The Legal Quagmire of Cryptocurrency

Cryptocurrency has been a trending topic of discussion for the last several years. Cryptocurrencies such as Bitcoin and Ethereum have captured the public’s attention with their unstable, and highly fluctuating market values, as well as their promises for quick and easy rewards.

But what exactly are cryptocurrencies? And how secure are they as an investment?     Questions such as these are precisely what Federal and State regulators, as well as Congress, are struggling to explore and answer.

Terms like “cryptocurrency,” “Bitcoin,” and “blockchain” are easily thrown around, captivating and confusing the public. But how is a cryptocurrency defined? Or a blockchain? Understanding terms such as these can help educate investors searching for ways in which they can shake up their investment portfolios.

Cryptocurrency is a form of exchange, similar to the U.S. dollar or the Euro. It uses encryption technology to monitor the generation of units of currency and to confirm any transfer of funds. A blockchain, on the other hand, is the technology that allows for the existence of cryptocurrency. Blockchain is a digital ledger that records any, and all, transactions made in cryptocurrencies.

While comprehending the literal definitions of these terms is one task, understanding their legal and regulatory implications is another. It is the latter aspect of cryptocurrencies that has baffled Federal and State regulators.

To this date, Federal and State agencies alike have failed to offer one explicit, and cohesive, definition for “cryptocurrency.” For Federal tax purposes, the Internal Revenue Service treats any form of virtual currency, or cryptocurrency, as property.  On the other hand, the Commodity Futures Trading Commission views cryptocurrency as a commodity.

The Securities of Exchange Commission (“SEC”) has agreed to examine and decide whether a cryptocurrency is a security on a case by case basis. Interestingly, to do so, the SEC employs the use of the Howey Test, which was established by the Supreme Court of the United States in 1946 to determine whether a particular transaction is deemed a security. The Supreme Court ruled that a transaction is a security when: “1) it is an investment of money; 2) there is an expectation of profits from the investment; 3) the investment of money is in a common enterprise; 4) any profit comes from the efforts of a promoter or third party.” SEC v. W.J. Howey Co., 328.U.S. 293, 301 (1946) A transaction can be deemed a security if, and only if, all four factors of the definition are met.

The profound disunity in the definition and understanding of cryptocurrency makes it that much more of a risk as an investment. The simple fact is that State and Federal regulators are unable to keep up with the evolving use of cryptocurrencies as a whole.

Today, more and more start-up companies are raising capital for their ventures using initial coin offerings (“ICOs”). ICOs are a fundraising medium in which new projects can sell their crypto tokens in exchange for cryptocurrencies such as Bitcoin, or even Ethereum. ICOs are now an alternative method of raising capital without having to sell stock, or visiting a venture capitalist. You can essentially collect and raise money by creating, and then selling, your own virtual currency. Should a coin be considered a security, it must consequently follow all relevant, pre-established security laws. However, to this date, no ICOs have been required to register with the SEC.

Now, what does all this inform an investor?

All of this ought to provoke deep reflection on the part of the investor. If you are in fact interested in this type of investment, you must familiarize yourself with the many risks present. Some form of regulation is required so as to bring about clarity within this industry. As of right now, the consumer is left unprotected.

If a business is interested in getting involved with this vehicle of raising funds, it should be careful about how it is structured. Only some legal counsel can protect the company, along with its investors, from potential liability or a loss in investment.