Policing cryptocurrencies has become a game of whack-a-mole for regulators

Just this week, the Securities and Exchange Commission obtained an emergency court order halting an initial coin offering by Titanium Blockchain Infrastructure Services that the agency claimed had defrauded investors out of about $21 million.

Regulators have become so concerned about misconduct that the SEC even unveiled a fake website for an initial offering of HoweyCoins — a play on a 1946 Supreme Court case that gave a broad definition of what constitutes a “security” — to demonstrate just how easy it is for investors to be fooled into parting with their money.

But fighting fraud in virtual currencies has almost become a game of whack-a-mole for regulators and federal prosecutors, who find each new iteration seemingly a few steps ahead them.

The challenge the authorities face is that cryptocurrencies are so new that they do not fit neatly into laws that were passed decades ago prohibiting misconduct in the securities and commodities markets. It will take time for those regulations to catch up.

Bloomberg reported that federal prosecutors were working with the Commodity Futures Trading Commission to determine whether traders are manipulating the price of Bitcoin, Ether and other cryptocurrencies. Unlike fraudulent schemes or theft from individual investors, this type of conduct cuts to the heart of the market for virtual currencies. It means that prices may not reflect any true value but instead are being driven up or down artificially by those seeking to profit.

The SEC’s jurisdiction only covers investments used to help fund companies, and Bitcoin hardly fits that model. Instead, the agency has focused on companies using initial coin offerings to raise money, arguing that doing so is the same as selling stocks or bonds to investors, and therefore the complex securities registration rules must be followed.

The trading commission may have better luck policing transactions in cryptocurrencies. A decision in March by Judge Jack B. Weinstein of U.S. District Court in Brooklyn, New York, held that virtual currencies “are ‘goods’ exchanged in a market for a uniform quality and value,” so they come within the definition in the Commodity Exchange Act that covers “all other goods and articles.” That means trading designed to defraud investors or manipulate the price of a commodity is subject to civil and criminal prosecution.

The decision was the first designating cryptocurrencies as a commodity. Whether other courts will agree is an open question. Defendants are sure to challenge any charges based on violating the commodity laws. They would most likely argue that virtual currencies are a medium of exchange rather than a commodity like gold or wheat.

Even if the commodity laws apply, proving manipulation can be difficult. The government must show that the trader intended to artificially affect the price. The U.S. District Court in Manhattan once explained that “entering into a legitimate transaction knowing that it will distort the market is not manipulation — only intent, not knowledge, can transform a legitimate transaction into manipulation.”

One challenge to proving a defendant tried to inflate (or deflate) the price of cryptocurrencies is that, unlike stocks, they are not traded on centralized exchanges. Even simply gathering information on trades may be a challenge for prosecutors and regulators trying to prove manipulation. Moreover, virtual currencies can be traded from just about anywhere on the planet, so even if there is a pattern of suspicious orders, the perpetrators may be beyond the reach of federal authorities.

Still, federal prosecutors possess two powerful weapons that are not available to the financial regulators at the SEC and CFTC: the mail and wire fraud statutes. These laws cover deception and schemes to defraud involving valuable property, including intangibles like Bitcoin and Ether.

Although cryptocurrency trading firms often call themselves “exchanges,” they are not registered with the SEC or the CFTC, and their clients have none of the protections afforded investors who trade stocks and commodities. If the government is serious about monitoring the markets for cryptocurrencies, it will need to require the trading firms to comply with the rules for exchanges, which include extensive record-keeping provisions.

Perhaps in a nod to the inevitability of greater regulation, Coinbase, a leading cryptocurrency trading venue, is in talks with the SEC about registering as a brokerage firm so that it can trade assets like Bitcoin and other tokens while complying with the securities laws. The company could create what is called an “alternative trading system” for buying and selling cryptocurrencies and tokens. Doing so would subject the firm to extensive capital and customer protection requirements along with oversight by the SEC and the Financial Industry Regulatory Authority, or FINRA. Coinbase clients could only trade assets that are properly registered with the SEC, another step toward treating cryptocurrencies as subject to the registration and disclosure requirements of the federal securities and commodity law.

Although becoming a broker would be costly, Coinbase could use that status as a marketing tool by telling potential customers they would be much safer trading through its platform rather than through unregulated firms that could see assets stolen or prices manipulated. Much like car companies tout their safety measures under rules they long fought, a broker can offer much greater client protection that customers may be willing to pay for.

As the value of cryptocurrencies swing wildly and those looking to abuse their investors proliferate, it may be up to Congress to finally designate an agency to be responsible for overseeing the markets. Maybe it is time to create a Crypto-Cop to bring some order to the system and combat those looking for an opportunity to cheat and steal.

This article originally appeared in The New York Times.

Policing cryptocurrencies has become a game of whack-a-mole for regulators

The lure of quick riches has attracted a growing number of investors to cryptocurrencies and initial coin offerings. It has also drawn scam artists.

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