The cryptocurrency industry is currently unregulated by third parties. Which means lots of shady activities that ordinarily wouldn’t see the light of day in traditional financial industries, are being perpetrated in the form of ICOs and token sales. Naturally, this has resulted in the proliferation of scam coins and significant financial losses for investors.
Unfortunately, because the cryptocurrency market is uncharted waters, banks and other financial regulatory bodies don’t quite know what to make of it yet.
The cryptocurrency market by its very nature, makes this very difficult because of its deregulated, decentralized and trustless nature. This is the key difference between cryptos and other conventional financial instruments.
To date, cryptos have been self-regulatory for the most part, thanks to a distributed blockchain ledger that eliminates the need for any human or third party interference. Blockchain's DLT also enforces objective, community driven rules that are usually agreed upon prior to launching a coin / issuing a native token. But the debate and discussion on whether or not cryptocurrencies are securities is growing and seems as though there will be plenty of regulatory actions handed down in the year of 2018. You can see our latest posts about Ethereum SEC ruling and the possibility of it being classified as a security which would send serious ripples into the marketplace.
Although, some financial institutions like the IRS and the SEC are beginning to surreptitiously wade into those waters, and are aiming to bring some sort of normalcy – see Fedcoin – although their influence is still somewhat restricted- and standard to the industry.
The IRS for instance, has stated that any income made from trading cryptos is taxable, essentially placing it in the same category as personal income. In a similar fashion, the SEC is aiming for regulation through the introduction of the Howey Test as a yardstick to new ICOs and those currently running.
Essentially, the Howey Test is meant to test the authenticity of any ICO, as well as protect the average American from being scammed.
So, What Is The Howey Test?
This is a checklist or a list of features that qualifies a financial instrument as a security. Traditional investment vehicles and assets like bonds, stocks and treasury bills in the US, are considered as security.
Any asset that isn’t in the same category as a security is considered illegal in the US. In line with this, the SEC has mandated that all cryptocurrencies, ICOs and token sales in the US must pass the Howey Test to be legal in the US and fall under its purview. Anything less and you would potentially have a financial crime on your hands.
The Howey Test comprises of four key components:
- It must be an investment of money
- With an expectation of profit
- In a common enterprise
- With the profit to be generated by a third party
Therefore, any cryptocurrency that doesn’t meet all four criteria doesn’t qualify as a security, asset, or investment vehicle. Stocks for instance, are a good example of securities. They meet all four criteria, which eliminates the risk of investors being scammed of their monies.
Companies are often mandated by the SEC to periodically –usually quarterly or annually- file financial reports to comply with the regulations and secure investors’ stakes in the companies.
Unfortunately, meeting all four criteria as well as publishing financial reports often requires a legal and accounting team. Most initial coin offerings are incapable of that kind of manpower, seeing as these ICOs are often run by a one man or multi-person startups that are often low on capital and incapable of funding such projects.
This is why most cryptocurrencies aren’t considered securities, and why the SEC has warned the populace about the risks of investing in cryptos.
The DAO Precedent
The need for regulation became evident after the 2016 DAO incident. The DAO was a German backed decentralized autonomous organization that had its token sale in 2016, grossing over 11 million ETH in the process.
Its token sale through crowdfunding was so successful it was described as the world’s largest token sale ever. During the sale, hackers hijacked the process, resulting in an Ethereum hard fork and a third of the proceeds lost.
The bottom line was that investors lost their monies, the company itself folded up and the token was delisted from multiple exchanges. A loss of this magnitude naturally attracted the attention of regulatory bodies, resulting in an investigation by the SEC.
The result of their investigation was published in a July 2017 statement regarding the DAO and all cryptos:
“These requirements apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology,” the SEC wrote. “In addition, any entity or person engaging in the activities of an exchange, such as bringing together the orders for securities of multiple buyers and sellers using established nondiscretionary methods under which such orders interact with each other and buyers and sellers entering such orders agree upon the terms of the trade, must register as a national securities exchange or operate pursuant to an exemption from such registration.”
Naturally, this statement generated a lot of concerns in the crypto community, with most stating that SEC regulations would impede the growth potential of the cryptocurrency industry.
For the critics, two things immediately jumped out from this statement. The first was that the statement appeared to target only the DAO as a security. Second, the statement wasn’t inclusive of all cryptocurrencies.
Bottom line, all cryptocurrency ICOs must be registered as securities henceforth. Any crypto ICO that isn’t registered is considered illegal, while US citizens and residents dissuaded from investing in them.
What Does The Future Hold?
For now, the SEC hasn’t released any new documents pursuant to its 2017 statement. This may be both good and bad.
Good in the sense that the SEC’s lack of a heavy handed approach might imply that the regulators are giving the crypto community to figure out exactly what cryptocurrencies are and the role they’ll play as securities.
The bad is that this vague approach might not bode well for the crypto industry. It’s possible the SEC might be taking a wait and see approach in the bid to eventually allow its hammer fall on many cryptocurrencies later on.
Unfortunately, that statement has put legitimate developers with worthwhile projects in a tight spot. Most of these developers cannot afford the cost of hiring legal and accounting professionals to help figure out if they are indeed a security or not. If anything, they depend on these ICOs to generate the capital they need to bring the project to fruition.
The cryptocurrency industry might need to keep fingers crossed about the SEC’s next line of action. It is hoped though, that the introduction of the Howey Test as well as the threat of a potential SEC action will help introduce some sanity into the market, and chase off the scam coins as well as the pump and dump coins too.