Speaking at the Yahoo Finance All Markets Summit, William Hinman – the US Securities Exchange Commission director of Corporation Finance – has given a very clear breakdown of how the SEC views cryptocurrency and ICOs with regards to their status as a security – and whether they should be policed under the same rules and other stock and bond investments.
Hinman’s in-depth analysis of securities law, rather amusingly titled Digital Asset Transactions: When Howey Met Gary (Plastic) – referencing two of the big precedent-setting cases in that particular area of law, SEC v Howey (a 1946 case that established what’s now know as the ‘Howey Test’ of whether something qualifies as a security) and another similar case from 1990 (Gary Plastic vs. Merrill Lynch) – sought to unpack what appears to be the overriding thinking of the Commission as it moves towards creating new rules – or not, as the case may be – to handle ICOs and their issuance.
The headline takeaway from it all is that currently, it appears the SEC does not consider Bitcoin and Ethereum to fall under its purview. In their current operation, the consider them to be currencies – a fact that, especially in the case of the latter, has caused significant relief among investors, as is could have severely limited where and how it could be bought, sold and used in the US.
The Status of Ether and Bitcoin
While some had questioned whether Ether qualified as a security, due to the way it was issued, the SEC has chosed instead to apply the law with a view to establishing – in Hinman’s words – “whether a digital asset offered as a security can, over time, become something other than a security.”
His comments on this aspect of the law went thus:
“In cases where the digital asset represents a set of rights that gives the holder a financial interest in an enterprise, the answer is likely “no.” In these cases, calling the transaction an initial coin offering, or “ICO,” or a sale of a “token,” will not take it out of the purview of the U.S. securities laws.
But what about cases where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created? I believe in these cases the answer is a qualified ‘yes’.”
What this means, in essence, is that the SEC is taking the view that the status of cryptocurrencies and ICO tokens can be fluid, and that it will take a similar dynamic view to their policing on a case-by-case basis – and amend that view over time. For example, Hinman says:
“Promoters, in order to raise money to develop networks on which digital assets will operate, often sell the tokens or coins rather than sell shares,” issue notes or obtain bank financing. But, in many cases, the economic substance is the same as a conventional securities offering.
“Funds are raised with the expectation that the promoters will build their system and investors can earn a return on the instrument – usually by selling their tokens in the secondary market once the promoters create something of value with the proceeds and the value of the digital enterprise increases.”
This kind of activity is, and in the US will be policed in the same manner as stocks and shares. That’s because:
“Just as in the Howey case, tokens and coins are often touted as assets that have a use in their own right, coupled with a promise that the assets will be cultivated in a way that will cause them to grow in value, to be sold later at a profit…
“As in Howey… tokens and coins typically are sold to a wide audience rather than to persons who are likely to use them on the network… Marketing efforts are rarely narrowly targeted to token users.
“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.
“I am seeing, strictly speaking, the token – or coin or whatever the digital information packet is called – all by itself is not a security, just as the orange groves in Howey were not.
“Central to determining whether a security is being sold is how it is being sold and the reasonable expectations of purchasers.”
Key to this is the idea that, and again we quote Hinman:
“The digital asset itself is simply code. But the way it is sold – as part of an investment; to non-users; by promoters to develop the enterprise – can be, and, in that context, most often is, a security – because it evidences an investment contract.”
As the speech unfolded, it then became clear that the SEC needs to see a hands-off approach to managing a cryptocurrency before it will begin to consider it as anything other than a security, which could cause problems with some coins. Ripple (XRP) is a prime example; due to the massive reserves of it that are held by Ripple (the company) that created, but insists it no longer has any say over the code itself, it could further down the line have its status called into question. That would greatly effect XRP’s future, though not necessarily Ripple the company’s.
“If the network on which the token or coin is to function is sufficiently decentralised – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts,” Hinman said, “the assets may not represent an investment contract.”
“When I look at Bitcoin today,” he continued, “I do not see a central third party whose efforts are a key determining factor in the enterprise. The network on which Bitcoin functions is operational and appears to have been decentralised for some time, perhaps from inception. Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value.”
Turning to Ether – which, under the oversight of the Ethereum Foundation has made significant efforts to decentralise and split itself from its creators – Hinman commented that “putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralised structure, current offers and sales of Ether are not securities transactions.”
Thus, in the case of both, he concluded, “applying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value”.
However, Hinman also stated that “the analysis of whether something is a security is not static and does not strictly inhere to the instrument,” before adding that “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.”
An opinion which leaves the door open for the SEC to step in a enforce rules whenever it thinks it needs to. The bottom line for those enitities managing cryptocurrencies and tokens, is that the SEC is watching closely how they control and use their systems, and reserves the right to jump in at any point – and just because a token was not a security yesterday, doesn’t mean it won’t be one tomorrow.