Investment Vehicles Investing in Digital Asset Securities

The SEC November 2018 statement also set out the SEC’s views on funds that invest in digital asset securities, stating that funds investing in crypto assets that are securities must be registered under the Investment Company Act and that the managers of the investment vehicles must observe the registration, regulatory and fiduciary obligations under the Investment Advisers Act.[78] The first “crypto fund” to register was the Arca US Treasury Fund in July 2020, a fund which invests in short-term treasury securities, with investors holding their shares in ArCoins, an ERC-1404 token.[79]

This approach is broadly comparable to Hong Kong’s approach where managers of funds investing 10% or more of their GAV in virtual assets are required to be registered for Type 9, however unlike the US, this applies whether or not the virtual assets are securities or futures contracts. Licensing requirements also apply to the distributors of virtual asset funds which require a Type 1 licence.

Trading Digital Asset Securities

The SEC statement also addressed the trading of digital asset securities, outlining that a trading platform which offers trading of crypto assets which are “securities” and operates as an “exchange” as defined under federal securities laws must be registered with the SEC as a national securities exchange or be exempt from registration. An exemption is available for an alternative trading system which is registered with the SEC as a broker-dealer and becomes a member of a self-regulatory organisation such as the Financial Industry Regulatory Authority (FINRA). FINRA has reportedly only approved a few of the many crypto broker-dealer applications it has received. This is comparable to Hong Kong’s current approach, with the SFC licensing exchanges which trade at least one security token.

Crypto trading platforms are also regulated by other agencies at both federal and state levels, for example a crypto exchange may be subject to regulation by the CFTC if it permits certain regulated commodities transactions or swaps in crypto-assets. FinCEN also requires businesses involved in buying cryptocurrency from or selling it to customers or transferring cryptocurrency on behalf of customers to register with FinCEN as money services businesses.[80]

The latest statement from the SEC came on 23 December 2020 when a statement was issued regarding the custody of digital asset securities by broker-dealers and compliance with Rule 15c3-3 (the Customer Protection Rule).[81] The SEC has long questioned whether digital asset custodians can effectively comply with the Customer Protection Rule and broker-dealer custody was therefore prohibited.[82] The statement is therefore a huge breakthrough as it provides a path for crypto-focused broker-dealers (operating in certain circumstances) to operate free from a possible SEC enforcement action on the basis that the broker-dealer deems itself to have obtained and maintained physical possession or control of customer fully paid and excess margin digital asset securities. The statement is effective for a period of five years while the SEC determines how best to regulate this area.

Crypto Wallets

New rules for crypto wallets were proposed by the FinCEN on 18 December 2020). Following President Biden taking office in mid-January, the proposals were frozen (effected by a general freeze placed on all FinCEN rule making pending review). It is understood that the freeze is not so much aimed at halting the substance of the rules but ensuring that Biden’s appointees have sufficient time to review the rules, with the freeze being effective for at least 60 days from 20 January 2021. The crypto market does however seem optimistic about a clear regulatory framework under the newly elected president.

The new rules are aimed at addressing AML “gaps” in digital asset transactions by imposing obligations on Virtual Asset Service Providers (VASPs). VASPs would be required to record the name and address of wallet owners in the case of deposits and withdrawals exceeding US$3,000 where a non-custodial wallet is involved and VASPs would be required to report any deposit or withdrawal greater than US$10,000 to FinCEN through a currency transaction report (CTR). This would broaden the current AML regime, which only sees record-keeping and reporting requirements imposed on VASP-to-VASP transactions. While different in scope, the focus on tightening AML regulation is also in focus in Hong Kong, which has recently proposed amendments to the AMLO to subject virtual asset exchanges which are not licensed under the SFO to the AML requirements in Schedule 2 of the AMLO.

Criticisms have been voiced by various parties, including eight congress members who sent a letter to the US Treasury Secretary expressing their concerns. It has been argued that VASPs will face practical difficulties obtaining the required information and that it will adversely impact the effectiveness of existing AML regulation,[83] or may simply not tackle the very risks they are seeking to tackle. For example, the new rules may easily be evaded by breaking transactions up into smaller amounts.[84] Others went so far as to suggest that the proposed rules would put a brake on development of the industry in the US completely.[85]

This proposal goes further than the FATF Travel Rule (which we discussed in an earlier webinar) which imposes requirements in relation to the collection, disclosure and transfer of beneficiary information when a VASP is transacting with another VASP.

• https://www.sec.gov/news/public-statement/digital-asset-securites-issuuance-and-trading
• https://www.theblockcrypto.com/post/70460/arca-sec-registration-ethereum-digital-share
• https://www.nortonrosefulbright.com/en-us/knowledge/publications/e383ade6/cryptocurrency-exchanges-and-custody-providers-international-regulatory-developments#section11
• https://www.sec.gov/news/press-release/2020-340
• https://www.clearygottlieb.com/news-and-insights/publication-listing/sec-issues-statement-and-request-for-comment-regarding-broker-dealer-custody
• https://www.coindesk.com/fincen-rule-crypto-wallets-could-be-ineffective-says-elliptic
• https://www.cpomagazine.com/data-privacy/proposed-new-fincen-rules-for-crypto-wallets-raise-privacy-concerns-larger-transactions-would-no-longer-be-anonymous/
• https://en.cryptonomist.ch/2021/01/21/joe-biden-freezes-regulation-of-crypto-wallets/

SEC Statement on “Framework for ‘Investment Contract’ Analysis of Digital Assets

As outlined above, there were a number of SEC enforcement actions involving ICOs which were found to be public offerings of securities conducted in breach of the US Securities Act 1933 since they were neither registered with the SFC nor able to rely on an exemption from the registration requirement. In April 2019, the SEC then issued a Statement on “Framework for ‘Investment Contract’ Analysis of Digital Assets providing guidance on when the offering and sale of a virtual asset will be considered to be an investment contract, and therefore a security. The framework applies the Howey Test (a test to determine whether certain transactions are “investment contracts”) which focuses not only on the form and terms of the virtual asset, but also the surrounding circumstances and the manner of offering, selling and reselling. This is similar to the approach in Hong Kong, where the regulatory treatment of ICOs is also determined on a case-by-case basis depending on an analysis of whether cryptocurrencies are regarded as securities under the SFO. However the issue of whether a cryptocurrency is a “security” has not yet come before the Hong Kong courts.

The most problematic of the Howey test’s three requirements is usually the “reasonable expectation of profits derived from the efforts of others” prong. This gives rise to three main inquiries.

• whether (a) a purchaser relies on the efforts of others, in particular the efforts of an active participant (AP) such as a promoter or other third party; and (b) whether those efforts are “undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise”.

Where the following factors are present, the more likely it is that a virtual asset purchaser relies on the efforts of others:

• the active participant is responsible for the development, improvement or enhancement, operation, or promotion of the network. If the network or virtual asset is still in development or not fully functional at the time of the offer or sale, purchasers would reasonably expect an active participant to further develop the functionality of the network or virtual asset;

• essential tasks or responsibilities will be performed or are expected to be performed by an active participant;

• the active participant supports or creates a market for, or the price of, the virtual asset;

• the active participant plays a leading or central role in decision making or judgement exercising concerning the network or characteristics or rights of the virtual assets;

• purchasers reasonably expect the active participant to undertake efforts to promote its own interests and enhance the value of the network or virtual asset.

• reasonable expectation of profits – profits can include capital appreciation resulting from the development of the initial investment or business enterprise or a participation in earnings resulting from the use of purchasers’ funds.

Examples of characteristics giving rise to a reasonable expectation of profits include (among others):

• rights for holders of the virtual asset to share in the enterprise’s income or profit or to realise gain from capital appreciation of the virtual asset;

• the opportunity may result from appreciation in the value of the virtual asset that comes, at least partly, from the operation, improvement or other positive developments in the network, particularly if there is a secondary market that enables virtual asset holders to realise a gain on reselling their virtual assets;

• present or future transferability or tradability of the virtual asset on a secondary market or platform;

• purchasers’ reasonable expectation that an active participant’s efforts will lead to the virtual asset’s capital appreciation and the realisation of a return;

• the virtual asset is offered broadly to potential purchasers rather than being targeted at expected users of the goods or services or those with a need for the network’s functionality;

• there is little correlation between the virtual asset’s purchase/offering price and the market price of the goods or services that can be acquired in exchange for the virtual asset;

• the virtual asset is marketed in a way that indicates that the virtual asset is an investment or that the holders will be investors or that the proceeds from the sale of the virtual asset will be used to develop the network or virtual asset; and

• marketing the virtual asset in a way that emphasises the potential appreciation in the value of the virtual asset or the potential profitability of the network or the availability of a market for trading the virtual asset, particularly where the active participant promises to create or support a trading market for the virtual asset.

• the transaction’s economic reality and whether the virtual assets are offered and sold for use by the purchaser. The Howey test is unlikely to be met where the following factors are present:

• the distributed ledger network and virtual asset are fully developed and operational;

• the virtual asset can be used immediately for its intended functionality on the network;

• the virtual asset’s design meets the needs of users and does not encourage speculation as to its value or the network’s development;

• the ability of a virtual asset (which is proposed to be a virtual currency) to be used to make payments in different contexts or to act as a substitute for real currency;

• the ability of the virtual asset to be redeemed within a developed network or platform for the goods or services.

Turnkey Jet no action letter

The SEC guidance was released in conjunction with a no-action letter which was sent to Turnkey Jet, Inc. in April 2019 by FinHub’s Chief Legal Advisor agreeing that the tokens used by the business travel start-up were not securities. The reasons given were that (a) the funds raised through token sales would not be used to develop the TKJ Platform, Network or App, all of which would be fully developed and operational by the time the Tokens were sold; (b) the Tokens had an immediate use at the time of the token sale; (c) the Token price was fixed at one USD; (d) the Tokens could only be used for air charter services (e) repurchases would only be made at a discount to the Token price; (e) Turnkey Jet marketed the Tokens in a manner emphasising their functionality rather than potential increase in value; and (f) the Tokens were transferrable only to TKJ wallets and not to wallets outside the network. According to FinHub’s division head, this decision was “easy” to reach as the “the tokens were clearly not intended to be securities”.[86]

The restrictions outlined in the no-action letter mean that it is unlikely to be of benefit to most ICO issues, i.e. those where the funds are used to develop the network and the tokens only have a future use. Another company whose ICO fell foul of US securities laws is ShipChain which was fined US$2.05 million in December 2020 for an ICO conducted in 2017-2018.[87]

In Hong Kong, there have been two statements issued by the SFC relating to STOs (the March 2019 statement on security token offerings) and ICOs (the September 2017 statement on initial coin offerings). However, these are far less detailed than the US SEC’s statement and, except for virtual assets which are essentially digital version of traditional securities (shares, debentures or interests in a fund) provide no real guidance on the circumstances which are likely to make a virtual asset a security. Although the SFC has given general warning statements about ICOs possibly being regarded as securities offerings, it has not specified the particular features which would bring an ICO within the definition of a “security”.

SEC Joint Statement on Activities involving Digital Assets

In October 2019, the U.S. Commodity Futures Trading Commission (the CFTC), the FinCEN and the SEC issued a joint statement to remind persons engaged in activities involving digital assets of their anti-money laundering and counter terrorist financing obligations under the Bank Secrecy Act.

The Bank Secrecy Act (BSA) applies to “financial institutions” such as futures commission merchants and introducing brokers who are required to register with the CFTC; money service businesses as defined by the FinCEN; and broker-dealers and mutual funds obliged to register with the SEC. In the case of financial institutions subject to the BSA, the AML/CFT obligations extend to digital asset activities.

In the US, where a person falls within the definition of a “financial institution,” that person’s AML/CFT obligations under the Bank Secrecy Act will be overseen by either the U.S. CFTC, the FinCEN, or the SEC depending on the activities carried out by the “financial institution.” For example, the AML/CFT activities of a money services business will be overseen by the FinCEN while the AML/CFT activities of a futures commission merchant will be overseen by the Commodity Futures Trading Commission, the Financial Crimes Enforcement Commission and the National Futures Association.

For those who are not regulated (“unregulated individuals and entities”), the digital assets must be carefully analysed in order to assess whether the digital assets are regulated financial assets and whether the digital asset activities would cause them to meet the definition of a financial institution under the BSA (i.e. brokers who do not typically deal with transactions in securities, need to carefully analyse whether the digital assets they transact with are considered securities). The SEC outlined in the joint statement that it is ultimately the facts and circumstances underlying the asset, activity or service, including its economic reality and use, that determines the general categorisation of an asset, the regulatory treatment of the activity and whether the persons involved are financial institutions for the purposes of the Bank Secrecy Act.

Among the AML/CFT obligations which the relevant entities are required to meet is the requirement to establish and implement an effective AML program and record keeping and reporting requirements, including suspicious activity reporting.

The Joint Statement notes that a key factor used to determine whether and how a person must register with the CFTC, FinCEN or the SEC is the nature of the digital asset-related activities that a person engages in. For example, certain “commodity” related activities may trigger registration and other obligations under the Commodity Exchange Act while other activities which involve a “security” may trigger registration and other obligations under the federal securities laws of the U.S.

• https://www.theracetothebottom.org/rttb/2019/8/31/sec-releases-framework-for-investment-contract-analysis-for-cryptocurrencies
• https://blockchain.bakermckenzie.com/2020/12/28/shipchain-is-the-latest-sec-ico-casualty/#page=1

Bitcoin ETFs

To date, the SEC has rejected all cryptocurrency ETF applications,[88] citing concerns relating to market manipulation, price volatility, hacking, and custody.

Bitwise would have been the first ever Bitcoin ETF had it been approved by the SEC. However, early last year, Bitwise Asset Management withdrew its application with the SEC for its proposed Bitcoin ETF. One of the biggest obstacles faced by Bitwise was the problem of market manipulation. Bitwise went to great lengths to address the SEC’s concern over market manipulation arguing that the volume data reported by virtual asset exchanges is inaccurate and actual volume is far lower than reported volume; the nature of bitcoin makes it resistant to manipulation since Bitcoin’s price is set on an open market with a global price and the fractured market provides an obstacle to manipulation to the extent there is no central market. Bitwise also emphasised that concerns regarding custody can be dealt with using Cold Storage which involves the creation of private keys on devices not connected to internet and offline storage – pointing out that none of the Bitcoin hackings involved cold storage and further pointed to the existence of regulated, insured third party custodians. Nonetheless, the SEC rejected Bitwise’s application, although the SEC did say that it was going to review the rejected application. Despite this, Bitwise Asset Management still withdrew its application but stated that they remain committed to developing a bitcoin exchange traded product.[89]

Following the recent price surges in Bitcoin, there has been renewed interest in Bitcoin ETFs. On 30 December 2020, VanEck filed an application with the SEC for the VanEck Bitcoin Trust which would invest in bitcoin.[90] This is Van Eck’s third application to date, with the last proposal being a bitcoin futures ETF.[91] On 22 January 2021, Valkyrie Digital Assets, a crypto subsidiary of Valkyrie Investments, then filed an application with the SEC for a Bitcoin ETF. Valkyrie would trade on NYSE Arca and Xapo would custody the Bitcoin, according to the proposal.[92] While the likelihood of the applications being accepted are unclear, it is evident that the environment is now more favourable given the recent growth in the bitcoin market, increased institutional interest and confirmation from the Office of the Comptroller of Currency in July 2020 that federally chartered banks can provide custody services for crypto assets.[93] Additionally, there has been a change in administration at the SEC and in the White House. Gary Gensler has been nominated as the next SEC chair – Gensler is known to be more “crypto-friendly” – and this has imparted hope with some stating that a US Bitcoin ETF is expected in 2021 if Gensler is confirmed as Chair.[94]

In Hong Kong, while distinct from an ETF, the SFC approved Hong Kong’s first-ever bitcoin index fund (designed for institutional investors) in April 2020.[95] The fund was launched by Arrano Capital, the blockchain arm of Venture Smart Asia, and is aiming for a target first-year size of US$100 million (or Hk$780 million).[96]

Virtual Asset Exchanges

Jurisdictions are now required to apply relevant measures under the FATF Recommendations to virtual assets and VASPs. Recommendation 15 explicitly sets out that countries should ensure VASPs are regulated for AML/CFT purposes, and licensed or registered and subject to effective systems of monitoring to ensure compliance with the FATF Recommendations. This recommendation is aimed at preventing the misuse of virtual assets for ML/TF purposes.

The FATF undertook a review after it issued its new guidelines in June 2019 with respect to crypto currency exchanges. The FATF Report on the US found that the US was largely compliant with the FATF Recommendations, stating that:

• most of the convertible virtual currency exchanges, administrators and other similar entities are regulated in the US as money transmitters or money service businesses under the Bank Secrecy Act and as such, these entities have to implement AML/CFT programmes;

• banks and other persons registered with or regulated by the SEC and CFTC, that engage in transactions denominated in value that substitutes for currency will be subject to the Bank Secrecy Act regulations; and

• money service businesses must register with FinCen and renew every two years. In addition, money service businesses must be licensed at the state level. This position differs from Hong Kong where crypto exchanges will currently only be licensed under the Securities and Futures Ordinance where they trade virtual assets that are “securities” or “futures contracts”. These exchanges are subject to the AML and CFT obligations set out in the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (AMLO). Exchanges which trade virtual assets that are not securities will however be required to be licensed and comply with AML and CFT obligations if the FSTB’s November 2020 proposals for these exchanges to be licensed under the AMLO are implemented. Crypto exchanges cannot be licensed as money service operators in Hong Kong.

Ultimately, the FATF noted that the US has met most of the new criteria of Recommendation 15 and that US authorities understand and are aware of the ML/TF risks relating to virtual assets. It considered that the five classes of VASPs were covered under a combination of various pieces of US legislation. However, the FATF found that the definition of VASP does not explicitly include all VASPs solely incorporated in the US but not performing any activity relating to US persons or having a US nexus.[97] As for Hong Kong, a new licensing regime for virtual assets exchanges has been proposed under the AMLO, a regime which aims to implement FATF recommendation 15 in relation to virtual asset exchanges. However, Hong Kong’s proposals are noticeably narrower than FATF’s requirements as they will not cover other categories of VASPs included in the FATF’s definition, such as businesses which provide crypto custody services without operating a crypto exchange platform.

US State Legislation

There is also regulation at the state level in the US. Each of the US states has its own State securities and financial services regulator and many have adopted regulations in relation to crypto currencies. New York has been the most active in terms of regulation, requiring any person (whether an individual or a company) engaging in Virtual Currency Business Activity to obtain a BitLicense. Virtual Currency Business Activity can fall into one of five types of activities involving New York or New Yorkers:

• receiving virtual currency for transmission or transmitting virtual currency;

• storing, holding, or maintaining custody or control of virtual currency on behalf of others;

• buying and selling virtual currency as a customer business;

• performing exchange services as a customer business; or

• controlling, administering, or issuing a virtual currency.

In the State of New York, virtual currency is defined as: “any type of digital unit that is used as a medium of exchange or a form of digitally stored value” and is “broadly construed to include digital units of exchange that: (i) have a centralised repository or administrator; (ii) are decentralised and have no centralised repository or administrator; or (iii) may be created or obtained by computing or manufacturing effort.”

This definition specifically excludes digital units that (i) are used solely within online gaming platforms, (ii) have no market or application outside of those gaming platforms, (iii) cannot be converted into, or redeemed for, fiat currency or virtual currency and (iv) may or may not be redeemable for real-world goods, services, discounts, or purchases. It further excludes digital units as part of prepaid cards and digital units that can be redeemed for goods, services, discounts, or purchases as part of a customer reward program with the issuer but cannot be converted into, or redeemed for, fiat currency or virtual currency. This is broadly comparable to Hong Kong’s definition of virtual assets.

Licensees are also required to satisfy certain compliance requirements including a minimum capital requirement and anti-money laundering and know-your client obligations. Entities that hold virtual currencies for third parties must hold them on trust with an approved custodian. Depending on their activities, entities holding a Bitlicense may also be required to obtain a New York money transmission licence.

As of 19 June 2020, the State of New York had 25 regulated entities, including Hong Kong-based XAPO Holdings, which was granted a Bitlicense in June 2018.

The Bitlicense has been controversial and a number of crypto businesses left the state citing overly burdensome disclosure requirements and regulatory requirements. This sentiment compares to the current regulatory requirements for the licensing of trading platforms and exchanges in Hong Kong which have also been viewed as excessively burdensome and the first licence for a crypto exchange was only granted in December 2020.

It is also important to note that legislation at the state level in the US differs from state to state which means that businesses with customers in multiple states have to comply with a number of inconsistent, and often burdensome, state money transmission laws. Further, since all virtual assets are treated as currency, the laws potentially apply to all issuers of tokens that have value, and anyone facilitating trading in them.[98]

Proposed Cryptocurrency Act 2020

The Cryptocurrency Act of 2020 was introduced in Congress in March 2020. The aim of the Act is to clarify which federal agencies regulate which type of crypto assets, and to require those agencies to clarify licensing conditions and registration requirements. To date, the only progress is a referral of the bill to the Committee on Financial Services and the Committee on Agriculture.[99] Media reports have suggested that this proposed Act should not be considered a serious legislative attempt as it lacks thorough understanding of the current legislative regime.

The bill defines “crypto-commodity,” “crypto-currency,” and “crypto-security,” proposing that the CFTC be the primary regulator of crypto-commodities, the FinCEN and the Comptroller of the Currency be the regulators of cryptocurrencies, and the SEC be the regulator of crypto-securities and “synthetic stablecoins.” The bill also proposes that FinCEN “shall issue rules to require each crypto-currency (including synthetic stablecoins) to allow for the tracing of transactions in the crypto-currency and persons engaging in such transactions in a manner similar to that required of financial institutions with respect to currency transactions.” Moreover, FinCEN “shall carry out audits of each reserve-backed stablecoin to ensure that each stablecoin is fully backed by currency issued by the United States or a foreign government.”

On the topic of stablecoins, the US President’s Working Group on Financial Markets issued a statement on key regulatory and supervisory issues relating to stablecoins on 23 December 2020 stating that stablecoin arrangements must comply with applicable US legal, regulatory and oversight requirements and emphasising that providers must meet all applicable AML/CFT obligations before products are brought to market.[100] As for the regulation of stablecoins in Hong Kong, they generally fall outside the scope of the SFC’s regulatory ambit, however the FSTB’s proposed definition of virtual assets specifically provides for the inclusion of stablecoins, so provided that the virtual asset business falls under the definition of VASP, the licensing regime will apply.

• https://www.thinkadvisor.com/2021/01/04/skybridge-capital-launches-bitcoin-fund-vaneck-tries-again-for-a-bitcoin-etf/
• https://www.coindesk.com/bitwise-withdraws-bitcoin-etf-application-with-the-sec
• https://www.sec.gov/Archives/edgar/data/1838028/000093041320002664/c100811_s1.htm#c100811_creation1
• https://www.thestreet.com/etffocus/market-intelligence/vaneck-launch-bitcoin-etf-again
• https://decrypt.co/55141/valkyrie-digital-assets-becomes-latest-company-to-file-for-bitcoin-etf
• https://www.thinkadvisor.com/2021/01/04/skybridge-capital-launches-bitcoin-fund-vaneck-tries-again-for-a-bitcoin-etf/
• https://news.bitcoin.com/crypto-etf-race-heats-up-in-2021-valkyrie-bitcoin-trust-files-to-list-shares-on-nyse/
• https://www.coindesk.com/hong-kongs-first-regulator-approved-bitcoin-fund-targets-100m-raise
• https://www.thestandard.com.hk/section-news/section/2/218298/HK-first-approved-crypto-fund-eyes-US$100m
• https://www.fatf-gafi.org/media/fatf/documents/reports/fur/Follow-Up-Report-United-States-March-2020.pdf
• C. R. Goforth. “US Law: Crypto is Money, Property, a Commodity, and a Security, all at the Same Time” available at https://ssrn.com/abstract=3272975.
• https://www.congress.gov/bill/116th-congress/house-bill/6154/all-actions?q=%7B”search”%3A%5B”crypto-currency+act”%5D%7D&r=1&overview=closed&s=2#tabs
• https://home.treasury.gov/system/files/136/PWG-Stablecoin-Statement-12-23-2020-CLEAN.pdf