As we reported last month, the US Securities and Exchange Commission has set up a new cyber unit that will look to protect retail investors from being scammed by people misusing ICOs and blockchain technology.
The SEC is on high alert for investment scams that misuse public excitement about relatively unknown technology. “Pump and dump” scams are age-old, and fraudsters often seize upon new market advances to prey on unsuspecting investors.
Legitimate market participants need to be particularly cautious not to get lumped in with the host of scammers that crop up in new industries.
We spoke to Trace Schmeltz, co-chair of the Financial and Regulatory Litigation and White Collar and Investigations Practice Groups, at law firm Barnes & Thornburg, about the SEC’s motivations and why it chosen to take action now.
Why has the SEC chosen to target ICOs and cryptocurrencies at this time?
“In short, the Commission is not targeting ICOs and cryptocurrencies at this time—it is simply reacting to technology it has been monitoring for years.
“The SEC formed a working group to address digital currencies in 2013, and changed its name to the Distributed Ledger Technology Working Group in November 2016 in order to address new technology, ensure it understood the regulatory impact of that technology.”
What effect do you think the moves will have on the wider crypto/ICO market, which has experienced very strong growth and investor interest over the last year?
“The market will undoubtedly slow down as it is clear the regulators are watching to ensure legal requirements are being met. In particular, coin offerings will slow down. But, cream rises to the top.
“One would expect companies that have quality ideas and intend to follow regulatory requirements will register initial coin offerings—and that such offerings will net significant returns for investors.”
How legitimate are the concerns that scammers could use the hype around ICOs and cryptocurrencies to fool investors?
“First, cryptocurrencies and ICOs have sufficient “buzz” that investors are interested in them. So, they make good vehicles for anyone interested in raising money.
“Second, ICOs appeared to be new fundraising tools that were not highly regulated—meaning lots of companies trying to raise capital turned to them in the hopes of raising money without having to clear high regulatory hurdles.
“Any new technology that is difficult to understand provides a vehicle for a predator to take advantage of the unsuspecting. With respect to initial coin offerings, they can be launched from anywhere in the world over the internet.
“Without appropriate disclosures—the type of disclosures that provide transparency to investors about the financial backing of an enterprise, the manner in which raised funds will be held and used, the management of the entity, the real nature of the business in which the enterprise is engaged—people can be scammed.”
“the market will undoubtedly slow down”
What can legitimate market participants do to try and ensure they do not get lumped in with scammers?
“When investing in cryptocurrency, potential investors should make sure they understand the entity issuing the currency. As the Commodity Futures Trading Commission (CFTC) noted in its recently issued primer on virtual currencies, investors should inquire into cybersecurity controls, the nature of the platform on which they are buying such currencies, and perform due diligence into trading counter-parties (or the exchange, if it is the central counter-party).
“Also, such investors should be wary of investing any more than they can afford to lose. Many cryptocurrency exchanges have limited liquidity, allowing a few large trades to radically impact the market.
“With respect to ICOs, an investor should obtain clear and complete disclosures about the nature of the offering and consider consulting with counsel as to whether the interest being offered qualifies as a security—and, if it does, stay away from the offering unless it is properly registered with the SEC.”
What role is the SEC playing with regards to Bitcoin now that virtual currencies are part of the SEC’s jurisdiction?
“With respect to virtual currencies like Bitcoin or Ethereum (as opposed to tokens offered in ICOs), it is the CFTC, rather than the SEC, is likely to be more involved.
“Indeed, the CFTC has concluded that cryptocurrencies are commodities—like gold or silver—and intends to regulate them when virtual currencies are traded in derivative contracts (like swaps or options), with leverage or margin, or when there is fraud or manipulation in a cryptocurrency transaction.
“Again, the CFTC’s fintech think-tank—LabCFTC—issued a primer on virtual currencies that is helpful for all potential cryptocurrency investors to review before investing.”