Current Developments in Digital Assets: November 12, 2020

Practical Law Legal Update w-028-3086 (Approx. 9 pages)

Current Developments in Digital Assets: November 12, 2020

by Practical Law Finance

China Launches Central Bank Digital Currency (CBDC)

Reuters reports that more than 2 billion yuan ($299.07 million) has been spent using China’s new digital currency so far in four million separate transactions, as reported by the People’s Bank of China (PBOC). China’s digital yuan is one of the most advanced central bank digital currency (CBDC) initiatives underway around the world, as authorities globally respond to plans for private cryptocurrencies such as Facebook’s Libra.

CBDCs are designed to replace physical cash with a digital currency giving the holder a direct claim on the central bank. China’s version follows a two-tier approach, with the PBOC issuing the digital yuan but commercial banks and big tech companies distributing it to consumers. China has launched several pilot schemes for the digital yuan, most recently in the southern city of Shenzhen last month, when the PBOC gave 200 yuan ($29.75) each to 50,000 consumers selected in a lottery to spend in selected stores.

Report: Crypto Crime Slows but DeFi Hacks Accelerate

According to a Reuters report, crypto-intelligence company CipherTrace has found that losses from cryptocurrency thefts, hacks, and fraud declined to $1.8 billion for the first 10 months of the year compared with last year, but crime in the decentralized finance (DeFi) sector rose. Crypto crime hit $4.5 billion globally in 2019. The report attributes the reduction to implementation of security measures in the cryptocurrency space.

So far in 2020, losses from thefts and hacks, excluding misappropriation and fraud, grew to $468 million as of end-October, up 30% from $361 million for the whole of last year, the report said. About 20% of those hacks, or roughly $98 million, came from DeFi, which are transactions on platforms that facilitate lending outside of banks.

The total number of loans on DeFi platforms was $12.6 billion as of November 9, 2020, industry site DeFi Pulse data showed, up more than 200% from roughly $4 billion in August 2020 – the culmination of the "summer of DeFi."

DeFi sites run on open infrastructure, with algorithms that set rates in real time based on supply and demand. According to the report, the surge in DeFi attracted criminal hackers, resulting in the most hacks for the sector this year. In 2019, DeFi hacks were negligible. DeFi networks are permissionless by design, which means they often lack clear regulatory compliance, anyone in any country is able to access them with little to no customer-verification hurdles involved.

NYDFS Approves PayPal for First Conditional BitLicense

The New York Department of Financial Services (NYDFS) announced that PayPal, Inc. is the first entity to receive a conditional BitLicense from NYDFS. With approval from NYDFS, PayPal, in partnership with Paxos Trust Company, has launched a new service enabling its customers to buy, sell, and hold certain cryptocurrencies. New York State-chartered Paxos will provide trading and custodial services to PayPal to enable PayPal customers to buy, sell, and hold, VC. Four DFS-approved virtual currencies will be initially available: bitcoin, bitcoin cash, ethereum, and litecoin.

Since 2015, DFS has approved 26 entities to engage in virtual currency business activity in New York State. For details on the NYDFS BitLicense framework, see Practice Note, NYDFS BitLicense Framework: Overview.

FinCEN Issues Major Penalty Against Bitcoin Mixer for AML Violations

The Financial Crimes Enforcement Network (FinCEN) announced that it assessed a $60 million civil money penalty against Larry Dean Harmon, founder, administrator, and primary operator of Helix and Coin Ninja, convertible virtual currency (VC) "mixers," or "tumblers," for violations of the Bank Secrecy Act (BSA) and its implementing regulations.

According to FinCEN, Harmon operated Helix as an unregistered money services business (MSB) from 2014 to 2017 and Coin Ninja from 2017 to 2020. Doing business as Helix and Coin Ninja, Harmon operated as an exchanger of convertible VC by accepting and transmitting bitcoin through a variety of means. From June 2014 through December 2017, Helix conducted over 1,225,000 transactions for its customers and was associated with VC wallet addresses that sent or received over $311 million dollars. FinCEN’s investigation has identified at least 356,000 bitcoin transactions through Helix. Harmon advertised the services as a way for customers to anonymously pay for illicit items. Mr. Harmon subsequently founded, and acted as Chief Executive Officer of, Coin Ninja, which operated as an unregistered MSB and in the same manner as Helix.

Harmon is currently being prosecuted in the US District Court for the District of Columbia on charges of conspiracy to launder monetary instruments and the operation of an unlicensed money transmitting business in connection with his operation of Helix. FinCEN coordinated on the action with the US Department of Justice’s Computer Crimes and Intellectual Property Section, the US Attorney’s Office for the District of Columbia, the Federal Bureau of Investigation, and the Internal Revenue Service Criminal Investigation division.

FinCEN clarified in its 2013 guidance that exchangers and administrators of convertible virtual currency are money transmitters under the BSA. As such, they have an obligation to register with FinCEN and maintain anti-money laundering (AML) compliance programs. FinCEN issued further clarification in 2019 that financial institutions that are mixers and tumblers of convertible VC must also meet these same requirements.

SEC v. Kik Interactive Inc.: US District Court Grants Summary Judgment to SEC Regarding Unregistered ICO

The US District Court for the Southern District of New York (SDNY), in US SEC v. Kik Interactive Inc., granted summary judgement to the SEC, ruling that Kik's $100 million two-phase initial coin offering (ICO) was an offer and sale of securities without a registration statement in violation of Section 5 of the Securities Act of 1933 (Securities Act) (U.S. S.E.C. v. Kik Interactive, Inc., (S.D.N.Y. Sept. 30, 2020)).

In both Kik and another recent SDNY ICO case, SEC v. Telegram Group, Inc. (448 F.Supp.3d 352 (S.D.N.Y. Mar. 24, 2020), the court focused on the economic reality of the transactions, which led to a ruling in favor of the SEC. Together, these two cases represent a challenge for companies seeking to offer digital tokens without SEC registration. With these and other related cases, the US unregistered ICO market has been effectively shuttered and the future utility of the simple agreement for future tokens (SAFT) called into question.

For further detail on this case, see Legal Update, SEC v. Kik Interactive Inc.: US District Court Grants Summary Judgment to SEC Regarding Unregistered ICO.

Other Noteworthy Developments

US Regulatory

FinCEN and Federal Reserve Board Issue Proposal Clarifying That BSA Regulations Apply to Virtual Currencies. FinCEN and the Federal Reserve Board jointly issued a proposed rule that would amend regulations under the BSA to clarify that the definition of money includes convertible VC and digital assets that have legal tender status. The proposed rule would clarify that "money," as used in certain BSA rules, explicitly includes domestic and cross-border transactions in convertible VC (CVC) and digital assets that have legal tender status. For further detail on the proposal, see Legal Update, FinCEN and Federal Reserve Board Issue Proposal Clarifying That BSA Regulations Apply to Virtual Currencies and Lowering Recordkeeping Thresholds.

Offshore Cryptocurrency Derivatives Exchange BitMEX Charged With AML and BSA Violations. The CFTC announced the filing of a civil enforcement action in the SDNY and the DOJ announced a related criminal action, charging owners and operators of offshore cryptocurrency derivatives trading platform Bitcoin Mercantile Exchange (BitMEX) with operating an unregistered trading platform and violating multiple CFTC regulations, including failing to implement required anti-money laundering (AML) procedures. For further information, see Legal Update, Offshore Cryptocurrency Derivatives Exchange BitMEX Charged With AML and BSA Violations.

CFTC Issues Advisory Regarding FCM Segregation of Virtual Currency Held as Customer Funds. The CFTC's Division of Swap Dealer and Intermediary Oversight (DSIO) issued CFTC Letter No. 20-34, in which DSIO addresses futures commission merchant (FCM) holdings of VC as customer funds. According to the advisory, because VC presents a degree of custodian risk that is beyond what is present with depositories such as banks and trust companies, DSIO reminds FCMs that they must adhere to certain requirements, enumerated in the advisory, when holding VC as customer funds. For details on the advisory, see Legal Update, CFTC Issues Advisory Regarding FCM Segregation of Virtual Currency Held as Customer Funds.

DOJ Releases Cryptocurrency Enforcement Framework. The US Attorney General's cyber-digital task force of the US Department of Justice (DOJ) published a cryptocurrency enforcement framework (CEF), which examines the efforts, strategies, and legal positions that DOJ employs to combat cryptocurrency-related crimes. The CEF is the second detailed report issued by the cyber-digital task force, which was established in February 2018. Among other things, the CEF provides the following examples of activities that would enable DOJ prosecution:

Use of virtual assets to import illegal products to the US.
Use of a US-located virtual asset service provider (VASP) or financial institution for money laundering.
Conduct involving cryptocurrency that provides material support to a designated foreign terrorist organization.

For further details on the DOJ framework, see Legal Update, DOJ Releases Cryptocurrency Enforcement Framework.

SEC Issues No-Action Letter on Role of Alternative Trading Systems (ATSs) in Settling Digital Asset Security Trades. The SEC's Division of Trading and Markets issued a no-action letter to FINRA regarding the process in which alternative trading systems (ATSs) can facilitate trades of digital asset securities without violating Exchange Act Rule 15c3-3 (the Customer Protection Rule). In its no-action letter, the Division stated it would not recommend enforcement action to the SEC if a broker-dealer operating an ATS that trades digital asset securities uses a three-step process specified in the letter for settling digital asset securities transactions, subject to certain conditions. For further information, see Legal Update, SEC Issues No-Action Letter on Role of Alternative Trading Systems (ATSs) in Settling Digital Asset Security Trades.

International Regulatory

Central Bank Group Issues Report on Principles and Features of Central Bank Digital Currencies (CBDCs) and FSB Finalizes High-Level Recommendations on Global Stablecoin Arrangements. A group of central banks and the Bank for International Settlements (BIS) have published a report on the foundational principles and core features of central bank digital currencies (CBDCs). Additionally, the Financial Stability Board (FSB) has published the final version of its high-level recommendations for the regulation, supervision and oversight of global stablecoin (GSC) arrangements. For details, see, respectively, Legal Updates, Central Bank Group Issues Report on Principles and Features of Central Bank Digital Currencies and Legal Updates, FSB Finalizes High-Level Recommendations on Global Stablecoin Arrangements.

European Commission Issues Legislative Proposal for Regulation of Cryptoasset Markets. The European Commission has adopted a legislative proposal for a Regulation on markets in cryptoassets (COM(2020) 593 final). The interinstitutional reference number for the legislative proposal is 2020/0265 (COD). The proposal establishes a new EU legal framework for cryptoassets that are not covered by existing EU financial services legislation, providing legal certainty for those cryptoassets and establishing uniform rules for cryptoasset service providers and issuers at EU level. For more information, see Legal update, European Commission Issues Communication on EU Digital Finance Strategy.

FCA Issues UK Ban on Retail Cryptoasset Derivatives Products. The UK Financial Conduct Authority (FCA) published a policy statement (PS20/10) prohibiting the sale to retail clients of derivatives and exchange traded notes referencing certain types of cryptoassets. The FCA considers that products referencing certain types of unregulated, transferable cryptoassets are ill-suited for retail clients due to the harm they pose and the risk from sudden and unexpected losses. If a party carries out marketing, distribution or selling activities in or from the UK of these products to retail clients, they must cease these activities by January 6, 2021. The measure is not expected to have broad market-wide impact, as the UK is an important but relatively small segment of the global market for these products. For further details, see Legal Update, FCA Policy Statement Bans Sale of Investment Products Referencing Cryptoassets to Retail Clients.

Further Information on Digital Asset Regulation

For information on regulation of digital assets, see Practice Notes:

See also Practical Law's Blockchain Toolkit and Update Tracker.

Current Developments in Digital Assets: November 12, 2020 | Practical Law