Friday, April 25, 2014

Elusive Bitcoin: Regulation of Bitcoin in the U.S. Part III

In this third chapter of my blog about Bitcoin regulation, I am going to focus on regulation of Bitcoin by the CFTC and the SEC.

The U.S. Commodity Futures Trading Commission (the "CFTC") is an independent federal agency that regulates derivative products tied to interest rates and commodities, such as swaps, options and futures.  Currently, the CFTC does not regulate Bitcoin or transactions involving Bitcoin.  However, as this article indicates, this may change quickly.

So, what could the CFTC regulate? It could treat Bitcoin as a “commodity” and regulate certain spot transactions involving it pursuant to its anti-manipulation rules in the spot market (although the CFTC jurisdiction over spot transactions is limited). As Bitcoin derivative market develops (and according to this article, it certainly is developing), the CFTC could also regulate certain Bitcoin transactions as swaps, options or futures. Check out also this article as well that goes into depth regarding the CFTC potential regulation.

However, as of now, the CFTC does not regulate Bitcoin or any transactions involving it.

The Securities Exchange Commission (the "SEC"), a federal agency charged with regulation of the U.S. securities markets, also currently does not regulate Bitcoin.

The definition of a “security” under the U.S. Securities Act of 1933  includes an investment contract. According to the well-known to all U.S. legal professionals case, SEC v. W.J. Howey Co.,  “an investment contract, for purposes of the Securities Act, means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party …”.

Bitcoin in itself is not an investment contract. Bitcoin users do not invest their money into a common enterprise with an expectation to derive profits solely based on the efforts of others.  They typically use bitcoins to pay for goods or services.  However, investments into funds or other investment vehicles that transact in Bitcoin are securities, and the SEC does have authority to regulate those offers and sales.

This was settled in August 2013, when a U.S. magistrate judge stated in a published memorandum opinion that investment in Bitcoin-related fund is an investment contract, and therefore, a security.  This ruling gave the SEC the mandate to charge Trendon T. Shavers, founder and operator of Bitcoin Savings and Trust (“BTCST”), with defrauding investors in a Bitcoin-related Ponzi scheme. Shavers advertised in 2011 that he was in the business of “selling Bitcoin to a group of local people” and offered investors "up to 1% interest daily.” He offered and sold Bitcoin-denominated investments through the Internet. Shavers raised at least 700,000 Bitcoin in BTCST investments, which amounted to more than $4.5 million based on the average price of Bitcoin in 2011 and 2012. According to the SEC, BTCST was a sham and a Ponzi scheme in which Shavers used bitcoins from new investors to make purported interest payments and cover investor withdrawals on outstanding BTCST investments. Shavers also diverted investors’ bitcoins for day trading in his account on a Bitcoin currency exchange, and exchanged investors’ bitcoins for U.S. dollars to pay his personal expenses. The SEC complaint can be found here.

Shavers main argument was that the BTCST investments were not securities because Bitcoin is not money, and is not part of anything regulated by the United States. The judge disagreed.  He said that 
“It is clear that Bitcoin can be used as money. It can be used to purchase goods or services, and as Shavers stated, used to pay for individual living expenses. The only limitation of Bitcoin is that it is limited to those places that accept it as currency. However, it can also be exchanged for conventional currencies, such as the U.S. dollar, Euro, Yen, and Yuan. Therefore, Bitcoin is a currency or form of money, and investors wishing to invest in BTCST provided an investment of money.”
The judge then reviewed other requirements of an investment contract. He determined that there was a common enterprise and that the investors were dependent on Shavers’ expertise in Bitcoin.  Also, investors clearly expected profits to come solely from Shavers’ efforts.

Contemporaneously with this case, the SEC issued an investor alert warning people about fraudulent investment schemes involving Bitcoin.

Interestingly, the same judge said that “Bitcoin is an electronic form of currency unbacked by any real asset and without specie.” However, as of now, neither the Federal Reserve Board, nor the U.S. Treasury, nor the CFTC stepped in to regulate Bitcoin exchanges or currency exchange-related transactions involving Bitcoin (although I think this is imminent).

The next, and final, post about Bitcoin regulation will focus on the treatment of Bitcoin by the IRS, and regulation by the states.

2 comments:

  1. About the need for regulation, authorities are actually working on bitcoin's liquidity. Hopefully, heist and transaction malleability reports will decrease. http://bitcoindaily.com/bitcoin-risks-and-the-need-for-regulation/

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