The cryptocurrency industry has received very little information concerning how the Securities and Exchange Commission (the “SEC”) will regulate digital currency or Initial Coin Offerings “(ICO’s”). On April, 5, the SEC chairman Jay Clayton gave the industry another glimpse of how cryptocurrencies and ICO’s will be regulated by the SEC during a discussion at Princeton University.
Briefly stated, cryptocurrencies and ICO’s will be regulated differently, and each will be examined on an individual basis to find whether the currency or issued token satisfies the Howey Test, the analysis the SEC uses to determine whether an instrument is a security. To satisfy the test, the instrument must be (i) and investment of money, (ii) in a common enterprise, (iii) with the expectation of profit, (iv) by the efforts of others. All four prongs must be met to satisfy the test.
Clayton used an interesting analogy to describe how the SEC’s currently analyzes whether cryptocurrency is a security:
If I have a laundry token for washing my clothes, that’s not a security. But if I have a set of 10 laundry tokens and the laundromats are to be developed and those are offered to me as something I can use for the future and I’m buying them because I can sell them to next year’s incoming class, that’s a security.
In other words, tokens that serve a utility will not fall under the SEC’s regulatory authority, however, where the token is being purchased and subsequently sold to other individuals for the purpose of realizing a profit, the SEC will have regulatory authority and the company that issues the token will be required to follow securities registration requirements.
Chairman Clayton has slowly been decrypting the SEC’s intended cryptocurrency regulation. As Clayton said at a U.S. Senate Hearing in February, “I believe every ICO I’ve seen is a security,” and he continued to emphasize that not a single ICO has been subject to SEC registration requirements. However, during this hearing, Clayton foreshadowed his current stance that every cryptocurrency is going to have to be examined on a case by case basis by emphasizing that ICO’s need to be separated from other cryptocurrencies in a regulatory perspective. As CoinDesk reported, Clayton said, “I want to go back to separating ICOs and cryptocurrencies. ICOs that are securities offerings, we should regulate them like we regulate securities offerings. End of story.”
Separating ICO’s and other cryptocurrencies makes sense considering that one of the prongs of the Howey Test requires that the investment be in a “common enterprise,” generally coming from a single issuer. The SEC’s registration rules regulate these issuers and protect investors by ensuring that the investor is not being defrauded by the issuer giving false or misleading information concerning the issued security. In comparison, Bitcoin, the most widely known and used cryptocurrency, is not issued through a single issuer. Purchasers rely instead on a massive network of unaffiliated individuals who mine the coin, provide exchanges, develop the software, etc. Moreover, to pull Bitcoin even further away from the Howey Test, there is not a single person or organization that is in control of the currency. Coin Center said it perfectly, “regulating Bitcoin as a security simply doesn’t make sense because securities regulation is largely focused on issuers, of which bitcoin has none.”
In addition to classifying cryptocurrencies individually and separately from ICO’s, Chairman Clayton highlighted that cryptocurrencies may fall in and out of the SEC’s authority over time. So, a coin issued through an ICO will most likely meet the Howey Test and thus fall under the SEC’s purview initially; however, as the coin evolves, it may begin to resemble a utility token and therefore fall out of the SEC’s purview. Clearly, the future regulatory structure that the SEC is setting up seems complicated, but the path is slowly being paved.
Chairman Clayton is taking a position that ensuring that ICO’s are properly regulated now will prevent regulators from heavily regulating the market in the future, ultimately stifling the currency.
“Is the approach taken in Washington by the SEC adversely affecting distributed ledger technology in other areas? My quick answer is that my hope is that it’s actually helping — because this technology is being used for fraud and to the extent that it’s being used for fraud, history shows that government comes down harshly on that technology later.”
On April, 5, he also expressed that he believes that “distributed ledger technology has incredible promise for the financial industry.” This statement with his purported belief that his regulatory action will actually help the industry shows his, and hopefully financial regulators as a whole, pivot towards a regulatory framework that will protect investors but not make issuing tokens or conducting ICO’s a messy, complicated, and expensive process (something that the cryptocurrency industry was basically created to avoid). This is refreshing in a political environment that is currently afraid of cryptocurrency, and instead of coming up with pragmatic solutions, would rather limit its use and prevent its application. This is likely a result of Clayton having spent time actually learning about distributed ledger technologies and cryptocurrency in general. Just like the general public, attempting to digest all of the information about this new technology is extremely intimidating. But as an understanding is achieved, the technology ceases to be intimidating and its beneficial uses are illuminated. Hopefully the SEC will continue to approach cryptocurrency regulation in a pragmatic manner with this new understanding and not approaching every ICO or cryptocurrency as inherently “bad” or “fraudulent” and will not attempt to make blanket statements about their statuses as securities.