Keyword: securities

Cryptoassets Taskforce: Cryptoasset Regulation May Be Coming

The regulation of cryptoassets is a question that has been troubling lawmakers and regulators across the globe. This new phenomenon has had a small but significant effect on how financial services function and facilitate new opportunities, but that has also brought risks and regulatory challenges. Currently, cryptoassets (a term preferred over cryptocurrency by regulators) are not, in themselves, regulated. Some cryptoassets will fall within the regulatory regime by way of representing or acting as traditional securities or other regulated financial instruments.

In October, the Cryptoasset Taskforce published its long-awaited report. The report sets out an overview of cryptoassets and the underlying technology before assessing their current, and potential future, role in the financial system as well as the risks and potential benefits. The report concludes with recommendations and ‘next steps’.

By way of background, the Cryptoasset Taskforce was launched by the Chancellor of the Exchequer in March 2018 and is made up of representatives from the Financial Conduct Authority (FCA), HM Treasury and the Bank of England.

In general, the report found that particular risks would need to be dealt with, but provides few concrete regulatory recommendations, and tends to focus on consultation, clarification of existing regulation and increasing awareness of the risks. It is important to note that this is not necessarily a bad thing and the overall message appears to be positive, particularly for those thinking about issuing cryptoassets (for example by way of an initial coin offering (ICO)). The Cryptoasset Taskforce seems less nervous of cryptoassets than other bodies, particularly the UK’s Treasury Committee (see our take on the UK’s Treasury Committee’s report here).

The report divides recommendations into distinct areas, explaining where regulatory action should be taken and where a ‘wait and see’ approach is more suitable.

Preventing financial crime

This is one of the few areas where action will be, and has been, taken. The concern over the use of cryptoassets for financial crime and in particular the transfer of criminal proceeds is often the cornerstone to any discussion on cryptoasset regulation. The report acknowledges that the use of cryptoassets for criminal activity is low, although increasing.

The Fifth Anti-Money Laundering Directive (5MLD) will require firms to bring certain activities relating to cryptocurrency within the scope of anti-money laundering regulation, for example fiat-to-crypto exchange firms. However, the UK government plans to go further and will consult on proposed actions in early 2019. Part of this consultation will be whether firms based outside the UK will be required to comply with AML obligations when providing services to UK consumers.

Regulating financial instruments that reference cryptoassets

From 1 August 2018, there has been a restriction on the sale of contracts for difference (CFDs) that reference cryptoassets. This is part of a European effort, led by ESMA. The restriction, although renewed on 1 November 2018, is only temporary until the FCA implements a domestic solution. The FCA is expected to consult on derivatives referencing exchange tokens and whether there should be a prohibition on the sale of these to retail investors by the end of 2018. This prohibition would not include those derivatives that reference cryptoassets that qualify as securities.

The FCA has also stated that it will not authorize or approve the listing of a transferable security or a fund that references exchange tokens unless it is confident in the integrity of the underlying market and that the other regulatory criteria are met. The FCA also confirmed that it has not approved the listing of any exchange-traded products with exchange tokens as the underlying asset.

Clarifying the regulation of security tokens

Tokens which represent securities or that have the same features of securities (‘security tokens’), fall within current regulation. However, it is not always clear whether certain tokens fall into this category, and there is not much guidance on this.

The FCA will consult by the end of this year on new perimeter guidance on the way regulation applies to security tokens. This additional clarity will be useful for helping token issuers understand whether, and to what extent, the tokens they issue fall within the regulatory regime and what, if any, authorization or permission is needed. However, it is important to note that this will not extend the regime. Security tokens are currently caught by regulation while other tokens remain outside it; this will not change. The FCA consultation will relate to further guidance on how to identify whether tokens are security tokens.

Consulting on extending the regulatory perimeter for ICOs

While the guidance noted above will not affect the regulatory status of any tokens, the FCA will also consider whether there needs to be any changes to the regulatory perimeter when it comes to cryptoassets. Notably, the FCA is concerned about when tokens may be comparable to security tokens but structured in such a way that they are not security tokens and therefore unregulated.

A consultation in early 2019 will consider whether such cryptoassets exist and whether an extension of the regulatory regime is required.

Addressing the risks of exchange tokens

Early 2019 will see a consultation on whether and how exchange tokens should be regulated. These tokens do not currently fall within the regulatory perimeter. It is not clear whether the clarification of the current regulatory regime, and how it applies to cryptoassets, or the extension of the regulatory perimeter for tokens which act like security tokens, will be sufficient to allay the regulators’ fears.

Ensuring a coordinated international approach

The Cryptoasset Taskforce acknowledges that an international approach is essential to mitigate the risks for consumers. There is continuous conversations with different international organizations, and the report outlines that the UK intends to take a role advocating for international bodies to address these issues.

Improving consumer awareness

The report reiterates messages from regulatory and governmental bodies that consumers should be cautious when purchasing cryptoassets. The authorities will continue to improve public awareness of the risks of purchasing cryptoassets.

Maintaining financial stability

The Cryptoasset Taskforce does not currently believe that cryptoassets pose a material threat to financial stability, either in the UK or globally. However, it acknowledged that this is a developing and growing area and that risks could emerge. This will continue to be monitored by the Bank of England.

In a subsequent speech, Christopher Woolard, Executive Director of Strategy and Competition at the FCA, hoped that ‘if someone in 10 years’ time was to pause on the world in 2018, they would see our taskforce work as a further step along our journey of encouraging beneficial innovation to thrive in the UK, but in a context in which financial crime is combatted, market integrity is safeguarded and consumers are adequately protected from harm’.

The important point to note here is that the taskforce is a step in the journey. While the report infers that regulation is coming, it does not have any immediate effect on the regulatory sphere. Assuming consultations are released in late 2018/early 2019, one can expect that any formal regulation is still a way off. However, this is no bad thing. The Cryptoasset Taskforce’s insistence on an international approach is encouraging; inconsistent regulation across jurisdictions will be less effective for an instrument which, by its very nature, is borderless. Nevertheless, guidance on the current regulatory regime, and how it applies to cryptoassets, will be welcomed as soon as possible by issuers and those who work in this world.

Learn more from this Blockchain alert.

A Foreboding View of Smart Contract Developer Liability

At least one regulator is attempting to provide clarity regarding the potential liability of actors who violate regulations through the use of smart contracts. On October 16, 2018, Commissioner Brian Quintenz of the Commodity Futures Trading Commission explained his belief that smart contract developers can be held liable for aiding and abetting CFTC rule violations if it was reasonably foreseeable that U.S. persons could use the smart contract they created to violate CFTC rules. As is typical, the Commissioner spoke for himself, but it seems likely that his views reflect the CFTC’s philosophy.

Generally speaking, smart contracts are code-based, self-executing contractual provisions. Smart contracts that run on top of blockchain protocols, like ethereum, are increasingly being used by companies in a wide variety of businesses to create autonomous, decentralized applications. Some of these applications might run afoul of CFTC regulations if they have the features of swaps, futures, options, or other CFTC-regulated products, but do not comply with the requisite regulatory requirements. The fact that smart contracts support disintermediated markets – a departure from the market intermediaries traditionally regulated by the CFTC – does not change the CFTC’s ability to extend its jurisdiction to them.

To identify where culpability might lie, Commissioner Quintenz identified the parties he believes to be essential to the functioning of the smart contract blockchain ecosystem:

  1. the core developers of the blockchain software;
  2. the miners that validate transactions;
  3. the developers of the smart contract applications; and
  4. users of the smart contracts.

Commissioner Quintenz dismissed the core developers and the miners as potential culpable parties by reasoning that while they both play a vital role in creating or administering the underlying blockchain code, they have no involvement in creating the smart contracts. He also limited the possibility of the CFTC pursuing enforcement against individual users because, as he explained, although individual users are culpable for their actions, “going after users may be an unsatisfactory, ineffective course of action.”

That leaves the developers of the smart contract code. Commissioner Quintenz stated that to ascertain the culpability of the smart contract code developers, the “appropriate question is whether these code developers could reasonably foresee, at the time they created the code, that it would likely be used by U.S. persons in a manner violative of CFTC regulations.” If such a use is foreseeable, Commissioner Quintenz believes that a “strong case could be made that the code developers aided and abetted violations of CFTC regulations.”

Commissioner Quintenz expressed that he would much rather pursue engagement than enforcement, “but in the absence of engagement, enforcement is the only option.” The Commissioner recommended that smart contract developers engage and collaborate with the CFTC prior to releasing their code to ensure that the code will be compliant with the law. The Commissioner even suggested that the CFTC is willing to rethink its existing regulations or provide regulatory relief, depending on the technology in question.

As blockchain and smart contract technology matures, we expect decentralized and disintermediated applications to come to market in increasing volumes. In his speech, Commissioner Quintenz provided valuable insight into how one regulator is thinking about applying existing laws to this new market. His remarks will be especially valuable if they influence other regulators, such as the Securities and Exchange Commission or the Financial Crimes Enforcement Network, to take a similar approach.

EtherDelta Founder’s Settlement with the SEC Has Grim Implications for Smart Contract Developers

The SEC recently brought its first enforcement action against the creator of a “decentralized” digital token trading platform for operating as an unregistered national securities exchange, and in doing so joined the CFTC in putting a scare into smart contract developers.

On November 8, 2018, the SEC issued a cease-and-desist order settling charges against Zachary Coburn, the creator of EtherDelta, an online “decentralized” digital token trading platform running on the Ethereum blockchain. The SEC charged only Coburn, the individual who founded EtherDelta, but no longer owns or operates it. Note that the SEC press release states that the investigation is continuing.

The SEC announced its action against Coburn a month after a CFTC Commissioner stated in a speech that smart contract developers could be found liable for aiding and abetting violations of commodity futures laws. Both agencies appear to be putting smart contract developers on notice that by releasing code into the ether, they are inviting potential liability for any rule violations, even if they sever their connections with the code.

The SEC found that EtherDelta provides a marketplace to bring together buyers and sellers of digital tokens. The platform facilitates these transactions through the use of a smart contract, which carries out the responsibilities generally assumed by an intermediary: the smart contract validates the order messages, confirms the terms and conditions of orders, executes paired orders, and directs the distributed ledger to be updated to reflect a trade. The SEC employed a “functional test” to determine whether EtherDelta constitutes an exchange and to hold Coburn, who “wrote and deployed the EtherDelta smart contract . . . and exercised complete and sole control over EtherDelta’s operations,” responsible. As the Chief of the SEC’s cyber unit stated in the press release, “[w]hether it’s decentralized or not, whether it’s on smart contract or not, what matters is it’s an exchange.”

EtherDelta is one example of the innovation that smart contracts can facilitate. Innovation, however, is not a substitute for compliance. Indeed, in the SEC’s press release announcing the settlement, Co-Director of Enforcement Steven Peiken acknowledged that blockchain technology is ushering in significant innovation to the securities markets, but cautioned that “to protect investors, this innovation necessitates the SEC’s thoughtful oversight of digital markets and enforcement of existing laws.”

Significantly, the SEC found that certain transactions on the platform involved digital tokens that constitute securities, but declined to identify those tokens. Senior SEC officials have previously stated that ether is not a security, but this case shows that the SEC has not reached the same determination for all tokens issued on the Ethereum blockchain.

Just Another Week on the Blockchain: September 10-16, 2018

The week of September 10th was particularly eventful and saw a rather large number of recent enforcement and regulatory developments, even by blockchain industry standards. Notable actions seen during the week included the first time the SEC has issued an order against a cryptocurrency company for operating an unregistered broker-dealer; the first time the SEC has brought and settled charges against a hedge fund manager that invested in cryptocurrencies while operating as an unregistered investment company; the first FINRA disciplinary action involving cryptocurrencies; a decision by EDNY Judge Raymond Dearie in U.S. v. Zaslavskiy; the authorization of two stablecoin cryptocurrencies pegged to the U.S. dollar by the New York Department of Financial Services; and the release of Chairman Clayton’s “Statement Regarding SEC Staff Views.”

For summaries of these developments, read our recent Blockchain and Cryptocurrency Alert.