New York Attorney General Launches Investigation Into Cryptocurrency Exchanges

April 24, 2018

Lisa LeFever

Modern financial markets are contending with the influx of an entirely new class of digital assets known as “virtual currencies,” which are described as “digital representations of value” that can function as a medium of exchange, unit of account, and store of value.[1] The term virtual currency is often used interchangeably with the term “cryptocurrency,” reflecting the assets’ ability to be transferred and verified through complex mathematical code in a process known as cryptography.  

Bitcoin, the most popular cryptocurrency, was introduced in 2008 by an author going by the name Satoshi Nakamoto, who proposed the concept of a “peer-to-peer electronic cash system” that bypasses third-party intermediaries and prevents double spending issues.[2] Traditional banking functions are performed by types of distributed ledger and blockchain technologies, which provide for immutable databases of transaction information. “Blocks” correspond to transactions and are connected in a chronological manner using cryptography and consensus mechanisms to form a perpetual “chain” of transparency. 

While some virtual currencies operate like an actual currency, other bear no resemblance to currency and function more like securities, commodities, software applications, access to services, or hybrid instruments. In 2017, so-called initial coin offerings (ICOs), a type of crowdfunding based on the distribution of blockchain tokens, gained mainstream notoriety, allowing businesses and startups to raise upwards of $5 billion.[3] At the end of the year, bitcoin’s price reached highs close to $20,000.[4]

The inherent novelties of cryptocurrencies make it difficult to ascertain their standing under the law and the appropriate agency of oversight. The Securities and Exchange Commission (SEC) asserted that most ICOs involve the sale of unregistered securities.[5] The Commodity Futures Trading Commission (CFTC) purported that virtual currencies are properly categorized as “commodities.”[6] The Internal Revenue Service (IRS) calls them “property.”[7] States have also attempted to define virtual currencies, varying from classifications as “alternative currency” to explicit exclusions from the definition of “money.”[8]

Despite the promise of the technology, the market is flush with fraud, volatility, and regulatory uncertainty. Regulators have begun to take substantial steps in determining how investors can be best protected in the developing market. The SEC launched a probe into the space earlier this year, warning that virtual currency exchanges that host products deemed to be securities must register as an exchange with the SEC or face regulatory consequences.[9] 

Following suit of the SEC, New York Attorney General Eric Schneiderman announced his office’s “Virtual Currency Integrity Initiative,” which seeks to investigate the operations of the platforms that facilitate trading in cryptocurrencies to ensure that they adequately serve and protect investors.[10]

Virtual currency exchanges have faced increased regulatory scrutiny recently due to several widely-publicized hackings and suspected fraudulent behavior. Coincheck, one of the largest Asian cryptocurrency exchanges, was hacked in December 2017 to the detriment of $530 million, impacting close to 300,000 investors.[11] Coinbase, the San Francisco-based exchange, similarly faced troubles in 2017 where it was alleged that insiders profited from the platform’s initial launch of the cryptocurrency bitcoin cash.[12] Coinbase also faced heat from the IRS, who ordered the exchange to release user information, arguing that the exchange’s customers were evading tax obligations.  

Schneiderman reported that his office sent information requests and questionnaires to 13 major cryptocurrency exchanges, including Coinbase's GDAX exchange and the New York-based Gemini exchange.[13] The inquiries request information regarding the exchanges’ operations, security, disclosures, internal controls, conflicts of interests, and other policies in order to “increase transparency and accountability in the virtual currency marketplace.”

The questionnaires highlighted areas of concern for regulators with a special focus on privacy, anti-money laundering, and market manipulation and suspicious trading activities.[14] The topics of inquiry revolved around categories of which are heavily-regulated in the case of exchanges that accommodate securities and regulated derivatives products. The exchanges’ responses will be telling with regards to whether self-regulation in the virtual currency industry is adequate to achieve the goals of regulators or whether additional steps need to be taken to police these new products.

The Initiative follows the state’s earlier attempt at regulating the unregulated virtual currency industry. In 2015, the New York State Department of Financial Services (NYSDFS) enacted its controversial BitLicense, which entails extensive licensure requirements for businesses handling virtual currencies.[14] The regulation was challenged in the court and condemned for its chilling effect on New York businesses. With only three companies being granted BitLicenses as of January 2017, some state representatives have expressed openness to reform of the statute.[15]

While it is uncertain whether the Attorney General’s investigation will yield any enforcement proceedings or impact legislative reform at the state level, it indicates that regulators will continue to pay close attention to conduct in the virtual currency space that challenges the fairness and integrity of the financial markets. Blockchain technologies will challenge the parameters of existing laws, regulations, and jurisprudence before the emergence of accepted standards of practice. It will be an area ripe for regulatory intervention in the coming months.

The information provided is for informational purposes only. It does not constitute legal or investment advice. 

[1]  See Financial Crimes Enforcement Network, Application of FinCEN's Regulations to Persons Administering, Exchanging, or Using Virtual Currencies, FIN-2013-G001 (March 18, 2013). 

[2]  Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System  1 (2008). 

[3]  See Daniel Diemers, Initial Coin Offerings, A Strategic Perspective: Global and Switzerland, PWC, Crypto Valley (Dec. 21, 2017), available at https://cryptovalley.swiss/wp-content/uploads/20171221_PwC-S-CVA-ICO-Report_December_final.pdf. 

Filecoin raised over $250 million to fund a “decentralized storage network.” Protocol Labs, Token Sale Completed (Sept. 13, 2017), available at https://filecoin.io/blog/sale-completed/. 

The Tezos project raised $232 million, promising to develop the next Ethereum, in its uncapped offering, which is now the subject of several ongoing investors lawsuits. 

In one of the first ICOs from an established company, the Canadian-based messaging app Kik raised close to $100 million. Howard Marks, The ICO Is Dead. Long Live the ICO 2.0, Hackernoon (Feb. 21, 2018), available at https://hackernoon.com/the-ico-is-dead-long-live-the-ico-2-0-7bb269987513. 

An ICO for a new web browser raised over $35 million in under 30 seconds. Jonathan Keane, $35 Million in 30 Seconds: Token Sale for Internet Browser Brave Sells Out, CoinDesk (May 31, 2017). 

[4] https://charts.bitcoin.com/chart/price

[5]  Jay Clayton, SEC Chairman, Testimony on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission,” Before the Committee on Banking, Housing, and Urban Affairs United States Senate (Feb. 6, 2018). 

[6]  See In the Matter of Coinflip Inc., d/b/a Derivabit, and Francisco Riordan, CFTC Docket No. 15-29 (Sept. 17, 2015); In re TeraExchange LLC, CFTC Docket No. 15-33, 2015 WL (CFTC Sept. 24, 2015); CFTC, A CFTC Primer on Virtual Currencies, Lab CFTC, 14 (Oct. 17, 2017). 

The CFTC’s jurisdiction is invoked where a virtual currencies are used “in a derivatives contract, or if there is fraud or manipulation involving a virtual currency traded in interstate commerce.” Id. “Beyond instances of fraud or manipulation, the CFTC generally does not oversee ‘spot’ or cash market exchanges and transactions involving virtual currencies that do not utilize margin, leverage, or financing.” Id. See also CFTC v. McDonnell, et al., No. 18-cv-361, ECF No. 29 (E.D.N.Y. Mar. 6, 2018) (holding that virtual currencies are properly regulated by the CFTC as commodities). 

[7]  IRS Virtual Currency Guidance: Virtual Currency Is Treated As Property for U.S. Federal Tax Purposes; General Rules for Property Transactions Apply, IR-2014-36 (March 25, 2014). 

[8]  See SEC v. Shavers, 2013 WL 4028182 (E.D. Texas Aug. 6, 2013) (finding that bitcoin investments were investments of money). Many states consider virtual currency transactions to be “money transmissions” such that licensure is required. See 23 NYCRR § 200 (New York’s “BitLicense”); H.B. 215, 2017 Leg., Reg. Sess. (Ala. 2017) § 8-7A-2(10) (Alabama’s Monetary Transmission Act); H.B. 7141, 2017 Leg., 2017 Jan. Reg. Sess. Gen. Assemb. (Conn. 2017); Ga. Code Ann. § 7-1-690(b)(1); 2017 North Carolina Laws S.L. 2017-102 (H.B. 229); H.B. 182, 2017 Gen. Assemb., Reg. Sess. (Vt. 2017); VA Code Ann. § 6.2-1900; Uniform Money Services Act. H.B. 1327, 63rd Leg., Reg. Sess. (Wash. 2013). But see H.B. 436, 2017 Leg.,165th Sess. (N.H. 2017) (exempting “persons who engage in the business of selling or issuing payment instruments or stored value solely in the form of convertible virtual currency or receive convertible virtual currency for transactions to another location” from the state’s money transmission laws). Some states, like Illinois, Kansas, and Texas, have explicitly excluded virtual currencies from the definition of “money.” See llinois Department of Financial and Professional Regulation, Digital Currency Regulatory Guidance, (July 13, 2017) (stating digital currencies are not “money” under the Transmitters of Money Act and therefore “[a] person or entity engaged in the transmission of solely digital currencies” would not be required to obtain license); Kansas Office of the State Bank Commissioner, Guidance Document MT 2014-01, Regulatory Treatment of Virtual Currencies Under the Kansas Money Transmitter Act, (June 6, 2014) (advising that cryptocurrency is not considered ‘money’ for the purposes of the Kansas Act); Jennifer Jensen, et al, Sales and Use Taxes in a Digital Economy, The Tax Adviser, (Jun. 1, 2015) (stating that the Nebraska Department of Revenue doesn’t consider the term “currency” to include bitcoin or other virtual currencies); Memo, Tx. Dep’t of Banking, Regulatory Treatment of Virtual Currencies Under the Texas Money Services Act (April 3, 2014) (stating that virtual currencies will not be treated as legal money in Texas); see also Florida v. Espinoza, F14-2023 (dismissing the charge of money laundering because virtual currencies are not “money” as defined by the state’s Money Laundering Act). 

 Cal. AB-129 (the “Alternative Currencies Act”) (amending Cal. Corp. Code § 107 which previously stated that “[n]o corporation, social purpose corporation, association, or individual shall issue or put in circulation, as money, anything but the lawful money of the United States”). 

[9]  See Nathaniel Popper, Subpoenas Signal S.E.C. Crackdown on Initial Coin Offerings, NY Times (Feb. 28, 2018), available at https://www.nytimes.com/2018/02/28/technology/initial-coin-offerings-sec.html. 

[10]  New York State Office of the Attorney General, A.G. Schneiderman Launches Inquiry Into Cryptocurrency “Exchanges,” Press Release (April 17, 2018), available at https://ag.ny.gov/press-release/ag-schneiderman-launches-inquiry-cryptocurrency-exchanges.  

[11] http://fortune.com/2018/01/31/coincheck-hack-how/

[12] https://www.coindesk.com/coinbase-hit-lawsuit-alleged-insider-trading/

[13] Id. at 10.

[14]  23 NYCRR § 200.  See also Theo Chino v. Dep’t of Fin. Serv. et al., Index No. 101880/15 (N.Y. Sup. Ct. Oct. 10, 2017) (challenging BitLicense).  

[15] https://www.coindesk.com/bitcoin-crypto-ny-lawmaker-pledges-make-bitlicense-something-works/