BitcoinCryptocurrencyDigital CurrencyDixon Gardner

Risk And Regulation Of Digital Currency

Risks And Regulation Of Digital Currency

Digital currency is a new electronic payment system that involves the use of software code to function as money over a computer network, much like the internet.  The most famous digital currency is Bitcoin. 

At under the tab “you-need-to-know” states “Bitcoin is an experimental new currency that is in active development….  Be prepared for problems and consult a technical expert before making any major investments, but keep in mind that nobody can predict Bitcoin's future.”  This website further advises that “Bitcoin is not an official currency”; a Bitcoin owner is responsible to pay taxes on all Bitcoin transactions; and to adhere to all tax, legal, or regulations “issued by your government” on Bitcoin.  This article provides information about the taxes, laws, and regulations that involve digital currency in the United States.

Digital Currency Trades In Unregulated Markets

Digital currency trades on unregulated markets that the public can access.  There are over

60 exchanges around the world (including the U.S.) to buy Bitcoin on  As of December 11, 2017, the Securities and Exchange Commission (“SEC”) issued a “Statement on Cryptocurrencies and Initial Coin Offerings”, stating “the SEC … has not to date approve for listing and trading of any exchange-traded products (such as ETFS) holding cryptocurrencies or other assets related to cryptocurrencies.  If any person today tells you otherwise, be especially wary.”  

One of the problems with digital currency is that there is no government oversight for the trading in digital currencies in the U.S. even though Treasury Secretary Steve Mnuchin recently said that the Treasury Department is closely following the growth of digital currency.  In January, 2018, Mr. Mnuchin said that digital currency needs more regulation and the Treasury Department is investigating how to track digital currency to prevent illicit use of it.  Mr. Mnuchin further stated that a company that provides a wallet (i.e. an electronic registry where the software for digital coins are kept on a computer network) for digital currency is subject to the same regulations as a bank in the U.S.  Without government oversight of trading in the digital currency markets, there is the opportunity for manipulation and fraud of such trading.

What Type Of Property Is Digital Currency?

An unresolved issue for digital currency is what type of property is it?  The Commodity Futures Trading Commission holds that digital currency is a commodity and subject to its regulations under Section 1a(9) of the Commodity Exchange Act. The IRS holds that digital currency is personal property and taxed as such.  Bankruptcy courts holds digital currency is intangible personal property (i.e. a right to property).  The SEC holds digital currency is a security if it is used to facilitate investment or speculation.

Regulations And Regulators Governing Digital Currency Or Its Issuer

The Commodity Futures and Trading Commission Regulates Commodity Exchanges

In 2016, the Commodity Futures and Trading Commission (“CFTC”) closed down an unregistered options exchange on digital currency against Coinflip, Inc., doing business as Derivabit because it was selling options and processing swaps on digital currency without being registered as a market maker with the CFTC.  The CFTC may be the agency that the Treasury Department uses to regulate digital currency exchanges (i.e. websites that buy and redeem digital currency) since the CFTC regulates commodities, which includes digital currency.

The Financial Crimes Enforcement Network Regulates Digital Currency Businesses

The Financial Crimes Enforcement Network (“FinCen”) defines a digital currency as “a medium of exchange that operates like a currency in some environments”.  As a result, FinCen requires any business that is a money service business (“MSB”) to register with FinCen within 180 days after such a business begins operations.  A MSB is a business that (1) exchanges digital currency into real currency or other digital currency; (2) issues digital currency and has authority to redeem it; (3) transmits money as a service; or (4) accepts money or other value that substitutes for a currency to another location or person by any means.  All of these definitions of a MSB encompass a company that issues digital currency.  MSBs have to reregister with FinCen every two years after the initial registration.

A MSB is required to report suspicious financial activity in financial transactions greater than $2,000.  A MSB must comply with the Bank Secrecy Act (“BSA”); the Patriot Act; and the anti-money laundering requirements of the BSA to prevent the MSB from being used for money laundering or to finance crime.  (See Title 31 U.S.C. Sections 5318(A)(2) and 5318(h)( and 31 Code of Federal Regulations Section 1022.210).

The Securities And Exchange Commission Regulates Digital Currency Issuances And Their Exchanges

The SEC holds digital currency is a security because it meets the test for a security under S.E.C. v. W.J. Howey Co. 328 U.S. 293 (1946): a security is a contract where an investor purchases it for a potential gain from an increase in price without any investor effort.  Further, all securities offerings must be conducted by a broker or a dealer registered with the SEC (i.e. an investment bank) under the Securities and Exchange Act of 1934 and the Investment Company Act of 1940. 

In July, 2017, the SEC issued an “Investor Bulletin: Initial Coin Offerings [called “ICOs”]”, in which the SEC advised potential ICO investors that digital currency is a security when there is an opportunity to make a gain on an investment in digital currency.  When this opportunity exists, an ICO must be registered with the SEC under a Form S-1 and requires the issuer to be licensed or registered with either the SEC or the applicable state securities regulator. 

            In December, 2017, the SEC stopped an ICO from being issued because it was promoted as potentially increasing value (i.e. each such coin in the ICO was a security) that was not registered with the SEC.  The ICO was to be used to buy and sell restaurant services and products.  The issuer (called “Munchee”) agreed to buy and sell the ICO in a secondary market, much like an exchange for securities.    

That said, there is no definitive ruling by any federal court that a digital currency with an unlimited supply of digital coins and a fixed price of one U.S. dollar (or other paper currency) is a security under the Howey test since there would be no way for a potential buyer of this currency to achieve a gain in it.

As stated above, the SEC has not given any approval for any listing and trading of any digital currency as security, but future SEC enforcement efforts most likely will seek to regulate any online issuances and redemptions of digital currency as a security.

The Internal Revenue Service Taxes Digital Currency As Personal Property

In 2014, the IRS issued digital currency guidance in IRS Notice 2014-21, stating that digital currency operates just like any other currency except that digital currency is not legal tender (i.e. the government cannot force you to accept it for payment).   All other tax reporting requirements are the same for digital currency as paper currency.  However, the taxpayer who pays with digital currency has two potential income tax issues: (1) the gain or loss from the actual purchase and sale of an asset with digital currency is measured by the price of the digital currency on the date of the transaction less the adjusted basis of the property; and (2) the increase (or decrease) in value of the digital currency to the taxpayer is an ordinary gain (or an ordinary loss).  A taxpayer needs to keep digital currency price records for transaction dates to establish the price of the digital currency to measure the value of the transaction to the purchase or sale of the foregoing asset and whether the taxpayer has an ordinary gain or loss in the digital currency.

The Federal Reserve May Attempt To Regulate Digital Currency

Since digital currency issuers create private money for the public and the Federal Reserve Board of the U.S. (”Federal Reserve”) has a similar function (i.e. it creates money for the public), the Federal Reserve may requests the U.S. Congress to give it authority to regulate digital currency and its issuers.  In Fourth Corner Credit Union v. Fed. Reserve Bank of Kan. City, 861 F.3d 1052, 1058, 17010-1073 (10th Cir. 2017), a credit union sued the Federal Reserve to force it to grant the credit union a master account (which all banks must have to use the Federal Reserve’s payment system).  The credit union lost the case because the Federal Reserve has sole discretion to issue or not issue a master account.  Fourth Corner at 1058, 1070-1073 holds that once a person uses any payment service governed by the Federal Reserve (which has a monopoly under its master account licenses over all processing of checks, ATMs, debit cards, credit cards, internet banking, wire transfers, etc. in the U.S.) to purchase property (such as digital currency), then U.S. federal banking law governs the transaction.  Since digital currency is a new payment system, it may be that the Federal Reserve – which holds a monopoly on payment systems for all banks in the U.S. -- becomes the main regulator of the digital currency.

The U.S. Government Will Use Digital Currency Information To Prosecute Controlled Substances Violators

No currency (digital or not) can be used to facilitate any transactions for substances (i.e. marijuana) prohibited by the Controlled Substances Act at 21 U.S.C. § 801 et seq. (“CSA”).  Fourth Corner at 1058, 1070-1073.  The CSA covers anyone who handles property involved in such a transaction and subjects such a person to criminal prosecution by the federal government under CSA, the Bank Secrecy Act, Money Laundering Control Act of 1986, and 18 U.S.C. Section 1956.  Section 1956 is draconian because it permits the U.S. Government to take all of an individual’s property after it proves that individual is involved in any transaction that violates CSA.  Knowingly doing business (such as accepting or handling money) with a buyer or a vendor of a controlled substance (i.e. marijuana) in violation of the CSA could subject a person to a criminal charge for money laundering under these statutes besides potentially forfeiting all of the person’s assets to the U.S. Government.  This is a reason that banks are reluctant (or refuse altogether) to do business with anyone who is involved in the trafficking in marijuana.  This is also the main reason that the credit union in Fourth Corner was created -- to service marijuana growing businesses in Colorado – and for which Fourth Corner’s application for a Federal Reserve Master Account was denied and upheld by the courts.  Fourth Corner at 1054-1055.

Since the blockchain of a digital currency records all transactions and identifies the buyer and seller of this currency in each transaction, this is an added risk to transactions that violate CSA.

Currently, there is the belief that the rise in the price of Bitcoin is a reflection of the level of black market activity in the U.S. and around the world.  If this belief is true, the current demand for Bitcoin’s price level can only continue if the buyers of Bitcoin’s digital currency are able to remain anonymous and not identifiable from their ownership of such currency.  It is an open question whether the black market participants can do so and for how long until regulators increase their sophistication in accessing, using, and regulating digital currencies and their blockchain records to investigate digital currency owners and their transactions. 

In November 2016, the U.S. Department of Justice released its news that the IRS served a summons on Coinbase Inc. (a digital currency company based in San Francisco, California) to request information about taxpayers who conducted digital currency transactions from 2013 to 2015.


            Digital currency is a next generation payment system that is in development.  Digital currency often trades in unregulated markets around the world.  In the U.S., digital currency may be issued and traded in violation of U.S. securities laws.  Digital currency is under scrutiny from the Treasury Department, SEC, CFTC, FinCen, IRS, and Federal Reserve.  One of these regulators will become the primary regulator of digital currency in the U.S.  While the black market may be a driving demand for use of digital currency now, this may change in the future as regulators impose their regulations on digital currency.

Dixon A. Gardner

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