US regulators turn gaze to cryptos

20 December 2018

Historically, the mantra that many fintechs have clinged to despite possessing many features of traditional financial services is ‘we are not financial institutions’.

The rationale behind that distinction is that during the sector’s infancy it was true, giving companies the space to innovate unconstrained and justified to regulators why many rules and regulations that apply to banks and other institutions need not apply to them.

But as some fintechs, especially those that fall under the banner of cryptocurrencies, have over time acquired more and more features of traditional financial services the regulatory lines have begun to blur.

ICOs are securities

On June 13, the US Securities and Exchange Commission (SEC) held a public forum in Atlanta, Georgia with cryptocurrency regulation issues high on the agenda. During the session, the SEC was quick to point out the difference between blockchain, also referred to as distributed ledger technology, and digital assets like cryptocurrencies and initial coin offerings (ICOs). The agency reaffirmed its commitment to support innovation for the former and taking a much more hands-off approach but took a much clearer regulatory stance on the latter.

Speakers at the SEC event were quite clear that about how many investment products that have sprung from cryptocurrencies, and the underlying distributed ledger technology, are becoming increasingly complex, with the regulator acknowledging that as these products continue to take technological steps forward, it too must take strides in improving its own data, security and oversight to embrace innovation, while mitigating potential risks.

‘[Cryptocurrency] has the potential to reduce the cost of investing,’ Commissioner of the SEC Kara Stein said during the meeting. ‘It could decease the cost of capital allocation. We are being challenged, we are being disrupted like everybody else is… and one of the things we’re thinking about is how embrace the innovation and make sure it’s used effectively. One thing we are thinking through is how to ideally anticipate and prevent problems before they arise.

‘I think remaining competitive requires, both us as regulators and market participants, to thoughtfully evolve with the innovation and not react to it after the fact,” she added. “For example, there are increased risks for pump and dumps and Ponzi schemes perhaps, because it’s so easy to now invest in that hotel resort community in some African nation.’

Chairman of the SEC Jay Clayton reiterated his colleague’s sentiments but took it a step further. While he stressed that blockchain technology has incredible promise for the securities industry, as well as a myriad of other use cases for numerous industries both within and outside of financial services, he also expressed concern about how the technology has been applied to fundraising, particularly with regards to ICOs.

Clayton conceded that while not all ICOs are fraud, many actively involved in the ICO space have used the alternative fundraising method to circumvent existing federal regulations that provide a governing framework for securities offerings – stating that an ICO is a security offering.

With that statement, Clayton and the SEC ‘made it very clear that if an ICO looks and smells like a security then it is a security and they will treat it like a security,’ Greg Wood, Senior Vice-President of Global Industry Operations and Technology at the Futures Industry Association (FIA) told Bobsguide.

The conversations we have had with regulators here in the US, particularly on the SEC and CFTC side for securities and derivatives markets, is that they look at [cryptocurrencies] as being something that fits into existing law and regulation,’ Wood added.

There is no denying that the growth of cryptocurrencies is a challenge for regulators to tackle and the US regulators approach to regulating the industry by applying existing laws instead of creating new regulations is certainly a solution, but one that is all too simple, according to Daniel Araya, a technology consultant and government adviser that specialises in cryptocurrencies and blockchain.

In a recent piece he wrote for the Brookings Institute, Araya said that US regulators decision to apply existing rules and regulations to ICOs is ‘short-sighted’, leaving a ‘vacuum in effective regulation’ that leaves the door wide open for market manipulation to remain a major issue, with more than 80% of ICOs identified as scams.

US regulators have not just talked tough, they’ve also been busy cracking down on fraudulent actors, with the number of class-action lawsuits levied at companies looking to raise capital via ICOs increasing rapidly in the last 12 months.

Two of the biggest, and most recent, ICO lawsuits to occur this year centres around Pincoin and iFan. The two ICOs were initiated by a company operating out of Vietnam, with the the pair running off with a combined total of approximately $660 million.

However, one of the most famous ICO scams has to be Centratech, a business that claimed to offer a Visa and MasterCard debit card service that made it simple and easy to convert any cryptocurrency into fiat money. The three founders, Raymond Trapani, Sohrab Sharma, and Robert Farkas, were found guilty of trying to defraud investors after the company raised around $32 million from investors after it regulators found out that they had lied about having money transmitter licenses and fabricated a fake CEO. The company gained a lot of notoriety because it was able to obtain endorsements from professional boxer Floyd Mayweather and music producer DJ Khaled.

Bitcoin too decentralised to count

The SEC’s decision to treat ICOs as securities had some investors and fans of Bitcoin – the world’s largest coin in terms of market value – worried that that US regulators would deem the that it also be regulated in a similar fashion to stocks and bonds.

But shortly after Clayton’s comments, the agency’s director of corporate finance William Hinman was quick to announce that both Bitcoin and Ether, which fuels the Ethereum network, were not considered a fundraising vehicle and, therefore, not treated like a traditional security.

‘An important feature of the US regulatory landscape is the split between digital assets that will be treated as securities, digital assets that will be treated as currencies and therefore fall under the CFTC’s regime and a third category that is best described as utility tokens,’ Will Acworth, Senior Vice President of Publications at the FIA said.

According to the SEC statement in June, acknowledged that some things within the cryptocurrency space fall outside of securities regulation. And, with regards to Bitcoin and Ether, the US regulator contends that both digital assets have become sufficiently decentralise to not be viewed as a security from a regulatory standpoint.

‘Based on my understanding of the present state of ether, the Ethereum network, and its decentralized structure, current offers and sales of ether are not securities transactions,’ Hinman said at Yahoo's All Market Summit: Crypto in San Francisco. ‘And, as with bitcoin, applying the disclosure regime of the federal securities laws to current transactions in ether would seem to add little value.’

Hinman did hold out hope for other cryptocurrencies to be afforded the same status as larger coins like Ether and Bitcoin, so long as they become ‘sufficiently decentralised’ over time and to a degree where ‘regulating the tokens or coins that function on them as securities may not be required’.

But for the time being, many cryptocurrencies, token sales and ICOs will be treated like securities and face scrutiny from US regulators just like any other investment vehicle. After all, these alternative fundraising techniques, even those that are not fraudulent, are designed to provide an injection of capital to finance startup, project, product or application that more often than not hasn’t even been made yet. In short, the SEC made it clear that with Bitcoin and Ether, the coins are used to power an entire decentralised ecosystem rather than as a simple fundraising tool employed by a single company.

Regulatory future

With the clear majority of ICOs found to be scams and Bitcoin’s 2017 boom primarily driven by coordinated price manipulation, it is no surprise that there is increasing interest from governments around the world to increase regulation in the sector next year, with the US regulators taking a closer look at the industry in the new year.

In the twilight of 2018 the CFTC announced that it is seeking public comment and feedback in a bit to better understand the technology, mechanics and markets for virtual currencies beyond Bitcoin, namely Ether and how it is used to power the wider Ethereum network.

The news highlights the pragmatic, methodical and thoughtful approach US regulators are taking towards this emerging market and one that other financial watchdogs should follow if they hope to create a regulatory framework that provides effective oversight but not at the expense of stifling innovation.

 ‘One particular fear is that overregulation will undermine innovation by discouraging risk-taking,’ he writes. ‘The value of ICOs is that they have radically democratised access to capital for startups. This suggests the need for a different set of regulatory obligations specifically designed to allow smaller, cash-poor companies to raise funds from a wide range of funders.’

‘As it stands, there are roughly three broad types of regulatory systems overseeing ICOs. These are closed (China), open and strict (USA), and open and liberal (Switzerland),’ he continues. ‘Nonetheless, the priority for most governments is combatting fraud, while at the same time enabling legitimate businesses to flourish.’

National governments are clearly taking notice of the crypto market and it appears that the sector will face increased scrutiny over the coming years and perhaps new rules and regulations to reduce incidents of fraud and safeguard digital assets. And, despite overregulation a real worry for the sector, regulation of the cryptocurrency market will hopefully provide a degree of stability, bringing in more institutional investors who, for the time being are remaining firmly on the fringes, which is not only limiting the size of the market but leading to massive value erosion.

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