Understanding the SEC’s Guidance on Digital Tokens: The Hinman Token Standard
- The SEC’s Corporation Finance Director William Hinman has suggested a regulatory framework for digital tokens based on the level of decentralization of the token network.
- A project should meet the standard for decentralization if it is more decentralized than the Bitcoin or Ethereum networks on June 14, 2018.
- Innovators should take comfort that this standard for decentralization, properly understood, is not overly burdensome or unrealistic, and seems to permit projects to have significant, necessary centralized leadership.
- The Blockchain Association urges the SEC and Congress to provide more regulatory certainly in line with this framework.
In order to realize the full potential of the token economy and all of the services it can offer, we need regulatory certainty for digital tokens. We must know when tokens qualify as securities and when they do not so that innovators know which regulatory regime applies. In 2018, the Securities and Exchange Commission (SEC) offered informal guidance on this topic in the form of enforcement activities, statements, and speeches.
The most important statement to date has come from William Hinman, director of the SEC’s Division of Corporation Finance, on June 14, 2018 in a now well-known speech at the Yahoo Finance All Markets Summit. The clearest and most important takeaway from this speech was that bitcoin and ether were not considered securities by the SEC as of that date. It did so because the factual record at the time demonstrated that the networks in which the two tokens function were “sufficiently decentralized.” Others have written extensively about the traditional Howey factors discussed in the Hinman speech, but the factors contributing to decentralization are less well understood.
Token projects can learn from the analysis Hinman applied to bitcoin and ether, with the key learning being quite simple: tokens from a network at least as decentralized as the Bitcoin and Ethereum networks were on June 14, 2018 are not securities. In this post we explore in detail the factual record and what qualities Bitcoin and Ethereum had on June 14, 2018 to understand more specifically what threshold is needed for a network to be “sufficiently decentralized.”
Why decentralization eliminates the need for securities regulations
Securities regulations exist to reduce information asymmetries between the promoter of an investment and investors who are hoping to see a return from the investment. These regulations require expensive disclosures (and middlemen), but these disclosures are necessary because they ensure a fair marketplace. They make sense for debt or equity instruments, but not for currencies (such as the dollar, euro, or even bitcoin), nor for credits to buy software services (from gaming credits to LivePeer tokens) because there is no centralized insider information in the latter cases.
Consider an analogy between buying a share of Google and buying a gold future; in the first case, Larry Page has company-specific information he could trade on unfairly, while, with gold, an extremely “decentralized” market, everyone can access market information. Page, like any CEO or executive team, is sufficiently central to the success or failure of Google, whereas many participants contribute to the supply and demand for gold and thus its market price.
Decentralization is a theme that aligns with the Supreme Court’s Howey Test, announced in a 1946 decision that provides a framework for determining what is an “investment contract.” An investment contract is a term that is included in the definition of a security under securities laws, but itself is not defined in the law. The Howey Test highlights the reliance on the efforts of a small (that is, centralized) group of actors as one component of what qualifies as an investment contract (and therefore a security). A key part of the Howey Test is how much influence a small (that is, centralized) group of actors has on the price of the item in question — the more influence, the more likely it is that a purchase is an investment contract and therefore a security regulated by the SEC.
While decentralization isn’t the only component of the Howey Test, the June 14, 2018 Hinman speech blessed decentralization unequivocally as a process that ensures that tokens offered as securities in initial token sales are no longer securities once the network is sufficiently decentralized. Therefore, according to this best available SEC guidance, if a token network does not rely — or transitions to stop relying — on a small, centralized group of people, tokens on that network are not securities and, therefore, disclosure rules meant to protect investors should no longer apply. We believe this is a thoughtful and reasonable policy.
How decentralized is sufficiently decentralized?
To understand the degree of decentralization needed to be sufficiently decentralized, we must look at the state of the Bitcoin and Ethereum networks as of June 14, 2018. Since the Hinman speech does not set out an exact threshold for sufficient decentralization, we aim to find it here. Of course, the standard itself possibly could be lower than this, but this helps pin down the threshold under current guidance.
The speech outlines a multi-factor test without fleshing out its substance or setting forth the factors that are most important. This is a common approach among regulators, and it gives the SEC flexibility to handle the unexpected and keep learning. Someone reading a list of a dozen factors might reasonably think that the SEC’s standard is scary and impossible to meet. But looking at the standard in the context of the underlying facts reveals that the SEC’s application of the standard is in fact minimal and commonsense, not restrictive.
As you will see in the chart below, as of June 14, 2018, Bitcoin and Ethereum were decentralized in many ways, but they also had considerable centralization and necessary leadership of their projects. In its simplest form, the standard seems to ask whether a token network has some basic level of functionality, whether its governance is more open and distributed than a single centrally-organized team, and whether at least some purchasers are users rather than speculators. This is the Hinman Token Standard.
The SEC cannot arbitrarily apply a lower standard to bitcoin and ether than it would apply to all other tokens, permitting bitcoin and ether to thrive while hobbling all subsequent projects. If the SEC deemed a token more decentralized than bitcoin and ether to be a security, it would be applying its own proposed guidance arbitrarily. The SEC is unlikely to do this, especially after publicly laying out the criteria that bitcoin and ether met.
Of course, this legal standard for decentralization is likely even lower, as the SEC never said that Bitcoin and Ethereum on June 14 were barely “decentralized” enough to pass the “Hinman Token Standard” test. So less decentralized networks may pass as well.
The table below shows our best understanding of the factors Director Hinman laid out and the factual record for bitcoin and ether on June 14, 2018, the day of this seminal speech. The SEC has invited conversation on this important topic, and we believe sharing this analysis publicly with the best minds can only improve our collective thinking.
The Hinman Token Standard should be the foundation of future policy making
We at the Blockchain Association are calling on the SEC to issue more formal guidance — or for Congress to provide the statutory clarity. Without more formal guidance, the SEC can change policy with a rule, or even another speech. This uncertainty has a stifling effect on investment, and we are already seeing innovative projects moving overseas to try to avoid regulatory uncertainty. Investors, entrepreneurs, and innovators need certainty to pursue the full potential of open blockchain technology.
In the meantime, developers of open source, public blockchain networks and those in the community that help foster their development should work with counsel to understand that the announced Hinman Token Standard likely has not set an impossibly or unreasonably high standard for decentralization. Open-source and cryptocurrency projects often need or choose to have some centralized leadership, and at times considerable centralized leadership on their path to decentralization. As demonstrated by both bitcoin and ether, the Hinman guidance has established that having some level of centralized leadership will not condemn a token to being classified as a security on that basis alone.
This post does not constitute legal advice and should not be relied on by any person. It is designed for general informational purposes. Developers, purchasers, investors, and any other participant in a token system should consult their own counsel.