United States: Regulators And Courts Clarify Virtual Currency Regulation, But Overall Framework Remains Murky

Introduction

This update serves to cover virtual currency regulatory developments over the past two months in the U.S., U.K. and EU. This follows our previous virtual currency regulatory updates1 as part of Shearman & Sterling's FinTech initiative, and we will continue to keep a close eye on these developments as they unfold.

Federal Court Upholds That Virtual Currencies Are Commodities

On March 6, 2018, the United States District Court for the Eastern District of New York confirmed that virtual currencies are commodities within the anti-fraud jurisdiction of the Commodity Futures Trading Commission (CFTC).2 The order, which came in the form of a preliminary injunction, follows the CFTC's January 18, 2018 civil enforcement action against Patrick K. McDonnell and his company CabbageTech, doing business as Coin Drop Markets (CDM), alleging that McDonnell had induced customers to send money and virtual currencies to CDM in exchange for virtual currency trading advice and purchasing on customers' behalf. The CFTC also alleged that McDonnell and CDM misappropriated investors' funds.3

The court considered whether virtual currencies are commodities under the Commodity Exchange Act (CEA) and whether the CFTC has jurisdiction over commodity fraud that is not tied to the sale of derivatives products. The court held that virtual currencies "fall well-within the common definition of 'commodity,'"4 and thus the CFTC maintains the jurisdictional authority to stop spot trade virtual currency fraud under the CEA.5 Further, the order clarified that the CFTC may exercise jurisdiction over spot transactions in virtual currencies when there is potential fraud, even if the fraud is not in conjunction with derivatives based on virtual currencies.6 

The ruling also marks the first time that a federal court has affirmed the CFTC's 2015 determination that virtual currencies are commodities as defined by the CEA.7 This provides the CFTC with further standing to police fraud in virtual currency spot markets. Given the recent rhetoric from CFTC commissioners,8 the CFTC is expected to continue to pursue similar enforcement actions.

However, the court's opinion does not differentiate among "virtual currencies," treating Bitcoin, initial coin offerings (ICOs) and tokens as all subject to the CFTC's authority. Moreover, the court's opinion suggests that other regulatory authorities, including the Securities Exchange Commission (SEC), the Treasury Department's Financial Crimes Enforcement Network (FinCEN) and state regulators, can assert concurrent jurisdiction with the CFTC over such virtual currencies.9 We would expect issues such as scope of authority to be refined as they further develop. In the meanwhile, market participants should review the range of laws and regulations that could apply to their activity and the regulatory authorities that could assert jurisdiction. 

SEC Issues Statement on Potentially Unlawful Online Platforms for Trading Digital Assets

On March 7, 2018, the SEC issued a statement warning investors of potential risks involving digital asset exchanges.10 The statement aims to protect investors trading digital assets through online platforms and serves as a warning shot to exchanges dealing in digital assets that may be securities. 

The first section of the statement outlines factors that investors should consider when trading digital tokens on online platforms. The SEC warns investors that many platforms that refer to themselves as "exchanges" may appear to be registered with and regulated by the SEC when in fact they are not; this means that they are not held to the same regulatory standards as national securities exchanges. The SEC also questions the adequacy of these platforms' trading protocols and data collection methods and cautions investors to perform due diligence and ask questions before trading any digital assets through them. 

The second section of the statement focuses on operators of online trading platforms. The SEC again said that any platform operating as an "exchange" and dealing in "securities," as defined by federal securities laws,11 must register with the SEC or have an exemption. The statement also cautions that even if an entity wishes to seek exemption from national securities exchange registration by operating as an alternative trading system (ATS), the entity must still register with the SEC as a broker-dealer and join a self-regulatory organization (SRO). 

Of particularly important note, the SEC's statement directly addresses digital wallets and those trading digital assets. The SEC warns that digital wallet platforms providing services for digital assets deemed securities may trigger registration requirements under federal securities laws. Additionally, the SEC stated that any exchange dealing in digital assets that are deemed securities and not registered with the SEC may be participating in the unregistered offering and sale of securities.

The SEC has repeatedly made it clear that certain digital assets, such as tokens, may be securities and has warned issuers and advisers that they may face disciplinary action for evading securities laws.12 However, this is the first time that the SEC has directly targeted exchanges and trading platforms in the context of virtual currencies and ICOs. Exchange operators and digital wallet service providers should exercise caution in ensuring that no tokens exchanged or held on their platforms meet the definition of "securities" under federal securities laws if they do not wish to register with the SEC, and any online trading platform that wishes to deal in securities tokens should comply with all federal securities regulations. Exchange operators and digital wallet service providers should also bear in mind that the SEC has repeatedly expressed a view that it would be very challenging to structure a token to not meet the definition of "security."13

Gemini Co-Founders Cameron and Tyler Winklevoss Propose Virtual Commodity Self-Regulatory Organization

On March 13, 2018, virtual currency exchange Gemini released a proposal to create the first SRO for U.S. virtual commodity exchanges.14 The so-called Virtual Commodity Association (VCA), as envisioned, would be a non-profit, independent regulatory organization that would operate to foster responsible virtual commodity markets by requiring members to implement specified sound practices and supervising members' implementation of such practices. The VCA would also encourage greater cooperation with relevant regulators in an effort to assist with the maturation of the virtual commodity industry.

The proposal noted that the VCA would not operate any markets, be a trade association or provide regulatory programs for security tokens or security token platforms. Initially, the VCA would be open to trading facilities that offer users the ability to transact in the virtual commodity spot markets, but may offer membership to additional categories of market participants in the future. 

The VCA would aim to foster responsible markets through a system of industry-sponsored standards, best practices and oversight that would promote price discovery, efficiency and transparency in virtual commodity markets. It would also require firms to adhere to the VCA's "Sound Practices" regarding responsible financial management, transparency and conflicts of interest, rules-based markets, cyber and information security and recordkeeping, surveillance, information sharing and cooperation with regulators. Shortly after publication of Gemini's proposal, CFTC Commissioner Brian Quintenz issued a statement encouraging the promotion of an SRO for virtual commodities.15 

While an independent, self-regulatory body could provide a form of oversight over virtual commodity spot platforms and promote best practices, many questions must still be answered. For example, who will assess membership qualifications, what sanctioning and penalty authority will the body have over members and, most importantly, what regulatory oversight will be imposed on the SRO by the CFTC (or other regulators)? CFTC Commissioner Rostin Behnam also raised concerns with virtual commodity SROs given the nascent nature of the industry and lack of a Congressional mandate (given that the regulatory framework for other SROs has been established by statute).16 However, there is still plenty of time for these questions to be answered, and it will be interesting to monitor how the VCA or any other proposed virtual commodity SRO navigates these issues.

Wyoming State Legislature Passes Several Measures to Foster Virtual Currency and Blockchain Innovation

The Wyoming state legislature recently passed the following virtual currency- and blockchain-focused bills intended to ease regulatory burdens at the state level for blockchain and digital asset ventures:

  • HB 0019 exempts virtual currency transactions within or outside the United States from money transmitter regulations under the Wyoming Money Transmitter Act.17
  • HB 0070 states that any developer, seller or person who facilitates the exchange of an open blockchain token (often referred to as a "utility token") is exempt from certain state securities registration and money transmission laws. These tokens must be exchangeable for goods and services and not marketed as an investment, and the developer or seller of the token may not enter into any repurchase agreement to locate a buyer for the tokens.18
  • HB 0101 authorizes the use of blockchain technology to maintain corporate records. Corporations may use a shareholder's private key on the blockchain to verify the shareholder's identity and accept shareholder votes if the private key corresponds to the shareholder's network address.19
  • SF 0111 exempts virtual currencies from property taxation laws.20
  • HB 0126 authorizes the establishment of "Series LLCs." The Series LLC corporate structure, which allows for the unlimited segregation of members, managers, transferable interests and assets, is frequently used by blockchain ventures.21

These pieces of legislation set an interesting precedent for token regulation at the state level and establish Wyoming as one of the most virtual currency- and blockchain-friendly jurisdictions in the country. While it is encouraging to see state legislators take initiative on digital asset and blockchain regulation, it is important to remember that state-level legislative actions do not address or supersede the federal securities law requirements that may apply to token transactions.

Virtual Currency Developments in the UK and the EU

On April 6, 2018 the U.K. Financial Conduct Authority (FCA) issued a statement clarifying its position on virtual currencies and virtual currency derivatives.22 The FCA stated that virtual currencies are not currently under FCA jurisdiction provided they are not part of other products or services regulated by the FCA. However, virtual currency derivatives may be deemed financial instruments under the Markets in Financial Instruments Directive II (MiFID II). The FCA warned that any firms dealing in, arranging transactions in or advising on or providing services relating to cryptocurrency derivatives, including futures, contracts for difference and options, must comply with all applicable rules in the FCA's Handbook and any relevant provisions in directly applicable EU regulations. 

Additionally, on March 22, 2018, the U.K. announced the launch of a Cryptoassets Task Force (Task Force).23 The Task Force will consist of HM Treasury, the Bank of England and the FCA and aims to explore the risks virtual assets may pose to the financial system, as well as the potential benefits of the underlying distributed ledger technology (DLT). The announcement stated that the Task Force will examine the U.K.'s future response to the rapidly growing arena of virtual currencies and will also explore potential regulatory measures. The Task Force is planning on publishing a report on its findings in summer 2018. 

This announcement follows an inquiry launched by the U.K. House of Commons Treasury Committee on virtual currencies and DLT in February 2018.24 The inquiry will cover the opportunities and risks of virtual currencies in the U.K. and examine the potential uses of DLT for financial institutions, including the Bank of England. Additionally, it will examine the regulatory response to virtual currencies from Parliament, the Bank of England and the FCA to determine how the U.K. can protect market participants while safeguarding innovation. The deadline for submissions is April 13, 2018. 

On March 14, 2018, the Government of Gibraltar published a white paper outlining forthcoming proposals to regulate token sales, secondary token market platforms and token investment services.25 Broadly, the proposed regulations would establish a regime that would require organizers of each token sale to designate an "authorized sponsor" to oversee and implement best practices relating to the sale. These "codes of practice," which the white paper says will be specified in the regulations, must be incorporated into the authorized sponsor's agreement with each of their sponsorship clients. The regulations will also set out requirements for secondary token market platforms regarding trading supervision and data disclosure, and cover investment services and advice for tokens, virtual currencies and central bank-issued digital currencies. The Government of Gibraltar intends to phase in these regulations in three parts, the last of which is expected to be completed by the end of October 2018.

The white paper also distinguishes most tokens from securities and makes clear that Gibraltar sees token sales, when conducted properly, as an effective means of crowd funding. This further establishes Gibraltar as one of the most token-friendly jurisdictions in the world, as Gibraltar also implemented a DLT regulatory framework in January 2018.26 It remains to be seen what effect these regulations will have going forward and whether other jurisdictions will follow suit.

In the EU, the European Commission (the Commission) issued a Communication on financial technology (FinTech) to European lawmakers and regulators on March 8, 2018.27 The Commission states that a review of the current European regulatory framework regarding virtual currencies and ICOs is necessary and must be conducted in a manner that promotes technological innovation while appropriately addressing market risks. The Commission also stresses the importance of international coordination and consistency and vows to work with supervisors, regulators, industry and civil society within the EU and with international financial standard setters to determine any further appropriate course of action. The Commission will continue to monitor developments in these spaces throughout 2018 and, based on their assessment, will determine whether regulatory action at the EU level is required. 

In the meantime, the Council of the European Union is continuing with its plans to bring within the scope of the EU's anti-money laundering framework virtual currencies, exchange service providers for virtual currencies and entities that safeguard private cryptographic keys. These are being made through amendments to the proposed 5th EU Money Laundering Directive, which includes the introduction of a definition of virtual currencies.28 

Regulators in both the U.K. and the EU to this point have kept a keen eye on developments in virtual currency markets and have been active in warning investors of potential risks involved, with the European Supervisory Authorities issuing the latest one in early February 2018.29 These task forces and forthcoming reports may paint a clearer picture by the end of 2018 of how regulators will tackle these issues within their respective jurisdictions.

Our Take

Although recent developments are providing additional clarity on the emerging regulatory environment, there is still significant uncertainty as to when and whether a clear and consistent regulatory compliance framework will emerge from the SEC, CFTC and other regulators. It is important for participants in this developing market to remain focused on regulatory developments and any sanctions regarding virtual currency30 at the U.S. federal and state levels and internationally.

Footnotes

1  Two of our most recent virtual currency regulatory updates are available here and here.

CFTC v. McDonnell, et al., No. 1:18-cv-00361 (E.D.N.Y. Mar. 6, 2018), available here. For more information, please refer to our earlier update, available here.

Id at 29.

Id at 24.

Id at 25.

Id at 26. 

See In the Matter of: Coinflip, Inc., d/b/a Derivabit, and Francisco Riordan, CFTC Docket No. 15-29 (Sept. 17, 2015), available here.

8  Chair J Christopher Giancarlo, CFTC, "Written Testimony of Chairman J. Christopher Giancarlo before the U.S. Senate Agriculture, Nutrition, and Forestry Committee, Washington, D.C." (Feb. 15, 2018), available here.

Id at 14.

10  SEC, "Statement on Potentially Unlawful Online Platforms for Trading Digital Assets" (Mar. 7, 2018), available here.

11  See 15 U.S.C. § 78c(a)(1), which defines an "exchange" as "any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood, and includes the market place and the market facilities maintained by such exchange." 

12  See SEC, "Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO," Exchange Act Release 81207 (July 25, 2017), available here; and Chair Jay Clayton, SEC, "Opening Remarks at the Securities Regulation Institute" (Jan. 22, 2018), available here.

13  See Chair Jay Clayton, SEC, "Chairman's Testimony on Virtual Currencies: The Roles of the SEC and CFTC" (Feb. 6, 2018), available here.

14  Gemini's VCA proposal is available here.

15  Commissioner Brian Quintenz, CFTC, "Statement of CFTC Commissioner Brian Quintenz on a Proposal by Cameron and Tyler Winklevoss for a Virtual Commodity SRO" (Mar. 13, 2018), available here.

16  Joe Rennison, "Call for U.S. Treasury to Fill Cryptocurrency 'Regulatory Vacuum'," Financial Times (Mar. 15, 2018), available here

17  H.B. 0019, 64th Leg., Budget Session (Wyo. 2018), available here.

18  H.B. 0070, 64th Leg., Budget Session (Wyo. 2018), available here.

19  H.B. 0101, 64th Leg., Budget Session (Wyo. 2018), available here.

20  S.F. 0111, 64th Leg., Budget Session (Wyo. 2018), available here.

21  H.B. 0126, 64th Leg., Budget Session (Wyo. 2018), available here

22  FCA, "FCA Statement on the Requirement for Firms Offering Cryptocurrency Derivatives to be Authorised" (April 6, 2018), available here.

23  See HM Treasury, "Fintech Sector Strategy: Securing the Future of U.K. Fintech" (Mar. 22, 2018) at 18, available here.

24  The announcement of the U.K. House of Commons Treasury Committee's inquiry is available here.

25  The Government of Gibraltar's whitepaper is available here.

26  Gibraltar's DLT regulatory framework is available here.

27  The Commission's Communication is available here. For more information regarding the Commission's Communication, please refer to our earlier update, which is available here.

28  The Council of the European Union's proposal is available here

29  See FCA, "Consumer Warning about the Risks of Initial Coin Offerings ('ICOs')" (Sept. 12, 2017), available here; and European Securities and Markets Authority, "ESAs Warn Consumers of Risks in Buying Virtual Currencies" (Feb. 12, 2018), available here

30  For example, on March 19, 2018, President Donald Trump issued an Executive Order barring any dealing in Venezuelan virtual currencies issued on or after January 9, 2018 by a U.S. person or within the U.S. The Executive Order is available here.

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