Since the creation of Bitcoin in 2009, cryptocurrency has become a common term used in the investments market. The rise of cryptocurrencies and initial coin offerings, however, has raised questions concerning regulation and investor protection.
Cryptocurrencies
A cryptocurrency is a digital or virtual currency that can be exchanged as an alternative form of payment or for investment purposes. Creation of cryptocurrency units and the cryptocurrency transactions are verified using cryptography. Cryptocurrencies in general are limited entries in a database that may be changed only under specific conditions.
Bitcoin, the first cryptocurrency created, and the most commonly known cryptocurrency, is a digital currency that functions as a peer-to-peer electronic cash system. Transactions are completed through the use of public and private keys for security purposes. There is no controlling authority for the transactions and no servers are involved. A block chain, which is a public ledger of all Bitcoin transactions, is used to monitor transactions and balances. Other types of cryptocurrencies include Ethereum, XRP, Tether, Binance and USD Coin.
A cryptocurrency “token” is a digital asset that can be described in units of value. Bitcoin, for example is a token, where an individual holds X Bitcoin tokens. A token can also be referred to as a “utility token.” Tokens can also represent tickets or coupons for a certain amount of goods or services. For example, a token that allows access to a certain amount of cloud storage is a utility token.
Cryptocurrencies versus NFTs
Unlike cryptocurrencies which rely on blockchain technology and do not depend on financial institutions to verify transactions, NFTs are unique digital assets that are stored on a blockchain, cannot be duplicated or cloned, do not necessarily have a physical manifestation. NFTs represent photos, music, videos, trading cards and other items. Any digital assets such as virtual real estate, original social media posts or even a collectible digital character can be created and purchased as an NFT. NFTs often have some value attached which is set by the creator of the NFT. NFTs are stored on distributed ledger technology (and blockchain is a common ledger technology), which allows NFTs be purchased, sold and managed online. Every NFT transaction on a block chain is publicly recorded on the digital ledger in order to substantiate the owner of the NFT.
Cryptocurrencies and Initial Coin Offerings
The largest trend currently in cryptocurrency is the Initial Coin Offering (“ICO”) by companies, which is the sale of coins of a cryptocurrency or token to raise large amounts of capital. ICOs are often offered to inside investors before the new cryptocurrency hits the market.
Bitcoin can be invested and used as a form of payment to merchants that accept Bitcoin. Bitcoin, and cryptocurrencies in general, however are a high-risk investment as their market value is highly volatile. Bitcoins are not rooted in any material goods and are considered by some economists to be a speculative bubble.
Cryptocurrency as a Security
Whether a cryptocurrency is classified as a “security” by the Securities Exchange Commission (“SEC”) is the central question to the regulation of cryptocurrencies. Currently, cryptocurrency brokerages in the United States must generally register as “money-transmission services”, which are regulated at the state level, not under the Commodity Futures Trading Commission (CFTC) or SEC. The regulatory framework for money transfer services, however, was not designed to regulate cryptocurrency trading platforms that function like securities, commodities and currency exchanges, which are regulated under the CFTC or the SEC.
In late 2017 and early 2018, the CFTC and the SEC filed lawsuits against alleged cryptocurrency scams, launched investigations into ICOs, and forced certain ICOs to close. In February 2018, the SEC issued dozens of subpoenas and information requests to technology companies and advisers involved in the cryptocurrency market.
Numerous cryptocurrency lawsuits have also been filed against cryptocurrency companies by investors. In February 7, 2018, a class action lawsuit was filed against Bitconnect, a U.K.-based cryptocurrency company, alleging Bitconnect implemented a classic Ponzi scheme, violating provisions of the Securities Act and the Securities Exchange Act. The investors seek damages and allege that they were guaranteed monthly return of up to 40% only a month before Bitconnect collapsed, and once the site was shut down, the cryptocurrency lost more than 90% of its value.
In March 2018, the SEC released a public statement stating that many of the platforms for the offering and sale of ICOs provide mechanisms that meet the definition of a “security” under the federal securities laws. A platform that offers trading of digital assets that are securities and operates as an “exchange” as defined in the securities laws, must register with the SEC (as a national securities exchange) or be exempt from registration.
NFTs as Securities
In their purest form, NFTs represent unique digital assets that are not intended to be financial products, even if they may be an attractive investment opportunity. However, if NFTs give their holder the right to income streams or a right to a share in an underlying portfolio of investment assets, the NFT then may become a regulated security.
Credibility of Cryptocurrency Exchange Companies
The credibility of exchange companies in the cryptocurrency industry received recent spotlight when in November of 2023, the founder of FTX, a leading centralized cryptocurrency exchange, Sam Bankman-Fried was convicted of defrauding cryptocurrency customers.
Also in November of 2023, federal agents seized $9 million worth of Tether cryptocurrency (a cryptocurrency linked to the US Dollar) from cyber scam organizations in California which convinced their victims to make cryptocurrency deposits by making the victims believe that they were investing in trusted firms and crypto currency exchanges.
Investors are highly advised to use platforms or entities registered with the SEC, such as the national securities exchange, alternative trading system (“ATS”), or broker-dealer. Not all platforms, including ICOs, that are labeled as “exchanges” meet the regulatory standards of a national securities exchanges.
Investors should be highly cautious of cryptocurrency companies and ICOs that do not provide sufficient detail on how the company technology operates, the viability of the technology over time, the history of the team members, and the legitimacy of the venture itself. Promises of high monthly returns from companies that are not legitimate business ventures is a red flag. Aggressive marketing campaigns such as celebrity endorsement and social media marketing statements do not necessarily mean that the ICO is a legal platform.