Blockchain-based platforms promise to improve the way the commodity trading and the supply chain industry operates by addressing inefficiencies and issues of trust with complex transactions typically involving multiple parties. Blockchain’s ability to transparently record complicated transactions, track goods, and reduce fraud makes it desirable for industry-wide adoption.
Initial coin offerings (ICOs) allow companies to transform the ownership of assets or other rights into blockchain-enabled digital, tradable tokens. These are frequently sold upfront to finance investments.
ICOs, however, have their share of drawbacks. One of the big ones is the issue of regulation. For instance, companies located in countries subject to international sanctions can use ICOs to work around restrictions and tap into international funding. This does not make regulators happy.
Yet creating and operating systems that recognize both tokens and conventional currencies in order to settle trades will be expensive and complex. Also, ICOs still need to prove they are a cheaper and better choice than other funding options for large industrial-scale commodity projects.
The relationship between regulators and ICOs is—not surprisingly—tense. On the one hand, the very spirit of ICOs is anti-regulation, separate from asset-based securities and commodities, an independent valuation that has nothing to do with traditional, centralized currencies (at least in its incipient form). On the other hand, many see regulation as not only inevitable, but desirable. Regulation will give recognition and, among other things, credibility.
This past Tuesday, a New York federal judge addressed the issue. The ruling from U.S. District Judge Raymond Dearie in Brooklyn allows federal prosecutors to pursue their case against Maksim Zaslavskiy. The Brooklyn resident was arrested in November on charges that he defrauded investors in two cryptocurrencies, violating the federal Securities Exchange Act.
Prosecutors said that Zaslavskiy last year raised at least $300,000 from investors in a cryptocurrency called REcoin, which he claimed was backed by real estate, and another called Diamond, which he claimed was backed by diamonds. No real estate or diamonds was backed by the virtual currencies, according to the prosecution.
In March, Zaslavskiy’s lawyers asked Dearie to dismiss the charges, arguing that REcoin and Diamond were currencies, not securities, and therefore not covered by the Securities Exchange Act. That argument was rejected by Dearie who said there is more flexibility in regulatory interpretation. Therefore, U.S. securities laws can be applied to fraud cases involving cryptocurrency offerings.
Thus, we may have seen one of the most important legal decisions in the short life of cryptocurrencies. “That is a first,” says Ian King, senior analyst for Banyan Hill Research. King uncovers companies ripe for innovation in this sector and investigates new uses for blockchain technology.
“In this particular case, the judge ruled that cryptocurrency ICOs should be regulated as securities. For this ICO, the defendant claimed that the cryptocurrency offering was backed by real estate and diamonds. In other words, you were buying something that represented ownership in a real world asset,” King writes to FreightWaves.
Cryptocurrencies can be separated into two classes: utility tokens and securities tokens. The latter comprises issuances such as the one in the court case, a token that represents something else of value.
Utility tokens, on the other hand, can be redeemed for something of digital value. There are cryptocurrencies that represent cloud storage or network bandwidth. The SEC head Jay Clayton has likened them to tokens at a laundromat.
The result of the ruling now incorporates the Howey test. The Howey test is what regulators have used to determine whether or not something is a security. These questions boil down to two points:
1. Does the token have value primarily as an investment or as a useful item?
2. Is there a single issuer backing up that value or is the value resulting from a network of unaffiliated participants in an industry and market?
“In this case, it is clear that cryptocurrency was issued as a security, but the jury is still out on the utility token asset class,” writes King.
Regulation of virtual currencies is still in its early stages, and Congress has not passed any laws addressing it directly.
In March, another federal judge in Brooklyn ruled that cryptocurrencies could be regulated as commodities by the U.S. Commodity Futures Trading Commission.