Token Resistance – Recent US Regulatory Developments

Recent actions show continued interest by state, federal and self-regulatory agencies in cryptocurrency, and digital assets. We highlight four recent developments addressing interesting regulatory points for players in the US crypto market.

1. FinCEN addresses Convertible Virtual Currencies

CVCs v Digital Assets

On May 9, 2019, FinCEN took two steps to address industry concerns over dealing in Convertible Virtual Currencies (CVCs).

The term CVC refers to unregulated forms of digital currencies, or “cryptocurrencies”, which can be exchanged for real, legally recognized, fiat currencies, such as U.S. Dollars, Euros, etc., and as such should be read to cover (roughly) the same ground as what the SEC refers to as “digital assets,” although in a different context.

Step 1 - new guidance on regulation of CVCs

First, FinCEN published new guidance affirming its regulatory framework of CVCs. While the new guidance merely consolidates and summarizes previous rules and interpretations dating back to 2011, it provides an important resource for the financial industry in determining when dealing in CVCs will fall under FinCEN’s authority and how to comply with subsequent regulatory obligations.

For example, the guidance confirms that transactions denominated in CVCs, regardless of whether termed “digital currency,” “cryptocurrency,” “cryptoasset,” “digital currency,” etc., will be subject to FinCEN regulation under the Bank Secrecy Act (BSA), so long as it falls within FinCEN’s elaborated interpretation of “value that substitutes for currency.”

As the guidance states, this determination is notwithstanding “whether the CVC is represented by a physical or digital token, whether the type of ledger used to record the transaction is centralized or distributed, or the type of technology utilized for the transmission of value.”

The guidance addresses specific applications of these concepts in a number of contexts, including:

  • Peer-to-Peer Exchanges;
  • CVC Wallets;
  • CVC Kiosks; 
  • decentralized applications (DApps);
  • anonymity-enhanced CVC transactions; 
  • payment processing services (including as performed by internet casinos); 
  • CVC trading platforms; and
  • initial coin offerings (ICOs).

The guidance also covers the status of CVC creators, mining pools, and cloud miners, as well as the subsequent anti-money laundering, record keeping, monitoring, and reporting requirements that may arise. 

Step 2 - advisory alert on identifying and reporting suspicious activities

Second, FinCEN issued an advisory alert to assist financial institutions in identifying and reporting suspicious activities concerning dealings in CVCs. 

As FinCEN points out, CVCs have a high potential for use in money laundering, sanctions evasion, and other illicit financing purposes. As such, FinCEN advises that dealers in CVCs be cognizant of numerous red flags when transacting with darknet marketplaces and unregistered or illicitly operating P2P exchangers, foreign-located money service businesses, and CVC kiosks, as well as other potentially illicit CVC-related activity, such as:

  • transactions initiated from non-trusted IP addresses;
  • declined requests for “know your customer” documents; or
  • numerous rapid transactions and multiple conversions between various types of CVCs (which indicates an attempt to break the chain of custody on the respective blockchains).
2. New York AG alleges crypto-fraud

Court order against Bitfinex and Tether

On April 24, 2019, the New York Attorney General obtained a court order preventing iFinex Inc., which operates the Bitfinex virtual asset trading platform, and Tether Limited, which issues the “tether” virtual currency, from further violating New York law. These entities, which are owned and operated by the same small group of managers and employees, were also ordered to turn over a trove of corporate documents to assist the AG in further investigating an alleged fraud to cover up $850 million of lost co-mingled client and corporate funds.

This case has a number of interesting lessons for the market which we will continue to monitor for further developments:

Details of the fraud

According to the AG, the alleged fraud entailed an attempt by Bitfinex/Tether to cover up an inability to retrieve funds from a Panamanian financial institution named Crypto Capital to which Bitfinex/Tether had entrusted over one billion dollars without a written contract or agreement.

Without ready access to liquid capital and facing client requests for money, Bitfinex was allegedly forced to dip into approximately $700 million in cash reserves held by Tether meant to back its virtual currency, without telling investors.

Response of Bitfinex

Bitfinex, however, responded that the transaction with Tether represented an “arms-length” and “commercially reasonable” revolving line of credit agreement. Claiming that the AG “has no authority to dictate how Bitfinex and Tether do business,” Bitfinex also contested the claims that the funds in question were “lost,” that Bitfinex had not been cooperating with the AG during the course of the investigation, and that Tether had not been forthright about the assets other than fiat currency backing its stablecoin. “Stablecoin” refers to a cryptocurrency pegged to an asset with a stable value, such as gold or traditional fiat currencies (see Bilal Memon, Guide to Stablecoin: Types of Stablecoins & Its Importance, MASTER THE CRYPTO (2019)).

Issue of lack of access to global banking system

The Bitfinex/Tether situation brings focus to an issue plaguing the crypto-exhange markets since the 2017 bull market run in cryptocurrencies — lack of access to the global banking system. 

When Wells Fargo abruptly stopped offering correspondent banking services to Bitfinex and Tether in March 2017, presumably in response to increased regulatory scrutiny of accounts relating to cryptocurrency businesses, Bitfinex faced the choice of either ceasing operations or going with a less regulated provider of custody and payment processing services. Opting for the latter, Bitfinex turned to Crypto Capital and opened additional accounts during 2017 and 2018, entrusting the payment processor with an increasing amount of its customers’ funds. 

Consequently, when regulators in Poland and Portugal seized some of Crypto Capital's money (or alternatively when these funds went missing), Bitfinex and Tether found themselves unable to access their accounts and funds, which lead to the present situation, which the AG has alleged as crypto-fraud. 

3. SEC and CFTC warn of investment fraud utilizing digital assets

Similarly, on April 24, the SEC and CFTC jointly published an Investor Alert warning investors to watch out for fraudulent digital assets and trading websites. Both regulators have recently observed investment scams purporting to take advantage of opportunities in digital assets to defraud investors.

For example, the Alert provided a recent example of the indictment of two Nigerian citizens by the U.S. Attorney’s office for the District of Oregon, in which the suspects solicited investments in bitcoins through websites by promising 20-50 percent return on investment for “zero risk” with instant withdraws.

To avoid such fraudulent schemes, the SEC and CFTC are warning investors to be on the lookout for the following red flags:

  • high rates of return for “zero risk,” “risk free,” “absolutely safe,” or “guaranteed profit” investments;
  • complicated jargon meant to confuse investors or mask underlying fraud, including claims that technology is “highly secret”;
  • unlicensed sellers;
  • investments that “sound too good to be true”;
  • unsolicited offers; and
  • undue pressure, for example, to buy “right now”.
4. FINRA establishes new Office of Financial Innovation

Finally, the Financial Industry Regulatory Authority (FINRA), the self-regulatory organization for the U.S.-registered securities broker-dealers, announced the establishment a new office for Financial Innovation.

The new office will serve as a central point of coordination for Fintech innovation and will incorporate FINRA’s existing Office of Emerging Regulatory Issues. FINRA sees the new office as an opportunity to identify, understand, and foster significant Fintech innovation. 

While that lofty mission is laudable, we suspect that the office will undoubtedly be tasked with, among other near-term concrete tasks, the review of digital asset usage by FINRA member firms.