1. Introduction
The rise of blockchain technology and the rapid expansion of cryptocurrency markets have introduced new challenges and complexities for regulatory frameworks, particularly in the domain of insider trading. While traditional financial markets are governed by established rules and regulatory bodies, such as the Securities and Exchange Board of India (SEBI) and the U.S. Securities and Exchange Commission (SEC), the decentralized and pseudonymous nature of cryptocurrencies complicates the enforcement of these rules, making it difficult to track and prevent insider trading effectively in the crypto space. In traditional markets, both SEBI and the SEC have implemented stringent regulations to curb insider trading and protect investors. However, the rise of blockchain technology and the rapid growth of cryptocurrency markets have exposed gaps and challenges in existing regulatory frameworks in both India and the United States, with the SEC grappling to classify digital assets within its regulatory scope.
This article explores insider trading in the context of blockchain and cryptocurrencies, analysing notable case studies from the USA and examining how the U.S. regulatory framework addresses these challenges. It also assesses the potential applicability of SEBI's current regulations to the evolving landscape of cryptocurrency markets, considering how Indian regulations may adapt in light of these global trends.
2. Understanding Block chain and Crypto Assets: A Categorical Overview
Blockchain is a decentralized, distributed ledger technology that ensures secure, transparent, and tamper-resistant record-keeping through a consensus mechanism. It can operate without the need for a central authority, allowing transactions and data to be securely recorded across a network of computers or nodes.
The technology is categorized into different types based on their functionality and use cases. Public blockchains, like Bitcoin and Ethereum, are open to anyone and allow anyone to participate in the network, making them transparent and decentralized1. Private blockchains are permissioned, meaning only authorized participants can access the network, making them suitable for businesses that require privacy and control over their data2. Consortium blockchains are hybrid, where multiple organizations govern the network, often used for business alliances or consortia3. Additionally, sidechains are separate blockchains connected to a parent chain, used for offloading work or enabling specific functionalities that the main block-chain may not support4. Each category of blockchain serves distinct needs, offering solutions for everything from cryptocurrencies to supply chain management, voting systems, and more.
Crypto-assets are a unique form of property distinguished by their reliance on distributed ledger technology, a system that semi-publicly verifies and records both the asset's features and its current ownership, without any central authority acting as a record-keeper. Crypto assets are sometimes referred to as virtual currency, coins, or tokens.
Transactions involving crypto assets are often executed via "smart contracts," which are programmed functions that automate specific actions when conditions are met. Crypto assets can be categorized into four overlapping types:
- Payment Tokens: These are used similarly to virtual currencies. For example, Bitcoin is widely accepted by some merchants as an alternative to traditional money.
- Utility Tokens: Designed to give holders access to specific products or services, utility tokens resemble gift cards or prepaid services5. For instance, Filecoin tokens allow users to redeem storage or processing space from the company. Other parallels include certain forms of crowdfunding, where supporters contribute funds with an expectation of future access to a product or service6.
- Security Tokens / Asset-Backed Tokens: These are tokens issued to raise funds for a business, often entitling holders to a share in the business's value. Comparable to traditional securities like stocks or bonds, security tokens are frequently sold through "initial coin offerings" (ICOs) to attract public investment. These tokens derive their value directly from other assets, often by tracking or amplifying the value of a primary crypto asset. An example is Bitcoin Futures, traded on the Chicago Mercantile Exchange (CME), which provide returns based on Bitcoin's value fluctuations or any other Real World Asset (RWA) backed token (e.g. security, gold, real estate etc.).
3. Insider Trading Risks in Blockchain and Crypto Markets
Blockchain and cryptocurrency markets are fundamentally different from traditional financial markets. Blockchain ideally operates on a decentralized network, where transactions are recorded on a public ledger7. This theoretically enhances transparency, but the pseudonymous nature of these transactions can obscure the identities of the participants, making it difficult to trace and regulate insider trading.
Insider trading in the crypto space can manifest in various ways. For instance, an individual with privileged and/ or price sensitive information about an upcoming token listing on a major exchange might buy large amounts of that token before the information becomes public. Once the listing is announced, the token's price typically spikes, allowing the insider to sell at a significant profit. This type of trading on non-public information undermines market fairness and can significantly impact investor confidence.
Notable incidents of insider trading have occurred in the cryptocurrency market in U.S. where a former Coinbase product manager Mr. Ishan Wahi was sentenced to two years in prison for insider trading8. Mr. Ishan Wahi and his brother Mr. Nikhil Wahi have agreed to settle charges of insider trading related to crypto asset securities. The SEC alleged that Mr. Ishan Wahi, while employed at Coinbase, shared confidential information about upcoming listing announcements with his brother and friend, who then purchased those assets before the announcements and sold them for a profit9. Both brothers have pled guilty to conspiracy to commit wire fraud in a related criminal case. As part of the settlement with the SEC, Mr. Ishan Wahi and Mr. Nikhil Wahi have consented to permanent injunctions against violating securities laws and will pay disgorgement of their ill-gotten gains10. This case demonstrates that existing insider trading laws apply to crypto asset securities, just as they do to traditional securities.
Another incident where Mr. Nathanial Chastain, a former product manager at Ozone Networks Inc. was sentenced to three months in prison for insider trading in Non-Fungible Tokens (NFTs). As announced by Mr. Damian Williams, the United States Attorney for the Southern District of New York, Mr. Chastain used confidential information about which NFTs were going to be featured on Open Sea's homepage for his personal financial gain11. In his role at Open Sea, Chastain was responsible for selecting NFTs to be featured on the platform's homepage. Open Sea kept the identity of featured NFTs confidential until they appeared on the homepage. Once an NFT was featured, its price, as well as the prices of other NFTs by the same creator, typically increased significantly. From June to September 2021, Mr. Chastain exploited his price sensitive and non- public knowledge of which NFTs would be featured to purchase dozens of NFTs shortly before their appearance on the homepage. After these NFTs were featured, Mr. Chastain sold them at profits ranging from two to five times his initial purchase price. To conceal his activities, Mr. Chastain used anonymous digital currency wallets and accounts on Open Sea.
4. Crypto as Securities: U.S. Regulatory Framework for Insider Trading
The primary legal framework governing insider trading is rooted in securities regulation, particularly in the Securities Act of 193312 and the Securities Exchange Act of 193413. These acts, supplemented by SEC rules and judicial interpretations, apply to trading in securities, a category that generally includes stocks, bonds, and similar instruments tied to a company's financial performance. Within this framework, insider trading restrictions are primarily enforced through three main statutory and regulatory prohibitions.
First, Section 1614 of the Securities Exchange Act of 1934 imposes a strict disgorgement rule on certain company insiders, including officers, directors, and shareholders holding at least ten percent of the company's shares, often referred to as "statutory insiders." Under this provision, any profits from trading the company's shares within a six-month period, commonly referred to as "short-swing profits," must be returned to the company. This rule operates mechanically, penalizing rapid trading by insiders regardless of whether they had access to nonpublic information, thereby curbing potentially speculative trading by those with privileged access.
Second, Securities Exchange Act's Rule 14e-315 is directed at preventing insider trading in connection with tender offers. This rule prohibits individuals from trading while in possession of material nonpublic information about a pending tender offer. Information is deemed material if it is likely that a reasonable shareholder would consider it important; generally, knowing a tender offer is forthcoming is considered material information. This rule applies to equities, bonds, and other securities and is particularly significant in the context of public tender offers, which involve publicly inviting shareholders to sell securities to an acquirer, often linked with attempts to take control of a target company without board approval.
The third prohibition falls under Section 10(b)16 of the Securities Exchange Act, which targets fraudulent or deceptive practices in the securities market. To pursue insider trading under this provision, often enforced through Rule 10b-5, regulators or plaintiffs must argue that insider trading constitutes fraud rather than mere unfairness. This requirement introduces a unique challenge because securities trade anonymously, where traders typically make no affirmative representations, let alone false ones. Insider trading law addresses this by recognizing certain circumstances where silence, when trading based on nonpublic information, can be deemed fraudulent.
Applying the Howey Test to Cryptocurrencies
In the US, the classification of cryptocurrencies as securities hinges on a legal framework established in a Supreme Court case in 1946 called SEC v. W.J. Howey Co17. This framework, known as the Howey Test which outlines four key elements that are:
- This involves committing capital with the expectation of financial return. In the context of crypto, it could be money used to purchase a coin or token.
- Investors' fortunes are tied to the overall success of the project or venture. For crypto, this may involve a cryptocurrency where the value is intrinsically linked to the success of the underlying blockchain project.
- Investors anticipate profits derived from the efforts of others, not solely through general market appreciation. For crypto, this could be a situation where profits are expected from the project's development or wider adoption, not just price fluctuations.
- Investors rely on the efforts of a third party (promoter or company) to generate profits.
How the Howey Test Applies to Crypto?
1. Certain cryptocurrencies, particularly those associated with Initial Coin Offerings (ICOs), often meet all four prongs of the Howey Test and are classified as securities18. ICOs typically involve raising funds by selling tokens that promise future returns based on the success of the underlying project. Investors in these scenarios contribute money (or cryptocurrency) to a centralized entity or team, which pools funds to develop the project or platform. The project's success is usually marketed as the primary driver of token value appreciation, making the expectation of profits directly tied to the "efforts of others." As a result, these tokens may be subjected to securities regulations under U.S. law, requiring issuers to register with the SEC or qualify for exemptions.
2. For established cryptocurrencies like Bitcoin, the applicability of the Howey Test becomes less clear. Bitcoin, for instance, lacks a centralized authority or team actively managing the asset to generate profits for holders. This decentralized nature makes the "efforts of others" prong difficult to satisfy. Additionally, Bitcoin and similar cryptocurrencies often function more as commodities or mediums of exchange rather than investment contracts, further distancing them from the definition of a security. Their value is driven by market dynamics and broader adoption rather than the performance or actions of a specific entity.
Do Crypto Assets Fall Under Insider Trading Laws?
The application of insider trading laws to crypto assets has been a topic of debate, with some questioning if these laws are even relevant given that American insider trading jurisprudence traditionally centres on common stock in publicly traded companies rather than digital assets. However, these arguments miss the mark; crypto assets indeed fall within the scope of insider trading regulations to a sufficient degree, allowing federal prosecutors to bring criminal actions.
Further bolstering this interpretation is the potential classification of crypto assets as securities or commodities, which would empower the SEC, Commodity Futures Trading Commission (CFTC), and private plaintiffs to enforce insider trading rules. In 2018, SEC Chairman Jay Clayton remarked that Bitcoin should not be classified as a security; however, the SEC has since clarified its stance in enforcement actions, suggesting that many crypto assets could indeed be securities. For instance, the SEC classified DAO Tokens as securities in 2017, setting an example of the agency's approach to crypto asset regulation and highlighting that a substantial number of these assets are likely securities subject to regulation19.
For those crypto assets classified as commodities20, the CFTC enforces anti-fraud provisions under the Commodity Exchange Act of 1936 (CEA), which extend to both spot and derivative markets. Federal courts have affirmed that virtual currencies, such as Bitcoin, qualify as commodities under the CEA, thereby granting the CFTC authority to address fraud within these markets. Bitcoin, one of the most well-known virtual currencies, has been determined to be a commodity under the CEA. As a result, the CFTC has jurisdiction over Bitcoin and other virtual currencies, particularly when it comes to derivatives and futures trading21.
While recent legislative proposals seek to exempt some crypto assets from securities laws, these exclusions are not retrospective and do not impact the CEA or federal mail and wire fraud statutes. Thus, crypto assets remain within the purview of insider trading regulations, underscoring the ongoing necessity for robust insider trading analysis and regulation in the evolving digital asset landscape.
5. The Indian Perspective: SEBI's Role in Regulating Crypto Markets
The SEBI plays a crucial role in regulating the Indian securities market, particularly in the prevention of insider trading. The SEBI (Prohibition of Insider Trading) Regulations, 2015 ("PIT Regulations") were enacted to establish comprehensive guidelines for curbing insider trading activities and ensuring that the securities market remains transparent and fair for all investors. Under Regulation 2(e) of PIT Regulations, 2015, an "insider" includes any person who is connected or has access to unpublished price-sensitive information (UPSI). Regulation 3 of PIT Regulations prohibits insiders from communicating, providing, or allowing access to UPSI to any person, except when it is necessary for legitimate purposes, the performance of duties, or fulfilling legal obligations. Additionally, Regulation 4 of PIT Regulations prohibits trading in securities by anyone in possession of UPSI, unless they can demonstrate that the trade was an off-market inter-se transfer between promoters who held the same UPSI without breaching regulations. These are the general provisions which defines what is insider and insider trading. These provisions are applicable on the securities.
Do Crypto Assets Fall Under Insider Trading Laws?
In India, cryptocurrency exists in a regulatory gray area, as it is not explicitly recognized as a security under current securities laws. The definition of 'Security22' under the Securities Contracts (Regulation) Act, 1956 (SCRA) is inclusive, encompassing a broad range of financial instruments. A security token exhibits the characteristics of a derivative, as its value is derived from underlying real-world securities or assets. Additionally, it functions as an instrument that establishes rights and interests in such real-world securities or assets.
Unlike traditional Securities such as shares, debentures, and derivatives, which are clearly defined and regulated under the SCRA, cryptocurrencies lack a dedicated regulatory framework. The Reserve Bank of India (RBI) has expressed concerns regarding cryptocurrency's potential risks to financial stability, leading to intermittent restrictions on their use. However, the SEBI has not classified cryptocurrencies as securities, largely due to their decentralized nature and the lack of a clear issuer. Consequently, while digital assets are widely traded, their classification as securities remains ambiguous, with potential legislative developments or Supreme Court rulings likely needed to provide clearer guidance on their status.
The regulation of Security Token Offerings (STOs) in India presents a range of legal hindrance due to their hybrid nature and reliance on block-chain technology. Security tokens often resemble derivatives, which under Section 18A23 of the SCRA, must be traded and settled on recognized stock exchanges—a requirement incompatible with block-chain platforms that are fundamental to their operation.
6. Conclusion
The rapid evolution of blockchain technology and the exponential growth of cryptocurrency markets have introduced unprecedented challenges to regulatory frameworks worldwide. Unlike traditional financial markets, where regulations are well-defined and enforced, the decentralized and pseudonymous nature of digital assets creates significant barriers to identifying and curbing insider trading. Case studies from the U.S., such as the Coinbase insider trading scandal, illustrate how regulatory bodies like the SEC have adapted by applying securities laws to cryptocurrency transactions. Using tools like the Howey Test, the SEC has successfully classified many digital assets as securities, bringing them under the purview of insider trading laws. These developments underscore the importance of extending established regulatory principles to this emerging sector to promote fairness, transparency, and investor trust.
In India, the absence of a clear regulatory framework for cryptocurrencies amplifies risks for retail investors, who are often the most vulnerable to market manipulation and insider trading. SEBI's current insider trading regulations under the PIT Regulations, 2015, are robust for traditional securities but fall short when addressing the unique attributes of digital assets. The ambiguity surrounding the classification of cryptocurrencies—as securities, commodities, or an entirely new asset class—has left a regulatory vacuum. While security tokens exhibit characteristics of securities and derivatives, their reliance on blockchain-based trading platforms creates incompatibility with existing laws like the SCRA. This regulatory gray area not only undermines market integrity but also jeopardizes investor confidence, highlighting the urgent need for legislative clarity.
Addressing these challenges requires a dual approach. First, policymakers must work to expand existing securities laws to explicitly encompass cryptocurrencies, ensuring that they fall under SEBI's regulatory jurisdiction. Second, a tailored framework should be developed to address the distinct characteristics of blockchain technology and digital assets. International collaboration, informed by lessons from jurisdictions like the U.S., can guide India in crafting comprehensive regulations that balance innovation with investor protection. Without such measures, the promise of blockchain technology risks being overshadowed by the perils of unregulated markets, leaving retail investors exposed to significant harm and stifling India's leadership in the global fintech ecosystem.
Footnotes
1. Government of India, Blockchain Types: Public Blockchain, National Portal on Blockchain Technology, accessed November 20, 2024, https://blockchain.gov.in/Home/BlockChain.
2. Ibid. (Private Blockchain definition)
3. Supra note 1 (Consortium Blockchain definition)
4. National Institute of Standards and Technology (NIST), Blockchain for Access Control Systems, NIST IR 8301, page 18, published April 2021, https://nvlpubs.nist.gov/nistpubs/ir/2021/NIST.IR.8301.pdf.
5. European Securities and Markets Authority (ESMA), Final Report on Markets in Crypto-Assets Regulation (MiCA), ESMA75-453128700-1229, page 351, https://www.esma.europa.eu/sites/default/files/2024-07/ESMA75-453128700-1229_Final_Report_MiCA_CP2.pdf.
6. Filecoin, official website, https://filecoin.io/.
7. Feliz-Viñas, Ester, Luke Johnson & Talis J. Putniņa, Insider Trading in Cryptocurrency Markets, Draft (June 11, 2024).
8. U.S. Attorney's Office, Southern District of New York, "Former Coinbase Insider Sentenced in First-Ever Cryptocurrency Insider Trading Case," U.S. Department of Justice, July 2023, https://www.justice.gov/usao-sdny/pr/former-coinbase-insider-sentenced-first-ever-cryptocurrency-insider-trading-case.
9. U.S. Securities and Exchange Commission, "SEC Charges Prominent NFT Creator with Insider Trading," SEC, July 2023, https://www.sec.gov/newsroom/press-releases/2023-98#:~=The%20SEC's%20complaint%2C%20filed%20on,be%20made%20available%20for%20trading.
10. Ibid.
11. U.S. Department of Justice, "Former Employee of NFT Marketplace Sentenced to Prison in First-Ever Digital Asset Insider Trading Case," United States Attorney's Office, Southern District of New York, December 2022, https://www.justice.gov/usao-sdny/pr/former-employee-nft-marketplace-sentenced-prison-first-ever-digital-asset-insider.
12. Securities Act of 1933, 15 U.S.C. § 77b(a)(1): The term "security" includes any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities, or any interest or instrument commonly known as a "security," or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to or purchase any of the foregoing.
13. Securities Exchange Act of 1934, 15 U.S.C. § 78c(a)(10): The term "security" means any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest or instrument commonly known as a "security"), or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to or purchase any of the foregoing.
14. 15 U.S.C. § 78p (Securities Exchange Act of 1934, § 16).
15. 17 C.F.R. § 240.14e-3 (Exchange Act Rule 14e-3).
16. 15 U.S.C. § 78j(b) (Securities Exchange Act of 1934, Section 10(b)).
17. U.S. Reports: S.E.C. v. Howey Co., 328 U.S. 293 (1946).
18. Ibid.
19. U.S. Securities and Exchange Commission, "Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO," Exchange Act Release No. 81207, 117 SEC Docket 745, July 25, 2017.
20. In 2015, the U.S. Commodity Futures Trading Commission (CFTC) issued a ruling affirming that Bitcoin is classified as a commodity under the Commodity Exchange Act (CEA). Section 1a(9) of the CEA defines "commodity" broadly to include all goods, articles, and services, except for certain items like currencies issued by governments. Based on this definition, the CFTC has jurisdiction over Bitcoin and other virtual currencies, particularly with respect to derivative trading and anti-fraud provisions. As such, cryptocurrencies such as Bitcoin are not only subject to federal anti-fraud laws but are also regulated under CFTC rules concerning commodities.
21. Commodity Futures Trading Commission (CFTC), Bitcoin Basics, December 2018, https://www.cftc.gov/sites/default/files/2019-12/oceo_bitcoinbasics0218.pdf.
22. Section 2(h), SCRA,1956 - The term
"securities" includes: (i) Shares, scrips, stocks, bonds,
debentures, debenture stock, or other marketable securities of a
similar nature in or of any incorporated company or other body
corporate;
(ia) Derivative;
Inserted by the Securities Laws (Amendment) Act, 2004 (w.e.f.
12-10-2004).
Inserted by the Securities Laws (Second Amendment) Act, 1999
(w.e.f. 16-12-1999).
Clause (ga) lettered as Cl. (gb) by the Securities Laws (Amendment)
Act, 2004 (w.e.f. 12-10-2004).
(ib) Units or any other instrument issued by any collective
investment scheme to the investors in such schemes;
Inserted by the Securities Laws (Amendment) Act, 1999 (w.e.f.
22-02-2000).
(ic) Security receipt as defined in clause (zg) of section 2 of the
Securitization and Reconstruction of Financial Assets and
Enforcement of Security Interest Act, 2002;
(id) Units or any other such instrument issued to the investors
under any mutual fund scheme;
(ii) Government securities;
(iia) Such other instruments as may be declared by the Central
Government to be securities; and
(iii) Rights or interest in securities.
23. Section 18A, Securities Contracts (Regulation) Act, 1956: This section explicitly states the conditions under which derivative contracts are considered legal and valid—when they are traded on recognized stock exchanges and settled through their clearing houses, as per the exchange's rules and bye-laws.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
