Originally published in the Legal Executive Institute.
By Joseph Raczynski
One of the most contentious debates in the cryptocurrency world surrounds classification of blockchain-based digital assets, tokens and cryptocurrencies. A panel at the recent Thomson Reuters Regulation of Financial Services Conference discussing the basics of cryptocurrenciesexamined this argument. With more than 1,650 cryptocurrencies or tokens trading in the public domain, it is important to understand their nuanced differences.
Dominating this conversation in the United States is whether specific coins are securities, and secondly, if a utility token can exist. In addressing the first part, the US Securities and Exchange Commission (SEC) recently shed some light by declaring both Bitcoin and Ethereum non-securities. This assertion defines that there is no expectation of equity or return on any investment in these virtual currencies. The overarching belief had held that Bitcoin is a currency and thus a competitor to the US Dollar or Euro; and Ethereum is more complicated.
The original intent behind Ethereum was that it supported smart contracts by using their blockchain token called Ether or ETH. In this case, a token stands as a digitized tool to perform a service, similar to those physical token coins used in some video game arcades or laundromats. In this digitized version, the Ethereum platform was intended to perform a service and store more complex, automated, yet immutable code on their blockchain (for example, storing a contract on the blockchain that dictates a sell order if the stock of Amazon reaches $2,000 per share on January 1, 2020).
What differentiates Ethereum from Bitcoin is that the token ETH is used to upload and save that smart contract to a blockchain using “gas”, basically the payment of ETH for each transaction. Therefore, many argue that ETH is a “utility token”, performing a service, i.e. saving that contract to the blockchain. What complicates this is that many start-up tech companies are using Initial Coin Offerings (ICOs) on the Ethereum platform to launch crowd-funding campaigns and raising money. The complication — raising money in this form — have some regulators and industry watchers arguing that these ICOs are more like securities, similar to stocks, even if they are sitting atop of the Ethereum token-based platform rather than on a stock exchange.
Now, a hybrid product that is emerging quickly is the tokenized security. Recently at Consensus in New York City, a company called Polymath created a platform for anyone who wishes to raise money for their company quickly can do so by issuing tokenized securities. The primary difference with this model is that the issuer is offering shares or portions of ownership of the company. There is also a belief that these types of securities will eventually adhere to SEC regulation, which is yet to be determined. What drives the regulatory discussion is a 1946 Supreme Court ruling now called the Howey Test, which determine if something is a security or not. The tenets of the Howey Test 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
For a token to be considered a security, each of the above must be true. The primary point of contention is around point four, “Any profit comes from the efforts of a promoter or third party”. This aspect is typically out of the hands of the investor and not something they can control. When these tokens are launched on third-party exchanges, this falls outside of that individual investors domain, and for many, nullifies the Howey Test.
Or as Ash Bennington of CoinDesk phrased it:
A long time ago, someone named Howey owned an orange grove.
Howey said: “I’ve got this orange grove and I’ve got no way to make money out of it — because I need money to make money.”
Tell you what. I’m going to sell you this orange grove and, in exchange, you get whatever profits are made from that little plot.
I’ll work the land. I’m going to pick the oranges. I’m going to squeeze the juice. You just pay me the money.
The plaintiffs said: “That’s a security.”
The SEC said: “That’s a security.”
Howey said: ‘No, no. That’s just selling plots of oranges.”
Ultimately, the Supreme Court said: “That’s a security” – because it passed this test: There was an investment of money. And a common enterprise. With the expectation of profit, primarily from the efforts of others.
Governments around the world are grappling with the classification of cryptocurrencies in what should become a multi-trillion-dollar industry within the next decade. With so much at stake for everyone from the garage startups to the Morgan Stanleys of the world, some regulation is inevitable. Most are merely hoping for clarity, not confines, which could hurt the innovation stemming from the once-a-generation revolutionary platform technology called blockchain.