The SEC and Cryptocurrency

What We Know About How the SEC View Cryptocurrency and Some Opinions

We take a look at how the SEC views cryptocurrency, including them potentially viewing ICOs as securities. Below is my interpretation of statements made by the SEC and actions taken by the SEC pertaining to cryptocurrency. See the citations for the documents I’m pulling from (largely SEC documentation and interviews and a Wall Street Journal Article).^{[1][2][3][4][5][6][7][8]}

UPDATE JUNE 2018: The SEC announced that Bitcoin and Ethereum are not securities. It is unclear if other major coins will avoid being labeled securities as well. With that said, it is confirmed that many (but not all) ICOs ARE securities.

What is the SEC? The SEC is the U.S. Securities and Exchange commission. They are “an independent federal government agency responsible for protecting investors, maintaining fair and orderly functioning of securities markets and facilitating capital formation.” They are essentially the agency who enforces laws and recommends rules related to investments in the United States. See: THE ROLE OF THE SEC.

The context: The SEC keeps strongly hinting at the idea that securities laws apply to cryptocurrencies and cryptocurrency exchanges. Specifically, they have expressed the idea that ICOs are securities and that exchanges that allow any ICO that might be a security to be traded must comply with SEC rules. That said, exactly what they are getting at has been unclear. Still, we can see from their actions that they have been going after entities like LongFin and Riot Blockchain, pyramid type crypto schemes, and some ICOs (as they have subpoenaed entities of each type; so proof is in their actions). While they have been issuing warnings and going after crypto scams since the early days, things have ramped up in 2017 – 2018 with a new focus on ICOs. The main issue here being ICOs using a fundraising mechanism that mimics an IPO, but doesn’t involve owing shares of a company or following existing regulations.

Why would certain cryptos be securities: The problem is more with the way in which ICOs like Ether raise funds, [ironically] have some degree of central control over the asset, and how investors buy these things with the expectation of returns. Essentially, one could rather easily argue that cryptos like Ripple, Ether, and ICOs fail the Howey Test (and are thus securities). NOTE: The Howey test is one of multiple tests that have historically been used to determine if an investment is a security (see risk capital test, reves test, and family resemblance test).

According to findlaw.com, under the Howey Test, an investment is a security:

1. It is an investment of money
2. There is an expectation of profits from the investment
3. The investment of money is in a common enterprise
4. Any profit comes from the efforts of a promoter or third party

With that list in mind, one can see why there is a potential problem here. In all these cases there was an investment of money, an expectation of profit (think “lambo” and “moon”), a common enterprise, and some form of promotion. That said, I’m not a legal expert, I’m just compiling information for you.

TIP: The SEC tends to think of ICOs as securities, and the problem here is that Ethereum started life as an ICO and pumps out ICOs. However, the Ethereum foundation has apparently spent a lot of time with lawyers and feels confident that Ethereum isn’t a security. One reason being that mining is required to create new coins, another is that today the Ether token is necessary for use on the Ethereum network.

Will the SEC Rule Ethereum is a Security? Time to Panic?. This video is smart and sums up the arguments on both sides well.

Does any of that equate to a ban on crypto? There seems to be no indication that any line of SEC thinking is leading toward a ban on cryptocurrencies in general, in fact it seems clear that cryptocurrencies are being gradually embraced to some degree. However, there is potential that this could lead to more regulations on cryptos and crypto exchanges. The idea being that it starts with ICOs and exchanges that trade ICOs, and then works its way to all cryptos from there. Currently exchanges have to comply with SEC rules if they trade any ICOs that are securities (but exactly which ICOs are securities doesn’t seem clear)… that makes things a little unclear in general.

An important implication: If “ALL ICOs” (in the broadest sense) are securities, and if there are new regulations and rules that goes along with that, then all exchanges operating in the U.S. and many of the top coins are potentially going to be subject to a new set of regulation and rules. Gemini, Coinbase, Robinhood, Square, potentially the NASDAQ, and bank-based trading desks are very likely to be able to maneuver through that without much of a problem, but it might create some complications for other exchanges and for decentralized exchanges. The reason it could effect substantially all exchanges is because Ethereum, TRON, OMG, NEO, EOS, and more are all ICO platforms and many originated as ICOs. Meaning, about 1/2 the top coins, plus many alts, technically could fall under the broad category of “ICO,” which would make them securities, which would theoretically make all exchanges dealing in them (which is literally all crypto exchanges) subject to SEC rules. I’ve heard a few theories on why this won’t be the case, and a few ways people have to get around this, but the set-up is there. Ethereum is the most mimicked crypto aside from Bitcoin, and all those Ethereum competitors and many of the tokens they spit out could broadly fall under this category. NOTE: Even some non-ICO cryptos like Ripple are getting the securities accusation thrown at them (simple transfer coins like Bitcoin, Bitcoin Cash, and Litecoin seem to be safe).

“I’ve never seen an ICO that wasn’t a security….

….If you want to know what our markets would look like with no securities regulation, what it would look like if the SEC didn’t do its job? The answer is the ICO market.”

– SEC Commissioner Robert Jackson

Also important: The SEC regulating things doesn’t necessarily mean that we should expect substantial changes in the crypto space. There is a big difference between a literal scam, and something that seems scammy. Without going into details, many MLMs, ENRONs, and Bernie Madoffs have operated under SEC scrutiny for years. Sometimes the outcome is a rule change and fees, sometimes it is federal prison and bans… but typically, when its a grey area and not a black and white thing, it is rule changes and fees. Meaning, while some worst practices might be filtered out the crypto space, it is very likely no significant changes will take place based on anything the SEC does (especially in terms of being an average Joe investor who invests in cryptos, as you likely aren’t running a pump and dump, spoofing with a bot, running a scam ICO, or trying to build out a decentralized ICO exchange, etc).

The irony: The IRS taxes crypto traders like they are trading investment property. Yet, the SEC is now taking a stance on cryptos like they are securities (or at least some cryptos are securities). One of the most difficult parts of trading crypto is the tax implications and in almost every way securities are taxed in a more favorable way than investment property.

On the legality of existing ICOs and those who facilitate their trading: If they are securities, then they are unregistered securities. If that is the case, then the initial sale of them was technically illegal. There is a rabbit hole here, but to stress what I’ve said above, while regulation is likely, a ban is not in my opinion based on my research.

On retroactive action: It is unlikely that even if it was deemed that past ICO sales were illegal that action would be taken retroactively. Or at least this seems to be the opinion of securities lawyers and former regulators.

NOTE: There has been talk that XRP is a security. XLM is essentially an XRP-like coin. The reality is there isn’t many coins that don’t have an Achilles heel when it comes to ways to regulate them. A few like Bitcoin wouldn’t be directly effected, but if substantially all cryptos are regulated, it is likely that the rest will be impacted as an effect.

TIP: If you want to know to what degree volatility might be curbed if cryptos were regulated like stocks, look at penny stocks and blockchain stocks. We can see countless examples of crazy price action that gives cryptos a run for their money, and then in some cases we see action taken. So, if we expect that, again we would expect that not much would change. Still, the chance that people will react calmly to news like this is near zero. So one should prepare and position themselves in a way that they aren’t blind sided by the inevitable FUD.

What the CFTC has to say: Crypto community favorite CFTC Chairman Christopher Giancarlo is a bit more bullish on cryptocurrency than other regulators. Giancarlo described cryptocurrency as “part currency, part security and part digital coin.” Of course, here again, it is the “part security” aspect that opens the door that leads to the rabbit hole. Ultimately however Giancarlo eludes to that which is the case and which is my next point, the US is a nation of laws and Congress (not the CFTC or SEC) makes the laws.^[9]

TIP: Congress makes the laws. The SEC enforces laws and suggests rules. There are rules and regulations that can be put in place by the SEC, but ultimately Congress is in charge. Congress is slightly less bullish on cryptocurrency in general than the SEC, the crypto community, hedge funds, banks, etc. Thus there are some known unknowns here. This page is about the SEC, not about every aspect of government as it pertains to the future of crypto in the United States. It is like with healthcare, the FDA, HHS, and CMS have some jurisdiction over healthcare, but power ultimately lies in the hands of Congress.

TIP: This is me just doing my best to string some logic together. Essentially everything anyone from the SEC has ever said about cryptocurrencies can be found on the SEC website (so check that out if you want further information). Also remember, opinions and rules can change. Further, I have no idea what the SEC will do. I’m just literally reading what they have said, looking at past actions, and using logic. Do your own research.

Opinions on the bottomline: First and foremost, the SEC has expressed the idea of striving for a balanced approach, with William Hinman saying, “We are striving for a balanced approach, and one that ensures capital formation while maintaining a strong focus on investor protection.” That sentiment is echoed in their words and actions thus far, and thus one shouldn’t expect any big ban or such as it stands now. Everything considered, in the grand scheme of things crypto is likely to roll along on the path it is on. That path is a gradual upward trajectory, with lots of volatility, where a few regulations are sprinkled in here and there as the market matures naturally and new players enter the space (as it has been). However, there is a potential speed bump in terms of a path that looks like this: 1. ICOs are deemed securities, 2. therefore 1/2 of the top coins are unregistered securities that spit out unregistered securities that all had illegal token sales, 3. therefore every crypto exchange is trading unregistered securities. Getting right would be as simple as following some rules and paying some fees, and that might at worst potentially filter out some current players, but one could see that having an epic FUD effect at first (it would be the type of news that could drop crypto prices hard). Still, it should be stressed, the SEC has essentially no history of getting in the way of investors making risky choices and trading volatile and even questionable assets in mostly free markets, more-so they are focused on protecting investors from true scams and making sure a basic set of rules is followed so markets don’t descend into chaos.

1. Statement on Potentially Unlawful Online Platforms for Trading Digital Assets. SEC.Gov.
2. SPOTLIGHT ON INITIAL COIN OFFERINGS AND DIGITAL ASSETS. SEC.Gov.
3. Chairman’s Testimony on Virtual Currencies: The Roles of the SEC and CFTC. SEC.Gov.
4. World’s Second Most Valuable Cryptocurrency Under Regulatory Scrutiny. Wsj.com.
5. Ethereum falls on report that the second-biggest cryptocurrency is under regulatory scrutiny. CNBC.com.
6. SEC is cautiously open to initial coin offerings, commissioner says. CNBC.com.
7. Is the SEC Gunning for Ethereum and Ripple? Fat Chance. Fortune.com.
8. Is ethereum a security? The answer could upend the crypto world. qz.com.
9. Bitcoin has ‘elements of all of the different asset classes,’ CFTC chairman says. CNBC.com