In an op-ed published in the Wall Street Journal on January 24, 2018, Jay Clayton, the Chair of the US Securities and Exchange Commission (SEC), and J. Christopher Giancarlo, the Chair of the US Commodity Futures Trading Commission (CFTC), warned that while some market participants may make a fortune by investing in initial coin offerings (ICOs), the risks are high and that “[c]aution is merited.” They described the challenges of monitoring and regulating cryptocurrency activities. For example, they note that federal authority to apply anti-money laundering rules to these activities is clear, but the ability to regulate other aspects of this market is “murkier.” Acknowledging that distributed ledger technology “may in fact be the next great disruptive and productivity-enhancing economic development,” the regulators made it clear that they “will not allow it or any other advancement to disrupt our commitment to fair and sound markets.” The SEC’s website published excerpts of the op-ed article.
The op-ed by Chairman Clayton and Chairman Giancarlo followed closely on the heels of a joint statement by the enforcement divisions of the two agencies, issued just days earlier, that they will aggressively pursue fraud cases involving digital assets. The joint statement succinctly stated that, “When market participants engage in fraud under the guise of offering digital instruments – whether characterized as virtual currencies, coins, tokens, or the like – the SEC and the CFTC will look beyond form, examine the substance of the activity and prosecute violations of federal securities and commodities laws.”
It was certainly no mere coincidence that at the same time the CFTC announced enforcement actions involving cryptocurrency fraud.
One complaint charged a cryptocurrency sponsor with fraud and misappropriation in connection with purchases and trading of Bitcoin and Litecoin. The CFTC alleged that the promotor induced customers to send money and virtual currencies, purportedly for trading advice and virtual currency purchases, but instead simply misappropriated the money.
Another complaint charged the defendants with fraudulently soliciting Bitcoin from customers, misrepresenting that customers’ funds would be pooled and invested in products including binary options, making Ponzi-style payments to commodity pool participants from other participants’ funds, misappropriating pool participants’ funds, and failing to register with the CFTC as a commodity pool operator and associated person of a CPO.
The states are taking an interest as well. On January 17, 2018, the Enforcement Section of the Securities Division of the Secretary of the Commonwealth of Massachusetts filed a complaint against a Cayman Islands entity and a Massachusetts resident for allegedly offering the sale of so-called “Caviar tokens” that were allegedly unregistered securities. The complaint suggests that the token sponsor, when questioned, claimed there had been no U.S. sales of the tokens. But the complaint quickly added that such sales had in fact taken place and that the screening process was so inadequate that a Securities Division investigator was able to apply “using the name of a popular cartoon character” and an uploaded photo of a government-issued photo ID obtained using a Google Image Search showing a name and address different from that given in the application. The complaint claims the investigator’s identification was “verified” and approved to participate in the ICO within 29 minutes of producing the false ID.
The SEC Division of Investment Management meanwhile entered the cryptocurrency regulatory fray in a letter dated January 18, 2017. In a careful two-step, the Division (a) acknowledged that cryptocurrencies, and financial markets innovation more generally, can provide market benefits, but (b) then basically said that cryptocurrency products are not ready for the primetime exposure that would come from including them in regulated funds or exchange-traded structures.
The Division staff went on to say, that until certain regulatory and structural questions are resolved, it has asked sponsors of funds that would invest substantially in cryptocurrencies or related instruments to hold off and not seek to register their fund shares with the agency. (Those with already filed registration statements were asked to withdraw them.) In the meantime, the letter invites “interested sponsors to engage” with the agency as the staff ponders its approach to regulation of cryptocurrencies.
The staff guidance, which addresses investment management regulation, follows other SEC actions that address whether cryptocurrencies are “securities” as defined under federal law and should be regulated under the Securities Act of 1933.
Among other things, the letter addressed the following issues:
Until these questions can be addressed to its satisfaction, the staff said that it does “not believe that it is appropriate for fund sponsors to initiate registration of funds that intend to invest substantially in cryptocurrency and related products.”
These various actions – taken within a matter of days of each other – paint a picture. The period of watching and waiting is ending; regulators are ready to devote significant time and resources to cryptocurrency issues.