Developing a Regulatory Framework that Recognizes the Unique Attributes of the Newest Payment Platforms

By: John Maguire

Digital currencies are relatively new products. Recently, there has been growing movement to establish a comprehensive federal regime that allows the market for digital currencies to continue to develop. To date, digital currencies have been regulated under older statutes that do not fully align with the realities of digital currencies. The proposed DCEA makes important strides in clarifying jurisdiction, but more could be done to prevent fraud.

Digital tokens, or cryptocurrency, are a relatively new entrant to financial markets. The first token, Bitcoin, was introduced in Satoshi Nakamoto’s 2007 whitepaper. Digital currencies are based on a decentralized network of computers, nodes that each keep a record of the “blockchain”. Each node contains a record of all of the transactions that have occurred on the blockchain. This creates a transparent, publicly available ledger where everyone is able to independently validate a transaction. A decentralized, public ledger removes the need for one centralized, trusted third-party to validate every transaction.

Bitcoin is the most well-known digital currency has seen its market capitalization grow from $6.5 billion dollars at the start of 2016, to $250B at the end of October 2020, an increase of 3,600% in five years. Accompanying that dramatic rise in value has been an interest in developing a regulatory regime appropriate for these new products.

Currently, the regulation of digital tokens at the federal level is shared between the Commodity Futures Trading Commission (CFTC) and the Securities Exchange Commission (SEC). The CFTF has determined that cryptocurrency is a commodity under the Commodity Exchange Act (CEA). Accordingly, the CFTC has jurisdiction when a cryptocurrency is used in a derivatives contract or when fraud is identified when trading virtual currencies in interstate commerce. Cryptocurrencies are also regulated by the existing financial regulations of the 50 states.

The SEC has jurisdiction when the sale of a virtual currency is considered a security. Currently, that determination depends on whether the sale is considered an “investment contract” under the Howley test. In 2017, the SEC first made the determination that digital tokens issued by a Decentralized Autonomous Organization (“DAO”) in an Initial Coin Offering (ICO) are considered an “investment contract” and subject to SEC regulation. An ICO is a method for raising money by issuing a new type of cryptocurrency. When a company wants to raise money, it can sell a cryptocurrency token to investors.

Increased ICO interest has led industry and legislators to propose alternatives to classifying ICO’s as “investment contracts” subject to SEC regulation. The Digital Commodity Exchange Act (“DCEA”) is one such proposal which envisions new procedures for bringing digital tokens to market.

The DCEA would establish the definition of “digital commodities” as  “any form of fungible intangible personal property that can be exclusively possessed and transferred person to person without necessary reliance on an intermediary, and which does not represent a financial interest in a company, partnership, or investment vehicle.” By distinguishing “digital commodities” from other commodities the DCEA recognizes the unique attributes of digital currencies and establishes a regulatory regime to accommodate them.  

Under the Act, entities that were “raising money to fund a digital commodity project” would be subject to existing securities laws. However, the DCEA would create a new regulatory regime for offerings of a promise or delivery of “digital commodities” called “digital commodity presale.” Transactions which met the definition of “digital commodity presales” would be regulated by the CFTC.

The DCEA’s rules are designed to provide similar protections as existing rules for IPO’s but accommodate the unique aspects of digital commodities. By limiting the resale of digital tokens after an ICO, the act would prevent insiders from dumping tokens. One limitation would be requiring any resale to be executed on a digital commodity exchange (“DCE”), defined as “a trading facility that lists for trading at least one digital commodity.”

Under the DCEA, DCE’s could opt-in to the CFTC’s federal regulation, which would enable similar oversight to what Designated Contract Markets (“DCMs”) allow for futures and options contracts and what Swap Execution Facilities (“SEFs”) allow for swaps. The requirements of DCEs would be similar to the compliance requirements of DCMs and SEFs and would include the following requirements: monitoring and reporting trading activity, establish capital minimums, and cybersecurity.

The DCEA would bring the regulation of DCEs under the exclusive jurisdiction of the CFTC. Providing one, centralized governing body to replace the current “labyrinth of 53 state and territory regulatory frameworks.” Platforms have been advocating for a change like this as interest owning and trading digital tokens have been expanded.

Recent SEC action accelerated the interest in a national standard for digital token regulation. The SEC brought an enforcement action against a digital token exchange for operating as an unregistered national securities exchange. This action by the SEC highlights the consequences of operating an exchange that does not align with the traditional paradigms of exchange platforms. At the same time, an increase in fraud means regulators will be asked to take a more active role in overseeing the digital token industry. The SEC is using its existing tools to step in and regulate a new market, and industries response is to lobby Congress for a regime that recognizes the unique characteristics of digital tokens.

The DCEA would establish a framework for determining whether a digital token is “not readily susceptible to manipulation.” Under this framework, regulators would look at the digital tokens “purpose, functionality, governance structure, distribution, and participation.” These considerations acknowledge the unique attributes of digital tokens, which share some characteristics with shares, swaps, and options, but also operate in distinct ways. For example, a digital tokens value could be linked to a physical commodity, but the token could be issued in order to raise money for a business. These are important distinctions and providing regulatory clarity should enable continued development of digital assets. In sum, this is a familiar development of a federal regulatory regime, moving from existing tools to a new framework. However, the unique nature of digital tokens means that oversight will need to continue to develop as the market matures and new use cases are developed.

One irony is the original idea of a digital token built on a blockchain was to minimize the need for “trusted third parties.” While the blockchain itself is secure, the opportunity for fraud related to digital tokens persists. Regulators have used their existing tools to try and prevent fraud in ICO’s, but Congress is proposing new regulations designed for digital tokens. As the SEC stated in their 2017 report, “The automation of certain functions through this technology, “smart contracts,” or computer code, does not remove conduct from the purview of the U.S. federal securities laws.” These “digital commodity exchanges” would occupy the same role as traditional exchanges but the market they provide access to is unique.

The DCEA’s effort to limit fraudulent ICO’s is a good starting point. The framework it establishes will provide clarity for the existing exchanges as the market matures. However, it will not prevent fraud in ICO’s for tokens that are never listed on exchanges, which present the greatest opportunity for fraud. Other actions should be considered that will do more to identify and prevent fraud in unregistered digital token offerings. One option would be to require the initial sales to occur via an Initial Exchange Offer (“IEO”) on a DCE, which would heighten scrutiny for any non-DCE advertised sales. These sales would introduce DCE’s at the earliest stage of the process, and could verify any new tokens before a public sale occurs. Expanding the DCEA to not only provide certainty for DCE’s, but also encouraging IEO’s provides a more comprehensive regime for digital tokens.

Instances of fraud demonstrate a need for regulation, and the DCEA shows that there is interest in developing a bespoke regime to accommodate this new technology. Whether or not DCEA gains traction, if interest in digital tokens continues to grow, so will the opportunity for fraud, and regulators will use whatever tools are at their disposal to address it.