Where Does the SEC Stand on Cryptocurrencies?
The SEC recently announced, in regard to a proposed Bitcoin ETF, that its decision will be delayed until September. Unfortunately, this makes the growing industry difficult to manage, especially when it is growing and moving faster than the regulations.
Current estimates show that over $20 billion has been raised through ICOs in 2017, and in 2018, the figure has only grown. Further, 10 percent of the funds raised have been either lost or stolen, and accordingly, ICOs are considered to be risky, full of hype, and unrealistic valuations. Another point of extreme uncertainty is the lack of legislative decisions concerning the blockchain industry. Further, on the state levels, each state has its own blue sky laws. Finally, regulatory bodies differ in their views as well. For example, the CFTC treats virtual currencies as commodities, the IRS treats them as property, and various courts have determined that they are “money” or “funds.”
The big question though is where the SEC stands on cryptocurrencies and why its determination is so important.
The SEC is the first federal regulatory authority over the securities markets. Founded in 1929, the purpose of the commission is to “protect investors, maintain fair, orderly, and efficient markets and facilitate capital formulation.” The commission handles the offering and sale of securities, it regulates exchanges on which securities are traded, and it ensures that companies do not disclose misleading information about performance or future prospects. Further, the commission aims to ensure that investors are traded July by dealers, brokers, and exchanges.
The SEC also has an administrative role in the crypto industry, as it imposes regulations that are noticed across borders and markets.
SEC’s Treatment of Different tokens
There are three categories of digital tokens – utility tokens, currencies, and securities. For a cryptocurrency to be properly categories, it must be examined individually. The categorization then allows platforms to determine whether they need to register with the SEC. Registration entails the platform disclosing the following:
(1) a description of the company’s properties and business purpose
(2) a description of the security being offered
(3) information about the company’s management
(4) financial statements about the company, certified by independent accountants
The SEC does not have jurisdiction over transactions in currencies or commodities, and it has a restrained regulatory approach concerning cryptocurrencies. In light of ICO growth though, it is clear that cryptocurrencies are being offered and sold as securities without the protections due to investors. As a result, the SEC got involved.
There are two issues concerning crypto regulation. First, whether investments purchased with cryptocurrencies can be considered securities and second, whether investments in cryptocurrencies are considered securities.
SEC v. Shavers controls the first question, while SEC v. W.J. Howey Co. controls the second. In terms of the latter, the matter is a bit more complicated. The case deterred that for a cryptocurrency to be classified as a security, it must meet all four conditions of the Howey test, which are as follows:
- It is an investment of money;
- There is an expectation of profits from the investment;
- The investment of money is in a common enterprise;
- Any profit comes from the efforts of a promoter or third party;
In terms of ICOs, many of them do meet the above conditions. SEC chairman Jay Clayton stated that every
“token, digital asset, where I give you money and you go off and make a venture, and in return for giving you money I say you can get a return’. . . is and will be considered a security.”
As a whole, the SEC takes a substance-over-form approach and indicates that simply naming tokens as a “utility/currency” tokens or public offerings as “token generation events” does not necessarily mean that a token is a de facto security.
The SEC’s director of corporate financing, William Hinman, stated:
“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 packed and sold as an investment strategy that can be a security.”
In regard to Ether, Hinman stated:
“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 disclose regime of the federal securities laws to current transactions in Ether would seem to add little value.”
Hineman’s stance shows that the SEC is treating its need to regulate the crypto space very seriously.
The Status of Crypto Exchanges
To protect investors from ICO scams and to prevent fraudulent and manipulative practices, the SEC issued a “Statement on Potentially Unlawful Online Platforms for Trading Digital Assets” in 2018. The statement reiterates 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.”
When labeled as a “securities exchange” or an “alternative trading system,” the platforms comes under the direct supervision of the SEC. However, at this point, no exchange is registered with the SEC and the only platform that has applied is Coinbase.
The final issue to ponder is the SEC’s pending decision concerning crypto-linked ETFs. Several platforms have filed requests for SEC approval of their ETF, there are many issues preventing approval, such as valuation and custody of funds, market liquidity, and investor protections.
Another worrisome issue is that most of the volume taking place on crypto exchanges is outside of the United States. The SEC also needs to determine that ETFs are backed by a physical bitcoin and are stored by secure custodians, whether they are in-house or outsourced to established crypto institutions.
While awaiting for the SEC to issue its final decision on crypto-linked ETFs, it can be expected that a positive decision will lead to a robust market. On the other hand, if the SEC rejects the application, as it did in the Winklevoss EFT proposal, the market may suffer a major blow.