No clear signals being offered for cryptocurrency rules

While it's clear that investments in cryptocurrencies have exploded — to a market cap of $269 billion from $97 billion in early July 2017, according to CoinMarketCap.com — it's less clear how they should be regulated and what's in store for institutional investors.

According to the 2018 Cryptocurrency Survey released by law firm Foley & Lardner LLP, a majority of respondents want greater regulatory certainty for the world of cryptocurrencies and initial coin offerings, which give investors the opportunity to exchange conventional currency or cryptocurrency in return for a digital asset labeled as a coin or token. The June survey, which garnered responses from more than 60 financial professionals, showed 84% wanted ICOs to be regulated by the federal government, states or both. Moreover, 68% wanted regulation for ongoing purchases and sales of cryptocurrencies, and 55% said it's needed when it comes to paying for goods and services.

Cryptocurrencies now are regulated by multiple agencies in the U.S., especially on the federal level, said Patrick Daugherty, partner and member of Foley & Lardner's blockchain task force. "Every thoughtful investor is consulting with lawyers who specialize in working with the complex cross-section of SEC, CFTC and Treasury FinCEN laws — no one should try this at home," he said. "You can be 100% certain that a particular crypto offering is unlawful, but the reverse is not true. It's virtually impossible to get to 100% confidence that a crypto project is lawful absent expert analysis or government endorsement, which is exceedingly rare."

Jeffrey P. Mahoney, general counsel for the Council of Institutional Investors, wrote Securities and Exchange Commission Chairman Jay Clayton in May to voice support for meaningful oversight when it comes to cryptocurrencies and ICOs.

"We remain cautiously optimistic that some cryptocurrencies and ICOs might flourish and facilitate capital formation that benefits all long-term investors and the economy generally," Mr. Mahoney wrote. "However, we strongly believe that the potential long-term success of cryptocurrencies and ICOs is dependent on those products, and those who participate in the markets for those products, operating within the purview of the federal securities laws."

The Commodity Futures Trading Commission has designated bitcoin as a commodity, which means that fraud and manipulation involving bitcoin traded in interstate commerce are within its purview, as is the regulation of commodity futures tied directly to bitcoin.

CME Group Inc. and Cboe Exchange Inc. each launched a bitcoin futures contract last year after receiving approval from the CFTC. As of mid-July, Cboe has had an average daily volume of 5,710 contracts since its launch, while CME has had average daily volume of 2,826 contracts in 2018.

Matt McFarland, senior director of Cboe Futures Exchange business operations and strategy at Cboe Global Markets, said trading from institutional investors has been light, but they are closely monitoring the space. "A more conservative type of investor really wants to let the product mature and make sure that the infrastructure that we have put in place is working properly," he added.

A secure feeling

The central question —"what is a security?" — looms large in the cryptofinance world.

When speaking at Yahoo Finance's All Markets Summit last month, William Hinman, director of the SEC's division of corporate finance, said he didn't consider bitcoin and ether — the two largest cryptocurrencies — securities, leaving them outside of SEC purview. In addition to bitcoin, "applying the disclosure regime of the federal securities laws to current transactions in ether would seem to add little value," he said, according to his remarks posted on the SEC website.

Bitcoin and ether do not get the security designation because there is no common enterprise asking for money, according to Gary Gensler, senior lecturer at the MIT Sloan School of Management and former CFTC chairman. Most other cryptocurrencies and ICOs are securities, according to Mr. Gensler.

The SEC uses what's called the Howey test to determine whether certain transactions qualify as "investment contracts." The test stems from a 1946 Supreme Court case, SEC vs. W.J. Howey Co., and poses four questions: Is it an investment of money or assets? Is the investment in a common enterprise? Is there a reasonable expectation of profits? Is it reliant on the efforts of a promoter or others?

David Yermack, professor at the New York University Stern School of Business, said whether an ICO qualifies as a security has a lot to do with the motivation of the purchaser. Many ICOs are "utility tokens" that are meant to provide access to a particular online platform or service, he said. "To the extent that purchasers are motivated by this utility function, then ICOs probably do not meet the Howey test and are likely not securities," Mr. Yermack said. He added that according to a recent study he completed with two co-authors, about two-thirds of prominent ICOs seem to have utility features, "which suggests that most of them would not qualify as securities in the U.S."

In his letter, Mr. Mahoney called on the SEC to "err on the side of investors and other market participants" when the result of an analysis might be in question "by interpreting the definitions broadly to conclude that the products are securities.

"In the longer term, we believe the SEC should consider whether additional guidance or rule-making might provide a clearer, more uniform, and a more forward-looking approach for applying the federal securities laws to these products," Mr. Mahoney added.

Currently, U.S. agencies like the SEC and CFTC approach the cryptofinance world primarily through enforcement. The SEC has brought at least seven enforcement actions pertaining to cryptocurrencies so far this year.

Looking ahead

In the Foley & Lardner survey, 86% of respondents said the cryptocurrency industry should develop common voluntary standards, while 89% said it should explore implementation of standards through formalized self-regulation.

It's an approach that CFTC Commissioner Brian Quintenz endorsed in a speech at the DC Blockchain Summit in March. "An SRO-like independent regulatory body could create uniform standards for these trading platforms, reduce the possibility of regulatory arbitrage, and avoid duplicative regulation," he said in remarks posted on the CFTC website.

Mr. Quintenz said that he is willing to explore how a new, private independent organization could perform an oversight function for U.S. cryptocurrency platforms, much like the model of the Financial Industry Regulatory Authority.

"While cryptocurrency exchanges can resemble traditional money transmission services, there are enough differences to warrant different regulatory treatment," Mr. Quintenz said in his speech. "As Congress works with federal and state regulators to determine the appropriate regulatory framework for cryptocurrencies, I believe an SRO-like entity could develop industry standards that could inform, or even serve as a blueprint for, future action."

Foley & Lardner's Mr. Daugherty said self-regulation is "probably premature" because the industry doesn't have common federal or international standards yet. "We're not at the fine-tuning stage because there are a whole lot of people who don't understand how to bring these products to market at all."

The SEC has issued several investor advisories on cryptocurrencies and ICOs. Earlier this month, the CFTC put out an advisory preaching caution to investors on the issue as well.

The two agencies issued a memorandum of understanding in June to help ensure continued coordination and information sharing on all issues. Kathryn M. Trkla, a partner at Foley & Lardner and another member of its blockchain task force, said the memorandum is a positive step for the agencies, but regulatory authority remains ambiguous.

"I think it may make it tougher to regulate in the sense of two federal agencies, each with their own legitimate regulatory interests and market and investor protection missions, to not be tripping over each other and coordinate with one another," Ms. Trkla said of cryptofinance regulation.

An SEC spokeswoman declined comment when asked if the commission was considering further regulation on cryptocurrencies and ICOs.