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SEC and CFTC Give Testimonies at Senate Hearing on Virtual Currencies

Today, February 6, 2018, the prospects for coherent U.S. regulation on cryptocurrencies became a little more clear, as were the impasses that were frustrating progress on the issue. The Senate Committee on Banking, Housing and Urban Affairs (the “Committee”) heard joint testimony from the heads of both the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). While both the SEC Chairman Jay Clayton and CFTC Chairman J. Christopher Giancarlo provided eBits testimonies on February 5, 2018, the statements from the chairmen as well as the answers later garnered from Senate questioning gave some clarity as to the direction U.S. regulation of “virtual currencies” is headed. Below is a general overview.

Jay Clayton Loves Blockchains, Lukewarm on Cryptos, Not a Fan of ICOs

In his opening testimony, the SEC chairman called the topic of regulating cryptocurrencies, ICOs and related trading activities important, stating that “these markets are local, national and international.” From a market regulatory perspective, he stated, “For ease of analysis, I break this space into three categories. First, a promising new technology referred to as ‘distributed ledger technology’ or ‘blockchain’ … The second and third categories are cryptocurrencies and ICOs.”

While the chairman lauded and even asked for blockchain technology startups to alleviate inefficiencies in market regulatory frameworks, he was less enthusiastic about both cryptocurrencies and ICOs, stating that they are “subsets of the products seeking to take advantage of the commercial opportunities presented by blockchain.” Cryptocurrencies, according to Clayton, are “promoted to be a replacement for dollars,” while ICOs in his view are “like a stock offering.”

Clayton went on to state that while “those who promote these so-called virtual currencies assert that they will make it easier and cheaper to buy and sell goods, particularly across borders” and “that transaction fees and costs will be eliminated or reduced … to date these assertions have proved elusive in many areas.”

While some could argue that the chairman’s opening commentary on cryptocurrencies was less than favorable, that impression was far overshadowed by his stance on ICOs. Per Clayton, “From what I have seen, initial coin offerings are securities offerings. They are interesting companies, much like stocks and bonds, under a new label.” He didn’t stop there, however, stating, “You can call it a coin, but if it functions as a security, it is a security.” Another cause of concern for Clayton on the ICO front:

An ICO may have nothing to do with distributed ledger technology beyond the coin itself.

The two problems “worth particular attention,” however, were the lack of regulatory oversight on the markets and that “many” ICOs are being conducted illegally by not following securities laws. Clayton wrapped up his opening volley at ICOs by warning the ICO market that “those who engage in semantic gymnastics or elaborate structuring exercises in an effort to avoid having a coin be a security are squarely within the crosshairs of our enforcement division.”

So much for ease of analysis.

Chairman Giancarlo’s Opening Remarks Add More Hopeful Balance

The CFTC chairman began his opening remarks by revealing a story about how his own children’s interest in investing bloomed only last year with the rise of Bitcoin. Giancarlo remarked, “It strikes me that we owe it to this generation to respect their enthusiasm about virtual currencies with a thoughtful and balanced response, not a dismissive one.” He did urge, however, that regulators “must crack down hard on those who try to abuse [the younger generations’] enthusiasm with fraud and manipulation.”

Chairman Giancarlo’s remarks went on to elucidate the CFTC’s wish for regulators to thoroughly educate themselves and the public in order to create good policy choices and sound regulatory frameworks to protect consumers.

Giancarlo followed up his prudent remarks by saying, “I suggest the right regulatory response to virtual currencies has at least several elements.” Specifying further, he stated that we must first “learn everything we can.” He then suggested that perspective with regard to the market cap of virtual currencies is key, stating that the “total value of all virtual currency in the world is around $313 billion. In comparison, global money supply is around $7.6 trillion, while the value of all the gold in the world is around $8 trillion.”

The next task, according to Giancarlo, is to educate consumers. According to him:

We’ve never conducted this much outreach for any other financial product.

Another element, according to the chair, is regulatory coordination because “no one agency has direct authority over virtual currencies.” He was careful to point out the need for finding a balance between exercising legal authority over virtual currency derivatives while clarifying the CFTC’s statutory limitations. Those limitations, as Giancarlo made abundantly clear, include the CFTC’s lack of authority over regulating the spot markets for cryptocurrencies. He did, however, say that the CFTC has enforcement authority in the spot markets through their authority over the cryptocurrency derivatives markets.

Patchwork Regulation Isn’t Enough

Senator Mike Crapo, the head of the Senate Committee, asked both regulators, “Both of you said you don’t have complete jurisdiction, but do you have sufficient jurisdiction? Should Congress address by law the issue [of regulating virtual currencies]?”

SEC Chairman Clayton posited that all federal banking regulators should come together and have a coordinated plan for dealing with a virtual currency trading market, though he noted that they may at some point in the future find they need additional legislative authority. CFTC Chair Giancarlo concurred but directed the Committee to look at “gaps in the legislation” that could be presented. According to Giancarlo, there is patchwork coverage, but it is not enough to handle a regulatory framework that could be covered by a coordinated effort.

ICOs That Have Raised Funds from U.S. Investors Violated U.S. Securities Laws

The issue of ICOs and their legality was an oft-revisited point during the Q&A portion of the hearing. The minority leader on the Committee, Senator Sherrod Brown, asked Clayton how much of the $4 billion in capital raised last year through ICOs was raised in the United States. The SEC chair couldn’t give any clarity but suggested the number was probably enough that regulators should be talking about the issue. Senator Elizabeth Warren also had her say on the issue, stating, “Some ICOs raise money for legitimate companies, but others, we know, are just Ponzi schemes.”

Senator Warren then referenced Facebook’s recent ban of cryptocurrency and ICO ads and asked SEC Chairman Clayton a series of questions “around” how to make ICOs safer. The senator asked, “In 2017, companies raised more than $4 billion in ICOs. How many of those companies registered with the SEC?” Clayton told Senator Warren that “not one” had registered. Pressing further, the senator asked the chairman how many companies with upcoming ICOs had registered with the SEC, to which Clayton gave the same answer. Unfazed, Senator Warren asked Clayton for a comment on why no one registered an ICO with the SEC. The chairman’s response was a vague admonishment of the “gatekeepers [the SEC] rely on” to assist them in ensuring securities laws are followed, saying they “have not done their jobs.”

Elaborating further, he stated, “What ICOs do is take the disclosure-like benefits of a private placement and then add to it general solicitation and promise to the investor of a secondary market without registering to us.” Senator Warren finished off her line of questioning, saying to Clayton, “I am understanding you to say [that] it [what ICOs do by not registering] is a violation of the law?” The SEC chairman simply answered, “Correct.” But he did moderate his views on the illegality of ICOs by stating, “I’m perfectly happy for these people to do private placements, but do them right.”

Senatorial Enlightenment: Hacks, HODLs and “Kimchi Premiums”

While not all of the questions were focused directly on clarifying future U.S. regulatory frameworks on “virtual currencies,” the cryptocurrency industry was made aware of the effort regulators and lawmakers alike took to learn about the new asset class.

Throughout the hearing, several senators demonstrated an awareness of problems currently plaguing the industry. References to the Coincheck hack in Japan, Mt. Gox and exchange vulnerabilities, and North Korean and Russian state agents’ potential for abusing prices in the cryptocurrency market all came up.

Senator Robert Menendez cited Venezuela’s attempt to circumvent sanctions using Petrocoin, while Senator Jack Reed stressed the need for technologists and computer expert personnel among the regulators to help them understand the burgeoning asset class. Senator David Perdue began a line of questioning about combating pump-and-dump schemes, regulatory arbitrage and financial arbitrage that prompted the CFTC chair to explain what “kimchi premiums” were. Most surprisingly, however, was Chairman Giancarlo’s attempt to define “hodling” to the Committee in the middle of an answer to Senator Mike Rounds about the commodity-like aspects of cryptocurrencies.

Some senators did conflate which countries took recent regulatory actions on virtual currencies, but it is a confusing enough subject that it is eBits for eBits.Co this month. While not directly indicative of which regulatory measures the U.S. will take, industry participants can take some benefit from knowing legislators and top regulators are making an attempt to educate themselves and to thoughtfully institute measured regulatory frameworks in an effort to protect investors while not ruining the industry.

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Regulation

Japan Toughens Oversight, Penalizes Cryptocurrency Exchanges

In its most sweeping crackdown yet, a Japanese regulator has penalized seven cryptocurrency exchanges, requiring two to halt operations for one month.

Japan’s Financial Services Agency (FSA) announced today, March 8, 2018, that it came down on the exchanges due to their failure to provide proper internal-control systems. All of the exchanges were ordered to step up efforts to improve security and prevent money laundering.

Business suspension orders were issued for FSHO and Bit Station, effective today. The FSA said FSHO was not properly monitoring trades and employees at the exchange had not undergone proper training. The FSA also alleged that a senior employee at Bit Station had used customers’ bitcoin for personal use.

The five other exchanges punished were GMO Coin, Tech Bureau, Mister Exchange, Increments and Coincheck. Coincheck was served with its second business improvement order since its security breach earlier this year, when $530 million worth of NEM (XEM) tokens eBits.

Coincheck to Repay Victims

In a news conference today, Coincheck also announced that it will begin compensating users who had their cryptocurrency stolen, beginning as soon as next week. The exchange was hacked on January 26, 2018, after a hacker used malware to gain access to an employee’s computer.

All of the 260,000 users impacted by the theft will be paid back in Japanese yen, based on NEM rates at the time of the theft, the Tokyo-based company said.

At the root of the problem, the cryptocurrency exchange had been keeping all its NEM in a hot wallet connected to the internet. In contrast, at any one time, U.S.-based exchange Coinbase keeps 98 percent of its funds in a more secure cold wallet. The vice president of the NEM Foundation, Jeff McDonald, also eBits eBits.Co that if Coincheck had been using a multisignature wallet, the problem would not have occurred.  

It is still not clear who was behind the Coincheck hack.

Tough Measures

The Coincheck hack was one of the largest thefts of cryptocurrency in the world since Mt. Gox, another Tokyo exchange, was eBits by hackers in 2014. What happened at Coincheck highlighted the risks of storing funds in cryptocurrency exchanges, and since then, Japan’s FSA has taken strong measures to protect its citizens and ensure the security of cryptocurrency exchanges across the country.

Following the Coincheck breach, Japanese authorities eBits on January 29, 2018, that they would investigate all cryptocurrency exchanges in the country for security gaps, and ordered Coincheck to, essentially, get its act together.

The FSA gave Coincheck until February 13, 2018, to submit a report summarizing the actions it would take to improve security and customer support.

Last year, Japan became one of the first countries to regulate cryptocurrency exchanges when it set up a licensing system. Some 16 exchanges in the country are currently registered, while another 16, including Coincheck, have been allowed to continue operating unregistered while they apply for licences. Five of the seven exchanges punished by the FSA are unregistered, including the two forced to suspend business. Subsequent to its business suspension, Bit Station withdrew its application for a license.

Japan’s crackdown on exchanges follows a series of efforts by U.S. regulators to tighten reins on the industry. Yesterday, the U.S. Financial Crimes Enforcement Network (FinCEN) eBits that anyone selling initial coin offering (ICO) tokens are unregistered money transmitters, while the U.S. Securities and Exchange Commission (SEC) warned that any exchange selling tokens deemed as securities must register with the agency.    

Overall, Japan remains one of the more cryptocurrency-friendly countries, distinguishing itself from crackdowns in South Korea and China.

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Regulation

Dutch Finance Minister Advises Government on Cryptocurrency

In a six-page letter to the Dutch senate and house, Finance Minister Wopke Hoekstra has outlined his concerns over the rapid and dramatic growth in cryptocurrencies.

Hoekstra emphasized that there has been little time to understand and react to the changing landscape and that the current supervision and regulatory framework is ill equipped to deal with it. Because of the cross-border nature of the technology and markets, closing those gaps requires a unified approach across governments and borders. The minister will actively be working in a European context, but the entire process will take time and coordination between disparate governments and agencies.

Like most other policy makers, Hoekstra sees the value in promoting and developing the technology behind cryptocurrency, such as cryptography and distributed ledger technology. However, in addition to the concern over fraud and hacking, the minister also expressed concern over the immature and unregulated nature of the market and how to better inform consumers of the potential risks.

Hoekstra described the following as starting points in his assessment of possible policies and regulations to control the risks associated with cryptocurrencies:

  • Gaps in consumer and investor protection must be true need to be closed, but measures must be proportionate.
  • The integrity of the financial system must be guaranteed.
  • The innovative technique behind cryptocurrency must be preserved, such as cryptography and distributed ledger technology (DLT).
  • The cross-border nature of cryptocurrencies requires one approach at the international level. National rules can simply be circumvented or difficult to maintain.

The minister further said that given the decentralized and cross-border nature of cryptocurrencies, a ban is not feasible, so it was more important to bring cryptocurrencies under the appropriate regulatory framework and the Dutch join with the French and German finance ministers to discuss cryptocurrency in the G20 context. The Netherlands wants to play a leading role in the European and international approach to cryptocurrency.

In further comments, Hoekstra stated, “I hope the usual process for the realization of legislation and regulations that these new rules can enter into force at the end of 2019. I foresee the changes to the [European Union] Fourth Anti-Money Laundering Directive will also contribute to the prevention of tax evasion.” This directive, which took effect in June 2017, lays out the most recent parameters and standards adopted by the EU to prevent money-laundering and terrorist funding.

He sees the change as helping to prevent the use of cryptocurrency for the purposes of tax evasion as well. While this letter is not policy, it does reflect the direction that The Netherlands, Europe and much of the world appear to be headed in.

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Regulation

New York Legislator Proposes BitLicense Alternative for Cryptocurrency Users

New York State Assembly legislator Ron Kim (D-40) has unveiled a bill that intends to protect cryptocurrency investors and ease the bureaucratic burden on crypto-related businesses. It’s the first comprehensive cryptocurrency bill in New York to make it past studies and commissions and into the hands of the legislative branch. Kim introduced the legislation on March 13, 2018, after he met with blockchain industry leaders on the subject.

Known as The New York Cryptocurrency Exchange Act (A9899), the bill relates to “the audit of cryptocurrency business activity by third party depositories and prohibits licensing fees to conduct such cryptocurrency business activity.”

If it were to take effect, the legislation would make amendments to Section 9 of New York’s Banking Law. With the addition of section 9-x, the law would mandate that any cryptocurrency business or entity be subject to routine audits by a public or third-party depository service. These audits would require that individuals and businesses alike safeguard assets with proper security measures, provide adequate insurance for account holder assets and produce proof-of-asset ownership.

Any entity in full compliance will receive a digital New York Seal of Approval to reassure consumers that the outlet is trustworthy and secure. This seal would ideally replace the BitLicenses currently issued by the New York State Department of Financial Services, doing away with this fee-based license in favor of one earned by audit.

Kim believes that earlier efforts to regulate the space have put enormous burdens on businesses trying to grow and operate in the cryptocurrency space. “What New York needs now,” he told eBits.Co, “are common-sense laws and security procedures to provide a degree of clarity for both businesses and the public. This legislation will give consumers and companies the confidence needed for widespread adoption of cryptocurrency in New York.”

While the bill is the first of its kind for New York legislators, this isn’t Kim’s first foray into cryptocurrency. As a precursor to the landmark legislation, Kim recently published a brief report titled “The Future of Bitcoin in NY.” His research identifies unregulated exchanges as “the weak point” in the blockchain ecosystem. This vulnerability, coupled with the cost of a BitLicense, has left New York lacking in legitimate crypto-companies and consumer confidence.

According to a statement from Kim’s office, there are currently fewer than 10 BitLicense holders in the entire state of New York, even though there are some 1,000 active job postings in New York for the blockchain industry. It’s Kim’s hope that the new legislation will foster a friendlier environment for companies in the space; one that will attract more business and generate increased revenue by connecting consumers with reliable, state-vetted entities.

Throughout 2017, the United States government remained relatively quiet on the subject of cryptocurrencies and blockchain. While other countries are beginning to outline clear eBits and legislative eBits, U.S. investors have had their ears filled with conflicting talk from the SEC, the CFTC and various state legislatures.

So far, however, it’s been a busy year for the United State’s regulatory efforts, both on eBits and eBits levels, and The New York Cryptocurrency Exchange Act is yet another installment in a growing series of litigation that finally broaches the topic of cryptocurrency regulations. If anything, the legislation may set a precedent for consumer protections in the industry, as well as a more lenient regulatory approach that might encourage job growth in the industry.

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