Financial technology advocates are seeking an answer from regulators on when things like digital tokens should be deemed to be securities, and they’re gaining a sympathetic ear in Congress.
Further clarity from regulators would encourage more U.S. growth in digital assets, the advocates say.
At issue is a new method of raising capital that’s come to prominence in the past few years: the initial coin offering, or ICO, in which investors buy digital tokens from an issuer seeking to raise money for some project. For many of these offerings, the “coins” are meant to eventually act as credit entitling the investor to a product or service, sometimes even in a form that’s independent of the issuing company.
With the rise of these coins, securities regulators have had to determine how they fit into an existing regulatory structure, with the Securities and Exchange Commission saying they largely fall under federal securities law because their value can fluctuate like a speculative investment. Whether the regulators will change that view is still an open question.
Advocates of the digital coins note that the SEC doesn’t regulate gift cards as securities and that some digital coins are designed to eventually function similarly.
Among those looking for answers are the Blockchain Association, a lobbying organization for this new financial technology, and Coin Center, a cryptocurrency advocacy group.
“The SEC has developed pretty good policy on a case-by-case basis,” said Peter Van Valkenburgh, research director at Coin Center. The problem, he said, is that there is not permanent guidance, leaving oversight to the whim at whoever helms the agency.
A landmark 1946 Supreme Court case, SEC v. Howey, determines what constitutes an investment contract. It holds that something is a security if it involves putting money into a common enterprise with an expectation of profits based on others’ entrepreneurial efforts. The case centered on a hotel operator in Florida who sold citrus grove interests as real estate transactions and not as securities. Along with a land sales contract, it included a service contract based on expected orange harvests.
William Hinman, the corporation finance director at the SEC, brought the example into the 21st century, when he said last year that an orange itself is not a security and neither are cryptocurrencies like bitcoin or ether. His comment seemed to suggest that the agency was considering a new approach, but the SEC hasn’t proposed a rule.
When investors are putting their trust in a third party, they have to receive disclosure about financial information and risks, he said, adding that investors who don’t expect the third party to generate a return may not see the coins as representing an investment contract.
Security or product
Advocates want regulators to say clearly when coins or tokens are deemed products, like an orange, rather than securities.
The Blockchain Association, which represents cryptocurrency exchanges and fintech companies, said the fintech industry needs certainty on that issue.
“We think it’s right to register an investment product like an ICO as a security when it functions like a traditional security,” said Kristin Smith, the association’s director of external affairs. “But when a token is used in a decentralized network and is no longer dependent on the entity that created it, we believe existing securities laws shouldn’t apply.”
Clarifying this issue, she said, is key to building a broader fintech economy in the U.S.
“We hope that Congress and the SEC will continue to work with industry to spur further innovation, supported by smart regulation,” she said.
Reps. Warren Davidson, an Ohio Republican, and Darren Soto, a Florida Democrat, said they are planning to reintroduce legislation from last year that further defines the term “digital token.” It would clarify that securities laws wouldn’t apply if the token doesn’t represent an ownership interest in a company.
Davidson said he is concerned the U.S. is lagging behind other countries in answering these questions, and he sees an opportunity to catch up.
“We didn’t get any kind of legislative certainty and places as diverse as Singapore to Switzerland to Liechtenstein provided some sort of legal framework and capital really started flowing there,” Davidson said.
SEC Commissioner Hester Peirce, a Republican who has been called “CryptoMom” for her support of cryptocurrency initiatives, mentioned the bill in a February speech as a possible solution.
Davidson, a member of the House Financial Services Committee, acknowledged that some companies launched ICOs because they thought they could bypass securities law that way.
“My concern, and a lot of the market’s concern, is that’s tainted the view at the SEC,” Davidson said.
The SEC has been addressing this issue through enforcement actions. Last month, for example, it charged Gladius Network LLC with conducting an unregistered ICO that raised around $12.7 million to develop a network for renting spare computer bandwidth to fight cyberattacks and enhance delivery speed. Once the agency’s stance that ICOs act like securities was clear, the company self-reported violations and, in a settlement with the agency, agreed to register its tokens with the agency.
Davidson said he plans to meet with House Financial Services Chairwoman Maxine Waters this month to discuss the bill. He noted that there’s bipartisan support, but that many Democrats are waiting on Waters’ approval.
A separate effort is underway in Congress to create a federal financial technology task force. If successful, Davidson expects more lawmakers will support his bill.
“We need to make sure that we are being aggressive with both innovation and encourage tech companies to want to be here and have some basic rules of the road so that they can have a consistent way to conduct business and keep public confidence,” Soto said.
Davidson said he ran the bill by Senate Banking Chairman Michael D. Crapo, who flagged it as one that could move in that chamber if it passes the House.