Blockchain, Digital Currencies, and Securities Regulation

As with any new investment product or asset class, cryptocurrencies and related blockchain technology have been the subject of a great deal of investor interest and regulatory activity, particularly as bad actors have exploited public interest to peddle unsuitable investments or--even worse--perpetrate frauds.

A blockchain is a public, distributed ledger that is replicated and hosted on numerous computers, creating thousands of identical digital copies that give the system credibility and oversight needed to create a secure public list of an asset.  That list can describe things such as identification, contracts, or cryptocurrencies--scarce, virtual assets represented on a blockchain.  The most well-known cryptocurrency is Bitcoin.  Other popular cryptocurrencies include Dash, Monero, Litecoin, Ethereum, and Ripple.  Blockchain technology is also sometimes referred to as distributed ledger technology (DLT) or distributed database technology. 

For regulatory purposes, federal agencies categorize cryptocurrency in different ways.  To the Internal Revenue Services it is property.  To the Commodity Futures Trading Commission it is a commodity.  The Securities and Exchange Commission says that cryptocurrency tokens can be a security. 

Many securities rules administered by the SEC and the Financial Industry Regulatory Authority (FINRA) are implicated by crytocurrency, as FINRA made clear in its report, "Distributed Ledger Technology: Implications of Blockchain for the Securities Industry" (March 2018)  For example,

• a DLT application that seeks to alter clearing arrangements or serve as a source of recordkeeping by broker-dealers may implicate FINRA’s rules related to carrying agreements and books and records requirements;
• DLT may have implications for trade and order reporting requirements to the extent it seeks to alter the equity or debt trading process; and
• FINRA rules such as those related to financial condition, verification of assets, anti-money laundering, know-your-customer (suitability), supervision and surveillance, fees and commissions, payment to unregistered persons, customer confirmations, materiality impact on business operations, and business continuity plans also may to be impacted depending on the nature of the DLT application.

DLT applications are being used or tested within the equity, debt and derivative markets.

Unsurprisingly, investors have been attracted to blockchain related investments.  A new fundraising vehicle, the initial coin offering (ICO)--also called a "token generation event" or "initial token offering"--allows accredited investors (those with a net worth of more than $1 million) to bankroll the creation of a blockchain in exchange for payment cryptocurrency "coins" or tokens."  In 2017, more than 200 ICOs raised more than $4 billion.  The size and nature of ICOs vary greatly.

The SEC issued an Investor Alert: Public Companies Making ICO-Related Claims (August 2017) warning "about potential scams involving stock of companies claiming to be related to, or asserting they are engaging in [ICOs]"  According to the SEC, "Fraudsters often try to use the lure of new and emerging technologies to convince potential victims to invest their money in scams.  These frauds include 'pump-and-dump' and market manipulation schemes involving publicly traded companies that claim to provide exposure to these new technologies." 

The North American Securities Administrators Association advises investors considering putting money into an ICO to exercise "extreme caution" in its "Informed Investor Advisory: Initial Coin Offerings" (April 2018) as follows:

• ICOs are very risky and are not suitable for many investors;
• Use extreme caution when dealing with promoters who claim their ICO offering is exempt from securities registration yet do not ask about your income, net worth or level of investing sophistication; and
• ask whether the “coins” or “tokens” are considered securities and whether the offering itself has been registered with appropriate securities regulators. 

State regulators, like the SEC, have engaged in active ongoing enforcement activity, including regulators in Texas, North Carolina, New Jersey, and Massachusetts.  Hey, let's be careful out there.