Clearly, the Bitcoin protocol alone does not provide a complete solution. Exchange regulation of Mt. Gox would have helped both Mt. Gox users and the Bitcoin economy. I dare you to rebut in the comments below.
Bitcoin exchanges must adopt mainstream exchange fee schedules, which incentivize market makers, in order to substantially increase liquidity. In this paper I will propose a hypothetical bitcoin exchange, modestly called the “Super-Exchange”, that will increase liquidity for all trading between currencies, however, BTCUSD will be used throughout the paper as an example. In the context of the Super-Exchange, liquidity means bitcoins can be traded for other currencies without causing a significant movement in the BTCUSD price and with minimum loss of value.
Unfortunately, all bitcoin exchanges currently use a flat percentage model, which does not promote liquidity. For example, Mt. Gox (Japanese based exchange), and CampBX (US based exchange) charge 0.6% and 0.55% respectively, for each transaction, to both the buyer and the seller. Under this model, especially with such high commissions, there is no incentive for market makers to participate.
Modern exchanges employ the “make-or-take” model to incentivize market makers to provide liquidity. Under the make-or-take model market makers make money it two ways, 1) “trade across the bid-ask spread,” and 2) “earning liquidity rebates.”
How market makers profit
The first way market makers generate revenue is to trade across the bid-ask spread by offering to buy a commodity or security at a certain price, and sell the same commodity or security at a higher price. For example, a market maker on the Super-Exchange exchange may offer to buy bitcoins at $4.90 USD, and sell bitcoins at $4.91. The market maker makes money by buying low to one trader and selling high to another trader many, many times throughout the day.
The second way market makers generate revenue is through liquidity rebates. Modern exchanges, like the NYSE, charge the “liquidity taker” a commission for every share bought or sold, typically three tenths of a penny. The exchange gives two tenths of a penny to the “liquidity maker,” called a liquidity rebate. The exchange keeps the last tenth of a penny as profit. Liquidity takers are traders that execute market orders against “resting limit orders.” Liquidity makers are market makers that submit “resting limit orders,”. A resting limit order is simply an order that is either an offer to buy below the current lowest ask price, or an order to sell above the current highest bid.
For example, on the NYSE, if the current highest bid for company C stock is $9.98, and the current lowest asking price is $10.01. The market making firm, “MM,” enters limit orders to buy and sell C’s stock for $9.99 and $10.00 respectively, narrowing the spread. If a liquidity taker, or “trader,” enters a market order to buy 50 shares of C from MM for $10.00, and another trader enters a market order to sell 50 shares of C to MM for $9.99, then MM will make $1 trading across the spread and $0.20 cents in liquidity rebates. As more market makers enter the exchange, the spread gets tighter and tighter because market makers must compete for volume. Furthermore, as the spread gets tighter, market makers generate substantially higher revenues through liquidity rebates rather than trading across the spread.
Under the make-or-take model, both market makers and traders benefit. In 2008, market makers made over $21 billion dollars. In 2009, Jim Simmons and Ken Griffin (who both run liquidity-making hedge funds) personally took home $2.2 billion and $900 million, respectively. Traders also benefit by having a stable exchange rate though tighter spreads that create insubstantial differences between trades, even with high volume transactions.
Applying Make-or-Take Model to Bitcoin Exchanges
The Super-Exchange must employ the make-or-take model between bitcoin and local currencies, because employing the make-or-take model will maximize liquidity and increase volume. Furthermore, the Super-Exchange will also increase revenue because an increase in liquidity also creates an increase in transaction frequency, which is when the Super-Exchange makes a profit. For example, the Super-Exchange charges the trader 0.0003 bitcoins per bitcoin bought or sold. The market maker receives 0.0002 bitcoins, and the Super-Exchange retains 0.0001 bitcoins as profit.
Note, the make-or-take model is only feasible because the Super-Exchange also holds the deposits of the market makers and traders. Under the example of the make-or-take model the commission is only 0.0003 bitcoins, whereas transactions across the bitcoin network, without an intermediary, are typically 0.01 bitcoins or higher. Thus, the commission to actually make the ownership transfer across the bitcoin network would be greater than the Super-Exchange’s commission, e.g., 0.0003 bitcoins.
Traders, or in this case depositors in the Super-Exchange, will enjoy tighter spreads and a much more liquid market with higher volume, rather than massive 1% jumps between two transactions executed seconds apart, often with a total transaction volume of less than 3 bitcoins.
Regulating High Frequency Trading: An Examination of U.S. Equity Market Structure in Light of the May 6, 2010 Flash Crash, Stephen Barnes, available at http://www.sec.gov/comments/s7-02-10/s70210-341.pdf, at 4; See SEC Concept Release on Equity Market Structure, 75 Fed. Reg. at 3607.
|Me:||[B]elow is a link to a blog post on what caused the BTCUSD crash on February 13th, 2012. ...|
|BTCUSD Trader:||There was no crash. Are you confused about market trends?|
|Me:||A crash is defined as a loss of more than 20%, as seen in 1929 and 1987. BTCUSD fell from $5.50 to $4.20 within 24 hours. That is a 23.6% drop. That is a crash.|
|BTCUSD Trader:||In that case, Bitcoins have had dozens of crashes...|
|Another Trader:||Yes - Bitcoins have had dozens of crashes. It's pretty exciting as markets go.|
Currently with each block mined the reward to the miners is 50 BTC of new currency issued. When issuance reaches the 10.5 million BTC milestone, the rate will drop from 50 BTC to 25 BTC per block. Hitting the 8.4 million mark today means that 80% of these “easy” bitcoins have now been mined.
The 10.5 million mark will likely occur around December of this year, but could deviate based on the rate of change in mining capacity with the target being hit in November or January instead being a possibility. At that point, exactly half (50%) of all bitcoins that will ever be issued will have been issued.
Read more here.
Are bitcoins commodities? In a previous article I showed that, under U.S. law, bitcoins are neither securities nor currency. So, what are bitcoins? Furthermore, what regulations, if any, apply to bitcoins designated as a commodity?
Bitcoins Are Commodities
Bitcoins are commodities. A “commodity” is defined under U.S. law as “[a] useful thing; an article of commerce; a moveable and tangible thing produced or used as the subject of barter or sale.” Ballentine’s Law Dictionary; See State ex rel. Moose v Frank, 114 Ark 47, 169 SW 333. A thing is tangible if it is “[c]apable of being possessed or realized; readily apprehensible by the mind; real; substantial; evident.” Ballentine’s Law Dictionary; See Williams v Board of Comrs. 84 Kan 508, 114 P 858.
Bitcoins are tangible, because each bitcoin is constructively possessed. Constructive possession is “control or dominion over a property without actual possession,” compared to actual possession, which is “[p]hysical occupancy or control over property” (Black’s Law Dictionary (9th ed. 2009), possession). U.S. courts have interpreted constructive possession to include, “an appreciable ability to guide the destiny” of the thing. United States v. Culpepper, 834 F.2d 879, 881 (10th Cir. Kan. 1987). Examples include electronic contracts, currency, child pornography, etc. See Pyro Spectaculars North, Inc. v. Souza, 2012 U.S. Dist. LEXIS 15801, 9-10 (E.D. Cal. Feb. 8, 2012); United States v. Moreland, 665 F.3d 137 (5th Cir. Miss. 2011); Walker v. United States, 2010 U.S. Dist. LEXIS 108981 (M.D. Ga. May 24, 2010); United States v. Riccardi, 258 F. Supp. 2d 1212 (D. Kan. 2003). Furthermore, many statutory provisions rely on constructive possession of electronic data, e.g., UCC 9-102(31) and 9-105.
Bitcoins are clearly useful articles of commerce capable of being possessed. Bitcoins are traded online every day for goods, services, U.S. dollars, and other currency. Each bitcoin is also controlled by a specific user. Even though every node on the bitcoin peer-to-peer network has knowledge of the bitcoins in each bitcoin wallet, however, the bitcoins in a particular wallet can be distributed only by the person with the bitcoin wallet.
U.S. Regulations Imposed on Commodity Contracts
Bitcoin is a commodity, but currently most bitcoin transactions are not subject to regulation by the U.S. Commodity Futures Trade Commission (“CFTC”), because bitcoins fall under an exception, 7 U.S.C. 1A(19). The CFTC was created by the U.S. congress through the Commodity Futures Trading Commission Act of 1974 (the “‘74 Act”). The mandate for the CFTC has been renewed through the recent Dodd-Frank Act. The ‘74 Act §2(a)(1)(A) gave the CFTC “exclusive jurisdiction” over all transactions that are substantially similar to, or commonly known as, an “option”, “bid”, “offer”, “put”, “call”, etc., and “transactions involving contracts of sale of a commodity for future delivery.”
The U.S. does not regulate commodity contracts whether delivery is made at the point of purchase (“PoP”), or is deferred; but, commodity options contracts are heavily regulated by the CFTC. See The Commodity Futures Trading Commission Act of 1974. The CFTC interprets the meaning of commodities broadly. A ”commodity” as defined under Commodity Exchange Act (7 U.S.C. 1A(4)) is:
wheat, cotton, rice, corn, oats, barley, rye, …, livestock, livestock products, …, and all services, rights, and interests …, in which contracts for future delivery are presently or in the future dealt in.
Not intuitively, however, the CTFC limited the use of the term “future delivery” such that the CFTC does not regulate commodities futures contracts (Commodity Exchange Act (7 U.S.C. 1A(19)):
The term “future delivery” does not include any sale of any cash commodity for deferred shipment or delivery.
A cash commodity is simply an actual physical commodity someone is buying or selling.
It is important to understand that even though the the ‘74 Act states “contracts of sale of a commodity for future delivery,” the types of contracts for future delivery regulated by the CFTC are traditionally known as options. Therefore the use of the term “forward contract” will refer to the commodity contracts exempted from regulation by the CFTC, the use of the term “options contract” will refer to the commodity contracts regulated by the CFTC. See In re Stovall, [1977-1980 Transfer Binder] Comm. Fut. L. Rep. (CCH) (CFTC Dec. 6, 1979).; and CFTC v. Zelener, 387 F.3d 624 (7th Cir. Ill. 2004). The issue then is to determine if the sale of a commodity is a forward contract or an options contract.
Differences Between Commodity Forward Contracts and Commodity Options Contracts
Forward contracts (a subset of futures contracts) are transferable contractual agreements to buy or sell a fixed amount of a certain commodity on a specified date; options contracts are the right to buy or sell a specified amount of a commodity within a certain period of time at a given price (called the strike price). Commodity Futures Trading Com. v. U. S. Metals Depository Co., 468 F. Supp. 1149, 1154-1155 (S.D.N.Y. 1979). Three functional distinctions between forward contracts and options contracts are (id. at 1155):
- The holder of a forward contract is obligated to receive the commodity, whereas a holder of an options contract is not;
- The price of a forward contract is applied to the ultimate sales price of the commodity, whereas the price of an option charges the buyer an initial nonrefundable premium; and
- Profit of a forward contract is realized when the actual sale price of the commodity exceeds the purchase price of the contract, whereas profit of an options contract is realized when price of the commodity increases beyond the strike price plus the premium.
U.S. courts look at three factors to determine whether a commodities contract is an options contract (including transactions in options involving foreign currency) (In re Stovall, [1977-1980 Transfer Binder] Comm. Fut. L. Rep. (CCH) (CFTC Dec. 6, 1979)):
- Directed operation to the general public,
- Standardized contracts, which resemble futures contracts, and
- Where the buyer does NOT take delivery of the commodity (most important).
The focus of the factors is to determine if the parties’ had a general expectation of delivery of the underlying commodity. See Id. In Stovall’s case, there was a single receiver for all purchasers of the contracts, therefore the court found that the contracts Stovall referred to as forward contracts were, instead, correctly designated as options contracts. Remember, U.S. courts will look to substance over form to determine whether a commodity contract is a forward or options contract. See Commodity Futures Trading Com. v. U. S. Metals Depository Co., 468 F. Supp. 1149.
Even commodity options contracts based on “spot and cash market” (e.g. contracts related to silver bullion, silver coin, foreign currency, etc. where the commodity is immediately received) are not beyond the scope of the ‘74 Act. CFTC v. American Board of Trade, Inc. 473 F. Supp. 1177 (S.D.N.Y. 1979). Metals Depository Co. sold options contracts of gold and silver, and argued that the ‘74 Act did not regulate options contracts unless those options pertain to future delivery. Id. The court disagreed and ruled that the ‘74 Act gives the CFTC exclusive jurisdiction over all commodity options contracts, including options contracts for foreign currency. Id.
Bitcoins are commodities, but, for the vast majority of transactions, bitcoins are not regulated by the CFTC. Most transactions on bitcoin exchanges are directed to the general public, however, standard contracts are not used and the buyer does intend to accept delivery of the bitcoins sold.
There are a handful of websites online that sell bitcoin forward contracts. These bitcoin forward contracts are usually sold by individual bitcoin miners. Successfully mining fifty bitcoins can take months, even for miners with considerable computing power. The BTCUSD market (where bitcoins are sold for U.S. dollars), however, is very volatile and subject to frequent crashes, and miners have a strong incentive to hedge against potential BTCUSD (or other currency) downturns by selling futures contracts. Furthermore, futures contracts provide leverage for miners to buy equipment to increase bitcoin production.
Bitcoin forward contracts do not have any of the characteristics of an options contract, and thus do not fall under the jurisdiction of the CFTC. The seller is obligated to send, and the buyer is obligated to receive, the bitcoins bargained for; the seller does not merely give the value the buyer would have received had the bitcoins actually been sent and received. The price of the forward contract is the price the bitcoins are being sold for, not simply a premium for the option to buy the bitcoins at a later time. The profit is realized when the bitcoins are received and exchanged, not when the exchange rate increases beyond both a strike price plus a non-refundable premium. Thus, bitcoin forward contracts are not regulated by the CFTC.
Bitcoin forward contracts sold primarily by large mining pools are not common place yet, however, bitcoin futures contract markets may soon evolve and become mainstream. Pools are groups of miners that combine computing power to increase the production of bitcoins. Pools divide the bitcoins produced between the members of the pool based on the amount of computing power donated by each member. The majority of bitcoins successfully mined are done so through mining pools because the combined computing power of a pool typically far outweighs an individuals computing capacity.
If a standardized futures market emerges where the sellers of the contracts are miners or mining pools, then contracts will likely not fall under the regulatory regime of the CFTC. If, however, a standardized futures market emerges where buyers may resell contracts, those transactions will fall under the jurisdiction of the CFTC. The most important prong of “the options test” is whether the buyer takes delivery of the commodity. In re Stovall, [1977-1980 Transfer Binder] Comm. Fut. L. Rep. (CCH) (CFTC Dec. 6, 1979). As long as buyers do not become the sellers, then clearly the buyers will take delivery of the commodity, and the CFTC does not have jurisdiction.
The emergence of bitcoin exchanges and brokers like Mt. Gox (largest bitcoin exchange located in Japan) and Bitcoinica (written by a 17 year old in Singapore), bring to light the realization that Bitcoin is dominated by nerds with the capacity to implement complex financial infrastructures and instruments very quickly. Bitcoinica, in particular, which already offers margin and interest bearing deposit accounts, may soon provide a standardized market for bitcoin futures contracts. It may also decide to offer bitcoin options contracts. I expect, however, strictly based on the overhead of regulation, to see standardized bitcoin futures contracts sold exclusively by mining pools, followed closely behind by bitcoin options contracts.
‘Fastest Growing Bitcoin Business’ Paying Interest On Deposits
Today Bitcoinica began testing an incentive to attract deposits to its leveraged trading service — the only one of its kind where bitcoin positions are traded. An announcement of the incentive was posted on the BitcoinTalk forum by Zhou Tong, Bitcoinica’s founder. Essentially, Bitcoinica has started paying interest to those holding balances in their accounts with the service and will start passing through interest rate differentials to those using leverage to hold BTC/USD positions.
Generally, those holding a long BTC/USD position (anticipating a rise in the exchange rate) will be paying interest and those with a short BTC/USD position (anticipating a drop in the exchange rate) will be receiving interest income.
Bitcoinica began operating its forex-like service in September, 2011 and has become the ‘fastest growing Bitcoin business’, according to Tong. That claim is likely true. Trades on Bitcoinica don’t measure the same as trades on Bitcoin exchanges as trades on Bitcoinica don’t cause bitcoins to actually trade hands. But the volume Bitcoinica sees daily can oftentimes exceed a third or more of all the bitcoin trades occurring on all the other Bitcoin exchanges combined!
A contributing factor to Bitcoinica’s growth has been that its margin accounts are trivially easy to open and leverage is granted automatically without restrictions. To get started a trader transfers bitcoins or USD funds even using methods convenient to bitcoiners. Those arriving funds will then show in the balances for the trader’s currency account.
An account’s margin balance is then calculated based on the combined currency account balances — the USD balance plus the current value of the bitcoins held on deposit. A trader can then self-manage the account’s leverage ratio, from 2.5:1 all the way up to a very risky 10:1.
Because a long BTC/USD position can be purchased using leverage gained through a margin balance funded by bitcoins themselves, Bitcoinica uses reserves of USDs to enable that leveraged transaction to be made. There has been more demand for these reserves than supply is available and as a result Bitcoinica has to deny new trades when reserves are insufficient — a condition that seems to have been occurring more often than not over the past several weeks.
By paying interest for deposits Bitcoinica hopes to attract additional funds. With USD deposits earning nearly 20% APY (the current cap set by the exchange), it would seem that the exchange should find no shortage of funds arriving from depositors seeking higher yields.
But there’s the rub.
Bitcoinica is today likely operating without being in full compliance with the law in jurisdictions where it has customers, including the U.S.
Tong claims to be the official operator of Bitcoinica and CEO of xWayLabs, Inc. which is registered out of Delaware. Unclear at this time is whether or not xWayLabs has any legal relationship with Bitcoinica other than having the same owner. Tong does indicate that “there is going to be a change in the corporate status to allow financial services to be provided with full compliance, but we are unable to disclose more information”.
Tong does admit “we are holding a huge amount of customer deposits” but also expresses his intention to “make our legal information fully available to our users” in a matter of “a few weeks”.
While Tong may be confident that customer deposits will be safe and that withdrawals can be made unimpeded, his comments might indicate naivety. Faced with a concern from a customer that withdrawal will require identification Tong responds “Currently we don’t have any KYC procedures. […] Just don’t worry about it.”
The young Zhou Tong is not the first individual to attempt to fly under the regulator’s radar while operating a business that is not yet in compliance. Bitcoinica has already grown large enough to be noticed but the addition of 20% APY interest payments on USD deposits plus not following anti-money laundering (AML/KYC) requirements is like painting a big red target on your chest. Even if Bitcoinica has a plan to get itself “in full compliance”, it may not have the “few more weeks” to do so.
On February 13th, 2012, starting at about 4:30 Eastern Time (2:30 MST), the BTCUSD crashed, concurrently, Trade Hill announced that it was closing it doors and returning all deposits. The images below are two, 24-hour, snapshots of the BTCUSD crash on February 13th and 14th. The red line in each chart is about the time Trade Hill announced it was closing its doors.
Trade Hill’s termination and subsequent selloff of at least a portion of the bitcoins it controlled likely instigated the crash. Trade Hill did not disclose how it intended to return the funds deposited, however, Trade Hill’s niche was its ability to receive wire transfers from all major banks and currencies. Thus, for certain account Trade Hill may need to convert its bitcoin back tot he currencies it initially received. It is not clear how large Trade Hill was or how much capital Trade Hill controlled, however, due to the wide range of products and services it offered (e.g., bitcoin.com, bitinstant.com, etc.), its capital is likely substantial. If Trade Hill was executing massive sell orders in order to return money to its depositors’ accounts, then the recent crash of February 13th may be artificial instigated, and then compounded with other market factors.
The closing of Trade Hill may be a sign of what is to come. Trade Hill cited that its close was due to increasing regulation (a topic I enjoy writing on) and chargebacks. Chargebacks are the mechanism by which PayPal and other banks will reverse an order based on the buyer’s dissatisfaction of the received goods or services (in this case bitcoins). Chargebacks have been a major source of uncertainty for BTC traders, and will likely continue to be a problem. Many BTC exchanges and traders use Dwolla, because it claims to not issue chargebacks. Recently, however, Trade Hill explained that even Dwolla will issue chargebacks in certain circumstances. If users are unable to due to fear of chargebacks, this could a death blow to the Achilles heal of bitcoins.
The second largest exchange for buying and selling bitcoins, TradeHill, has shut down its trading operation and is returning funds on deposit from its clients.
The announcement from the exchange’s CEO, Jared Kenna, blames ‘increasing regulation’ and losses exceeding $100K USD when transfers to the exchange were reversed by a payment processor (presumable the July 2011 incident in which TradeHill claimed Dwolla withdrew funds). A post on BetaBeat regarding today’s closure also references the exchange’s trouble processing transactions after an issue in January affecting their account at Citibank.
Though Kenna describes the intention to pursue licensing and raise funds, the TradeHill staff are now working on Bitcoin.com with a release planned before the end of the month. There was no mention of what service this site will offer.
No, bitcoins are not a security because it is not an “instrument commonly known as a ‘security’”, investment contract, or a foreign currency. Securities and Exchange Act of 1934 § 3(a)(10). A instrument commonly known as a security includes stocks, options, bonds, futures, etc., which bitcoins are clearly not. The last two, however, investment contract and foreign currency, need a more in depth analysis.
Bitcoins are not investment contracts. An investment contract is defined as “any transaction in which 1) individuals were led to invest money, 2) in a common enterprise, 3) with the expectation that [the investor] would earn a profit, and 4) solely through the efforts of the promoter or of some one other than [the investor].” SEC v. W. J. Howey Co., 328 U.S. 293, 298 (U.S. 1946).
Bitcoins do not fit within the legal definition of “money” in the U.S. Money means dollar bills and coinage. Frank v. ITT Commer. Fin. Corp. (In re Thompson Boat Co.), 230 B.R. 815, 820 (Bankr. E.D. Mich. 1995). Money is defined in the UCC, Article 1, §1-201 as:
A medium of exchange authorized or adopted by a domestic or foreign government.
The official comment states:
The test is that of sanction of government, whether by authorization before issue or adoption afterward, which recognizes the circulating medium as a part of the official currency of that government.
Bitcoins are also not earned solely through the efforts of another. Bitcoins are mined using computing power, often times within pools, but not solely through the efforts of others. Each miner that donates computer power to a pool is reward only in proportion to the amount computer power contributed to the pool. In Howey, investors bought small portions of an orange grove (“plot”) from a promoter. The entire orange grove was managed, cultivated, and harvested by the promoter, or the promoter’s contractors. Id. Each investor received a ratio of the profits equal to the percentage of the orange grove the investor owned after the oranges were sold. Id. Howey argued that the scheme employed was merely a general partnership. Id. The court, however, ruled that Howey’s scheme was a horizontal commonality (pooling of investment funds and pro rata sharing of profits) and each plot sold was merely an investment contract because some amount of work is expected by each partner in a general partnership. Id.
Bitcoins are not investment contracts because 1) bitcoins are not money, and 2) bitcoins are earned based on the work of the miner. Miners do “invest” in specialized hardware to increase productivity. This is, however, more analogous to a miner or farmer that merely buys tools and equipment to increase output.
Bitcoins are not currency. Hollywood has incorrectly labeled bitcoins as currency by simply determining whether or not bitcoins are exchangeable. The Good Wife, Episode 13, Season 3. (A lawyer in the episode argued that bitcoins, unlike airplane miles, used to pay for a hotel stay, can then be used by the hotel to buy a book on Amazon.) The correct test, however, was laid out by the Supreme Court in California Bankers Assn v. Shultz, 416 U.S. 21, 41 (U.S. 1974):
"Currency" is defined in the Secretary’s regulations as the "coin and currency of the United States or of any other country, which circulate in and are customarily used and accepted as money in the country in which issued
Bitcoins are not issued by the U.S. or any government that the U.S. recognizes. Bitcoins are also not sanctioned by the U.S. or any government that the U.S. recognizes. Therefore bitcoins are not a currency.
Bitcoins are not securities because bitcoins are not investment contracts, currency, or instruments commonly referred to as a security. This may quickly change. The securities laws are meant to be broad in the absence of an alternative regulatory scheme. See Reves v. Ernst & Young, 507 U.S. 170 (U.S. 1993). The U.S. may employ other doctrines (e.g., family resemblance test”) to designate bitcoins as securities.
Can the U.S. regulate bitcoin, even if bitcoin is not a security? Absolutely. I have already discussed how the U.S. regulates bitcoin brokers (part 1, part 2). The U.S. may also regulate other bitcoin organizations, e.g. banks and exchanges, through the Bank Secrecy Act and Anti-Money Laundering act and other securities laws. Even though bitcoins are not securities, trading bitcoins, or other bitcoin instruments, are still regulated by the U.S.
Continued from Part 1…
Can the US regulate bitcoin brokers (as defined in part 1), even if bitcoin is not designated as a security or currency? Absolutely:
The US Supreme Court defined that an investment contract as any transaction in which 1) individuals were led to invest money 2) in a common enterprise 3) with the expectation that [the individuals] would earn a profit 4) solely through the efforts of the promoter or of some one other [the investors] (the “Howey Test”). SEC v. W. J. Howey Co., 328 U.S. 293, 298 (U.S. 1946). Although the Supreme Court in Howey said the profits must be derived solely from the efforts of others, lower courts have accepted that the investor’s efforts in the common enterprise may contribute to profits. The efforts of the managers, however, must be predominant; the investors must be mostly passive.
The Howey Test embodies “a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” SEC v. W. J. Howey Co., 328 U.S. 293, 299 (U.S. 1946). Securities Law is meant to be broad and far reaching in order anticipate needed regulation in cases where the underlying instrument is not an expressly designated as a security, and there is no alternative regulatory scheme. Daniel 439 U.S. 551.
The policy of the Securities Act “affords broad protection to investors is not to be thwarted by unrealistic and irrelevant formulae.” W. J. Howey Co., 328 U.S. 293. Furthermore, “[t]he fact that some purchasers, by declining to enter into the service contract, chose not to accept the offer of the investment contract in its entirety, does not require a different result, since the Securities Act prohibits the offer as well as the sale of unregistered, nonexempt securities.” Id. In Howey, the court found that selling portions of a citrus grove coupled with a contract for cultivating, marketing and remitting the net proceeds to the investor to be an investment contract. Id.
Similarly, when a broker, like Ultima Fund, offers to manage other people’s bitcoin, with the expectation to make a profit, based on the broker’s efforts, the transaction is an investment contract, and will subject to regulation. This does not mean that all transactions involving bitcoins make bitcoin its self a security, but that brokers (as defined in part 1) are subject to regulation. Even those that are argue that bitcoin is not a security agree that brokers may still be regulated. See “Why Bitcoin Isn’t a Security Under Federal Securities Law,” http://www.lextechnologiae.com/2011/06/26/why-bitcoin-isnt-a-security-under-federal-securities-law/
Again, the US understands that international commerce is important and vital to a growing US economy and the SEC’s intent to help cultivate a healthy market for mutual benefit. When it comes to securities, even with bitcoin, permission is always better than forgiveness (because there is no forgiveness regardless of intent). See Dixon, 536 F.2d 1388.
Yes, the US does regulate brokers trading bitcoin, even if the exchange is foreign. Failure to register is as a broker or dealer is a violation of §§ 15(b) and 21C of the Securities and Exchange Act of 1934 (the “Exchange Act”). ”Broker” and “Dealer” are defined broadly in §§ 3(a)(4) and 3(a)(5), respectively, of the Exchange Act. A broker is defined as (note, there are a few exceptions enumerated in the code that do not apply in this discussion):
Any person engaged in the business of effecting transactions in securities for the account of others.
A dealer is defined as:
Any person engaged in the business of buying and selling securities for such person’s own account through a broker or otherwise.
Accordingly, the Guide to Broker-Dealer Registration (the “Guide”), issued by the Division of Trading and Markets U.S. Securities and Exchange Commission (the “SEC”) in 2002, in Article II(D)(6), states that all broker-dealers that are 1) physically operating within the US, 2) attempt to induce securities transaction in the US, or 3) use any means or instrumentalities of interstate commerce, must register with the SEC as a broker-dealer.
The US Supreme Court has made it clear that the US Congress has plenary power to regulate all commerce within US boarders, and between US citizens, regardless of location. The language used in part three of the Guide is particularly relevant. The phrase “instrumentalities of interstate commerce” is the phrasing used by the US Supreme Court granting plenary power to the US Federal Government (specifically Congress) to regulate any matter related to commerce that goes on within the US boarders or its citizens. See US v Lopez (1995).
In effect, if 1) any citizen of the US acts as a broker; 2) a broker within the US that trades on a foreign market; 3) a foreign broker has any US clients; or 4) a broker, foreign or domestic, uses US communication lines; that broker is in violation of US securities law unless the broker is registered with the SEC. Furthermore, if caught that broker can be punished to the full extent of the law.
The US government intends to protect its citizens, whether or not a particular broker is foreign or domestic, or whether the market place is foreign or domestic. The securities market is filled with so called “expert” or “experienced” money managers that have been found guilty of ponzi schemes and other forms of fraud. The interest of the US in protecting its citizens is not diminished merely because a market place, or broker, resides outside of its boundaries.
Whether or not the broker intended to mislead investors, the SEC has authority to issue sanctions against a company or persons acting as an unregistered broker-dealer in violation of the registration provisions of the Exchange Act. See United States v. Dixon 536 F.2d 1388 (2d Cir. N.Y. 1976). In the matter of RAM CAPITAL RESOURCES, LLC, MICHAEL E. FEIN, and STEPHEN E. SALTZSTEIN the court ruled that the SEC may issue sanctions, but not limited to, suspension from association with any broker or dealer for a period of twelve (12) months or more, and exceed $1 Million USD. See SEC Release No. 34-60149. Such sanctions constitute a felony under Form BD, which is the registration application for a broker-dealer license.
The US understands that international commerce is important and vital to a growing US economy and the SEC’s intent to help cultivate a healthy market for mutual benefit. As stated in the Guide, “[t]he SEC staff stands ready to answer your questions and help you comply with our rules.” The guide also includes the SEC’s contact information to help those that are interested find answers to questions regarding registration. When it comes to securities, even with bitcoin, permission is always better than forgiveness (because there is no forgiveness regardless of intent). See Dixon, 536 F.2d 1388.
Continue to Part 2
@BitcoinAnalyst from http://www.bitcoinbullbear.com, in response to: Are you still bullish on BTCUSD?
The added increase to BTCUSD and decrease in value over the last 5 days is likely the fault of MtGox. In a recent reply regarding an attempted withdrawal, the MtGox support team stated:
We apologize for the delay. Our Dwolla transfer system are currently on hold due to some update. We will notify you through this ticket once we have an update.”
On 1st of January, 2012, at 03:32:12 GMT, after selling GTC @ 6.7 USD/GTC, I requested a withdrawal to my Dwolla account. As usual I was told that the money should show up in my Dwolla account in “a few hours.” I waited nearly 48 hours before submitting a support ticket, to which I received the following statement:
We have located your transfer and it will become processed soon. At the moment we are experiencing with slight delay so it may take extra 1-2 days for it to become processed into your dwolla account. If the funds do not arrive within the stated days, please send us a message back to our support and we will further investigate into this matter.
After two days had past the transaction had still not taken place. I replied again, letting the MtGox support team know that Dwolla has still not received my withdrawal, however, my MtGox account reflected that I did not have the funds to trade any more either. The MtGox team responded:
We apologize for the delay. Our Dwolla transfer system are currently on hold due to some update. We will notify you through this ticket once we have an update.
Since then I have been effectively locked out of trading. MtGox will not let me continue trading the money that it has not yet deposited into my Dwolla account, and I still don’t have my USD. Furthermore, I am certainly not putting anymore GTC or USD into my MtGox account until this problem has been resolved.
My experiences seem to be coordinated with the recent market decline and increase in volatility. Since this is evidently a site-wide issue, many people have likely had similar experiences over the same time period. Thus, many other traders have also likely been effectively frozen. If so, it would explain the extreme volatility of GTCUSD, since volatility rises as liquidity dries up.
In the long run, neither MtGox nor the BTCUSD market will be affected by this issue. While It is essential for an exchange to provide liquidity and be trustworthy, this problem is no where near the magnitude of the flash crash of the NYSE. Furthermore, this liquidity shortage is artificially caused by technical mishaps, which is likely temporary and will make MtGox more stable as the exchange grows with the bitcoin market. Overall I have been generally pleased with MtGox, their services, and support; and I plan to resume trading as soon as this issue is fixed.