SEC Chair Jay Clayton Urges Caution regarding ICOs and Cryptocurrencies

SEC Chair Jay Clayton asserted that initial coin offerings (“ICOs”) are likely to involve the sale of assets that qualify as securities, and urged investors to proceed with caution when considering ICO or cryptocurrency-related investments. His formal statement is directed at investors and market professionals acting as gatekeepers, and warns the latter group to focus on their responsibilities under the securities laws.

Chair Clayton urged market professionals to review the SEC report on the application of securities laws to initial coin offerings. In the report, the SEC applied longstanding securities law principles to determine that particular ICO tokens qualified as securities and, thus, were subject to relevant federal securities laws. Chair Clayton asserted that tokens and offerings that incorporate features and marketing efforts that emphasize the potential for profits based on the entrepreneurial or managerial efforts of others bear the hallmarks of securities. He warned professionals that they cannot avoid regulatory requirements simply by representing that a particular token or coin provides utility or “structuring it to provide some utility.” He said that such representations “elevate form over substance.” While Chair Clayton acknowledged the possibility that certain cryptocurrencies and ICO tokens may not comprise securities, he urged regulators and other market participants to fulfill their responsibilities in order to ensure investor protection. He also noted that he has instructed the SEC Division of Enforcement to police ICO offerings vigorously, and warned that in addition to securities registration, promoters should consider broker-dealer and exchange registration requirements.

Chair Clayton also urged market professionals to act with particular vigilance when dealing with cryptocurrency transactions. He encouraged broker-dealers and other market participants that allow for payments in cryptocurrencies to ensure that cryptocurrency transactions do not interfere with their ability to meet anti-money laundering and know-your customer obligations. While cryptocurrencies may or may not ultimately be considered as securities, Chair Clayton added, the SEC will closely monitor their impact on and interaction with the securities markets.

CFTC Chair J. Christopher Giancarlo praised Chair Clayton for his statement, noting that virtual currency markets are still largely unregulated and present challenges for regulatory agencies. According to Chair Giancarlo, “CFTC and SEC staff are in regular communication on these issues,” and investors should be aware of associated volatility and risk.

Futures Exchanges Self-Certify Bitcoin Futures Products

CME Group (“CME”), CBOE Futures Exchange (“CBOE”) and the Cantor Exchange each announced that they have “self-certified” new bitcoin products. CME and CBOE self-certified the initial listing of bitcoin futures products, while Cantor self-certified a contract for bitcoin binary options.
CME Group self-certified the initial listing of its bitcoin futures contract beginning on December 18, 2017. CME stated that the bitcoin futures will be cash-settled based on the CME CF Bitcoin Reference Rate – a “once-a-day reference rate of the U.S. dollar price of bitcoin.” The contract will be made available for trading on the CME Globex electronic trading platform, and for submission for clearing through CME ClearPort. CME Group CEO and Chair Terry Duffy said that the contract “will be subject to a variety of risk management tools, including an initial margin of 35 percent, position and intraday price limits, and a number of other risk and credit controls that CME Group offers on all of its products.”

CBOE said that its product will be cash-settled based on the Gemini’s price for bitcoin (in U.S. dollars). CBOE has not yet announced the launch date.

The Cantor Exchange is also yet to announce a launch date, but declared that the “bitcoin swaps” will be unleveraged, allow for the ability to trade across a range of bitcoin prices and trade for dates that are one month, two months and three months in advance.

Noting the “relatively nascent” and “largely unregulated” markets here, which involve a commodity “unlike any the Commission has dealt with in the past,” CFTC Chair J. Christopher Giancarlo explained that the CFTC worked with the exchanges and facilitated “significant enhancements” to provide for greater investor protections. At the same time, he said, investors should remain cognizant of the “potentially high level of volatility and risk in trading these contracts.”

The CFTC stated that it will continuously monitor the exchanges as trading in bitcoin futures commences. The CFTC said it will focus on size and development of the market, changes in positions, open interest, initial margin requirements, variation margin payments and stress testing. The monitoring process also will encompass designated contract markets, derivatives clearing organizations, clearing firms and investors taking part in bitcoin futures products. The CFTC also released a fact sheet providing information on the self-certification process, under which exchanges are able to certify products pursuant to their own determination that such products are in compliance with the CEA and CFTC Rules.

The CFTC promised cooperation with the National Futures Association (“NFA”) in monitoring bitcoin futures-related activity of member firms. The NFA released an Investor Advisory outlining important precautions for investors considering trading bitcoin futures.

Lofchie Comment: What does this do to clearinghouse risk?

FRB Vice Chair Warns about Risks Presented by Privately Developed Digital Currencies

Board of Governors of the Federal Reserve System Vice Chair for Supervision Randal Quarles described innovation in the U.S. payment system and highlighted the risks presented by digital currencies.

In remarks at the 2017 Financial Stability and Fintech Conference, Mr. Quarles asserted the need to find a balance between innovation and stability in the payment system. He explained that while innovation in this area has traditionally been inhibited by high barriers to entry, those obstacles get removed as more users adopt new technologies. At the same time, Mr. Quarles said, the reduction of technological barriers may result in the introduction of additional risk.

As an example of this additional risk, Mr. Quarles discussed the dangers inherent in the use of digital currencies. He described how the main payment networks use centralized technology to process and safeguard the public’s electronic fund transfers. Regulated banking institutions provide deposit money to the public and are a main source of trust for these systems. Digital currencies, however, are not backed by secure assets and do not carry the same level of trust. The widespread use of currency that “cannot be predictably redeemed for the U.S. dollar in times of adversity” may have serious implications for liquidity, price risk and credit risk, he said. If a digital currency becomes the center of a large-scale payment system, he cautioned, it would be unclear how the system would be able to respond to economic stress.

Mr. Quarles also urged a high level of caution with respect to the prospect of a central-bank-issued digital currency. He noted the potential risk of serious cyber attacks and extensive legal issues that would accompany any foray by the U.S. into central-bank-issued digital currencies. He encouraged continued study in the area, particularly surrounding “secure limited-purpose digital currencies for use as a settlement asset for wholesale payment systems.”

Going forward, Mr. Quarles stressed the importance of enhancing the stability of the existing payment system, and of continuously working to find improvements that are not likely to have detrimental effects on safety and resiliency. He encouraged cooperative efforts to build a safer and more efficient system based on existing institutions.

Lofchie Comment: Vice Chair Quarles raises reasonable concerns about how a virtual currency would perform in a time of stress. One specific worry – that a central bank would adopt digital currency – seems unlikely, given that the central bank would, thereby, lose control over its own currency. A more realistic concern is that fears of an unreliable central bank (think Venezuela) would motivate a population’s movement away from use of that bank’s currency.

CFTC Provides Guidance on Virtual Currencies

The CFTC published a “primer” that (i) provides a high-level overview of virtual currencies, (ii) outlines the CFTC’s oversight of the space and (iii) cautions market participants of the risks associated with virtual currencies.

The primer outlines potential use-cases for virtual currencies and blockchain, as well as situations in which CFTC jurisdiction is indicated. The report notes that virtual currencies are commodities, but acknowledges that, beyond preventing fraud or manipulation, the CFTC generally does not oversee “spot” markets in commodities; i.e., short-term trades settled by the delivery of the relevant product.

The primer, produced by the CFTC’s “LabCFTC,” is intended to be the first in a series of publications intended to help market participants understand technological innovation in the financial space and the CFTC’s role.

Lofchie Comment: The division of authority between the CFTC and the SEC can be quite complex.  That said, the CFTC is absolute correct in noting the fact that “virtual currency” or an “ICO” may be both (i) a “commodity” for purposes of the Commodity Exchange Act and (ii) a “security” for purposes of the securities laws.  The primer also correctly acknowledges that the CFTC does not have authority over ordinary cash-market transactions in a commodity, but only in derivative or certain financing transaction with respect to a commodity.  Accordingly, persons trading in these assets must be mindful that the terms of the transaction will determine the financial regulations to which they are subject.

SEC Determines Interests in Virtual Organizations Are Subject to U.S. Securities Laws

The SEC determined that tokens sold to investors by a “virtual” organization may be considered securities and, thus, are subject to applicable federal securities laws.

In an Investigative Report, the SEC explained that organizations using blockchain or other distributed ledger technology in capital-raising activities must ensure compliance with securities laws. In the report, the SEC scrutinized an incident involving a “Decentralized Autonomous Organization” (“DAO”). A DAO is described as “a ‘virtual’ organization embodied in computer code and executed on a distributed ledger or blockchain.” In this matter, the DAO offered tokens in exchange for initial cryptocurrency investments and eventually was victimized by a hacker who diverted significant cryptocurrency assets raised by the DAO. The SEC investigated whether the DAO had violated securities law by offering and selling unregistered securities.

The SEC decided not to pursue charges but sounded a warning to issuers:

“[Registration] requirements apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.”

In an Investor Bulletin, the SEC cautioned investors about potential risks associated with initial coin offerings. The SEC explained the function of distributed ledger technologies, such as blockchain, as well as virtual currency and how it is traded via the exchanges. The SEC warned investors that virtual currency offerings may be particularly susceptible to fraud and theft, and that tracing these currencies is difficult. The SEC noted that virtual currency offerings are often unregistered and operate unlawfully or overseas. As a result, recovering stolen virtual currency can be particularly difficult. The SEC warned investors to be wary of several signs that may indicate investment fraud, including “guaranteed” high rates of return, unsolicited offers and unlicensed issuers.

Lofchie Comment: Notwithstanding the somewhat exotic nature of the relevant asset (i.e., the virtual currency), the SEC’s finding that an asset that represents an ownership interest in a profit-making venture (or that depends on the management expertise of others) is a completely unsurprising result and well within the bounds of existing law.

Bitcoin Exchanges Targeted in Cyberattacks

At least two prominent bitcoin exchanges were targeted by cyberattacks that interrupted normal operations and trading.

BTC-e and Bitfinex were targeted by distributed denial-of-service (“DDoS”) attacks, a form of cyberattack which typically uses multiple compromised systems to flood a target with message traffic that exceeds its processing capacity.  The attacks temporarily disrupted service for both exchanges but reportedly did not cause a loss of funds or protected information. According to a CNBC report, service interruptions like those caused by the DDoS attacks could allow traders to “manipulate the bitcoin market.”

Both exchanges have resumed normal service.

GAO Reports on FinTech

The Government Accountability Office (“GAO”) issued a report on four types of financial technology (“FinTech”): marketplace lending, mobile payments, digital wealth management (also known as “roboadvisor”), and distributed ledger technologies (“DLTs”) such as blockchain. The GAO addressed functionality, risks and benefits, industry trends, and regulatory oversight.

The GAO did not make specific recommendations concerning oversight, noting that very little commonality exists between the differing types of FinTech. However, the GAO acknowledged the challenges involved in regulating FinTech:

“With respect to virtual currencies, federal and state regulators have taken varied approaches to regulation and oversight. The existing regulatory complexity for virtual currencies indicates that regulatory approaches for future applications for DLT will also be complex.”

Lofchie Comment: The GAO report serves as a good introduction to each of the four FinTech subsectors, and to some of the more significant legal and compliance issues that each business raises.

FRB Governor Powell Describes Challenges to Real Time Payment Systems and Blockchain Technology

Federal Reserve System Governor (“FRB”) Jerome Powell described the challenges and policy objectives behind (i) the creation of a real-time retail payment system, (ii) the use of distributed ledger technology for clearing and settlement services, and (iii) the issuance of digital currencies by central banks.

In an address before the Yale Law School Center for the Study of Corporate Law, Governor Powell criticized the sluggishness of the U.S. payment system. He stated: “our traditional bank-centric payments system, sometimes operating on decades-old infrastructure, has adjusted slowly to the evolving demands for greater speed and safety. Innovators have built new systems and services that ride on top of the old rails but with mixed results, and over time, our system has grown more fragmented.” Arguing that “it will take coordinated action to make fundamental and successful nationwide improvements,” Mr. Powell said that efficiency and safety were the FRB’s primary objectives regarding the development of a faster payment system utilizing real-time payments (see FRB Policy on Payment System Risk). Mr. Powell highlighted some of the work being done by the FRB Faster Payments Task Force, which recently completed reviews of 19 faster payment proposals.

On the use of DLT and blockchain technology, Mr. Powell noted recent developments and collaborations between banks and market infrastructures, including plans to use DLT by a few major U.S. clearing organizations. However, Mr. Powell observed that:

  • the financial industry has focused on the development of systems that require permission for access to ledgers, functions or information, rather than the open access system contemplated by Bitcoin;
  • firms are still trying to determine the business case for upgrading and streamlining payment, clearing, settlement, and other functions related to DLT;
  • technical issues – including issues of reliability, scalability, and security – remain unresolved;
  • governance and risk management will be “critical” to the success of DLT; and
  • the legal foundations supporting DLT, including jurisdictional issues, need more attention.

Mr. Powell also discussed the prospect of central banks issuing digital currencies. He cautioned that major technical and privacy challenges, as well as competition with private-sector products, might “stifle innovation over the long run.”

SEC Chair White Calls for Vigilance of the “Unicorns”

SEC Chair Mary Jo White outlined the opportunities, challenges and risks of “Silicon Valley” technology in the financial markets and urged entrepreneurs and issuers of private companies – particularly of “unicorns” (private start-up firms with valuations that exceed $1 billion) – to focus on investor interests.

Chair White examined the following challenges for new and evolving markets:

  • Pre-IPO Financing: Chair White asserted that despite broad sophisticated investor awareness that the majority of pre-IPO companies fail, venture capital firms, private equity funds, smaller retail investors and the “next . . . student whose great idea needs funding” all equally lose when “participants choose – with eyes wide open – to invest in private companies at valuations that may be ethereal or over-inflated.” She called for vigilance of so called unicorns, by establishing robust internal controls and governance procedures to provide accurate disclosures of financial results.
  • New Models of Capital Formation: Chair White declared that the SEC will hold brokers and funding portals responsible to be “bulwarks of investor protection” in securities-based crowdfunding that was recently introduced by Regulation Crowdfunding. She also emphasized that the SEC is counting on advisers as “gatekeepers” presenting information on the significant risks involved to make secondary market trading work fairly for investors. Although Chair White recognized that many secondary market participants may be “buy and hold” investors seeking exposure to late round pre-IPOs to profit from an eventual IPO or acquisition, she asked for regulators to scrutinize these emerging platforms to ensure they provide a functioning market that operates within the disclosed parameters.
  • Financial Controls and Corporate Governance: Chair White noted a “current slow-down” in IPOs and that unicorns are staying private longer. She called on entrepreneurs and their advisers, venture capital and private equity investors as well as general industry leaders to request that private startups develop enhanced governance structures and internal control environments to match their respective size and impact.
  • Fintech: Chair White highlighted that the SEC is exploring whether: (i) blockchain technology applications require registration under existing SEC regulatory regimes, such as those for transfer agents or clearing agencies; (ii) “robo-advisors” meet Investment Advisers Act obligations and their fiduciary duties when they solely provide automated advice; and (iii) online marketplace lending platforms provide adequate information to investors on offered securities and whether these offerings are registered or made using an exemption.

Chair White concluded by encouraging cooperation between the SEC and Silicon Valley.

Chair White delivered her remarks at the SEC-Rock Center for Corporate Governance speaker series, “The Silicon Valley Initiative: Protecting Investments in Pre-IPO Issuers.”

Lofchie Comment: While it is certainly appropriate for the SEC to concern itself with investment in private issuers, the SEC should also be concerned that the costs of the regulation that it imposes might discourage companies from going public. Put differently, the SEC should consider whether it is selling a “product” (access to the public capital markets and exchange liquidity) that is unattractive in light of its subsequent costs.

Congress should also be concerned about the deterrent costs of needless regulation. When issuers and investors see that the costs of going public include regulatory requirements such as those relating to “conflict minerals” or “compensation ratios” that have no reasonable benefit to either party, they may forsake liquidity for the sake of rationality.


CFTC Commissioner Cautions Global Regulators against Impeding Blockchain Technology Innovation

CFTC Commissioner J. Christopher Giancarlo cautioned global regulators against impeding innovation of blockchain technology. In an interview with Energy Metro Desk Editor-in-Chief John Sodergreen, the CFTC Commissioner reaffirmed remarks delivered at the Energy Metro Desk annual conference.

Mr. Sodergreen reported that Commissioner Giancarlo maintained a “decidedly not-so-grim . . . outlook” and expressed his enthusiasm for the potential of blockchain technology:

[T]he great promise of blockchain technology is in its ability to help market participants manage the enormous operational, transactional and capital complexity brought about by the legion of disparate mandates, regulations and capital requirements promulgated in the wake of the 2008 financial crisis.

Mr. Sodergreen reports that Commissioner Giancarlo stated that global regulators must be cautious not to impede blockchain innovation with “protracted regulatory uncertainty or an uncoordinated regulatory approach,” and instead should establish uniform principles.

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