Cryptocurrencies: Litigation and regulatory risk

Cryptocurrency volatility and consumers

Virtual or cryptocurrencies, which have now expanded far beyond Bitcoin, are a digital representation of monetary value, generally based on a blockchain technology which is not backed by any tangible asset or public authority and are, to date, largely unregulated.

As illustrated by their recent dramatic fluctuation in price (the value of Bitcoin rose 1769% in 2017 and fell 46% from its peak during January 2018), crypto-currencies are a volatile investment. This volatility, and long held concerns about the potential for cryptocurrencies to be used to facilitate money laundering, are now prompting authorities worldwide to consider a crackdown. The potential effect of those steps for those with interests in cryptocurrencies may be significant.

Are cryptocurrency products regulated in the UK?

Cryptocurrencies have to date been largely unregulated. However, this is changing rapidly worldwide in response to concerns over money laundering, increasing levels of consumer involvement and cryptocurrencies’ increasing integration with the mainstream banking sector and broader financial system. Key jurisdictions have begun taking significant action: the Chinese government has outlawed initial coin offerings (ICOs) and bitcoin mining; South Korea has indicated that it is planning to ban cryptocurrency trading entirely; the Securities and Exchange Commission (SEC) Chairman Jay Clayton has repeatedly said that many cryptocurrencies and ICOs fall under US securities law; and US courts have confirmed that cryptocurrencies are commodities and should be regulated by the Commodity Futures Trading Commission. Further, the SEC has many cryptocurrency investigations ongoing. These investigations have predominantly focused on fraudulent behaviour such as that into AriseBank, which, it is alleged, fraudulently claimed to be using an ICO to fund the world’s first “decentralised bank” and misrepresented itself to retail consumers as offering Federal Insurance Deposit Corporation-insured accounts. Regulatory enforcement is however also increasing in respect of perfectly legitimate token issuers where no allegations of fraud have been made. For instance, the SEC’s investigation into restaurant review app Munchee Inc. which concluded that tokens offered were in breach of US securities law. Munchee cooperated with the investigation and avoided a penalty, but was forced to halt its ICO and to refund investors.

In the wake of Davos 2018 there have been increasing indications of a potential appetite for an integrated international approach to regulating crypto products and ICOs. Following a report to be given by the Financial Stability Board this month, the regulation of cryptocurrencies is on the agenda for the G20 summit in Buenos Aries.

The key concern for UK businesses in 2018 will be the potential for forthcoming regulatory and/or enforcement action from the Financial Conduct Authority (FCA). In late 2017 the FCA issued consumer warnings in relation to ICOs and cryptocurrency contracts for difference (crypto-CFDs). The market anticipates that the FCA will follow its international peers and begin taking action in this area soon.

Initial Coin Offerings

An ICO is a digital way of raising funds using a cryptocurrency where the investor, in return for a payment of legal tender or frequently an established cryptocurrency such as Bitcoin or Ether, accepts a proprietary “coin” or “token” related to the specific firm or project raising funds.


Source: www.coinschedule.com/stats

Whilst the FCA has warned that they are “very high-risk, speculative investments”, ICOs are increasingly big business. More than $1bn was raised worldwide in ICOs in January 2018, compared to only $2m in January 2017. This fundraising is increasingly significant in many industries and now surpasses more traditional venture capital as the vehicle of choice for early stage start-up fund raising.

Typically ICOs have been in practice unregulated with the result that fundraisers’ “white papers” (in effect the ICO’s prospectus), have been able to include informal and unsupported claims principally aimed at generating sufficient hype to launch the firm or product.

However it is likely that regulators will now begin taking a stronger approach. The FCA has warned that, while many ICOs will fall outside of the regulated space, some will result in the firms concerned having conducted a regulated activity. In particular, some ICOs feature parallels with Initial Public Offerings, private placements of securities, crowdfunding and collective investment schemes. Some ICO tokens may also constitute transferable securities and therefore may fall within the prospectus regime.

Businesses considering conducting or facilitating an ICO must therefore be mindful of the risk that their activities could amount to regulated activities. Conducting such activities in the absence of authorisation could prompt future enforcement action from the FCA.

Cryptocurrency derivative products

The most popular cryptocurrency-based derivative products are contracts for differences, binary options and futures. Trading in each of these products is regulated by the FCA. As a result firms offering these products must be authorised and supervised by the FCA.

The increasing use of cryptocurrency derivative products by consumers is likely to prompt an increased focus from the FCA which in December 2017 warned that “you should only invest if you are an experienced investor with sophisticated knowledge of financial markets and you fully understand the risks associated with CFDs and cryptocurrencies”. Such action is being mirrored across Europe. The French financial regulator AMF has announced that financial products based on cryptocurrencies will be regulated as derivatives, requiring trading platforms to be authorised and banning online advertising. The European Securities and Markets Authority is currently considering whether to ban crypto-CFDs altogether.

However there is little indication that the blitz of regulatory warnings in the last few months has cooled consumer interest in these products. Various small European, and in particular Swiss, banks are stepping into the space vacated by large banks hostile to cryptocurrencies and are offering consumer products, including bitcoin trackers, and brokerage start-ups are working to make cryptocurrency trading increasingly easily available.

Risk of consumer litigation

The increasing legal risk profile for business involved in cryptocurrencies is not limited to regulation. In 2017 a large number of opt-out class action law suits were filed in the US in respect of allegedly fraudulent ICOs and losses caused by the actions of cryptocurrency exchanges.

The English courts have yet to see litigation relating to disputes over cryptocurrencies. This lag is unsurprising given the greater limitations placed upon class actions, which in general require potential claimants to opt-in to the litigation, and the UK’s less developed ICO market, which is currently concentrated in jurisdictions such as Switzerland and the US. However given the high levels of consumer interest, the obvious potential for significant loss, which could lead to a consumer action being brought by a single or small group of high net worth individuals not reliant on a class action, and the international popularity of the English courts it seems more likely than not that cryptocurrency disputes will come before the English courts in due course.

Implications

Bitcoin and other cryptocurrencies are an increasingly high profile, high growth area of finance. They are, despite regulatory action, likely to continue being integrated into the wider financial system. However those financial institutions and asset managers already involved or intending to become involved must be mindful of the full breadth of the legal risks.

Notwithstanding increasing levels of risk due to the potential for enforcement action by regulators worldwide, regulation in jurisdictions such as the UK is likely to be a good thing for the FinTech sector and the digital asset economy generally. The establishment of recognised and enforced regulatory frameworks and consumer protections will help to support the long term stability of the industry and the elimination of fraudulent practices in some sections of the ICO market. Whilst a number of jurisdictions may take a stricter approach, following comments from the Bank of England, the Prudential Regulatory Authority and Parliament’s Treasury Committee, it seems likely that UK regulators will attempt to strike the right balance between regulation to protect consumers and business and measures which might stifle innovation.