On October 3, 2018, the U.S. Commodity Futures Trading Commission (CFTC) issued a statement saying that Judge Rya W. Zobel of the U.S. District Court for the District of Massachusetts declared “virtual currencies” are commodities. The order coming from Judge Zobel is one of several rulings and statements that have gripped the crypto-sphere over the last year or so as digital asset creators, their investors, exchanges, and various companies and organizations attempt to gain clarity over whether their distribution, purchase and selling, and use of digital assets is legal in the United States. Unfortunately, the ruling from Judge Zobel and subsequent statement from the CFTC only seems to muddy the waters further.
This lack of clarity has caused more than a modicum of consternation within the digital asset ecosystem. For example, Michael Arrington, the founder and CEO of Arrington Capital, recently stated on Twitter:
We received a second subpeona from the SEC, again collecting information from us as investors in a U.S. company. The legal costs of dealing with these are not insignificant. We will not invest in any further U.S. deals until the SEC clarifies token rules. Pivot to Asia.
— Michael Arrington (@arrington) September 28, 2018
The lack of clarity is not only causing confusion, it also has a very real cost with associated legal fees. The other very real cost comes in the form of lost opportunities, especially to the crypto ecosystem in the U.S. Arrington specifically stated he is not going to invest in other U.S. based crypto companies until clarity is provided.
How did we get here? Is there an answer to the question about digital assets being securities, commodities, or something else entirely?
Previous rulings and statements
One of the first rulings that specifically involved digital assets came from the U.S. Securities and Exchange Commission. The digital asset in question in this case was DAO, which stood for Decentralized Autonomous Organization. The SEC published a report about its findings about the DAO.
The main crux of the DAO was that the token, itself, represented an unincorporated “virtual organization”. The SEC found that DAO met all four requirements of the Howey Test, which finds its precedent in SEC v. W. J. Howey Co. (1946). According to the Howey Test, investors in DAO:
- Invested real money in DAO by exchanging Ethereum (ETH) for DAO;
- Investors understood they were investing in a “common enterprise” which was the DAO itself;
- Investors had a reasonable expectation of profits from DAO based on the execution of various contracts on the DAO network that would generate fees and, subsequently, profits that would be paid out in the form of dividends; and
- Expected the managerial team of Slock.it, Slock.it’s co-founders, and “curators” that the DAO would select to “manage The DAO and put forth project proposals that could generate profits for The DAO’s investors.”
In essence, the DAO, even though designed as a token and “virtual organization,” was no different from any other company, such as Disney, Coca-Cola, etc., that sells securities to the investing public. The SEC has stated unequivocally that if a token is designed to represent the traditional qualities of an investment asset of any organization, it will be deemed a security.
ICOs can be securities, too
The SEC is less clear about whether an ICO is considered a securities offering. According to the SEC website, “ICOs, based on specific facts, may be securities offerings, and fall under the SEC’s jurisdiction of enforcing federal securities laws.” This statement does nothing to clarify whether investors can be sure that an ICO won’t later be deemed a security offering, which could lead to lawsuits, legal fees, and potentially fines and/or prison time.
Read the statement from the SEC again. There are a couple of problems. The first item that needs clarification is the phrase “based on specific facts.” What facts? What does a token creator, and subsequent investors, need to know to ensure that the token will not later be deemed a security? These facts seem highly relevant.
The second one is “may be securities offerings.” So, some “facts” may be the same from one token to the next, however, one token could be deemed a security while another token is not. Why? Because the clause “may be” without knowing what “specific facts” are being looked for leaves those “specific facts” open to subjective analysis instead of objective, fact-based, analysis.
The only statements about ICOs that have been made are from the current chair of the SEC, Jay Clayton. In June, 2018, Clayton stated that “If you have an ICO or a stock, and you want to sell it in a private placement, follow the private placement rules. If you want to do any IPO with a token, come see us.” He went on to say, “A token, a digital asset, where I give you my money and you go off and make a venture, and in return for giving you my money I say ‘you can get a return’ that is a security and we regulate that. We regulate the offering of that security and regulate the trading of that security.”
In short, the SEC needs to clarify what “specific facts” token creators need to keep in mind as they prepare to offer their tokens to the public for the first time so that an objective analysis of the offering can be made before enforcement activities begin.
Are bitcoin, ether, and XRP securities?
Jay Clayton, in the same interview above, made the following statement: “Cryptocurrencies: These are replacements for sovereign currencies, replace the dollar, the euro, the yen with bitcoin. That type of currency is not a security.” So, it seems, Bitcoin gets a pass. However, Ethereum was not mentioned in that interview and many continue to speculate that its tokens are used for securities purposes instead of utility purposes.
XRP was specifically mentioned by former CFTC Chairman Gary Gensler and that a “strong case” could be made that XRP was a security.
However, in an interview with Modern Consensus, Michael Didiuk, who worked in the SEC’s Office of Compliance Inspections and Examinations out of the SEC’s San Francisco Office, stated that XRP did not meet the four requirements of the Howey Test. His argument seems sound coming from a former employee of the SEC who worked in the office that would determine whether compliance was an issue or not, therefore, these statements would seem to carry some weight.
Regulation is a global concern
At the recent SWELL Conference, hosted by Ripple, Ross Leckow, the deputy general counsel of the International Monetary Fund (IMF), had the following to say during a session on crypto regulations:
I don’t want to express an opinion on XRP, but I think that in determining whether particular tokens are securities, it’s important to remember that it’s a global issue, and one shouldn’t focus on the treatment under one jurisdiction. Different countries have different definitions of securities, and you have to look at it more broadly.
This statement encapsulates the regulatory uncertainty that is present within the digital asset space. Some countries seem to be moving forward with regulations while others, especially the U.S., seem to be lagging behind. However, the issue of whether a particular digital asset is or is not a security extends far beyond the borders of one nation. If digital assets are to be utilized to their fullest, then some sort of global consensus must be reached regarding, at least, the basic foundation of how digital assets should be viewed.
The digital asset space is being restrained from experiencing the rate of growth it would experience if there were a clear regulatory structure in place. Lower Court judgements and statements from individuals, whether they are still in an official capacity or not, are no substitute for a written regulatory framework that is available for review by the crypto community as well as by the lawmakers ultimately responsible for the laws that underpin those regulations.
Finally, U.S. lawmakers need to remember that digital assets are not native only to the U.S. Rather, digital assets are being used in various jurisdictions all over the globe. The U.S. should be willing to step up and help lead the global regulatory effort. By doing so, the digital asset community would begin to feel as if the U.S. is taking more than just a passing interest in digital assets and, instead, can see the potential for the digital asset industry to continue creating efficiencies throughout the current use-cases being explored and for those that developers have yet to conceive.
If regulatory clarity is not found the innovations that could stem from the further development of digital assets will be never be realized due to the fears that exist within the digital asset ecosystem, or, developers will move to those jurisdictions that are encouraging exploration and development of distributed ledger and blockchain technology. Does the U.S. want to lose its lead in the technology arena? Without proper regulatory guidelines—more than just Lower Court judgements and some off-hand statements—we could be looking at that very real possibility. And the cost of this loss will be substantial: loss in innovation, loss in credibility, loss in new business, loss in job creation, and loss in economic growth.
The stakes are high. The U.S. must take the lead in developing a proper regulatory framework for the industry and let the world know that we will be the standard-bearer for technological innovation today and tomorrow.