Currency in the Digital Age

SEC IM Guidance
Written By Meghan Sundquist

By Meghan Sundquist, Compliance Consultant

Introduction

Over the last several years, it’s no secret that digital currencies, like Bitcoin and Ethereum, have stolen the show both from a regulatory and investment standpoint. From news headlines to court cases, cryptocurrency and other digital assets have become almost impossible to ignore.

But what is cryptocurrency? How does it work? What are the risks? Is the hype warranted?

While this topic is complex and multi-layered, we hope to address some of these questions and provide additional resources for those who want to dive deeper into this technology.

Let’s start with the thing itself. What is cryptocurrency?

Digital Payment Reimagined

Imagine you go to the grocery store. You need broth, carrots, and onions for soup to make for dinner tonight. You walk into the store, grab your items plus a pack of mints and head to checkout. After either you or a cashier scans your items, you pull out your credit card to pay. You tap/insert the card, the transaction clears, you grab your receipt and off you go. Later that week, you review your credit card transaction history and see the purchase. Maybe you could have paid with cash, but you didn’t. You used a digital form of payment. If you live in the United States, your transactions will show in USD currency. Cryptocurrency functions similarly, just with wildly different transaction verification methods.

It is important to note that some aspects of traditional currency apply to cryptocurrency. In some places, you may see signs that say they accept Bitcoin or some other cryptocurrency. Imagine those signs said that Euro or Yen was accepted instead. You can exchange your native currency for a cryptocurrency similar to exchanging USD for Euro or Yen to pay. Some differences between crypto and traditional currencies are that there is no physical representation of the currency itself, it’s not issued by a government, and the means of verifying the digital transactions is decentralized.

When someone makes a transaction using Bitcoin, for example, this transaction is broadcast across the Bitcoin network. Rather than a centralized bank or other financial institution confirming the transaction is legitimate like a credit/debit card, Bitcoin uses a process called cryptography to help secure and authorize transactions. It’s complicated.

Each user has a private keys (sk) and public keys (pk) to create digital signatures and technology that creates a unique code every time a transaction is added to a ledger (transaction history) and signed off. If you own cryptocurrency, your private key is unique to you, and you cannot access your currency without it. The private key acts like a secret password to digitally sign transactions and prove ownership.  As of the time of this blog posting, this technology has not been cracked. If you don’t have your unique private key, your currency is lost. The public key allows the network to verify that the transaction was properly authorized by the owner without disclosing the private key.

In the Bitcoin world, everyone has their own ledgers, or transaction history. Each time a transaction occurs, it is broadcast to the entire network. Each time a transaction is added to a ledger, it creates a new block. As transactions are added, new blocks form and are added to the previous blocks to create a comprehensive history of transactions. This is called a blockchain.

There are few elements required for a block to be considered legitimate and thus added to a blockchain. The people verifying the transactions, called miners, have to discover what is called a cryptographic hash function. This creates a “proof of work.” Generally, the rule is that whichever block has the most computational work to solve the hash is the legitimate block. Each block’s hash is influenced by the unique digital signature as well as the hash from the previous block which depends on the hash of the block before that, etc. Miners receive the hash function output, usually a collection of 256 bits (code), and use a hefty amount of computer power to find the hash unique to that specific block that will produce that specific hash function output (the 256 bits of code). This code starts with a certain number of zeros and is changed periodically so that it should take an average of 10 minutes to find the hash that produces the specific code. You have the hash function output and a block with an unknown unique hash. The job of miners is to figure out what the unknown unique hash is that, when put through the function, gives the specific output from which they’re starting. It’s like solving a math problem where you only have one part of the equation and the answer, and you have to find the missing parts by trial and error. Just a lot more complex.

Once the hash is found, the blocks are added, miners receive some extra currency that is added to the ledger as a thank you, and everyone starts on the next block. When you use Bitcoin, you can also add a transaction fee to the transaction as another way to compensate miners for their verification work. Generally, the blockchains with the most work are considered the most accurate. Each block has a limited number of transactions depending on the specific currency you’re using. 

Some blockchains use a different verification method called “proof of stake”. Instead of miners solving the hash function through computing power, validators lock up, or “stake,” their crypto assets to help validate transactions and propose new blocks. Validators can earn rewards for honest participation and may face penalties if they act improperly. Ethereum now uses this type of proof of stake model.

To own and/or use cryptocurrencies, you don’t have to know all of this. But we do think it’s helpful to understand when discussing the regulation of cryptocurrencies and other digital assets because they’re so different from everything else the regulators are dealing with. Let’s leave the technological details behind and think about this from a regulator’s perspective.

To Be a Security, or Not to Be Security?

Is cryptocurrency a security? This is the question regulators have been struggling with for years. Is it a commodity? Under which regulatory branch does it fall? Does current legislation govern it effectively, or does there need to be new legislation?

SEC Chairman Paul Atkins has also addressed this issue in discussing the SEC’s approach to digital assets. In remarks on Project Crypto, Atkins indicated that the SEC expects to consider a token taxonomy anchored in the longstanding Howey investment contract analysis, recognizing that not every crypto asset or transaction should be treated the same.

To start peeling apart these layers, let’s review the Howey Test.

Commonly known as the “gold standard” to determine whether an investment is a security or not, the Howey Test is made up of four prongs. A security is:

  • An investment of money,

  • In a common enterprise,

  • With the expectation of profit,

  • To be derived from the efforts of others.

Let’s hold cryptocurrency in its basic, technical form up these four prongs based on the information we just reviewed and see where we land.

An investment of money: If we assume an investment is an asset acquired to generate income or gain appreciation, then cryptocurrency fits the bill.

In a common enterprise: While cryptocurrencies are decentralized, there is still a communal aspect to them. They have their own platforms and exchanges where ledgers are stored and transactions are made. It’s plausible to argue that cryptocurrency is a common enterprise.

With the expectation of profit: While you could just exchange your currency for Bitcoin (or any other cryptocurrency) just to have an alternative payment method, you could also exchange your currency for Bitcoin with the expectation of profit.

To be derived from the benefit of others: Now we get to the crux of the matter. How does cryptocurrency go up in value? Is it due to the mining activity or some managerial activity? As far as we can tell, the answer is no. The value of cryptocurrency appears to be heavily influenced by public sentiment, adoption and supply in demand. Digital tools that make up cryptocurrency perform a practical function. Purchasers are not expecting profits from the essential managerial efforts of others. This is why some cryptocurrency may not satisfy the Howey Test and a large contributing factor to the trouble it’s caused regulators.

However, there are still instances when cryptocurrency can become a security.

Some cryptocurrency, by itself, does not meet the definition of a security but can be sold or packaged into transactions that are securities. The most common example of this is a crypto ETF. Spot crypto ETFs track the value of cryptocurrency by actually holding the asset. Investors can buy shares on the exchanges just like they would any other ETF or stock, but they don’t hold the actual cryptocurrency itself. Other crypto ETFs hold crypto futures which are agreements to buy or sell cryptocurrency on a specific date at a specific price. These ETFs have share prices that reflect the price of derivatives rather than the cryptocurrency itself.

These products are then considered securities because investors purchase shares of an investment product managed by others, rather than directly holding the cryptocurrency itself.

Risks of Cryptocurrency and Crypto-Products

As with any technology, there are certain risks that come with cryptocurrency. Some are unique to the technology; some are more generic.

Counterparty Risk: This is a common risk for most other investments. A third party holds the asset. If the third party is fraudulent or goes under, you’re out your investment. If you’re looking into investing in cryptocurrency for yourself or your clients, be sure to do thorough due diligence on the platform holding the cryptocurrency.

Cybersecurity Risk: While the nature of cryptography can reduce this risk, it is still there as it is with anything online. Unfortunately, if cryptocurrency is somehow taken on the blockchain, it can be almost impossible to recoup the funds as the private key is usually necessary.

Market Manipulation Risk: Due to the decentralized nature of cryptocurrency, its value is almost entirely dependent on public sentiment. This makes it extremely vulnerable to market manipulation, often resulting in high highs and low lows.

Liquidity Risk: Some of the larger cryptocurrencies are fairly liquid (Bitcoin, Ethereum), but this is not always the case with some of the minor players in the crypto space. Liquidity can be limited due to low volume and high volatility. In these cases, any movement out of the cryptocurrency could trigger a large price swing. There is additional liquidity risk if investors participate in staking of any kind. This is when an investor commits or “locks up” their cryptocurrency as collateral in order to gain more rewards through validation. Often, these funds are unavailable for a specific period of time.

Operational Risk: This refers to the practical stuff like losing/forgetting your private key or password. Without your private key, you lose access to your assets. Period. End of story. Additionally, most transactions are irreversible due to the nature of the “ledger.” Once a transaction is made, it cannot be undone.

Price Volatility Risk: As mentioned previously, the volatility of cryptocurrency is largely due to its susceptibility to market manipulation.

Programming Risks: Similar to the cybersecurity risk, programming risks are present whenever technology is present. The greater the dependency on the technology, the greater the ramifications of bugs or faulty coding. In the crypto space, these issues could result in permanent loss of assets.

Regulatory Risk: Regulatory risk can go both ways – either it’s rapidly evolving and rules could pass that inhibit purchase or maintenance of the asset, or there isn’t enough regulation in the space resulting in rampant fraud and scammer activity. Both appear to be true in the case of cryptocurrency. For a long time, there hasn’t been much regulation, and issues have been left to the courts to figure out. However, as the SEC, CFTC, and Congress are getting involved and more intentionally searching for sustainable solutions to the issues cryptocurrency poses, rules could come into play that negatively affect current investors.

Conclusion

Hopefully, this overview provides a little more context into this thing that’s been making headlines, financial or otherwise, in the last several years. While there is a lot of uncharted territory opened up by cryptocurrency and the cryptographic technology, a basic understanding can still provide helpful information as firms try and navigate the new terrain. Sure, there’s a lot still unknown, but there’s a lot that is known, and firms can use this information to make educated policies and decisions surrounding cryptocurrency and other digital assets. Yes, the list of risks is long, but the potential for this technology to transform the financial space is not all negative. We didn’t cover tokenization, smart contracts, or other forms of digital assets in the article, but we’ve linked some helpful resources below if you want to learn more about this technology.

As this technology develops, we also recommend firms prepare for continued regulatory development. Even where final rules are not yet settled, you and your firm leadership can review policies, due diligence processes, custody practices, disclosures, cybersecurity controls, vendor oversight, and client communications involving digital assets. At the same time, blockchain technology is likely to keep influencing the financial industry through areas such as tokenization, settlement, recordkeeping, and smart contracts. Preparing now can help your firm respond more thoughtfully as both the technology and the regulatory framework continue to mature.

In the meantime, we hope this information helped pull you out of the hype/fear bubble and kickstart productive conversations at your firm. As always, we’re here to help you process the use of cryptocurrency in your portfolios and the various compliance implications involved.

‍Resources

If you want further reading/watching/listening, we’ve included some helpful resources below. These are articles and videos we’ve worked through and discussed as a firm, found helpful, and provided a lot of the information in this article.

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