Are Cryptocurrencies and Tokens Securities? The Basics.
If you’ve been following cryptocurrencies and tokens in the news, you’ve probably heard about people getting in trouble with the Securities and Exchange Commission. Most recently it’s been the Munchee initial coin offering (ICO), which the SEC shut down earlier this month. Before that it was Canadians Dominic Lacroix and Sabrina Paradis-Royer for their involvement in PlexCoin. Before PlexCoint it was Maksim Zaslavskiy and his real estate and diamond backed tokens, REcoin and Diamond Reserve Club. And of course, the one that started it all, the DAO Organization and its much-publicized hack and eventual implosion.
But with the skyrocketing number of ICOs and players entering the marketplace, the SEC has indicated their intent to take a more hands-on approach. They are clearly watching this cryptocurrency experiment very closely and tamping down on the worst actors. In a recent statement, SEC Chairman Clayton, warned that the majority of ICOs implicate a sale of securities and are subject to federal securities laws. While the SEC has been relatively taciturn, they have given us a few useful insights into how cryptocurrencies might fit into the securities laws. For many though, both neophytes and insiders alike, there is still a lot of uncertainty around what makes a cryptocurrency or token a security in the first place.
As it turns out, the SEC is approaching cryptocurrencies and tokens the same way it’s been approaching hard to classify financial products for decades. By learning the basics of what constitutes a security, we can begin to formulate a general framework for thinking about cryptocurrencies and tokens.
The test for whether a cryptocurrency or token is a security has four-parts. There has to be (1) and investment of money, (2) in a common enterprise, (3) with an expectation of profit, (4) based solely on the efforts of others.
The test seems straight forward, right? For some cryptocurrencies or tokens, it is. Take the DAO Token for example. Here was a token that pooled money from token sales and deployed it in various investments. Token holders were rewarded with profits from those investments. This passes the test with ease. Here’s the breakdown: (1) token purchasers bought in with money, (2) they all sink or swim together, (3) they expect their initial investment to grow, and (4) they all count on the folks running the show to pick winning investments.
After the DAO collapsed, the SEC issued an official report waking through this analysis and concluding that the DAO Token was, to no one’s surprise, a security. And while the DAO Report is helpful because it signals that the standard four-part test for securities is the tool the SEC will use, it’s not terribly useful when we want to know how to consider cryptocurrencies or tokens that are not so obviously securities.
For example, lots of tokens do more than just facilitate an investment pool, like the DAO. So-called “utility tokens” are tokens that act more like fuel for powering a product. For example, you might buy a cryptocurrency that lets you store files on a decentralized application, or access a distributed digital marketplace. Are these securities? This question is much harder to answer. But in his recent remarks, Chairman Clayton emphasized that the SEC won’t be persuaded by the labels a token is given: “Merely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security.” And the same goes for cryptocurrencies, or tokens that are intended to act like a traditional currency, which is not a security. Chairman Clayton again emphasized that the SEC will examine the particular characteristics of each cryptocurrency to see if it meets the test for a security.
Most cryptocurrencies or tokens possess at least some of the key characteristics of a security. Almost all involve an investment of money. A common enterprise exists where investors’ fortunes are tied together, or to the founders’ efforts or fortunes. This seems more likely to exist where tokens are purchased primarily as a store of value or investment mechanism, and less likely where people intend to use up their tokens to access a product or service. This is also true of expectation of profits. The more functional a token is, and the more purchasers intend to use their tokens to get at the functionality it enables, the less likely it is that they are expecting to profit from their purchase. And finally, relying solely on the efforts of others to realize a profit seems more likely when a token’s usefulness depends on a future build-out of a product or service than when the token can be used up immediately.
This is just a superficial exploration of what a security is and how cryptocurrencies and tokens might fit into the framework. Being armed with this basic knowledge can help you be smarter about the products you are considering creating, selling, or buying. This knowledge is certainly not a substitute for diligent research or the advice of a securities lawyer, but it might be enough to help you know when you may be flirting with a potential problem. And who knows, it might just keep you from ending up a cryptocurrency headline for the wrong reasons.
For a deeper look at how cryptocurrencies and tokens may stand up under the securities laws, be sure to visit Uinta Blockchain Research.
