Drawing Legal Lines in Cryptocurrency Regulation: The Importance of Decentralization
The cryptocurrency market is exciting to watch. Based on the revolutionary blockchain distributed ledger system, cryptocurrencies have exploded on the marketplace. As with any new “gold rush” to hit a market, cryptocurrency has attracted scammers and common fraudsters, as well as sophisticated hackers who attack the cryptocurrency markets to steal valuable coins or other tokens.
For the law-abiding investors and exchange operators, the CFTC, SEC and state regulators are all dealing with difficult line-drawing and regulatory issues to ensure proper monitoring and legal activities. Both the SEC and the CFTC exercise broad anti-fraud authorities to protect investors from fraudsters and scammers operating in the cryptocurrency market.
In the past months, the SEC officials have made numerous statements warning cryptocurrency industry participants that initial coin offerings (“ICOs”) to raise capital are “securities” offerings. No one really questions the SEC’s authority in this area because one of many SEC purposes is to protect and monitor securities offerings.
In recent weeks, the SEC has been providing guidance on the issue of the SEC’s authority over cryptocurrencies in general – especially with regards to the largest players, Bitcoin and Ethereum. In an important pronouncement or clarification, Clayton recently stated that cryptocurrencies that operate as a currency – that is, when they are used for executing transactions – will not be treated as securities. Clayton explained that when Bitcoin is used to conduct a transaction, such as a purchase of an item in exchange for Bitcoin, the use of Bitcoin is not a regulated transaction under SEC rules. However, Clayton clarified that any currency that represents an investment in a venture that may affect the value of the token or coin would be considered a “security.” Clayton emphasized that the key distinction is when Bitcoin or any other cryptocurrency is tied to an investment rather than a currency or transaction function.
William Hinman, head of the Division of Corporation Finance at the SEC, recently gave remarks offering additional clarity. In his speech at a Yahoo! Cryptocurrency event, Hinman emphasized that the primary determination of whether or not a cryptocurrency is a security or not centers around the “reasonable expectations of purchasers.” The delineation revolves around whether purchasers hold an expectation of a return from a third-party, specifically the party that created and sold the asset will provide some return. Building on this point, and incredibly important for cryptocurrency, is that he sees decentralization as a key factor in this determination. If an asset is truly decentralized, there can be no expectation of a return from any third party, since no third party truly controls it.
Further, and much to the relief of crypto-enthusiasts everywhere, Hinman went on to specifically declare that Ethereum is not a security. When addressing Ethereum, Hinman noted that “[b]ased on my understanding of the present state of ether, the Ethereum network, and its decentralized structure, current offers and sales of ether are not securities transactions,”
The implications of this distinction should not be lost on the public – cryptocurrency exchanges will be required to register with the SEC in order to deal in those tokens linked to investment purposes and any ICO or IPO of investment-based cryptocurrencies. The SEC regulates the offering or the selling of a security. To the extent that cryptocurrencies become a replacement mechanism to raise capital for business ventures, the SEC will always play a prominent role in such offerings.
Clayton has restated on several occasions that the SEC will not redefine or make exceptions to its regulatory responsibilities by excluding cryptocurrencies from its jurisdiction. In Clayton’s mind, anything that represents an underlying asset or the value of a project will be considered a “security” for SEC purposes. The next frontier in line drawing will be cryptocurrencies that may involve an initial fundraising element but transform into a decentralized project with no leadership or defined investment other than creating a self-funding ledger program designed to reward those that improve the system with additional coin-defined assets.