Cryptocurrencies, including Bitcoin, have been in the news a lot lately, but many people still don’t know what they are—or whether they’re regulated. Here’s a quick rundown.
What Are Cryptocurrencies?
Cryptocurrencies are decentralized digital cash systems. Eschewing centralized control, such as a bank or government, cryptocurrencies instead rely on pseudonymous peer-to-peer networks—think Napster of yore—in which all actors in the network must recognize and reflect a transaction. To illustrate how this works, if Person A has an apple and trades it to Person B for her orange, Person A cannot thereafter trade that apple to Person C because everyone knows from a public ledger that Person A has already traded his one apple.
The security of the public ledger is then of paramount importance—so how do cryptocurrencies ensure ledger security? They rely on people called miners. Miners are basically the bookkeepers of the public ledger, and anyone with the time, energy, and equipment can be a miner. When a transaction occurs, it is not immediately added to the public ledger; instead, a miner must first confirm it. To do so, miners generate a complicated code that: (1) memorializes the data relating to the transaction; (2) refers to the previous confirmed transaction in the system (a sequential timestamp of sorts); and (3) complies with the particular cryptocurrency’s specific requirements. This is a challenging and necessary task that protects the public ledger—a transaction won’t be confirmed if a code can’t be generated that aligns with previous ledger entries. Using the earlier example, once Person A’s apple-orange trade has been confirmed, he can’t trade the apple again because any code generated after that reflects that he has already traded his apple. Without an acceptable code, no new transaction can be confirmed.
Miners race against each other to confirm transactions because each confirmation earns the miners a specified amount of the cryptocurrency, which is finite in supply. Once confirmed, the transaction is permanently recognized and irreversible. In essence, cryptocurrencies attempt to ensure legitimacy through a crowd-sourced ledger in which lines may not be deleted and may be added sequentially only after users, who are paid for their efforts, solve recognized and complicated puzzles.
Are Cryptocurrencies Regulated as Securities?
Cryptocurrency values have skyrocketed this year: Bitcoin has tripled in value and the value of Ethereum, another cryptocurrency, has jumped by more than 2,000 percent. The resulting buzz has attracted government attention around the globe. Recognizing both the potential risks and rewards, many countries have begun attempts to regulate cryptocurrencies, to varying degrees.
In the US, both the SEC and FINRA have warned investors about the greater risks—due to anonymity, volatility, and lack of central authority—surrounding any investment in cryptocurrencies. More recently, the SEC has also issued guidance on digital coin sales, or initial coin offerings (ICOs), and has taken the position that “offers and sales of digital assets by ‘virtual’ organizations are subject to the requirements of the federal securities laws.”
For example, in its Report of Investigation of Slock.it UG, a German corporation, and the DAO, an affiliated “virtual” organization, the SEC “stress[ed] that the U.S. federal securities law may apply to various activities, including distributed ledger technology, depending on the particular facts and circumstances . . . .” It then “demonstrate[d] the application of existing U.S. federal securities law to this new paradigm” by using Slock.it and the DAO’s ICO as an example:
The DAO was created by Slock.it and [its] co-founders, with the objective of operating as a for-profit entity that would create and hold a corpus of assets through the sale of DAO Tokens to investors, which assets would then be used to fund “projects.” The holders of DAO Tokens stood to share in the anticipated earnings from these projects as a return on their investment in DAO Tokens.
Analyzing these facts in the context of federal law, the agency concluded that the DAO tokens constituted securities. The securities laws therefore applied “to those who offer and sell [the tokens] in the United States,” regardless “whether the entity is a traditional company or decentralized autonomous organization,” “whether . . . purchased using U.S. dollars or virtual currencies,” or “whether [the tokens] are distributed in certificated form or through distributed ledger technology.” While the SEC did not bring charges in this instance, its report was intended to send the message that the SEC is keeping its eye on cryptocurrencies, and that we may see future enforcement actions in this area.
Foreign governments have likewise increased regulation, though to differing degrees and with different goals. China, home to one of the largest cryptocurrency trading markets, has taken steps to clamp down on such trading. Just last week, Chinese authorities ordered all domestic cryptocurrency exchanges to immediately cease trading. Exchanges were also directed to come up with a plan for the orderly return of funds to investors. By contrast, Russia has taken the opposite approach. Despite skepticism from the central bank, President Vladimir Putin has signaled his support of cryptocurrencies and more widespread adoption.