Well, we’ve been holding off addressing the topic of cryptocurrencies in general, and Bitcoin specifically, as the topic historically has not been relevant to the securities industry. However, the development of these instruments (there are now over one hundred different cryptocurrencies) and markets has been so rapid that the SEC, FINRA and other global regulatory bodies have all issued guidance and in some cases regulations covering this space. In addition, the market value of Bitcoin and a few other cryptocurrencies has increased dramatically and become a veritable reminder of the Dutch Tulip Bulb mania of several centuries ago.
What is Bitcoin?
Bitcoin is a form of digital currency that is created and stored electronically (i.e. encrypted for security and ownership purposes). The SEC has stated that a virtual, crypto or digital currency is “a digital representation of value that can be digitally traded and functions as medium of exchange, unit of account or store of value”. In simple terms, Bitcoin is money. It can be exchanged for real currencies and can be used to purchase goods or services. The list of legitimate businesses that accept Bitcoin as legal tender currently ranges from pizza shops to car dealerships and is growing in adoption. Bitcoin is decentralized: it is not backed by any government or central bank and it not accepted by banks as a component of money supply. The IRS has issued guidance that it will treat cryptocurrencies as property for federal tax purposes.
How does it work?
According to a FINRA information circular, Bitcoin is essentially “a sophisticated computer program that encrypts, verifies and records transaction”. Users are anonymous, but a public record known as a block chain is shared between Bitcoin users and the authenticity of transactions are verified via mathematical proofs.
Bitcoins are created by a process called “mining” (analogous to that of precious metals). The creators or “miners” are individuals or entities that use computer algorithms to find new blocks which entitles them to receive new Bitcoins. The process has become quite complicated and resource intensive such that the average person cannot individually procure Bitcoin.
As mentioned, Bitcoins can be bought and sold online (and now starting at some physical locations) and/or used to purchase goods and services. Bitcoins are stored in a digital “wallet” which is similar to the notion of a bank account. Various startups have come to life to provide services such as wallet facilities and currency exchange marketplaces.
Given that nature of Bitcoin, its development and some of the illicit uses for which it is know it is clearly understood that there are risks associated with using Bitcoins. FINRA has cautioned the public in the following areas:
- Bitcoin is not legal tender and not required by law to be accepted as a form of payment. Bitcoin use is based on voluntary adoption by the marketplace. Thus, Bitcoin’s intrinsic value is a function of the degree of its adoption. If not enough adoption occurs or it drops significantly Bitcoin can become worthless.
- As has happened in several high profile cases, Bitcoin exchange and wallet facilities have been hacked. Thus, theft, fraud and loss of funds are significant risks—particularly given the anonymity which proves tracking and recovery of lost funds virtually impossible.
- There is no FDIC or similar government protection provided to digital wallets.
- Bitcoin payments are not reversible. Thus, notions of refunds, adjustments or cancels of transactions do not exist.
- Bitcoin has at times been used in illegal activities such as drug dealing and money laundering. This leads to the risk that at some point governments may decide to restrict or even prohibit the use of Bitcoin platforms and exchanges.
- Because of the risks highlighted above and especially due to a speculative asset pricing phenomena (i.e. bubble/mania) associated with Bitcoin and other cryptocurrencies, prices have been volatile and subject to significant price swings as seen in the chart below.
Source: Google Finance (9/20)
Initial Coin Offerings (ICOs)
An extension of crypto or virtual currencies is the concept of initial coin offerings (ICOs). A recent development, ICOs are used to raise capital and are similar in theory to initial public offerings (IPOs). The difference is that developers, businesses and even individuals sell coins (currency instead of equity shares) to purchasers with the proceeds ostensibly to be used to fund development of initiatives in the space such as software (e.g. digital wallets), platforms (e.g. exchanges) and other components of the blockchain world.
As one can imagine, the ICO arena has been rife with the potential for fraudulent sales, investor misrepresentations (“guaranteed high returns”) and theft of investment proceeds. As such, the SEC in July 2017 issued an investigative report covering the use of blockchain technology as a means to raise capital. The result is that the SEC determined that the issued coins or tokens are deemed to be securities. Thus, those involved with the offer and sale of those securities in the U.S. “are required to comply with federal securities laws, regardless of whether those securities are purchased with virtual currencies or distributed with blockchain technology”.
Just a reminder of firm policy, Quest Capital does not allow private securities transaction participation by its registered representatives, any capital raising as part of any outside business activities or any other investment-related initiatives outside the purview of the firm’s written prior approval. ICOs fall within this prohibition and thus registered representatives are prohibited from participating in any ICO or ICO-related activities.