In the decades that followed the enactment of the Homestead Act of 1862, more than 1.6 million U.S. citizens and intended citizens filed applications with the U.S. government to lay claim to 160 acres of land guaranteed to each applicant willing to settle, farm and improve the lands.
Settlers quickly encountered a major problem. The land was fertile, but virtually tree-less, and farmers needed fences to contain the boundless plains over which cowboys shepherded their cattle. Farmers tried growing thorn bush hedges, but they were impractical because they were slow-growing and too rigid to manipulate along a property line. Smooth wire fences were equally unworkable because cattle could simply push through them. Lacking a solution, many settlers abandoned their homesteads.
By 1871, the U.S. Department of Agriculture concluded that, despite its immense fertility, the vast and uncharted expanse of plains west of the Mississippi would not be cultivated —and therefore the American West would not be “settled” (at least as that term was understood within the concept of “manifest destiny” then sweeping the nation)— until farmers had a fencing that worked. The technology that emerged to solve this problem was barbed wire. With barbed wire, homesteaders fenced off their tracts, allowing them to effectively control and develop their lands, and the “Wild West” transformed into the “American West.” For better or for worse, the development of barbed wire and the legal landscape that followed in its wake transformed the concept of land ownership in much of America, and revolutionized what the Homestead Act could not: private ownership of land in the West. With it, the law of possession (nine-tenths of which is control) rapidly transformed from theory to practice.
Fast forward to present day and a similar, but more modern transformation is underway. Blockchain technology is being developed to revolutionize what the internet could not: trust in, and reliance upon, third parties (i.e., banks, governments and corporations) in commercial transactions. As the Illinois General Assembly Blockchain and Distributed Ledger Task Force recently summarized:
“While intermediaries fill a vital role in transacting value, relying too heavily on them often comes at the expense of inclusive prosperity. Intermediaries add costs and frictions to our economy for both businesses and consumers. They monetize vast amounts of data privacy and leave over a quarter of the world’s population out of the global economy.”
The solution is a peer-to-peer digital economy that can securely exchange, store and manage anything of value, including virtual currencies, or “cryptocurrencies” (e.g., bitcoin), in a time-stamped, non-repudiable database that chronologically and publicly records each transaction in real-time (i.e., a blockchain).
But who controls, or regulates, the conduct of parties surrounding transactions of virtual currencies? In recent years, and particularly with bitcoin’s extreme pricing surge in the latter half of 2017, federal regulators have increasingly focused their attention on this question.
Last month, in CFTC v. McDonnell, 2018 U.S. Dist. LEXIS 36854 (E.D.N.Y. Mar. 6, 2018), the U.S. District Court for the Eastern District of New York became the first federal court to address and adopt the CFTC’s determination that virtual currencies are commodities, as defined by the Commodities Exchange Act (CEA), and thus subject to CFTC’s anti-fraud and anti-manipulation enforcement authority. In McDonnell, the CFTC alleged that the defendants violated the CEA by operating a fraudulent scheme in connection with trading and investment services offered relative to virtual currencies. The CFTC sought a preliminary injunction against the defendants, while the defendants argued that the action should be dismissed for lack of jurisdiction. The Court denied defendants’ motion to dismiss and granted the CFTC’s application for a preliminary injunction, holding that: (1) virtual currency may be regulated by the CFTC as a commodity; and (2) the CEA permits the CFTC to exercise its jurisdiction over fraud that does not directly involve the sale of futures or derivative contracts. In so holding, the Court stated that “[v]irtual currencies are ‘goods’ exchanged in a market for a uniform quality and value,” and thus “fall well within” both “the common definition of ‘commodity’” and “the CEA’s definition of ‘commodities.’” The Court continued to explain that the CEA, as amended by the Dodd-Frank Act, provides the CFTC the authority to exercise enforcement over fraud or manipulation in not only futures and derivatives markets, but also over fraud or manipulation in underlying spot markets. While McDonnell is notable as the first federal decision to address and apply the CFTC’s determination that virtual currencies are commodities under the CEA, it is also the first federal decision to clarify that “jurisdictional authority of the CFTC to regulate virtual currencies as commodities does not preclude other agencies from exercising their regulatory power when virtual currencies function differently than derivative commodities.” Accordingly, the Court noted that that “[u]ntil Congress clarifies the matter, the CFTC has concurrent authority along with other state and federal administrative agencies, and civil and criminal courts, over transactions in virtual currency.”
To this end, the SEC has asserted jurisdiction over the “crypto” market, opining that: (1) “products linked to the value of underlying digital assets, including bitcoin and other cryptocurrencies, may be structured as securities products subject to registration under the Securities Act of 1933 or the Investment Company Act of 1940”; and (2) many virtual currency trading platforms “give the impression that they perform exchange-like functions” and may, in fact, “operate as an ‘exchange’ as defined by federal securities laws,” thereby requiring registration with the SEC. The SEC has begun taking action consistent with these statements. See, e.g., SEC v. Plexcorps, 17-CV-7007 (E.D.N.Y.) SEC Compl., ECF No. 1 (“This is an emergency action to stop Lacroix, a recidivist securities law violator in Canada, and his partner Paradis-Royer, from further misappropriating investor funds illegally raised through the fraudulent and unregistered offer and sale of securities called ‘PlexCoin’ or ‘PlexCoin Tokens’ in a purported ‘Initial Coin Offering.’”).
Similarly, the IRS has declared that “virtual currencies that can be converted into traditional currency are property for tax purposes, and a taxpayer can have a gain or loss on the sale or exchange of a virtual currency, depending on the taxpayer’s cost to purchase the virtual currency.” Under this authority, the IRS has sought and obtained trading records from virtual currency exchanges concerning transactions by U.S. citizens. See, e.g., United States v. Coinbase, Inc., 2017 U.S. Dist. LEXIS 111756 (N.D. Cal. July 18, 2017). According to one recent estimate by a former J.P. Morgan Chase strategist and current Managing Partner and Head of Research at Fundstrat Global Advisors, U.S. households may owe approximately $25 billion in capital gains tax for their virtual currency holdings this year.
In addition, the U.S. Treasury Department, U.S. Department of Justice, and New York Department of Financial Services have begun pursuing regulatory and/or enforcement efforts relative to virtual currencies. CFTC v. McDonnell, 2018 U.S. Dist. LEXIS 36854, at *14-16 (E.D.N.Y. Mar. 6, 2018).
The regulatory landscape surrounding virtual currencies, much like the technology underlying virtual currencies, is in its infancy. Nonetheless, cryptocurrencies and the blockchain technology on which they are based may prove to be both disruptive and transformative to the formation and distribution of capital in years to come. The success of virtual currencies, however, may be more firmly linked to the establishment and maintenance of a reliable regulatory regime than many “crypto” purists want to believe.
Just as the fecundity of America’s heartland could not be optimized without the development of technology that transformed an abstract theory of ownership into a practical exercise of control, so, too, may the promise of virtual currencies and blockchain technology be impaired by uncertainty surrounding the establishment and maintenance of a reliable regulatory regime under which virtual currencies are transacted. As the McDonnell Court aptly noted, state and federal regulators will continue to have “concurrent authority… over transactions in virtual currency” unless and until Congress determines a more tailored regulatory scheme is warranted. Accordingly, these recent actions by the CFTC, SEC, and IRS remain important building blocks in creating and defining a regulatory landscape to govern the virtual currency space.