SEC Issues Crypto-Warning: Here’s What You Need to Know

The Chairman of the Securities and Exchange Commission, Jay Clayton, made a public statement on the SEC’s website that leveled some cautionary words for the cryptocurrency markets. His warnings mainly focused on initial coin offerings (ICOs) and “tales of fortunes” that are luring investors into the market, with his concern particularly on those who cannot necessarily afford to take speculative risks.

Mr. Clayton balanced some of his warnings with concessions that the technology driving cryptocurrencies could someday be very valuable to the world. Indeed, there is no denying that blockchain technology could revolutionize the way businesses and governments operate. But that does not guarantee that all investors will profit proportionately, and in fact just the opposite could be true. Mr. Clayton warns that cryptocurrency investors would be wise to expect a wild ride.

There were two main warnings Clayton issued when it comes to cryptocurrencies.

First, while there are cryptocurrencies that do not appear to be securities, simply calling something a “currency” or a currency-based product does not make it a security.  Before launching a cryptocurrency or a product with value tied to cryptocurrency, its promoters must either (1) demonstrate that the currency or product is not a security or (2) comply with applicable registration and other requirements under the SEC’s securities laws.

Second, brokers, dealers and other market participants who allow for payments in cryptocurrencies; allow customers to purchase cryptocurrencies on margin; or who use cryptocurrencies to facilitate securities transactions should exercise particular caution, including ensuring that their cryptocurrency activities are not undermining their anti-money laundering and ‘know-your-customer’ obligations. The SEC insists that vendors/merchants/businesses treat cryptocurrency as if it were cash being handed from one party to the other.

Finally, there is a matter of cryptocurrency exchanges and where a person is transacting business. Mr. Clayton sought to remind investors that these markets sand exchanges span national borders and have trading that may occur on systems and platforms outside the United States. That means that a person’s invested funds may quickly travel overseas unbeknownst to the investor, which in and of itself can amplify risk. It also means that the SEC may not be able to effectively pursue bad actors or recover funds.

The SEC also has not to date approved any exchange-traded products (such as ETFs) for listing and trading holding cryptocurrencies or other assets related to cryptocurrencies. In Mr. Clayton’s own words: “If any person today tells you otherwise, be especially wary”. 

A Cautious View of ICOs

Mr. Clayton makes it clear that while ICOs could be wonderful mechanisms for entrepreneurs and new companies to raise funding, they must also be analyzed and considered with caution. What investors must understand is that, to date, no initial coin offerings have been registered with the SEC.

Certain ICO sellers have attempted to highlight ‘utility’ characteristics of their proposed initial coin offerings, in an effort to claim that their proposed tokens or coins are not securities. But Mr. Clayton warns that these assertions appear to elevate form over substance. “Merely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security,” he says. That means that investors should treat tokens as they would securities, where securities lawyers, accountants, and consultants, need to offer process and disclosure requirements for the sake investor protection.

Mr. Clayton also cautions market participants against promoting or touting the offer and sale of coins, without first determining whether the securities laws apply to those actions. Since selling securities generally requires a license, and experience shows that excessive selling of a security in a thinly traded and volatile market can be an indicator of “scalping,” “pump and dump” and other manipulations and frauds, investors and issuers should be aware that they may be operating unregistered exchanges or broker-dealers that are in violation of the Securities Exchange Act of 1934.

The SEC’s Bottom Line

Investors need to note that there is substantially less investor protection than in the SEC’s traditional securities markets, with correspondingly greater opportunities for fraud and manipulation. For investors interested in investing in cryptocurrency markets, Mr. Clayton says it is critical to ask questions and demand clear answers.

Mr. Clayton’s strongest words, which investors should remember not only about cryptocurrency but any security that bears risk: “As with any other type of potential investment, if a promoter guarantee returns, if an opportunity sounds too good to be true, or if you are pressured to act quickly, please exercise extreme caution and be aware of the risk that your investment may be lost”.