The migration of assets – from land, commodities, and specie through paper records to electronic records – has been driven in large part by a desire to reduce transaction costs and increase the speed of transactions and hence the liquidity of assets and the markets for those assets. As electronic transactions evolved, one goal of that evolution has been to create unique electronic assets that cannot be counterfeited or duplicated. The ability to create a unique electronic asset allows it to be transferred and traded without (or with minimal) concern that the asset is not real and not a copy. Distributed ledger technology using blockchains appears to have met this goal. This technology has also triggered the creation of electronic assets that appear to have value in their own right, if only because people will deliver other assets in exchange for them. The term “cryptocurrencies” was coined and has been applied to assets that meet this description, such as bitcoin and a range of other electronic assets that have more conventional value characteristics.
For financial institutions, especially banks, the creation of a new financial asset raises a host of legal and practical questions, including: What is the asset – an electronic representation or claim on some other asset or merely a unique set of digital characters? What is the asset for regulatory purposes – a loan, security, commodity, or something else? What law governs the ownership and transactions in the asset – private contract, statutory commercial law such as the Uniform Commercial Code (UCC), common law, or some combination of these? Is the asset an asset that is useful and permissible for a bank or other financial institutions to acquire? Even if a financial institution cannot acquire, or has no interest in acquiring, the asset, is it something that customers will want to acquire or hold, and how will that affect the financial institution’s dealings with those customers? Is there a role for financial institutions in clearing or settling transactions in the asset? How does the asset affect the creditworthiness of the
financial institution’s customers? Will the financial institutions take it as collateral, or will they consider
it a risky investment?
These questions often can, and should, take a long time to sort out because premature decisions can stifle innovation, competition, productivity, and economic growth. Despite the risks of early characterizations, in our highly regulated world of financial services, one of the first questions that comes up is whether or not the asset is a security. Questions as to whether transactions in the assets can be used for money laundering, terrorist financing, or other illegal purposes and whether trading in the asset will trigger commodity regulations, which often follow shortly behind.
As we discuss in the rest of this article, the answer to the security question for assets labeled as cryptocurrencies so far depends on the character of the particular asset, but other regulatory issues have arisen (most notably, in New York), and transactions in cryptocurrencies have been found to be subject to the Commodity Exchange Act (CEA). It is too early to try to address these issues comprehensively, but the following discussion is intended to help financial institutions start to think about them.
BLOCKCHAIN AND CRYPTOCURRENCY
Blockchain is the backbone technology that – along with numerous other use cases – currently is best known for powering all cryptocurrencies. Although there is no standardized definition for blockchain technology, it can be described as a distributed system of ledgers containing immutable time-stamped and connected blocks of data, which is operated generally in a decentralized manner; through pre-defined consensus mechanisms in lieu of a central authority; and by employing cryptography in order to prevent the ability to edit or tamper with the information recorded on the blockchain.
Blockchain was first developed in 2008 as the technology underlying what is widely agreed to be the world’s first and best-known cryptocurrency, bitcoin. As set forth in the bitcoin white paper, bitcoin was intended to provide a means for peer-to-peer payments. However, due to the high level of price volatility of bitcoin and many other cryptocurrencies (for example, Ether, Ripple, Zcash, etc.), many believe that cryptocurrencies’ use ultimately will be confined primarily to investment purposes rather than to use as stores of value or means of exchange. We think, however, that this vastly oversimplifies the cryptocurrency landscape and how financial institutions and other service providers should evaluate cryptocurrencies when determining whether or not to provide services with respect to this new asset class.
THE CRYPTOCURRENCY LANDSCAPE
Cryptocurrencies are not a homogeneous asset class; rather, they come in many varieties. For example, there are what can be described as truly decentralized cryptocurrencies, such as bitcoin and Ether, which, as we discuss below, the Securities and Exchange Commission (SEC) has stated are so decentralized that they no longer should be deemed to be securities. Tokens are another variety of cryptocurrency offered in initial coin offerings (ICOs) as a means of raising capital for a business or blockchain project. A shared characteristic of many truly decentralized cryptocurrencies and many ICO tokens is that they generate their values intrinsically – their values are what everyone agrees their values to be. In contract, there is another variety of cryptocurrencies called asset-backed cryptocurrencies, which, as the name suggests, generate their values through a pool of collateral (e.g., real estate, fiat currency, precious metals, other cryptocurrencies). One example of an asset-backed cryptocurrency is called a “stablecoin.”
Stablecoins are a class of cryptocurrencies that seek to maintain price stability with respect to an asset with a stable value, such as U.S. dollars. There are two main varieties of stablecoins: collateral-backed coins and algorithmic coins. Collateral-backed coins rely on collateral to back the value of the coins. Collateral can be U.S. dollars, gold, euros, or any other “stable” asset. The collateral is placed in an account, with a bank or other financial institution, and is subject to audit to ensure that the collateral truly exists and is sufficient to cover the amount of the outstanding obligations. The Gemini Dollar and the Paxos Standard are both examples of collateral-backed stablecoins. Both are pegged to the U.S. dollar at a one-to-one ratio. Algorithmic stablecoins rely on a liquid market of digital bonds to expand and contract the stablecoin supply, thus creating price stability in the stablecoin. (NOTE: This dynamic is similar to that used by securities market makers, with the notable difference that market makers are intermediaries that make a market in an instrument issued by a third party. In contrast, in the case of an algorithmic stablecoin, the stablecoin algorithm itself is responsible for expanding and contracting the supply of the stablecoin). Algorithmic stablecoins substitute monetary supply policy dynamics for collateral as the mechanism for maintaining a stable coin value. The potential benefits of the algorithmic approach include a scalability and automation that may not be feasible with the collateral approach. Examples include Basis, which pegs its value to the U.S. dollar by controlling the supply of the stablecoins in circulation.
CRYPTOCURRENCY: THE SECURITIES LAW PERSPECTIVE
Given the variety of cryptocurrencies, it is important for financial institutions and other service providers to understand how regulators view cryptocurrencies and what those views mean from a risk perspective. In considering the truly decentralized cryptocurrencies and ICO tokens, the SEC has applied the investment contract test set forth in SEC v. W. J. Howey Co., 328 U.S. 293 (1946) (“Howey”). The factors of the Howey case are: (1) whether purchasers of the instrument contributed money (or valuable goods or services); (2) whether purchasers invested in a common enterprise; (3) whether purchasers reasonably expected to earn profits through that enterprise; and (4) whether the expected profits are to be derived from the efforts of others.
Most of the analysis to date under the Howey case as applied to cryptocurrencies has focused in particular on whether token purchasers rely on the efforts of others with respect to any expectation of profits by those purchasers. As a result, even in the case of tokens that are called “utility tokens” as opposed to “security tokens” because the tokens provide purchasers with a utility function on a blockchain platform (rather than merely an economic interest) the tokens may be (and likely will be) deemed to be investment contracts, and therefore securities, if the value of the tokens is based on the efforts of the ICO issuer/promoter. As stated by the SEC, “[w]hether a particular investment transaction involves the offer or sale of a security – regardless of the terminology or technology used – will depend on the facts and circumstances, including the economic realities of the transaction.”2 (NOTE : See, e.g., Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, SEC Release No. 81207 (July 25, 2017) (“The DAO Report”).
To date, the SEC has demonstrated a very careful and nuanced application of the Howey case to cryptocurrencies that shows an appreciation for the variation among cryptocurrencies. As mentioned above, the SEC staff has distinguished between what it has determined to be truly decentralized cryptocurrencies, bitcoin and Ether, which it believes are not investment contracts and therefore not securities and other types of cryptocurrencies. In a landmark speech on June 14, 2018, William Hinman, director for the Division of Corporation Finance of the SEC, stated that the analysis of whether a token is a security is “not static and does not strictly inhere to the instrument.”3 (NOTE: Director of the Division of Corporation Finance William Hinman, “Digital Asset Transactions: When Howey Met Gary (Plastic),” SEC Speech, Remarks at the Yahoo Finance All Markets Summit: Crypto in San Francisco, Calif., June 14, 2018). As a result, decentralization could develop over time, even after an initial token sale launch, and therefore a token that starts its life cycle as a security could at some point become a non-security. This means that, unlike records stored on a blockchain, a token’s treatment under U.S. federal securities laws is mutable. (NOTE: This concept of mutability has been expressed in the reverse (for example, a loan may start its life cycle as a commercial instrument but end its life cycle as a security), but until now, mutability has not been expressed so as to turn a security into a non-security).
The SEC and its staff have yet to apply Howey or any alternate security analysis to the context of a stablecoin. Under a Howey analysis, it is not clear that stablecoins should be deemed to be securities. Unlike the more volatile cryptocurrencies or the ICO tokens, stablecoins would seem to “fail” one of the principal Howey factors: that a purchaser must have an expectation of profit. A purchaser of a stablecoin has no such expectation; rather, a purchaser of a stablecoin expects the value of the stablecoin to remain constant. We predict, therefore, that stablecoins, as described above, will not be determined to be investment contracts under the analysis in Howey, although it is possible that stablecoins could be deemed to be securities under other rationales.
TREATMENT OF STABLECOINS BY THE
N.Y. DEPARTMENT OF FINANCIAL SERVICES
On September 10, 2018, the New York Department of Financial Services (NYDFS) approved the issuance of stablecoins by both Gemini Trust Company and Paxos Trust Company, both New York limited-purpose trust companies chartered under New York State banking law.5 As conditions for approval, both Gemini and Paxos represented to NYDFS that they would – along with a list of other anti-fraud, anti-money laundering (AML), and consumer protection measures – (1) ensure that the stablecoins are fully exchangeable for a U.S. dollar, with provisions to ensure monitoring and recordkeeping;6 (2) implement, monitor, and update effective risk-based controls and appropriate Bank Secrecy Act/AML and Office of Foreign Assets Control controls to prevent the stablecoins from being used in connection with money laundering or terrorist financing; and (3) maintain policies and procedures for consumer protection and to promptly address and resolve customer complaints.
Interestingly, the NYDFS approval of Gemini Dollar and Paxos Standard makes no mention of securities law and in no way indicates that New York State thinks that the issuance of the collateral-backed stablecoins constitutes the issuance of a security.
CRYPTOCURRENCY: THE COMMODITY LAW PERSPECTIVE
Whether or not a cryptocurrency is determined to be a security, the Commodity Futures Trading Commission (CFTC) takes the position that all varieties of cryptocurrencies are commodities for purposes of the CEA.7 The term “commodity,” defined in Section 1a(9) of the CEA, is extremely broad, covering everything from physical commodities to “services, rights, and interests.”
Because cryptocurrencies are deemed to be commodities, it means that the CFTC has jurisdiction over margined or leveraged transactions in cryptocurrencies that involve “retail” investors (called noneligible contract participants). Perhaps more importantly, however, by virtue of being deemed a commodity, cryptocurrency transactions imbue the CFTC with anti-fraud and anti-manipulation authority. As a result, even when securities law anti-fraud and anti-manipulation authority does not reach a particular transaction, commodities law authority now does.
Considerations for Financial Institutions and Other Services
Financial institutions and other service providers that are considering providing cryptocurrency-related services – such as custody, valuation, and lending, among others – will need to consider not only the variety of cryptocurrencies, as discussed above, but also the relevant regulatory treatment of each variety.
For example, a bank that is considering providing custodial services with respect to ICO tokens would want to understand whether the tokens in question are securities, and, if so, what securities regulatory requirements apply to their safekeeping. Similarly, if a bank that is considering financing a customer with significant cryptocurrency assets, such as bitcoin and Ether, would want to understand both how they are treated for regulatory purposes (such as margin lending) as well as how they are treated for commercial law purposes (including transfer and security interests).
Ultimately, a decision to provide cryptocurrency-related services must consider the relative risk of the type of cryptocurrency involved, the regulatory treatment of that cryptocurrency, relevant commercial law, and whether the regulatory treatment and relevant commercial law increases or decreases the relative risk a financial institution takes on in providing the requested services.
Because the array of new electronic assets, whether they come under the rubric of cryptocurrencies or some other characterizations, will only expand, legal and valuation questions associated with them will continue to evolve for some time to come. For the foreseeable future, analysis of the commercial and legal issues associated with these assets will need to proceed on a case-by-case basis. In the meantime, it will be necessary to understand the structures and technologies that underlie these assets to understand how they will affect traditional as well as new banking services.
1 This dynamic is similar to that used by securities market makers, with the notable difference that market makers are intermediaries that make a market in an instrument issued by a third party. In contrast, in the case of an algorithmic stablecoin, the stablecoin algorithm itself is responsible for expanding and contracting the supply of the stablecoin.
2 See, e.g., Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, SEC Release No. 81207 (July 25, 2017) (“The DAO Report”).
3 Director of the Division of Corporation Finance William Hinman, “Digital Asset Transactions: When Howey Met Gary (Plastic),” SEC Speech, Remarks at the Yahoo Finance All Markets Summit: Crypto in San Francisco, Calif., June 14, 2018.
4 This concept of mutability has been expressed in the reverse (for example, a loan may start its life cycle as a commercial instrument but end its life cycle as a security), but until now, mutability has not been expressed so as to turn a security into a non-security.
5 Because they are New York limited-purpose trust companies, NYDFS reviews and approves all of Gemini’s and Paxos’ virtual currency activities. As New York limited-purpose trust companies, Gemini and Paxos are subject to regulation similar to that required under the New York Virtual Currency Law – the “Bitlicense” – but are not directly regulated under the Bitlicense.
6 In the case of Gemini, this condition appears to be addressed as follows: (1) U.S. dollars that correspond to the Gemini dollars issued and in circulation are held at State Street Bank and Trust Company; (2) the U.S. dollar deposit balance is examined monthly by BPM, LLP, a registered public accounting firm, in order to verify the 1:1 peg and audits are publicly available; and (3) the code of the Gemini dollar smart contracts has been audited by Trail of Bits, Inc., an information security research and development firm, whose report is publicly available. In the case of Paxos, this condition appears to be addressed as follows: (1) the entire supply of the Paxos Standard (PAX) is collateralized by USD in dedicated omnibus cash accounts at FDIC-insured U.S. banks; and (2) auditing firm Withum performs attestation procedures (established by the AICPA) on FDIC-insured accounts and the PAX tokens on a month-end basis.
7 This position was recently upheld by the District Court of Massachusetts. See CFTC v. My Big Coin Pay, Inc., Case No. 1:18-cv-10077 (D. Mass. Sept. 26, 2018) (Memorandum of Decision).