To many lawyers, cryptocurrencies might seem like an asset category operating on the fringes. However, 10% of all Americans (and one-third of all Millennials) are active in this rapidly growing market — as are retailers, financial institutions and numerous other businesses.
Many of those using cryptocurrencies for transactions and investments are intrigued by the perceived opportunities they offer. But all should know the risks to protect themselves. The main risks stem from multi-level regulatory compliance, cybersecurity challenges, criminal activity, investment issues and professional liability.
Cryptocurrencies and Blockchains
A cryptocurrency is a currency that exists only in digital form. It usually has no third-party authority involved such as a bank or credit card company; instead, it uses a decentralized ledger system to record transactions and eliminates the middlemen. They freely cross state and national boundaries. Transactions are effectively anonymous and not reversible.
Blockchain is the record-keeping ledger technology on which cryptocurrencies reside. It is a digital database containing “blocks” of information (such as records of financial transactions) that is encrypted and shared within a decentralized and publicly accessible network. This exciting new technology is rapidly being adopted for many uses other than cryptocurrencies — such as monitoring supply chains, managing data and digital voting.
A cryptocurrency, in short, is a type of content. Blockchain is the technology on which the content is stored. The first cryptocurrency was Bitcoin, which was released in 2009. Today, there are approximately 1,600 cryptocurrencies.
Federal regulatory risks
Because cryptocurrencies are so new, regulatory agencies are scrambling — balancing the interests of consumer protection, anti-criminal activity and innovation — to apply pre-existing law to this new, unfamiliar technology.
At the federal level, the Commodity Futures Trading Commission, the Securities and Exchange Commission, the IRS and the Financial Crimes Enforcement Network all classify digital assets differently — making compliance difficult and risky.
Most cryptocurrencies are considered commodities. Under the Commodity Exchange Act, the CFTC has brought enforcement actions against cryptocurrency trading platforms that fail to register as futures commission merchants as well as those that allow the execution of illegal commodity transactions.
The SEC has asserted jurisdiction (especially over the past two years) over several types of crypto-based investment products and operations — such as initial coin offerings, crypto-exchanges and crypto broker dealers.
Last October, the SEC announced the launch of its Strategic Hub for Innovation and Financial Technology to oversee SEC efforts concerning securities laws as related to digital asset technologies.
In an effort to provide guidance, in April FinHub issued a 13-page “Framework for ‘Investment Contract’ Analysis of Digital Assets.” While securities lawyers praised the effort, they generally find the Framework lacking specificity.
In determining if cryptocurrencies are securities, the SEC relies on 85-year old laws and the U.S. Supreme Court’s 1946 Howey test. However, Congress is in the process of considering legislation directly regulating cryptocurrency and associated technologies.
Based on the SEC’s enforcement actions and its framework, most cryptocurrencies will likely be considered subject to federal securities laws. The SEC has been largely successful as have private litigants in persuading federal and state courts to apply the Howey test. Compliance failures create great risks to companies and their managements. Of note to broker-dealers is the Regulatory and Examination Priorities Letter issued by the Financial Industry Regulatory Authority in 2018, which prioritizes ICOs and cryptocurrencies among sales practice risks.
The IRS treats cryptocurrency as property, not currency. Therefore, general tax principles for property transactions are applied to cryptocurrency exchanges as well. Also, owners face reporting requirements under the Foreign Account Tax Compliance Act and for Foreign Bank and Financial Accounts for some purchases made on foreign exchanges.
FinCen takes the position that cryptocurrency administrators and exchanges are “money services businesses” and therefore subject to the Bank Secrecy Act and its wide-ranging anti-money laundering regulations. It actively pursues operators who fail to register.
State and foreign regulatory risks
Like the federal government, most states have been applying decades old laws to cryptocurrencies.
However, in 2014, New York was the first state to adopt a crypto-specific regulatory regime — requiring those involved in “virtual currency business activity” to obtain a special license. A handful of other states have adopted legislation addressing cryptocurrencies using a variety of approaches —including money transmission laws, licensing requirements and regulatory guidance.
In May 2018, Wyoming became the first state to enact favorable pro-crypto legislation when it exempted currencies like Bitcoin and Ethereum from money transmitter laws, allowing individuals and businesses to trade crypto without being penalized. The intent is to foster Wyoming as the jurisdiction of choice for cryptocurrency.
Colorado recently also adopted crypto-friendly legislation. In March, Governor Polis signed the Colorado Digital Token Act, which distinguishes between the use of cryptocurrency for speculative or investment purposes which are subject to the Colorado Securities Act and their use for consumptive purposes which it exempts from the act. The new law goes into effect Aug. 2.
Nonetheless, Colorado has taken a number of significant actions to closely regulate cryptocurrency ICOs. In 2018, the Colorado Securities Division instituted an ICO Task Force to probe possible fraudulent projects aimed at cryptocurrency investors. The division has filed 18 cessation orders against ICOs offering unregistered securities with more pending.
Cryptocurrencies pose particular challenges within the world of international finance and taxation because they operate across national boundaries. Countries with laws and regulations currently favorable to cryptocurrencies include Switzerland, the United Kingdom, Denmark, Germany, the Netherlands and Finland. Countries not favorable to cryptocurrencies include China, Russia, Sweden and India.
Many of the factors that make cryptocurrencies attractive also make them vulnerable to cyberattack. Since they are decentralized, there is no central administrator overseeing the creation, movement and management of a currency and their security audits or controls are lacking.
Because the blockchain network is publicly accessible, there are many points of entry for hackers. Hackers can use tools such as spoofing, phishing and malware to target individuals as well as service handling and storage areas. They can use malware to infect computers to drain crypto storage “wallets” of individuals, companies and exchanges. Plus, cryptocurrency transactions are irreversible. Once a cryptocurrency “key” has been stolen and used, there is no way for those funds to be recovered.
Illicit activities risks
One of the most significant attributes of cryptocurrency is substantial anonymity — which makes it an attractive vehicle to criminals. Some cryptocurrencies are specifically designed to make it harder for law enforcement to track illegal activity transactions.
Criminals use cryptocurrencies to operate on the Darknet to purchase drugs, weapons, stolen merchandise, fake documents, sex workers and even hired killers. They are regularly used to launder criminal proceeds and evade taxes.
When criminals engage in ransomware attacks (using computer bugs to infect and disable a computer, server or mobile device), they demand ransom payments by cryptocurrency. Cryptocurrencies can also be used to commit criminal fraud. Reports suggest that as many as 80% of ICOs in 2017 were fraudulent.
Volatility and illiquidity risks
Price volatility continues to be a defining feature of cryptocurrencies, which — defying the conventional norm of value — have no inherent worth other than market demand. Should acceptance of cryptocurrencies as mediums of exchange grow — buy merchandise, close business transactions and pay taxes — there may come price stabilization. But currently, volatility remains a substantial risk.
The value of Bitcoin, for example, has swung widely. When it was first introduced in 2009, it had little if any value. At its high in December 2017, it was valued at $20,000 per coin. it recently traded as low as under $4,000.
There is a finite amount of any cryptocurrency, which exposes it to liquidity concerns. Plus, limited ownership and lack of safe-guarded exchanges can make a cryptocurrency susceptible to market manipulation.
Risks to lawyers
The SEC and other agencies are increasingly targeting what they term the “gatekeepers” involved in ICOs and other cryptocurrency transactions — the advising lawyers, accountants and other professionals. They clearly risk investigation and prosecution right alongside their clients.
Lawyers who advise clients who are operating within the cryptocurrency sector must be aware of the many risks involved at many levels of regulation — state, federal, international and professional.Lawyers who accept payment in cryptocurrency from their clients must be aware of and comply with ethics and other factors.
In December, recognizing cryptocurrency as a developing practice area, the American Bar Association hosted a panel on “Legal Ethics and Cryptocurrency,” which addressed the ethical issues that arise when lawyers provide legal counsel to cryptocurrency businesses — serving clients whose business models may be ahead of the law.
Notwithstanding the challenges of these and other risks, it certainly appears that with its accelerating acceptance cryptocurrency has established its viability in the marketplace. •
— Thomas Tenenbaum is the founder of Tenenbaum Law