Cryptocurrency Exchanges Face Ramped-Up Regulation, Court Battles

Keep up with the latest developments and legal issues in the telecommunications and emerging technology sectors, with exclusive access to a comprehensive collection of telecommunications law news,...

By Michaela Ross

Online sites that exchange bitcoins and other digital assets will face heightened legal and regulatory challenges in 2018, regardless of whether the value of the assets continues to skyrocket.

Hundreds of companies and people raised funds in 2017 through the sale of the assets, known as cryptocurrencies, coins, or tokens. Those initial coin offerings (ICOs) became popular among investors and buyers in part because of how easy they are to conduct.

It’s not always clear what existing regulations apply to the cryptocurrency industry as its technology continues to evolve, making it difficult for exchanges to comply. Token exchanges have also operated with fewer safeguards for purchasers than other types of exchanges, meaning users may be exposed to unexpected risk.

Regulators are starting to pay attention. Cryptocurrency and digital asset exchanges are likely to be hit hard with legal and regulatory challenges in 2018 because they’re usually more established and easier to identify than the companies or people developing the coins, financial attorneys and digital asset trade and advocacy groups told Bloomberg Law.

“I think that this is all a lot closer than people think, because quite frankly the amounts of money involved now are too significant for regulation and litigation not to be coming,” James Taylor-Copeland, the founder of Taylor-Copeland Law who specializes in cryptocurrencies and blockchain litigation, told Bloomberg Law.

More than 1,300 token types tracked by industry research site had a collective value of $295.6 billion as of Nov. 30. That’s up from about 600 token types worth about $17.7 billion at the beginning of 2017, the site’s data show.

More Lawsuits, Enforcement

The building global regulatory wave may impact how cryptocurrencies and assets are structured and valued. More lawsuits and heightened enforcement may encourage exchanges, such as Bitfinex and Poloniex, to be more mindful of transparency and consumer protection, leading to more credible operations, financial attorneys, digital asset think tanks, trade and advocacy groups said.

Still, those observers warn that stringent regulation, frivolous lawsuits or excessive caution by exchanges may make it tough for purchasers to trade some assets, causing valuation swings. Exchanges leery of legal breaches may limit the token types they issue or restrict who can trade on their platforms. That could discourage new issuers from developing new businesses or raising funds using the technology.

“If enforcement actions close or suspend trading on these alternative coin exchanges, the terrain for future ICO issuances could look very different,” Andrew Hinkes, a dispute resolution attorney at Berger Singerman LLP, told Bloomberg Law.

Several U.S. agencies are likely to issue guidance or fines, or launch enforcement actions against exchanges that are manipulating markets, committing fraud, or aren’t registered with the proper agency. International regulators, including in China and the U.K., have cracked down on token exchanges or issued early warnings to investors that some platforms can be risky and fraudulent or don’t comply with securities laws, according to Bloomberg Law data.

Class action lawsuits from retail investors who fueled the market’s heady growth will swell if the market cools, as expected, and fraud is exposed, financial and commercial litigation attorneys, digital asset think tanks and advocacy groups said.

“The bottom line is, if someone has $1 million worth of x coins and they lose that because of something an exchange does or a third party does, they’re going to file a lawsuit,” Stephen Palley, corporate and commercial litigation attorney at Anderson Kill P.C., told Bloomberg Law. “When you’re trying to figure out who to sue, you look for the most obvious, you look for defendants who are easiest to identify and who have assets.”

Eagle-Eyed Regulators

U.S. regulators—including the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), and the Treasury Department’s Financial Crimes Enforcement Network (FinCEN) and Internal Revenue Service (IRS)—will likely issue specific guidance for exchanges and fine those that don’t comply, attorneys, think tanks and groups said.

“They are clearly engaged, they are clearly looking at this,” Brian Knight, a senior research fellow at the Mercatus Center at George Mason University, told Bloomberg Law.

Bitfinex pulled out of the U.S. market in August, citing a “more challenging” regulatory landscape ahead.

A top priority for U.S. regulators will likely be determining how to classify digital coins. Some tokens are used like securities, while some are accepted as currencies. Others can be traded for goods or services. Regulatory classifications largely will dictate which agency mandates exchanges will need to observe.

“There’s going to be some burden being placed on these exchanges to do some diligence as to what these tokens actually are,” Knight said.

Federal agencies’ regulatory approaches to regulating digital currencies have been generally thoughtful in light of the fast-moving technology, financial attorneys and token trade and advocacy groups said. Regulators’ push to tighten industry oversight should be balanced against the spirit of innovation that has fueled the industry’s growth, they said.

The SEC warned platforms in a July investigative report that it is illegal to trade security-like tokens without registering with the agency or getting an exemption.

“In addition to requiring platforms that are engaging in the activities of an exchange to either register as national securities exchanges or seek an exemption from registration, the Commission will continue to seek clarity for investors on how tokens are listed on these exchanges and the standards for listing; how tokens are valued; and what protections are in place for market integrity and investor protection,” SEC Chairman Jay Clayton said in a Nov. 8 speech.The CFTC considers virtual currencies to be commodities that can also be used as securities. The commission has fined two exchanges that traded derivatives of virtual currencies, or offered margin or leverage trading without first registering with the agency. In October, the agency also clarified its oversight of exchanges in cases of fraud or manipulation.

The Treasury Department’s FinCEN, which mainly combats money laundering and other financial crimes, asserted its authority to regulate cryptocurrency exchanges by requiring them to register as money services businesses. The agency has already filed enforcement actions against two exchanges, including issuing a $110 million fine to what had been one of the world’s largest exchanges by volume, BTC-e, in July, for violating money-laundering laws.

“Treasury’s FinCEN team and our law enforcement partners will work with foreign counterparts across the globe to appropriately oversee virtual currency exchanges and administrators who attempt to subvert U.S. law and avoid complying with U.S. AML safeguards,” Jamal El-Hindi, Acting Director for FinCEN said in a July statement.

The IRS, which summoned U.S. exchange Coinbase Inc. to produce thousands of records to investigate its users’ possible tax evasion, may issue guidance for exchanges, Peter Van Valkenburgh, research director at Coin Center, a blockchain advocacy group, told Bloomberg Law.

“Tax implications for exchanges are complicated in part because the IRS has never issued really clear guidance on the reporting an exchange is supposed to do in regards to its customers’ tax information,” Van Valkenburgh said.

Lawsuit Surge?

Private lawsuits against exchanges also may start answering questions about how platforms should operate and whether assets are securities, Marco Santori, who leads Cooley LLP’s fintech practice, told Bloomberg Law.

“I think one of the overlooked paths for this to take is that the private litigants who bring cases alleging violation of SEC law will have to demonstrate in court that the underlying asset was a security,” Santori said.

Several class action cases have already been filed. There are many potential offenses customers might cite to file more lawsuits, commercial litigation attorneys said.

Investors who didn’t realize their tokens were a security may also file suits if they see values drop, Knight said.

Most token platforms also don’t have traditional protections that exchanges for registered securities or derivatives are required to have, such as asset-loss insurance, the SEC and CFTC have warned. The lack of these guardrails may make them more vulnerable to future consumer complaints, Hinkes said.

Token purchasers and traders may also target exchanges for alleged trading glitches, slow responses to trade orders or to flash crashes, market manipulation, trading against their own customers, artificially inflating trading volumes, and insufficient cybersecurity, David C. Silver, plaintiff attorney in several class action suits against exchanges, told Bloomberg Law.

There have been dozens of hacks or theft of digital assets on some of the world’s largest exchanges, such as Mt. Gox in 2014 and Bitfinex in 2016. The high amount of instantly liquid tokens held on token exchanges, unlike securities exchanges, make them prime targets for hackers.

Tokens, similar to stocks, are also subject to being split into two entities, but with differing values, a technical process called “forking.” And exchanges haven’t always built the needed internal infrastructure to recognize the new assets, triggering some allegations of theft, Van Valkenburgh said.

Regulators and courts likely will tackle that and other questions in the year ahead, as they catch up with the burgeoning technology. The big question heading into 2018 is how much the new regulation and litigation will impact cryptocurrency exchanges trying to operate alongside traditional exchanges and financial offerings.

To contact the reporter on this story: Michaela Ross in Washington at

To contact the editor responsible for this story: Keith Perine at

Copyright © 2017 The Bureau of National Affairs, Inc. All Rights Reserved.

Request Tech & Telecom on Bloomberg Law