On July 18, 2018, Acting Director Mick Mulvaney of the Consumer Financial Protection Bureau (“CFPB”) announced that Paul Watkins will head the CFPB’s new Office of Innovation. According to the press release, the office, which Mulvaney created to focus on consumer-friendly innovation, “will focus on creating policies to facilitate innovation, engaging with entrepreneurs and regulators, and reviewing outdated or unnecessary regulations.” Watkins previously managed the first state fintech regulatory sandbox in the United States out of the the Arizona Office of the Attorney General, which we have previously reported on here. He is expected to take charge of a sandbox initiative that the CFPB is working on in coordination with the Commodity Futures Trading Commission (“CFTC”). A sandbox program aims to provide relief from various regulatory requirements and regulatory guidance to start-ups, while providing insight into fintech startups and technology innovation to regulators.
In a speech delivered at Mansion House on 21 June 2018, Mark Carney, the Governor of the Bank of England (BofE), made the case for a modernised financial services sector, which would be underpinned by a thriving FinTech sector, especially in the area of payments.
The remarks reinforce the BofE’s plan for FinTech in central banking, which started last year when it partnered with a range of firms to look into the functionality the BofE would need to offer to support the sector. The result came when the BofE announced that a new generation of non-bank payment service providers would be eligible to apply for a settlement account under its real-time gross settlement system (RTGS). Those proposed changes were also focused on widening access to UK payment systems, supporting financial stability through greater diversity and risk-reduction technologies, and creating a more level playing field for non-banks wishing to compete with banks.
CFTC Customer Advisory
On Monday, the Commodity Futures Trading Commission (“CFTC” or “Commission”) issued its fourth virtual currency customer advisory, Customer Advisory 7756-18, as part of its outreach effort to educate market participants. Titled, Use Caution When Buying Digital Coins or Tokens, the advisory warns customers of the risks of speculation of future value and fraud; it ultimately advises that the best protection is to exercise caution and to extensively research digital tokens and coins—and those who offer them for sale—prior to purchase.
While the SEC continues to target fraudulent crypto-projects, we’ve seen a marked increase in the number of class actions targeting a wider-range of ICOs. The crypto-industry is watching these cases intently; awaiting the judiciary’s play in the on-going game of “Are Crypto-Tokens Securities?”. Earlier this week, United States Magistrate Judge Andrea M. Simonton (Southern District of Florida) laid an early card in Rensel v. Centra Tech, Inc. Although the Report and Recommendation is not the in-depth analysis of a functional, utility-heavy token the industry desperately needs, it nonetheless offers some food for thought.
Analyzing the plaintiffs’ motion for a temporary restraining order, the court asked whether the plaintiffs had a likelihood of succeeding on the merits of their securities fraud claims. Part of that analysis involved applying the Howey Test to determine whether Centra Token (“CTR”), the token powering Centra Tech’s purported “crypto-debit card” is a security. Judge Simonton had little trouble concluding that the token-purchasers met the first two Howey-prongs because the plaintiffs invested USD, Ether, and Bitcoin in an operation they had little control over. Moreover, “because the success of Centra Tech and the Centra Debit Card, CTR Tokens, and cBay that it purported to develop was entirely dependent on the efforts and actions of the Defendants,” the court also concluded that CTR satisfied the remaining Howey prong (that there be an expectation of profits derived solely from the efforts of others). Ultimately, Judge Simonton concluded that CTR meets the requirements of an investment contract and, thus, for now, the unregistered Centra Tech ICO could have violated the Securities Act of 1933.
However limited, Judge Simonton’s analysis is interesting for several reasons. First, the court focused on how the defendants’ efforts impacted the success of not just the CTR token, but also the products and applications operating around CTR, namely the cBay marketplace and the Centra Debit Cart. Second, rather than inquiring whether the defendants themselves created an expectation of profits, the court was satisfied that such an expectation existed, regardless of its origin. Ultimately, the precedential value of this opinion is limited because the defendants conceded for the purposes of the motion that CTR are securities. In an industry searching for clarity, however, interested parties in all corners will undoubtedly rely on Rensel to make their respective points. With time and repetition, the contours of the Howey test as it applies to crypto-tokens will begin to take shape; whether other courts should follow the path laid in Rensel remains to be seen.
The parties have the opportunity to lodge objections to Judge Simonton’s Report and Recommendation before it is ultimately considered by United States District Judge James Lawrence King.
 See e.g., Jacob Zowie Thomas Rensel v. Centra Tech, Inc., No. 17-CV-24500 (S.D. Fla.); Coffey v. Ripple Labs Inc. et al., No. 3:18-cv-03286 (N.D.C.A.); GGCC LLC v. Dynamic Ledger Solutions Inc. et al., No. 5:17-cv-06779, (N.D. Cal.).
 Rensel, v. Centra Tech, Inc., No. 17-CV-24500, 2018 BL 227097 (S.D. Fla. June 25, 2018).
 A magistrate’s report and recommendation is subject to objections by both parties. After the parties object, the report and recommendation goes to the assigned district court judge who will make the final decision whether to reject, adopt, or adopt in-part the magistrate’s decision.
 Under the so-called Howey Test, a particular scheme is considered a security if it qualifies as an investment contract whereby a person  invests money in  a common enterprise and  is led to expect profits  solely from the efforts of the promoter or a third party. SEC v. W.J. Howey, 328 U.S. 293 (1946). Although some courts apply this as a three-prong test, the same essential elements are required.
Last week, the Market Oversight and Clearing and Risk Divisions of the Commodity Futures Trading Commission (“CFTC” or “Commission”) issued Staff Advisory No. 18-14 regarding virtual currency derivative product listings. The advisory serves as guidance to exchanges and clearinghouses in the context of listing derivative contracts based on virtual currency under Commission Regulations 40.2 (self-certification) or 40.3 (voluntary submission for Commission review and approval) in order to promote effectiveness and efficiency in the emerging area virtual currency derivatives.
Specifically, the advisory clarifies CFTC priorities and expectations for virtual currency derivatives listed on a designated contract market (“DCM”) or swap execution facility (“SEF”) or cleared by a derivatives clearing organization (“DCO”) with regard to enhanced market surveillance, coordination with CFTC staff, large trader reporting, stakeholder outreach, and DCO risk management. The Commission notes that this latest effort at providing regulatory clarity is not a “compliance checklist,” and the extent of its relevance depends on the terms and conditions of each virtual currency contract.
Enhanced Market Surveillance: DCMs and SEFs are responsible for having an oversight program designed to ensure listed contracts are not readily susceptible to manipulation and to detect and prevent manipulation, price distortion, and disruptions of the delivery or cash-settlement process. To increase visibility into underlying spot markets and manage risks related to the trading of listed virtual currency derivatives, the Commission advises having an information sharing arrangement in place with the underlying spot markets that may contribute to the cash-settlement price in order to provide the derivatives exchanges access to a broader range of trade data, including trader identity, prices, volumes, times, and quotes.
The Commission also advises a heightened level of real-time monitoring that involves continuous monitoring of relevant data feeds (particularly around settlement) and making inquiries where appropriate in the event of identified anomalies or disproportionate moves in spot markets.
Coordination with CFTC Staff: The Commission expects exchanges to regularly discuss virtual currency derivatives contracts surveillance issues with CFTC staff and to provide information upon request, including data related to the settlement process referenced by the derivatives contract.
Large Trader Reporting: The Commission may raise or lower reporting levels in specific markets under the Commission’s Large Trader Reporting System. Exchanges can set the reporting level of contracts in a particular commodity at a lower level than specified in CFTC regulations, but the Commission recommends setting the large trader reporting threshold for any virtual currency derivative contract at five bitcoin (or the equivalent) to facilitate surveillance.
Stakeholder Outreach: The Commission expects exchanges to take extra care to engage meaningfully with stakeholders due to the novel and evolving nature of virtual currency contracts and concerns related to price volatility and lack of transparency. The effort should include soliciting comments on a broad array of topics related to the listing that go beyond the terms and conditions and manipulation susceptibility from members as well as other relevant stakeholders that go beyond those interested in trading the contract (e.g., clearing members and futures commission merchants (“FCMs”). When submitting a virtual currency derivative contract listing, an exchange should provide as much information as possible, including explanations of substantive opposing views and how the exchange has addressed them.
DCO Risk Management: CFTC staff will request and review from the identified DCO: (1) proposed initial margin requirements to assess whether they are commensurate with the risks; (2) ability of proposed margin requirements to adequately cover potential future exposures to clearing members based on an appropriate historic time period (and may require adjustments); (3) information related to the governance process for approving the proposed contract(s), including explanation of views of approving clearing members and the response to dissenting reviews; (4) adherence to internal governance procedures for new contract approval; and (5) any other information relevant to the clearing of the proposed contract.
Exchanges and clearinghouses are currently evaluating new crypto products, and these guidelines setting forth the Commission’s expectations with regard to that process will help streamline the new contract listing procedures. It also emphasizes a current priority for the CFTC, which is to obtain more information regarding the crypto spot markets, which they hope to accomplish via the registered platforms. Market participants are looking forward to seeing a wider variety of crypto derivative products, and hopefully this guidance will speed that process.
One of the greatest developments for marketers in 2018 is likely to be the proliferation of new and innovative applications on the blockchain in the context of marketing and promotion, particularly in connection with loyalty programs, ad fraud mitigation, and ongoing CRM activities that combine brand affinity and peer-to-peer influencing. The potential magnitude of the changes that the promotion marketing industry could see in the next 12 months, especially in the loyalty area, is simultaneously thrilling and daunting. The technological challenges of simply understanding the blockchain is hard enough. In addition, cryptocurrency fraud and money laundering concerns have delayed public acceptance of blockchain-based promotional activities.
This week, the Massachusetts Secretary of State ordered five companies, 18Moons, Across Platforms, Mattervest, Pink Ribbon, and Sparko, to cease and desist from engaging in initial coin offering (“ICO”) campaigns as part of an ongoing government investigation of token sales. The companies allegedly offered and sold unregistered securities in violation of the Massachusetts Uniform Securities Act (Chapter 110A of Massachusetts’ General Laws) and corresponding regulations. The orders, among other things, (1) prohibit the companies from selling unregistered or non-exempt securities in Massachusetts until they are in compliance, including filing a Form U-2 Consent to Service of Process; (2) require the companies to provide the Enforcement Section with written notice of securities offerings prior to making future offers or sales; and (3) mandate rescission of sales to investors that purchased the tokens at issue prior to the order date, pursuant to specified terms. The Enforcement Section may take further actions if the companies fail to comply, including re-instituting investigations.
The announcement of the Massachusetts enforcement actions was announced five days after Arizona announced becoming the first U.S. state to enact a fintech regulatory “sandbox.” The Arizona Governor signed House Bill 2434 into law on March 23, which aims to foster innovation by allowing companies to launch and test innovative products under limited conditions in the Arizona market outside of the scope of potentially burdensome and costly regulatory requirements. The Office of the Arizona Attorney General will administer the sandbox program and will likely begin accepting applications for entry in late 2018, which will require detailed descriptions of the product or service and a to-be-determined fee. Approved participants will have one year to test their product or service on Arizona residents, with the possibility of a year-long extension before July 2028, when the program ends. Other limits include caps on the numbers of individuals who may participate in each agreement, the amount of loans that may be issued, and those related to financial transactions under Arizona law. The sandbox participants also will be subject to the Arizona Consumer Fraud Act. Notably, a reciprocity provision allows the Attorney General to provide sandbox participants the opportunity to participate in similar programs that other jurisdictions may develop in time.
Startups often are at the forefront of creating unique solutions with the ability to have a tremendous impact on various industries. The Miami Blockchain Group, a legal technology startup, has created a novel blockchain application specifically for the international dispute resolution community. The Smart Arbitration & Mediation Blockchain Application, SAMBA, debuted at the 2018 Global Legal Institute for Peace Conference at the University of São Paulo on March 14.
Recent news about blockchain has focused primarily on cryptocurrencies and crypto tokens, such as financial regulator statements regarding whether initial coin offerings could constitute securities. Here we see a use for the technology in a completely different industry, and a traditionally conservative one with respect to technology. As we have described in our paper Blockchain – Distributed ledger technology and designing the future, a blockchain, also known as distributed ledger technology (DLT), is a digital record, or ledger, of transactions. Blockchain is unlike a traditional ledger however and is stored collectively by all the participants on its network. Each transaction is stored with others in a unit of data called a block and those blocks securely link to one another, forming a “chain” of records going all the way back to the very beginning of the ledger.
SAMBA intends to utilize a blockchain to eliminate the need for couriers, hard copies and mailing. The application gives claimants the ability to use a blockchain portal, held by an arbitral institution, to file requests for arbitration. Documents can be drafted within the portal, finalized, and submitted directly to the tribunal. Additionally, claimants will have the option to conduct electronic discovery by way of a drop box, allowing for hearings to become virtual. Claimants will also be able to view their final award on portal.
SAMBA is likely to positively impact the international dispute resolution process. The legal industry certainly will be watching for the success of this initiative. We will be eagerly watching for additional blockchain backed applications introduced in other areas of the legal industry that will hopefully drive efficiency, transparency and trust amongst legal professionals.
The City of Berkeley, California will be the first U.S. city to explore blockchain-based financing to tackle social issues such as affordable housing. Mayor Jesse Arreguin and Councilmember Ben Bartlett are collaborating with the UC Berkeley Blockchain Lab and San Francisco-based financial startup Neighborly for the Berkeley Blockchain Initiative (“BBI”) to develop a tokenized municipal bond. According to Forbes, Berkeley had a similar idea twenty years ago with a local currency called “Berkeley Bucks.” This time, Neighborly explains, “[t]he initiative will explore how to harness the power of blockchain and cryptocurrencies to democratize access to public finance and improve social outcomes.”
Termed an “initial community offering” rather than an initial coin offering (“ICO”), municipal bonds will be divided into micro-bonds and sold as a token as a new source of capital that will enable more Berkeley residents to invest directly in their community through various projects at low denominations. According to Coindesk, Councilmember Bartlett claims the offering will be less risky than an ICO because the tokens will be backed by an underlying bond. Residents will be able to choose specific social impact projects of interest compared to the traditional nature of a single bond that may be raising funds for multiple municipal projects. Councilmember Bartlett believes “[b]lockchain’s benefits, such as security, efficiency, transparency and speed, are not only applicable, but much needed at the government level to deliver better and more streamlined services to the people who need it most.”
Details on what this new token will be named and whether it will be issued on a private or public blockchain are up in the air, but the plan is to keep the initiative local to Berkeley. Issuing tokenized micro-bonds through blockchain will fund smaller ventures like purchasing an ambulance at first, but the City of Berkeley envisions the model will eventually fund affordable housing projects and could potentially give the homeless population access to other goods and services in the future.
This project may be a signal that tokenized public finance models could become mainstream in the near future. Local investors may like the flexibility that these municipal tokens allow in investing in smaller investments in specific projects the investors support. Bonds issued by states, cities, and municipalities are exempt from the registration requirements and certain of the reporting requirements under the federal securities laws. Nevertheless, these products are subject to the Securities and Exchange Commission’s (“SEC”) antifraud rules and therefore it is important that issuers make appropriate risk disclosures with respect to the crypto market and nature of the tokens to investors.
Issuers also should carefully weigh the risk of special treatment by the SEC. The agency may more carefully scrutinize bonds issued as crypto tokens out of concern that the issuer chose to issue crypto token bonds rather than traditional bonds to garner attention or to capitalize on the euphoria associated with crypto investments. This offering will test the waters for new security token issuances amid an environment where the SEC is scrutinizing a broad swath of so-called “utility” tokens for being unregistered securities.
In a speech given on Friday 2nd March, the governor of the Bank of England, Mark Carney, said that cryptocurrencies are “failing” as a form of money. Mr.Carney also stated that cryptocurrency should fall under the “regulatory tent” and argued that “the time has come to hold the crypto asset ecosystem to the same standards as the rest of the financial system”. The governor of the Bank of England is the latest prominent figure to speak out on the cryptocurrency market – and he has made his views clear.