On April 17, 2018, New York Attorney General Eric T. Schneiderman took the first steps in launching the new Virtual Markets Integrity Initiative through a fact-finding questionnaire sent to thirteen of the major cryptocurrency trading platforms. The Initiative’s focus is protecting consumers and increasing transparency for both investors and enforcement agencies.  “Yet too often, consumers don’t have the basic facts they need to assess the fairness, integrity, and security of these trading platforms,” Attorney General Schneiderman explained in a statement.

As such trading platforms serve as initial points of entry into the virtual currency market, questions have arisen in recent months “given reports of the theft of vast sums of virtual currency from customer accounts, sudden and poorly explained trading outages, possible market manipulation, and difficulties when withdrawing funds from accounts.” The questionnaire asks for various disclosures so the average investor better understands the risks and nature of such an investment.

Specifically, the questionnaire requests information across the following categories:

  • Ownership and Control, such as subsidiaries, directors, officers and ultimate beneficiaries;
  • Basic Operation and Fees, such as types of currencies traded on the platform, custodians, bank or other institutions holding customer funds and policies and procedures for margin trading;
  • Trading Policies and Procedures, such as processes for matching bids and offers, methods used to determine the price for exchanging virtual currency for fiat currency and policies and procedures in place concerning the use of “bots” or other automated trading;
  • Outages and Other Suspensions of Trading, such as policies and procedures for completing, canceling or postponing open orders during a suspension or outage and details regarding past suspended trading or outages;
  • Internal Controls, such as restrictions on directors, employees or affiliates trading, procedures for protection of non-public information and details regarding third-party audits;
  • Privacy and Money Laundering, such as details regarding personally identifiable information collected, anti-money laundering protocols in place and procedures for the protection of personal and/or transaction history of customers
  • Protection Against Risks to Customer Funds, such as protocols in place to protect currency or financial instruments in its custody and details regarding insurance; and
  • Written Materials, such as copies of the current terms and conditions and a copy of the initial application, if any, to the New York State Department of Financial Services for a charter or BitLicense and for preapproval to trade virtual currency.

While this may be the first time we have heard New York State Attorney General Schneiderman address such concerns, the Securities and Exchange Commission (“SEC”) and the Commodity Futures Trading Commission (“CFTC”) continue to warn consumers about the speculative nature of, and the need for greater transparency surrounding, virtual currencies, blockchain and initial coin offerings (“ICOs”).

SEC Chairman Jay Clayton and CFTC Chairman J. Christopher Giancarlo in February testified jointly before the Senate Committee on Banking, Housing and Urban Affairs and focused on the lack of regulatory oversight and their concerns regarding virtual currencies, blockchain and ICOs.  While they each addressed their individual concerns currently facing the industry, they ultimately had the same message. Distributed ledger technology, virtual currencies, and specifically, ICOs, are changing the financial markets; federal financial services regulators need to work together to establish a regulatory framework that will support this new technology, but also protect main street investors. Clayton and Giancarlo also published a joint op-ed in the Wall Street Journal in January where they emphasized the need for investor protection and their concern regarding the potentially deceptive nature of the cryptocurrency markets. While these markets may in many ways resemble the regulated securities markets and trading platforms, in reality, “investors transacting on these trading platforms do not receive many of the market protections that they would when transacting through broker-dealers on registered exchanges or alternative trading systems.” In their view, the uncertainties and major risks surrounding the cryptocurrency markets call for additional oversight.

To that end, Chairman Clayton testified that he and Chairman Giancarlo were working closely with the Board of Governors of the Federal Reserve System and the Treasury Department to discuss the jurisdictional limits of each agency and to address ways to fill the gaps in the regulatory framework. When asked during questioning whether current legislation was sufficient, Chairman Clayton noted they may be back to ask Congress for additional legislation.

CFTC Commissioner Brian Quintenz also has recognized the need for guidance in the cryptocurrency industry and consistently advocates for the creation of a cryptocurrency self-regulatory organization (“SRO”).  Addressing the Chamber of Digital Commerce D.C. Blockchain Summit in March as the keynote speaker, he noted the various advantages of such a private independent organization, including increased efficiency in adopting and amending rules and clearer guidance provided by industry professionals with practical experience.  Quintenz believes, while it has been the process recently, setting policy through enforcement actions is not the appropriate course of action as it does not have the same force as a commission ruling or a court decision.

Shortly thereafter, an application for just such an SRO, to be called the Virtual Commodity Association (the “VCA”) was filed with the CFTC.  The VCA would function as a non-profit, independent organization, governed by a Board of Directors, for the U.S. virtual currency industry, specifically virtual commodity exchanges and custodians.  As proposed, it would undergo periodic examinations of its members and issue reports regarding the member’s compliance with VCA’s policies and obligations, impose penalties on members not in compliance and facilitate an outreach program to educate regulators and legislators.  Quintenz released a statement praising such a proposal – “a virtual commodity SRO that has the most independence from its membership, the most diversity of views, and the strongest ability to discover, reveal, and punish wrongdoing will add the most integrity to these markets.”

While various key regulators have recognized the need for guidance in this rapidly evolving industry, it still is yet to be seen whether enforcement actions will be brought against virtual currency exchanges, ICOs and the like purely on the basis that they are not following applicable securities and financial market regulations. As discussed in our post from December and as seen in the CFTC’s most recent series of enforcement actions, both agencies have focused on obvious cases of fraud. However, the testimony given by each chairman and the disclosures requested in the questionnaires of the Attorney General hint of more concentrated attention on overall regulation of this growing industry.