterization of the ICO or token, the ICO entity must also address anti-money laundering (AML) and counter-terrorism financing (CTF) concerns by ensuring some level of due diligence and know your client (KYC) measures.
The ICO regulatory and enforcement issues are, if anything, less established than the Bitcoin/altcoin regulatory issues discussed above, and the current state-of-play in U.S. regulation and enforcement regarding of Bitcoin/altcoin can be summarized as follows:
- The Securities and Exchange Commission (SEC) is currently the most active U.S. regulator in the ICO space, and considers ICOs to be investments. The SEC has already made it clear that it intends to crack down on ICOs that are not in compliance with legal requirements or that otherwise threaten injury to investors. The SEC devotes a webpage to teaching investors about ICOs (https://www.sec.gov/ICO) and has issued numerous investor bulletins, alerts, and employee speeches regarding virtual currencies. In addition, the SEC has brought 11 ICO related enforcement actions in the past rolling calendar year, including an enforcement action claiming operation of an unregistered securities exchange, defrauding exchange users, and making false and misleading statements in connection with an unregistered offering of securities (SEC v. Jon E. Montroll and Bitfunder).
- State securities regulators are also taking action against ICOs. The North American Securities Administrators Association (NASAA) issued a statement on January 4, 2018 entitled “NASAA Reminds Investors to Approach Cryptocurrencies, Initial Coin Offerings and Other Cryptocurrency-Related Investment Products with Caution”. Joseph Borg, NASAA president and director of the Alabama Securities Commission, is quoted in the statement as saying that investors should go beyond the “headlines and hype” to learn about risks associated with these investments. That same day, the Texas State Securities Board issued an emergency cease-and-desist-order against U.K.-based BitConnect, halting the company’s Jan. 9 initial coin offering.
The nascent worlds of Bitcoin/altcoin cryptocurrency and ICOs, and the regulatory issues around them, will continue to change and evolve.