Blockchain Technologies and Cryptocurrencies in California

Blockchain technology developed years ago as a way to use a shared, digital public ledger.  While it is best known for its use in digital or cryptocurrencies like Bitcoin to protect and document financial transactions, recently, enthusiasts, developers and entrepreneurs have been actively exploring new uses.  Despite its increasing use, blockchain remains an area that can be difficult to understand from both a legal and technology standpoint.  Any parties using blockchain technology and/or digital currencies in a transaction should consult an attorney to avoid potential liability and financial losses.

A cryptocurrency is a digital or virtual currency that is secured by cryptography, unique digital signatures and complex mathematical algorithms to protect the currency from counterfeiting.  Many cryptocurrencies rely on blockchain.  Transactions generate virtual “tokens,” which are represented by ledger entries recorded and transmitted via the blockchain.

Some virtual currencies can be purchased for, or exchanged into, U.S. dollars, euros and other real currencies.

The most well-known cryptocurrency is Bitcoin.  However, there are many others (sometimes referred to as “alt-coins” or “altcoins”), including Litecoin, Namecoin, Ethereum and EOS.  New cryptocurrencies are created every day.

A creator of a new cryptocurrency typically first offers it to the public through an initial coin offering (ICO).  The offering is usually preceded by a white paper that explains how the cryptocurrency will work, why it is beneficial and why people should invest in it.  The investing public will typically determine the value of the currency based on the white paper, interest in the project or speculation on price changes.

• Pros: There are several advantages to cryptocurrencies over traditional currencies.  Cryptocurrency transactions are not subject to the rules of a centralized authority, such as a bank or credit card company.  Potentially, this allows parties to transfer funds more easily and reduces processing and transaction fees.  It also allows citizens of countries with unstable banking institutions and currencies to conduct business across borders.  Additionally, crypto transactions provide a certain degree of privacy as users are identified by numerical codes, making it difficult to trace back to the user from a certain transaction.  The blockchain technology also offers protection from hackers, as the shared public ledger cannot be altered without the consensus of the network of members.  However, notably, exchanges of cryptocurrency may still be hacked if an individual’s “private key” is accessed by an unauthorized party.  A private key is a secret number akin to a password that is often used in the crypto world to withdraw funds and prove ownership of a blockchain address.

• Cons: Despite their convenience, cryptocurrencies also present risks.  The effective anonymity of cryptocurrency transactions has allowed them to be used for money laundering, tax evasion and other illegal activities.  Further, the crypto regulatory landscape remains uncertain.  In the U.S., cryptocurrency offerings are regulated much like securities offerings and compliance can be intricate and demanding.  Many companies have run into legal issues following non-compliant ICOs, and token issuers should be careful to ensure legal compliance in ICOs.  Finally, cryptocurrency values tend to fluctuate widely and are subject to various investor risks including speculation, fraud and manipulations.

As cryptocurrency use has increased, the U.S. and global governments have sought to regulate the industry.  In the U.S., various federal and state laws apply to crypto transactions.  These include:

• Federal Securities Laws
  Crypto regulations are constantly evolving.  As of today, it remains highly debated whether a particular token should be categorized as a security and which agency has the power to regulate it.  At the current stage, token issuers and investors should be aware that their token could be deemed a security and thus subject to the regulations of the Securities and Exchange Commission (SEC).  ICOs may also be considered securities offerings that must be registered. On the other hand, the Commodity Futures Trading Commission (CFTC) considers virtual currencies as commodities subject to agency oversight.  However, CFTC’s jurisdiction is limited to virtual currencies used in a derivatives contract, or if there is fraud or manipulation involving a virtual currency traded in interstate commerce. Both the SEC and CFTC have issued guidance regarding cryptocurrency transactions.

• Internal Revenue Service (IRS)
  Under IRS rules, virtual currency transactions are taxable like any other property transaction and must be reported on the taxpayer’s tax returns.  This includes selling or exchanging virtual currencies, using them to pay for goods or services or holding them as an investment.

• FinCEN
  The Financial Crimes Enforcement Network (FinCEN), a bureau of the United States Department of Treasury, regulates money laundering and other financial crimes.  Unlike the IRS, which typically views virtual and cryptocurrencies as property, FinCEN generally treats these tokens as alternative currencies, subject to the same rules and restrictions governing money laundering and illegal financing.  FinCEN’s published advisories provide guidance to individuals and institutions regarding the legal use of virtual currencies and red flags in virtual currency transactions.

• California Securities Law
  In California, crypto assets are under the purview of the California Department of Financial Protection and Innovation.  Like many other states, California has made efforts to regulate the crypto ecosystem, although it has experienced some hurdles.  Despite its recent failure to enact a licensing regime similar to New York’s BitLicense, the legislature is actively exploring solutions. Crypto exchanges and investors should pay close attention to any new regulations that might be applied to them.