How a cryptocurrency will be regulated may come down to whether it is treated as a commodity, which have a lighter regulatory burden, or a security, which have a heavier regulatory burden.
ICOs are run by developers who make promises. This makes them more likely to be classed as securities than “pure” cryptocurrencies like Bitcoin, or Ethereum.
When I write that we are living through history, I mean that we are living through the invention of something new, something that has never been tried before, something that will upset the apple cart, and impact the world in a big way. We are living through BIG changes. The governments of the world slowly turn their gaze upon this brewing revolution.
Early cryptocurrency advocates, and detractors, have argued that Government will be Bitcoin’s Final Boss: the greatest obstacle in its path. The assumption of antagonism stems from the Bitcoin community’s cypherpunk and Austrian economic roots. The cypherpunks advocate privacy through encryption. Austrian economists advocate for limits on government’s role in economic affairs. Bitcoin is decentralized because the expectation is that governments will attempt to shut down a technology manifesting these principles.
The world is not black and white however: the same capabilities that pose challenges to government control also create enormous opportunities for innovation. Governments all around the world are responding differently to cryptocurrencies, but in the U.S. there is cautious cause for optimism as elected officials and regulators seek to strike a balance between maintaining control and innovating.
Interested observers got to witness in real time as members of the House Financial Services Subcommittee on Capital Markets, Securities, and Investment grappled with these issues along with three representatives from the cryptocurrency industry and a securities law academic.
The hearing gives insight both into the government’s approach to cryptocurrency regulation, as well as what the cryptocurrency industry wants from regulators.
Those who want to see the highlights from the source material can check out this knovigator research thread where we’ve ranked and annotated the most interesting commentary, along with video excerpts for your viewing and learning pleasure. For analysis with examples keep reading.
The House of Representatives has many individual members, each with their own view of the merits and dangers of the cryptocurrency phenomenon. The range of perspectives can best be summarized by the following two extremes.
The sceptic: “Cryptocurrencies are a crock. What social benefit do they provide?”
The optimist: “I tend to believe people are in these things for good. That they’re trying to improve their own lives and hopefully the lives of people around them”
Overall sentiment at the hearing seemed cautiously favorable. Most congressmen and women gave credence to the idea that cryptocurrencies represented some kind of useful innovation to the financial system, but expressed concern about the risks posed to retail investors and the flouting of securities law by Initial Coin Offerings, the topic of conversation for much of the hearing.
Initial Coin Offerings happen when some group of developers creates and sells cryptographic tokens to fund the development of a proposed decentralized application. Typically developers promise that the software they build will somehow require this token to operate (making it a “utility token”). If the project succeeds, and the application sees wide adoption, demand for the token should cause its price to go up, rewarding early investors for recognizing and financing the opportunity.
These tokens are similar to traditional cryptocurrencies in that they are cryptographically secure and can be bought and traded on the open market, but instead of being recorded on a native blockchain they’re usually recorded on a host blockchain. For example tokens for a decentralized prediction market called Augur are not recorded on their own blockchain. Augur uses the Ethereum blockchain, which is optimized for hosting derivative tokens. Investors use the Ethereum’s native coin, ether, to purchase the hosted tokens issued by Augur.
ICOs are interesting because tokens are programmable money capable of being interwoven into the functioning of the software they power in innovative ways. Developers issue tokens to solve a common “chicken and egg” problem faced by applications who rely on network effects for their utility. Developers bootstrap their application by incorporating a potentially appreciating currency to incentivize early adopters to use the software.
ICOs are also much quicker and easier to run and have a much larger investor pool than traditional methods of raising money, like venture capital and Initial Public Offerings, from both a logistical and regulatory perspective.
Venture financing requires wooing a small number of accredited investors for funding in exchange for equity and a measure of control over the company’s vision. Selling company stock to the public through an IPO requires paying an underwriter, registering with the Securities and Exchange Commission, suffering strict liquidity controls, and submitting various investor disclosures.
It’s easy to see why developers have rushed to ICOs whose low barrier to entry has exposed the existence of an untapped billion dollar, non-accredited investor market.
Instead of giving up equity to venture capitalists, decentralized applications allow developers to yield control to the token holders using or investing in the network. Instead of paying underwriters, developers and investors enjoy instant liquidity on cryptocurrency exchanges. Instead of paying underwriters, token sales can be deployed with a few lines of code.
Life is all about trade-offs. The opening up of the venture market to “unsophisticated” retail investors, and the lack of mandatory disclosures for developers creates opportunities for abuse.
Without these rules, investors bear ultimate responsibility for making sure the projects they fund are honest attempts at delivering something of value. In many cases, unscrupulous developers promise the Moon and then disappear with the money. These abuses draw the ire of elected officials, and have focused their attention on ICOs in particular, as opposed to “pure” cryptocurrencies.
ICO Tokens are distinct from “Pure” cryptocurrencies, as Peter Van Valkenburgh, Director of Research at Coin Center, referred to them, or “virtual currencies” as Mike Lempres, the Chief Risk Officer of Coinbase, refers to them. Both represent opposite extremes on the decentralization spectrum.
“Pure” cryptocurrencies are the most decentralized. They run on their own native blockchain implemented on a peer to peer network with no central point of control. The lack of government or corporate backing requires that the network issue a currency to incentivize participation. This currency is created (aka “mined”) by peers willing to join and run the software to validate and secure that network’s transactions.
Tokens like Augur, or Civic, are more centralized, despite being hosted on a decentralized blockchain (as discussed above). Tokens are created and issued by a software development team promising to deliver a software product. Regulators squint at this situation and it starts to look very much like a securities offering: there are people in charge, and they’ve made promises to deliver something.
Who is in charge of silver? Of oranges?
Similarly there is no one in charge of “pure” cryptocurrencies; no one to make promises. Because of this regulators are interpreting digital assets like Bitcoin, Ethereum, and Litecoin more like commodities than securities.
Van Valkenburgh makes the analogy explicit at the hearing: bitcoin is a scarce token for tranferring value similar to gold, ether powers a decentralized computer similar to oil powering an engine, and filecoin represents hard disk storage, similar to digital real estate.
Much of the debate about how to regulate cryptocurrencies has coalesced around attempting to distinguish between cryptocurrencies that should be treated as commodities vs cryptocurrencies that should be treated as securities.
Some on the Committee expect that the regulatory infrastructure that already exists for commodities (CFTC) and securities (SEC) to be sufficient for regulating cryptocurrencies. In fact, we already see this happening with the IRS announcing that cryptocurrencies are to be treated as a commodity asset class for tax purposes and the SEC putting out statements that it believes many of the ICO tokens meet the definition of a security which would bring them under its regulatory authority.
From the perspective of those in the cryptocurrency industry this distinction is of the utmost importance. That is because securities have a higher regulatory burden than commodities. Any cryptocurrency considered a security will be forced to have its issuer register with the SEC, as well as perform various disclosures about themselves in the name of protecting investors.
We can see how this impacts Coinbase, probably the premiere brand in the cryptocurrency industry, in how they make decisions about which cryptocurrencies to list for sale on their exchange:
Coinbase will only list “pure” cryptocurrencies because they’ve received guidance from the CFTC and SEC that regulators will treat these as commodities instead of securities. Coinbase won’t consider listing any ICO tokens on their exchange until they have regulatory clarity on how these will be treated by regulators: commodities? securities? Something new?
The faster regulators make this distinction, or share the framework for how they will decide the better it will be. Until then we can look at how regulators have made the distinction when looking at more traditional financial instruments.
We can see how important it is to cryptocurrency proponents that network tokens not be subject to securities law when Van Valkenburgh attempts to make a distinction between: a) developers issuing promises for tokens which, according to him, are a security “in the true, meaning and spirit of the Howey test” and b) actual utility tokens being used in a functioning decentralized application which he argues should still be treated as a commodity so that trading them does not incur the same restrictions that a security would.
The test referenced by Van Valkenburgh is called the Howey Test after a 1946 Supreme Court case whose ruling laid out the threshold a financial instrument has to cross to be considered a security by regulators:
“The test [for whether something is a security] is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.”
You can see the argument Van Valkenburgh is making. At the time of the ICO when no decentralized application exists developers who issue the promise of a token in the future are issuing securities since their efforts to deliver a working system will meet the “solely from the efforts of others [the developers]” criteria of the test.
But, Van Valkenburgh argues that, once a functioning application exists, the utility tokens which power it will no longer be under the control of the developers (the third party), and could thus be considered a commodity.
We will be hearing a lot about the Howey Test as SEC regulators figure out ways to apply it to the various ICO tokens.
The debate between industry and regulators about which coins deserve to have investor protections typically afforded to securities will make or break projects.
Pure currencies mined by peers and running on their own native blockchains are very likely to be treated as commodities. Tokens issued by centralized development teams are in a regulatory gray area and are at risk of coming under a burdensome regulatory regime which may stifle their potential or viability.
Decentralization is King.
We already understood that decentralization protected cryptocurrencies from the logistical efforts of antagonistic state actors, but now we are starting to realize that decentralization actually grants cryptocurrencies relief from the most restrictive regulations in the first place.
One moment in the hearing stood out to me most of all. It was when cryptocurrency sceptic Congressman Sherman challenges the panel to explain the social benefit of cryptocurrency:
In response, the panel falls silent. In the moment, no one was able to articlulate an answer. This was disappointing and in the next post I will make the case for the societal benefits of cryptocurrencies I wish the panelists had made.
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