There has been plenty of tough talk coming from the US Securities and Exchange Commission (SEC) recently, but exactly what are its issues with blockchain-driven coin offerings?
Today (Feb 6th, 2018), the US Securities and Exchange Commission (SEC) head, Jay Clayton, will sit down before the Senate Committee on Banking, Housing, and Urban Affairs, as part of a session titled Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission.
It is a session that will go a long way to putting on record what role US regulators want to play in the future of the currently volatile cryptocurrency markets. The real question, however, seems to be whether that means bringing them into the existing US regulatory fold, or establishing new rules to cover blockchain innovation.
The most important legal issue at present is essentially one of definition, though: do initial coin offerings – ICOs – fall under the brief of the SEC as ‘securities’. The seeds of today’s important session were essentially sown by the SEC’s intervention in the events surrounding the collapse of The DAO, a blockchain-driven investment fund that collapsed after a large-scale hack last year. That collapse led the commission to undertake an investigative report that would include the conclusion the DAO Token ICO essentially equated to the company issuing a security, and should therefore have been under its rules and regulations to protect investors.
This decision put all US ICOs firmly in the SEC’s spotlight, and heralded the legal intervention of the Commission in other similar offerings, as well as a fair amount of sabre rattling in the press warning of new regulation and legal action where it saw “fraud and abuse”.
But what does that really mean, and does the SEC currently have power over ICOs?
The ‘Securities’ in Securities and Exchange Commission is a blanket term covering investments like stocks, bonds and options. The US legal precedent for the definition comes largely from what’s known as The Howey Test, established in SEC v Howey (1946). It establishes three simple criteria for defining a security: the investment of money, in a common enterprise, with the expectation of profits from the efforts of others.
It’s a pretty clear, easy to understand, concept; something the SEC’s Co-Director of Enforcement, Stephanie Avakian, is keen to point out when she says of ICOs that “the innovative technology behind these virtual transactions does not exempt securities offerings and trading platforms from the regulatory framework designed to protect investors and the integrity of the markets.”
Getting Around Howey
How ICOs can circumvent the Howey Test has long been a subject of conversation among cryptocurrency specialists, who had seen this showdown coming for some time. That conversation has largely revolved around creating an offering that goes beyond what is considered a ‘security’. A 2016 article by Marco Santori outlined four criteria that he believed would change the offering significantly enough:
Issuing something with consumptive use – selling something that can be considered to be consumed and put to real use, avoiding offerings that aren’t technically required for the product to work.
Decentralising development and operation – because the more investors who are also involved in producing and operating the product the less likely it is to fit the definition of being ‘from the efforts of others’.
Having a ‘minimum viable product’ ready before they undertake a sale – as issuing a coin prior to a product going live may beat any definition of it having consumptive use.
Issuing developer kits – if this is possible, it would point to a “real, tangible evidence that the thing you are selling is ill-suited to speculators and investors.”
Santori also adds that “a buyer’s speculative intent is okay, so long as the seller can point to compelling evidence of predominantly consumptive intent.” The point being that it’s okay selling somebody a physical product that doesn’t work in the hope it will down the line – or that they can create one that does from it – but ICOs are on shakier ground if they sell the idea that there will be a utility feature further down the line.
A recent letter from Dalia Blass, the SEC’s Director of Investment Management, dated January 18th offers a significantly more detailed insight into the cryptocurrency related conversations going on within the SEC, and the consumer issues it sees them as creating. Addressing rejected applications for the establishment of Mutual and Exchange Traded Funds that track the value of a portfolio of cryptocurrencies, Blass outlined 30 “significant outstanding questions” the commission would seek assurance on before approving any such investment opportunities.
Top of that list was how, with the price of cryptocurrencies currently proving so volatile, could companies implement policies and procedures to value their products fairly? It also queried how funds would and could account for a cryptocurrency that forks, how could funds maintain liquidity and meet its withdrawal rules, how funds could “validate existence, exclusive ownership and software functionality of private cryptocurrency keys and other ownership records” , address cybersecurity threats to their holdings, as well as questions concerning the manipulation of cryptocurrency markets.
It all adds up to the SEC casting doubt on whether such funds – and cryptocurrency in general – is suitable for “the wide range of investors, including retail investors, who might invest”, and builds on comments by Jay Clayton that questioned the way some ICOs are being handled. In reality, it also blocked any plans for these types of schemes for the foreseeable future.
Blass’ questions effectively outline significant ethical and philosophical issues. Issues that the SEC will frame as driving its push to regulate ICOs and blockchain-driven investments in general as the technology moves from early adopters into more consumer-facing products and investments. It also, in tandem with other statements and comments coming from the Commission, hints that firms simply looking to avoid falling under its purview on technicalities and legal definitions that exist now may not be enough to avoid its glare in the future.
While such a stance cuts to a wider debate about regulation vs. innovation, which will probably never be settled, it is easy to forget that regulation is ostensibly there to protect investors, and provide a framework for best practice. Such a framework for ICOs – that codifies the already well trodden path of the best recent offerings – may not be to the taste of small-scale start-ups that were looking to raise funding using the newly fashionable technology, but it may not necessarily be such a bad thing for the future of the technology.