Regulators Are Catching Up to Cryptocurrency and Blockchain Technology within the Financial Services Industry

The proliferation of cryptocurrency and blockchain is being driven by the efficiencies and protections afforded to early adopters. The operational efficiencies and resulting cost savings are readily apparent in the financial services industry and are equally coveted by the entities trying to implement them and by the customers who will benefit from the implementation. However, neither party can fully enjoy these benefits without first understanding and overcoming the various regulatory hurdles.

By no means is this meant to be an exhaustive discussion of the financial regulatory burdens faced by this technology. To cover the entire regulatory landscape would be too great an endeavor, given what we can cover in this article. In Part I of this article, we would like to focus on some of the common regulatory issues faced by market participants in this space.

The Securities and Exchange Commission (SEC)

The regulatory uncertainty for cryptocurrencies, aka virtual currencies, starts as early as their Initial Coin Offerings (ICOs). This uncertainty is in part thanks to the diverse views of what is being offered along with the objectives and motivations each architect of various ICOs has in mind when defining what differentiates their coin. First there is the definition. Some are offering coins, others tokens and others altcoins. It is easy to get lost in the semantics of each term. Some are issuing coins to build a completely new cryptocurrency, others as a means of fundraising to develop “improved” blockchain technology and others to develop completely unrelated technology and products such as coins that are backed by Real Estate Investment Trusts (REITs). An ICO's “pitch” as to why a prospective purchaser should buy into an ICO is delivered through its white paper. This is where the ICO's technology, financials and overall application are laid out and it is also where the SEC will begin to evaluate if the ICO should be considered a security.

In July of this year the SEC issued release No. 81207, titled “Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO,” which contemplated the threshold question as to when an ICO would be considered a security and subject to the federal securities laws and regulated by the SEC. The guidance stopped short of stating all ICOs are securities but rather applied a test (known as the Howey test) for when a coin offering should be treated as a security offering. Citing both federal regulation and current case law, the SEC noted that a security includes an “investment contract,” which is: 1) an investment of money or other valuable consideration (it need not be fiat currency, other cryptocurrencies will do); 2) in a common enterprise; 3) with an expectation of profits; and 4) to be derived from the entrepreneurial or managerial efforts of others.

One may be able to create arguments to support a narrative as to why a particular ICO should not be considered a security, but the SEC left a lot of open questions and regulatory uncertainty in the market with the “The DAO” release. And the market is continuing to observe a “growing wave” of ICOs that are not heeding the SEC's July warning to adhere to the federal securities laws if applicable. In recent months the SEC has taken enforcement action against individuals, companies and unlicensed brokers for violating SEC registration and disclosure requirements in connection with the sale of tokens that constitute securities. It is advisable to adhere to federal and state securities regulations, if there is a chance that your ICO can be deemed a security under the guidance in The DAO or applicable state securities regulations.

The Financial Crimes Enforcement Network (FinCEN)

FinCen (a bureau of the U.S. Department of the Treasury) issued FIN-2013-G001 in 2013 that defined the participants in generic virtual currency arrangements, using the terms “user,” “exchanger,” and “administrator.” A user is a person who obtains virtual currency to purchase goods or services. An exchanger is a person engaged as a business in the exchange of virtual currency for real currency, funds, or other virtual currency. An administrator is a person engaged as a business in issuing (putting into circulation) a virtual currency and who has the authority to redeem (to withdraw from circulation) such virtual currency.

An administrator or exchanger who: 1) accepts and transmits a convertible virtual currency; or 2) buys or sells convertible virtual currency for any reason is a money transmitter under FinCEN's regulations, unless a limitation to or exemption from the definition applies to the person. This is significant as it creates a large regulatory burden. For example, now the exchanges must have a robust Anti-Money Laundering (AML) program and must establish and maintain an effective Office of Foreign Assets Control (OFAC) compliance program (discussed below).

Under the regulations, a “money transmitter” shall not include a person that only:

• Provides the delivery, communication or network access services used by a money transmitter to support money transmission services;
• Acts as a payment processor to facilitate the purchase of, or payment of a bill for, a good or service through a clearance and settlement system by agreement with the creditor or seller;
• Operates a clearance and settlement system or otherwise acts as an intermediary solely between BSA regulated institutions. This includes but is not limited to the Fedwire system, electronic funds transfer networks, certain registered clearing agencies regulated by the SEC, and derivatives clearing organizations or other clearinghouse arrangements established by a financial agency or institution;
• Physically transports currency, other monetary instruments, other commercial paper or other value that substitutes for currency as a person primarily engaged in such business, such as an armored car, from one person to the same person at another location or to an account belonging to the same person at a financial institution, provided that the person engaged in physical transportation has no more than a custodial interest in the currency, other monetary instruments, other commercial paper or other value at any point during the transportation;
• Provides prepaid access; or
• Accepts and transmits funds only integral to the sale of goods or the provision of services, other than money transmission services, by the person who is accepting and transmitting the funds.

In 2014, FinCen clarified with FIN-2014-R011. Here the agency states “that a company which facilities the transfer of value, both real and virtual, between third parties meets the definition of money transmission.” Virtual currency exchanges often argued that they were not moving money but were rather acting as a “payment processor” facilitating the purchase of a good (the coin/virtual currency) through a clearance and settlement system (the exchange) by agreement with the seller. Within their guidance, FinCen quickly dismantled this argument and stated they do not consider providing virtual currency for real currency or vice versa as a non-money transmission related service.

Next month, in Part Two of this article, we will continue to focus on additional common regulatory issues faced by market participants in this space.

*****
Craig Nazzaro is Of Counsel in the Atlanta office of Nelson Mullins Riley & Scarborough LLP. His practice areas include Alternative Lending & Other Non-Bank Financial Services, FinTech, and Payments & Digital Commerce. Dowse Bradwell “Brad” Rustin, IV, is a partner in the firm's Greenville, SC, office whose practice areas include Banking & Financial Services, FinTech and Payments & Digital Commerce. John M. Jennings is a partner in the firm's Greenville office whose practice areas include Banking & Financial Services, Blockchain & Digital Currency, Private Equity and Securities Offerings.

As we head into 2018, cryptocurrency and blockchain will continue to be a top initiative for pioneers in the financial services industry. Within financial services, this space includes everyone from those looking to issue a new cryptocurrency, FinTech firms looking to disrupt the financial services industry though creative uses and implementation of the technology, and banks and non-bank lenders of all sizes looking to see how they can best utilize the technology to cut costs and drive advancements in service. As with any innovation within the financial services industry, the regulators are never far behind and are doing their best to keep up. Those that enter this space will find that they also have to pioneer the controls to manage the regulatory risks this technology presents.

For the benefit of the uninitiated, cryptocurrencies, also known as “virtual currency,” such as the well-known “BitCoin” and “Ethereum,” are the results of just one application of blockchain technology. One should not visualize cryptocurrencies as actual currency or legal tender (we discuss why below). Instead, think of cryptocurrency as a means of utilizing the underlying blockchain technology to create a “store of value.” Anything that can function as a vehicle to save, house, move and maintain value and/or wealth can be utilized as a “store of value.” For example, gold, silver, real estate, diamonds, fine art and stocks are all “stores of value.” Viewing cryptocurrency in this manner will enable you to understand its regulation within the financial services industry.

As previously stated, blockchain is the technology upon which cryptocurrencies are built. At a high level, blockchain technology is simply a decentralized or distributed ledger, meaning that there is no master copy of a ledger maintained by an individual or a single organization (although some banks are beginning to keep a “master copy” or “golden copy” as a means to control risk). The potential applications for this technology within the financial services industry are enormous. For example, recently a group of Japanese financial institutions came together and announced their successful testing of blockchain technology in Over the Counter (OTC) derivative contracts such as the ISDA Master Agreement. Others are exploring how to use the technology as a means to complete debt offerings, settle and maintain a record of credit default swaps, revolutionize mortgage lending, title insurance, simplify and manage correspondent banking relationships and the implementation of smart contracts to speed clearing and reduced counterparty costs.

The proliferation of cryptocurrency and blockchain is being driven by the efficiencies and protections afforded to early adopters. The operational efficiencies and resulting cost savings are readily apparent in the financial services industry and are equally coveted by the entities trying to implement them and by the customers who will benefit from the implementation. However, neither party can fully enjoy these benefits without first understanding and overcoming the various regulatory hurdles.

By no means is this meant to be an exhaustive discussion of the financial regulatory burdens faced by this technology. To cover the entire regulatory landscape would be too great an endeavor, given what we can cover in this article. In Part I of this article, we would like to focus on some of the common regulatory issues faced by market participants in this space.

The Securities and Exchange Commission (SEC)

The regulatory uncertainty for cryptocurrencies, aka virtual currencies, starts as early as their Initial Coin Offerings (ICOs). This uncertainty is in part thanks to the diverse views of what is being offered along with the objectives and motivations each architect of various ICOs has in mind when defining what differentiates their coin. First there is the definition. Some are offering coins, others tokens and others altcoins. It is easy to get lost in the semantics of each term. Some are issuing coins to build a completely new cryptocurrency, others as a means of fundraising to develop “improved” blockchain technology and others to develop completely unrelated technology and products such as coins that are backed by Real Estate Investment Trusts (REITs). An ICO's “pitch” as to why a prospective purchaser should buy into an ICO is delivered through its white paper. This is where the ICO's technology, financials and overall application are laid out and it is also where the SEC will begin to evaluate if the ICO should be considered a security.

In July of this year the SEC issued release No. 81207, titled “Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO,” which contemplated the threshold question as to when an ICO would be considered a security and subject to the federal securities laws and regulated by the SEC. The guidance stopped short of stating all ICOs are securities but rather applied a test (known as the Howey test) for when a coin offering should be treated as a security offering. Citing both federal regulation and current case law, the SEC noted that a security includes an “investment contract,” which is: 1) an investment of money or other valuable consideration (it need not be fiat currency, other cryptocurrencies will do); 2) in a common enterprise; 3) with an expectation of profits; and 4) to be derived from the entrepreneurial or managerial efforts of others.

One may be able to create arguments to support a narrative as to why a particular ICO should not be considered a security, but the SEC left a lot of open questions and regulatory uncertainty in the market with the “The DAO” release. And the market is continuing to observe a “growing wave” of ICOs that are not heeding the SEC's July warning to adhere to the federal securities laws if applicable. In recent months the SEC has taken enforcement action against individuals, companies and unlicensed brokers for violating SEC registration and disclosure requirements in connection with the sale of tokens that constitute securities. It is advisable to adhere to federal and state securities regulations, if there is a chance that your ICO can be deemed a security under the guidance in The DAO or applicable state securities regulations.

The Financial Crimes Enforcement Network (FinCEN)

FinCen (a bureau of the U.S. Department of the Treasury) issued FIN-2013-G001 in 2013 that defined the participants in generic virtual currency arrangements, using the terms “user,” “exchanger,” and “administrator.” A user is a person who obtains virtual currency to purchase goods or services. An exchanger is a person engaged as a business in the exchange of virtual currency for real currency, funds, or other virtual currency. An administrator is a person engaged as a business in issuing (putting into circulation) a virtual currency and who has the authority to redeem (to withdraw from circulation) such virtual currency.

An administrator or exchanger who: 1) accepts and transmits a convertible virtual currency; or 2) buys or sells convertible virtual currency for any reason is a money transmitter under FinCEN's regulations, unless a limitation to or exemption from the definition applies to the person. This is significant as it creates a large regulatory burden. For example, now the exchanges must have a robust Anti-Money Laundering (AML) program and must establish and maintain an effective Office of Foreign Assets Control (OFAC) compliance program (discussed below).

Under the regulations, a “money transmitter” shall not include a person that only:

• Provides the delivery, communication or network access services used by a money transmitter to support money transmission services;
• Acts as a payment processor to facilitate the purchase of, or payment of a bill for, a good or service through a clearance and settlement system by agreement with the creditor or seller;
• Operates a clearance and settlement system or otherwise acts as an intermediary solely between BSA regulated institutions. This includes but is not limited to the Fedwire system, electronic funds transfer networks, certain registered clearing agencies regulated by the SEC, and derivatives clearing organizations or other clearinghouse arrangements established by a financial agency or institution;
• Physically transports currency, other monetary instruments, other commercial paper or other value that substitutes for currency as a person primarily engaged in such business, such as an armored car, from one person to the same person at another location or to an account belonging to the same person at a financial institution, provided that the person engaged in physical transportation has no more than a custodial interest in the currency, other monetary instruments, other commercial paper or other value at any point during the transportation;
• Provides prepaid access; or
• Accepts and transmits funds only integral to the sale of goods or the provision of services, other than money transmission services, by the person who is accepting and transmitting the funds.

In 2014, FinCen clarified with FIN-2014-R011. Here the agency states “that a company which facilities the transfer of value, both real and virtual, between third parties meets the definition of money transmission.” Virtual currency exchanges often argued that they were not moving money but were rather acting as a “payment processor” facilitating the purchase of a good (the coin/virtual currency) through a clearance and settlement system (the exchange) by agreement with the seller. Within their guidance, FinCen quickly dismantled this argument and stated they do not consider providing virtual currency for real currency or vice versa as a non-money transmission related service.

Next month, in Part Two of this article, we will continue to focus on additional common regulatory issues faced by market participants in this space.

*****
Craig Nazzaro is Of Counsel in the Atlanta office of Nelson Mullins Riley & Scarborough LLP. His practice areas include Alternative Lending & Other Non-Bank Financial Services, FinTech, and Payments & Digital Commerce. Dowse Bradwell “Brad” Rustin, IV, is a partner in the firm's Greenville, SC, office whose practice areas include Banking & Financial Services, FinTech and Payments & Digital Commerce. John M. Jennings is a partner in the firm's Greenville office whose practice areas include Banking & Financial Services, Blockchain & Digital Currency, Private Equity and Securities Offerings.