Blockchain Week in Review - February 2019

by Perkins Coie
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U.S. Developments

Kik Publicizes Response to Possible SEC Enforcement

On January 27, the Wall Street Journal published an article describing the impending legal battle over cryptocurrency Kin and its 2017 ICO. That same day, Ted Livingston, the founder and CEO of Canadian company Kik Interactive (Kik) and the developer behind Kin, published the Wells Notice he received from the Securities and Exchange Commission (SEC) on November 16, 2018, as well as Kik’s response.

By way of procedural background, a “Wells Notice” is a communication of a preliminary determination by the SEC Enforcement Staff to recommend an enforcement action or administrative proceeding against the recipient.  The Wells Notice generally identifies the possible charges to be made against the recipient.  The recommendation is made to the SEC Commissioners, who determine whether to accept or reject the Enforcement Staff’s recommendation.  For the most part, the SEC almost always provides proposed defendants and respondents the opportunity to submit a written response to the allegations contained in the Wells Notice, although not technically required to do so.  In addition to filing a response, a recipient of a Wells Notice may request access to parts of the SEC’s investigative file, as well as meetings with the SEC Staff to discuss the enforcement action recommendation.

At issue here is Kin’s 2017 ICO, in which roughly $100 million of Kin was sold. Kin is a cryptocurrency native to the Kik app and built on Ethereum to the ERC-20 standard. The SEC’s Wells Notice warned Kik that the SEC would allege that the Kin ICO violated Sections 5(a) and 5(c) of the Securities Act of 1934 (issuing non-exempt securities without SEC registration).

On December 10, 2018, Kik responded to the Wells Notice by making three arguments against enforcement. First, Kik argued that Kin is a “currency” and therefore cannot, by definition, be a security under the federal securities laws. Second, Kik argued that the token pre-sale and public distribution were not “investment contracts.” Third, Kik argued that public policy advises against enforcement because Kik attempted to comply with current guidance and because an enforcement action would amount to “regulation by enforcement.”

In a post on Medium, Ted Livingston wrote: “This situation is not unique to Kik. There are dozens of projects at a similar point with the SEC. We all believe that this industry needs regulation, but we also believe that this is not the way to get it.”

To date, the SEC has not concluded whether to accept the Enforcement Staff’s recommendation.  Stay tuned as this action unfolds.

Please click here for the Kik Interactive Wells Notice and Wells Submission.

ISDA Guidelines for Smart Derivatives Contracts

The International Swaps and Derivatives Association (ISDA) has published the first in a series of guidelines for smart derivative contracts. This series of papers is intended to “provide high-level guidance on the legal documentation and framework that currently governs derivatives trading, and to point out certain issues that may need to be considered by technology developers when introducing technology into that framework.”

The introductory ISDA guidance, published on January 30, discusses what smart derivative contracts are, the legal complexities inherent in such arrangements, principles and models for smart derivative contracts, and considerations for technology developers.

According to the ISDA, derivatives provide a clear use case for smart contracts, as derivative payment and delivery is largely dependent on conditional logic. However, derivatives transactions create a web of legal complexities that a smart contract would need to accommodate. The ISDA guidelines articulate several principles to guide development of derivative smart contracts, including compatibility with existing standards and required legal validation.

Please click here for the guidelines.

House Passes Bills to Study Cryptocurrency’s Link to Crime

The U.S. House of Representatives passed a bill on January 28—H.R. 502, named the “Fight Illicit Networks and Detect (FIND) Trafficking Act of 2019”—that would require the Comptroller General of the United States to investigate how cryptocurrencies and online marketplaces enable sex and drug trafficking. The result of such a study would be regulatory and legislative recommendations to impede such illicit uses of cryptocurrencies.

In a press release, Representative Juan Vargas noted, “While evidence points to the growth of virtual currencies as a payment method for illicit sex and drug trafficking, the true scope of the problem and potential solutions are still unknown.”

This type of research-related bill dovetails with another bill in the House—H.R. 56, named the “Financial Technology Protection Act”—which would establish “the Independent Financial Technology Task Force to Combat Terrorism and Illicit Financing, which must research terrorist and illicit use of new financial technologies and issue an annual report.” This bill was passed by the House by a voice vote on January 28.

Industry Developments

SWIFT Announces Blockchain Project with R3

SWIFT, the global financial messaging service, announced on January 30 that it was partnering with R3, a blockchain startup aimed at bridging the gap between blockchain and the banking industry, to launch a proof-of-concept project. The project, called gpi Link, will utilize the blockchain platform Corda to allow institutions to authorize and settle payments through banks and receive credit confirmations on distributed ledger technology. SWIFT’s announcement for gpi Link claims that 50% of SWIFT gpi payments are credited within 30 minutes.

The gpi Link project will initially focus on utilizing R3’s distributed ledger technology. However, the hope is that it will expand to support other blockchain and non-blockchain environments in the future. SWIFT’s chief market officer noted that “[w]hile DLT-enabled trade is taking off, there is still little appetite for settlement in crypto-currencies and a pressing need for fast and safe settlement in fiat currencies.” The results of SWIFT’s trial will be presented at Sibos—a banking and finance conference—in September 2019.

Please click here for the SWIFT press release.

International Developments

QuadrigaCX Applies for Creditor Protection

Canadian cryptocurrency exchange QuadrigaCX filed for creditor protection with the Nova Scotia Supreme Court on January 31. According to a statement on the company’s website: “For the past weeks, we have worked extensively to address our liquidity issues, which include attempting to locate and secure our very significant cryptocurrency reserves held in cold wallets, and that are required to satisfy customer cryptocurrency balances on deposit, as well as sourcing a financial institution to accept the bank drafts that are to be transferred to us. Unfortunately, these efforts have not been successful.”

According to CoinDesk’s review of QuadrigaCX’s court filings, the exchange owes customers roughly $190 million. Much of its cryptocurrency holdings are in cold storage, meaning the tokens’ private keys are stored offline for greater protection. QuadrigaCX’s founder Gerald Cotton controlled the company’s cold storage. Unfortunately, Cotton passed away in India in December 2018, which means access to the stored tokens is uncertain.

Saudi Arabia and UAE “Aber” Project

On January 29, the Saudi Arabian Monetary Authority (SAMA) and the United Arab Emirates Central Bank (UAECB) issued a joint statement about launching Aber, a blockchain technology for financial settlements between the two countries. The hope is that digital currency technology will support the development of international remittances. Both countries are also interested in learning if distributed ledger technology can be used as “an additional reserve system” for domestic payment settlement in case of systematic disruption. The initial steps toward this project were taken in December 2017, when the UAE Central Bank governor, Mubarak Rashed Al Mansouri, first announced that Saudi Arabia and the UAE were discussing developing a cryptocurrency for cross-border transactions.

Iranian Draft Cryptocurrency Regulations

According to Al Jazeera, the Central Bank of Iran has released early drafts of cryptocurrency regulations. This release coincides with the Electronic Banking and Payment Systems conference being held in Tehran. The draft regulations would recognize cryptocurrencies and authorize initial coin offerings. However, the regulations would restrict the use of cryptocurrencies (other than a state-backed cryptocurrency launched by Iran’s Central Bank) as a method for payment within Iran, as well as require special licenses and certifications for banks and trading platforms within Iran handling cryptocurrencies. According to an official statement (link in Persian) from the Governor of the Central Bank of Iran, Abdolnaser Hemmati, regulations will not be finalized until there is adequate input from technology experts in the field.

This is a change in outlook from April 2018, when the Central Bank of Iran banned Iranian banks and credit institutions from dealing in cryptocurrencies. Additionally, in November 2018, the U.S. Department of Treasury’s Office of Foreign Asset Control (OFAC) took action against two Iranian citizens and their Bitcoin wallets, citing their use in the SamSam ransomware scheme. This was the first time OFAC included digital currency addresses in its Specially Designated Nationals and Blocked Persons List. You can read more about the OFAC actions here.

South Korea Continues Ban on ICOs

South Korea’s Financial Services Commission (FSC) will continue its 2017 ban on raising money through virtual currencies, including ICOs. In a January 30 press release, the FSC discussed the results of a survey sent out to 22 companies. The takeaways from the survey include the following: (i) investments in ICOs are still very risky, and poor returns for ICO purchasers is a cause for concern; (ii) companies outside of South Korea are conducting ICOs in more favorable jurisdictions and raising funds from domestic Korean investors; and (iii) there is still a lack of uniform data and information for investors to digest before making ICO investment decisions.

Because of these issues, the ban on ICOs in South Korea will continue. However, the FSC’s press release also discussed plans by the Korean government to research and foster regulated blockchain initiatives. These include pilot projects, tax credits for research and development costs, and training initiatives.

Please click here for the press release.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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