Edmund Mokhtarian and Alexander Lindgren have written a fascinating discussion of “operational issues and best practices” for cryptocurrency traders. As part of this broader discussion, they have provocative things to say about the regulatory system in the U.S. and about where, if anywhere, bitcoins and other cryptocurrencies fit into it.

The regulatory system in the United States is both fragmented and functional. There is no single administrative body whose job it is to oversee the capital markets as a whole, working toward efficiency on the one hand and working against fraud on the other. Instead, there are several agencies involved in this task or these tasks, the most important of which (the Commodity Futures Trading Commission and the Securities and Exchange Commission) are distinguished from each other by the sort of investment vehicle they oversee. As the names suggest, the CFTC oversees commodities trading, the SEC securities trading.

The fragmentation is “functional” in character in that the distinction is defined by the function the two types of instrument perform.  Commodities and securities have much in common.  They are both traded on markets, they are both quite liquid, and they both serve both profit seekers and risk hedgers. But what distinguishes them? Seventy years ago the Supreme Court gave the following functional definition if a security: it is an instrument by which “a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”

The Function of a Security

By design, that definition is very broad, in order to make it difficult for security fraudsters to escape responsibility by saying that they aren’t really securities fraudsters.  The function of a security, whether called a stock or bond or something else, is to allow an investor to gain exposure to the gains of an enterprise (commonly a listed corporation) without making any further ‘effort’ other than the infusion of the money itself.

It would be very difficult to shoehorn investment in the cryptocurrencies into this notion of the purchase of a security. What is the common enterprise? There are lots of enterprises in SCOTUS’ sense within the bitcoin ecosystem, or the ecosystems of the other cryptos:  but simply owning the ‘coins,’ waiting for a price increase, and selling into the market for a profit doesn’t constitute investing in any of them.

Nor is a cryptocurrency a currency sans phrase. The Internal Revenue Service, for example, has made it clear that it regards what it calls “virtual currency” as a form of property, an asset. Thus, “general tax principles that apply to property transactions apply to transactions using virtual currency.”

As Mokhtarian and Lindgren observe, in their paper for the Stanford Journal of Law, Business, and Finance, “most of the established and highly traded cryptocurrencies, such as Bitcoin and Ether, qualify as commodities rather than securities.”  

This means in the opinion of the authors that cryptos “present a far greater risk of fraud or investor losses than a traditional hedge fund, as cryptocurrency markets lack the liquidity, stability, and regulatory certainty of traditional securities markets.”

What about the CFTC?

What, then, about the CFTC? Mokhtarian and Lindgren remind us that the pooled investment vehicles and trading advisors that use designated self-regulatory exchanges are required to register with the CFTC, and that this puts them under a set of requirements similar to those of the Advisers and Investment Company Acts.

The Dodd-Frank Act, drafted in the waked of the Global Financial Crisis and with the goal of cracking down on the shenanigans that, in the eyes of the drafters, had enabled that crisis, or at the least cranked up its severity, expanded the scope of CFTC jurisdiction to include all commodity swaps and derivatives contracts of any type. The only escapees from this regulatory net were to be forward delivery contracts involving cash settlement and physical delivery, because those were regarded as the concerns of operational businesses rather than finance, Main Street rather than Wall Street.

So: do cryptocurrency investment funds fit into this framework?  Mokhtarian and Lindgren make the case that the activity of a crypto fund could indeed fall within that lonely exception to the scope of the expansion of the CFTC’s authority: Crypto tokens could be regarded as the subject of forward delivery contracts with physical delivery and cash settlement. Thus, “the unique challenges of crypto funds will require new and different solutions than the best practices embodied in current regulation.”