Are Cryptocurrencies Securities? A Comprehensive Guide to the Blockchain’s Biggest Battle
As the blockchain and the concept of cryptocurrency matured, a variety of pressing legal and extralegal concerns have created intense debates. The nature of a decentralized blockchain with anonymous forms of currency threatens to shake the foundations of some of the world’s most powerful institutions.
Not just banks are challenged by the currency; loss of public acceptance of fiat currency would be a dangerous consequence for governments all around the world following a domination by cryptocurrencies.
Furthermore, the quickly-changing nature of the cryptocurrency ecosystem presents several problems for governments looking to gain their legal bearing on the new technology. The very backbone of the currencies is predicated on fluidity and constant innovation.
Many regulations that cater to specific technological components of the blockchain would likely become moot points with the next big revision to the technology, or with the next leading application.
The final nail in the coffin of difficulty for governments looking to regulate cryptocurrencies is the international inclusivity of the system. Because cryptocurrencies like Bitcoin operate entirely without borders or geographical restrictions, it would be erroneous to attribute the currency to any specific government’s jurisdiction.
This further complicates the adjudication of cryptocurrency issues, because countries are generally unable to independently take action against institutions or citizens operating in another nation.
Despite the obvious barriers to effective regulation, recent developments have thrown fuel on the fires of several important debates surrounding the regulation of cryptocurrencies.
In particular, a public statement made by the SEC in early March 2018, as well as a class-action lawsuit against Ripple Labs, have highlighted the potential for SEC classification of cryptocurrencies as securities. For the most part, new cryptocurrencies created for Initial Coin Offerings, or ICOs, are the target of prospective governmental regulation.
If cryptocurrencies are regulated as securities in the United States, the results could be expansive. Ripples of the change could be felt across the entire cryptocurrency landscape and would affect nearly every coin currently in existence.
Cryptocurrencies have historically avoided the brunt of governmental regulation. Recently, we have saw many updates regarding Ethereum and whether or not it is a security. Because of their decentralized and anonymous nature, and because changes to the blockchain are constant and innovations expected, regulatory efforts have been slow. Consequently, the industry has generated trillions of unregulated and generally untaxed funds.
In this unregulated era of cryptocurrencies, several new products were introduced to the world. Massive crowdfunding campaigns led to billion-dollar organizations being created, and many investors climbing into the status of millionaires. But like all quickly-growing industries, eventual regulation by the powers that be is to be expected. And in 2018, a series of developments have heightened public interest in the prospect of regulation.
As the SEC and courts in the United States gear up to decide the fate of cryptocurrencies, this guide seeks to consolidate information on what constitutes a security, the ways that cryptocurrencies can become securities, what this might mean for popular currencies, and the market’s most informed predictions for the future of the blockchain.
The Crux Of The Debate: What Constitutes A Security?
The concept of what can be known as a security sits at the core of the debate surrounding cryptocurrency regulation within the United States. Securities are a type of valued item regulated and evaluated by the SEC, or the Securities and Exchange Commission. This agency is responsible for verifying that businesses offering investors stock in their company are abiding by existing rules and are not swindling investors.
According to U.S. law, securities are any investments that involves risk and can be exchanged for some sort of value. This value does not necessarily have to be monetary in nature. Securities need to be transferable, must involve risk, and has to hold a kind of value. Securities by themselves come packed with a significant number or regulations and rules imposed and enforced by the Securities and Exchange Commission.
Another major definitional consideration in the cryptocurrency regulation discussion is the idea of a securities exchange. A securities exchange is any platform that facilitates the trade of stocks, bonds, or any kind of security. If an institution is known as a securities exchange, then that organization is thus bound by the rules for exchanges created by the SEC.
There are several reasons why the definition of a security becomes important to the regulation of cryptocurrencies and ICOs alike. It is first clear that, in order to begin to properly regulate a financial entity, it is important to first agree on to what category of entity it belongs. This is a considerable concern in the United States because different types of financial assets fall under different regulatory jurisdictions.
The Securities and Exchange Commission is renowned for its meticulous audits, exhaustive supplies of red tape, and affinity for regulation of all securities and exchanges. In fact, the threat of being at the heel of the SEC was so frightening that some ICO-running organizations purposely lowered their hard cap for funding to below $5 million to avoid regulation in the U.S. as an exchange.
But even the concept of a security continues to evolve. In the initial days of the New York Stock Exchange, the definition of a security was primarily restricted to paper stocks that offered a percentage of fund entitlement in a company. As the prevalence of paper stocks declined and bonds became commonplace as well, the definition shifted with the times.
In this age of rapidly-developing technologies and decentralized interest on the internet, it would be no surprise that the definition of a security is to be expanded to include these new types of currencies. But still, with some of the world’s greatest technical and legal minds standing behind the freedom of cryptocurrencies and all that they stand for, there are substantive arguments against classification as a security.
As an operating definition for the rest of this guide, a security should be understood in the present day as an investment with risk and the ability to be exchanged for something of value. Additionally, a securities exchange is an entity that offers the sale, purchase, and trade of these investments.
A Target of Regulation: What Is An ICO?
Perhaps the most contingent area of debate in the classification argument concerns the existence of decentralized crowdfunding campaigns known as Initial Coin Offerings, or ICOs. ICOs are crowdfunding operations run by startup companies on the blockchain. For the most part, ICOs feature the creation of a new cryptocurrency, or token/coin, on the Ethereum blockchain.
As Ethereum made it incredibly easy for anyone to create their own cryptocurrency, the platform’s blockchain protocol has quickly become one of the most popular in the entire industry. Thousands of companies have offered stock in their company through the ICO system, and many million-dollar corporations have resulted from the unique process.
When a company holds an ICO, they offer investors the opportunity to buy coins from them that represent either direct value in the company, or access to a product that is eventually going to be created. Users with more tokens are entitled to a larger share of the value they are being given.
This unique method of raising funds goes hand-in-hand with the democratic roots of blockchain technology. Rather than venture capitalist businesses dominating profitable investments while smaller investors squabble for scraps, it is the casual investor that helps to shape the successes and failures of businesses. The nature of the blockchain is that the people—not the banks—oversee the economic structure and ecosystem. This ideological argument is integral to understanding the deep community interest in this new method of raising money.
But problems resulting from the distinct lack of oversight in the field have been a cause for institutional concern. Because no agency exists to check the validity of companies and their share offerings, scams have been incredibly prominent in the ICO field. This is a main reason for movements for regulation, and one of the few problems recognized in both sides of the intense debate; pump and dump schemes are bad for the cryptocurrency economic ecosystem.
Much like cryptocurrency itself, ICOs are constantly shifting as well. Following government regulations applied to some companies early in 2017, a few organizations adopted an entirely new model of transaction for their ICO, forcing governmental entities to once again revise laws to re-categorize a shifting operational paradigm.
This issue is once again compounded by the international nature of ICOs. Many come from third-world or foreign countries to the United States, making it all the more difficult for U.S. regulatory authorities like the SEC to apply their definitions and rules to the organizations. Perhaps more troubling for the average ICO investor, this means that investment funds lost to scams or misleading information is unlikely to ever be recovered in the status quo.
This creates a difficult, multi-layered problem for governments of the world. While the currencies being traded on these markets are being sometimes manipulated and investors are regularly defrauded, regulation would require a very calculated series of moves. Even if lawmakers were able to successfully defend an ICO's categorization as an exchange of securities, getting international companies to cooperate with U.S. regulations is an entirely difficult problem to overcome.
Despite the mistrust and scamming inherent to the market, ICOs have been incredibly popular, dwarfing venture capitalism for the most popular way to raise funds in the blockchain ecosystem in the past three years. ICO statistics reveal that 871 Initial Coin Offerings raised an astonishing $6 billion in 2017 alone. And ICO-based companies continue to grow, some ICO prices growing by thousands of percentage points in just one quarter. You can take a look at the top 15 coins trying to chase bitcoin's crown down just to get an idea of the biggest coins vs new tokens that are popping up daily.
It is, then, no secret that these fundraising campaigns are incredibly popular and effective. With billions of dollars on the line, regulation seems to be a natural next step for the governments of the world. But the concept of increased regulatory statutes has been met with significant backlash within the cryptocurrency community. Expressing both practical and ideological reasons for opposition, hundreds of industry professionals have spoken out against the classification of ICOs as exchanges.
But there does seem to be some level of merit to the argument of some governmental officials. Though the technology used to transmit and signify the value of the stock changes drastically from the traditional system, the exchange of tokens in ICOs do seem to constitute the trade of stocks with both risk and potential value. As the debate rages on, ICOs continue to be a primary area of concern for both speculators and regulatory agencies in the United States and all around the world.
Cryptocurrencies: Virtual Currency Under Evaluation
Before the formation of ICOs added a new dimension to the ongoing debate, cryptocurrencies were still being scouted as potentially being classified as securities. An SEC statement in December of 2017 revealed that the SEC was still evaluating the place of cryptocurrencies in existing security law. They concluded that the way that the currency is being used is an integral factor in its classification as a security or a commodity.
Cryptocurrency exchanges are a billion-dollar industry particularly concerned with the outcome of this financial deliberation. The exchanges offer the element of risk, the promise of potential profit, and the exchange of items of distinct varying value.
Recent statements made by the SEC are damning for opponents of the classification of cryptocurrencies as securities. The SEC has made it obvious in a March 6th statement that they do, in fact, view cryptocurrencies as being primarily securities, and that sellers of these items should comply with all relevant security laws.
It is interesting to note that, to date, no ICO has successfully been accepted by the SEC as an exchange to market securities. The implications of these reality could vary greatly. On one hand, it is entirely possible that the SEC does not believe that the ICOs that have applied for such a classification meet the requirements to be a legitimate company to offer stock to American investors.
On the other hand, however, it is likely that very few coin offerings have seen it necessary to even apply for this classification. Doing so would either result in rejection or in seriously increased regulatory burdens and standards to contend with—a true lose-lose situation.
The regulation of all cryptocurrencies as securities would shake the very foundation of the decentralized economy. It would no longer just be the ICO-using startups forced to comply with the extensive regulations native to the traditional stock market. Both investors in cryptocurrency and the exchanges at which they congregate would also be held to the same standards of investors and exchanges operating on Wall Street.
Naturally, this is a conflict of interest and a major problem for many within the cryptocurrency community. More regulations could spell trouble for individuals and could eventually lead to a significant drop in market faith, both problems big indicators of a market in trouble.
The deliberation on cryptocurrencies continues, however. Though the SEC’s stance that some cryptocurrencies could constitute securities has remained constant, it is unclear thus far what the exact legal parameters for which currencies will fall under the category might be. For this resolution, the name of the game is going to be to wait and see.
Reasons To Regulate
Even considering the massive public backlash regarding increased regulations, there seem to exist several reasons why regulation might be good for the cryptocurrency community. For the most part, regulations deal with the safety of the investor and the verification of the validity of businesses using coins for profit. But there also exist compelling arguments that a regulated cryptocurrency community would yield significant benefits for the economic ecosystem it creates.
First, the SEC has been clear that the lack of regulatory authority in the ICO industry has two negative impacts for investors. For one, the ICOs currently on the market do not fall under the category of approved exchanges. Because of this, these exchanges are not regularly checked and examined by the SEC. There is consequently no way for investors to verify the fairness and validity of the stocks that they are being sold.
Furthermore, the SEC has warned that the lack of authority the agency has over Initial Coin Offerings makes it functionally impossible for investors to get their lost funds back after being scammed. From the SEC perspective, regulation could allow investors to invest safely into institutions which are vetted and examined for fairness and legitimacy.
It should also be noted that, aside from being required to pay taxes on capital gains (which many do anyway), cryptocurrency investors would not be required to conform to very many additional regulations following SEC clarification of ICO tokens as securities.
Next, it is postulated that regulating could have a stabilizing, positive effect on the industry of cryptocurrency. As it stands, millions of potential investors are afraid of the prospect of losing their money to one of the many, many scams posing as legitimate ICOs. Regulation is likely to inspire an increased consumer faith in the ICO department, as they will be insured and backed by the biggest financial regulatory agency on Wall Street.
Finally, many analysts view regulation as the first step to increased institutional involvement in blockchain technology and its development. Though the public sector has found several creative uses for blockchain’s public information/transaction ledger, there still exists a certain amount of trepidation from governments working with startups in the sketchy industry.
A well-regulated blockchain could mean that institutional forces in the public sector feel comfortable teaming up with the innovative minds of the private technological sector. This is not unprecedented; medical facilities and financial institutions alike have expressed interest in the application of Bitcoin’s blockchain technology or the integration of Ethereum-based applications in their own information networks.
The development of smart contracts further incentivizes the government to get involved with the increasingly-sophisticated blockchain ecosystem. The technology promises to objectively and often anonymously arbitrate high-profile transactions. This is clearly a desirable option for governments such as the United States.
This regulation could also serve to stabilize the cryptocurrency market. The current prevalence of price manipulation and scamming has led to an incredibly volatile marketplace. Consumers are afraid of being ripped off, and overall faith in the validity of the ICO industry continues to fall with each controversy. By providing insurance and research/regulation for a variety of ICOs being offered, the United States government could pique the interest of investors and help to minimize volatility inside the changing online economy.
Though ideological opposition to regulations may be significant, there exist clear reasons why regulation may be good—not bad—for cryptocurrency and Initial Coin Offerings. The lack of regulatory action in the current market has several notable negative impacts, and regulation could help to stabilize and stimulate the developing economy.
Keep Crypto Free: Cons to Regulation
A growing body of legal and technological minds are uniting behind the viewpoint that cryptocurrencies should not be considered to be securities in the United States, and that ICOs should subsequently not be viewed as securities exchanges. Though the primary arguments concern ideological convictions and philosophical qualms, there are also substantive reasons why SEC involvement in ICOs would be bad for the cryptocurrency ecosystem.
It is obvious, first of all, that the concept of a decentralized currency falling under the jurisdiction of a governmental entity is problematic. Bitcoin was initially founded as a way for an economic system to be generated, operated, and regulated solely by the consumers who comprise it. From the creation of transactions to hard-fork decisions to the verification of the public ledger, every step of the financial process on the blockchain is run by the people.
For the SEC to regulate Bitcoin would be a reversal of the very ideologies which initially coined the cryptocurrency. And Bitcoin is not alone in this conviction, either. The core idea of a decentralized currency seems mutually-exclusive with governmental authority. For many users of cryptocurrencies, their participation in an alternative system is a passive resistance of the compulsory traditional capitalist system.
There is also an argument of ineffectiveness. As previously stated, the biggest obstacle for regulation may not be legislation, but instead enforcement. Many ICOs are not run in the United States. Consequently, the SEC would have no authority to impose additional regulations on many of the biggest offenders in the cryptocurrency scene.
This enforcement issue also becomes clear when analysts recognize the anonymous and decentralized nature of the blockchain. Transactional information on the public ledger is encoded using complicated cryptology. From a collection perspective, it would be nearly impossible for the agency to independently verify which transactions belong to whom on the massive economic web of the blockchain.
The most compelling argument against regulation also happens to be the most empirically backed. Many argue that over-regulation of the cryptocurrency and ICO markets will lead to stagnation and an eventual crash. This is exactly what happened, on a much smaller scale, when the SEC released information one day ago regarding their discussions to regulate cryptocurrencies and Initial Coin Offerings. Prices for Ethereum and Bitcoin both fell by five and ten percentage points respectively.
Market specialists predict that, if cryptocurrencies like Bitcoin were to suddenly fall under a regulated category of security, and if ICOs suddenly had to follow the same regulations followed by major stock exchanges on Wall Street, there could be serious market correction. Many smaller businesses using ICOs would no longer have the resources to keep up, and millions of potential investors might shy out of the market.
There are legitimate reasons why regulation as a security might be bad for the cryptocurrency economy and community. As the regulatory hand of the Securities and Exchange Commission evaluates the place of the new currency, it is important to understand the empirical and philosophical reasons behind mainstream backlash to discussions of increased financial scrutiny and regulation.
A Case To Consider: Ripple Labs
The SEC is not the only part of the United States government currently evaluating the place and obligations of online Initial Coin Offerings in the consumer-friendly economy of the U.S. A recent lawsuit against crypto-company Ripple Labs alleges that the company sold unregistered securities in a way that constitutes a violation.
The class-action suit makes several claims concerning the nature of the Ripple corporation. The chief complaint is that the company conflated the relationship between XRP, the currency created for their ICO, and the company itself. Consequently, buyers were erroneously led to believe that the value of the currency was tied to the relative success of the company.
Instead, the plaintiff in the case claims that the company made most of their profit off of the sale of the coins which they had inflated in value through the Initial Coin Offering, and that this was a distinct, purposeful strategy to obtain a profit. If true, this represents a significant issue. The company had used their corporation to artificially inflate the value of a currency which initially had no innate worth, and then had lost millions for investors when they dumped their own shares and the price crashed.
But the biggest implications of this particular case have very little to do with Ripple Labs alleged defrauding of investors. The case could constitute yet another court precedent on what constitutes a security. This consideration is of extreme importance, because a court precedent ruling in favor of the plaintiff’s claim that these currencies are securities could help to inform and shape the SEC’s regulatory decision regarding the technology’s future status.
The Ripple case is one to watch because it directly pits two competing interpretations against one another. The spokesperson for Ripple Labs has officially stated that the company maintains that cryptocurrencies should not be classified as securities. When this case moves through the court systems, the decision made could be huge for the larger debate surrounding cryptocurrencies and ICOs as securities and security exchanges.
The Howey Test As A Metric To Determine Securities
In order for something to be a security, it needs to represent value, involve risk, and have the possibility of being exchanged for something of value. But there is also another condition to something being a security that was determined in the Supreme Court case SEC V. Howey. The test is intended to decide whether or not eh “value of a transaction” for party A depends on the work of party B. If the answer is yes, the value of the transaction is dependent on the work of one party, then the investment is a security.
There continues to be debate about whether or not ICOs constitute a passing of the Howey test, and there seems to be merit to both arguments.
One persuasive argument against the ICO classification as a security under the Howey definition is that Ethereum requires the verification of transactions by miners. This means that it is no longer party B that determines the worth of the transaction for party B. Instead, some analysts argue that the involvement of a multitude of parties in the transaction makes the Howey example non-applicable.
Additionally, the fact that the distribution of Ethereum is not controlled by any one organization, as well as the relatively small amount of ETH held by the founders and developers of the project, are arguments used to debunk claims that the business model of the company is as an exchange of a security.
Similar arguments are going to crop up in nearly every cryptocurrency debate. The blockchain, by its very function, means that there are never merely two parties involved in a transaction. Furthermore, there exists no singular entity that controls the distribution, flow, or decision-making behind the spread of Bitcoin along the network.
Impacts And Possibilities: Bitcoin
Bitcoin is the first of the cryptocurrencies and continues to be the most expensive among them. So far, very little substantive progress has been made in the debate surrounding whether or not Bitcoin constitutes a security by itself. However, it is fair to say that the SEC’s position on the situational metric for determining a currency’s status as a security is germane to Bitcoin. That is to say, it depends on how the currency is used.
Bitcoin would be affected the most by the choice to classify all cryptocurrencies as securities. Following the May 7th announcement that the SEC intends to regulate the cryptocurrency market more, Bitcoin saw the biggest hit to their price with a drop of nine percent. Though the coin has not by any means lost its value entirely, falling below the psychologically-significant ‘10,000’ mark is a large penalty to the currency.
It is important to note that the currency currently under investigation by the Securities and Exchange Commission for possible violations of a securities act is Ethereum, not Bitcoin. The impact of the Ethereum findings, however, will most certainly have an impact on the placement of Bitcoin as an asset on the blockchain and on Wall Street.
Ethereum is the primary topic of discussion for the SEC in May of 2018. As mentioned above, supporters of the cryptocurrency have argued extensively against Ether’s classification as a security. In addition to the reasons mentioned above, supporters believe that Ethereum being classified as a security would be disastrous for an already-fragile market.
Unfortunately, most professionals speculate that an actual decision is unlikely to come for some time. There are several important considerations that need to come before a substantive discussion on the nature of Ethereum within existing securities laws. Additionally, it is clear that the Ethereum Foundation is completely prepared to wage a legal battle, should the SEC decide to pull the trigger and make Ether into a security.
Speculators argue that, if Ethereum were to be suddenly classed as a security, its price would take a significant hit. Furthermore, all trading on the network would be forced to cease until the site complies with all necessary federal securities regulations, laws, and standards.
It isn’t just Ethereum at risk, either. If the company is found to be in violation of security laws, it is incredibly likely that many of the hundreds of ICOs operating on the Ethereum blockchain protocol will also be found guilty of violations. This would again have a significant impact on the overall ecosystem, as millions of dollars in fines will be paid and hundreds of businesses shut down—at least for a while.
Ethereum continues to be a core topic of debate for the Securities and Exchange Commission. Though no official ruling is expected any time soon, recent developments have helped to highlight how volatile the legal and economic situation truly is for Ethereum’s platform and currency.
Wide Impacts: Alternative Cryptocurrencies aka Altcoins
Smaller coins are not unaffected by the prospect of regulation by the SEC. If the commission were to classify cryptocurrencies like Bitcoin as commodities, smaller cryptocurrencies all over the world—their numbers now in the thousands—would also likely fall under the category of a security. Especially for smaller ICOs without the funds to hire a legal team to fend off the SEC, this could mean utter disaster.
Though they are often overlooked, one cannot overstate the impact of alternative coins on the overall cryptocurrency market. The trade of altcoins helps to lend artificial weight to the price of bigger coins, providing users with constant additional markets to dive into and explore.
But these currencies often fluctuate wildly already, and many will not be able to comply with complicated SEC regulations which would be brought forth by a classification change. Although those at the head of Ethereum have already been clear on their intent and ability to fight the legal battle necessary to prevent being classified as securities, smaller currencies are much less likely to pick such an enormous fight.
Alternative coins are viewed by some as being the lifeblood of the cryptocurrency scene; they represent the pinnacle of the consumers running the economy through the generation of their own currency with which to transact.
Altcoins becoming securities would also make it near-impossible for small startups to generate their own altcoin in order to crowdfund their project.
The future of many alternative coins is put into clear peril by the discussions to classify larger coins like Ethereum as securities.
Tokens Vs. Coins—An Important Distinction
The final distinction that should be made when examining the regulation of cryptocurrencies is that crypto-coins and tokens from ICOs might be fundamentally different things. While cryptocurrencies function as a genuine type of currency with direct monetary value, tokens sold in ICOs represent a share in a company, a value, or access to a specific product that is to be created.
In either scenario, it is clear that tokens from ICOs are not the same thing as a currency such as Bitcoin. The problem with this distinction, however, is that currencies that are created to function as tokens during an ICO are still attributed with a specific monetary worth. As the price rises, that is supposed to represent success and profit on the part of the company.
But consumers are not able to make any more shareholder-like decisions with a token-share in a company as they are if they have a substantial amount of Bitcoin. In either scenario, consumers rely on multiple parties for the success or failure of their investment. There will also need to be the topic of ICO vs Pre-ICO and how those are handled from the top down.
Conclusion: An Uncertain Future
The fate of cryptocurrency’s community has yet to be decided. The Securities and Exchange Commission continues to deliberate on several definitional issues concerning the cryptocurrency Ethereum. In doing so, the organization introduces a direct challenge to all of the blockchain community.
While many hold ideological opposition to the prospect of increased governmental regulation of a supposedly decentralized and open currency, there are also genuine motivations to rebuff the advances of the SEC.
Still, though, some regulation may have its merits. The status quo lacks any kind of institutional protection for investors in a sketchy market of ICO investment.
It is certain that the decisions made in the Ripple court case and in the Securities and Exchange Commission deliberations will have a profound impact on the cryptocurrency ecosystem. Only time will tell how, moving forward, the markets react to changing legal tides.
For futher reading on Cryptocurrencies as a Security and whether or not the Howey Test applies/passes/failes, please read our guide here and let us know your thoughts on what seems to be one of the biggest obstacles the industry will pass through and overcome in due time.