Financial Services Law and Cryptocurrencies

This post is not about cryptoequity (cryptocurrencies with embedded contractual obligations that resemble an equity stake in the company), but about cryptocurrency trading generally.  In the cryptocurrency community, there is a significant contingent of entrepreneurs who want to develop financial services-like products. I don’t like these business models and I get exasperated advising them, because frequently they are creating unnecessary middle-men at the cost of expensive regulatory obligations.  They obscure the reality that direct ownership of crypto is possible unlike traditional ownership models.

Exchanges?

People throw around the term “exchange” quite loosely. Sometimes, they mean a currency exchange, where the counterparty is the centralized market-maker selling the cryptocurrency for a set price (Coinbase) but maintaining custody of crypto for customers. Sometimes, they are referring to exchanges that function like the stock exchange, where users are posting bid and ask prices and transacting with each other, and the centralized entity is providing escrow services (Localbitcoins.com). A third category is a blend of the two, where the centralized entity is holding the crypto for users to set their bid and ask prices and transfers are done within a darkpool (Cryptsy).

These are all currently referred to as exchanges but they are very different. To recap the application of consumer protection laws: Market-maker exchanges are your garden-variety money transmitters. They fall under all the legal obligations, partially because they commonly insist on maintaining custodial accounts. The stock exchange model, on the other hand, is completely unregulated – it might as well be craigslist – maybe the escrow regulations apply at the most. No centralized party holds the accounts on behalf of customers. The third category is also a money transmitter, but if they do not receive fiat they may have much lower costs.

Securities and Assets

In the financial services world, cryptocurrency market-makers are not exchanges nor broker-dealers, they are vendors. Despite the terminology, they are not regulated by the SEC as broker-dealers. The SEC’s rules only apply to securities, which are distinct from assets. When you own crypto, even if you hold it in a centralized account, you own the property directly. Securities, on the other hand, are legal artifices created for more complex forms of ownership. They are always defined by contractual obligations. As the State of Texas articulated:

A unit of cryptocurrency is also not a claim. It does not entitle its owner to anything, and creates no duties or obligations in a person who gives, sells, or transfers it. There is no entity that must honor the value of a cryptocurrency, or exchange any given unit of a cryptocurrency for sovereign currency. For comparison, under federal law U.S. coin and paper currency must be honored for payment of all debts, public charges, taxes, and dues, and the U.S. Treasury Department must redeem it for “lawful money.” But the owner of a unit of a cryptocurrency has no right or guaranteed ability to convert that unit to sovereign currency. The only way to convert a unit of cryptocurrency to sovereign currency is to find a willing buyer.

This statement was made in conjunction with distinguishing cryptocurrency from money, but the same concepts apply to distinguishing it from securities. The rationale excludes both Localbitcoins and Cryptsy from traditional exchange law. The CFTC again only applies to securitized commodities – futures contracts and other derivatives. The SEC’s exchange regulation powers only apply to securities, of course. Collecting bid and ask prices for cryptocurrencies could be defined as a barter exchange, but does not properly fall under any of the financial services exchange categories.

Financial services, after all, are more than just pricing mechanisms, but creating and transferring legal abstractions.

Tax?

Incidentally, barter exchanges have 1099-B filing requirements if they hold custody (like Cryptsy but not Localbitcoins). Those filings only apply if there is capital gain, however. Cryptsy could argue they do not have 1099-B filing requirements on the basis that transactions of similar property qualify for delayed taxation under Section 1031. Section 1031 barter exchanges have existed in other forms, as well – real estate can be found listed on websites designed to provide like-kind real estate markets (e.g.).

Watch Out

Having said all of this, New York has raised a red flag suggesting this may change. New York now regulates “virtual currency exchanges” (undefined, may include Coinbase, Cryptsy, and/or Localbitcoins versions) as investment companies. We’ll have to see what they mean by that, but it is likely they intend to treat the customers as holders of deposit accounts at a non-commercial bank institution. That would mean less state regulations, and also (as described above) exemption from federal regulation (unless they voluntarily elect to use FDIC insurance)