‘US regulated’ BlockFi in hot water with Alabama regulators too

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Digital currency platform BlockFi’s dismissal of the brushback pitch thrown by New Jersey regulators could have major ramifications for company execs and those who helped promote unregistered securities.

On Monday, the New Jersey Bureau of Securities issued a ‘cease and desist’ order against several BlockFi entities, preventing them from offering or selling unregistered securities to state residents. BlockFi offers digital currency interest-earning accounts known as BlockFi Interest Accounts (BIA), into which customers deposit select crypto assets that BlockFi loans to other customers.

Effective July 22, BlockFi must cease offering any security, including any BIA, to New Jersey residents unless said security is registered with the Bureau. However, the Bureau’s order doesn’t preclude BlockFi from paying interest on existing BIAs or refunding the principal to New Jersey-based BIA investors.

New Jersey’s brushback was followed Wednesday by a similar message from the Alabama Securities Commission (ASC), which gave BlockFi 28 days in which to “show cause why they should not be directed to cease and desist from selling unregistered securities in Alabama.” The ASC also took issue with BlockFi advertising itself as a ‘US regulated entity’ despite the fact that BIAs aren’t registered with the ASC “or any other securities regulator.”

After receiving New Jersey’s C&D order—the first of its kind targeting a digital asset lending platform – BlockFi CEO Zac Prince tweeted that it was discussing the matter with regulators in a bid to convince them that BIAs are “lawful and appropriate for crypto market participants.” Prince added that BIAs are “not a security, and we therefore disagree with the action” taken by the Bureau.

Prince may view BlockFi products as lawful and appropriate, but some fine print in the company’s T&C’s might leave some customers asking, ‘appropriate for whom?’

Specifically, BlockFi grants itself the right “to hold the cryptocurrency held in your account in BlockFi’s name or in any other name, and to pledge, repledge, hypothecate, rehypothecate, sell, lend, or otherwise transfer, invest or use any amount … without retaining in BlockFi’s possession and/or control a like amount of cryptocurrency.”

In plainer terms, BlockFi has the right to leverage customer deposits to whatever degree it fancies, including creating further leverage by pledging assets as collateral to multiple individuals. Remember that BIAs offer interest rates well in excess of rates offered by bank accounts or short-term investment grade fixed-income securities, so BlockFi boasts a much higher tolerance for risk than more traditional investment platforms.

The Bureau’s C&D order notes that BlockFi investors have no idea how the platform allocates its investments, nor are customers informed as to the identity or creditworthiness of the borrowers to whom the platform lends material amounts of digital currency.

The Bureau warned that the roughly $14.7 billion worth of digital currency that BlockFi holds in its BIAs are neither protected by the Securities Investor Protection Corporation (SIPC) nor insured by the Federal Deposit Insurance Corporation (FDIC). The Bureau also chided BlockFi for failing to disclose to investors that BIAs aren’t currently registered with federal or state securities regulators.

New sheriff’s patience already wearing thin

As if on cue, Wednesday brought a speech by Gary Gensler, the new chairman of the Securities and Exchange Commission (SEC), to the American Bar Association Derivatives and Futures Law Committee. Gensler’s speech included a swipe at the credit default swap shenanigans that led to the 2008 global financial meltdown and the resulting need for “reducing risk and increasing transparency” in securities markets.

Gensler closed his remarks by discussing “the intersection of security-based swaps and financial technology, including with respect to crypto assets.” Gensler noted the rise in the number of platforms offering “crypto tokens or other products that are priced off of the value of securities and operate like derivatives.”

Gensler clarified that it didn’t matter “whether it’s a stock token, a stable value token backed by securities, or any other virtual product that provides synthetic exposure to underlying securities. These platforms — whether in the decentralized or centralized finance space — are implicated by the securities laws and must work within our securities regime.”

Gensler added that the SEC had already “brought some cases involving retail offerings of security-based swaps; unfortunately, there may be more.” Gensler warned that his agency would “continue to use all of the tools in our enforcement toolkit to ensure that investors are protected in cases like these.”

If/when the tide goes out

While Gensler’s speech was primarily directed at the types of stock tokens that the beleaguered Binance exchange formerly celebrated but recently disavowed after other regulators expressed concern, it’s clear that the ‘rules don’t apply to us’ stance adopted by so many digital currency platforms is now as rock solid a defense as humming Shaggy’s It Wasn’t Me.

Gensler’s speech recalled that the pre-2008 market euphoria “allowed many banks to lower regulatory capital requirements to dangerously low levels.” Similarly, the potentially excessive leverage employed by the likes of BlockFi could leave digital currency customers clutching at straws should a sudden market pullback cause a run on the undercapitalized bank.

But unlike the 2008 crash, from which major financial institutions emerged largely unpunished, a digital currency reckoning may leave state and federal regulators far more interested in making a few examples. A crypto rogues’ gallery could even feature third parties that saw fit to promote unregistered securities to U.S. residents.

Like U.K. podcaster Peter McCormack, who has on multiple occasions tweeted his ‘bullish’ support for and ‘trust’ in BlockFi. McCormack, who is currently embroiled in a civil matter with Bitcoin white paper author Craig Wright, could find his barrister bills growing even larger should his BlockFi advocacy turn out to have been compensated promotional work.

McCormack, who has attended some BTC love-ins on U.S. soil, may decide discretion is the better part of valor should other state or federal authorities decide to shine their regulatory spotlight on BlockFi. That said, we’re sure Pete would prove a minor celebrity should he deign to appear at the next CoinGeek Conference at the Sheraton New York Times Square Hotel, October 5-7. Just be sure to clock all the emergency exits upon arrival, just in case.

Follow CoinGeek’s Crypto Crime Cartel series, which delves into the stream of groups — from BitMEX to Binance, Bitcoin.com, Blockstream, ShapeShift, Coinbase, Ripple and
Ethereum—who have co-opted the digital asset revolution and turned the industry into a minefield for naïve (and even experienced) players in the market.