What Makes a Cryptocurrency Token a Security, Why It’s Really Bad to Be Classified as One, and How to Avoid It

With the recent Telegram injunction, the SEC has made it very clear that it’s going to be as aggressive as it can be in categorizing cryptocurrency tokens as securities. But what does it even mean for a token to be a security, and is it a bad thing? For that matter, is Libra a security? Is Filecoin a security? Is Celo Gold a security? Will Telegram be classified as a security when all is said and done? In this post, I’m going to cover what makes a token a security according to the SEC, why it’s a really bad thing, and how to avoid it. This will set us up to discuss the specifics of Telegram, Libra, Filecoin, Celo, and others in my next post.

What’s the Point of the SEC?

A security is a “thing” that’s regulated by the SEC (the Securities and Exchange commission). Therefore, to understand what makes something a security, it’s important to understand why the SEC exists in the first place and what it’s trying to do when it regulates something.

In the 1930’s, in the midst of the Great Depression, markets crashed and liquidity dried up to the point where nobody was willing to invest in anything for fear that prices would continue to decline. Fearing the perpetuation of a downward spiral, Congress enacted the Securities Act of 1933 to restore public faith in markets by requiring uniform disclosures for public companies, among other things. This act also created the SEC, with the following mandates:

1. Restore investor confidence in the market.
2. Eliminate fraud and insider trading.
3. Establish a registration system for securities.

The last one is the most relevant to our discussion. Basically, with the creation of the SEC, anything that was classified as a “security” would be under their jurisdiction, and retail investors wouldn’t be allowed to trade it without it being “registered,” in other words “approved,” by the SEC.

The goal of this was to give investors confidence that the things they were trading weren’t scams or frauds. So did it work?

Well, the depression lasted another twenty years, only abating with the onset of WWII, and since then we’ve had plenty of market crashes that the SEC’s presence did little to mitigate. Moreover, if one were to consult an economist today on the best way to restore confidence in markets in the wake of a financial melt-down, their first answer would almost certainly be to lower interest rates, not increase reporting requirements on companies or create frictions in an otherwise liquid market. Given this, one has to wonder: Why did Congress decide to create the SEC in the wake of the depression rather than respond with the now-obvious answer of expanding the money supply? My honest answer is, “because they had a misguided understanding of monetary policy,” but that’s an argument for another time…

The point is that the SEC exists now, and its goal is to put a relatively high bar on companies before the investing public is allowed to trade them. Think of them as the bouncer at a nightclub, only the nightclub is the stock exchange and the bouncer doesn’t really want to let anyone in because he thinks it’s already too rowdy in there.

What Makes Something a Security?

So if the SEC’s job is to regulate the things investors trade with each other, what determines whether something falls under the SEC’s jurisdiction? Interestingly, the answer to this question didn’t become particularly clear until ~1945, ten years after the SEC was established, when a landmark court case introduced the Howey test. This test states that something is a security if it is:

• an investment of money into a common enterprise with the expectation of profit due to the efforts of a promoter

So anything that satisfies all four of the bolded prongs above is something the SEC will want to regulate, which means you’ll have to get their approval if you want to list it or have people trade it.

For example, the SEC ruled that Bitcoin and Ethereum weren’t securities because they w̶e̶r̶e̶ ̶t̶o̶o̶ ̶p̶o̶p̶u̶l̶a̶r̶ ̶t̶o̶ ̶d̶e̶-̶l̶i̶s̶t̶ were “decentralized enough” to allow them to win the argument that they don’t satisfy the “promoter” prong of the Howey test anymore. However, if a token does have an identifiable promoter or “issuer” at some point, and if the other three prongs are satisfied, then the SEC could technically come after that promoter if the tokens start trading among retail investors without their approval.

Generally, it seems as though the SEC has given all tokens listed before 2019 a pass and instead has been focusing its efforts on projects that raised money with a centralized entity but have not launched yet, with Telegram being arguably the most prominent recent example, followed by Libra, Filecoin, Celo, etc… And although it has allowed a fair number of cryptocurrencies to be grandfathered in before this point, it seems likely that the SEC will be pursuing unlaunched cryptocurrencies very aggressively and adversarially going forward. This means that even a relatively weak argument that a project has a centralized promoter will be used against it to classify it as a security (as we’ve arguably seen the court do with Telegram). I would even go so far as to say that any centralized entity that has raised money from investors to launch a cryptocurrency token is likely to have that token classified as a security by the SEC if it hasn’t launched yet, but I will make the argument behind why this is the case in my next post when I dissect the Telegram injunction.

Why Is It Really Bad for a Cryptocurrency to Be a Security?

Simply put, if something is classified as a security because it satisfies the Howey test, then a lot of really bad things happen:

• It can’t trade among retail investors until it’s approved by the SEC, and even then it has to comply with a litany of nearly-hundred-year-old reporting requirements that are very difficult for a cryptocurrency to meet. The bright side is that, because the SEC isn’t a fan of crypto, you’ll probably never have to worry about those reporting requirements because it’ll probably never get approved. This means the answer to “when binance” is basically “uh.. never” if your token is a security.
• When something is classified as a security, the centralized entity that gets tied to it as the “issuer” (aka promoter) is liable to be sued if people lose money for various reasons. The legal liability foisted onto this “issuer” also makes a transition to a “decentralized” cryptocurrency very difficult. Specifically, nothing has ever been formally classified as a security and then transitioned to not being one, and it is unclear whether it’s possible without breaking some laws during the transition, for which the issuer will be liable.
• If something is a security it generally also has to do KYC/AML checks on everyone, which basically compromises user privacy, and further complicates the ability to become decentralized in the long run.
• Aside from being subject to nearly a hundred years of red tape from the securities side, other regulators will likely take an interest in you if you raise your hand as a security, such as the OCC, which regulates banks, who by the way will probably hate you, and the IRS, which… well, you know.

So, is it technically possible to make a crypto project work if it gets classified as a security? Technically, maybe? But the reality is that if your cryptocurrency token gets classified as a security then you will have hoards of regulators who don’t want you to exist questioning you adversarially at every turn, which makes your odds pretty bad (see Libra).

So What Can You Do to Avoid Securities Status?

Given the litany of issues associated with being classified as a security, it seems critical to ensure that one’s token is never classified as a security at any point during the project’s life-cycle. This is more difficult than it seems, however, because if there’s any whiff of a centralized entity supporting the network, even before it’s launched, then the SEC can argue that that entity is a promoter and that the whole thing is a securities “scheme” (that’s literally the technical term they use to “non-disparagingly” describe something that’s trying and failing to pretend it’s not a security). So forget about forming a company and raising money for your project — your only real shot at avoiding the death-knell of securities status going forward is a completely anonymous launch of your cryptocurrency after you’ve fully developed it on your own dime.

Perhaps if the SEC’s leadership changes in the future, this won’t be the case. But with the recent Telegram injunction, which I’ll be covering in detail in my next post, the current SEC leadership seems to have made it abundantly clear that it will look for any shred of a promoter it can to aggressively regulate an unlaunched cryptocurrency as a security.

But… Launching Anonymously Without Raising Money Seems Hard

Well, Bitcoin did it, and so did the Ultranet, the first blockchain marketplace. Is it difficult toiling away for years alone without any funding developing something? Yes. Is it difficult launching the thing you’ve spent years toiling on without any social proof behind it just hoping that someone will see its value for what it is? Yes, it’s even worse. So why even do it?

Because someone has to. Because if Satoshi didn’t create Bitcoin, the unchecked power of the banks would have evolved into unchecked oppression. And because, I believe, if I didn’t create the Ultranet as the only marketplace where orders are end-to-end encrypted and your listings can’t be censored, then the platform oligarchy consisting of Amazon, Alibaba, Google, Baidu, Facebook, WeChat, etc… would come to control virtually everything we see, everything we hear, and, ultimately, what we can and can’t do with our lives.

Because centralized power needs a check, and we shouldn’t let status-quo-preserving hundred-year-old legal frameworks stop us from providing that check.