By Phil Glazer, Investing @ MGV. Previously @KKR_Co & @UCBerkeley
This piece is part of a monthly series covering regulatory updates related to cryptocurrencies (here are January, February, and March). As covered in the January piece, many predicted that 2018 would be the year that significant new regulation comes to cryptocurrencies and in the past few weeks that process has begun. This piece provides important regulatory updates since the March piece broken down by developments in the United States and the rest of the world.
- The SEC issued a warning to cryptocurrency exchanges that facilitate transactions of unregistered securities (March 7th, 2018): The SEC made explicit that exchanges are responsible for activity that they facilitate, including the exchange of coins that originated through an ICO process that qualify as a security but solicited investment from unaccredited investors (read this piece for an overview of United States ICO regulation). As explained in the statement, “A number of these platforms provide a mechanism for trading assets that meet the definition of a “security” under the federal securities laws. If a platform offers trading of digital assets that are securities and operates as an “exchange,” as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration. The federal regulatory framework governing registered national securities exchanges and exempt markets is designed to protect investors and prevent against fraudulent and manipulative trading practices.” This statement means that, going forward, US exchanges will likely be more conservative in which projects they decide to list. Additionally, US exchanges may delist projects that likely qualify as securities to avoid legal consequence.
- The SEC announced a probe to examine more than 100 cryptocurrency hedge funds (March 22nd, 2018): The SEC announced that it is evaluating more than 100 cryptocurrency hedge funds to ensure that funds are treating investors properly. The key concerns for the SEC in this probe are making sure that funds market themselves properly and only to eligible investors and that the funds are executing the strategies and exposure they have promised in fund documents. In the past year, there has been an explosion in the number of new hedge funds registered in the space.
- A note from FinCEN written in February but released in early March suggests that ICOs will be held to higher standards of Know Your Customer (KYC) and anti-money laundering (AML) laws (March 6th, 2018): ICOs will be held to the standards outlined in the Bank Secrecy Act which would require offerings to register with FinCEN and take an active role in investigating customers and reporting suspicious transactions to authorities. The change would qualify the ICO process as a “money transmitter” and introduce a host of obligations meant to prevent facilitation of criminal activity. This hurdle will likely further cool ICOs.
- The Winklevoss Twins have submitted a proposal to create the Virtual Commodity Association, an industry non-profit focused on self-regulation amongst exchanges (March 13th, 2018): This is a step that has already been taken in Japan following the hack of CoinCheck (review the March Update for more details). In the US, there is meaningful precedent for this; as explained by Bloomberg, “Regulators including the CFTC and U.S. Securities and Exchange Commission heavily rely on self-regulatory organizations, or SROs, to help them monitor trading in everything from obscure swaps to shares in the biggest U.S. companies. The Financial Industry Regulatory Authority, which is funded by the industry, is the front-line regulator for Wall Street brokerages. Currently, no federal regulator has direct authority over the cadre of exchanges that trade cryptocurrencies in the spot market. Instead, there’s a patchwork of state laws serving as the legal framework that critics say invites abuse and potential manipulation.” Overall, a move towards self-regulation would likely improve the standards held by exchanges while also helping regulators better understand the industry’s issues to craft better policy going forward.
- The UK government is launching a cryptocurrency task force (March 22nd, 2018): The purpose of the initiative is to create a formal government organization responsible for assessing the risks and potential benefits of cryptocurrencies. One optimistic angle of the announcement focuses on the potential to leverage the underlying blockchain technology to help financial firms meet regulatory requirements. As explained in the statement, the “pilot schemes to help new fintech firms, and the financial services industry more widely, comply with regulations by building software which would automatically ensure they follow the rules, saving them time and money.” Overall, the statement strikes a cautious tone with respect to cryptocurrencies themselves but a general acknowledgement of the potential for blockchain applications to improve financial transparency and compliance adherence.
- The Brazilian National Bank for Economic and Social Development (BNDES) is tokenizing the country’s national currency through ethereum’s public blockchain to increase transparency (March 6th, 2018). As explained by Suzana Maranhão, a leader on the BNDES project, “Any Brazilian can see the companies involved in the transaction and the transactions carried out. Critical information will not be stored in a database within BNDES. They will be public in the blockchain.” The project will run as a proof of concept until May and, if successful, may lead to adoption through similar projects in other countries (a related program is being piloted in Canada). Overall, it is exciting to see governments experimenting with blockchain technology as a way to increase transparency and trust.
- The IMF reiterated its concern regarding the potential for cryptocurrencies to be used for money laundering (March 13th, 2018): In a post on the IMF’s blog titled “Addressing the Dark Side of the Crypto World,” author Christine Lagarde makes clear that the IMF worries deeply about the potential for cryptocurrencies to enable bad actors. As she says, “The same reason crypto-assets — or what some people call crypto-currencies — are so appealing is also what makes them dangerous. These digital offerings are typically built in a decentralized way and without the need for a central bank. This gives crypto-asset transactions an element of anonymity, much like cash transactions.The result is a potentially major new vehicle for money laundering and the financing of terrorism.” However, the piece goes on to acknowledge that while cryptocurrencies may pose significant risks, the underlying technology may be the solution to mitigating the risks created. The author suggests that these mitigating solutions would take the form of distributed ledger technology (DLT) that works as a permissioned blockchain to keep financial institutions and regulators coordinated along with biometrics and artificial intelligence to improve digital security and identify suspicious behavior. The piece concludes with a call for global, coordinated efforts to understand and regulate the cryptocurrency space. Overall, this piece is in line with statements made by the IMF in recent months expressing concern for cryptocurrencies but optimism for the underlying technology.