Cryptocurrencies and ICOs occupy a grey area when it comes to regulatory frameworks. Some countries view them as commodities, some as currencies, and others as securities. This is because they represent a new type of asset which, unlike financial derivatives, haven’t been created by financial institutions, and do not have any underlying assets behind them. However, the regulatory frameworks seem to be pushing forward, with the SEC increasing its hearings and research into this new phenomenon.
For now, most cryptocurrencies to be listed on U.S. exchanges have to pass the Howey test, The SEC v. Howey Co. – leading to the creation of the test of the same name which, based on a simple criterion, determines whether an asset is a security or not: whether an investment is made with the profits to come solely from the efforts of others. For a full overview of the case, follow this link to the U.S. Supreme Court website.
In the case of cryptocurrencies, despite most projects being open-source, the only people making repositories are the actual teams behind the project, with the investors waiting to benefit from their investments. In the case of an ICO, this scheme is even further developed as most of the time, no product has been developed and the code is private to avoid intellectual property theft, with Quantstamp being a good example.
The decision on whether an asset is considered a security or not is crucial. Security tokens are legislated by the SEC, which has the ultimate authority to determine whether U.S. investors can invest in the financial instrument in question, as well as whether these need to be accredited investors. On a side note, this system is all but fair, given the fact that to become an accredited investor, one must have a net worth of $1 million, or have an income of at least $200,000 per year – enabling the rich to get richer, by providing lucrative investment opportunities not available to the broader public.
Another implication of whether a token is a security or not concerns exchanges. When a token is deemed to be a security by the SEC, all exchanges listing the token within its offering are required to apply for licenses from federal regulators – explaining the reticence of Bittrex, which is a US-based exchange, to list any new tokens over the last months.
Is Ether (ETH) a Security Token?
As previously mentioned, we are still in a grey area in regards to how to treat crypto assets from a legal perspective. However, on June 14th, William Hinman the SEC Division of Corporation Finance released a statement declaring: “Putting aside the fundraising that accompanied the creation of Ether […], the Ethereum network and its decentralised structure, current offer and sales of Ether are not securities transactions”.
In regards to considering a token as a security token, or from another asset class, the primary factor is whether the purchaser is seeking a return on their investment or buys the assets for other purposes, such as running smart-contracts. In the case of the Ethereum network, which has no central authority, and the token being intended to be purchased for deployment and use of smart-contract – Ethereum is no security. In the case of Bitcoin, the cryptocurrency is not a security neither, and its purchase is primarily motivated for the trade of good and services.
In short, as of today, the native token of the Ethereum Network, Ether or ETH, has been said not to be deemed a security as the blockchain is considered to function sufficiently in a decentralised way. It also means that all exchanges are able to trade or list the token without breaking the law.
The keyword for not considering Ethereum as a security token is decentralisation. However, how decentralised is the Ethereum Blockchain? In a study investigating the extent of decentralisation by measuring the network resources of nodes, and the interconnection among them, it has been found that the top Ethereum miner has never had less than 21% of the weekly mining power, that 61% of the weekly power was shared by only three Ethereum miners, that over 50% of the mining power has exclusively been shared by five miners, and that 90% of the mining power is being held by 11 entities – demonstrating that the platform relies heavily on very few distinct miners to maintain the blockchain – thus determining the enterprise’s success, while having a clear interest in profiting from the rise in ETH’s price. (Gencer, Basu, et al., Decentralization in Bitcoin and Ethereum Networks).
Through this research, we can extrapolate that to the SEC, decentralisation doesn’t refer to whether a group of miners can determine the fate of a token or network, but rather to the nature of the blockchain itself. The qualities needed to be viewed as a utility token by the agency are that the blockchain must be open-source, utilised by many, and last but not least, have a strong coder base which is improving the code on a “voluntary basis”, without seeking gains.
Examples of tokens which are seen as securities are all exchange’s native coins such as Binance Coin (BNB), Kucoin Shares (KCS), or Huobi Token (HT) as these are purely driven by the success of their respective business owners. Additionally, tokens which might appear (or described) as utility tokens such as Quantstamp also lie within securities law as the code is not open-sourced and the team is the unique decider of the fate of the project. In essence, unless a DApp (and protocol) is up and running, the likelihood that they will be seen as securities by the SEC is extremely high.
What About ICOs?
However, in regards to ICOs, the outcome is quite different. In their current states, all ICOs are to register with the SEC, and be closed to non-accredited investors, regardless of the token being offered, or the platform being promoted. The rationale for including ICOs within the securities offering framework is that the economic substance of investing in ICOs is exactly the same as for other securities as the ultimate purpose of investing is to gain a return on investment – given the long-long type of investing in an early stage company which does not have a platform in development yet.
Moreover, there is always a central authority promoting the fundraising. For instance, the Ethereum Foundation, which distributed the token to the public, and which was responsible for raising the capital to run its operations, may have been within the bounds of security laws – as the raising of funds was for the initial team to promote and develop the product themselves. Another problem with ICOs is that most teams keep most of the supply to themselves, leading to a clear centralised scheme, at least in the beginning, where the founders are benefiting from price upswings. In short, ICOs are an efficient way of raising capital, however, they are to be considered in the same way as other capital-raising schemes – especially when the founders of the project keep a large supply of the token for themselves.
The primary factor in determining whether a crypto asset or ICO should fall under the scrutiny of security law, is whether a person or group sponsors the creation and sale of the asset, and plays a significant role in its development and maintenance. The problem is that tokens are often exactly the same as other financial assets that have a promise that the asset will grow in value, to be later sold at a profit. In the current environment, we believe that all tokens are securities – given that the whole market is driven by trading and speculation.
Do we think that only accredited investors should be able to invest in these securities at the ICO level? Absolutely not. However, the SEC’s mission is to protect investors, maintain fair, orderly, and efficient markets, facilitate capital formation, and to ultimately promote a market environment that is worthy of the public’s trust, which the cryptocurrency space fundamentally lacks.
The system is built to protect investors might be true when it comes to scams. Conducting due diligence requires time, knowledge, and more often than not, contacts and money, as you might need to travel on-site to avoid disastrous investment decisions. Therefore, the fact that the SEC is pushing towards requiring companies to provide an ICO prospectus, in the same way as companies release an IPO prospectus, is something we are looking forward (to), as most whitepapers tend to lack substance as they only describe the current bottlenecks which they believe they can solve, as well as the potential market sizing they are going into.
However, being highly liberal from the perspective of freedom, equality, and fairness, we believe that each and every individual should be able to make their own decisions, whether good or bad, and that it is not the role of the government to dictate how people should invest their money. The system that is said to be in place to protect investors’ interests has only one true outcome: it makes the rich richer. Looking at IPOs and its underpricing phenomenon, where institutional investors are getting the stocks at a discount, we can see how “normal investors” are being discriminated against as they often have to buy these stocks at a premium in comparison to their accredited counterparts.
Now, despite the SEC’s statement being highly positive for the market as a whole, it raises many questions, such as how blockchains with masternode systems, which give investors dividend-like rewards, or Delegated Proof of Stake (DPoS) or Proof of Authority (PoA) blockchains, where the success of the platform relies on the actions of a few, should be considered. Lastly, with them being an increasing occurrence, how should airdrops be considered? Given that more and more high-profile projects are employing airdrops, such as Ontology and Polymath, this will once again pose a new hurdle for the SEC to take on – as they do not raise capital from public crowd sales, but instead raise funds from accredited investors and airdrop the rest of the tokens freely to a wider audience.