Virtual Currencies: What Banks Need to Know | Wolters Kluwer
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  • Virtual Currencies: What Banks Need to Know

    Published January 15, 2019

    (As published in ABA Bank Compliance magazine)

    Virtual currencies, or cryptocurrencies, along with initial coin offerings (ICOs) and tokens, have attracted a lot of attention from individual investors and participants, financial advisors, analysts, banks, brokers, and federal and state regulators. One in 10 Americans own cryptocurrency, 33 percent of millennials were expected to hold cryptocurrencies by the end of 2018 and 20 percent of brokers are examining cryptocurrency-related investments.[1] ICOs raised $4 billion and continue to remain active despite the fluctuations in market value of cryptocurrencies in 2018.[2] Goldman Sachs and other major investment banks have designated leaders looking at or overseeing cryptocurrency related activities.[3] The first bank-owned cryptocurrency exchange (dubbed “VCTRADE”) was launched in July 2018 by SBI Holdings, a Japanese bank and financial firm holding company formerly known as Softbank.[4] And in August 2018, Starbucks, the Intercontinental Exchange, Microsoft and BCG announced that they were starting a new cryptocurrency platform, Bakkt, for consumer use.[5]

    In addition, federal, state and foreign regulators have disseminated important guidance and statements suggesting that certain virtual currency, ICO and token activities are subject to banking, securities, commodities and tax regulation and related financial risks.[6]

    Banks may be providing custody services, managing cryptocurrencies or providing services, such as payment networks, to virtual currency exchanges. Given the heightened attention, bank directors, leaders, managers, and those in compliance roles need to understand virtual currencies, ICOs and tokens, and the important regulatory risks. This article is intended as a helpful introduction.

    What is a Virtual Currency or Cryptocurrency?

    A virtual currency or cryptocurrency is an asset that exists only in digital, not physical, form and uses a cryptographic hash for security. Bitcoin and cryptocurrencies in general are types of decentralized digital currencies that are not managed by a central bank or administrator. In other words, a cryptocurrency is not typically supported or overseen by a national bank or government.

    What is Blockchain?

    A blockchain is an organized chain of electronic blocks of data that are shared simultaneously and publicly, known as a distributed ledger. The distributed ledger relies on consensus among participants to verify agreement about the quality and state of the data in each block among users. A public record of all the linked blocks is maintained and updated. A cryptographic hash is used to verify the authenticity of each new block added to the chain.[7]

    Why do Cryptocurrencies and Blockchain Get Confused with One Another?

    The close relationship between cryptocurrency and its technology (blockchain) is the cause of the confusion. Cryptocurrency is a store of value that is recorded and managed in electronic data. Blockchain is the distribution system for a cryptocurrency. In other words, a cryptocurrency is the content that is stored and identified via blockchain technology.

    Blockchain was the original distribution mechanism for Bitcoin beginning in 2009 although today blockchain is used for many types of stored data besides cryptocurrency.[8] Recently, many blockchain business applications and custody products have hit the market.[9]

    What is an Initial Coin Offering and What are Tokens?

    An initial coin offering is a new alternative method to raise funds using electronic means rather than traditional stock offerings. In 2017, substantial capital was raised through ICOs, which became a significant alternative to initial stock offerings, and ICO activity has been even greater in 2018.[10] In an ICO, the funders receive tokens, which are electronic instruments representing a digital asset or utility. There are different kinds of tokens. Some represent a right to a not yet released product or application (utility tokens). Others represent equity and are often intended to be converted into a cryptocurrency at a later stage in the development of the funded venture (equity tokens).

    Why are Virtual Currencies and ICOs Important?

    As mentioned at the beginning of this article, a growing number of investors generally—and millennials specifically—treat virtual currencies as acceptable alternatives to traditional currencies and investments. In addition to the rapid rise of the ICO as a new funding mechanism for businesses, cryptocurrencies and related exchanges, and financial derivatives, have proliferated. Although Bitcoin is the most well-known, today there are over 1,500 cryptocurrencies.[11]

    Some businesses take certain cryptocurrencies as payment, and the financial markets are devising instruments that pay out in cryptocurrency. In December 2017, Bitcoin futures began trading on both the Chicago Board of Options Exchange and the Chicago Mercantile Exchange. And other virtual currency-related pooled investments and financial derivatives have been offered.

    The Roller Coaster of Virtual Currency Valuation

    Bitcoin in particular has seen significant fluctuations in market values throughout its relatively short life. Bitcoin was valued at virtually nothing from its inception until around May 2010, when the value of a single Bitcoin rose to near $0.01.[12] By February 2011, the value of a single Bitcoin was approximately $1. July 2011 saw the first Bitcoin bubble with a high of approximately $31 per coin. By December 2011, the value of a Bitcoin had dropped to $2. The next highpoint was April 2013 with a per coin valuation of $266, followed by a low of $100 two months later. In November 2013, prices had hit $1,242 per coin.

    Prices bounced up and down between $1,000 and approximately $300 until March 2015, when prices hit a low of $200 per coin. The biggest price spike—from a low in January of $750 to a high in December of $17,900, occurred in 2017. In 2018, the roller coaster change in prices generally trended downward to an early July price of $6,560 per coin.

    The high price volatility of Bitcoin and other cryptocurrencies is attractive to investors and other market participants in spite of the financial risks. In addition to the high volatility risk of virtual currencies, it is important to note that over 800 virtual currencies are reported to be dead or have a current valuation of a penny or less.[13]

    The Use of Virtual Currencies by Bad Actors

    Because virtual currencies are not overseen or managed by a central bank or government, many participants expect that virtual currency transactions are free of government oversight. This is a false assumption due to the regulatory issues discussed below. However, it did result in the notorious use of Bitcoin and other virtual currencies by criminals of various kinds, including most famously the dark cyber-underworld website known as the “Silk Road.”[14]

    The use of virtual currencies by such bad actors has caused some to shun any participation in virtual currency markets.[15] In addition, there have been some significant instances of virtual currency theft reported.[16] Paradoxically, the distributed ledger inherent in the blockchain technology underlying all virtual currencies essentially results in a permanent record of ownership that could make certain criminal activities easier to trace.

    What are the Biggest Regulatory Issues with Virtual Currencies & ICOs?

    SEC and CFTC Regulation. Regulation of virtual currencies, ICOs and token activity in the United States by the Commodities Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) is probably the most important virtual currency issue financial institutions face today. Although the CFTC primarily regulates commodities futures activities, it does regulate against fraud in the underlying commodities spot markets. The CFTC’s authority to regulate cryptocurrency-related fraud activity was confirmed in a recent federal district court ruling.[17] The CFTC has also successfully pursued regulatory action against cryptocurrency trading platforms.[18] On July 16, 2018, the CFTC issued its fourth advisory about virtual currencies, warning customers to use caution and do extensive research before purchasing virtual coins and tokens.[19]

    The SEC has concluded that certain tokens (and possibly certain virtual currencies) could be characterized as securities for purposes of securities regulation.[20] Significantly, in 2017 the SEC issued a report concluding that DAO tokens were securities subject to SEC regulation.[21]

    Subsequent remarks from SEC officials have chilled the market because the agency has made it clear that tokens and cryptocurrencies can, depending on the facts, be considered securities subject to SEC regulation, and that commodity and security classification are not mutually exclusive.[22] Note that in June 2018, SEC Director of Corporate Finance William Hinman made it clear that Ethereum was likely not considered a security and therefore not likely subject to SEC regulation. However, the speech also stated that other cryptocurrencies and tokens could be considered securities.[23]

    In addition, the SEC issued an alert in March 2018 that trading platforms and others participating in the sale of tokens and virtual currencies that are considered securities are subject to SEC regulation and registration as securities exchanges unless an available exemption applies.[24] As a result, Coinbase and other virtual currency exchanges are considering registering as securities exchanges with the SEC.[25]

    The Federal Trade Commission has also begun regulating cryptocurrency and blockchain activities.[26] The treatment of ICO tokens (and possibly certain cryptocurrencies) as securities subject to SEC regulation and related exchanges being subject to SEC regulation are the most chilling aspects of the current regulatory climate. Nevertheless, ICOs raised more money in the first three months of 2018 than the whole of 2017.[27] This suggests a conflict in market behavior and regulation that will likely result in new disruptive guidance and enforcement actions in 2018 and beyond. Financial institutions should consider the potential risks and liabilities of participating in virtual currency and ICO and token activities given the statements of the CFTC and SEC.

    FINRA Regulation. FINRA is the largest independent regulator of U.S. securities exchanges, firms, participants and employees. Banks that operate as brokers or as securities advisory firms can be subject to FINRA oversight.[28] As discussed above, certain cryptocurrencies or tokens could be treated as securities under federal securities laws. On July 12, 2018, FINRA issued Notice 18-20.[29] The notice asks FINRA member firms “to promptly notify it if it, or its associated persons or affiliates, currently engages, or intends to engage, in any activities relating to digital assets, such as cryptocurrencies and other virtual coins and tokens.” As a result, banks that participate, change or intend to participate in the cryptocurrency and token markets should consider whether FINRA notification is appropriate in light of the notice.

    Anti-Money Laundering

    On March 18, 2013, FinCEN (the U.S. Financial Crimes Enforcement Network) released guidance regarding the application of FinCEN regulations in the context of virtual currencies.[30] Importantly, the guidance provides that “an administrator or exchanger that (1) accepts and transmits a convertible virtual currency or (b) buys or sells a convertible virtual currency for any reason is a money transmitter under FinCEN’s regulations…”

    In March 2018, FinCEN issued a letter to Senator Wyden concluding that developers and exchanges participating in ICOs and the issuance of equity tokens would be money transmitters subject to FinCEN-related AML and Know Your Customer (KYC) rules and regulation.[31] FinCEN Director Kenneth Blanco, in August 2018, stated that the money service business requirements apply equally to domestic and foreign-located convertible virtual currency money transmitters, even if the foreign located entity has no physical presence in the United States, as long as it does business in whole or substantial part within the United States.[32]

    Accordingly, participating in virtual currencies and token activities (other than as a user defined in the related FinCEN guidance) likely results in AML-related risks and liabilities. AML noncompliance may result in sizable penalties and charges against banks. For example, U.S. Bancorp reached a $613 settlement over charges it willfully failed to have adequate anti-money laundering controls.[33] AML concerns relating to cryptocurrencies and tokens should be a critical focus of bank compliance officers.[34]

    Tax Issues

    In 2014 the IRS issued general guidance on the tax treatment of certain virtual currencies.[35] For U.S. income tax purposes, the notice treats affected cryptocurrencies as property, not currency. As a result, the disposition of cryptocurrency gives rise to taxable gain and potentially taxable loss.

    The rapid roller coaster cycles in the valuation of cryptocurrency could result in substantial taxable income or loss. In a November 2017 court decision, the IRS succeeded in requiring Coinbase to turn over information regarding certain customers’ virtual currency transaction activity.[36] The IRS has publicly stated (as recently as March 2018) that taxpayers must report their virtual currency-related income on their tax returns. It is believed that taxpayer reporting of virtual currency income is substantially lower than the amount of income actually recognized.[37]

    Ominously, on July 2, 2018, the IRS announced an enforcement campaign within its Large Business & Industries (LB&I) division to address “noncompliance related to the use of virtual currency through multiple treatment streams including outreach and examinations.”[38] Focus by LB&I suggests that the IRS will focus on enforcement by way of deep-pocketed financial market participants in cryptocurrencies and tokens.

    Forks

    Sometimes the underlying blockchain relating to a specific cryptocurrency is revised or changed. This can be done to make processing faster or for other important reasons. Such changes can make a new block unable to link to a prior block. This inability to link the new block to prior blocks creates a break in the chain. Essentially a new chain begins. The separation of an old chain from a new chain creates what is called a “fork.” There have been issues with the processing of forks. Some exchanges were unable to give investors access to the new form of a virtual currency.[39] In other words, forks can give rise to operational issues for virtual currency exchanges and other participants. In addition, forks could resul in recognition of taxable income, based on existing tax law regarding distributions of property and the lack of specific IRS guidance.[40] Forks have become a regular occurrence and seem likely to continue.[41]

    Foreign Regulation

    Countries around the world have issued guidance on regulatory issues relating to cryptocurrencies, with a focus on anti-money laundering.[42] Regulators have formed a global task force, the Joint Chiefs of Global Tax Enforcement (J5), to collaborate in the fight against international and transnational tax crime and money laundering, and cybercrime through the use of cryptocurrencies.[43]

    State Regulation

    State regulators, like the New York Department of Financial Services, have issued guidance applicable to virtual currencies.[44] Its February 2018 release reminds market participants in New York to adopt a policy that “[I]dentifies and assesses the full range of fraud-related and similar risk areas, including, as applicable, market manipulation.” Reporting to the state is required if wrongdoing is detected. As a result, financial institutions and others considering participating in the virtual currency, ICO or token markets must understand and evaluate regulatory requirements and risks at a state level and likely on a multi-jurisdictional basis.

    Other Challenges

    Making or accepting payments in virtual currencies could give rise to tax information reporting and withholding. In Notice 2014-21 the IRS concluded that Forms 1099-K, 1099-MISC and W-2 reporting can apply to cryptocurrency payments. Also, withholding taxes may apply.[45]

    The introduction of Bitcoin-related futures contracts, the offering of cryptocurrency investment trusts and exchange-traded notes (ETNs), and the development of virtual currency secured or paying notes, loans and other instruments are likely to raise new and different regulatory concerns.

    Conclusion

    Our world rapidly changes around us. Virtual currencies, ICOs and tokens are one more set of examples of change. In spite of the risks and a perceived level of notoriety, there has been substantial growth in consumer and investor participation in the virtual currency, ICO and token-related markets. Nevertheless, there are substantial regulatory issues of significance. Law and regulatory guidance and enforcement is evolving. Ignoring virtual currencies and blockchain seems unwise given the level of growth. Bank leadership, management, and those in compliance roles need to take steps to understand these products, their technologies and their markets, as well as the current and evolving regulatory risks in order to take advantage of new opportunities while avoiding unnecessary costs.



    [5] https://www.cnbc.com/2018/08/03/starbucks-partners-with-microsoft-ice-on-new-cryptocurrency.html

    https://www.forbes.com/sites/michaeldelcastillo/2018/08/09/ibm-maersk-blockchain-platform-adds-92-clients-as-part-of-global-launch-1/#5528811668a4.

    [8] There is a growing awareness and application of data storage and smart contracts blockchain solutions for business. For example, IBM and the world’s largest shipping company, Maersk, are collaborating with over 90 participants to move their work to a blockchain. https://techcrunch.com/2018/08/09/ibm-teams-with-maersk-on-new-blockchain-shipping-solution.

    [9] Coinbase and Prime Trust have announced they have custody products aimed at aiding cryptocurrency adoption. https://www.coindesk.com/coinbase-rolls-out-crypto-custody-product-for-institutions, https://www.coindesk.com/prime-trust-enters-crypto-custody-race-will-hold-any-ethereum-token.

    [17] Commodity Futures Trading Comm’n v. McDonnell, No. 1:18-cv-00361-JBW-RLM, slip op. (E.D.N.Y. Mar. 6, 2018) (mem.). The ruling confirms that cryptocurrencies are defined as commodities. But as further discussed, that does not mean that a specific cryptocurrency or token could not also fall within the definition of an investment contract that is treated as a security for purposes of securities regulation.

    [18] https://www.cftc.gov/PressRoom/PressReleases/pr7380-16. The scope of CFTC regulation of trading platforms is not currently comprehensive. For example, it has not pursued regulation of non-leveraged cryptocurrency products. See, e.g., J. Cieplak and C. Griffith, Cryptocurrency and Initial Coin Offerings: Despite a Plethora of Regulators, Gaps Remain, Banking & Financial Services Policy Report (April 1, 2018).

    [19] https://www.cftc.gov/PressRoom/PressReleases/7756-18. See https://www.cftc.gov/Bitcoin/index.htm for the CFTC’s virtual currency webpage that includes podcasts, advisories, primers and other brochures.

    [20] The determination of whether a particular cryptocurrency or token is a security depends on whether it is considered an “investment contract” under the so-called Howey test. Note that the CFTC and the SEC acknowledge that a virtual currency or token could simultaneously be both a commodity (subject to CFTC fraud-related oversight) and a security (subject to SEC regulation). SEC Warns Cryptocurrency Trading Platforms Raise Significant Federal Securities Laws Compliance and Liability Risks, Stevie D. Conlon, Anna Vayser, and Robert Schwaba, Wolters Kluwer, April 30, 2018, CS-18-4949 227872948 SEC Blockchain Commentary.; SEC v. W.J. Howey Co. (Sup Ct 1946), 1945-47 CCH Dec. ¶90,341.

    [21] http://www.sec.gov/litigation/investreport/34-81207.pdf. The SEC report confirmed that issuers of distributed ledger or blockchain technology-based securities must register offers and sales of such securities unless a valid exemption applies.

    [24] SEC Warns Cryptocurrency Trading Platforms Raise Significant Federal Securities Laws Compliance and Liability Risks, Stevie D. Conlon, Anna Vayser, and Robert Schwaba, Wolters Kluwer, April 30, 2018, CS-18-4949 227872948 SEC Blockchain Commentary.

    [26] J. Cieplak and C. Griffith, Cryptocurrency and Initial Coin Offerings: Despite a Plethora of Regulators, Gaps Remain, Banking & Financial Services Policy Report (April 1, 2018). https://www.crowell.com/files/20180401-Cryptocurrency-and-Initial-Coin-Offerings.PDF.

    [32] https://www.fincen.gov/news/speeches/prepared-remarks-fincen-director-kenneth-blanco-delivered-2018-chicago-kent-block.

    [34] Cryptocurrency Global Regulations Tighten as Financial Crime Risks Intensify, Melonia A. Bennett, July 13, 2018, https://www.theblockchainmonitor.com/2018/07/risk-and-regulation-in-aml-tax-ico-scrutiny-provenance-pocs; New Q2 2018 Report Reveals Dramatic Increase in Crypto Theft and Corresponding Three-fold Rise in Cryptocurrency Money Laundering, July 3, 2018, https://ciphertrace.com/pr-crypto-aml-launch-report; Executive Order 13827, March 19, 2018, https://www.treasury.gov/resource-center/sanctions/Programs/Documents/13827.pdf.

    [35] Notice 2014-21, IRB 2014-16, 938. For a general discussion of the notice, see Taxation of Bitcoin, Its Progeny, and Derivatives: Coin Ex Machina, Stevie D. Conlon, Anna Vayser, and Robert Schwaba, Tax Notes, February 19, 2018.

    [36] Note that the scope of the summons was narrowed substantially. U.S. v. Coinbase, Inc., et al., 3:17-cv-01431-JSC (DC Cal. ND); Taxation of Bitcoin, Its Progeny, and Derivatives: Coin Ex Machina, Stevie D. Conlon, Anna Vayser, and Robert Schwaba, Tax Notes, February 19, 2018, p. 1015.

    [41] This is probably because technology continues to evolve which leads to enhancements to blockchains.

    [43] https://www.irs.gov/pub/irs-utl/j5-media-release-7-2-18.pdf.

    [45] Taxation of Bitcoin, Its Progeny, and Derivatives: Coin Ex Machina, Stevie D. Conlon, Anna Vayser, and Robert Schwaba, Tax Notes, February 19, 2018.



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