Any person who regularly monitors the U.S. financial markets has likely noticed the recent emergence of digital currency, also referred to as “cryptocurrency,” in recent months. For example, the price of bitcoin, the most widely known form of cryptocurrency, surged from a price below $800 per bitcoin in 2016, to a remarkable $17,000 per bitcoin recently in 2017. Despite this potential volatility, the acceptance of cryptocurrencies as legitimate forms of currency is likely; as evidenced by an array of local, national and international markets as well as an increasing range of products and participants, associated with these currencies. With the potential for these currencies to be used in everyday transactions, many questions are raised. What are cryptocurrencies? Can cryptocurrencies and their associated products be used to secure investments? And if so, can secured investments using these products be regulated? The commissioner of the Security Exchange Commission (SEC) released a statement in December 2017 addressing these issues, and many of the answers depend on the familiar adage: substance over form. Accordingly, one contemplating a transaction utilizing cryptocurrencies should first consider how these currencies might be regulated.
Cryptocurrencies are digital currencies that purport to be items of inherent value, such as cash or gold. However, unlike fiat money (such as the U.S. Dollar) they are decentralized, virtual stores of value, and are exchanged directly and between different parties over the internet while preserving the anonymity of the parties. These currencies are also not controlled or backed by any bank or central government authority. Consequently, these characteristics generate unique benefits, including financial transactions without geographic limitations or middle-man intervention, finality of transactions, low transaction costs and the ability to publicly verify transactions on the internet.
Regulation as a form of currency
When used only as currencies, cryptocurrencies may very well be subject to regulation by the SEC. While their direct use in transactions takes place anonymously over the internet, one must first exchange fiat currency to gain an interest in these transactions at some point. This is where the SEC seeks to focus its regulation – where fiat currency enters and exits the digital system. In particular, the commissioner noted that securities firms engaging in transactions such as taking payments for securities made in cryptocurrencies, setting up structures that invest in cryptocurrencies and extending credit to customers to purchase cryptocurrencies; all could be subject to SEC regulations, depending on the particular characteristics and use of the digital asset in the transaction. So when used as currency being injected into the U.S. securities markets, the SEC will seek to fulfill its responsibilities with respect to the effects of those currencies, just as it monitors the effects of other currencies on the U.S. securities markets like the U.S. Dollar and Euro.
Regulation as a security
Another function of cryptocurrency is to be used as an asset or vehicle for investment purposes in financial products, similar to securities. The markets for digital currencies include a vast range of financial products, including what are being called initial coin offerings (ICOs). In ICOs, individuals and companies raise capital for businesses and similar investments whereby investors exchange U.S. dollars for digital assets labeled “coins” or “tokens” that represent an interest in the business. The SEC instructs that substance over form controls here, and if the transaction looks like a security investment, the SEC will seek to regulate it like one. Thus, the key question becomes “is the coin or token being offered through the ICO a security?” Unfortunately, the answer is not always straightforward because of the range of products and names for these assets.
One investing in an ICO would be wise to examine whether the asset could implicate federal securities regulation. The simplest characteristics of coins and tokens one should be weary of, are those most similar to securities investments – opportunities to profit from the efforts of others, and situations where promoters offer ICOs as assets with the potential to be sold in secondary markets. Such ICO structures generate financial activities the SEC will seek to regulate under the federal securities laws. However, not all ICOs require these characteristics. For example, the Commissioner explained that other structures, such as where an already-formed-business offers coins to investors who receive products from the business in return for the investment (such as a book club distributing books to coin holders who finance the club by purchasing coins), will not represent a “security” subject to regulation. These investments do not carry the same inherent risks that the securities laws seek to regulate –such as promoters offering opportunities to profit in unpredictable markets – but instead, offer an efficient vehicle for investing in an enterprise that would otherwise go unregulated.
Investments offered by promoters can carry great risks, and the SEC will seek to regulate transactions utilizing cryptocurrencies like securities that have traditionally carried the same risks for decades. Before investing in transactions utilizing these currencies, despite their newfound popularity and appeal, an investor would be prudent to examine the facts and ask “does this look like a security?” If the answer is “yes,” and the substance of the transaction is subject to regulation despite the label or form of the digitally-backed asset, then an investor should be certain to determine whether the transaction is structured to comply with SEC requirements. The unique benefits of cryptocurrencies make it likely that these products are here to stay. Therefore, investors, promoters, and other industry professionals must seek to educate themselves on exactly what these currencies and products represent, and consider each in the context of the rules of the current financial systems when determining what regulations might apply.