Despite calls for international unity on financial regulations following the 2008 financial crisis, the United States is unlikely to follow Europe in exploring a unique regulatory regime for “cryptoassets,” whether for payment models like bitcoin or utility tokens that have been touted by celebrities as can’t-miss investments.
The U.S. approach, which has been reaffirmed several times by regulators, is to apply standard rules and tests dating back to the 1930s to fintech, or financial technology, products when determining whether agencies have authority over them.
Cyrptocurrencies such as bitcoin and ethereum are not securities, according to the Securities and Exchange Commission, and will not be subject to disclosure under federal securities law. But tokens and offerings that feature and market the potential for profit based on the entrepreneurial efforts of others contain the hallmarks of a security under U.S. law.
This line, drawn tentatively at first as cryptocurrency prices and initial coin offerings exploded in 2017, has only become clearer as time passed.
William Hinman, the SEC’s director of corporation finance, noted last year the agency’s thinking that a digital currency itself like bitcoin is just code and not an investment contract. However, assets could be grouped and sold in a way that constitutes a security offering.
Likewise, the digital tokens put for sale in initial coin offerings, known as ICOs for short, are not securities, but are often sold or marketed in a way that makes them securities.
Supreme Court ruling
The Supreme Court ruled in the 1946 landmark case SEC v. Howey that an investment contract occurs when money is put into a common enterprise with the expectation of profit from the entrepreneurial efforts of others. The case involved a hotel owner named W.J. Howey who sold citrus grove interests to guests. The Supreme Court determined Howey wasn’t selling real estate, but rather the chance to profit from work others have done in the citrus grove.
ICOs often promote their ability to create a new, innovative application of blockchain technology in which, similarly to the Howey case, the investors who buy coins are not actually doing the work, but buying these tokens to gain a profit in the future.
“The purchaser usually has no choice but to rely on the efforts of the promoter to build the network and make the enterprise a success,” Hinman said. “At that stage, the purchase of a token looks a lot like a bet on the success of the enterprise and not the purchase of something used to exchange for goods or services on the network.”
Without a regulatory framework governing ICOs, investors could be put in harm’s way, underscoring why ICOs should be policed by the SEC, he said.
For cryptocurrencies like bitcoin, the absence of a third party integral to the enterprise has put them outside of SEC regulation. However, determining whether an asset is a security isn’t governed by the type of asset.
The SEC could oversee trading of bitcoin, or other cyrptocurrencies like ethereum, if the economic circumstances conform to the Howey test.
“Even digital assets with utility that function solely as a means of exchange in a decentralized network could be packaged and sold as an investment strategy that can be a security,” Hinman said in a speech in July. “If a promoter were to place bitcoin in a fund or trust and sell interests, it would create a new security. Similarly, investment contracts can be made out of virtually any asset, including virtual assets, provided the investor is reasonably expecting profits from the promoter’s efforts.”
In November, the SEC offered further guidance, giving examples of the enforcement actions it took against various cryptoasset ventures.
Path to compliance
The agency entered into two settlements that month in which parties agreed to register digital tokens with the SEC and to file periodic statements, after the agency determined investors must receive disclosure called for by the Securities Act of 1933 for certain offers and sales of digital asset securities.
“These two matters demonstrate that there is a path to compliance with the federal securities laws going forward, even where issuers have conducted an illegal unregistered offering of digital asset securities,” the agency said at the time.
The SEC staff also urged operators of funds that invest in digital assets, or that advise others about such investments, to be mindful of the registration, regulatory and fiduciary duties under the Investment Company Act of 1940 and the Investment Advisers Act of 1940.
In one case, an SEC order from September found a hedge fund guilty of an unlawful, non-exempt, public offering. In this case, the fund invested more than 40 percent of its assets in digital securities and engaged in a public offering.
For trading of digital assets, the agency’s enforcement authorities have focused on whether the activity requires registration as a securities exchange or as a broker-dealer.
For example, the agency has taken action against a marketplace that billed itself as a digital currency “superstore” that brought buyers and sellers of digital securities together, without registering with the SEC. The organization allowed investors to make purchases, and acted as a dealer by purchasing and then reselling digital tokens.
“Entities using blockchain or distributed ledger technology for trading digital assets should carefully review their activities on an ongoing basis to determine whether the digital assets they are trading are securities and whether their activities or services cause them to satisfy the definition of an exchange,” the staff said at the time.
And in a highly publicized case, the agency in November settled charges with hip-hop music producer DJ Khaled and boxer Floyd “Money” Mayweather Jr. for failing to disclose payments they received for promoting investments in initial coin offerings — its first cases to charge touting violations involving ICOs.
If the U.S. were to deviate from its current path, it might require legislative intervention. But that seems unlikely, especially with members of Congress looking to fintech as a jobs creator and a boon to the U.S. tech industry.
That appears to be the thinking of the Congressional Blockchain Caucus, a bipartisan group to foster the digital ledger technology, whose members say it will offer benefits beyond its use in digital assets. Blockchain is the digital ledger that underpins bitcoin, though it’s being put to use to track more than just digital currency transactions.
Reps. Tom Emmer, R-Minn., and Bill Foster, D-Ill., two of the group’s 19 members, noted blockchain is being explored in Cook County, Ill., to rework the county’s “cadaster,” an official register of land property ownership, in an effort to create a non-falsifiable ledger that would reduce fraud and could be employed in many legally binding registries.
Emmer said the Congressional Blockchain Caucus wants to facilitate innovation of the technology for use in areas such as logistics, transportation, food safety and health care. He called on the U.S. government to lightly regulate the emerging technology.
“There are all kinds of different applications that I think it’s incredibly important we keep in mind this light-touch approach by the government would be very helpful in allowing that innovative process to grow,” Emmer said.
He said there should be more collaboration between regulators and innovators with expertise in the technology. But he went further, arguing there’s no solid definition on what constitutes a security among digital assets, unlike currencies and physical commodities.