Last September, after perhaps the most “2021” of all possible 2021 insider-trading scandals, NFT marketplace OpenSea’s head of product, Nate Chastain, stepped down from his role.
The reason? Chastain purchased non-fungible tokens (NFTs) that he knew were set to display on the front page before they appeared there publicly. It was a seemingly innocent act, similar to a Foot Locker employee purchasing a pair of Air Jordans with his employee discount before the sneakers hit the shelves – right?
Wrong. NFTs aren’t shoes; they’re digital assets minted on a blockchain, and in some cases, they can even be considered securities. The Internal Revenue Service (IRS) counts NFTs when you do your taxes – even receiving an NFT as a gift triggers a taxable event. And U.S. Securities and Exchange Commission (SEC) Commissioner Hester Peirce, who has a reputation for being crypto-friendly, told CoinDesk last October that consumers should be “very careful” when trying to determine if the crypto assets are securities.
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Emerging crypto regulation
While it wasn’t the SEC that investigated Chastain – collectors tracked his wallet activity on the blockchain, which instigated an internal investigation by OpenSea – the story raises questions about whether federal regulators are tracking blockchain activity, too.
Legal measures against crypto insider trading are still fuzzy, particularly at this time when the industry produces new utility tokens, NFTs and altcoins every day. Innovation is constant in the crypto world, happening organically to meet new needs and build solutions, and often through significant venture capital funding.
The crypto scene is tight-knit. Despite the wide-scale appeal and booming popularity of crypto, its decentralized nature means a lot of information gets shared through community-generated means such as Twitter, Discord channels and in-person fireside chats and social events. Professionals, for the most part, use discernment (except for instances like Chastain’s NFT opportunism), but overall, the general vibe is that crypto folks are pretty open book. Furthermore, like the OpenSea incident proves, there’s a certain amount of self-regulation built into the ecosystem through the public nature of blockchains (sort of like a pickup basketball game).
Do regulators consider cryptocurrencies to be securities?
In all the euphoria, however, it’s easy to want to open up your MetaMask or Coinbase wallet like you would your Robinhood or E-Trade app and add a few extra coins or tokens to your portfolio once you learn about exciting new projects and developments. But when traders – even hobby traders – get information from insiders about any new cryptocurrency or product, they should ask themselves whether those details are privileged, says Chicago-based Lisa Bragança, a former SEC branch chief.
“The best way to approach it is to presume that every time somebody makes a recommendation about a token, that it is just like a stock,” she told CoinDesk.
The SEC considers just about all cryptocurrencies to be securities, according to Bragança. The only ones that are safe (i.e., just assets) are bitcoin – it truly is decentralized, says Bragança – and ether.
But even these guidelines are still debated among insiders. The SEC’s allegations against crypto exchange Ripple, for instance, demonstrate that the issue of what defines a crypto security is still being determined.
“We should get a ruling in that trial some time here in the next couple of months maybe,” Paul Atkins, a former SEC commissioner who's now CEO of consulting firm Patomak Global Partners, said during a CoinDesk “First Mover” interview last month. “That may be an indication of where things are going to go," he said.
But while we wait to see how these lawsuits play out in court, the central question of what is a security will be the elephant in the room around which the nearly $2 trillion crypto industry is built.
“The SEC does not have jurisdiction over a trading platform if it’s not trading a security. So we come back to that essential question,” Atkins said.
Blockchain compliance and enforcement
Given the current back and forth, plus the novelty of blockchain technology, the likelihood of consumers getting nabbed for insider crypto trading with the same regularity and enforcement as they would with traditional securities is low – for now.
“The SEC doesn’t have a practice of going and checking the blockchain to see what transactions are being reported,” Bragança says. “And even if they could, they would have to figure out who was engaged in that trading because it’s often anonymous.”
Then comes the issue of enforcement. The ability to enforce insider-trading laws for crypto, according to Bragança, is “really impaired” and not something that’s happening regularly.
Regulators, however, do have the ability to cherry-pick when suspicious activity is flagged.
“Let’s say somebody is getting divorced,” Bragança says. If a spouse finds out or knew that their ex was engaging in insider trading on a decentralized exchange, that disgruntled spouse could report that to the SEC. “And then the SEC could investigate,” Bragança says.
The same considerations to determine if someone is guilty of insider trading apply to crypto as traditional assets: The information must be material – i.e., important enough that share prices could potentially be affected – and not public.
While crypto exchanges aren't regularly sending consumer data to regulators, Bragança argues that centralized exchanges in particular are more than likely going to seek compliance with federal regulators over time.
“As these exchanges are seeking to get more authority, they are seeking legitimacy and status in the markets,” Bragança says. “So that’s when you will probably see, even without a law, [an exchange] decide to crack down and report suspicious trading.”