The regulation of cryptocurrency fund managers is heavily dependent on how crypto digital assets are classified. In early analysis, US government regulatory bodies often categorized digital assets differently. Below is a brief overview of the various asset classifications by the SEC, the CFTC, the IRS, and Fincen, which are the US regulators most critical in governing the activities of crypto asset hedge fund managers. Note that US regulation of crypto-asset funds is in a state of flux, with a litany of regulatory issues that have yet to be resolved, and which may change over time.
As a preliminary matter, US regulators have adopted no official designations for classifying token types, but certain terminology has been applied to various tokens based on function and property right.
The terms “cryptocurrency” and “virtual currency,” have generally been applied to tokens that not only represent a store of value, but that can be used as a medium of exchange. The terms have also been applied more broadly, to encompass digital assets, whether value is derived as a potential medium of exchange, store of value, utility function, or otherwise.
“Utility tokens” refer to coins that serve a non-incidental functional purpose, or give the owner a right to access goods, services, licenses, etc. Some utility tokens may constitute securities, while others do not. “Securities tokens,” sometimes referred to as “investment tokens,” are tokens that represent a security interest, based on a transaction that constitutes a securities transaction under the Howey Test. Classification of various digital assets as “securities” is the subject of ongoing analysis with an uncertain future.
- Securities Under the SEC
The issue of whether various digital assets meet the definition of a “security” plays a pivotal role in the scope of US regulation of various cryptocurrency market participants, including custodians, exchanges, broker/dealers, and centralized distributed ledger token issuers.
Section 2(a)(1) of the Securities Act enumerates various financial instruments that meet the definition of a “security,” such as stocks, bonds, and investment contracts. Under the four-part test laid out in SEC v. W.J. Howey Co. (i.e., the Howey Test), a transaction is considered an investment contract transaction—and thus, a securities transaction—when there is:
- an investment of money,
- with the expectation of profits,
- in a common enterprise,
- from the efforts of others.
The SEC has not made official pronouncements categorizing various virtual assets, but rather, has taken the position that virtual currencies that meet the definition of an investment contract under the Howey test will be treated as securities. On April 3, 2019, the SEC published a framework for analyzing whether a digital asset constitutes a security under the Howey Test. Likewise, in various communications, SEC leadership members have provided strong language indicating that the SEC does not classify decentralized networks like Bitcoin.
In addition, there is an early indication from SEC leadership that a digital asset’s classification can shift as the network becomes increasingly decentralized. On March 12, Coincenter, a cryptocurrency legislative advocacy group published a letter from SEC chairman, Jay Clayton, to a US congressional representative, who had requested clarification based on public comments made by another SEC representative. Chairman Clayton stated that in his opinion, a crypto asset that sufficiently shifts central management functions being carried out through a decentralized network, the transaction would cease to be a security. In Chairman Clayton’s words:
If, for example, purchasers would no longer reasonably expect a person or group to carry out the essential managerial or entrepreneurial efforts. Under those circumstances, the digital asset may not represent an investment contract under the Howey framework.
- Commodities Under the SEC
The CFTC has stated that Bitcoin and other blockchain-based virtual currencies are “commodities” under Section 1a(9) of the Commodities Act and subject to the CFTC (see In Re-Coinflip, Inc., d/b/a Derivabit, and Francisco Riordan). The CFTC has taken the position that virtual currencies and other cryptocurrencies will not be treated as currency under the Commodities Exchange Act of 1934 (Commodities Act) because they do not have legal tender status in any jurisdiction. Note that with the expansion of various country initiatives, it is foreseeable that this issue may be revisited or refined.
- Property Under the IRS
In early analysis, the IRS, under the US Department of Treasury, has taken the position that digital assets, including virtual currency intended as a medium of exchange, such as Bitcoin, is considered “property,” and will not be treated as foreign currency.
In 2014, the IRS released Notice 2014-21, addressing the taxation of Bitcoin and other virtual currency transactions. The IRS determined that Bitcoin and other cryptocurrencies will be treated as property for tax purposes, and are therefore subject to capital gain and loss treatment under the Internal Revenue Code. The IRS also noted that virtual currencies will not be treated as “foreign currency.” As with the CFTC’s early designation of virtual currencies as property, the designation of virtual currency by the IRS in 2014 was based, in part, on the lack of legal-tender status of Bitcoin or other virtual currencies in any jurisdiction at the time.
- Currency Under FinCEN
The Treasury’s Financial Crimes Enforcement Network has classified virtual currency as currency when applied to money transmitters under the Bank Secrecy Act of 1970, also known as the Currency and Foreign Transactions Reporting Act (the BSA). The BSA is the US statute requiring regulated market participants to provide US regulators with disclosures needed to detect and prevent money laundering. The BSA governs, among others, foreign exchanges, money transmitters, administrators, and users.
In a 2013 release on the Application of FinCEN's Regulations to Persons Administering, Exchanging, or Using Virtual Currencies, FinCEN noted the distinction between “real currency” and “convertible virtual currency.” Instruments that are accepted as legal tender constitute real currency. Conversely, virtual instruments that act as a medium of exchange, which has an equivalent value in real currency, or performs a role as a substitute for real currency, is convertible virtual currency. https://www.fincen.gov/resources/statutes-regulations/guidance/application-fincens-regulations-persons-administering. In its 2013 release, FinCEN stated that the definition of a money transmitter does not differentiate real currencies from convertible virtual currencies and that certain centralized and decentralized virtual currencies will be treated as currency as applied to money transferors.
For additional information on the regulation of cryptocurrency hedge funds, please see our blog post, “SEC and CFTC Regulation for Startup Cryptocurrency Hedge Funds.”