Recently, we have seen an explosion in the number of different digital tokens/cryptocurrency/personal digital money. Investor interest is at an all-time high in what some call digital currency and others, including the SEC, call securities.
Let’s take a look at some of the legal and economic risks for sellers, promoters, and the trading platforms.
Is it a security?
The SEC has not really defined what is a security. We know that stocks and bonds are securities. We also know that promissory notes are securities. Beyond these guidelines things get fuzzy.
The SEC can also regulate a cryptocurrency if it involves an investment contract.
What is an investment contract?
An investment contract is an investment of money in a common enterprise with a reasonable expectation of profit from the efforts of others.
If the cryptocurrency is a security or an investment contact, then it is subject to U.S. securities laws.
First, this means that all offerings of either must be registered with the SEC unless there is an exemption. Second, the offer and sale of the cryptocurrency is subject to certain anti-fraud rules.
In practice, this creates compliance risk for sellers and promoters of cryptocurrency with respect to the both the registration requirements and the anti-fraud rules.
To make matters worse, senior SEC officials have made it clear that they believe that most digital tokens are securities.
Is the trading platform an unregistered exchange?
Tokens typically trade on some form of a trading platform. The problem is that regulators may view the platform as an unregistered exchange.
One of the most famous instances of this was where the SEC alleged insider trading and subpoenaed Coinbase, which was the largest cryptocurrency exchange at the time. In response, Coinbase moved to register itself as a registered exchange.
Few crypto trading platforms were set up with the idea of registering with the SEC or becoming an “exchange” in the same sense as the NYSE.
If your trading platform is deemed to be an unregistered exchange, it could be forced to either: register or shutdown.
In order to register as an exchange, the trading platform would have to develop and enforce a digital asset framework for vetting cryptocurrencies wanting to list on the exchange.
Your trading platform registering would not result in a total loss, but a shutdown of the platform would likely result in a total loss in the value of coins trading on the platform.
Is the cryptocurrency platform or seller a money service business?
For the trading platforms, the issue here is do they fall within the reach of the U.S. Financial Crimes Enforcement Network (“FinCEN”).
FinCEN has stated that it considers the following to be money service businesses (“MSB”): 1. virtual currency exchanges, and 2. an administrator of a centralized depository of virtual currency who can issue or redeem a virtual currency.
These definitions would seem to encompass most crypto trading platforms.
If the trading platform is deemed to be a MSB, then it must comply with at least two significant rules: 1. anti-money laundering, and 2. specifically designated nationals and blocked entities list. In practical terms, these compliance costs can make the economics unfavorable for the trading platform.
Lastly, sellers and promoters should be aware that various states regulate MSBs where the entity is issuing and/or selling stored value.
Taken together, these compliance requirements and economic risks create real uncertainty for coin sellers, promoters and trading platforms.