Cryptocurrency (also spelled crypto currency) is everyone’s new favorite hot topic. Even if you’ve done no research into the topic, you’ve probably heard of the most (in)famous cryptocurrency: Bitcoin. But what are cryptocurrencies? And how are they affecting the securities industry?

What is a Cryptocurrency?

Virtual currency is defined by the US Commodity Futures Trading Commission as “a digital representation of value that functions as a medium of exchange, a unit of account and/or a store of value.” In other words, a currency is represented by alphanumeric codes, unlike “fiat currencies” such as the dollar, euro, renminbi, or yen. Additionally, the currency lacks the backing of a government body.

Cryptocurrency is one type of virtual currency. The prefix “crypto-” refers to a mathematically intensive encryption process designed to enhance data protection and authentication. Cryptocurrencies offer personal anonymity and the absence of government regulation or oversight. However, some worry that these features may facilitate illicit trading and financial transactions.

Cryptocurrency and the Securities Industry

Cryptocurrencies raise a lot of questions for investors and market professionals:

  • Is the product legal?
  • Is it subject to regulation, including rules designed to protect investors, and, if so, does it comply with those rules?
  • Are those offering the product licensed to do so?
  • Are the trading markets fair? Can the prices on those markets be manipulated?
  • Are there substantial risks of theft or loss, including loss from hacking?

As it is now, cryptocurrency markets have substantially less investor protection than traditional securities markets, which means substantially more risk of fraud or manipulation. Additionally, investors must recognize that these markets span national borders; thus, significant trading may occur on systems and platforms outside of the United States, and invested funds may quickly travel overseas without an investor’s knowledge. This increases the risk that the SEC and other market regulators may not be able to effectively pursue bad actors or recover funds.

Market professionals must keep in mind that while there are cryptocurrencies that do not appear to be securities, simply calling something a currency (or currency-based product) does not mean that it’s not a security. Before launching a cryptocurrency or a product with its value tied to one or more cryptocurrencies, its promoters must:

  • Be able to demonstrate that the currency or product is not a security; or
  • Comply with any and all applicable registrations and requirements under securities law.

Broker-Dealers and other market professionals should exercise caution if they choose to: allow for payments in cryptocurrencies, allow customers to purchase cryptocurrencies on margin, or otherwise use cryptocurrencies to facilitate securities transactions. Firms should ensure that their cryptocurrency activities do not undermine their anti-money laundering or know-your-customer obligations.

The SEC and Cryptocurrencies

According to SEC Chairman Jay Clayton in his Statement on Cryptocurrencies and Initial Coin Offerings, the SEC is keeping a sharp focus on how cryptocurrencies are affecting the securities market. Currently, the SEC has not approved any exchange-traded products (such as ETFs) holding cryptocurrencies (or other assets related to cryptocurrencies) for listing and trading.

FINRA and Cryptocurrencies

In their 2018 Regulatory and Examination Priorities Letter, FINRA briefly addressed the growing popularity of and interest in virtual currencies. Due to the increase in media, public, and regulatory attention, FINRA is closely monitoring developments in the areas of digital assets (such as cryptocurrencies), including the role that firms and registered representatives may play in carrying out transactions in such assets.

Where the digital assets are securities, FINRA may review the mechanisms – for example, the supervisory, compliance, and operational infrastructure – firms have put in place to ensure compliance with relevant securities laws and regulations and with FINRA rules.

For more on digital assets like cryptocurrencies, check out our other posts on the topic.