Wednesday, July 18, 2018

CFTC joins regulatory chorus in warning investors about the hazards of digital tokens

By Brad Rosen, J.D.

The CFTC has issued a customer advisory aimed at would-be investors of virtual coins and ICO’s warning them of potential risks and pitfalls associated with these novel products and emerging markets. With its release titled Use Caution When Buying Digital Coins or Tokens, the CFTC joins recent pronouncements by FINRA and the SEC in raising concerns and potential red flags in connection with these burgeoning digital instruments.

In its advisory, the CFTC observes that “Digital tokens and coins can also be derivatives or commodities, depending on how they are structured.” A CFTC spokesperson elaborated stating, “The development of blockchain technologies makes it possible to digitize or tokenize virtually any asset, including physical commodities. Tokens can take many forms, including that of being a contract. The CFTC would look to the terms of the contract to determine whether it may constitute a future or a swap. For example, a token could include terms that promise delivery of a commodity at a later date.”

The core warning. The CFTC’s front-row, center, and bolded warning for investors is this: “[E]xercise caution and conduct extensive research before purchasing digital coins or tokens, including those self-described as “utility coins” or “consumption coins.” Understand what rights are attached to the coin or token being sold, and what underlying factors could affect its value. Be especially wary of promises or guarantees of future value.”

Factors to consider. In its advisory, the CFTC identified a number of factors that could impact the future value of a digital token. These include:
  • the potential for forks that could split away market participants, increase the number of digital coins, or render coins obsolete; 
  • decreasing mining or validation costs (if price is tied to those factors); 
  • acceptance of other currencies, coins, or tokens for offered goods and services; 
  • the link between the value of a digital coin or token and the offered product or service; 
  • adoption of the digital coin or token as a broad medium of exchange or store of value; 
  • future competitors or technological changes that could disrupt the underlying business; 
  • future demand or uses for an application, network, product, or service; 
  • liquidity in the market for a specific digital coin or token; 
  • changes to the underlying technology that could devalue your digital coins or tokens; and 
  • risk of theft from hacking. 
Self-protection. The advisory also suggests that a would-be investor to engage in thorough research before any digital coin purchase. Some specific pre-investment recommendations include:
  • Conduct extensive due diligence on any individuals and entities listed as affiliates of a digital coin or token offering. Ask if they participating in the coin offering. If you can’t easily find information about affiliated entities or individuals, that should be a red flag; 
  • Before investing in an ICO, ask whether the digital coins or tokens are securities and if the offering is registered with the SEC; and 
  • Find out how your money will be used, if you can get it back, and what rights the digital coin or token provides you. These rights should be clearly spelled out in the business plan, white paper or development plan. Make and keep copies of this information.
The advisory notes that many ICOs have been identified as fraudulent. As a result, if fraud or theft should occur, an investor may not be able to get its money back.

An industry observer weighs in. Gary DeWaal, Special Counsel at Katten Muchin Rosenman’s New York City offices, and a frequent speaker and writer on crypto-regulation, captured some irony regarding the CFTC’s advisory, noting, “They say that blockchain technology is disruptive technology. In the last two weeks, FINRA—a securities self-regulator—has indicated it wants information from its members regarding all their digit asset activity—including futures transactions. And now the CFTC—a derivatives regulator—is warning about utility tokens and security tokens, in addition to tokens that act as virtual currencies.” DeWaal concludes, “It seems that blockchain technology is disrupting law and regulation too!”