Bitcoin-based start-ups are struggling to navigate uncharted regulatory territory as blockchain technology seeps into various corners of the financial services community, where multiple regulatory regimes often apply.
The obstacles are confronting firms working to overlay ledger-based settlement systems into the investing community, whether through derivatives exchanges that reference the value of Bitcoins– or exchanges that use Bitcoins to invest in other assets.
“The blockchain provides the potential for more efficient markets so it is extremely attractive to try to build it into existing financial services infrastructure,” said Grant Fondo, partner at Goodwin Procter who represented such firms as Sand Hill Exchange and Ripple Labs in recent settlements with the federal government.
“The problem is offerings can cross a variety of regimes, and on top of that there are rules such as in New York that if you change your business model ‘materially’ you have to check in with the government. So it is becoming extremely important for these firms to navigate the regulatory regimes carefully, because regulators have put the industry on notice.”
The ongoing trend was punctuated last week by the SEC’s settlement with Sand Hill, a Bitcoin-based exchange that was offering derivative contracts referencing the value of pre-IPO tech firms.
Lawyers say firms have long been confronted with whether or not to try and be fully regulated for security purposes or to stay outside of the scope of established regulatory regimes so as to maintain flexibility. But the Sand Hill settlement has “made an impact” with the agency and the industry, said sources.
The SEC two weeks ago convened a private panel with lawyers in Silicon Valley on the back of the Sand Hill settlement to explain the ins and outs of start-up firms offering investment instruments to retail investors – or offering derivative-like instruments without being a regulated exchange.
Sand Hill highlighted those issues because it was not regulated as a national securities exchange nor was it following the rules associated with offering derivative contracts to retail investors – who must be deemed ‘Eligible Contract Participants’ under SEC law.
“The SEC is trying to send a message that if you want to do any securities-related product, you’ve got to look closely at the definitions,” said one participant close to discussions.
“Dodd-Frank provided a very wide band for the definition of a ‘swap’ and that can now include even offerings like a bet between two people on a stock – for example in so-called Fantasy Stock Trading websites. The agency also does not want people thinking that if you use Bitcoin to make payments you can avoid regulation.”
The build-outs are not limited to start-ups though.
In May, Nasdaq announced a pilot programme testing blockchain technology for trading shares in private companies on its Nasdaq Private Market exchange, somewhat akin to the Sand Hill offering.
On June 8, Overstock.com, one of the earliest adopters of Bitcoin, announced an offering of US$25m of the world’s first cryptobond –a bond using the cryptographically-protected distributed ledger that underlies Bitcoin.
“Among the companies that are launching or trying to use Bitcoin-based technology, there is a wide variety in the types of offerings that are coming to market,” said Sarah Martin, VP at industry group Digital Currency Council.
“It’s still an unregulated space so firms are trying to manoeuvre as much as possible before things get clamped down. There’s a calculation of knowing the law and making a business decision around whether or not to move into a regulated space or stay out until the market fleshes itself out some more.”
