Blair Wiley, Evan Thomas
Dec 18, 2018
While 2018 began with prices for cryptoassets like bitcoin and ether at or just off record highs, it appears that the year will end with prices down 75% or more.
Meanwhile, securities regulators, primarily in the United States, have announced an increasing number of settlements and enforcement actions against individuals and companies that have dealt in cryptoassets without complying with applicable securities laws.
On the surface, it would appear that cryptoassets resemble a bubble bursting under the combined weight of irrational retail investor exuberance and regulatory intervention. However, the narrative is perhaps not so simple. The initial coin offering, or ICO, phenomenon of 2017 is now clearly on the decline, but institutional interest in cryptoassets has held steady, and has perhaps increased, over the past year. This suggests 2019 will see the continued institutionalization and professionalization of cryptoassets.
The rise and fall of the initial coin offering
In 2017 there was a rapid emergence of the ICO, which generally consisted of an offering of cryptoasset tokens, primarily to retail investors in multiple jurisdictions, sometimes globally, to raise capital for a blockchain-based project or business.
In 2018, both U.S. and Canadian securities regulators repeated previous warnings that most ICOs were subject to securities laws, including prospectus and registration requirements. In March, the Securities and Exchange Commission (SEC) issued a statement regarding unregulated cryptoasset trading platforms and exchanges, which was followed by a similar investor warning from the Canadian Securities Administrators (CSA) in June. The CSA also issued a new Staff Notice that amplified previous CSA warnings that Canadian regulators would take enforcement action against projects and businesses that engaged in token offerings or trading without complying with applicable securities laws.
Consistent with these warnings, the tempo of enforcement activity increased through the year. In May, the North American Securities Administrators Association (NASAA) announced “Operation Cryptosweep,” a co-ordinated series of enforcement actions in 40 states or provinces. This sweep initially involved 70 inquiries or investigations concerning fraudulent initial coin offerings and other cryptocurrency-related investment products, growing to over 200 investigations by August.
While the enforcement focus began with allegedly fraudulent offerings, regulators are conducting a broader investigation into companies and individuals issuing, trading, promoting or otherwise dealing in ICOs. Enforcement efforts by the SEC have recently resulted in a number of settlements with individuals and companies that issued, brokered or promoted ICO tokens or that operated trading platforms for ICO tokens. These have all the hallmarks of templates for future settlements with those who have engaged in ICO-related activities without complying with applicable securities laws.
In Canada, few details have been publicly disclosed, but securities regulators are unquestionably looking into those involved in issuing, trading or otherwise dealing in cryptoassets that may be securities. We expect that Canadian regulators will follow an enforcement strategy similar to their U.S. counterparts and announce more settlements and enforcement proceedings in 2019.
This aggressive regulatory response has undoubtedly contributed to the decline in the use of the ICO, which peaked roughly midway through 2018 and fell dramatically thereafter. As well, many ICOs conducted in 2017 have fared poorly, with token prices falling well below issuing prices and many projects collapsing entirely. Our expectation is that this will lead to an increase in private litigation by unhappy token holders. However, between the decline in prices for the cryptoassets that were contributed to these projects and the ongoing expenditures on development, many ICO-funded projects may have little in the way of assets to be recovered by successful plaintiffs.
Institutional activity steadily grows
Despite the dramatic market swing and the decline of the ICO, institutional interest in the major cryptoassets, particularly bitcoin, continues to grow, albeit cautiously. We view this as consistent with expanded regulatory oversight of cryptoassets, and we anticipate that institutions will increasingly enter the space as regulators clarify their positions with respect to cryptoassets.
The growth in institutional interest is perhaps most clearly shown by the many announcements by companies hoping to provide the infrastructure necessary to serve that interest. Companies such as Coinbase and BitGo are introducing cryptoasset custody solutions organized as regulated trust companies, which they presumably expect will satisfy regulatory requirements applicable to institutional investors that wish to acquire cryptoassets. As well, major financial intermediaries such as Fidelity and ICE have announced plans to introduce cryptoasset trading platforms primarily for institutional investors.
Within Canada, Canadian financial institutions remain cautious about providing banking and other financial services to cryptoasset businesses due to money laundering and fraud concerns, but they are increasingly willing to provide commercial banking to trading platforms, over-the-counter brokers and other crypto-asset businesses that demonstrate strong compliance programs.
We anticipate this trend will continue once the status of cryptoassets under Canada’s primary anti-money laundering law, the federal Proceeds of Crime (Money Laundering) and Terrorist Financing Act (PCMLTFA), becomes clearer. In June, the federal Department of Finance issued draft regulations under PCMLTFA that address virtual currencies. While final regulations have not been published and may not be in effect until 2020, the draft regulations provide considerable detail regarding anticipated future record-keeping and reporting requirements for transactions involving cryptoassets.
Although securities and financial regulators have been developing their public positions with respect to cryptoassets, guidance from tax authorities remains limited. However, this may be changing. In July, the Canada Revenue Agency joined tax authorities from the U.S., the United Kingdom, Australia, France and the Netherlands in an initiative known as the Joint Chiefs of Global Tax Enforcement, or J5, whose mandate includes collaboration to reduce the threat of cryptoassets to tax administrations. We anticipate more extensive guidance in 2019 from Canadian and other tax authorities regarding taxation of cryptoasset transactions. This would reduce another source of uncertainty that may be limiting institutional entry into cryptoassets.
With cryptoassets, like with any emerging technology, there will be periods of wild speculation and painful price corrections. Nonetheless, the blockchain technology underlying most cryptoassets, which permits assets to be represented and transmitted securely across a global decentralized ledger, remains very promising. Combined with institutional involvement and increased clarity regarding the regulatory status of cryptoassets, there remain many reasons for optimism about the space over the longer term.