Aside from the State and FinCen regulations concerning digital assets and cryptocurrencies, various federal agencies also have regulations that affect the industry as a whole. These agencies include the IRS, the CFTC, and the SEC. IRS specifies the taxes related to digital assets and cryptocurrencies. Whereas CFTC has oversight related to the derivatives built around crypto. While the Securities and Exchange Commission (SEC) has the power to regulate all types of assets deemed a security, including digital assets. This article offers an overview of the Securities and Exchange Commission’s stance on cryptocurrencies and initial coin offerings. It also discusses the cryptocurrency Exchange Traded Funds (ETF).
The Securities and Exchange Commission is a federal agency in the US that enforces various regulations and rules designed to protect investors from manipulation in the securities markets. This means that issuers of securities, as well as financial services firms and their professionals, must be registered with the SEC. Securities regulation is generally focused on the ownership of securities. This includes many types of instruments such as bonds, stocks, and investment contracts. When it comes to Cryptocurrencies, the SEC has a critical determination to make. If a Cryptocurrency is considered to be an investment contract security, therefore it is a security and must be registered with the SEC or exempted from registration.
The Howey testing and crypto
The SEC has issued guidance on the Howey test, which is a standard that determines if an asset is an investment contract. It is a three-part test that includes the following components: an investment of money; a common enterprise; and a reasonable expectation of profit obtained from entrepreneurial or managerial work. It is used by the Supreme Court to identify that an investment contract exists. If an asset does not meet these three criteria of the Howey test, then it is not considered an investment contract and hence, not a security. The SEC has clarified that, while neither bitcoin nor ether is determined as securities under the Howey test, but also mentioned that in case a digital asset is considered an investment contract at a specific time is unique to both the asset and circumstances at which it is being sold or resold. If the Howey Test parts are all met, then they are still subject to the same rules when it comes to registration and or SEC exemption.
The payment method has to be accepted with a different cryptocurrency or a fiat currency. This satisfies the first condition of the Howey test. The second prong can be satisfied by two or more investors, by pooling their contributions, or by having a common interest in a third party that is tied to the investor’s success. The third way to meet the second prong is by establishing a vertical commonality. This concept is best achieved by establishing a common interest between an investor and a third party and sharing the profits. If the asset, its investors’ fund, or the control over it is not held by a central entity, or there is not one person to whom the success of the asset can be tied to, then the Howey Test is not met. The third prong is the expectation of profit. It refers to the holder’s rights to profit from the issuer’s income and profits or to achieve gain from the price increase of the asset. Promoters’ or issuers’ statements can lead to investors expecting a profit. The increase in the value of an asset is more likely to be achieved by an identifiable third party if it is derived from the efforts of a third party. Then this test is more likely to satisfy if the increase is from a general market change or if the developers have launched a digital asset. So when the developers play a crucial role in the maintenance and growth of digital assets, the third prong will be satisfied. The success of a commodity purchase depends on the general market conditions not on individuals’ efforts and will not meet the last prong.
Bitcoin is not a security because it doesn’t meet the Howey Test. Although it satisfies the first prong of the test because it is an investor offering money for the asset, bitcoin. Note that the second and third conditions of the Howey Test are not met by purchasing bitcoin. Bitcoin does not have a horizontal or vertical commonality because each investor has their own set of rules and regulations when it comes to buying digital currency. Also, it does not have a third party that controls the investor’s success when dealing with the purchase of bitcoin. Also, the success of an individual investor condition is not satisfied because the price of bitcoin is tied to the market price of bitcoin, and not the efforts of others. This is because there is no such common enterprise that all of the investors are participating in.
A digital asset can have its status as an investment contract changed over time. For instance, Ethereum was first launched with an investment of money (an investor purchased ether with bitcoin). It was launched in a common enterprise (all the ether was sold from one entity, ethereum.org). It was expected to be profitable (with the price of Ether set from the pre-sale going up after the first two weeks of purchase) and the profits were actually dependent on others (investors trusted Ethereum developers to use the bitcoin to develop Ethereum). Since its launch, ether has been sold through an entity and satisfied Howey’s test. But instead of being exchanged, it was obtained through mining, similar to bitcoin. In 2018, William Hinman, the Director of the SEC’s Division of Corporation Finance, stated that despite the changes in the Ethereum network’s structure, current offerings and sales of Ether are not securities transactions. Changing a crypto’s designation can happen quite often and affects its classification as a security. For instance, Ethereum 2.0 might be considered a security given that Ethereum is transitioning from a mining network to a cryptocurrency staking system. However, there has been no definite statement from the SEC regarding this change.
Initial Coin Offerings
Initial coin offerings are a type of crowdfunding that a company can use to raise funds. The coin can be a part of a company’s stake or a specific project, or it can serve as a utility for the company or its offerings. The Securities and Exchange Commission has classified ICOs as securities, which means that they could be considered an investment contract. And this is because tokens offered represent a monetary investment in a common enterprise that has a reasonable expectation of profits. The SEC has found that digital assets are typically more prone to security concerns if the promoter is responsible for the continuous development and operation of the project. Then there is a higher possibility of identifying the ICO as a security. An ICO is also considered a security if the promoter controls or issues a coin or acts to limit the supply of coins. The SEC has pursued over 70 actions against unregistered ICOs since 2013. These actions are mainly against individuals and entities.
A security that tracks an index or asset-backed security is known as an ETF, and it can be bought and sold on a stock exchange similar to other stocks. And as a security, the SEC has the ability to regulate ETFs. In the last few months, there have been growing concerns as to whether or when the SEC will confirm a crypto ETF, mainly a Bitcoin ETF.
Over a dozen applications have been submitted to the US Securities and Exchange Commission for Bitcoin and Ethereum exchange-traded funds. There have also been a few applications for Ethereum.
The SEC staff letter stated that the agency had identified several issues that would prevent an exchange-traded fund from being approved. These issues included the valuation of the ETF assets, the liquidity of the assets, and the custody of the assets, arbitrage between the ETF price and its net asset value, and potential manipulation.
According to SEC Commissioner Hester Peirce, the prior justification for not approving a Bitcoin exchange-traded fund is getting weaker. She also noted that if the same requirements were applied to other products, at least one Bitcoin ETF fund would have been approved. Gary Gensler, the chairman of the SEC, has expressed his concerns regarding the lack of regulation for the cryptocurrencies exchanges. This issue is expected to be resolved this year or more.
The rules indicating whether an asset is a security are very technical and are often very specific. If you are planning on entering the Cryptocurrency market or even if you already have an existing business in this field, then it is important to determine if you will need to register or do an exemption to avoid getting caught in the SEC’s regulations. If you fail to register with the SEC, the agency can issue a costly and problematic action. The regulations concerning Cryptocurrencies and digital tokens are always subject to changes especially when it comes to whether it will approve an ETF. This week, Chairman Gensler talked about the various aspects of regulation for digital tokens and other cryptocurrencies.