The first Bitcoin ETF began trading today in the United States. Although this ETF is a Bitcoin Futures ETF, the world’s largest digital currency manager announced today that an application to convert its Bitcoin Trust into a Bitcoin Spot ETF has been filed. Bitcoin, other Cryptocurrencies and digital assets in general will continue to gain popularity, both as an individual investment and as a business opportunity, and there are plenty of new terms and concepts to be aware of. The below is a non-exhaustive overview of some of the most important and prevalent concepts within the world of digital assets. For instance, there are over ten thousand different cryptocurrencies; however only Bitcoin and Ethereum are listed below as they are by far the two largest coins in terms of market capitalization.

If you are already familiar with some of the below terms but are wondering how to further pursue any opportunities within the industry, make sure to review the articles describing the various State Regulations of Digital Assets, FinCen Rulings regarding Cryptocurrencies, the IRS’s view on Cryptocurrencies, the SEC’s view on Cryptocurrencies, and the CFTC’s view on Cryptocurrencies each of which can help point you in the right direction of ensuring that you do not run afoul of the various regulations facing Digital Assets. Additionally if you already own Cryptocurrency and are wondering how you can use your Cryptocurrency, take a look at my previous article providing an overview of a few different uses of cryptocurrency to help inform you of some options regarding your property.

Feel free to reach out with any questions regarding any of the concepts below, or any of the previously covered topics, and how they can apply to you.

Term Description
Address Unique identifier which serves as the location where the cryptocurrency can be sent. You need to have an address to be able to send, receive, or hold Cryptocurrencies in a Wallet. It’s like a bank account.
Altcoin Any Cryptocurrency that isn’t bitcoin.
Bitcoin A peer to peer network allowing users to send payments directly to each other via bitcoin.
bitcoin (BTC) The virtual coin generated by the Bitcoin network.
Block A file containing the data for a number of transactions for a specific network. Once the transactions in a block are validated by the Miner, and the Miner solves the mathematical equation associated with the Block, the Block is posted to the Blockchain.
Block Reward The reward that the first Miner to solve the mathematical equation associated with a Block receives for solving the equation.
Block Size Describes the amount of data that can be added to an individual Block of a specific Blockchain.
Blockchain The underlying technology that Cryptocurrencies use to record and validate transactions on the network, each validated block gets added to the chain, and each block is cryptographically connected to the previously validated block. Serves as a digital Ledger.
Cold Storage A method of storing cryptocurrencies offline, can be in a device like a USB drive or a hardware wallet.
Cryptocurrency A virtual currency. Allows users to exchange the currency directly between one another.
Custody A service in which a third party holds the cryptocurrency on behalf of the owner.
Decentralized Autonomous Organization (DAO) An organization that is automated and decentralized, the traditional decision making of a company is replaced by the members of the DAO.
Decentralized Applications (DApps) Applications deployed on a blockchain that carries out actions without an intermediary. It is an open-source application that is built on a blockchain and is intended for real-world use.
Decentralized Finance (DeFi) Financial activities that are conducted without the involvement of an intermediary third party.
Decentralized Exchange (DEX) An exchange in which individuals can exchange cryptocurrencies directly without any middleman.
Digital Asset A non-tangible asset that is created, traded, and stored in a digital format.
Ether (ETH) The cryptocurrency for the Ethereum network.
Ethereum A decentralized network allowing developers to create decentralized applications, including smart contracts.
Exchange A platform allowing buyers and sellers to trade various digital assets.
Fork The result of changes in the rules of a specific blockchain creating multiple distinct Digital Assets. The two types of Forks are Hard Forks and Soft Forks.
Genesis Block The first block in a specific blockchain.
Halving A term specific to Bitcoin in which the mining reward is cut in half, this occurs every four years and significantly reduces the supply of new bitcoin.
Hard Fork A change in a specific blockchain which results in a new blockchain based on the new rules.
Hash A unique combination of numbers and letters that identifies Blocks and is tied to buyers and sellers of Cryptocurrencies.
Hash Rate The amount of hashes a Miner computes in a specific time. The higher the Hash Rate, the more blocks the Miner obtains.
Initial Coin Offering (ICO) A method for capital to be raised for a new company or project, they are similar in nature to initial public offerings.
Keys Long codes used in digital asset transactions. A public key is available for anyone to see and is used as the output in a transaction, and a private key is only known to the owner of the key and is used to sign off on the transaction.
Ledger The record of all the transactions on a specific blockchain.
Mining A method by which Cryptocurrencies (specifically bitcoin) are created and transactions are added to the blockchain. The first miner to solve a specific mathematical equation can then publish a new block on the blockchain, and receives the reward associated with the block.
Mining Pool Occurs when Miners join together and share in the rewards from blocks that are mined.
Multi-Signature A security feature of digital assets requiring multiple Private Keys to sign for a transaction and allow the movement of funds.
Node Software that serves as a transaction validator (outside of mining) and as digital wallets for a specific Blockchain.
Non-Fungible Token (NFT) A Token that can be used to represent the ownership of any unique asset including art, music, or even a deed to real estate eventually.
Private Key An encrypted code that allows you to access your Cryptocurrency, it’s similar to a bank account password.
Proof of Authority (PoA) A Blockchain validation method in which a few specific Nodes are granted the right to approve a Miner’s ability to create a Block.
Proof of Work (PoW) The method that Bitcoin uses to verify new transactions and add them to the Bitcoin Blockchain. The ability of a Miner to validate a new Block and obtain the reward is dependent upon the Hash Rate.
Proof of Stake (PoS) The process that various Cryptocurrencies use in selecting which network participant gets to add the next Block to the specific Blockchain in exchange for that Blockchain’s coin. The ability of a Miner to validate a Block is based on the number of coins of that Blockchain that each Miner has.
Public Key An individual’s wallet address that can be shared with others in order to send and receive Cryptocurrency.
Satoshi The smallest denomination of a bitcoin, there are 100,000,000 Satoshis in one bitcoin. Think of a bitcoin as a dollar and a Satoshi as a cent.
Smart Contract A program that enacts the terms of a contract automatically based on its code.
Soft Fork A Fork that is compatible with the previous Blockchain so it does not result in two separate distinct Blockchains, however if a user wants to use the new rules associated with the Fork, they must upgrade their software.
Stablecoin A Cryptocurrency that pegs its value to a non-digital currency or commodity.
Token A digital asset that has a value proposition beyond just a transfer of value, as an example it can represent the ownership in a company.
Utility Coin A cryptocurrency that can be used for purposes beyond just transactions.
Wallet The place where Cryptocurrencies are stored.

 


The information provided herein is general in nature and is purely for informational purposes and does not constitute legal advice, nor does it create an attorney-client relationship. You should accept legal advice only from a licensed legal professional with whom you have an attorney-client relationship.

Uses of Cryptocurrency Overview

As previously detailed, there are a number of regulations surrounding Cryptocurrencies which vary by location (State Regulations) and by federal agency (FINCEN Regulations, IRS Regulations, SEC Regulations, and CFTC Regulations) and these regulations guide what you can and cannot do with any Cryptocurrency that you acquire. This blog will provide a high-level overview of the different things you can do with Cryptocurrency and how you can become more involved in the space. In addition to the below, entities can create their own tokens and offer them via an Initial Coin Offering (“ICO”) process, as well as create utility tokens, to generate funds for the company. Given the complexity involving ICOs and utility tokens, neither is discussed in this article. Please be aware that as the regulations change and vary from state to state, your state of residence can heavily determine what options, and Cryptocurrencies, are available to you.

Cryptocurrency Payments

At its core, Cryptocurrencies were invented to be just that, a currency. Cryptocurrencies can be used to buy various things, both digital and physical goods, as well as pay for services. In fact, the first time a Cryptocurrency was used in a transaction was on May 22, 2010, when two large Papa John pizzas were purchased and delivered in exchange for 10,000 Bitcoin. At the time, 10,000 Bitcoin were worth roughly $41, and two large Papa John pizzas were $25. As of this writing, 10,000 Bitcoin are worth in excess of $550 Million, and two large Papa John pizzas are approximately $32. Since that initial purchase, using Cryptocurrencies for purchases of physical personal property has become more popular. Companies such as Microsoft, AMC, and Overstock among others accept Bitcoin for payment. The Dallas Mavericks accept both Bitcoin and Dogecoin. Furthermore, some sellers of real estate accept payment in Cryptocurrency. Certain technologies, such as the Lightning Network, are being developed to help facilitate transactions among Cryptocurrency users. Lastly, as of September 7, 2021 Bitcoin is considered legal tender in El Salvador, and accordingly multi-national retailers such as McDonald’s and Starbucks now accept Bitcoin in their El Salvador locations.

Collectors and sellers of rare assets have also started to accept Cryptocurrency for payment. For example, in July of 2021, Sotheby’s announced that they would be accepting payment for the sale of a 101.38-carat diamond in Cryptocurrency. The diamond sold for a price of $12.3 Million. This transaction was on the heels of Sotheby’s selling a piece of artwork created by Banksy for $12.9 Million. Both of these sales pale in comparison to the Beeple created Non-Fungible Token (“NFT”) titled “Everydays – The First 5000 Days” selling for $69 Million in Ethereum. Recently, NFTs such as Cryptopunks, Lazy Lions, and Bored Ape Yacht Club, to name a few, have been selling for as much as eight figures in US Dollar terms. NFT owners generally only accept Cryptocurrencies as payment given that the ownership of a NFT is tracked on a specific Blockchain.

Although you can spend your Cryptocurrency, as you can tell from the Bitcoin Pizza transaction, the prices of goods relative to the value of Cryptocurrency can substantially decrease. Additionally, when you spend Cryptocurrency, per the current IRS guidelines, that is a taxable transaction. For that reason, many people prefer to hold their Cryptocurrency as a long-term investment.

Long Term Investing

One of the most popular non-technical terms for Cryptocurrencies investors is “HODL” which means to hold on to the coins. Given that Cryptocurrencies are an extremely new asset class, they are extremely volatile. For example, let’s look at Bitcoin.

In December of 2020, Bitcoin began the month at $19,7000, dropped as low as $17,570, and went as high as $29,300 before ending December just below $29,000. Then, in 2021 Bitcoin, as of this writing, has reached as high as $64,895 and as low as $28,600, and is currently hovering around $55,000. That type of volatility, a close to 300% rise, followed by a 50% decline and then roughly a 100% increase again, all within less than a year, is extreme. Not to mention, because Bitcoin is taxed as property, any purchase and subsequent sale of Bitcoin during the above described time period resulting in a gain would be taxed as ordinary income.

On the other hand, Bitcoin has a 10-year compound annual growth rate (“CAGR”) of between 150% and 200% as of this writing. For a point of reference, the S&P 500 has a 10-year CAGR of just over 11% over the same time. On a shorter time horizon, there have only been two years in which Bitcoin had a negative one-year return, 2014 and 2018. The other nine years since 2010 have resulted in seven years having over 100% yearly returns, with 2015 and 2019 only having 35% and 95% returns respectively. As of this writing, 2021 has had just about a 100% return. While I used Bitcoin as the example, it is a similar story for other Cryptocurrencies (including Ethereum and Litecoin to name two others). Below is a chart comparing the returns of the S&P 500 and the stock of some publicly traded companies against Bitcoin over the last decade. Other Cryptocurrencies are not included in this chart because for all intents and purposes, all other Cryptocurrencies are less than ten years old.

Asset October 2021 Price October 2011 Price Percent Increase
Bitcoin $57,485.97 $3.93 1,462,647.33%
S&P 500 $4,368.31 $1,207.25 261.84%
Amazon $3,257.00 $236.64 1,276.35%
Disney $173.62 $32.96 426.76%
JPMorgan Chase $165.75 $32.76 405.95%

An added benefit of holding the Cryptocurrency for longer than a year is that any gains from an eventual sale of the currency is treated as a long-term capital gain and therefore receives more favorable tax treatment. This strategy of long-term holding does not just apply to individuals, but to businesses as well. Companies such as Microstrategy and Tesla hold Bitcoin on their balance sheet. Since Microstrategy announced its first Bitcoin purchase in August 2020, its stock price has increased from under $150 per share to over $730 per share as of this writing. Coinbase is an example of a company that holds Ether on its balance sheet.

The above is not meant to be financial advice in any manner whatsoever, it is just an illustration as to why some people choose to take a long-term investing and holding the perspective with respect to their Cryptocurrency. Other people prefer to try and time the large swings in the value of the Cryptocurrencies and prefer to frequently buy and sell Cryptocurrencies.

Day Trading

Although some people prefer to HODL their Cryptocurrency, others attempt to take advantage of the extreme volatility and profit from short-term trading of various Cryptocurrencies. This trading is not just limited to Cryptocurrency only platforms such as Coinbase and Gemini, but also platforms that allow for investing and trading of traditional assets. In fact, Robinhood reported in August that 41% of its total revenue in the Second Quarter of 2021 was derived from commissions on Cryptocurrency trading and that more than 60% of its customers traded Cryptocurrency in the Second Quarter. Coinbase saw 8.8 Million individual users during the Second Quarter, good for $462B in trading volume. Clearly, there are a large number of investors that trade Cryptocurrencies.

A key difference between the Cryptocurrency market and the traditional stock market from a day trader’s perspective is that that the Cryptocurrency market is never closed. The Cryptocurrency market is open twenty-four hours a day, seven days a week. Certain exchanges crash from time to time and are unable to execute trade orders that are placed, or even allow orders to be placed, but the market itself is never closed. Another challenge with pursuing day trading of Cryptocurrencies is the sheer volume of different currencies. The number of different coins along with the still-evolving regulations can make it very hard to properly research the various Cryptocurrencies to the same depth an investor can research a publicly-traded company. Additionally, certain Cryptocurrency exchanges allow investors to trade on leverage, sometimes up to as much as a 300 to 1 leveraged amount. Given the extreme volatility that Cryptocurrency markets are subject to, day trading Cryptocurrencies is extremely hard to profit from, and day trading Cryptocurrencies with leverage is an extremely risky endeavor. Again, the foregoing is not meant to be financial advice in any manner whatsoever, it highlights why certain people are attracted to pursuing a day trading strategy involving Cryptocurrencies.

Borrowing and Lending

As is done with traditional asset classes, such as real estate, an owner of Cryptocurrencies can use their Cryptocurrency holdings as collateral for loans. The interest rates on these loans vary depending on the type of Cryptocurrency being used as collateral, the loan-to-value ratio of the collateral, the term of the loan, and the platform on which the loan is being created under. For instance on one platform created for Cryptocurrency lending and borrowing, if you wanted to take a loan of $100,000 USD collateralized by Bitcoin the interest rate associated with the loan ranges from 1.00% to 8.95% percent depending on whether the loan-to-value ratio is 25% or 50%. However on a different platform, for the same $100,000 USD Loan, the interest rates range from 6.5% to 13.25% depending on whether the loan-to-value ratio is 20% or 50%.

In addition to these platforms offering the ability for Cryptocurrencies holders to obtain loans collateralized by their Cryptocurrency, they also offer Cryptocurrency holders the ability to earn interest on their holdings. Similarly to how the interest rate that a borrower must pay varies from Cryptocurrency to Cryptocurrency and from platform to platform, so does the yield that a holder can earn by depositing their Cryptocurrency into a borrowing and lending platform. For instance, on one platform someone depositing Bitcoin can earn 6.20% interest on their first Bitcoin deposited and 3.51% on all subsequent Bitcoins in their account, while on that same platform interest rate for Ether is 5.35% for the first 100 Ether deposited and 5.05% for any subsequent Ether deposited. Interestingly, USDC (a stablecoin tied to the value of the US Dollar) can be deposited and the person depositing the coins can earn 8.88% interest on those holdings. However, on a separate platform, a participant can receive up to only 4.5% interest on Bitcoin, 5% interest on Ether, and 8.25% on USDC.

While using Cryptocurrency as collateral for loans may seem like a great idea, because of the extreme volatility inherent in Cryptocurrencies there is a high risk of the value of the collateral falling below the loan-to-value ratio, and thus requiring more collateral to be deposited or risk losing the already posted collateral. It is also extremely important to note that a growing number of state security regulators have been looking into the borrowing and lending platforms to determine whether the interest payments that users are receiving are unregistered securities. As of this writing, no action has been taken against these platforms, but that does not mean that future action will not be taken.

Summary

As you can see, there are quite a few different ways to approach using your Cryptocurrency once you have acquired it. As a reminder, you can purchase Cryptocurrency from various exchanges, you can participate as a miner for a specific blockchain to acquire the Cryptocurrency for that blockchain, or you can be paid for goods or services in Cryptocurrency. Similarly to being paid for goods or services in Cryptocurrency, you can also pay someone else for goods or services with Cryptocurrency. Given the extreme volatility that Cryptocurrencies incur, some people choose to hold their Cryptocurrency for years as the technology becomes more widely adopted, while others attempt to profit in the short term from frequent trades. Finally, some people also choose to use their Cryptocurrency as collateral for obtaining loans; and others choose to lend their Cryptocurrency in return for interest payments. As previously stated, these are just a few ways that Cryptocurrencies can be used, and the available uses vary greatly from state to state. If you have any questions regarding the above, please do not hesitate to reach out.

 


The information provided herein is general in nature and is purely for informational purposes and does not constitute legal advice, nor does it create an attorney-client relationship. You should accept legal advice only from a licensed legal professional with whom you have an attorney-client relationship.

As previously discussed, there are quite a few regulatory schemes surrounding Digital Assets and Cryptocurrencies. In addition to the FinCen Rulings, each State has its own regulations. The Internal Revenue Service (“IRS”) has its stance on taxation of Digital Assets and Cryptocurrencies, and the Securities and Exchange Commission (“SEC”) is also further developing its stance on the industry. Another federal agency with some regulatory oversight of Cryptocurrencies is the Commodity Futures Trading Commission (“CFTC”). This article will provide a brief introduction to the CFTC, its stance on Cryptocurrencies and why it is important to be aware whether you or your business is subject to CFTC regulations.

Overview of the CFTC

The CFTC is an independent United States government agency that regulates the United States derivatives market which includes commodity futures and over the counter markets. The CFTC also regulates trading organizations and intermediary entities that act as agents for other people when dealing with derivatives. The trading organizations largely fall into one of two groups, a Designated Contract Market (“DCM”) or a Swap Execution Facility (“SEF”). A DCM is an exchange that hosts future trading (the Chicago Mercantile Exchange is the best example of a DCM). A SEF is a platform that matches counterparties in swap transactions (SEF’s are also subject to SEC regulation). The intermediaries include the below categories as well as Major Swap Participants. However, as of July 2021 per the NFA website, there are no registered Major Swap Participants. If your business will place you in one of the below five buckets, you will need to register with the CFTC.

CFTC Regulated Intermediaries
Intermediary Description
Commodity Pool Operator A fund that combines investor contributions to trade on the futures and commodity markets.
Commodity Trading Advisor An individual or entity that gives investment advice for commodity and futures markets.
Futures Commission Merchants An individual or entity that accepts orders to buy or sell any commodity for future delivery.
Introducing Brokers An individual or entity that solicits or accepts orders to buy or sell derivatives but does not accept money or other assets from customers to support the orders.
Swap Dealers An individual or entity that serves as a swap broker, makes markets, or enters into swap contracts with counterparties.

The CFTC on Digital Assets and Cryptocurrencies

Regarding Digital Assets, the CFTC has said that depending on the structure and use of the Digital Asset, the asset itself can be encompassed within the definition of a commodity. If the asset falls under the definition of a commodity, depending on the activities you are pursuing, you are subject to the purview of the CFTC. The Commodity Exchange Act broadly defines a commodity to include all goods, articles, rights, and interests in which contracts for future delivery are presently or in the future dealt in.

Cryptocurrencies, including bitcoin, are properly defined as commodities because there can be a contract for future delivery of the specific Cryptocurrency. The CFTC considers “virtual currency” to be any digital representation of value that functions as a medium of exchange and any other digital unit of account used as a form of currency. This does not mean that by buying or selling bitcoin or other Cryptocurrencies you need to register with the CFTC. It means that if you are pursuing activities involving Cryptocurrencies which fall under one of the five intermediaries listed above, or serving as a DCM or SEF, you are subject to CFTC regulations and need to register with the CFTC.

As of this writing, it is not yet determined whether Non-Fungible-Tokens (“NFT”) are considered a commodity. It stands to reason that if futures, options, or swap contracts are developed based on NFT’s, there will be future rulings bringing NFT’s under the purview of the CFTC.

The CFTC has also stated that actual delivery of retail commodity transactions in virtual currencies occurs when two criteria are met. The first is that a customer has the ability to take possession and control of the entire commodity and use it freely in commerce within 28 days from the transaction date. The second is that neither of the offeror or counterparty seller has any right, interest or control over any of the commodity purchased on margin, leverage, or other financing arrangement at the expiration of 28 days from the date of the transaction.

An example of the first condition being met is that within 28 days of entering into the contract, the purchased Cryptocurrency has been transferred to a blockchain address in the sole possession and control of the purchaser. An example of the second condition being met is that within 28 days of entering into the contract, the seller delivers the purchased Cryptocurrency to an unaffiliated depository at which point the purchaser has full control over the Cryptocurrency and there are no continuing liens on the Cryptocurrency relating to the use of margin, leverage or financing used to obtain it.

Summary

The CFTC was created in 1974 and has had its jurisdiction expanded several times since then. As Digital Assets and Cryptocurrencies increase in popularity, you can be sure that there will be more regulations created around these assets. In fact, just last week, CFTC Commissioner Brian Quintenz stated that “the SEC has no authority over pure commodities or their trading venues, whether those commodities are wheat, gold, oil…or crypto assets.” Clearly, the regulations around Digital Assets and Cryptocurrency are evolving. Therefore, it is important to be aware and stay updated as to the various stances the CFTC has on participants within the Cryptocurrency industry, because falling under the purview of the CFTC requires compliance with enhanced reporting requirements. Particularly, the entity, its principals and associated persons must register with the NFA, various individuals will have to obtain certain licenses and there are different annual required filings to comply with. If you have any questions as to whether an opportunity you are pursuing in the Digital Asset or Cryptocurrency space will bring you under the regulations of the CFTC, do not hesitate to reach out.

 


The information provided herein is general in nature and is purely for informational purposes and does not constitute legal advice, nor does it create an attorney-client relationship. You should accept legal advice only from a licensed legal professional with whom you have an attorney-client relationship.

As previously discussed, in addition to the State Regulations and FinCen Rulings pertaining to Digital Assets and Cryptocurrencies, there are a host of other federal agencies with regulations that affect the industry. The Internal Revenue Service (“IRS”) determines how Digital Assets and Cryptocurrencies are taxed and the Commodity Futures Trading Commission (“CFTC”) has oversight regarding the derivatives built around Cryptocurrencies. Additionally, the Securities and Exchange Commission (“SEC”) has the authority to regulate all assets deemed a security, which can include a variety of Digital Assets depending on the characteristics of the specific asset. This article provides a high-level overview of the SEC’s stance on Cryptocurrencies, Initial Coin Offerings and Cryptocurrency Exchange Traded Funds (“ETF”).

The SEC is a federal agency that regulates the securities markets within the United States. The SEC enforces certain disclosure requirements and financial filings in the name of protection against market manipulation. Issuers of securities need to be registered with the SEC, as well as financial service firms and the professionals of those firms. The SEC has regulation over securities, and a security is generally defined as a financial instrument that holds some type of monetary value. This includes instruments such as stocks, bonds, options and investment contracts among many other instruments. More specifically in terms of Cryptocurrencies, the determination of whether a Cryptocurrency is an investment contract is critical. If the Cryptocurrency is determined to be an investment contract, and therefore a security, it is subject to SEC regulation and must either be registered or be subject to an exemption from registration.

The Howey Test and Cryptocurrency

The Howey Test is the standard to determine whether a financial instrument is an investment contract, and is therefore subject to SEC Regulation. This is a three-part test in which the Supreme Court determined that an investment contract exists when there is (1) an investment of money; (2) in a common enterprise; (3) with a reasonable expectation of profit derived from the entrepreneurial or managerial efforts of others. If an asset does not meet all three prongs, it is not an investment contract, and not a security. Importantly, the SEC has stated that neither bitcoin nor ether are securities under the Howey test, but also specified that whether a digital asset is an investment contract at a particular time is unique to both the asset and the facts and circumstances at the it is being sold or resold. If the Howey Test is satisfied, then the issuance of the asset must be registered with the SEC, or be eligible for an SEC exemption.

Payment for a Cryptocurrency with either fiat currency or a different Cryptocurrency has been held to satisfy the first prong of the test. The second prong can be met in one of three ways. First, if two or more investors pool their contributions and receive profits on a pro-rata basis, there is a horizontal commonality. Second, if there is a common interest between the investor and the promoter or a third party in which all of the investor’s success is tied to the expertise of the promotor or third party, there is a vertical commonality. Third, if the investors and the promoter share in the profits, there is a narrow vertical commonality. So, if the asset, the investor funds, or the control over the asset is not held by a central entity; or there is not one person to whom the success of the asset can be tied to, the second prong of the Howey Test is not met. The third prong is the cornerstone of the Howey Test. An expectation of profit is likely when the asset gives the holder rights to share in the issuer’s income or profits, or to realize gain from the price increase of the asset. Statements by the issuers or promoters promising a return can lead to investors expecting profit as can marketing and selling the asset to members of the general public. If the increase in value of the asset is derived from the efforts of an identifiable third party, it is more likely to satisfy this prong as opposed to if the increase is from general market changes. Additionally, the activity of the developers after a digital asset is launched can be indicative as to whether the last prong of the Howey Test is met. Therefore, when the developers need to play a crucial role post launch in the maintenance and growth of the digital asset, it is much more likely to satisfy the last prong. On the other hand, generally the success of a purchase of a commodity depends on the general market changes, not on the efforts of an individual and will not satisfy the last prong.

An example of a cryptocurrency that does not meet the Howey Test and is not a security is bitcoin. Purchasing bitcoin definitely satisfies the first prong of the Howey Test, because it is an investor giving money for the asset, bitcoin. However, the second and third prongs of the Howey Test are not satisfied by the purchase of bitcoin. Bitcoin does not have a horizontal commonality because each investor acts on their own accord when purchasing bitcoin, there is not a pooling of funds among the investors. Additionally, bitcoin does not have a vertical commonality because there is no promoter or third party who controls the investor’s success when dealing with the purchase of bitcoin. The third prong is not satisfied because the success of an investor who purchases bitcoin is tied to the market price of bitcoin, and not the efforts of others. Accordingly, bitcoin does not satisfy the Howey Test because there is no common enterprise that all the investors are pooling their funds into, there is no promoter or issuer, and the success of the investor does not depend on the efforts of others.

As previously stated, a digital asset can have its status as an investment contract change over time. For instance, when ether (the token for Ethereum) was first launched, there was an investment of money (an investor purchased ether with bitcoin), in a common enterprise (all of the ether was sold from one entity, ethereum.org), with a reasonable expectation of profit (the set price of ether from the pre-sale increased after the first two weeks it was available for purchase), and the expectation of profits could be said to have been dependent on others (the investors were trusting the Ethereum developers to use the bitcoin to develop Ethereum). Therefore, it could be argued that ether satisfied the Howey Test when it was first launched. However, over time ether was no longer sold via an entity but rather was obtained via mining, in a manner similar to bitcoin. Recognizing the change in the Ethereum network, in 2018 William Hinman (at the time the Director of the Division of Corporation Finance for the SEC) stated that notwithstanding the fundraising that accompanied ether, based on the current state of ether, the Ethereum network and its decentralized structure, current offers and sales of ether are not securities transactions. Clearly, the changes a cryptocurrency undergoes throughout its lifetime can change its classification as a security. There is speculation as to whether Ethereum 2.0 will be classified as a security given that Ethereum is changing from a mining system to a staking system, but as of this writing there has been no definitive statement one way or the other by the SEC.

 

Cryptocurrency and The Howey Test

Prong Satisfaction Cryptocurrency Example
1. An investment of money Payment of fiat or digital currency for an asset Buying a digital coin with US Dollars
2. In a common enterprise

·   Investors pooling assets for pro-rata profits

·   Common interest between the investors and promoters

·   Investor and promoter share in the profits

·   A company is raising funds via the sale of a digital coin

·   Both want the digital coin to increase in value

·   Both receive profit from the performance of the company

3. With a reasonable expectation of profit derived from the efforts of others Asset grants the holder the right to share in the issuer’s income or profits, or realize gain from the price increase of the asset The purchasers of a coin reasonably believed that the coins would increase in value based on the issuer’s efforts

Initial Coin Offerings

An Initial Coin Offering (“ICOs”) is a method a company can use to raise funds. The coin itself can represent a stake in the company or specific project, or may have some utility in using the product or service the company is offering. The SEC has classified that ICOs can be considered an investment contract, and therefore a security, because the tokens being offered can represent an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others. The SEC has found that the common enterprise aspect typically exists in the case of digital assets generally, as does the investment of money in a common enterprise. If the ICO promoter is responsible for the ongoing development, operation and promotion, there is a higher likelihood of finding the ICO as a security. Another factor indicative of an ICO being a security is if the promoter controls the creation or issuance of the coin, or acts to limit the supply to support the price. Notable examples of the SEC pursuing unregistered ICOs include actions against Ripple Labs Inc. (XRP), Telegram Group Inc., and Kik Interactive Inc. in addition to 73 other actions against various individuals or entities since 2013.

Cryptocurrency ETF

An ETF is a type of security that tracks an index or an asset and can be bought or sold on a stock exchange just like any other stock, and as a security, the SEC has the ability to regulate ETFs. In the last few months, there has been growing speculation as to whether or when the SEC will approve a Cryptocurrency ETF, mainly a Bitcoin ETF. As of this writing, there have been over a dozen applications submitted the SEC for a Bitcoin ETF including applications by Fidelity, VanEck, ARK Invest, SkyBridge Capital, Valkyrie and NYDIG among others. There have also been a few Ethereum ETF applications submitted. Additionally, in foreign countries such as Canada, ETFs for Bitcoin and Ethereum have already been approved and are actively trading. In a 2018 staff letter, the SEC stated that there were a number of investor protection issues precluding the approval of a Cryptocurrency ETF including the valuation of the ETF’s assets, the liquidity of the ETF’s assets, the custody of the ETF’s assets, arbitrage between the ETF price and its net asset value, and potential manipulation. However, Hester Peirce, an SEC commissioner, has stated that the prior rationale for not approving a Bitcoin ETF keeps getting weaker and that if the same standards were applied to Bitcoin ETFs as other products, at least one Bitcoin ETF would have already been approved. One concern that Gary Gensler, the SEC Chairman, has voiced is that none of the exchanges where Cryptocurrencies are traded are regulated by the SEC. In any event, a SEC ruling is expected to happen this year on one or more of the Bitcoin ETF applications, although the anticipated decision dates have been delayed numerous times. For example, the VanEck Bitcoin ETF has had its decision date delayed once in April and again a second time in June.

Summary

The rules determining whether an asset is a security, and therefore subject to SEC regulation, are extremely technical and very fact specific. This rings even truer in an emerging industry like Cryptocurrency. If you are considering pursuing an opportunity in Cryptocurrency, you should make sure to determine whether you will need to register with the SEC or if you qualify for an exemption from registration. If you are required to register with the SEC, and fail to do so, an ensuing action by the SEC can be very problematic and costly. These regulations and the SEC’s stance on Cryptocurrencies are subject to changes, specifically regarding whether it will approve an ETF. In fact, just this week Chairman Gensler spoke about regulation regarding digital tokens, Cryptocurrency trading platforms, and a Bitcoin ETF among other aspects.  Please feel free to reach out with any questions.

 


The information provided herein is general in nature and is purely for informational purposes and does not constitute legal advice, nor does it create an attorney-client relationship. You should accept legal advice only from a licensed legal professional with whom you have an attorney-client relationship.

There are multiple regulatory schemes to be aware of when considering or pursuing opportunities within the Digital Asset and Cryptocurrency industries beyond the various State Regulations and the FinCen Rulings. In what looks like a bowl of alphabet soup, there are a host of other federal agencies with their own rulings and restrictions pertaining to Cryptocurrencies including the Commodity Futures Trading Commission (“CFTC”), the Internal Revenue Service (“IRS”), and the Securities and Exchange Commission (“SEC”). This article will provide a high-level overview of the IRS’s stance on Cryptocurrencies.

In the IRS’s view, Cryptocurrencies are considered to be convertible digital tokens, a virtual currency that can be exchanged for other fiat or virtual currencies. As of this writing, the IRS treats Cryptocurrencies as property and therefore Cryptocurrencies are subject to general tax principles for property transactions. This means that generally Cryptocurrencies, including bitcoin, are treated as a capital asset and are subject to the capital gain and loss rules.

Regarding Cryptocurrencies, converting a Cryptocurrency to a fiat currency, converting a Cryptocurrency from one coin to another, or using a Cryptocurrency to pay for goods or services are all considered to be a taxable event. Accordingly, if you acquire a Cryptocurrency and hold it for longer than one year, if or when you eventually dispose of it, your gain or loss will be subject to long term capital gain rules. If you dispose of the Cryptocurrency within a year of acquiring, the gain or loss will be subject to short term capital gain rules. The holding period to determine whether a gain or loss on the exchange or use of the Cryptocurrency starts on the day after acquisition of the Cryptocurrency, and ends on the day you exchange or use it. An exception to this general rule of Cryptocurrency being taxed as property is when a business holds Cryptocurrencies to sell to customers in the ordinary course of business. Importantly, moving Cryptocurrency from one wallet that you control to another is not a taxable event.

Additionally, if you are paid for goods or services that you provide in Cryptocurrency, that constitutes income at the fair market value of the Cryptocurrency received (as measured in U.S. dollars on the receipt date). A donation of Cryptocurrency to a charity is eligible for the charitable contribution deduction, and is equal to the fair market value of the Cryptocurrency at the time of the donation provided you held the Cryptocurrency for at least one year. If the donated Cryptocurrency has been held for less than a year, the deduction is the lesser of the basis in the Cryptocurrency or its fair market value at the time of the contribution. From time to time a Cryptocurrency goes through a “fork” which occurs when certain miners who work on the blockchain of a specific Cryptocurrency decide to implement a new protocol. Some of the miners accept the new rule, others do not, and that is how a fork occurs. Bitcoin Cash is an example of a fork from the Bitcoin blockchain. Sometimes, when a fork occurs, holders of the original Cryptocurrency receive the new Cryptocurrency. A receipt of a new currency from a fork is considered income, and is taxable. Below is a chart providing an overview of potential actions and whether a taxable event is created.

Cryptocurrency and Potential Taxable Events
Action Is it Taxable? Calculation of Gain or Loss
Purchase of a cryptocurrency with US Dollars No No gain or loss
Transfer of cryptocurrency from an exchange to a wallet you control No No gain or loss
Sale of a cryptocurrency for US Dollars Yes Fair Market Value of sold cryptocurrency less its cost basis
Exchange of one cryptocurrency for another Yes Fair Market Value of acquired cryptocurrency less cost basis of transferred cryptocurrency
Spending cryptocurrency on goods and services Yes Fair Market Value of received goods and services less cost basis of the cryptocurrency
Earned cryptocurrency Yes Fair Market Value of received cryptocurrency

When determining the gain or loss on Cryptocurrency, you can either specifically choose units of the currency that you sold, exchanged or used, or use the first in first out basis (“FIFO”). In order to specifically identify a unit of Cryptocurrency being sold, exchanged or used, you must show (1) the date and time each unit was acquired, (2) the basis and fair market value at the time of acquisition, (3) the date and time the unit was sold, exchanged or used, and (4) the fair value of each unit when sold, exchanged or used and the amount of money or value of the property received for the unit. The FIFO method results in treating the unit that sold, exchanged or used as being the first unit of the specific Cryptocurrency you acquired. This is an important distinction because it can have massive implications as to calculating the gain or loss on your Cryptocurrency. For instance, assume that you acquired one bitcoin in 2016 for $1,000, a second bitcoin in 2019 for $10,000, and a third bitcoin in 2020 for $25,000. You then sold one bitcoin in 2021 for $60,000. Depending on which method you choose, your taxable income on the 2021 sale can be as high as $59,000 or as low as $35,000.

As Section 1031 like-kind exchanges are now only available for real property, 1031 transactions are not available for Cryptocurrencies. At one point there was a grey area as to whether the exchange of one type of Cryptocurrency for another could qualify as a 1031 transaction, but the IRS has now made it clear that a Cryptocurrency exchange is not a 1031 transaction.

As the saying goes, the only two things certain in life are death and taxes. Accordingly, it is very important to be aware of how Cryptocurrency is taxed if you are considering investing the industry. Cryptocurrency is taxed as property, is subject to capital gains taxes, with a holding period determined as the day after acquisition to the day of disposition, and is not eligible for Section 1031 transactions. However, any Cryptocurrency that you earn is taxable as ordinary income. This includes Cryptocurrencies earned through mining and Cryptocurrencies acquired from the forking of a blockchain. These rules are subject to change, and it is very important to be aware of any potential changes. If you are considering entering the Cryptocurrency industry and have questions on the above material, do not hesitate to reach out.

 


The information provided herein is general in nature and is purely for informational purposes and does not constitute legal advice, nor does it create an attorney-client relationship. You should accept legal advice only from a licensed legal professional with whom you have an attorney-client relationship.