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Why Cryptocurrencies and Tokens Are Securities

 8 min read / 

“We are the Investor’s Advocate” are the first words visible to visitors on the Securities and Exchange Commission (SEC) websiteThe revered and feared SEC is an independent agency of the United States federal government. It is controlled by a commission and its chairman and, importantly, is not under direct control of the executive branch.

While the SEC is constitutionally part of the executive, the US President has limited power over the agency and only statutes passed by Congress officially define the purpose of the SEC. This system grants the SEC the primary and exclusive responsibility for proposing, amending, and enforcing securities laws and regulating the securities industry. As a result, all proposed laws and statute changes must pass through several committees and sub-committees before reaching Congress to be enacted into law.

Ambiguity in the Crypto Sphere

In the field of ICOs and cryptocurrencies, this process is problematic because only the SEC can change the definition and criteria of what constitutes a security. Currently, the SEC is undecided about their approach to ICOs, tokens and crypto markets. So far their focus has been on the entire cryptocurrency industry. ICOs as a separate concept is mostly unaccounted for, as financial records are limited to the total amount raised and the total number of ICOs to-date.

SEC Chairman Jay Clayton recently stated that 99% of ICOs qualify as securities because of the ability to trade “utility tokens” on the secondary market, enabling investors to make a profit.

The reasoning applied here is based on the concept of the Howey test, used to establish whether a product qualifies as a security. This might not be the best approach, as strictly speaking, according to the Howey test rule, all current ICOs are breaking the law and should be shut down. Indeed, many ICOs and exchanges have been hit with lawsuits and “cease-and-desist” notices at the state and federal level. All the while, many trading platforms and exchanges have scrambled to obtain SEC authorisation and become fully compliant with the respective SEC rules and regulations which is a positive development.

Towards A Digital Securities Commission 

New securities call for new rules. All digital assets – coins, tokens and copyrights – are made to be stored or traded for profit and therefore should be classed as “digital securities” and regulated accordingly.

Leaving digital assets in the “grey zone” is absolutely and positively the wrong approach and misguides unwitting investors and market participants. As soon as all digital assets are classified as securities, exceptions can be made for “utility tokens” that are used in an ecosystem or community for the sole purpose of serving and benefitting its participants. This would include such examples as book tokens in a book club or membership tokens to a community.

The Need for a New Agency

Clearly defining the characteristics and criteria for “digital securities” will be the first step towards successful digital
asset regulation. Considering the vast market cap of all digital assets, it might be worthwhile – or even necessary – to create an entirely new federal agency that keeps up-to-date on developments in the crypto sphere and has the resources to regulate the entire digital asset industry.

 A fully functional “Digital Securities Commission” would likely face resistance from the SEC and other federal and
state agencies, but in the long run would benefit the government, the financial industry and all market participants.
 

Federal Law and Global Compliance

The biggest challenge for the SEC will be to address the decentralised and borderless nature of cryptocurrencies and, by extension, ICOs and all digital assets.

This is a fundamental problem because the SEC can only exert its authority within the confines of its borders. As soon as a digital asset or security is moved and stored outside US borders and jurisdiction, the SEC can no longer control or regulate that security, financial instrument or digital asset. What makes this task even more difficult is that digital securities can be moved across borders and jurisdictions quickly and are only tracked by distributed ledger technology.

In the current financial system, criminals can move digital assets in the form of cryptocurrency across borders using the dark web and other law-evading networks with minimal traceability which makes compliance and law enforcement more difficult rather than easier.

By taking advantage of blockchain technology, the SEC and other law enforcement agencies could keep better track of digital asset movements, ensuring regulatory and legal compliance.

In the meantime, the SEC has taken the first and decisive step by appointing a new Crypto Czar. Having been with the SEC since 1997, Ms Valerie Szczepanik is a seasoned attorney who will be in charge of SEC oversight of cryptocurrency coins and tokens as “senior advisor for digital assets and innovation”.

In a statement released by the SEC, Ms Szczepanik – who led its distributed ledger working group –– will “coordinate efforts across all SEC Divisions and Offices regarding the application of U.S. securities laws to emerging digital asset technologies and innovations, including initial coin offerings and cryptocurrencies.” Her stance on ICOs is pretty straightforward and considered positive news in the ICO industry:

“ICOs are a relatively cheap and frictionless way to raise a whole lot of money with a liquid secondary market,” said Szczepanik at the SINET Innovation Summit in New York.

Tackling the subject of cryptocurrencies and tokens is already a challenge because the various federal agencies don’t agree on the definition of a coin or token.

Shortly before Szczepanik spoke, a separate gathering of regulators—representing the SEC, CFTC and FINRA—addressed the topic at a blockchain summit at the New York City Bar Association.

In the course of the event, the moderator pointed out how different regulators don’t even use the same language to define digital tokens.

In the words of the event moderator:

“The SEC says they’re securities, the CFTC says they’re properties, FinCen says they’re currency, and the IRS says they’re property.”

Furthermore, David McGill, an attorney at the firm Kobre & Kim, pointed out that it is illogical for cryptocurrencies and tokens to be defined by the IRS as “property” when these financial instruments have all the characteristics and attributes of a security that can be traded on the financial markets.

Now that the SEC has made a decisive move in the right direction, it is expected that crypto regulation will soon be enacted and passed at the federal level with one crucial provision that all owners, custodians and exchanges must disclose all digital asset holdings. This will then ensure that all tokens within the United States are accounted for and that non disclosure or concealment is punishable by federal and/or state law.

A comprehensive and clearly-defined federal law would be a game-changer in the financial industry as a whole and, in due time, could be the catalyst for global compliance.

A New Universe of Digital Assets on Blockchain

Classifying cryptocurrencies and tokens as “digital securities” to be disclosed according to the clearly defined criteria of “digital assets”, and removing any ambiguity about ICOs, cryptocurrencies and copyrights should be the focus of the SEC in the near future.

While those steps might go against the true essence of the decentralised nature of cryptocurrencies, they should remove most – if not all – of the illegal and criminal components of cryptocurrency transactions.

Regulating tokens and digital assets on a global level would legitimise and benefit the entire cryptocurrency industry by increasing investor confidence, exponentially increasing adoption into the mainstream global economy and potentially reducing market volatility.

Clearly-defined rules and regulations in relation to digital assets would then pave the way for fair business practices and the inclusion of all market participants, from retail investors to professional stockbrokers, levelling the playing field in the industry. By doing so, the SEC would open up a new world for digital asset trading and investment.

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