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2019 CHAINSIGHTS | Former SEC Commissioner Roel Campos: the State of Blockchain and Cryptocurrency Regulation

Abstract : You have to always worry if you are in the world of fintech with what is called the Financial Crimes Enforcement Network or the FINCEN which is part of treasury.

ChainDD
ChainDD

Oct 18

The former SEC commissioner Roel Campos has delivered the closing keynote address at the 2019 CHAINSIGHTS Fintech and Blockchain Summit hosted by ChainDD on October 10 in New York, in which he talked about the way that cryptocurrency and fintech is regulated in the United States and gave some rules and guidance as to how to stay out of trouble.

CHAINSIGHTS is a global platform to connect the blockchain and fintech innovators with the supporters and investors from East and West and carry the critical mission to unlock our community's potential, to empower revolutionaries to challenge the status quo and to create a better digital future of our financial life.

The following is the transcript of his speech:

Good afternoon to all of you. Thank you for hanging around this long. It's a long day with wonderful presentations. I always feel that it's difficult to follow an act like Daniel's just did. I sometimes think to myself maybe if I had it to do over again, I would choose to be an entrepreneur and come up with great ideas and great videos and that sort of things, as opposed to being instead of a mere lawyer, who is going to tell you some rules and try to give you some guidance as to how to stay out of trouble, in terms of the United States.

I will say that when I was a commissioner at the SEC, I had the opportunity, and I'm very proud of the fact that I was the very first SEC commissioner to visit China and to establish a relationship with China Securities Regulatory Commission (CSRC), which is a Chinese commission that regulates securities, and that relationship has been maintained over the years. This was in essentially in 2006, 2005 to be exact. The Chinese regulators that regulate securities and the markets, collaborate very carefully with the securities regulators here in the US. I'm very happy to have had that opportunity to open the relationship.

Today I will briefly talk about the way that cryptocurrency and fintech is regulated in the United States. It is complicated. It's fairly detailed, so I won't cover all of that. I can't make you experts today in a short discussion like what I'm doing. What I hope you'll take away, and what you'll learn, is that if you are your partners, whether you be from China, whether you be here in the US, like Daniel, you need to have good guidance. You need to have a lawyer that understands this area, understands where mistakes can be made, and where the regulators will become upset with you, potentially bringing charges against you, for not registering correctly, for not getting the proper licenses. Again, you don't have to choose me as your lawyer, but you should have someone that is an expert in this area before you end up providing tokens to investors, before you end up setting them a platform or you do any of the things having to do with fintech or cryptocurrency.

Let me begin by just summarizing very quickly the different groups that you have to think about in terms of regulation. So obviously the SEC, the Securities and Exchange Commission, my old and former agency that I was a commissioner at, is responsible for regulating virtual currencies that qualify as securities. That tends to be the first agency that you need to be concerned about. However, what we call the Commodity Futures Trading Commission, the CFTC also has some jurisdictions and has declared, for example, that bitcoin is a commodity, therefore they have some rights. So essentially CFTC gets involved if you have derivatives from virtual currency or from bitcoin or other crypto. Anything that can be deemed as a security, the SEC has primary jurisdiction. I'll leave it at that. It's more complicated. Often times it could be that both agencies are involved. You have to always worry if you are in the world of fintech with what is called the Financial Crimes Enforcement Network or the FINCEN which is part of treasury. They are worried about money laundering, they are worried about dark money coming from illegal sources, whether they are drugs or human trafficking, whatever it may be. There is that concern, so there are things called Know Your Customer and other regulations that have to be followed. You need guidance in that area. There are also rules having to do with licenses of money, depending what you're doing in terms of moving money around. It's a very complicated network. The state regulators in the US also have jurisdictions. In New York the state department of financial services engages with business activities and it essentially requires a very significant application and disclosure. It's deemed to be obtrusive by some, but nonetheless it is the way the state views its obligation to protect its public.

On the other hand, other states are more lack of, or maybe that's not the right word, more flexible. Wyoming, for example, takes a different approach. It eventually amended its Money Transmitter Act to exempt cryptocurrencies. Therefore, you have to be careful as to where you do businesses. I'm just giving you the highlight, and this is why it is important to have good counsel.

So why do you want to do an ICO if you're in this particular business? Is it just that it is currently popular among investors? Does it seem glamorous? Well, probably the primary advantage of doing an ICO, an initial coin offering, as a company, is the range and the geographic distribution of potential investors. It is just large, and it gives you instant and instantaneous access to many investors that perhaps to provide cryptocurrency as investing. Raising funds quickly through crypto, and having it available, as I said instantaneously, allows a company to have cash quickly and to be able to move. One major disadvantage, because we don't have full advantages everywhere, is that there is also the constant risk that regulations will change. In the US, it's a much studied area, and regulators are continuously worried about investors being cheated. Additionally, as a company, as the funds of a company rise, they could also be subject to sudden volatility, because everyone knows how volatile the cryptocurrency is. Hence, if you have a business that is based on Ether or Bitcoin or some others, you know that its value, in terms of fiat currency, can vary a lot. So it's a risk that you have to take.

Again, things that you have to worry about with an ICO have to do with whether you need to register with the Federal Communications Commission (FCC). Often if you do register, which is probably wise in many circumstances, again you need every individual situation requires its own advice. You have to worry about the resale, make sure your investors understand that if they are using an exemption from the SEC registration, they may be restricted for a year, often, as to when they can resell their particular tokens.

These are details that your lawyer would be able to review in your circumstances. You might use in the US crowd funding. That's a relatively new exemption. However, you have to be aware that you can only raise $1 million in a twelve-month period, and individual investors are limited to about $10,000 if they are relatively a high net worth. Many individual investors have to invest a lot less because of the protections of that particular exemption. There's something called Reg D, which is a very popular way to go to do a private placement. Again, there are various categories of Reg D, and I'm not going to make this into a law class, but rule 506(C) has been used by a lot of ICOs. You would be guided by your legal counsel on this, but 506(C) allows for only accredited investors. It allows for advertising, which was not allowed by the SEC previously. So all those things are positive. But you do have to make sure that you only have accredited investors and show the regulator that you've done a good job in assuring that, that is the case. And you have to be careful that your investors don't resell in less than a year. The time can vary under other circumstances. There is also another regulation that is being used. Some of these names you should keep in mind. Regulation A has been used far less. There are two types. One is capped at 20 million, and the other is capped at 50 million. The interesting thing about Reg A is that there is no restriction on resale if you can use this particular exemption correctly. However, to use Reg A is difficult. My old agency has been careful and takes a long time to approve an offering of Reg A and requires almost like an IPO registration statement so it's not available for everyone.

So about the SEC, I'll just share with you very quickly. Its biggest concern is that it is worried as an agency, and I know its chairman Jay Clayton very well, and you can watch his recent speeches. He is concerned that there is no scandal, and that small investors are not punished and defrauded. Therefore, the crypto and this whole area are viewed with some suspicion and worry by the SEC. After all, small investors are not sophisticated in many cases, and they don't understand what crypto is. They think it is like a security or like a stock. They are worried there will be misunderstandings. That's the broad view that people who are in cryptocurrency have to understand from the SEC. They are going to be very worried if small investors are involved in your offering or in your ICO. One interesting thing is that both Bitcoin and Ether have been declared not to be securities, which means that they don't have to be registered if they are used. Again, a friend of mine who is the director of the Corp Fin has said in a speech that he believes, and therefore the SEC believes, that Bitcoin and Ether are such that they are decentralized, that they are in a network that doesn't have central management, and that's the key. If it doesn't have central management and it is a loose network of engineers or miners, as you know, that term is used, then it doesn't have to be registered as a security.

However, I want to point out how incredibly difficult it is to be in the situation that Bitcoin and Ether are in. Essentially they had a period when they were below the radar, regulators were not very aware of potential for crypto, and individuals were able to form a network without a centralized management team. Today almost all plants need a central manager and you need, whether it's a CEO or a president, you need a group guiding a business plan. If you have that sort of thing, a business plan, then you almost always will have to register with the SEC. Essentially the SEC has put out the guidance. There is something called the Howie test. Again these are details that I would explain to you if you were a client. This is an old case. When I went to the Law school at Harvard, I studied this particular case. Essentially the dramatic finding in Howie is you can have something that doesn't look like a security, a stock or a bond. It can be a security, if there is a centralized management, and if people who buy shares or tokens believe that they will be entitled to some form of profit in the future, whether the asset grows in value, like shares of stock, whether they participate in dividends or what looks like dividends. This is the test the SEC does. There is a lot of guidance out there. The SEC has put out a guidance item that is available on the Internet, and they discuss all the aspects of the Howie test. In particular, whether investors view their tokens, if it is an ICO, whether they view them to somehow entitle them to a gain in the future. If that is the case that it is likely a security, and if you haven't registered as a security, you might get in trouble with the SEC, they may issue a cease and desist order and bring charges and seek a substantial penalty against you. Guidance and being aware is the norm here in this area.

So one recent case, I'll just share that very quickly with you and I'll look at my notes so that I can tell it to you efficiently. It was called Block 1. Maybe some of you know Block 1. Established in 2016, Block 1 developed the ECO software, which is an operating system that underlies one or more sophisticated ECO blockchain. From June 2017 to June 2018, Block 1 conducted an ICO and sold 900 million digital assets in exchange for Ether.

We talked about Ether already. It's like Bitcoin. So they did this to raise capital to develop the ECO software and promote the launch based on Bitcoin. The ICO began one day after the SEC had given another set of guidance. Well, because the SEC invested Block 1 and Block 1 decided to reach a settlement with the SEC, but it announced that the Block 1 did not register its offers, and they should have. This indeed was a security pursuant to the guidance under Howie. The tokens that they have sold had a reasonable expectation by their owners of obtaining a future profit. Again, we talk about another key item. If people are buying these tokens, and thinking that there is going to be a future profit, then it's likely to be a security. This is what the SEC basically held. 

Now, there is an old movie that essentially says that sometimes when you lose, you actually win; and sometimes when you win, you lose. Here, in the settlement, it just occurred on September 30, 2019, just almost within a month. The SEC settled the charges, and Block 1 will pay a $24 million civil penalty which is large in absolute terms, without admitting or denying the SEC findings. Block 1, in characterizing the settlement, said well, it was a victory. Because after all, they raised $4 billion with a live product during the year‑long sale of tokens. So sometimes a regulator doesn't perhaps punish enough. But in this case, Block 1 seems to feel very happy with the way it ended. Of course, my theme here is that they had good lawyers, so that helped.

All right, we are going to see what is happening in Europe. One of the problems is that the US is not as friendly perhaps as other jurisdictions, so in the EU, France leads with regulation that having established the means of registering and taxing cryptocurrency operators, and they believe that the EU members should follow in their footsteps. In 2019, the European Securities and Markets Authority, so‑called the ESMA that I used to deal with when I was a commissioner, indicated support for applying the financial instrument regulation to digital assets. There have been calls for a new regime of digital assets among the various EU regulators, so they are very aware of it. We have to wait and see what they actually come up with. But you can look at France's system which perhaps being the framework for that.

In Asia as you know, many of you are from China, it varies from country. China has banned all activities related to cryptocurrencies primarily due to a concern over associated financial risks. Meanwhile, China is reportedly considering its own digital currency through its Central Bank. On the other side of the Asia, in 2017, Japan put in place infrastructure to regulate cryptocurrency exchanges, as well as establishing anti-money laundering. Japan essentially is welcoming the industry in one respect, and we'll see what happens in China. I suspect that China will allow some types of cryptocurrency activities as its government regulators get comfortable. 

So what are the benefits of adopting cryptocurrency? If you have successfully implemented a decentralized cryptocurrency, there are advantages that traditional centralized financial systems don't provide, because they are created without the single point of failure where hackers and others can get to a central bank. Cryptocurrency is decentralized. That's one advantage, so it's very difficult to hack in terms of its different points. I must say crypto has been hacked in the past. However, this assumes that we have a way of stopping traditional. The problem that hackers would have is that they can't stop a whole network. They could get in, but they might be limited in what they can do and the various networks can probably keep it from being worse. The biggest disadvantage of cryptocurrency, there's much discussion about this, is that it's not scaleable, at least not right now. If you look at the payment giant Visa alone dwarfs cryptocurrency in the numbers of transactions in a day, and it's able to complete transactions if a speed that cryptocurrency cannot yet do. We'll see what you can do with blockchain in the future.

A few companies in the US are talking about cryptocurrency or the stable coin. JP Morgan, despite his calling Bitcoin a scam in 2017, is now leading JP Morgan to become one of the first major American banks to have its own digital coin. In February 2018, they announced that they were going to create a cryptocurrency called JPM coin, which would be incorporated into its wholesale payment system, and would be a so‑called stable coin, 1: 1 fiat. There is not a lot of news about how far that has gone. Presumably it's still being worked, and it is a major intention of JP Morgan. Fidelity as you know, one of the institutional investors, one of the largest managers of capital in the world, created Fidelity digital assets in 2018, a full service enterprise trade platform for securing trading and servicing and maintaining digital assets. In May 2019, it began to offer Bitcoin trading to its institutional customers. Fidelity's decision to enter this industry is widely seen as a response to sustained demand of customers, so we'll see where it goes with Fidelity. If that is successful, you can expect that the vanguard and the other large asset managers will follow. We all know about Facebook and its Libra, but since it was announced, US regulators and politicians have asked Facebook to halt its development, and we'll see where it goes. I think Facebook has to convince both regulators, congress, even the public that Libra is something that is not dangerous to investors. There is a big aspect of marketing that it has to go through. They are a massive company, and it is very skilled in this area. They may yet get it, but it is probably going to take several years, just a guess, before Libra could be a functioning system.

Amazon has also stated that they would consider doing Amazon pay. Patrick Gauthier, one of the senior people at Amazon, said in a speech that Amazon would only consider creating its own cryptocurrency in several years time, saying it is fresh and speculative. We don't really deal with the speculations that are currently going now at Amazon.

So a couple of quick things about where regulation is in the US. There are a lot of regulations through congress, and congress after all can pass laws and could change regulations, for there to be a single regulator of cryptocurrency and a single regulator perhaps of fintech, to enable everyone to work with one regulator, and not with all the many agencies that I just mentioned to you, including the states that has some support. I don't expect something to pass like that very soon. Instead, what we have is that the SEC and the CFTC and other agencies essentially are trying to apply laws that were passed in the 1930s, not quite 100 years, but to the modern world of cryptocurrency and fintech. It is very difficult, but that is why they have things like the Howie test and other things that seem arcane to today's young entrepreneurs and people who are in this particular world. 

In the US, there is also a concern for driving a potential and strong industry. Cryptocurrency and blockchain will go to other shores if the regulations are too strenuous and doesn't allow for growth. It is a broad concern. This concern of course competes with the concern and the interest of protecting investors. Therefore, somewhere has to be a space to allow innovation in a new industry like fintech and cryptocurrency to prosper, but in a way that doesn't smother it with new regulations or with difficulties in bureaucracy so that it goes to other shores. The US today, in our SEC, in our agencies, is worried that there is no more IPO and that foreign companies are coming less to the US. This is part of the concern that exists in today. I spent my current career living in Washington DC, so I can learn about not only the politics that are going on. I'm not a political person, but I stay near the SEC. Being a former commissioner, I listen carefully, and I'm invited to small gatherings which the senior SEC people do. I listen a lot to see what they are thinking, where they are going. I don't generally try to persuade them one way or the other but I listen to where they are going. I provide this insight to clients and to my friends, and I'll end by saying to you that if you need my help, I will take your call. As I said, you should call someone if you are planning to start a crypto business or an ICO. It doesn't have to be me, but you need a good lawyer. I'll stop and thank you very much for your kind attention.

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