Mary Donohue
Associate Editor
Loyola University Chicago School of Law, JD 2020
On March 6th, 2018 the. District Court for the Eastern District of New York upheld the classification of cryptocurrencies, such as Bitcoin and Litecoin, as commodities. The ruling subjects the cryptocurrencies to the regulation of the U.S. Commodity Futures Trading Commission (CFTC).
Court’s Classification of Cryptocurrencies
Since the first white paper “Bitcoin: A Peer-to-Peer Electronic Cash System” was published under the pseudonym Satoshi Nakamoto in 2018, investors and regulators alike have wondered whether this new cash system would be classified as a security or a commodity and which regulatory body would have the power to regulate it. This ruling gives the CFTC the legal precedent necessary to bring cases and possibly begin efforts to codify rules regarding their regulation.
Cryptocurrency regulation is a topic ripe for debate; many traders and professionals would prefer this industry stick to its narrative as an unregulated, peer-to-peer network, while investors and some firms waiting to enter the market would prefer it was subject to stauncher regulations to prevent market manipulation and fraudulent activity.
CFTC Claims against Fraudulent Cryptocurrencies Company
Judge Weinstein’s decision to classify cryptocurrencies as a commodity led the CFTC to bring its case against defendants Patrick K. McDonnell of Staten Island, New York and CabbageTech, Corp d/b/a Coin Drop Markets (CDM), McDonnell’s New York-based company, ordering them to pay over $1.1 million in civil monetary penalties and restitution in a lawsuit where the CFTC alleged fraud in connection with virtual currencies.
In his decision Weinstein found that McDonnell and CDM engaged in a deceptive and fraudulent virtual currency scheme from January through July of 2017. Victims of the scheme believed they were paying for the purchase and sale of virtual currencies and expert virtual trading advise, but the defendants misappropriated the customers’ funds.
Defendants told customers the company had multiple offices and that McDonnell was the “boss” of CabbageTech. In truth, the company was run by McDonnell alone from his basement in Staten Island. Defendants were ordered to pay restitution in the amount of $290,429 as well as a civil monetary penalty of $871, 287 and were issued a permanent injunction.
This case represents the first of likely many cases that will be brought by the CFTC in an effort to tackle fraudulent trading practices in the world of cryptocurrencies. Another such case involves My Big Coin Pay, Inc., where the CFTC charged defendants with fraud and misappropriation in ongoing virtual currency scam.
Rules enacted by CFTC to address fraudulent cryptocurrency activity
So far most of the activity involving regulatory enforcement actions of cryptocurrencies have been brought by CFTC and Securities and Exchange Commission (SEC). The enforcement has focused on fraudulent activity rather than providing guidance about trading and listing cryptocurrencies on exchanges.
While CFTC has issued podcasts discussing the future landscape of digital assets and blockchain-based technologies, customer advisories about purchasing digital coins, and risks of virtual trading, the regulatory landscape is likely to come into clearer view as the CFTC continues to bring cases. In June 2018, CFTC shifted its focus to coordinating and harmonizing work in cooperation with the SEC and its counterparties on cases involving virtual currencies. The two organizations updated their ten-year-old memorandum of understanding to facilitate information sharing related to swaps, and security-based swaps data, fintech developments, and market events. CFTC enforcement director James McDonald said, “our mission is to foster financially sound markets, and we understand as a regulator that requires a certain amount of [flexibility] in our approach.” McDonald’s statement likely signals the CFTC shifting its focus into regulatory efforts, including more enforcement actions, rule-making, and coordination with whistleblower policies similar to its existing protocols. The ruling from McDonnell might just have given the CFTC the green light it needed to further its efforts in encouraging financially sound markets.
SEC actions in regulating cryptocurrency
Despite the ruling of cryptocurrencies as commodities, there is still some suggestion by the SEC that there are instances when they may be subject to regulation as securities. The SEC recently rejected a second attempt by the Winklevoss Twins, founders of the crypto exchange Gemini, to list shared of what would be the first-ever bitcoin exchange-traded fund (ETF).
Following the news of the 3-1 decision by the commission, the price of bitcoin dropped 3% to $7,880. The agency said in a release they did not support the Winklevoss’ arguments that Bitcoin markets are “uniquely resistant to market manipulation.” The SEC emphasized that disapproval does not rest on an evaluation of whether Bitcoin and blockchain technology has value as an investment; but that their mission is to prevent fraudulent or manipulative acts and they were not certain that the opportunity provided ample consumer protection. The SEC noted that more than three-fourths of the volume in bitcoin occurs outside the United States and much of the volume occurs on non-U.S. exchanges. The release explained that most of the daily trading volume for bitcoin occurs on exchanges outside the US on poorly capitalized, unregulated exchanges and their practices significantly influence the price discovery process. The implications of high volumes of offshore trading means that much of the trading is in an unregulated environment, which makes it more difficult to ensure trades are legitimate and not a part of a larger scheme.
In the coming months, we are likely to see more enforcement actions taken by both regulatory bodies, with the CFTC taking the lead. As the CFTC begins to get its bearings in this new area of regulation, it might begin to issue rules, more practical guidelines for working in cryptocurrency markets, and promotions of its whistleblowing program.