Member Article

When it comes to digital coins or tokens, it’s best to approach with caution, ask plenty of questions and conduct extensive research before making an investment, warns the Commodity Futures Trading Commission (the “CFTC”).

Given the novelty of the market combined with the relatively short operating history of the businesses offering digital coins and tokens, the CFTC is warning customers that there is no widely accepted standard for valuing digital coins or tokens, which may put customers and any money invested at risk.

Additionally, the CFTC highlights the Securities and Exchange Commission’s (the “SEC”) recent position that, depending on the circumstances, digital coins and tokens may be considered securities that are subject to the federal securities laws. In particular, where buyers are promised a return on their investment, a share of future returns related to specific projects or are relying on a profit due to increased popularity and value, the SEC may determine that the digital coin or token is a security under U.S. securities laws. Accordingly, when coins or tokens are determined to be securities, the coins or tokens may not be lawfully sold to the public unless they are registered with the SEC or are issued pursuant to an exemption from registration.

The classification of digital coins and tokens highlights interesting developments regarding regulatory agencies’ oversight and enforcement abilities. Specifically, while the CFTC agrees with the SEC’s position that some coins and tokens may be considered securities, the CFTC maintains that some digital coins and tokens can also be derivatives or commodities, depending on how they are structured.

As recently as July 12, the U.S. District Court for the Eastern District of New York held that cryptocurrency fraud, when the cryptocurrency is considered a commodity, is subject to the CFTC’s anti-fraud and anti-manipulation enforcement authority (See Commodity Futures Trading Comm’n v. McDonnell, 287 F. Supp. 3d 213 (E.D.N.Y. 2018), adhered to on denial of reconsideration, --- F. Supp. 3d ---, No. 18-CV-361, 2018 WL 3435047, 2018 U.S. Dist. LEXIS 117939 (E.D.N.Y. July 16, 2018)).

In any event, the risk investors face in this context is rooted in classification uncertainty. Indeed, the legal classification of any given digital coin or token is invariably subject to fact-intensive standards. The various regulatory agencies’ misaligned regulatory interests regarding classification, moreover, amplify investors’ risk by adding uncertainty regarding the appropriate agency for enforcement actions. Such uncertainty has been augmented as recently as July 27, 2018 when the Financial Industry Regulatory Authority (“FINRA”) also alerted investors of its regulatory role and reaffirmed the CFTC and SEC concerns regarding investor risk associated with initial coin offerings (“ICOs”).

Since the cryptocurrency boom in 2017, the CFTC, SEC, and FINRA have each noted that while ICOs may provide honest and new investment opportunities, fraud is becoming increasingly prevalent.

Accordingly, prior to purchasing coins or token in an ICO, the CFTC, SEC, and FINRA are urging investors to conduct extensive due diligence on any individuals and entities listed as affiliates of an ICO, review the white paper or development plan for the coin or token, understand the rights as a holder of the coin or token and to ask questions about the coins or tokens and whether they are securities and if the offering is being registered with the SEC. Additionally, the CFTC notes that it is important to weigh factors that could impact the long-term value of the coin or token, including:

• The potential for forks in open-source applications that could split away market participants, increase the number of digital coins, or make your coins obsolete.
• Decreasing mining or validation costs (if the price is tied to those factors).
• Acceptance of other currencies, coins, or tokens for offered goods and services.
• The link between the value of a digital coin or token and the offered product or service.
• Adoption of the digital coin or token as a broad medium of exchange or store of value.
• Future competitors or technological changes that could disrupt the underlying business.
• Future demand or uses for an application, network, product, or service.
• Liquidity in the market for a specific digital coin or token.
• Changes to the underlying technology that could devalue your digital coins or tokens.
• Risk of theft from hacking.

For more information regarding investor considerations in the context of an ICO, please see the following CFTC and SEC resources:

 

CFTC - Use Caution When Buying Digital Coins or Tokens

SEC - Investor Bulletin: Initial Coin Offering

SEC - Initial Coin Offerings (ICOs)

 

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