DISRUPTION BY DECENTRALIZATION: INITIAL COIN OFFERINGS & CRYPTOCURRENCY EXCHANGES, Vol. 2
The Roman Republic first invented the idea of selling shares to the public. At that time, business entities were referred to as a publicani and there were no secondary markets to trade the shares. As the modern era approached, the Dutch East India Company made the first modern initial public offering by offering shares of stocks and bonds on the first publicly-traded exchange, creating a secondary market for shares.
Most recently, the methods of offering the public a chance to partake in the success of a company are changing. Notably, initial coin offerings are becoming an increasingly popular way for the public to partake in blockchain-based technologies. Consequently, this creates a secondary market for the blockchain-based coins to be traded. Digital currency exchanges allows the public access to the secondary market where coins can be bought and traded with fiat currencies. Regulators have recently taken notice to both initial coin offerings and digital currency exchanges.
On July 25, 2017, the Securities Exchange Commission (SEC) issued warning to developers of any Decentralized Autonomous Organization (DAO) or other blockchain-enabled way for raising capital. Specifically, the SEC warned that coins or tokens offered in connection to an initial coin offering may be subject to securities disclosure rules under federal law.
To illustrate, the SEC issued the advisory as part of an investigation into The Dao, a crowdfunding vehicle that used blockchain technology to organize investors. In short, investors would invest in the Dao fund with rthereum (ETH), a cryptocurrency, and in return would receive Dao tokens, another cryptocurrency, that granted voting rights and rights to future payments on projects funded by the Dao fund. ETH can be purchased at a digital currency exchange. The SEC had to determine whether Dao tokens were securities, to which they answered in the affirmative, noting that the arrangement resembled an investment contract otherwise subject to securities regulation.[1] Although the SEC only issued an advisory note specific to the DAO fund, law firms are already offering services to structure initial coin-offerings to circumvent securities registration.[2]
To invest in Dao tokens, an investor would need to convert cash to ETH, or to bitcoin then ETH, then invest ETH in the Dao fund to receive the Dao token. Remember, most of these transactions can be done anonymously. This begs the question, who regulates the digital currency exchanges?
In short, a (digital) money exchange is classified as a money transmitter and falls under the purview of the Bank Secrecy Act (BSA), a body of law that aims to prevent money-laundering.[3] Most recently, the Financial Crimes Enforcement Network (FinCEN) fined a Russian virtual currency exchange, BTC-E, under the BSA for facilitating illegal transactions. Specifically, FinCEN found that BTC-E was a money transmitter and needed to be registered with FinCEN and failed to act in accordance with the BSA in a number of ways including failure to implement an anti-money laundering (AML) program, failure to file suspicious activity reports (SAR), and failure to obtain and retain records.[4]
FinCEN’s position on cryptocurrencies is clear—users who obtain cryptocurrencies as a result of “mining” are not money transmitters subject to the BSA, but digital currency exchanges are. Due to the broad definition of money transmitter, an initial coin offering could theoretically be classified as a money transmitter because it exchanges currencies.
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