State Of Play: The SEC's Current Positions On Cryptocurrency

State Of Play A Comprehensive Analysis of Where the SEC Stands on Cryptocurrency and the Bitcoin ETF applications

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In the wake of SEC’s announcement that it would push back its decision on the proposed Bitcoin ETF to September this year, the need for cryptocurrency regulation was, once again, thrust into the media spotlight.

All novel technologies and newly emerging industries are moving faster than regulation. It’s a cat-and-mouse game, and that’s the way it’s always been — the blockchain industry is just the most recent and most vibrant exemplar of it.

The recent lightspeed proliferation and consequent popularity of cryptocurrency markets created all sorts of problems for regulators and various industry stakeholders. According to some estimates, over $5 billion has been raised through ICOs in 2017, and this number has been surpassed in just the first three months of 2018. However, over 10% of all of the funds raised have been either lost or stolen, and ICOs have, as a result, become synonymous with excessive risk, hype, and unrealistic valuations.

Legislative uncertainty is unquestionably the key risk factor in the blockchain industry. Not only do different states enact different blue sky laws and take divergent regulatory approaches, but various regulatory authorities hold diverse (and often opposing) opinions regarding the status of cryptocurrencies. The CFTC, for example, considers virtual currencies as commodities; the IRS taxes them as property; while some courts consider them “money” or “funds,” and others don’t.

But where does the SEC stand on cryptocurrencies? And why is SEC’s stance on the issue so important?

SEC’s Mission and Jurisdiction

Established in 1929 as the first federal regulatory authority of the securities market, the Securities and Exchange Commission’s mission is “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” Their primary area of focus is dealing with the offerings and sales of securities, regulating exchanges on which securities are traded, ensuring that companies are not disclosing misleading information about their performance or future prospects, and that investors are treated justly by dealers, brokers, and exchanges.

Bearing that in mind, it becomes clear that the SEC plays a crucial administrative role in the crypto industry, and their imposed regulations are instantly felt beyond US borders across the global crypto markets.

Different Tokens – Different treatment

Cryptocurrency is a generic term for a large set of digital assets that use encryption techniques to generate tokens (or units of currency), verify transactions, and transfer value. These digital assets are broadly grouped into three categories: utility tokens, currencies, and securities.

Currently, there are more than 1800 cryptocurrencies on the market, each of which (as you may guess) must be examined individually before it can be properly categorized. This categorization of digital assets is very important from a legal standpoint. All securities, for example, must be registered with the SEC and all companies offering securities must disclose: (i) a description of the company’s properties and business purpose, (ii) a description of the security being offered, (iii) information about the company’s management, and (iv) financial statements about the company, certified by independent accountants.

The SEC has no jurisdiction over transactions in currencies or commodities, and for years the SEC had a restrained regulatory approach regarding cryptocurrencies. In the midsts of the ICO craze, however, it became clear that cryptocurrencies are being offered and sold as securities with zero institutional protection to investors and, consequently, the SEC became the institutional authority compelled to take action.

Generally speaking, there are two different issues in regards to cryptocurrency regulation: (i) whether investments purchased with cryptocurrencies can be considered securities, and (ii) whether investments in cryptocurrencies are considered securities.

Regarding the first legal issue, both federal and state courts consider investments purchased with cryptocurrencies as securities (see SEC v. Shavers).

As for the second issue, things get a bit more complicated. Under SEC regulations, in order for a certain cryptocurrency offering to be classified as a security, it must meet all four conditions of the Howey test:

  1. It is an investment of money;
  2. There is an expectation of profits from the investment;
  3. The investment of money is in a common enterprise;
  4. Any profit comes from the efforts of a promoter or third party;

This means that, as SEC chairman Jay “if it’s a security – we’re regulating it” Clayton rightly points out, Bitcoin – the first and largest cryptocurrency on the market with more than 53% market domination – is not a security and is not under SEC jurisdiction.

That being said, most ICOs do classify as securities, it seems, and will be closely monitored by the SEC. In a recent CNBC interview, Mr. Clayton stated that every “token, a digital asset, where I give you my money and you go off and make a venture, and in return for giving you my money I say ‘you can get a return’…” is and will be considered a security.

The SEC takes a substance-over-form approach and highlights that merely naming tokens as “utility/currency” tokens or public offerings as “token generation events” does not change the point that the token is de facto a security.

Sometimes, however, like in the case of Ether, rightful classification of certain digital assets is easier said than done. The Ethereum project evolved from a small group of enthusiasts lead by Vitalik Buterin to a truly global and decentralized undertaking with more than 100.000 contributing developers. This just points to the complex issue that all regulators are facing — a cryptocurrency can start as a security and later evolve into a utility token/currency.

William Hinman, the SEC’s Director of corporate finance emphasized exactly this: “…the analysis of whether something is a security is not static and does not strictly inhere to the instrument. 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.”

Speaking of Ether, Hinman points out that “based on [his] understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions. And, as with Bitcoin, applying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value.“

And even though Hinman’s opinion doesn’t necessarily reflect the official position of the SEC (obligatory disclaimer), it shows that the commission is taking crypto seriously and tries very hard to provide legal certainty without suffocating the blockchain space with impetuous and inadequate laws and regulations.

What about crypto exchanges?

In an effort to protect investors from ICO scams and shield the market from fraudulent and manipulative trading practices, on March 7, 2018 the SEC issued a “Statement on Potentially Unlawful Online Platforms for Trading Digital Assets” reiterating that platforms that act as exchanges and trade tokens which meet the definition of a security “must register as a national securities exchange or operate under an exemption from registration, such as the exemption provided for ATSs under SEC Regulation ATS.”

Being officially labeled as a “securities exchange” or an “alternative trading system” will bring crypto trading platforms under the direct oversight of the SEC. As of now, however, there are no crypto exchanges registered with the SEC and Coinbase is the first trading platform to apply for registration.

Surprisingly, even though the SEC is “underwhelmed by the crypto exchanges self-reporting,” they refrained from all-guns-blazing crypto exchange crackdowns and gave crypto trading platforms some leeway to adjust to the new circumstances.

Bitcoin-linked ETFs coming soon…?

In the next two months, the SEC is set to make the final decisions on the proposed crypto-linked ETFs. Even though several market participants have eagerly requested SECs approval for ETFs (currently counting 9 pending proposals and 1 rejected), the reality is that many issues – such as the valuation and the custody of funds, market liquidity, as well as the protection of investors – need to be resolved before the market is ready to implement ETFs.

Perhaps the most worrisome issue for the SEC is the fact that ¾ of the volume in bitcoin occurs outside the U.S. and 95% of the volume takes place on crypto exchanges based outside the U.S.

Furthermore, the SEC needs to be assured that bitcoin-linked ETFs are de facto backed by “physical bitcoin” stored by secure custodians – whether it be in-house or outsourced to established crypto institutions.

We are, hopefully, only few months away from SEC’s final decision regarding crypto-linked ETFs; if approved, they will bring big institutional investors into the market, thus making the market more robust than ever. If rejected, as in the case of Winklevoss’s ETF proposal, the markets will suffer a big blow and remain provisionally closed to large institutional investors.

All things considered, the SEC’s measured approach is justified, and shows that they’re taking things seriously: cryptocurrency is out of the bag, and, recognizing this fact, the Commission is trying not to wreak havoc in the industry by making rash decisions.

The author is not current invested in any digital asset.

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