Tag: Bitcoin

Risk Alert on Digital Asset Securities

The Securities and Exchange Commission’s Division of Examination has been visiting firms that have been involved in digital assets. The Division published a Risk Alert that you should read if your firm has digital assets in client accounts.

Right off the bat, the risk alert hedges on its definition of “digital assets” to say that it a particular digital asset may or may not be a security. I believe the SEC’s current position is that BitCoin is not a security. Everything else it potentially a security.

There is the usual expected requirements for investment advisers and fund managers: books and records, disclosure and custody.

Custody continues to be one of the most difficult aspects of putting digital assets in client accounts. Have fun trying to meet the custody rule requirements. Even if you do, the security around digital asset keys should keep you up at night. That’s true for Bitcoin as well, even though its not a security.

One highlight was due diligence and evaluation of the risks involved in digital assets. You really need to vet these investments like you would any other investment recommendation. I like this example of required diligence:

“that the adviser understands the digital asset, wallets, or any other devices or software used to interact with the relevant digital asset network or application, and the relevant liquidity and volatility of the digital asset)”

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Bitcoins Are Not Securities

In a completely unsurprising statement, a high-ranking official at the Securities and Exchange Commission said that Bitcoins are not securities. William Hinman, Director, Division of Corporation Finance at the SEC, gave detailed speech on cryptocurrency.

When we see that kind of economic transaction, it is easy to apply the Supreme Court’s “investment contract” test first announced in SEC v. Howey. That test requires an investment of money in a common enterprise with an expectation of profit derived from the efforts of others. … In articulating the test for an investment contract, the Supreme Court stressed: “Form [is] disregarded for substance and the emphasis [is] placed upon economic reality.” So the purported real estate purchase was found to be an investment contract – an investment in orange groves was in these circumstances an investment in a security.

Just as in the Howey case, tokens and coins are often touted as assets that have a use in their own right, coupled with a promise that the assets will be cultivated in a way that will cause them to grow in value, to be sold later at a profit. And, as in Howey – where interests in the groves were sold to hotel guests, not farmers – tokens and coins typically are sold to a wide audience rather than to persons who are likely to use them on the network.

In the ICOs I have seen, overwhelmingly, promoters tout their ability to create an innovative application of blockchain technology. Like in Howey, the investors are passive. Marketing efforts are rarely narrowly targeted to token users. And typically at the outset, the business model and very viability of the application is still uncertain. The purchaser usually has no choice but to rely on the efforts of the promoter to build the network and make the enterprise a success. At that stage, the purchase of a token looks a lot like a bet on the success of the enterprise and not the purchase of something used to exchange for goods or services on the network.

It seems clear that the SEC’s default position on Initial Coin Offerings is that they are securities offerings. The coin promoters are not offering oranges for sale, but interests in the orange grove.

I did find it interesting that Mr. Hinman indicated that even if the ICO was an illegal securities offering, eventually the cryptocurrency could evolve into not being a security. Eventually, you are not exchanging interests in the orange grove, but exchanging actual oranges. He went to the next biggest coin platform: Ether.

And putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.

As for the rest of the coin and ICO universe, Mr. Hinman offered up six factors to consider:

  1. Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?
  2. Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
  3. Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
  4. Are purchasers “investing,” that is seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
  5. Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?
  6. Do persons or entities other than the promoter exercise governance rights or meaningful influence?

That is just for coins based on being able to buy some future service. If the digital coin includes some profits interest in the coin network, it’s always going to be a security.

The other factor to take into consideration is the trading platform for the digital coins. If a platform offers trading of digital assets that are securities and operates as an “exchange,” as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration. If the platform just handles Ether and Bitcoin, it’s okay based on the Hinman speech. Those two are not securities. Others are still suspect.

What is left out is the whether Bitcoin, Ether, or any of the other non-security digital coins are commodities or currency.

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SEC Says “NO” to Cryptocurrency ETFs and Mutual Funds

When Bitcoin was rapidly increasing in value, there were lots of people looking to invest in that space. The SEC has repeatedly raised concerns about fund sponsors creating a fund or ETF focused on cryptocurrency. In a letter to the Investment Company Institute and Securities Industry and Financial Markets Association, the SEC said don’t even think about it.

Actually, it said you can think about it, but what about all of these issues. These issues are very compliance-related so I thought it was interesting to look at these compliance issues in light of this new asset class.

Valuation

Proper value of a fund assets is critical. For Bitcoin and various crypto-currencies there are multiple exchanges that are often far apart in the exchange rate. Bitcoin itself has little ascertainable value. Few merchants accept it as payment and few holders are willing to part with it, instead holding it as an investment. The value is determined as other currencies, based on the exchange rate into dollars. That exchange rate can vary significantly from provider to provider.

The SEC lays out out a long list of questions that would have to be addressed in a valuation policy.

Custody

This is the big problem. Most of the successful hacking of crypto-currency has been a a hack into the depositories/wallets that hold the crypto-currency. Investment advisers have regualtory custody requirements and ’40 Act funds have a stricter set of rules.

The SEC points out that it is not aware of any custodian providing custodial services for crypto-currencies.

The problem with custody is that you have to have the private crypto key as well as the record in the blockchain.

Arbitrage

For ETFs that trade during the day, you have problems with differing price movement at the different exchanges for crypto-currencies.

Market Manipulation

As I pointed out yesterday, cypto-currencies seem to targets for market manipulation. That also means that any derivatives from the crypto-currencies are also subject to market manipulation.

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Pump and Dump Cryptocurrency

Cryptocurrency is a lawless land.

Ten days ago, the Securities Exchange Commission and the Commodities and Futures Trading Commission issued a joint statement on virtual currency:

“When market participants engage in fraud under the guise of offering digital instruments – whether characterized as virtual currencies, coins, tokens, or the like – the SEC and the CFTC will look beyond form, examine the substance of the activity and prosecute violations of the federal securities and commodities laws. The Divisions of Enforcement for the SEC and CFTC will continue to address violations and bring actions to stop and prevent fraud in the offer and sale of digital instruments.”

Take a look at BigPump.org. Go ahead and take a look. I’ll wait.

“We do pumps…. Big pumps.”

Right there on a public website, the group advertises its strategy for pumping and dumping cryptocurrency. It came to my attention through an article by Paris Martineau:
Inside the Group Chats Where People Pump and Dump Cryptocurrency.

I was skeptical that a strategy that was so brazenly illegal would be so easy to spot. So being skeptical, I dug into the underlying information. There it was, publicly displaying a pump and dump scheme.

In their defense, they claim their pumping schemes are fair. Of course, there is also a note that premium pumps will be coming soon. I have to assume that those premium pumps are less fair to those outside the premium group.

It does not take much to find examples of pump and dump. Look at this chart for the Crave cryptocurrency.

Some people made a bunch of money by rallying interest in this cryptocurrency and selling at the top before the price.

That is not the way a price chart for any “currency” should look. It’s not the way chart should look for any investment.

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Compliance Lessons from Star Wars – Rebels

With the pending release of Episode VIII – The Last Jedi, I’m joining Tom Fox in tying compliance and the Star Wars franchise together in some posts this week. Star Wars is about the rise of the evil galactic empire and the rebels who fight against it. I think some Bitcoin advocates are trying to be the rebels who portray the the Federal Reserve as the evil Galactic Empire. The battle is for freedom of money.

“This is a fantastic fundamental hedge and store of value against autocratic regimes and banking infrastructure that we know is corrosive to how the world needs to work properly,” said Chamath Palihapitiya, the founder of Social Capital and an early Bitcoin investor. “You cannot have central banks infinitely printing currency.”

In response to that, I give you this picture of the Treasury Secretary showing a new sheet of money to his wife dressed in Darth Vader garb. (Add a helmet and it’s complete)

Of course the Treasury is not the Federal Reserve and this printed money is not the same as the Federal Reserve buying bonds with money pulled out of thin air. Since we have entered a post-factual world in Washington, I’m not sure we need to let facts get in the way of a great picture.

The underlying technology of Bitcoin, blockchain, is a brilliant shared ledger. It has the ability to replace some proprietary databases of transactional information. I’m less interest in Bitcoin itself. Digital currency moves control of the currency from the central banks to computer servers.  While currency can be inflated be the central banks, Bitcoin is limited to a slow creation on the servers running blockchain.

As a naysayer, I failed to see the rise of Bitcoin. If I had a bought a few bitcoins when I first looked down my nose at it, I would have made a pile of cash.

The Federal Reserve, at the heart of the Galactic Empire, has pushed Bitcoin aside. Janet Yellen, the current Chair of the Board of Governors of the Federal Reserve System on Wednesday called Bitcoin a “highly speculative asset” and “not a stable source of value”, and “it doesn’t constitute legal tender.”  In response, Bitcoin did not back down and the exchange rate stayed stable. The empire would have to find other ways to attack cryptocurrency.

The rebellion has grown from Bitcoin to other cryptocurrencies. They are launching their attacks in Initial Coin Offerings. No initial coin offerings have been registered with the Securities and Exchange Commission as the sale of securities. They are operating outside the oversight of the SEC, failing to give purchasers/investors the protections that come with SEC registration and oversight.

If you invested in an ICO, should you be worried that the offering might be targeted by the SEC? Yes, you should be worried. That ICO is Alderaan and the SEC has the Death Star. A million voices will scream out about the injustice. So much real money and false value will be destroyed.

The SEC stopped an ICO this week for Munchee. Munchee was seeking $15 million to improve an existing iPhone app for restaurant meal reviews and to create an “ecosystem” in which Munchee and others would buy and sell goods and services using the tokens. The company emphasized that investors could expect that efforts by the company would lead to an increase in value of the tokens and it would take steps to create a secondary market for the tokens.  As the SEC has said in the DAO Report of Investigation, a token can be a security based on the long-standing facts and circumstances test that includes assessing whether investors’ profits are to be derived from the managerial and entrepreneurial efforts of others. The Munchee ICO was an illegal IPO.

The Empire of regulatory oversight has many factions. This week the IRS won a case against Coinbase, one of the largest digital currency brokers. The IRS claimed that virtual currency gains have been underreported based on the disproportionate number of taxpayers reporting gains from Bitcoin compared to the number of Coinbase account holders. Coinbase has approximately 5.9 million customers and has provided $6 billion in Bitcoin exchanges. However,  the IRS has identified only 800 to 900 taxpayers in each of the years from 2013 through 2015 who reported gains or losses that the IRS believes are “likely related to bitcoin.”

The battle will rage on. Rebel cryptocurrency against the regulated dollar. Which will allow you to buy a coffee at Dunkin Donuts? and which will you use?

See Tom’s posts:

Blockchain for Corporate Records

Jamie Dimon, chief executive of JPMorgan Chase & Co, speaking at a bank investor conference said Bitcoin “is a fraud” and will blow up. Further, that if any JPMorgan traders were trading the crypto-currency, “I would fire them in a second, for two reasons: It is against our rules and they are stupid, and both are dangerous.”

I’ve said it before. I don’t find Bitcoin to be a currency and it’s utility is suspect. But like Tesla stock and Dutch tulip bulbs, people will trade on the item if there is a dollar to be made. I don’t think it’s a fraud. There is value.

The interesting part of Bitcoin is the underlying blockchain technology that traces who holds all of the bitcoins in circulation. Imagine if Bank of America, JP Morgan, US Bank, Wells Fargo and all of the other banks used one ledger to track the movement of cash and each of them had a copy to prevent fraud. That’s blockchain, a distributed ledger.

Blockchain has uses outside of the tracking of money. It can be used to track almost anything.

Delaware and Nevada passed laws this summer allowing Blockchain to be used to track corporate records. It sounds innovative, but I’m skeptical.

The grand theme of Blockchain is trust. Since many people have copies of the distributed ledger, you prevent fraud. Because everyone has direct access information, you cut out intermediaries who would intervene to charge a transaction fee.

Most corporate records don’t fall into that category. There is a single instance and that is all that is needed.

The exception is stock ownership. I see some utility there to track ownership of a firm’s shares. For it to work, all of the shareholders and the firm would need to have the Blockchain ledger. For a small firm, it’s probably overkill. For a large company there may be some economies of scale.

I’m not sure how it works for a public company. Trading in public companies is fraught with issues. The markets do more than just transfer ownership. Their main role is pricing the shares. Blockchain could be used for the record-keeping but not does not lend itself well to the pricing.

For Bitcoin, Blockchain does a great job of tracks who holds the currency. The pricing comes from converting bitcoins into dollars which is outside of Blockchain and done by intermediaries who charge a fee. I assume the same would true if company moved the trading of public company shares onto blockchain.

The other problem is whether one Blockchain instance could address the shares at multiple firms or would there need to be separate instances of Blockchain. That also has some scaling issue.

I think there are tremendous uses for Blockchain to share value and information across firms and eliminate transaction costs. In these early days, it sounds more like people with a hammer thinking everything looks like a nail.

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Initial Coin Offerings and the Securities Laws

Regulators have been trying to figure out what to do with the new currencies coming to the marketplace. Bitcoin was the vanguard, bringing its blockchain technology into the public’s view. The Securities and Exchange Commission has issued a Report of Investigation that provides some insight into when these currencies and their rollouts are going to violate securities law.

I find Bitcoin’s distributed ledger technology called the blockchain to be intriguing. Bitcoin as a currency has its problems. The wild swings in its conversion rate make it look more like a commodity than the steady values expected of a currency. In the US we have distinct regulatory structures between commodities and securities.

(Speaking of currency, if you have some extra currency then use it to fight cancer. Support my Pan-Mass Challenge Ride.)

The SEC took a close look at the initial coin offering of DAO Tokens to see if it violated securities laws. The first test was whether the DAO Tokens were securities. The short answer is yes.

The hurdle with rolling out new virtual currencies is getting enough into circulation at launch to make them useful of enough to act like a currency. Bitcoin has been out long enough and is widely used enough that it has passed this hurdle. But the first person with a Bitcoin couldn’t do much with it.

I think it’s important to note that the DAO Tokens that are the subject of the report are not the virtual currency. The DAO Tokess were used to fund the enterprise that was intended to fund projects involving the Ether currency and the Etherium blockchain.

The DAO was essential a venture capital organization and the DAO tokens were the capital commitments. Fund managers will tell you right off the bat that the partnership interests in a venture capital fund are securities.

In looking at the DAO tokens, the SEC went right to the Howey test.

Participants invested money. Of course, cash is not the only way to invest. For the DAO tokens, the investors used Ether which has value and easily meets this prong of the test.

Participants had a reasonable expectation of profits. The DAO organization was set up as a venture capital endeavor and explicitly stated that DAO token holders would share in profits from any of the projects that generated revenue.

The difficult part of the prong was the “managerial efforts of others.” DAO token holders had voting rights but the promoter, Slock.it, was key to moving the enterprise forward according to the SEC. DAO would have “Curators” instead of managers who would chose the projects for voting by the DAO token holders.

Slock.it chose the initial batch of Curators.  Token Holders could vote to replace a Curator. But the decision to send the proposal to a vote is subject to approval of the Curators.  Curators had the responsibility and power to “(1) vet Contractors; (2) determine whether and when to submit proposals for votes; (3) determine the order and frequency of proposals that were submitted for a vote; and (4) determine whether to halve the default quorum necessary for a successful vote on certain proposals. Thus, the Curators exercised significant control over the order and frequency of proposals, and could impose their own subjective criteria for whether the proposal should be whitelisted for a vote by DAO Token holders.”

The SEC went on further to conclude that the DAO Token voting rights are closer to those of corporate shareholder, than an active participant in the management.

If the DAO Tokens are securities then the whole securities law regulatory regime applies unless there is an exemption for the offering of the DAO Tokens. The sponsors took no steps to limit the offering in a manner consistent with a offering exemption.

In the end, it was not the initial coin offering that was a problem, it was the offering of interests in the organization behind the coins that was a problem.

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The Pan Mass Challenge has many choices for those looking to participate and raise money to fight cancer. I have a friend who is a virtual rider. Due to injuries she is not ready to spend hours on a bike. I’m not a virtual rider. Not only am I riding the two days of the Pan Mass Challenge, I’m adding an extra Day Zero and riding 75+ miles just to get to the start of the Pan Mass Challenge.

Help me fight cancer by donating your real currency through one of the links below.

Thank you,
Doug

No BitCoin ETF

I’ve said before that BitCoin is the Dutch Tulips of investments. The blockchain approach to recordkeeping is an interesting use of decentralized computed power for recordkeeping, but BitCoin units are less interesting. The main users are less than scrupulous users looking for ways to avoid things like anti-money laundering rules.

Many bankers/traders see BitCoin as a way to make money. All of those transactions and lack of regulation seem ripe for profit-making.

One tactic has been to set up an ETF to track BitCoin prices. Much a like a gold ETF means you don’t need a safe and security guard for gold bars. A BitCoin ETF would allow you profit on runaway BitCoin prices without having to get involved with all of the technical stuff of BitCoin.

I should say, at least people are trying to set up a BitCoin ETF. Two requests have been denied recently. The decisions from the Securities and Exchange Commission state that they fail to “to prevent fraudulent and manipulative acts and practices” and fail “to protect investors and the public interest.” In an identical statement for the two rejections:

The Commission believes that, in order to meet this standard, an exchange that lists and trades shares of commodity-trust exchange-traded products (“ETPs”) must, in addition to other applicable requirements, satisfy two requirements that are dispositive in this matter.  First, the exchange must have surveillance-sharing agreements with significant markets for trading the underlying commodity or derivatives on that commodity. And second, those markets must be regulated.

One problem that surfaces is that is hard to pin the value of BitCoin. The Chinese exchanges for BitCoin have become a separate market from the US. Even in the US, there are different exchanges with different values. Each of the rejected ETF planned to use a different measure for the ETF value.

The linchpin in the SEC’s denial is the lack of regulation. The very thing that attracts user to BitCoin, the lack of government oversight, is the main reason the SEC rejects the ETFs.

For the commodity-based EFTs approved so far, there have been well-established, significant, regulated markets for trading futures on the underlying commodity. Those are gold, silver, platinum, palladium, and copper.

BitCoin is not to the SEC’s liking.

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The SEC Says Be Wary of Bitcoin

bitcoin

Bitcoin has been the Dutch Tulips of investment for a few years. So of course that means the fraudsters have latched on. The Securities and Exchange Commission has piled on and issued an Investor Alert: Bitcoin and Other Virtual Currency-Related Investments.

This is the second investor alert from the SEC on Bitcoin. The first was part of an enforcement action against an alleged Ponzi scheme.

It’s not that Bitcoin is inherently illegal. It actually has an interesting approach on funds transfers. Transfers are free of transaction costs. That’s in sharp contrast to the swipe fees charged by Visa, Mastercard, and the other credit card companies.

One of the current problems with bitcoin is that the value has fluctuating wildly. That’s not what you want in a currency. You want to know that a gallon of gas costs about $4 today and will be about $4 next month. You don’t want the uncertainty that it could be $2 of $8 next month. That turns bitcoin from a currency into an investment.

The IRS recently issued guidance that it will treat Bitcoin and other virtual currencies as property for federal tax purposes. As a result, general tax principles that apply to property transactions apply to transactions using bitcoin.

Bitcoin fraud schemes look like other fraud schemes. The fraudsters use the lure of high returns in a lightly regulated asset. The growth chart of value in Bitcoin is an irresistible lure. Don’t forget to look for the red flags like “guaranteed returns” and “no risk” opportunities. If it sounds too good to be true, it probably is not true.

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Is Bitcoin a Security?

bitcoin

You may have noticed that I focus on SEC actions against real estate companies. At the core of that interest is a look at whether the Securities and Exchange Commission has jurisdiction. The SEC is limited to securities. Commodities get covered by the CFTC and real estate gets covered by …..

Bruce Carton pointed to another item in the news that also addresses the realm of what is and is not a security: Bitcoin.

The SEC brought charges against Trendon T. Shavers, who is the founder and operator of Bitcoin Savings and Trust (BTCST). The SEC alleged that he was running a Ponzi scheme based on a “virtual currency” arbitrage on Bitcoin. Shavers apparently used the handle Pirateat40.

Beginning in November of 2011, Shavers began advertising that he was in the business of
“selling Bitcoin to a group of local people” and offered investors up to 1% interest daily “until
either you withdraw the funds or my local dealings dry up and I can no longer be profitable” Shavers obtained at least 700,467 Bitcoin in principal investments from BTCST investors, or $4,592,806 in U.S. dollars, based on the daily average price of Bitcoin.

Shavers argued that the BTCST investments are not securities because Bitcoin is not money, and is “not part of anything regulated by the United States. Shavers also contends that his transactions were all Bitcoin transactions and that no money ever exchanged hands.

The SEC argued that the BTCST investments are both investment contracts and notes, and therefore are securities. The SEC said that Shaver returned about 500,000 Bitcoins to investors, but made off with another 200,000

Bad news for Shavers. A decision in the case this week ruled that BTCST investments meet the definition of investment contract, and as such, are securities. The court concluded that it had subject matter jurisdiction to hear the SEC’s case.

15 U.S.C. § 77b of the U.S. Code defines “security” as “any note, stock, treasury stock, security future, security-based swap, bond…[or] investment contract…”  Under the Howey line of cases, an investment contract is any contract, transaction, or scheme involving (1) an investment of money, (2) in a common enterprise, (3) with the expectation that profits will be derived from the efforts of the promoter or a third party.

Investment of money

Bitcoin can be used to purchase stuff. The only limitation (and its a big one) is that it is limited to places that accept it as currency. Bitcoin can also be exchanged for conventional currencies, such as the U.S. dollar. It was that recent spike in the exchange rate between Bitcoin and the US dollar that attracted so much attention.

Common enterprise

A common enterprise requires interdependence between the investors and the promotor, for example where the investors colelctively rely on the promotor’s expertise. The investors were giving Shaver their bitcoins and he was supposed to trade them and get more value back them.

Expectation of profits from efforts of others

In this case, the investors were not taking an active role in the investment. They were relying on Shavers.

The court’s finding that it has subject matter jurisdiction means that the SEC’s case against Shaver can  move forward. The SEC still has not proven fraud and will likely face another round of arguments on jurisdiction.  The SEC still has to prove fraud.

The interest rate Shavers gave to investors was a staggering 7% per week for large investments. That smells like a Ponzi scheme. Personally, I don’t think I’d hand any money, bitcoin or US dollars, to someone named “Pirate.”

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