Blockchain, Cryptocurrencies and ICOs: The Emerging Regulatory Framework
Blockchain technology, initially conceptualized by the renowned Satoshi Nakamoto, basically refers to a time-sequenced and continuously growing list of data records. The blocks in the structure hold the address of the transactions made as well as the previous block; whereas the blockchain expression represents a register, a "ledger", where an unalterable list of these operations is kept.
With regards to the implementation of the technology, the blockchain containing all operations is held by systems called "miners"1. The consensus protocol is used to select the node that will form the block. With this protocol, a miner node is selected, and the new block is added to the blockchain. The blocks are linked with hash values; a general hash value is generated from the hash value in the previous blocks, enabling the summary of the previous block to also be stored.
By way of using these hash functions actively, it is possible for each block to retain the validation of the previous block; whereas any alteration to an operation in the system structure requires calculation of all the blocks in the chain.
In this regard blockchain technology, which establishes a transparent, decentralized and distributed data recording structure, replaces many financial functions such as the creation of cryptographic currencies; and making fast, cost-free and secure transactions with such currencies, as well as being used in a transparent and secure manner for voting in elections; proving that a certain document exists at a certain time; managing supply chains, buying, selling and transferring digital media products in legitimate formats.
Since 2009, the year in which Bitcoin began operating, the cryptocurrencies industry has witnessed the emergence of hundreds of different cryptocurrencies, through the alteration of the Bitcoin protocol that is open source and non-permissioned.
A cryptocurrency can be construed as a digital token within a specific cryptocurrency system, the governing rules for which is specified and enforced by all nodes. Some of these cryptocurrencies adopt the concepts of Bitcoin2, some on the other hand, offer significant functions with a level of innovation, and the uses cases of cryptocurrencies differ accordingly.
In this respect, the use cases of cryptocurrencies can be grouped under the following categories:
From a regulatory perspective; considering the above-mentioned use cases, cryptocurrencies have been divided into two significant token classes; which are (i) "security token" and (ii) "utility token" (generally referred to as app tokens). Since there is no specific definition under the laws on the distinction between the token classes, the U.S. Securities and Exchange Commission ("SEC") utilizes a pre-determined standard, the "Howey test", to conclude whether a cryptocurrency qualifies as a security. The Howey Test is in fact a three-factor standard for an investment contract, a contract in which (i) a person invests in a common enterprise, (ii) with a reasonable expectation of profits, (iii) to be derived from entrepreneurial or managerial efforts of others.3Additionally, SEC emphasizes the importance of a case-by-case evaluation of the cryptocurrencies and the projects in question in order to accurately determine the qualification of the relevant cryptocurrencies.
An ICO can be construed as an initial distribution model for cryptocurrency tokens, through which cryptocurrency tokens are sold in exchange for fiat currency, in order to fund the relevant new cryptocurrency project. ICO is a similar method of crowdfunding cryptocurrency projects, in which participants invest upon a potential profit, being the increase in the value of the relevant cryptocurrency token. To date, an ICO has become a widespread fundraising option for entrepreneurial technology initiatives, due to the fact that ICOs minimize transaction costs, dis-intermediate financial institutions and circumvent regulatory compliance. ICO projects collectively raised more than $5.6 billion in 2017 and additional $5.8 billion in Q1 - Q2 2018.4
A majority of prominent ICOs pursue a structured time sequence, in other words a roadmap. The founders announce the underlying project, followed by an executive summary presenting the project to investors, in turn a whitepaper providing detailed information on how the project is drafted, then a preliminary offer is made to certain investors. Upon the signing of the relevant offer the launch of the ICO is announced and subsequently, following the conclusion of the initial phase the ICO is launched.5
Smart contracts are in fact automated programs that encode traditional ways of contracting. Simply, the terms and conditions of a contract between parties are executed by computer protocols. The notion of smart contracts was first conceptualized by Nick Szabo, as "a set of promises, specified in digital form, including protocols within which the parties perform on these promises". The automated and self-executing aspects of smart contracts stem from the encoding of the terms and conditions of an agreement and enabling the code underlying the system to respond to predefined messages, transactions and conditions.
The blockchain technology subsequently allowed the transactional logic behind smart contracts to be imbedded in the distributed ledger architecture. By way of providing more powerful platforms and programming languages (i.e. Ethereum's Solidity), the complexity of smart contracts increased exponentially, alongside with a broad array of use cases. A smart contract can rely on another smart contract encoded specifically for calculating an external independent source of data (i.e. a financial derivative)6.
One of the prominent use cases of blockchain-based smart contracts was the concept of Decentralized Autonomous Organization ("DAO"). Maciej Ołpiński7, regards DAO as a collective definition for various types of economic networks that operate along the same lines as Bitcoin, not necessarily operating for the purpose of creating a new cryptocurrency, but rather investment platforms, prediction markets, virtual worlds and social networks.8 However the fact that an early experiment of these economic networks, the DAO, ended in a dramatic downfall9, raised a growing number of concerns with regards to the legal issues facing smart contract implementations. Such considerations are mainly focussed on the legal status of smart contracts based on the general provisions of contract law, consumer protection, commercial law, and data protection.
From a regulatory perspective, determining the appropriate regulatory model to which such contracts shall be subject is difficult to handle taking into account that the automated, code-based enforcement functionality of smart contracts inevitably restricts the contracting parties' ability to negotiate on the terms and conditions of the agreements, as well as disregarding the social complexities arising in the conclusion of an agreement.
Although the majority of governments do not have a law or regulation comprehensively governing the products, services and transactions relating to the aforementioned concepts; many regulatory authorities and competent agencies worldwide are actively exploring and evaluating the opportunities as well as the risks that the use cases of blockchain and other distributed ledger technologies entail.
The regulatory trend towards blockchain technology, cryptocurrencies and ICOs differ in jurisdictions. With regards to cryptocurrencies and ICOs, certain existing sectoral regulations such as consumer protection, anti-money laundering and anti-terrorist financing have legal grounds for application, yet their legal status substantially vary and remains undefined.
For instance, in the United States, cryptocurrencies such as bitcoin are considered as falling within the scope of a separate category called exempt commodities under the U.S. Commodities Exchange Act. Therefore, The U.S. Commodity Futures Trading Commission ("CFTC") can exercise anti-fraud and anti-manipulation authority over virtual currency transactions and futures and options contracts and swap transactions are subject to comprehensive regulatory oversight by the CFTC.10
The U.S. Bank Secrecy Act requires money transmitters to register with Financial Crimes Enforcement Network and money transmitters may also be required to obtain a license from competent authorities, depending on the federal regulation of the state in which the company operates. Accordingly, the New York State Department of Financial Services started offering a "BitLicense" for companies that store, hold, or maintain custody of or control virtual currency for others, buy and sell virtual currency, act as an exchange, or control, administer or issue a virtual currency11.
With respect to ICOs, SEC has issued guidelines for consumers in order to make investors aware of potential risks of participating in ICOs12. Since, SEC has jurisdiction over ICOs when they are sold to U.S. citizens, a set of rules were set forth in order to determine whether an ICO shall be considered as a tradeable security or not. As also stated above, SEC underlined that if a crypto-asset issued by a company increases in value over time depending on the performance of the company, it shall be considered a security. If that is the case, the relevant ICO shall be subject to all the same regulations as public stocks, and they must be registered with the Federal Trade Commission.
The idea of creating a Bitcoin Exchange-Traded Fund ("ETF") has also emerged as a result of the tendency to buy Bitcoin without investing directly in cryptocurrencies. ETFs function as an investment fund in which investors can track the price of certain assets such as gold, silver, oil and natural gas. A Bitcoin ETF can be construed as an ETF where the underlying asset is Bitcoin, and which therefore tracks the real-time price of Bitcoin. However, SEC rejected several proposals13 for a Bitcoin ETF, due to concerns orbiting around market manipulation and fraud. SEC further determined that ETFs lacked surveillance sharing agreements in place enabling SEC to monitor and prevent potential price manipulations in Bitcoin markets.14 On the 22nd of August SEC rejected another proposed ETF, which was to be based on Bitcoin future contracts due to the fact that the proposal was inconsistent with the requirement that a national securities exchange's rules be designed to prevent fraudulent and manipulative acts and practices15, in particular. Taking the potential entry of institutional money and retail investors in the Bitcoin markets, the SEC may adopt a more positive approach with respect to the CBOE EFT proposal, which is extended to be decided upon by 30 September 201816.
Russia on the other hand, finalized and published the Draft Law on Digital Financial Assets (hereinafter referred to as the "Draft Law"), regulating the relations arising in the creation, issuance, storage and circulation of digital financial assets, as well as the exercise of rights and performance of obligations under smart contracts. As per the Draft Law, cryptocurrency is construed as "a type of digital financial asset created and accounted for in the distributed registry of digital transactions by participants in this registry in accordance with the rules of maintaining the registry of digital transactions." the purview of the Draft Law, a token is defined as "a type of a digital financial asset that is issued by a legal entity or an individual entrepreneur, an issuer, in order to attract financing and is recorded in the registry of digital records" and specific principles and procedures are determined with regards to ICOs. The Draft Law further states that an offer for the release of tokens, an investment memorandum, rules for keeping the register of digital transactions, as well as other documents must be disclosed prior to the sales. The Draft Law also prohibits the offering of tokens to potential purchasers in any form or by any means using advertising.
Despite the user-generated excitement around cryptocurrencies, as well as the growing interest in the underlying blockchain technology; the Turkish government preferred to adopt a distanced approach. However, the uncertainty on the legal status of the main key concepts, restrict the financial and technology-enabling actors' ability to experience the implementations and potential use cases of the blockchain technology.
Alongside with the growing interest on Bitcoin, the Banking Regulation and Supervision Agency ("BRSA") issued a press release17 determining that Bitcoin shall not be considered as falling within the scope of the Law on Payment and Securities Reconciliation Systems, Payment Services and Electronic Money Institutions, numbered 6493 (the "Law numbered 6493") and therefore shall not be subject to the surveillance and supervision of the BRSA, due to the fact that there are "no guarantees for its collateral and that is not issued by an official or private institution". In its press release the BRSA further emphasized the volatility of Bitcoin's market value the risks arising in connection with operational errors and illegal use.
Within the purview of the Law numbered 6493, it could be there is no restrictive provision for payment services to intermediate in the transfer in the transfer of the values arising from the purchase and sale of cryptocurrencies.
With the emerging regulatory considerations, a research report Crypto-Currency Bitcoin was published by the research department of the Capital Markets Board of Turkey ("CMB") in December 2016. The report provided for an initial handling of many key concepts including the blockchain technology, ICOs, bitcoin transactions, bitcoin mining, bitcoin network as well as bitcoin exchanges and altcoins.
Within the purview of the report, the legal status of cryptocurrencies and ICOs remained unclear. However, it shall be deemed that the CMB is authorised to determine the legal tender status of cryptocurrencies. Pursuant to Article 5(1) of the Capital Markets Law, numbered 636218 the CMB is authorised to determine the procedures and principles to which capital market instruments to be offered to the public or to be traded on the exchange. Capital market instruments, on the other hand, are construed as securities and derivative instruments as well as other capital market instruments designated in this context by the CMB, including investment contracts.
Since there is no specific definition under the Turkish laws, it is of great importance to determine the legal status of cryptocurrencies in consideration of the use cases in question in order to make a precise statement on the applicable regulation. In line with the consideration of cryptocurrencies as a commodity, there may be storage solutions for virtual solutions, also introducing a non-networked defence mechanism for thefts by way of hackings19.
ICOs on the other hand, shall inevitably be subject to further regulatory concerns as regards the legal status, varying and differing as securities, commodities and specified investment contracts upon the evaluation of the relevant use cases.
Nevertheless, it is indispensable that cryptocurrencies, ICOs and cryptocurrency exchanges are gaining legitimacy in a number of jurisdictions.
1 It should be noted that the term refers to the Proof-of-work concept, initially introducing as the blockchain consensus protocol in the Bitcoin Whitepaper, yet different protocols can be determined for different types of blockchains.
2 In Satoshi Nakamoto's whitepaper, Bitcoin was initially conceptualized as a P2P cash system, a store of value and a medium of exchange. However, now Bitcoin is deemed as an asset class.
3 Memorandum from Skadden, Arps, Slate, Meagher & Flom LLP & Affiliates, Heather Cruz et al., SEC Issues
Guidance on Regulation of Initial Coin Offerings (Aug. 1, 2017).
5 Initial Coin Offerings — Emerging Practices, Risk Factors, and Red Flags, by Wulf A. Kaal & Marco Dell'Erba
6 Blockchain 'Smart Contracts' – A New Transactional Framework by Laura E. Jehl and Brian Bartish - Baker & Hostetler LLP.
7 Founder of the Userfeeds.io project, a platform for media applications based on open blockchain protocols,
and also, animator of the Ethereum community in Poland.
8 Blockchain, smart contracts and DAO by Wardyński & Partners.
9 "Hard Fork" Coming to Restore Ethereum Funds to Investors of Hacked DAO by Morgan E. Peck.
10 Global Challenges: Blockchain Solutions, The GBBC 2018 Annual Report by GBBC.
11 Title 23. Department of Financial Services Chapter I. Regulations of The Superintendent of Financial Services, New York State Department of Financial Services, PART 200. VIRTUAL CURRENCIES.
13 SEC disapproved a proposed rule change to list and trade shares issued by the Winklevoss Bitcoin Trust in March 2017. (Exchange Act., Release No. 80206, (March 17, 2017) File No: SR-BatsBZX-2016-30.
14 Exchange Act., Release No. 34-83723, (July 26, 2018); File No: SR-BatsBZX-2016-30.
15 Exchange Act., Release No. 34-83904 (August 22, 2018); File No. SR-NYSEArca-2017-139.
16 Exchange Act., Release No. 34-83792 (August 7, 2018); File No. SR-CboeBZX-2018-040.
17 Press Release numbered 2013/32 (English version available here).
18 Published in the Official Gazette numbered 28513, dated 30 December 2012.