Truly, it was a tale of two cities.
On February 6, 2018, the U.S. Senate Banking Committee held a hearing on the oversight role of the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) in respect of virtual currencies like Bitcoin and Initial Coin Offerings (ICOs). The SEC views ICOs as being similar in nature to the securities it traditionally polices, while the CFTC sees markets for virtual currencies like Bitcoin as commodities subject to certain forms of its jurisdiction.
Although the basic categorization scheme is clear (ICO = SEC; virtual currency = CFTC), detailed practical criteria for distinguishing between what products fall into which category was not discussed in the hearing. The general rule for differentiating a commodity from a security is that substance prevails over form in the analysis, and so, according to Chairman Clayton “simply calling something a ‟currencyˮ or a currency-based product does not mean that it is not a security.”
A Tale of Two Cities
Based on their testimony at the hearing, one fact became quickly apparent: SEC Chairman Clayton views ICO regulation through a very different lens compared to that through which CFTC Chairman Giancarlo views the regulation of virtual currency – hence, the “tale of two cities” reference above.
To the extent these deep philosophical differences among agency heads shape – or are reflective of an internal consensus regarding – policy at their respective institutions, they will likely have major consequences for the markets in which these different products are traded.
1. Intrinsic Value
No question surrounding Bitcoin is as divisive as the question of whether Bitcoin has any intrinsic value at all – is it effectively worthless, or does it have a minimum value higher than zero?
For the leaders of the SEC and CFTC, differing perceptions of intrinsic value arguably affect their assessment of whether Bitcoin as a whole is a fundamentally positive, or a fundamentally pernicious, phenomenon – and thus, whether it should be regulated with a light or a heavy touch. The question was posed by Senator Richard Shelby, who asserted that;
“these cryptocurrencies lack intrinsic value… I don’t know where the bottom [value] is,” then asked for comment. Chairman Clayton basically agreed, stating, “a lot of smart people think there is some value for cryptocurrency, [based on] international exchange… I’m not seeing those benefits manifesting themselves in the market yet.”
However, Chairman Giancarlo disagreed, pointing out that “some economists posit that there is a relationship between Bitcoin value and the difficulty, or cost, of mining… there is some sort of floor, the level set is not zero.”
Not surprisingly, these different value judgments regarding whether Bitcoin is an essentially worthless fad, or not, arguably reflect themselves in differing assessments of how heavy-handed the regulation of digital assets needs to be, as will be discussed below.
SEC Chairman Clayton is of the view that ICOs are nothing new under the sun. In general, he believes tokens issued in ICOs constitute securities under the existing federal securities laws and do not require Congress to grant new powers to the SEC via new legislation because the agency already possesses the authority to regulate them under existing law. Most ICOs are. Chairman Clayton’s remarks, taken as a whole, suggest that he considers the use of blockchain technology in ICOs to be a case of “old wine in new bottles” – in other words, a cosmetic change involving novel facts which does not affect the legal substance of an ICO transaction, which is typically an issuance of securities.
Chairman Clayton’s testimony demonstrates that he does not view ICOs as being a fundamentally new phenomenon not captured by existing law, and conveys his visceral displeasure and frustration at the way that market participants and certain so-called “gatekeepers” such as securities lawyers and accountants have frequently reached contrary (mistaken, in his view) conclusions on this question:
“Some say… the law is not clear.I do not buy that for a moment… [E]very ICO I have seen is a security.”
Thus, for SEC Chairman Clayton, the typical ICO is a securities offering. And because no ICO has ever registered with the SEC, the implication is that the typical ICO is illegal under the federal securities laws (unless a registration exemption applies, which would require marketing restrictions that ICOs to date frequently have not observed). Thus, the failure to register by itself would be an avenue to pursue enforcement actions and impose liability for registration failures against the entrepreneurs or sponsors responsible for launching the ICO – affirmative fraud would not be necessary.
Indeed, this is arguably the lesson of the SEC’s Munchee enforcement action in December 2017 – despite the absence of fraud, the SEC halted the ICO because of its failure to register with the SEC. And such a registration failure could also result in liability for intermediaries who facilitate an ICO but fail to themselves register with, and be supervised by, the SEC as securities exchanges or broker-dealers.
Given the universality of Chairman Clayton’s stance, that virtually all ICOs to date have likely been conducted illegally, Senator Mark Warner actually asked about whether the SEC intends to disturb the finality of ICOs that have already been completed:
“certain ICOs, the SEC has not stopped, others they have stopped… [a]re you going to go back and review the ones that have already gone forward?”
Chairman Clayton effectively dodged the question, saying he counted on “gatekeepers” to do their job, but did not address whether he intends to pursue enforcement action against already-completed ICOs.
By contrast, CFTC Chairman Giancarlo’s approach appears both philosophically and practically very different from that taken by SEC Chairman Clayton, in three major ways.
First, on a philosophical level, Chairman Giancarlo – unlike Chairman Clayton – believes virtual currencies like Bitcoin, which are CFTC-jurisdictional commodities, constitute a fundamentally new asset class. Unlike ICOs, Bitcoin and other virtual currencies are not simply “old wine in new bottles.” Instead, they are, as Chairman Giancarlo remarked previously, “a commodity unlike any the Commission has dealt with in the past,” and as such a genuinely new phenomenon (not just cosmetically so, but substantively).
The second major difference between CFTC Chairman Giancarlo and SEC Chairman Clayton is the perceived need for “new thinking” – and new law. Chairman Giancarlo is of the opinion that – because Bitcoin and other virtual currencies are a genuinely new economic and financial phenomenon – such virtual currencies’ characteristics are not captured by, and not subject to, existing law, given that existing law was not designed with their unique properties in mind, and that this jurisdictional deficit applies not just to the CFTC but to all federal regulatory agencies.
Chairman Giancarlo’s message is clear: a change in the laws is needed for the CFTC to able to comprehensively regulate the Bitcoin spot market (in which trades are for prompt delivery) the same way that it regulates the Bitcoin derivatives market (in which trades are made for future delivery or may never result in physical delivery, settling instead by cash or netting).
In derivatives markets, the CFTC can impose liability on entities for, among other things, failing to register or to obey extensive business conduct requirements. But in spot markets, it basically is restricted to policing fraud and manipulation. This affects the types of enforcement actions the CFTC can bring. And perhaps the most consequential implication of this view is its implicit recognition that such markets are not presently illegal under existing laws – if new laws are required to regulate them, then applicable laws currently in effect could not declare them wholly illegal.
Chairman Giancarlo’s third major point of departure from Chairman Clayton is arguably his basic belief that the optimal regulatory regime for spot markets for virtual currencies like Bitcoin is one involving the lightest possible regulatory touch, with a view towards avoiding stifling the developing markets for digital assets through excessive regulation.
Unlike Chairman Clayton’s preference for declaring virtually the entire ICO market illegal and his apparent focus on policing registration and marketing violations wherever occurring, even in the absence of fraud, Chairman Giancarlo believes that a lighter touch approach is appropriate (though with enhanced protections for retail investors) for blockchain-based assets, drawing a positive parallel with the laissez faire attitude adopted by the Clinton administration and a Republican-controlled Congress during the birth of the Internet:
“Do no harm” was unquestionably the right approach to development of the Internet. Similarly, I believe that “do no harm” is the right overarching approach for distributed ledger technology.
The next step from here will be an inter-agency conferral between the SEC, CFTC, Federal Reserve, Treasury, Internal Revenue Service, and state banking regulators, among others, to identify gaps in their respective statutory frameworks and whether new legislation is needed. Chairmen Clayton and Giancarlo promised they would report back to Congress with the results of such conferral, and we expect potential legislative action to ensue at that future time.
David Felsenthal is a partner at Clifford Chance, resident in the firm’s New York office. His practice focuses on trading, structured transactions, fintech and financial regulation. He has worked extensively on a range of derivatives – including derivatives linked to credit, foreign exchange, interest rates and equities – and other financial transactions, such as structured securities, repos and securities lending. His fintech experience involves blockchain, shared ledgers and regTech.
Jesse Overall is an associate at Clifford Chance. He represents issuers and underwriters in public and private initial and follow-on offerings of equity and debt securities, banks and hedge funds in secondary market par and distressed debt trading, and sponsors of and liquidity providers to securitization vehicles in connection with transactions and regulation applicable to their activities. While in law school at Georgetown, Jesse served as a two-semester intern at the CFTC, in the Divisions of Swap Dealer and Intermediary Oversight and Enforcement, and as a two-semester intern at the SEC, in the Division of Corporation Finance and in the Office of International Affairs.