The Blockchain Report: Cryptocurrency & United States Regulations

(This transcript about cryptocurrency and US regulations has been edited for search engine optimization and clarity to the reader.)

Scott: We wanted to take this opportunity to create a community for investors, issuers, people on the regulatory legal side pretty much from all different angles, who are looking at the crypto-currency space, see that it is a trend that is spread like wildfire throughout the world over the past few years, especially. And try to bring a little deeper understanding of some of the issues and trends that would, that have been coming out in the past six months to a year. Specifically, today we wanted to address kind of the general regulatory environment in the United States. What’s going on with ICO’s? There’s been quite a bit of news. So we just wanted to take this chance to discuss that. I mean, there have been multiple regulatory comments provided by a number of agencies in the United States regarding ICO’s, regarding cryptocurrency, regarding who governs them, what are they, how does one classify them if they are indeed our security or a currency I think the two most interesting pieces of news were from a few weeks back when you had the SEC come out with very clear guidance where they basically said, look: the vast majority of tokens that were issued are in — are actually securities and therefore don’t need to be registered as such, if the, if the issuer and investors are located in, in the United States. And so that’s a big, a big deal and a big piece of news because it was also followed by what was reported to be over a hundred subpoenas that were sent out by the SEC to issuers and attorneys who were involved in what’s called the “offering” of ICO’s. I think in most cases it was an issue where ICO’s were issued as utility tokens, meaning that they were not classified by the issuer as the security and therefore were done in what’s called an unregistered manner.

So the SEC basically came out and said, “Hey, actually the vast majority of these tokens or that were issued as ICO’s are, are actually, ICO should be classified as securities and issuers who are planning on doing it in the United States or selling to us investors need to register them as such.” And that’s a big piece of news that came out. The SEC regards something, an investment or a consideration paid in money for an instrument, whether it be a token or whatever it might be. If the expectation of the individual investing is to get a return, then it’s a security. In other words, if the reason why you’re investing in something in a 10 cent token is because you think it’s gonna go to 50, aftersome milestones are met or what have you based on say, the guidance provided in an ICO white paper — you believe that the value of the token will go up.

Then you have the Howey test, which is a way you can assess whether an instrument is indeed a security. And so the SEC — it’s important because the SEC has come out and saying, well actually, the vast majority of these tokens and ICO’s are securities and now there are legal proceedings against many issuers in the United States and elsewhere who we’re selling to US investors. So it’s creating a bit of a cloud around the whole ICO market. And I think that has a lot to do with a lot of the volatility we’ve seen around cryptocurrencies as well.

Ian: 03:31 Some token issuers or coin issuers have told people already that theirs are strictly a utility token. Can the SEC just say, “No, I don’t care what you say or how you classify your coin. I’m telling you as the SEC that you are a token.” Can they do that?

Scott: 03:51 They can take you to court and you can spend years in court fighting with the Securities and Exchange Commission over whether or not your instrument is your token, for example, in this case is classified as a security or not. You may or may not win, but the legal costs and reputational costs and other costs are so vast that usually for a startup or an ICO, which is generally just a start-up company to have to allocate a disproportionately large amount of your initial proceeds to legal fees to defend your issuing or, issuance category, or however you want to define it, would be, that’s a very high cost to pay, I guess I could put it that way.

Ian: 04:32 And very expensive to investors because you think that you’re going to get your money earlier and then it could get caught up in funding the defense costs, the legal defense costs in response to the SEC, cases where they’re, claiming that, in fact, is a token as a security.

Scott: 04:51 So I guess the key takeaway is what does that really mean? Like why should we care about that? Because the typical person might look at it and say, well why does that matter to me? Well, to your point, it matters because if you invest in ICO that claims it’s a utility, or issuing utility token, and then the SEC subpoenas them and begins to, initiate legal proceedings against them and instead of the, let’s assume, let’s say an ICO raises $10,000,000. If they need to spend $3,000,000 on legal fees over a five year period, it kind of has, could have an impact on the company’s ability to execute its, its plans as defined in the, in the white paper. In other words, if they have large technology development costs and suddenly their legal fees are going through the roof… that’s an issue.

Scott: 05:36 Also. If they lose then I think there were a couple of instances where issuers were forced to return capital to investors because they had engaged in an unregistered offer. If I’m a cryptocurrency investor, how can I know whether I’ll be affected by any of this and how soon? I think in the case of enforcement actions by the Securities and commission, the general rule of thumb is that your investment could be at risk in the sense that if the company is hit with very large legal costs and they’re new and they’re startup, obviously that’s damaging to the development of the company right out of the gate. So from that perspective, it’s more of a financial risk in terms of the legal risk to the individual investor. Obviously, every situation varies and I am speaking broadly. The risk to individual investors in scenarios where the Securities and Exchange Commission is going after the issuer is zero to very limited. The risk to investors who would be more related to guidance provided by a group or department called FinCEN. They basically came out with guidance, I believe last week where they were essentially saying that if a token — if a cryptocurrency is traded and the AML and KYC, which is anti-money laundering and know your client checks are not executed. Then, they’re basically saying that arguing that in principle, the issuer or even an individual who’s trading a cryptocurrency would be classified as what they call a “money transmitter”. And that would mean that they would need to comply with KYC and AML requirements for each transaction. And this is very serious because it’s actually a criminal matter. It’s not a civil matter in that case. So basically what I’m saying is, is that if you’re a crypto currency investor sitting in the United States and you’re looking at buying a token that has zero regulatory classification under us securities or other law,– meaning that it’s registered as an equity or a bond or commodity or currency, those would be kind of the four options that we would look at — then FinCEN and the Treasury Department would say, “Well, OK, if that’s the case, then you’re just transmitting money value between person A and person B. And if you don’t identify all the parties involved in each of those transactions, then you’re violating anti money laundering rules that have been established by the United States for many, many years now. And that’s a very serious matter.

Ian: 08:11 Part of the promise to crypto-currency investors has been that they can engage in a practice of anonymous transmission and earning of money. This is a direct collision with the entire function and culture of cryptocurrency in many ways. Does that sound right?

Scott: 08:33 It is, it absolutely is. I mean, that was the anonymity of the whole concept of a distributed ledger technology and the cryptocurrencies associated with them, with blockchain applications are absolute runs contrary to a, sovereign states monitoring the flow of Fiat currency between countries and individuals, whether it be inside or outside the country. And essentially what crypto-currency, the concept of cryptocurrency as it has evolved, has been precisely that — not necessarily for nefarious reasons, but just for the purposes of more of a libertarian concept that that to have absolute global freedom with the global currency that you can use transfer value hopefully at a lower cost than traditional methods, transmitting Fiat currency. But absolutely, this is a point I think in the evolution of blockchain and cryptocurrency investing where you’re seeing a lot of volatility and risks associated with, with this regulatory crackdown that’s been happening not only in the United States but also in other OECD [Organization of Economic Cooperation and Development] countries.

Scott: 09:42 The outcome of which I wouldn’t say is unknown. And I think the critical point here is that the regulatory pressure coming down on cryptocurrency investment, whether it’d be on the issuer or the individual would have you, has nothing to do with the validity of the underlying blockchain technology, which is really what this revolution is about. The development of and use of distributed ledger technology to change the way we transact, to change the way we do things. That that’s the issue I think that investors need to understand. So you can gain exposure to cryptocurrency, which is basically blockchain because as we all know when we think about blockchain, the use case, it’s use cases and applications. Basically, you have blockchain technology, which is the core concept that’s truly revolutionary. Blockchain needs the cryptocurrency in order for the for the use-cases to work.

Scott: 10:34 And that’s what we’re talking about here. So the question is, is does the regulation of those cryptocurrencies, is that going to kill the blockchain story? Is it going to kill investment in cryptocurrency? I would argue, absolutely not. Is it going to change the way people invest in their, depending on which market they’re located in? Absolutely, yes. In our opinion, we think things are changing very quickly and that in a year you’re going to see a very different landscape, particularly for us investors in the cryptocurrency space.

Ian: 11:01 So Scott, it seems to me that crypto-currency investors are now being confronted with what to them is culturally a bit of a paradox. On the one hand, they’re used to thinking that they’re going to be getting involved in some kind of new distributed ledger technology that is sort of just a deal between them and the issuer and the United States government really hasn’t played into it too much, but at this point issuers are going to have to be registered with the government and doing formal using formal mechanisms in order to raise money for their de-centralized in anonymous and so on, application. So how can someone as a previous stage cryptocurrency investor reconcile this cultural shift? How should they deal with it?

Scott: 11:52 The reality is is that the previously unregulated cryptocurrency market and world of ICO investing, at least for the — in the case of us investors and US issuers, is now being regulated and it’s not just getting regulatory guidance from one agency, but from about five or six across the federal government in every, bucket, if you will. So I think the way you reconcile it is, the underlying blockchain technology concept and its relevance is not undermined by the fact that federal governments are beginning to regulate ICO’s. I think you have to kind of separate those two things. So the technologies make sense. It’s truly revolutionary. And there are many, many exciting use cases that are going to reduce costs and disintermediate traditional business models and disrupt them so that’s on one side of it.

Scott: 12:43 The investment thesis for many of these use cases many of these ICO’s are absolutely valid and are not impacted by new issuers in particular. I won’t speak to issuers that have already issued ICO’s and may be subject to enforcement action, but let’s just say going forward, looking at new opportunities, the way investors can reconcile this is to basically acknowledged that we probably will see a trend towards regulated offers where you have securities offered as an ICO. So it looks like a traditional investment, but the underlying technology and goal is to develop, blockchain use cases, et cetera. depending on what, whatever the, the application is a, but the initial stage will be registration of a lot of these ICO’s using traditional securities because there currently is no new guidance and there is no new regulatory structure that’s been laid out like for example, by the sec, for the issuance of cryptocurrency ICO’s.

Scott: 13:44 My understanding is that there probably will be in a few years, but I think what’s going to happen is these early-stage companies that are coming out and that want to issue in the United States and where us investors see the opportunity, they’re saying, “OK, well we’re going to be issuing as either a preferred equity share or have some type of hybrid fixed income instrument.” I mean there are a bunch of ways you can slice it, but the bottom line is you’re going to see regulated issues as the norm I think over the next, in the coming months.

Ian: 14:10 So what should a cryptocurrency investors look for in new offers?

Scott: 14:14 In the case of a US investor looking to invest in an ICO, obviously there are opportunities that are out of the United States, and I can’t really speak to that in this, in this conversation, but let’s assume that we’re talking about us investors looking at issuers ICO’s that are where the teams are actually based in the United States.

Scott: 14:34 And there are many of them obviously. I think that the focus really should be on making sure the investors should really make sure that they understand what is being issued. In other words, is it a utility token that is not in any way registered or conforming with any of the guidance that’s been provided by the Securities and Exchange Commission by CFTC, by FinCEN, over the treasury or have they, as we like to say, has the issue or chosen a lane. In other words, when you look at these CIO’s I’m, the instrument you’re buying is either a utility token, which the SEC guidance for the that was provided would argue is a kind of weak argument in most cases. But it could be utility token, in which case it wouldn’t need to be registered, right? And that would be probably the minority of ICO’s. Then it, then after that, if it, if it is indeed some regulated instrument, it’s either going to be a stock, a bond, a commodity or currency, and so investors should really try to understand if it is defined as such, then is complying with the current regulatory guidance associated with issuing or trading in any of those instruments.

Scott: 15:45 And I think that’s, that’s an important way to look at it on. The other thing that is important is a matter of governance and legal rights that are defined to an investor in and offering documents. So for example, if you invest in ICO, that’s simply a typical model that’s been followed thus far globally there’s really no legal structure or domicile of the issuer. You know where the team is or some of them, but generally speaking, it’s been unclear. It’s bit of a hazy area. And what rights do you have as a token holder as well that that’s another issue too, to think about?

Ian: 16:24 Scott for some people, cryptocurrencies were their first investment, the first thing that they bought for themselves, thinking that they’d make some more money, but now it looks like the environment is changing to where they’re going to have to start getting back to basics and thinking about the underlying business and the team. And was the business profitable before blockchain? Tell me more about how the overall landscape is shaping up for investors and how are they going to have to change their game a little bit?

Scott: 16:51 I kind of categorize blockchain Crypto use cases into sort of two broad categories. I guess one is about what would fall into the category of blockchain infrastructure, like technologies that are globally scalable, that help develops any particular use case in particular enterprise vertical. So you have kind of like the broad blockchain, tech application, like IoT connectivity or connecting one blockchain to another blockchain, if they have similar uses and there might be, interconnectivity things related to security, things related to the efficiency of transactions or latency, speed, things of that nature. So that’s kinda one broad bucket. And then obviously the second bucket is a bunch of enterprise verticals where you have, like, an industry-specific use case, where it may or may not be scalable, which is obviously a major issue. But I would say the regulatory news flow that we’ve seen has not really impacted the thought process and how people look at those investments.

Scott: 17:58 Because the idea is that if a cryptocurrency is kind of required for, let’s say for example, there’s related to electricity for example. You might want to look into how scalable that use case is. So let’s assume that you have a token that’s issued for a particular — in the case I’m using the electricity sector, right? And there are a number of them out there. When we look at that and we talk about scalability, we need to make sure that the token would be used by many people in many places so that the argument that it could become a store of value in a medium of exchange as an actual cryptocurrency and actually have some value and use is kind of realistic if the use case is extremely esoteric or limited in terms it’s the ability of the team to get it adapted globally quickly, without regulatory hurdles, things of that nature.

Scott: 18:56 Even if it’s in a very narrow enterprise vertical. If the use case is globally scalable and kind of unhindered in terms of the way it would be rolled out for the blockchain technology, whatever it might be, then you could make the argument that it’s scalable. If it’s burdened by regulatory, state level, government level restrictions and approval processes that would slow down the ability to actually create an ecosystem that goes beyond, say a particular country, for example, than the global scalability would be limited and that’s kind of antithetical to the sort of concept of a global cryptocurrency.

Ian: 19:35 How much time should a cryptocurrency have to scale? I mean, do they, can they tell people up front or do, do people have to wait and see?

Scott: 19:43 Whether or not a, a use case, a platform, and objective is achievable and whether the milestones laid out are achievable and I guess is partly related to whether they’re using existing leveraging off existing technology and platforms like, for example, that’s why I think we see a tremendous amount of development application potential based on an ethereum because that’s, that it allows people to develop teams to develop concepts without having to focus entirely on a new protocol, a new way of designing these platforms.

Scott: 20:16 So from that perspective, and that’s a little bit lower risk. It depends on the sector. ICOI think that there are a couple of checks, any investor looking at market expectations, market share expectations which might be relevant for, for a particular use case needs to really make sure they understand that, that the claims made in the white paper or in whatever offering documents are provided on our — are roughly in line with factual information. In other words, is the size of the market that the team is claiming exists, is accurate, more or less is, are their market share assumptions accurate in terms of how they’re going to grow. If you publish a white paper and you do not register the token as a security in any market or any jurisdiction, let’s just assume it’s in the United States, there is no consequence for a misrepresentation or poor evidence or inaccurate information, things of that nature or unrealistic expectations or targets. Whereas when you are regulated or you’re following the guidance and you’re doing, whether it’s a Title III for Reg A+ or a Reg D offering, whatever it might be, you’re required to the best of your knowledge provide accurate information in an offering document that clearly defines what is your strategy, what are the risks associated with your business, what are the options, what does — not that you need to be so specific as to clarify the statistical probability of success, which of course no one knows, right? But you, you certainly are required to, to, to provide accurate information to investors so that they can make a reasonable decision based on facts not on your interpretation of facts. I guess that’s the way I would put it.

Ian: 22:07 In a more regulated environment, can investors have perhaps a better information to rely on as they make their investment decisions?

Scott: 22:14 Absolutely. Because the issuer is required to, according to the regulations, provide accurate information and and that’s why to like for example, in when an investor looks at, at, whether it’s crowdfunding or a token offering, but let’s assume it’s a registered, offering, ICO there are things called bad actor checks, that make sure that the people that are issuing the securities are not criminals or are individuals in relatively good standing. Whereas, to be very, very explicit and clear here, let’s just walk through an ICO that’s unregulated and let’s just pick something that’s like kind of funky just to give investors an idea of like what they’re looking at here. Let’s assume that you invest in an ICO that’s located in, let’s just call it an unnamed country in eastern Europe, and let’s assume that their bank accounts are in Cyprus and they don’t really provide much information as to who’s really in charge of what. the technology and the concept of the distributed ledger is that you can create an ecosystem and an architecture of a trustless in which is verified, on a public blockchain application for example.

Ian: 23:29 But there’s always a team that’s indicated in these things. There’s usually, upwards of a dozen or more people involved and, here’s our team and, eighty percent of them are it people and then the other two, the other is just like a marketing person. And then there’s like some kind of successful business person. How is it that the team that is indicated in these white papers and offerings and things like that are not the owners? Is that what I’m hearing?

Scott: 23:57 Yeah. Well, let’s put it this way. We don’t know. In other words, when you invest in a, in ICO, obviously if it’s an early stage venture capital investment, clearly the team members and individuals who are in control will be known by those investors who would perform due diligence. Obviously in the case of an ICO where there’s a large retail base of global investors with a very small fractional interest in the company or in the technology or in the ICO itself, the cryptocurrency. We don’t know who’s in control of the funds that are raised. We don’t know where those funds are banked. We don’t know how they’re allocated. There is no governance, there is no recourse. There are no rights that are defined to the holder of the cryptocurrency. So let’s assume that the vast majority of ICO’s are performed by individuals who are acting in good faith. Well, OK, then that’s not an issue, but how, how is one to know if you can’t identify domicile… location…?

Ian: 25:00 So sometimes the team is not the entirety of the people that are offering this ICO. And sometimes there are business people who are just not disclosed in a white paper or in an…

Scott: 25:14 Absolutely. Yeah. And, and that’s a concern you in most cases, it shouldn’t really matter in most cases. Issuers who are doing ICO’s are acting in good faith. They’ve got very good teams. They’re technically savvy. They’re people that are known in the space so in most cases it’s not an issue. However, in some instances, it may be an issue and I think that’s where a lot of the regulatory concern is coming from.

Ian: 25:37 OK. Scott, thanks very much for joining us on this episode of the blockchain report. And everybody out there, please listen, subscribe, share, let people know that we’re trying to make them very useful contribution to the field. And thank you very much for your time and we’ll see you on the next Blockchain report. Thanks very much.