Blockchain: Worldwide Regulations and Case Studies Series #1
Hi friends! 👯♀️ My name is Elif Hilal! I produce content in the fields of blockchain, software, smart contracts, and law. If you are reading my articles for the first time, welcome to my world 🙂
🐝 Since this will be a long series and there are so many things I want to convey, I made this article a series. Thus, instead of reading everything in just one article, I summarized what I know in several different articles. You are reading the first article of the series right now, but don’t forget that there are 3 more articles to follow 🤍🤍
First of all, I would like to list the main topics that you will see and learn in this article.
- Developments from the World
- Token & Coin Separation
- Token
- Coin
- Token Types
- SEC and Howey Test
Now, before we get to the long part, there are (as you might guess) some concepts and situations to know about blockchain and web3. For example, some of these concepts are as follows:
It will not be time to describe them all in this article. However, what kind of directive or legislation has been published, how important institutions react to these concepts, etc. we will see 💥
📌If you are ready, I want to start with a few developments:
Developments from the World!
In the most general context, I have summarized the developments in crypto assets from around the world with a picture, let me share it with you right away.
The European Union Banking Authority (EBA) released a Crypto Asset Report in 2019. According to this report, EBA evaluated crypto assets in 3 different categories:
- payment
- swap
- currency unit
Later, they added 2 more categories to this classification:
- crypto assets with investment properties
- crypto assets that provide rights/benefits to the user
Later, the draft of European Union, -Markets in Crypto Asset Regulation- was published as a draft in September 2020, according to this draft, crypto assets were classified in 3 different ways:
- Asset-referenced tokens
- E-money tokens
- Utility tokens
After these classifications, in July 2020, American national banks were allowed to store crypto assets by the The Office of the Comptroller of the Currency (OCC)
Why are these classifications important?
Because, according to international regulations, first of all, the class of crypto assets should be determined and processed accordingly. As we will see later in the article, the obligations that coins and tokens are subject to are not the same. Tokens are already a HUGE framework on their own. There are dozens of different tokens. I will explain them all in order, don’t worry 🙂🍀
TOKEN & COIN!
From here on out, I want you to read what I wrote much more carefully, dear readers. Because, as I said above, when a classification is required, the most common issue, even in regulation studies, is the classification of the asset in question. When the crypto asset is a token or a coin, different paths are followed. That’s why it’s really important to know this distinction.
As it can be understood from this title, Token and Coin expressions are different concepts from each other. They belong to different classification. They may show common features, but they are DIFFERENT.
I will show you a small classification with an image, but the diversity in this list is increasing day by day, so I want you to know that it is not limited to just that.
Blockchain technology, which we keep talking about, is a huge universal cluster. When we look at this set, we encounter too many subsets. Tokens and Coins can also be expressed as two separate subsets of this set.
Although these two terms are sometimes used interchangeably, it is important to remember that they are different in meaning and functionality.
TOKEN ⛱
In the simplest and most concise terms, the concept of Token also appears as Jeton. So what exactly do we mean?
- Digital crypto assets representing a certain value or utility on a blockchain
- A digital tool created by blockchain technology
- Some kind of crypto asset
- Transferable digital properties on the blockchain
It is possible to add many more definitions to this list, but it is important to understand the gist here. The important thing is to understand what it does and what it is used for 📘
Now, besides the above, I will introduce a technical definition. Then it will be very easy for you to grasp the distinction between coins and tokens.
Token is a crypto asset that does not have any Blockchain infrastructure of its own and therefore uses the Blockchain of another Coin (existing on another chain).
There is also the purpose of use, of course, here we will learn the concept of Whitepaper. The explanatory report, which is expected to write the features of this token by the entrepreneurs who make a Token project using blockchain technology, is called a Whitepaper. (It also has an incredible importance in regulations).
The extent to which the Token is used is specified in the Whitepaper where the issuer (producer) of the Token is introduced.
In other words, details such as the function, usage functions, content, roadmap, supply, use cases of any token should be explained and written by the founder of the token project in the Whitepaper.
Let me tell you about the importance of this, for the buyers of the token, trust is required. Why do people invest? Because they trust the project and the future of the project. One of the best ways to ensure this is to take the whitepaper seriously and write it honestly. Especially for buyers and investors, the reliability and honesty of the project are important.
(Do your own research!! Don’t be influenced by popular people’s or popular investors’ recommendations, open and read the whitepaper 🎀)
COIN ⛱
You will remember this concept from Bitcoin. The words Coin and Token are used for very similar meanings. I explained the main difference above. Crypto assets traded on their own blockchain are coins. How is Coin defined?💻
- Digital representation of value that can be used as a payment method
- Currency-like digital value with its own blockchain
- Crypto assets produced with a cryptographic encryption method and have purchasing power
While the token exists on another blockchain (eg Ethereum) Coins have their own chains.
After the first cryptocurrency and crypto asset bitcoin emerged, thousands of projects emerged. Some as tokens, some as coins. These crypto assets that have different functions and duties after Bitcoin are called altcoins (alternatives).
Token Types⛱
- Usage Token
- NFT Token
- Community Token
- Equity Token
- Work Token
- Asset Token
- Utility Token
- Security Token
- .
- .
- ..
The Security Token is a type of token that will appear continuously from now on and can be separated more easily from the others in terms of regulation. Because thanks to the SEC and Howey testing, it is easy to detect. The SEC defines whether an asset is a security token by asking only 4 questions 🙂 On the other hand, the security token constantly appears in lawsuits as it is considered to be real money/stock.
🍊 Howey Test and SEC 🍊
And we come to the most important issue. I’m sure you’ve heard of the SEC before, especially from the Ripple (XRP) lawsuit or dozens of other major lawsuits.
SEC: United States Securities and Exchange Commission. The Digital Assets Framework, the SEC’s long-awaited guide to blockchain projects, is only eleven pages and has been written using plain English to make it user-friendly and accessible. In this article, I would like to talk about the content of this framework, the decisions of the SEC, and most importantly how the Howey Test is used to find security tokens.
The Howey test, named after William Howey, who was sued by the SEC in 1946, appears as a Regulation that sheds light on the ICO and web3 ecosystem.
Pursuant to Section 2(a)(1) of the Securities Act of 1933, securities such as stock exchanges, notes, books, debentures, and stocks that qualify as “investment contracts” shall mean all securities (produced, invested, sold. .) must register with the Securities and Exchange Commission (SEC) in the US.
We will now use the above information.
Howey was a citrus magnate. In addition to large orange groves in Florida, guests had a hotel in the area where they drank a lot of orange juice. Guests would receive a glass of orange juice upon check-in. In addition, clients had the opportunity to invest in some of Howey’s orange groves.
If you bought a “share” in the orange groves, Howey’s workers would tend the orange trees, pick the oranges and sell the produce. They claimed that as the price of oranges skyrocketed, the land would become more and more valuable, so customers began to see it as a great long-term investment. However, no client has mentioned this to the SEC or gone and informed about this investment.
On the one hand, this seemed reasonable. People always invest in real estate with the expectation that it will increase in value, right? On the other hand, something looked suspicious! Like the promise of future profits and the fact that they offer customers nothing but orange juice?
Clients were sued by the SEC for circumventing the law by not recording a securities registration notice. The Supreme Court, in making a choice, stated that the plaintiffs’ understanding of renting back the orange grove was a form of agreement. Thus, the Supreme Court created a landmark test to decide whether exchanges are investment contracts that are subject to securities registration requirements.
The Howey test was first introduced in 1946 in the Supreme Court, SEC v. W.J.Howey Co. was the subject of the case. And it has continued to be used ever since.
The Howey test says that an “investment (stock) contract” exists if these conditions exist:
The SEC’s framework has eight pages on what you can’t do, but it also has two pages on what you can do (with perhaps, possibly, a lot of caveats). In fact, the SEC is an institution that wants to protect investors. The reason why they examine and research so much is that they do not want their investments/investors to be harmed.
There was a section above when I told you about tokens, and whitepapers! Especially during the ICO process, the SEC spends serious time on projects and examines which project aims for what.
For example, whitepapers have a very important aspect. This is exactly what we call “information asymmetry”. In other words, the SEC examines whether the planning specified in the whitepaper and the timeline of the project in real life are compatible.
For example, if investors and managers are making reports to hide their massive losses, that’s a problem.
For example, I would like to explain this information-asymmetry issue by giving a great example. Roadmaps are shared to eliminate hesitations and build trust while starting and progressing the ICO process.
There was a project in the past, it appeared in the USA. This project, called ReCoin, is an ICO that has also been reviewed by the SEC. During the creation of the ReCoin project and during the ICO, ReCoin Group Foundation and DRC World (Diamond Reserve Club) made a statement about the project, “ReCoin TOKEN IS AN ASSET BASED ON A DIAMOND/PROPERTY”. And in the content of the whitepaper, it is written that the project owners consist of professional lawyers and investors. An investigation by the SEC found that there was no such attorney or investor. Thus, the statements were refuted.
Is there a downside to ignoring the SEC?
There are two major categories of enforcement action:
- The SEC has the power to seize (almost) all ICO funding. Examines ICO processes and crypto projects. And if there is an error or if they are not informed, they take a significant percentage from the project.
- Or the SEC seizes a single-digit percentage of ICO funding.
Examples where almost all of the ICO funding has been seized by the SEC:
- Telegram, a non-US company, had to return all of its $1.2 billion to its investors who participated in its ICO and pay the SEC an $18.5 fine on top of that. That money was confiscated, despite Hester Peirce, one of five SEC commissioners who did not support SEC enforcement action.
- BitClave had to pay all of the $25.5 million it raised in its ICO + $3.4 million in interest + $400,000 in fines.
- Unikrn paid a fine of $6.1 million, all assets of the company. And this was nonetheless taken despite the words of Commissioner Hester Peirce, “I disagree with my colleagues’ view that Unikrn’s token offering constitutes a security offering.”
- Others, like ParagonCoin, again had to pay some fines for legal fees in fighting SEC enforcement action.
Now that you are familiar with the SEC, let’s take a look at the various token offerings and their associated SEC risks.
If you are one of the cryptocurrencies shown in the image below, or if you are confident enough that your token will not be classified as a security (for example, using the Crypto Rating Council’s Scorecard), you are fine, no problem. But that’s the way you have to go. Answering the 4 Howey test questions above and making sure your ICO is successful.
As the previous SEC chairman and current SEC chairman have pointed out, they view many ICOs as securities offerings. IEO’s are only ICOs on exchanges and IDOs are only ICOs on DEXs, so they all carry the same regulatory risk in the eyes of the SEC.
INOs (Initial NFT Offerings)
To be honest, modern NFTs looked more like art or products to me than securities. However, this does NOT mean that many of them will not be considered securities in the future. The SEC is spending a lot of time and effort on this right now ✌🏻
I say this because the SEC seems to be trying to have as broad coverage as possible for NFTs, airdrops, and ICOs…. If I were an ordinary person who hadn’t looked at the SEC, I would say NFTs are clearly not securities. However, the SEC is being very meticulous about this and we may soon see some NFTs on the SEC’s radar as well.
What would be a sensible approach?
1- Just make your INO
2- To follow the SEC
3- If the SEC shows that they think NFTs are securities, you should report yourself to them.
That’s exactly what Gladius Network did with their ICO and they were never fined because they went and reported themselves🐝
Now this series has an additional 4 articles, and I am writing them. See you in my other articles🤍🍀
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