FAQ on Crypto Regs

Frequently Asked Questions: Cryptocurrency Regulation in the U.S.

By Jesse Brown, Compliance Associate, Cordium

The number of hedge funds investing in cryptocurrencies is soaring, which means regulators are taking notice. The Securities and Exchange Commission (SEC), Financial Industry Regulatory Authority (FINRA), and Commodity Futures Trading Commission (CFTC) have all made statements over the past year about digital assets, but what does this mean for investment advisers looking to create cryptocurrency products? Jesse Brown, one of our compliance associates, outlines the regulatory trends U.S. advisers should consider when thinking about investing in cryptocurrencies.

Q. What are cryptocurrencies?

Jesse Brown, Cordium

A: A cryptocurrency is generally defined as a medium of exchange that only exists digitally, for example Bitcoin, Ethereum and Ripple. These were envisioned as a new form of currency that weren’t under government control and didn’t need a bank’s participation to transfer funds between parties. A decentralized system called blockchain technology records these cryptocurrency transactions, which are encrypted so that only participants can see and verify them. The creation of new cryptocurrency units is also controlled by encryption on the blockchain.

Q. How do US regulators view cryptocurrencies?

A: The SEC announced in its 2018 exam priorities that it will monitor the sale of cryptocurrencies and initial coin offerings (ICOs). They have made general statements noting that the underlying blockchain technology may have the ability to transform a variety of industry models. The agency’s priorities are now focused on making sure it has an appropriate regulatory framework, while still allowing for innovation in the space.

Another regulator that’s paying attention to cryptocurrencies is the Financial Industry Regulatory Authority (FINRA), which recently surveyed its members to see how involved they are in digital assets. They supplemented this with a regulatory notice published on July 6, 2018 asking FINRA members to notify the regulator if they or an affiliate engages or intends to engage in activities related to digital assets. This fact-finding exercise will likely result in new FINRA regulations by the end of the next year.

As of now, there are no concrete guidelines from the SEC or FINRA on cryptocurrency, but the U.S. Commodity Futures Trading Commission (CFTC) has defined cryptocurrencies as commodities. Advisers should treat them as such by applying the same compliance controls they would with any other commodity asset.

Q. Are they considered securities?
A: Since the SEC regulates securities, the determination of which cryptocurrencies end up being defined as such remains a hot topic. If an adviser holds a cryptocurrency that is officially defined as a security, it could lead to material changes in the adviser’s assets under management calculations, and even affect their registration status with the regulator.

1. Is there an investment of money?

2. Is there an expectation of profits?

3. Is the investment of money in a common enterprise?

4. Are any profits coming from the efforts of a promoter or third party?

If the answer is “yes” to these questions, then the cryptocurrency investment is a security.

This poses an issue for funds that are registered or plan to register as an ERA. To qualify, an adviser must only manage solely private funds and have less than $150 million in regulatory assets under management. However, funds that created to manage cryptocurrency products should consider the Howey Test when determining their registration status.

Q. What are Initial Coin Offerings (ICOs)?
A: ICOs are capital-raising projects to fund a new cryptocurrency venture. Similar to an Initial Public Offering structure, an ICO is an exchange of the underlying cryptocurrency, such as EOS, Tezos, or Filecoin, for another cryptocurrency, often Bitcoin or Ethereum. ICOs have become a controversial alternative method to bypass the rigorous fundraising process required by venture capitalists or banks.

Q. How are ICOs treated by the regulators?
A: Earlier this year, SEC Commissioner, Jay Clayton, noted that Initial Coin Offerings (ICOs) are securities. This is due to the marketing done to promote the cryptocurrency – oftentimes, the expectation of the investors is an increase in value. The SEC states that ICOs, which are securities, most likely need to be registered with the SEC or fall under a registration exemption.

Regulators have been focused on this aspect of the cryptocurrency industry due to the higher possibility of fraud. For example, the creators of REcoin were indicted when the SEC suspected the tokens were never created and the blockchain technology they marketed never existed. The co-founders of Centra Tech were also indicted for running a fraudulent ICO when it was discovered they made false statements, including a claim that their company had partnered with Visa MasterCard to issue virtual currency debit cards.

Although the SEC and FINRA haven’t come out with concrete guidelines, firms should treat cryptocurrency investments like they would any other investment. Rules for determining if an investment is a security, registering based on the amount of assets under investment, and custody all apply. In addition, CFTC compliance controls apply as cryptocurrencies have been defined as commodities.