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On September 18, the Office of the New York State Attorney General (the "Office") released a report following a crypto exchange initiative it began several months prior. The Office has been liaising with crypto exchanges to learn more about the current state of digital asset platforms.
The most notable takeaway is the three areas of concern that the report discusses: Conflicts of Interest The report outlined many worrisome conflicts of interest. Exchanges often have several lines of business (e.g. acting as an exchange and a broker-dealer) that pose conflicts of interest, which would be prohibited or monitored if they were traditional exchanges. Additionally, employees of these exchanges may have access to non-public information. One concerning conflict that the report discusses is that exchanges often trade in their own proprietary accounts (i.e. an exchange buys/sells crypto that it holds in its own account). This should be worrisome for investors because it means exchanges may be artificially affecting crypto liquidity and prices. Abuse Safeguards Exchanges do not have consistent safeguards in place (e.g. effective trade monitoring), and there currently is no way to monitor suspicious trades across exchanges. Few exchanges restrict or monitor the use of bots. The Office noted that these risks leave exchanges vulnerable to abuse like price manipulation, and only a few crypto exchanges have taken meaningful measures to mitigate these kinds of risks. Customer Protections Are Limited Exchanges don't currently have consistent auditing standards for the crypto they have custody over, and a few noted that they don't have an independent audit done at all. This makes it difficult to gauge whether crypto exchanges adequately protect the crypto they hold, especially in light of the significant risks exchanges face (e.g. possible hacks). The Office also questioned the adequacy of any insurance an exchange may have (or lack completely). Take Away The concerns mentioned may stem from the lack of standards in the industry, not necessarily from insufficiency; it's hard to evaluate something with no guiding principles. The NY report doesn't raise particularly novel issues, but it does show that crypto exchanges have their work cut out for them. *** Reginald Young is a licensed attorney in San Francisco, California, where he works with private investment funds and startups in the crypto industry. You can connect with him here.
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Chairman Jay Clayton of the Securities and Exchange Commission ("SEC") recently made some comments that could have significant impacts for crypto and securities regulations. These statements, made at the August 29 Nashville 36|38 Entrepreneurship Festival, seem to have been missed by many.
ICOs Chairman Clayton began his speech saying that “[n]o conversation about recent efforts at the SEC to foster innovation would be complete without mentioning our approach to distributed ledger technology, digital assets, and [initial coin offerings ("ICOs")].” He gave a short overview urging caution for investors in the ICO space, but made this short comment in passing: “Bill [Hinman] recently outlined the approach the staff takes to evaluate whether a digital asset is a security, and I strongly encourage you to take a look at Bill’s speech.” Translation: Clayton endorsed the analysis that SEC Division of Corporation Finance Director, William Hinman, made in his June 4 speech at the Yahoo Finance All Markets Summit. You know - the talk where he said Ethereum probably isn’t a security. Which is significant in ways most haven’t appreciated yet. You can read about the significance of Director Hinman’s comments here, but, in many ways, Director Hinman’s comments were the first recognition that there is a new “digital asset” class.* In even simpler terms: Chairman Clayton arguably endorsed Director Hinman’s statements and analysis that Ethereum is not a security. Private Offerings The other significant comment that Chairman Clayton made was that the SEC needs to rethink the current offering exemption framework. Generally, sales of securities in the US must be registered or qualify for an exemption. Right now, one of the most commonly used exemptions is for private offerings, which often requires that an investor is “accredited” (aka, has more than $2.1MM in net worth, or regularly earns $100k in annual income). Chairman Clayton generally outlined how the SEC should approach rethinking the exemptions, but he makes a particularly interesting comment: “We also should consider whether current rules that limit who can invest in certain offerings should be expanded to focus on the sophistication of the investor, the amount of the investment, or other criteria rather than just the wealth of the investor.” Aka, maybe it’s time to re-think the “accredited investor” requirement and open up the private offering exemption to more people. The ICO ecosystem was partially built on a frustration that only the wealthy can access good investments due to the accredited investor threshold. Of course, these kinds of restrictions are meant to protect everyday mom-and-pop investors who can’t (or shouldn’t) take the risk of being misled to invest in something like Bitconnect. But now that crypto is waking up the reality that a lot of tokens are securities, expanding private offering exemptions would open the floodgates for capital to flow into crypto, and fuel the ICO market even more. We’ve already seen some attempts to open up the offering exemptions. For example, one of the exemptions in Reg A+ looks at the amount an investor invests relative to his or her overall income or net worth. Reg CF similarly looks at an investors income and net worth, but doesn't outright ban investors under $100k; instead, it just limits how much they can invest relative to their income or net worth. So the trend towards softening the "accredited investor" requirements has been brewing for a while, but Chairman Clayton's comments sound like the SEC is ready to revamp the whole framework in a way that could open up capital formation for private companies a lot more. Takeaway TL;DR: the Chairman of the SEC arguably endorsed that Ethereum is not a security, and that the timing is ripe to rethink private offering requirements like "accredited investor" status. Both of these are good news for the future of crypto. ** Reginald Young is a licensed attorney in California, where he works with private investment funds and startups in the crypto industry. You can connect with him here. ** *Recent regulatory trends increasingly suggest that crypto may correctly be imagined, generally, as: (i) “currency” tokens like Bitcoin, that are meant to function entirely as digital money and are not securities; (ii) “digital assets” like Ethereum that have utilitarian functions in addition to or instead of currency functions, and may be securities; and (iii) security tokens that are, in essence, tokenized forms of equity or ownership. Of course, this is a simplification and you can add additional categories and subcategories. But it illustrates the point that Director Hinman’s comments may be viewed as the first recognition that the second category (“digital assets”) may be a new asset class of potential non-securities. One of the biggest problems facing the digital asset industry currently is custody. But what does that exactly mean?
Custody, Generally “Custody” means what you would expect – how something is held or kept safe. Most existing ways to "custody" or hold crypto are imperfect. Hot storage (i.e. crypto wallets that are connected to the internet) can be hacked. Cold storage (i.e. crypto wallets that are not connected to the internet) requires protecting and maintaining the hardware. Storing your Bitcoin or Ethereum on Coinbase is probably safer than storing it on a computer in your basement but, á la Nick Szabo, trusted third parties are security holes. Better yet – any trusted humans are security holes. No solution will ever be perfect, and there are increasingly better options like multisig wallets (i.e. wallets that require multiple private keys to access them). But, compared to the traditional securities world, crypto custody lacks standards, transparency, and is young and untested. All of those factors create a very uncertain future. What will custody look like in six months? Are multisig wallets really that safe? What would “institutional grade” cold storage look like? Why Custody Matters The uncertain state of custody has become a big bottleneck in the growth and adoption of digital assets. Institutional investment firms have duties to their investors. Family offices aren’t as risk seeking. These types of investors can bring significant capital to the cryptoscape, but they won't risk making investments if how those investments are custodied is uncertain. The best standards today may be easily hackable tomorrow. Time will ease custody concerns, but we just don’t have the certainty the industry needs yet. Qualified Custodians Another good example is the “qualified custodian” requirement for certain investment advisers. For example, investment advisers (think: hedge fund manager) that are required to register with the SEC (aka, they have more than $150MM in assets under management) must hold assets with a “qualified custodian”. The term “Qualified Custodian” (“QC”) is defined in Rule 206(4)-2 of the Investment Advisers Act of 1940. It generally means a bank or savings association with FDIC insured deposits, a registered broker-dealer, a registered futures commission merchant, or foreign institution that typically acts in a similar custody role. In simple terms: a qualified custodian is usually an entity like a bank, that is subject to robust regulation and compliance requirements. As of the date of writing, only Kingdom Trust is the only self-advertised crypto QC (but there is some debate on whether it actually is a qualified custodian, which means there may not actually be any QCs). But even then, Kingdom Trust's offerings are limited to crypto like Bitcoin, Ethereum, and ZCash. Many institutional investors are staying out of crypto because they have to hold assets with a QC...but there aren't great QC options right now (in fact, there may not actually be any options). However, there are lots of promising efforts underway, like those by Coinbase and BitGo. Startups Custody also matters for crypto startups. They need think about how they should properly custody tokens in an industry without clear standards. Exchanges need to have sufficient protocols and protections in place to protect assets, and need to account for situations like how tokens will be held in bankruptcy. Time Will Tell The standards for crypto custody will become clearer over time, but they’re something the industry needs to focus on and develop. Recent developments are promising, however. For example, the Winklevosses (…Winkevai?) have gotten support from a CFTC commissioner for their proposed self-regulatory organization, which would help establish regulatory standards for the crypto industry. ** Reginald Young is a licensed attorney in California, where he works with private investment funds and startups in the crypto industry. You can connect with him here. Recently, the SEC denied seven more Bitcoin-based ETF applications by ProShares and Direxion. ETFs have been a hot 2018 topic for cryptocurrencies, and we've written about and explained them before. Interestingly, the crypto markets didn't react all that terribly to the news, though many investors probably expected the denials since the SEC has yet to approve a crypto ETF.
Practically, though, the SEC denial doesn't mean much. Why? Reason for Denial The SEC based it's denial decision on the fact that BTC markets are not inherently resistant to manipulation. In other words, there aren't enough protections in the crypto markets that prevent, say, bots or exchanges from fraudulently manipulating the price. The same logic was used when the SEC recently denied the Winklevoss's ETF proposal. The Winklevoss's (...Winklevai?) tried to minimize the risk of manipulation by working with Nasdaq, but that wasn't enough for the SEC. So the more recent ETF proposals tried to further minimize the risk of price manipulation by basing their value on CBOE and CME bitcoin futures markets, which are regulated markets. However, the SEC still rejected this as insufficient protection from manipulation. In other words, the BTC futures markets just aren't robust and traded enough yet to trust their pricing. Interestingly, the SEC also recognized that approval of a BTC ETF or similar investment instrument would have benefits. Specifically, they noted that it would provide investors with additional protections (i.e. by allowing investors to access BTC in a more regulated route). Why It Probably Doesn't Mean Anything So there's no Bitcoin ETF yet. So what? The crypto market is so, so young. Of course it's not "resistant to manipulation" yet. A new asset class was just born, and it's going through growing pains. The CBOE and CME futures markets were launched within the last year, in the middle of a speculative bubble. No wonder their usage is low and dropping now that the froth has faded. The SEC's denial does NOT mean that future crypto products like ETFs or publicly traded index funds will never happen. It just means the market isn't robust enough for regulators yet. Which, given the growing pains (read: scalability) that Bitcoin experienced in its 2017 surge, makes total sense. And besides, the digital asset community should focus on the things that actually matter, like figuring out how to scale better, and how the industry should be regulated (note: "regulation" doesn't just mean "prohibit or restrict; it can also mean "enable" or "allow"). In other words, investment instruments like ETFs are probably not where we should be planting the next flag. Focusing on an ETF approval would be "form" ("an agency says the quality of BTC is trustworthy") over "substance" ("BTC is a quality asset"). Next Steps The SEC has "stayed" (aka, paused) the ETF denial for further review. Don't get excited, though. This is a standard administrative process, and is done because the SEC delegated the decision to staff. The higher-ups at the SEC will not review the staff's decision. More likely than not, the SEC will let the decision stand. But it's possible they could reverse it and approve the ETFs. There are a few other SEC ETF decisions looming on the horizon (like the VanEck-SolidX ETF), but, as this whole post is about, they won't make or break the future of crypto (though there are some compelling arguments an ETF may obliterate prices for a while). One really interesting, under-appreciated item to note, however, is that Commissioner Hester Pierce dissented from the recent Winklevoss ETF denial. This is not done that commonly. In other words, a Commissioner went out of her way to publicly state that the Winklevoss ETF should have been approved. With that in mind, it's only a matter of time before one is. And then, of course, there's Bakkt, which may help stabilize and legitimize Bitcoin pricing. That stability could make the SEC more comfortable that BTC markets aren't subject to pricing manipulation, and more open to approving an ETF. ** Reginald Young is a licensed attorney in San Francisco, California, where he works with crypto investment funds and startups. You can connect with him here. William Hinman, the Director of the Division of Corporation Finance of the Securities and Exchange Commission ("SEC") recently made remarks at a finance summit. In them, he stated that "current offers and sales of Ethers are not securities transactions."
This is big for crypto regulationy. Until now, we've only gotten guidance that Bitcoin isn't a security, and that every other token the SEC has seen is probably a security. But most of the initial coin offerings ("ICOs") that are brought to the SEC's attention are likely fraudulent. So there's got to be a good swath of tokens that are NOT securities, but veritable utilitarian assets. Most in the crypto industry have anticipated that the SEC would give more guidance by planting a flag on Ethereum. The fact a director has publicly stated Ethereum is probably not a security is seriously seriously seriously great news. Quick disclaimer - Hinman's statements do not reflect the SEC's final determination about Ethereum. As a Director, he is an influential person, but it's possible the SEC could ultimately come out the other way and say Ethereum is a security. But ok, why is it such a big deal? Guidance It's hard for the digital asset industry to develop when it knows regulation is aggressively ramping up. So Director Hinman's statements give us a better idea of the "utility-to-security" spectrum. As Director Hinman notes, don't look at the token - look at the circumstances around it. Too many ICOs claim they're not securities because their digital assets can only be used for utilitarian purposes. That's misguided - instead, they should be asking if people are buying into their ICOs with the expectation of selling the digital assets for profit. Based on Hinman's statements, the following suggest a digital asset is a security:
Digital Asset Conversion Director Hinman said he doesn't believe Ethereum is currently a security. But he makes an interesting statement before that: "putting aside the fundraising that accompanied the creation of Ether...." In other words, the launch and funding of Ethereum may have been centralized enough that it should be considered a security. But that means a digital asset can start as a security, and transition to non-security. This has been "theory" for a while, but Hinman's statements now strongly suggest it's the way forward. Which points us to... SAFTS If Ethereum is ultimately not a security, Simple Agreements for Future Tokens ("SAFT") are viable. There's been a lot of FUD since the SEC is targeting SAFTs. As a result, thought leaders have questioned whether the SAFT is a viable tool. SAFTs were built so that they're securities on the front-end, and non-securities on the back-end. But if the ultimate digital assets on the back-end are securities, there's no point in using a SAFT instead of a Simple Agreement for Future Equity ("SAFE"), and all the securities regulations it comes with on both the front- and back-end. But Hinman's statements strongly suggest SAFTs are indeed viable - an investment can begin as a security, and convert to non-security digital assets. Non-Securities Exchanges? If Ethereum is ultimately not a security, it's possible there can be crypto exchanges that only exchange utility tokens (note the word "exchange" and not "trade", as "trading" would be buying to profit). If an exchange doesn't have any securities...then it may not have to adhere to all the regulations securities exchanges have to (you can read about how crypto exchanges are regulated here). Next Up? The next big line to be drawn in the sand? Ripple. But the answer to whether XRP is a security might not come from the SEC... ** Reginald Young is a licensed attorney in California, and he works with private investment funds and startups in the crypto industry. You can connect with him here. Want More? This Time Is Not Different: A Brief History of Private Money & Crypto Crypto Exchange Regulations "If a token forks in the woods...how should it be taxed?"
The taxation of forks is a vexing, unresolved issue right now. Consider for example, that a forked cryptocurrency is like a stock split (which is taxed one way) or a stock dividend (which is taxed another way). Or maybe it should be taxed like interest, and treated as a "capital" asset. The American Bar Association ("ABA") recently called on the Internal Revenue System ("IRS") to provide guidance on the issue. Specifically, the ABA has asked the IRS to provide a temporary safe harbor while they sort out just what the heck a fork is. The ABA proposed that the harbor treats forks as taxable events, and that the owner gets a basis of zero. This effectively means the owner is taxed on the full amount of the newly forked digital assets. Additionally, under these rules, the holding period starts at the time of the fork. This matters because once a "capital" asset is held for a year, it gets a much more favorable tax rate. So you could say that the ABA's proposal isn't exactly friendly to fork recipients. But since there's no guidance whatsoever on how to actually account for forks, it may be better for crypto holders to be able to comply with a tax law (even if it's unfavorable) than be potentially non-compliant depending on whatever the IRS later decides. Lately, there's been a flurry of activity from federal and state agencies targeting cryptocurrency exchanges lately. Exchanges have been the predicted "next target" by professionals in the industry that I've talked to ever since the Securities and Exchange Commission ("SEC") started sending letters related to initial coin offerings ("ICOs"). For example, New York sent a barrage of letters in April to crypto exchanges, probing for more information. Similar to the SEC's letters to investment funds, NY's letters seem to be aimed at educating regulators for the time being, rather than any type of actual enforcement or regulation. This makes sense; you can't regulate what you don't understand. But since digital asset exchanges are likely to only grow bigger and bigger (like how NASDAQ could add a crypto exchange soon) it's inevitable that regulators will start taking enforcement actions and actively regulating these exchanges with increasing frequency and intensity. But, as the crypto regulation refrain goes, this is OK because it's a crucial step in the growth, stability, and credibility of the crypto industry. But how, exactly, could exchanges be regulated?  Exchanges like Coinbase are experiencing increased regulation. Image courtesy of Wikipedia. SEC Exchange Registration
Exchanges must be registered with the SEC or qualify for an exemption. The most feasible exemption for crypto exchanges is the Regulation Alternative Trading System ("Reg ATS"). Reg ATS is the more likely option for crypto exchanges, since full registration with the SEC is extensive, and associated more with public stock exchanges like NYSE and NASDAQ. ATS exchanges don't need to fully register with the SEC. They must register as broker-dealers and make some initial filings and give some forms of notice to the SEC. But overall, they're more lightly regulated than fully registered exchanges. The SEC issued a release in March 2018 expressing concern over the fact that, currently, no crypto exchanges are registered or have qualified for the ATS exemption. Oops. Coinbase is leading the charge to be the first ATS, though. Internal Revenue Service ("IRS") The IRS has already imposed (some) user reporting requirements on crypto exchanges like Coinbase. How extensive their reporting and disclosure requirements will end up being are up for debate, given Coinbase successfully pushed back and limited the IRS request. FinCEN In 2013, FinCEN released a report on "virtual currencies". In this report, the agency determined that crypto exchanges must register as "money service businesses" ('MSBs"). One sub-type of MSB is a money transmitter, which you can read about more here, and is one of the main ways many crypto-related businesses are currently facing regulation. Any crypto exchange that has custody of users' cryptocurrencies will be regulated as an MSB, meaning it must register with FinCEN, collect certain information on its users, and have certain compliance policies in place. AML/KYC The Bank Secrecy Act ("BSA") imposes anti-money laundering ("AML") and know-your-customer ("KYC") requirements on exchanges. Many exchanges are currently self-imposing these requirements (think about that driver's license you had to upload when registering on Kraken). Generally, these requirements are aimed at identifying who actually owns assets and accounts, in order to minimize money laundering and/or other illegal behavior. Anti-Fraud The SEC may also target exchanges with anti-fraud tools. For example, this may include targeting exchanges that seem to be manipulating prices themselves. State Regulations And, of course, in addition to the above regulations, each state may impose its own regulations on exchanges that operate in-state. Want To Learn More? This Time Is Not Different: A Brief History of Private Money & Crypto Initial Coin Offering (ICO) Security Exemptions Questions? Comments? Let us know below! UPDATE - I spoke with a VC in San Francisco that confirmed he/she considerably saw the adverse selection effect in ICOs in 2017. As noted, this effect likely doesn't apply to all ICOs, but it is another layer to consider. *** Zhao Changpeng, the CEO of Binance, recently wrote a post claiming that initial coin offerings are "necessary" in light of the venture capital world. "[R]aising money through ICOs is about 100 times easier than through traditional VCs, if not more," he wrote. He focused on the absurdity of courting VCs, preparing business plans and presentations, negotiating terms with lawyers, VC control, and other "drawbacks" of the VC world. "ICO investors are early adopters (and learners)," Changpeng writes. Counter argument: VCs sift and winnow the good from the bad, so that companies that spurn VC funding and choose to do an ICO are actually subject to adverse selection. Viability Hurdle VCs function as hurdles many entrepreneurs need to face. Yes, it's additional work to making your idea reality. But maybe it's a necessary hurdle to proving your idea has some viability. Changpeng writes that having to come up with business plans and pitches is a "downside" of the VC process. But this ignores the fact that many entrepreneurs haven't fully formed their idea or even thought about logistically bringing it to market. The VC System Has Benefits Business plans force nascent companies to ask hard questions. For example, many tech entrepreneurs start by valuing their total addressable market with a top-down approach. They say "well, we think it's reasonable we could get 1% of the market, which is worth..." But that's lazy. That's the easy way. And a good VC will call it out by asking the hard questions, because they've likely seen the failure of companies that didn't ask those tough questions. "We can't get what we want so we're gonna make our own capital raising ecosystem!"  The VC system vets and snuffs out this self-deceiving naivety. It forces founders to learn skills like pitching, thinking through the true costs involved, actually verifying demand, etc. And VCs bring experience and networks. While ICO investors may be "early adapters", as Changpeng writes, what are they early adopters of? Most of them don't have the first-hand experience helping companies grow that VCs do. They don't add much value other than capital. They may be early adapters, but maybe they're early adapters of a system where the blind lead the blind. Throw irrational herd behavior on top of that and you should be skeptical that ICO investors can accurately choose and value tokens (see, for example, the current crypto market value despite very, very few validated test cases outside of a "store of value"). All an ICO needs to be successful is effective (...scammy?) marketing **cough** BitConnecct **cough**. Adverse Selection It's possible that ICOs attract the worst businesses, the ones that weren't good enough to get VC funding. There are many companies that truly and earnestly belong on blockchains and require native digital assets...but it's possible many token companies out there slapped a blockchain in their model so they don't have to face the hard, experience-earned vetting that venture capital requires. And so there may be an adverse selection ICO effect: it's possible the companies that choose ICOs over VC funding are companies that aren't viable since they couldn't (or wouldn't) have gotten funding under the VC model. Thoughts? Comments? Let us know below. Further Reading: This Time Is Not Different: A Brief History of Private Money and Crypto Initial Coin Offering (ICO) Security Exemptions Given increasing scrutiny from the Securities and Exchange Commission (“SEC”), Initial Coin Offerings (“ICOs”) are trying to limit their exposure to SEC regulation by placing themselves outside SEC jurisdiction. The main way ICOs are doing this (...or are unintentionally trying to do this) is by fitting into Regulation S (“Reg S”).  ICOs are trying to avoid the SEC via Regulation S Initial coin offerings ("ICOs") are facing increased regulatory scrutiny, and are likely to be seen as securities by agencies. We've written before about the securities exemptions ICOs may use to comply with the Securities and Exchange Commission (the "SEC"): Reg D, Reg CF and Reg A+.
Reg A+ (Tier 2, in particular) has started to get attention in the cryptocurrency world because it offers advantages over the others that make the most sense for digital assets. Well, there's good regulatory news (...which seems uncommon right now for most of crypto). The US House of Representatives has passed the "Regulation A+ Improvement Act" (the "Reg A+ Act") that increases the cap on investments under Reg A+. Increased Reg A+ Caps Reg A+ is divided into Tier 1 and Tier 2. If you issue an exempt security offering under Tier 1, you can raise up to $20m in a 12-month period. If you issue the offering under Tier 2, you can raise up to $50m in a 12-month period. The new Reg A+ Act would increase the investment cap by 50% ($30m for Tier 1, $75m for Tier 2). ICOs & Reg A+ Several ICOs have already used Reg A+: Gab, RideCoin and WeDemand. So Reg A+ has been shown to work in practice for crypto offerings. And with an increase in capital raising potential, it will likely increase. Limits There are still a few key limits on using Reg A+:
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