How the SEC is forcing Crypto to seek shelter with Finra Broker Dealers

2017 will be remembered for a long time as the year when cryptocurrencies rose from being perceived as a fad among mostly tech geeks to gaining widespread recognition. No doubt, this entry into the mainstream was driven by the rally in Bitcoin, widely regarded as the ‘Big Daddy’ among cryptos, but other digital currencies like Ethereum, Ripple, and Litecoin also played a major part in it. This wild rally in cryptocurrency prices and the widespread media coverage it got made it the new gold rush, with everyone from your humble Uber driver to the senior manager at your office making inquiries and trying to be a part of it. However, like the other gold rushes in the past, this one too has come with its fair share of problems.

In last year alone, there was a bombardment of ICOs (Initial Coin Offerings) with a few of them turning out to be duds. During the same time, the news of hackers stealing coins from digital wallets or coin exchanges engaging in shady practices has also gone up. With billions of dollar changing hands, wide-scale speculation and ‘Main Street’ investors (as the SEC likes to call retail investors) getting involved, it was evident that regulators were taking notice of this phenomena. From some calling it a ‘Ponzi scheme’ to others considering it the future of money, the reactions from central bankers and financial regulators across the world has been extremely divisive.

The U.S., in particular, has become a hotbed of debate concerning the regulation of these cryptocurrencies; given the country’s position as the dominant financial power in the world, and a leader when it comes to creating regulatory frameworks for new asset classes. However, cryptocurrencies are not your conventional asset classes that can be easily regulated.

First, there is the question of how to classify them – as a security or a currency? Then there is the distributed ledger technology (DLT) on which cryptos are based. This technology makes it extremely difficult, if not impossible, to track transactions. Apart from these fundamental problems, there are other issues like inexperience among regulators in dealing with this new technology and lack of clarity regarding which agency is eligible for regulating this new asset class. All these issues have made the debate even more confusing.

Whose Regulatory Headache is it Anyway?

Before we proceed to what crypto companies and new ICOs should be doing in order to ensure that they can do their business smoothly, we must take a look at where the different regulators stand on the topic of cryptocurrencies. The Commodity Futures Trading Commission (CFTC) was the first regulatory body that gave cryptocurrencies some legitimacy by allowing Chicago Board Options Exchange (CBOE) to launch derivative products on Bitcoin last year. Apart from that, it is also the only regulatory body whose tone concerning cryptocurrencies has been mostly been positive. Last month, while testifying in front of the members of the US Senate banking committee J. Christopher Giancarlo, chairman of the CFTC, said “It strikes me that we owe it to this new generation to respect their enthusiasm about virtual currencies with a thoughtful and balanced response, not a dismissive one.”

During the same hearing, John Clayton, chairman of the Securities and Exchange Commission (SEC) took a more cautionary stance. He informed the committee that his team at the SEC is keeping a close track on new ICOs and people, “who engage in semantic gymnastics or elaborate structuring exercises in an effort to avoid having a coin be a security are squarely within the crosshairs of our enforcement division.” While some experts have estimated that companies launching ICOs have raised over $4 billion in 2017, Mr. Giancarlo revealed that no ICOs has ever registered with the SEC. Nevertheless, he agreed with Mr. Giancarlo when he said that there was “significant” potential in distributed ledger technology (DLT), the technology that powers cryptocurrencies.

The same cautionary stance was maintained by Mr. Clayton during the recently held SEC Speaks conference, where he predicted that there can be more enforcement actions in the near future against bad players in the cryptocurrency ecosystem if they don’t change their behavior. Robert Cohen, the chief of the SEC’s Cyber Unit validated Mr. Clayton’s views by acknowledging, at the same conference, that his department has been very active during the last few months in bringing cryptocurrency related cases.

While the SEC and the CFTC are treading the path of cryptocurrency regulations with cautious optimism, other agencies and regulators are yet to reveal their cards and have mostly stayed away from the debate apart from releasing statements warning retail investors about the ongoing fraudulent activity in the cryptocurrency world. In December last year, The Financial Industry Regulatory Authority (FINRA), issued an investor alert, which warned investors of investing in companies that tout high returns associated with cryptocurrencies. It stated that:

“Unrealistic predictions of exponential returns and unsubstantiated claims made through press releases, spam email, telemarketing calls, or posted online or in social media may be signs of a classic “pump and dump” scam. The people touting such deals are typically unlicensed.

In January this year Treasury Secretary Steven Mnuchin, while speaking at Economic Club in Washington, told the audience that regulators are monitoring illegal activities in the cryptocurrency space. He echoed the same sentiment at the World Economic Forum in Davos later the same month when he said that his number-one focus on cryptocurrencies was, “to make sure that they’re not used for illicit activities.”

No Solution in Sight

With regulators in disarray, the path towards a consensus on how to regulate digital currencies seems to be riddled with obstacles. It is not only a question of which agency should regulate them and how, but also of whether they fall under federal or state jurisdictions. The answer to that latter part lies in what should cryptocurrencies be classified as – currencies, or securities?

The Currency Vs. Security Debate

A lot of the confusion regarding what should be the regulatory framework on cryptos and which agency should regulate them, could have been even avoided if there was a proper categorization of what cryptos or ICOs are? If deemed just as a currency (which bitcoin and other first-generation cryptocurrencies are) then the answer was simple- regulatory oversight needed could be minimal. However, many ‘tokens’ that have been issued in ICOs in the last few quarters cannot be categorized as a currency because they were issued to raise funds for a new idea or business, thus making them a security.

The SEC tried to shed light on this currency or security dilemma when it released its investigative report on The Dao last year in July. The conclusion it reached after analyzing the rise and fall of The Dao, which was a digital decentralized autonomous organization, was:

“Whether or not a particular transaction involves the offer and sale of a security— regardless of the terminology used—will depend on the facts and circumstances, including the economic realities of the transaction. Those who offer and sell securities in the United States must comply with the federal securities laws, including the requirement to register with the Commission or to qualify for an exemption from the registration requirements of the federal securities laws.”

The agency further clarified its stand on the topic when it released a public statement on Cryptocurrencies and Initial Coin Offerings, last December. In that statement, Mr. Clayton revealed how after the release of the investigative report on The Dao, ‘certain market professionals have attempted to highlight utility characteristics of their proposed initial coin offerings in an effort to claim that their proposed tokens or coins are not securities.’ However, he asserted, ‘Merely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security. Tokens and offerings that incorporate features and marketing efforts that emphasize the potential for profits based on the entrepreneurial or managerial efforts of others continue to contain the hallmarks of a security under U.S. law.’

While the SEC is clear that tokens issued in an ICO which are meant for raising funds for a new business are to be treated as a security, the agency is not dismissive of that approach being followed by entrepreneurs for fundraising. In the same statement, Mr. Clayton wrote:

“I believe that initial coin offerings – whether they represent offerings of securities or not – can be effective ways for entrepreneurs and others to raise funding, including for innovative projects. However, any such activity that involves an offering of securities must be accompanied by the important disclosures, processes and other investor protections that our securities laws require. A change in the structure of a securities offering does not change the fundamental point that when a security is being offered, our securities laws must be followed.”

If one reads the above paragraph, it is clear that the SEC is not against ICOs or fundraising that is done through ICOs, all it wants is that the tokens issued such ICOs be properly deemed as a ‘security’ and are subject to the same regulatory oversight that other securities are. This stand is further clarified when Mr. Clayton writes:

“On cryptocurrencies, I want to emphasize two points. First, while there are cryptocurrencies that do not appear to be securities, simply calling something a “currency” or a currency-based product does not mean that it is not a security. Before launching a cryptocurrency or a product with its value tied to one or more cryptocurrencies, its promoters must either (1) be able to demonstrate that the currency or product is not a security or (2) comply with applicable registration and other requirements under our securities laws. Second, brokers, dealers and other market participants that allow for payments in cryptocurrencies, allow customers to purchase cryptocurrencies on margin, or otherwise use cryptocurrencies to facilitate securities transactions should exercise particular caution, including ensuring that their cryptocurrency activities are not undermining their anti-money laundering and know-your-customer obligations.”

Is Crypto Regulatory Compliance Imminent?

Ever since Bitcoin, and later other cryptocurrencies captured public’s imagination there has been a strong rhetoric about how they are the currency of the future, free from the ambit of any central bank, and can’t be manipulated like fiat currencies. Proponents argue that any sort of regulatory interference will kill this movement, will make them just like any other currency. While all these statements may be true for Bitcoin, Ripple (XRP) or other initial cryptocurrencies, whose uses are confined to that of a currency, it is not true for most cryptos and tokens being issued in recent ICOs. These tokens or coins have been issued to raise funds for a development of a product or platform, thus they are not currency, but a security just like a share or bond of a company. Yes, they can be traded or exchanged among other market participants, but that still doesn’t make them a currency.

The SEC highlights in the statement it released that a company or individual(s) coming to the market with a new ICO will have to demonstrate that the ‘token’ or ‘coin’ they are issuing is not a security, otherwise they will have to ‘comply with applicable registration and other requirements under our securities laws’. This means that whether immediately or at a later date, but most crypto companies and ICOs will have to register with regulators if they want to continue doing business, at least in the United States. The question now is what approach should these companies or ICOs follow?

The Way Forward For ICO Advisors

Now that it is clear that a number of token or coins that are being issued through ICOs would most probably be classified as a security, let us see how crypto companies can conduct business in the United States without facing regulatory obstacles.

First of all, let’s understand the regulatory framework that already exists when it comes to issuing a security. If a company is planning to issue any security that will be offered publicly in the United States, it has to file a registration statement with the SEC. Although there is no exemption to that rule, one can skip the registration process altogether if the offering comes under the purview of Securities Act Regulation A+ or is done through a private placement to accredited investors (Regulation D under the Securities Act). Since the registration process is both time-consuming and expensive, a lot of ICOs are going for the private placement route, which allows them to raise money legally and not get entangled in regulatory compliances. However, only a broker-dealer is allowed to issue a private placement offering, which means that a crypto company that plans to have an ICO will either have to register as a broker-dealer (again a time-consuming process) with the Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) or it will have to buy an existing broker-dealer.

There has been a recent fled to safety by advisors that have been creating ICOs ever since the SEC clarified its position on cryptos. With the ‘wild west’ feeling coming to an end, these advisors have been trying to come into the regulated world; many of them looking to now buy, or start broker-dealers in the US. Moreover, as the SEC reigns in, it is imminent that these previously unregulated crypto creators – the promoters, brokers and third parties previously involved – will likely need to become licensed as registered reps.

At CXG, we’ve been seeing a recent increase in ICO advisors seeking to purchase broker-dealers. However, many of these companies don’t understand regulations, or what it means to become a part of FINRA. About ½of the firms are seeking to ‘piggyback’ on another (already existing) BD license; chaperoning if you will. We’ve made it clear that this is the wrong approach. When dealing within the regulated world, there’s only one way to operate – above board.

The Good News

FINRA & the SEC look to broker-dealers for guidance when it comes to drafting new regulation. For those companies that do decide to take the regulatory plunge, not only will they be 1st to market, thereby giving them a significant competitive advantage, but the regulators will likely lean to them to aid in the creation of what will become their own regulatory guidelines. Additionally, once the SEC becomes more assertive (our estimates being in the next 6 months or so) about registration and sales practices, those firms that have decided to register will be the only game in town; cornering the market, at least in the near term.

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