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Virtual Currencies and Its Risks

We end this month’s blog with an overview on virtual currencies and its risks. Last month, we fleshed out our understanding of blockchain technology and the legal quandaries that surround it. This month we narrowed our focus to the specifics of one of its uses: currency.  Virtual currencies have great potential to provide liquidity and trust to markets, and have ushered in the beginning of a modern era of prosperity and exponential economic growth. Regulators have not quite figured out how to manage them because they are innovative and unique. Also, the courts have not quite figured out how to handle cases brought about by disputes surrounding them.

Despite their many attributes, digital currencies pose risks as well. For example, their largely unregulated status leaves them more vulnerable to the threat of hacking and any crime that might be associated with it. There have been cases where virtual currencies have been used for illegal and immoral activities, like sex trafficking and purchasing illegal narcotics.  Not only companies, but potential investors, should be aware of all the risks of noncompliance with regulation.

To quickly clarify, digital currency is any currency that exists in digital form, whereas virtual currency, a subset of digital currency, is digital currency that is not tethered to any “real” or official currency.  All digital currencies pose risks of hacking, but legal approaches to the broader category of digital currency might differ from legal approaches to the narrower category of virtual currency.

Purchasing virtual currencies on the cash market – spending dollars to purchase Bitcoin for your personal wallet, may come with the following risks:

  1. They are not regulated or supervised by a government agency;
  2. Platforms lack safeguards;
  3. Volatile cash market price swings or crashes;
  4. Cash market manipulation;
  5. Cybersecurity risks – e.g., hacking electronic wallets; and
  6. Unfair disadvantages to customers due to platforms selling from their own accounts.

The market changes that affect the cash market price of a virtual currency can affect the price of virtual currency futures and options.

In terms of regulation, the novelty of virtual currencies has meant that they have eluded protection by the Electronic Fund Transfer Act or Federal Deposit Insurance Corporation. Although, not always considered a security, virtual currency can still fall under CFTC’s and SEC’s jurisdiction.  In fact, the CFTC has published the following statement:

Bitcoin and other virtual currencies have been determined to be commodities under the Commodity Exchange Act (CEA). The Commission primarily regulates commodity derivatives contracts that are based on underlying commodities. While its regulatory oversight authority over commodity cash markets is limited, the CFTC maintains general anti-fraud and manipulation enforcement authority over virtual currency cash markets as a commodity in interstate commerce.

This is because of its potential consideration as a commodity, which has been demonstrated by investor behavior in larger markets. Furthermore, trading of virtual currencies on derivative markets and exchange-traded funds is starting to become more popular.  Regardless of whether virtual currency is considered a security, the trading of securities based on virtual currency, as well as the virtual currency based on derivatives requires the same compliance as trading based on anything else.

The Financial Crimes Enforcement Network (FinCEN) has declared that any entity that facilitates or enables virtual currency transactions must register as a Money Services Business. This puts them under the scope of further regulation and requires strict reporting and record keeping.

At this time, the use of virtual currency does not indicate anything illegal. However, because it has been used to facilitate a lot of illegal activity in the past, law enforcement agents are suspicious of any activity. It is often more closely scrutinized simply for the fact that it is virtual.

It is important for legislatures and courts to tackle illegal activity itself, and not an otherwise healthy innovation simply as a proxy for other illegal activity.  Although, investors are not subject to consumer protections when they purchase virtual currencies, however they decide whether reliability outweighs the lack of entitlement to certain legal remedies.  It would be shortsighted to forsake aspects of a product with so much potential for wealth production because it is also abused.  Instead, regulators should tailor the laws to a more nuanced understanding of the technology so as to maximize and not hinder it.

At our law firm, we help clients navigate through the legal obstacles.  Please do not hesitate to contact our virtual currency attorneys for any questions.