Cryptocurrencies: Caution is the Watchword as This Digital Avenue Grows

Digital currencies such as bitcoin and ethereum may be the wave of the future – but that future is not here yet and may not be for a while. Advisers, investment companies and broker-dealers looking at cryptocurrencies should consider holding back until the SEC and other regulators work out a number of outstanding questions, many of which have a direct bearing on investor protection and fiduciary duty.

The SEC, in a recent statement and testimony by chairman Jay Clayton, a staff letter from Division of Investment Management director Dalia Blass, and various forms of guidance, has let the asset management industry and cryptocurrency advocates know of its concerns. While the agency sees potential promise in electronic currencies and attempts to raise electronic capital through initial coin offerings (ICOs), it first wants a number of issues addressed.

"Investors should understand that to date no ICOs have been registered with the SEC, and the SEC also has not approved for listing and trading any exchange-traded products (such as ETFs) holding cryptocurrencies or other assets related to cryptocurrencies," said Clayton in February 6 testimony before the U.S. Senate Banking, House and Urban Affairs Committee.

"The technology on which cryptocurrencies and ICOs are based may prove to be disruptive, transformative and efficiency enhancing," he said. "While advising clients, designing products and engaging in transactions, market participants and their advisers should thoughtfully consider our laws, regulations and guidance, as well as our principles-based securities law framework, which has served us well in the face of new developments for more than 80 years."

Questions of definition and investment

Cryptocurrencies raise both interest and concern because, while there is a lot of buzz around the terms, many individuals and firms are not clear on what they are. The answer, in short, is that investors purchase electronic currencies like bitcoin online, purchasing units on a digital ledger that they can then access with a private digital key. Those who purchase shares of ICOs do much the same thing.

The answer to the always-central question of, "but what is it worth?" is that it is worth what the market says it is worth. Cryptocurrencies, unlike traditional currencies like the dollar or the euro, are not backed by the full faith and credit of any government. Nonetheless, according to Clayton, "cryptocurrencies, ICOs and related products and technologies have captured the popular imagination – and billions of hard-earned dollars – of American investors from all walks of life."

Advisers and others should keep in mind that, for all the interest being shown in this growing investment methodology, few advisers appear to be taking part. "I am not aware of any retail advisory firms currently investing client dollars in cryptocurrencies or ICOs, said Kirkpatrick Townsend partner Paul Foley. "The most important thing for investment advisers today is that they need to act responsibly, hold themselves to high standards and remember their fiduciary duty. The SEC is relying upon ‘gatekeepers,’ including advisers, to help protect crypto and ICO investors – a role tied to their fiduciary duty."

"It’s probably a little premature for advisers to start jumping in, but it’s certainly okay to start thinking about it and finding out more," said Mayer Brown attorney Adam Kanter. "Advisers may be considering using bitcoin because of recent publicity about good returns, and may be anticipating that their clients or other investors will be coming to them with questions about investing, but it’s sort of like the Wild West out there right now."

The threshold question

The key question that the SEC wants to determine is whether cryptocurrencies, either existing or newly formed from ICOs, are securities. Why? If they are securities, they fall under agency registration, and most of the SEC’s rules and guidance apply, just like for any other security. If they are not securities, the agency would appear to have no regulatory authority over them, which would raise all kinds of investor protection and fiduciary duty issues.

"The SEC regulates securities transactions and certain individuals and firms who participate in our securities markets," said Clayton. "The SEC does not have direct oversight of transactions in currencies or commodities, including currency trading platforms."

He noted that while cryptocurrencies currently exist 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. . . . If a cryptocurrency, or a product with its value tied to one or more cryptocurrencies, is a security, its promoters cannot make offers or sales unless they comply with the registration and other requirements under our federal securities laws."

The SEC’s point of view, said Kanter, appears to be that "cryptocurrencies offered through ICOs that walk and talk like traditional securities – even if they have some ‘token utility’ features – should be regulated like traditional securities offerings."

"If you are a registered investment adviser, you need to act with extreme caution, for now it is prudent to assume that all cryptocurrencies and ICOs are securities, and make sure you comply with all the rules," said Foley.

The questions that remain

"There are a number of significant investor protection issues that need to be examined before sponsors begin offering these funds to retail investors," said Blass in the January 18 Investment Management Division staff letter, which was sent to the Investment Company Institute and the Securities Industry and Financial Markets Association.

Here are some of the questions the SEC wants answered:

• Valuation. Mutual funds and ETFs have to value their assets daily in order to strike a net asset value. "Would funds have the information necessary to adequately value cryptocurrencies or cryptocurrency-related products, given their volatility, the fragmentation and general lack of regulation of underlying cryptocurrency markets, and the nascent state and current trading volume in the cryptocurrency futures markets?" Blass asks. "How would funds develop and implement policies and procedures to value, and in many cases ‘fair value,’ cryptocurrency products?" Beyond these, she sees a need for answers in terms of how funds’ accounting and valuation policies address the information related to significant events that might affect cryptocurrencies; and, among other things, determining which policies a fund would need to implement to identify, and determine eligibility and acceptability for newly created cryptocurrencies offered by promoters, such as an "air drop."
• Liquidity. Here’s some of what the Division of Investment Management staff would want to know: What steps would funds investing in cryptocurrencies or cryptocurrency-related products take to assure that they would have sufficiently liquid assets to meet redemptions daily? How would funds classify the liquidity of cryptocurrency and cryptocurrency-related products for purposes of the new fund Liquidity Rule? How would a fund prepare for the possibility that funds investing cryptocurrency-related futures could grow to represent a substantial portion of the cryptocurrency-related futures market?
• Custody. These questions relate to how a custodian would do its job when the assets it would have custody of would be electronic. "To the extent a fund plans to hold cryptocurrency directly, how would it satisfy the custody requirements of the 1940 Act and relevant rules? . . . How would a fund intend to validate existence, exclusive ownership and software functionality of private cryptocurrency keys and other ownership records? To what extent would cybersecurity threats or the potential for hacks on digital wallets impact the safekeeping of fund assets under the 1940 Act?"

Until these and the other questions listed in the staff letter "can be addressed satisfactorily, we do not believe that it is appropriate for fund sponsors to initiate registration of funds that intend to invest substantially in cryptocurrency and related products, and we have asked sponsors that have registration statements filed for such products to withdraw them," Blass said.

The enforcement side

Nor has the SEC let the grass grow under its feet in terms of policing what it sees as cryptocurrency violations. "The ability of bad actors to commit age-old frauds with new technologies coupled with the significant amount of capital – particularly from retail investors – that has poured into cryptocurrencies and ICOs in recent months and the offshore footprint of many of these activities have only heightened . . . concerns," said Clayton.

To address these concerns, the SEC in September 17 created a Cyber Unit within the Enforcement Division to focus on misconduct involving distributed ledger technology and ICOs, the spread of false information through electronic and social media, brokerage account takeovers, hacking to obtain nonpublic information, and threats to trading platforms. Another body, the Distributed Ledger Technology Working Group, works with the Cyber Unit.

Consider the following:

• The agency on February 21 filed a federal district court complaint against a former bitcoin-denominated platform and its operator. The SEC alleged that the founder of the platform was "operating an unregistered securities exchange and defrauding users of that exchange."
• On February 16, the agency suspended trading in three companies "amid questions surrounding similar statements they made about the acquisition of cryptocurrency and blockchain technology-related assets," according to the SEC.
• Charges against an individual were brought in September 2017 for allegedly defrauding investors in a pair of ICOs that were supposedly backed by investments in real estate and diamonds.
• An emergency asset freeze was obtained by the agency in December 2017 to halt an alleged ICO fraud that purportedly raised up to $15 million from thousands of individual investors.

"I have asked the SEC’s Division of Enforcement to continue to police these markets vigorously and recommend enforcement actions against those who conduct ICOs or engage in other actions relating to cryptocurrencies in violation of the federal securities laws," Clayton said.