Last year, Bitcoin and other cryptocurrencies sparked a modern gold rush spurred on by stories of individual investors making millions in a short period from their investment in Bitcoin. The desire to get rich quickly encouraged every man on the street to own a virtual wallet to buy cryptocurrencies and saw the advent of many new cryptocurrencies. The mad rush to buy cryptocurrencies also led to regulators scrambling to establish some form of regulation for cryptocurrencies as an investment if only for tax purposes.
A cryptocurrency is a digital and decentralised currency in the form of a stream of data blocks that uses a peer-to-peer network to process transactions. It is facilitated by blockchain or distributed ledger technology which records the transactions between two individuals in a data base, much like duplicate accounting entries in a ledger. But investing in cryptocurrency is the acquisition of an interest in a ledger entry, and as an investment it is that interest that conceptually must be classified and regulated.
Is it cash?
A currency is a generally accepted form of money, usually in the form of coins and paper notes but can also be an entry in a bank account. It is issued by a government and is a medium of exchange for goods and services. A traditional currency used to be issued by the Central Bank of a country and backed by gold and silver. But now most major currencies (including the U.S. dollar and the Euro) are regarded as fiat currencies which are backed only by the legal tender of the government that issued them. Although there is no underlying gold or silver, the guarantee of the particular government gives the currency its value. The price of the currency also remains relatively stable in order for it to retain value as a currency offering a set price for an exchange for goods and services.
The cryptocurrency holding represented as an interest in a ledger entry can be viewed as a similar concept to an entry in a bank account. But there is no government or Central Bank that has issued cryptocurrency and granted it legal tender. Arguably, it can be given legal tender by each user prepared to accept payment of cryptocurrency in exchange for goods or services, and there are many major companies that are prepared to do that. But if something goes wrong then there is no recourse to a government or entity. Furthermore, the current volatility of the price of cryptocurrencies could move it out of the realm of a viable currency to be used in exchange for goods or services.
Is it a security?
The rise and popularity of the initial coin offering (ICOs) has led to a number of regulators including the U.S. Securities and Exchange Commission (SEC) to view these ICOs as a potential issue of securities or shares. The ICO offers investors units of a new cryptocurrency or a crypto-token in exchange for more established cryptocurrencies like Bitcoin and Ethereum, and has become a popular crowdfunding technique for new ventures. ICOs provide a means by which start-up companies can avoid the costs of regulatory compliance and intermediary financial organisations, but at a high risk to the investors.
The investment in a ICO, which has been viewed as a share issue, should be distinguishable from the general investment in cryptocurrency. A holder of cryptocurrency is not entitled to any bundle of rights and liabilities that are attributed to a shareholder such as voting rights, residual assets and profit share. There is also no connection to an underlying company or its assets, which would be implicit in an ICO or shareholding.
Is it a commodity?
The U.S. Commodities Future Trading Commission has classified virtual currencies such as Bitcoin as commodities. A cryptocurrency has a number of similar characteristics to commodities. It can be traded for goods and services in the same way that gold and silver are traded. A commodity is also traded to take advantage of its relative value and fluctuations against other currencies and assets which is seen in the current trading of cryptocurrencies. But it should be noted that cryptocurrency does not represent an underlying object with use value which is inherent in every commodity, and so it does not fall clearly within the definition of a commodity.
Is it property?
The U.S Internal Review Services has classified cryptocurrencies as a property for U.S. Federal tax purposes (IRS Notice 2014-21). There are four key rights that are attributed to property rights: (1) the right to use the good, (2) the right to earn income from the good, (3) the right to transfer the good to others and (4) the right to enforce property rights. In terms of the concept of property rights, it could be argued that the acquiring cryptocurrency which is an interest in a ledger entry represents an intangible property right. However, treating cryptocurrency as property is also problematic in that it is traded on a regular basis, can be exchanged for goods and services and the price is extremely volatile. A taxable transaction would occur in the hands of the holder every time a cryptocurrency is exchanged for a good or service. It is clear that the classification of cryptocurrencies as property may be too forced and artificial a construct given the unique attributes of cryptocurrency.
Cryptocurrency itself has been difficult to regulate because as a digital currency it operates across borders without any jurisdiction. It is, however, possible to regulate an investment in cryptocurrency based on the jurisdiction of the investor. This aspect, as well as the completely novel underpinning technology, places the regulators in unchartered waters and makes it difficult for cryptocurrencies to fit into some of the current standard investment classifications.
Given the rise and popularity of cryptocurrencies it would not be advisable to ignore them completely. The most prudent approach for those seeking to classify cryptocurrency as an investment would be to regard cryptocurrency as an undefined asset most analogous to a commodity, and keep an eye on local and international regulatory developments.
Kerry has a BBusSc LLB (cum laude) and MCom (Financial Management) and was admitted to the New York bar in 2008 and as an attorney in South Africa in 2012. She has worked as an associate in the corporate department at Davis, Polk & Wardwell LLP in New York and in financial services and investment management at Bowman Gilfillan. Kerry subsequently took up positions as a legal advisor at Sanlam Investments and an associate in asset management and investment funds at Arthur Cox in Dublin. She joined Caveat in 2017 and specialises in commercial and financial services law.