Analysis: SEC securities definition of crypto ‘unlawful’, says research

The SEC has it all wrong on cryptocurrency exchanges, a controversial paper claims, aiming to shake up the industry.

When it comes to regulating trading Bitcoin either peer-to-peer or through an exchange like Coinbase, Kraken or Binance, the authority is wading into matters it has no jurisdiction over, claims Penn State Law visiting Assistant Professor Michael O’Connor.

At the heart of O’Connor’s argument is the idea that when traded on exchanges, cryptocurrencies are not securities.

“The further problem is in viewing tokens in isolation,” he says, speaking from the 8,000-acre campus in the north-eastern US. “Looking at the technical characteristic of a token without considering the exchange.”

The fundamental mistake the SEC are making is that they are not seeing trading exchange transactions as a bilateral exchange between parties, O’Connor says.

He tells CryptoNewsReview: “I’ve not yet seen a technical challenge to my fundamental thesis, that in order for it to be an investment contract under contract law, this includes a promise of future value increase.”

It’s a technical point, but one which if it gains traction, could flip the SEC’s intervention into cryptocurrency exchanges on its head.

In fact, two lawmakers are trying to challenge the SEC’s definition of cryptocurrency as a security right now.

As a disclaimer, O’Connor concedes that he holds a fairly broad basket of cryptocurrencies. Bitcoin (“the unrivalled leader on the currency side”), Ethereum (the “unrivalled leader on the utility side”) along with a smattering of privacy-focused coins like Monero and ZCash.

An edited version of his draft paper is due for publication in Drexel Law Review in 2019.

Insecure

Securities law is one of the more challenging areas in legal practice. Vast tomes cover corporate governance, standards for prosecutions, or litigation over the issuing of stocks and bonds. The SEC is just its public face, and often a whipping boy for the ire of investors.

The agency flaunts a healthy $1.6bn-a-year budget in line with such a huge mandate. It made much of an autumn crackdown of returning funds to scammed ICO investors. The end of November saw another crushing blow to crypto-evangelists.

Chairman Jay Clayton again struck down hopes of a Bitcoin exchange-traded fund, something that fund managers see as key to encouraging more new money into cryptocurrencies. Clayton told CNBC that no decision on the ETF would be made “without more market surveillance”.

More recently, in a 6th December speech covering SEC rulemaking on digital assets, he signalled that enforcement activity would continue through 2019.

Some suggest that behind closed doors the Trump appointee is softening his stance on ICOs.

Clayton noted “I believe that ICOs can be effective ways for entrepreneurs and others to raise capital”.

But there is little to cheer from crypto companies forced to spending a higher proportion of their budget on compliance. He added: “The novel technological nature [of ICOs] does not change the fundamental point that when a security is being offered, our securities laws must be followed.”

Traded cryptos are not securities

Orange groves, a chain of grocery stores, even a beaver farm. Under US law anything that is issued with the promise of a future increase in value counts as a security.

O’Connor’s paper makes the point that to be an “investment contract” and to fit this literal definition, a crypto token must also come with a promise from the person or company that issued it that it will be developed in future or that its value will increase.

The argument is this: an issuer provides the token but also promises further development and price appreciation. An exchange promises neither, so the token is not a security.

There is a fundamental difference that separates a token when it is issued by a developer, as compared to when it is traded on an exchange.

The assumption that a cryptocurrency or token is a security when it is issued and therefore a security when it is traded is incorrect. As such, the SEC has no right to threaten cryptocurrency exchanges with enforcement for trading in unlicensed securities.

The yardstick for what a security actually is rests with the Howey Test. This is the ultimate ruling of the US Supreme Court in 1946, focusing on the case of a farmer in Illinois who was trying to prove what he did and didn’t owe. It has underpinned the broad outline of all financial cases for the last 70 years.

The SEC played on this and displayed a rare sense of humour when it launched the fake Howeycoin website, mimicking the most egregious false claims made by dodgy ICO sellers.

Decentralised thought

If the SEC are way out of bounds, should the CFTC have jurisdiction instead? Is an entirely new organisation needed to regulate?

“I would be surprised if you would need a genuinely new organisation,” O’Connor says, “but to answer your question, I don’t know. Regulatory bodies cover a lot of ground. They already deal with a tremendously complex web of unlicensed securities,

“It’s very difficult to say conclusively. There are three potential viewpoints on what a cryptocurrency actually means to centralised authorities. Either A), it’s a financial instrument. The federal courts have come to different conclusions on this. B), it’s a commodity. On this one, some federal courts have been in favour of this, while none to my knowledge have come out and said cryptocurrencies are not commodities. Or finally C), it’s a security. What I will say as a caveat is that US law is not a model of clarity on the regulatory boundaries between asset classes. Federal agencies overlap and have a history of close collaboration.”

One argument in particular has us thinking about whether decentralised organisations can ever fit into mainstream society. Or is it the case that mainstream society will have to dismantle and reform its centuries-old institutions just to catch up?

O’Connor writes of decentralised autonomous organisations (DAOs):

“While the SEC’s conclusion regarding the DAO seems a straightforward application of the Howey test, it nonetheless raises several questions. For example, in a truly distributed autonomous organisation, no authority exists beyond the code, the token holders, and those selected by the token holders. Those token holders may number in the millions and be scattered around the world, like shareholders in a major corporation. Even assuming the tokens are securities, do the modern securities laws present a realistic model for enforcement against such an entity?”

Hel puts it like this: “The problem is that they (Satoshi and the liberalists) want to try to create a new form of organisation, new rules, and then also squeeze and fit inside regulatory body that was never designed to take on an organisation of this type.

“You could be giving up on the autonomous dream so that when you step down from your decentralised cloud to step your toe on the ground, the SEC is gonna sue your ass.”

Not every lawyer is in agreement with O’Connor, of course.

Tamara Roberts, a private counsel at Seattle VC firm Pithia, negotiated the first ever buy of public stock with cryptocurrency earlier this year. She told us: “It’s an interesting argument but I think [the paper] will lose out to the weight of history.”

But with lawmakers gearing up on both sides to exclude cryptocurrency from the definition of a security, it may not be long before this argument becomes enshrined in law.

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