Securities: Ethereum, ICOs & Traditional Financial Regulatory Framework

In what continues to be a fascinating journey, the legislative process is slowly but surely being applied to cryptocurrencies, with the US regulatory authorities extending what appears to be a reasonably well thought out and measured approach to engaging with the emerging crypto-asset space, in particular with regards to the application of securities legislation to decentralised networks.

William Hinman, head of the Division of Corporate Finance for the SEC, last week provided a particular degree of clarity, with his personal assertion that Ether should not be considered a security. This is supposedly due, in his opinion, to the level of decentralisation now established across the Ethereum network, despite the nature of its initial fundraising. In a speech at Yahoo Finance All Markets Summit, Hinman made a series of points surrounding the cryptocurrency world and its relationship to securities legislation, which seemed to indicate many ICO projects would likely pass the ‘Howey Test’ and as such be deemed unregistered securities.

There has been a great deal of speculation within the cryptocurrency community over the past few months regarding the status of a number of crypto-assets in relation to securities regulations. US securities legislation is set at the federal level and relates to everything from the issuance and sale of securities, investment companies and the conduct of “professionals” within the investment landscape. This legislation has been established, through numerous revisions, over the best part of the last century, with such regulation almost entirely absent prior to the Wall Street crash of 1929. The ‘Howey’ test is a key means of determining whether an asset can be considered a security or “investment contract”, and relates to a historic case dating back to 1946, wherein the defendant was responsible for the sale of orange groves to hotel guests, alongside a service contract for the running of the same orange groves.

A handful of commentators within the crypto-community have been looking into the possible status of Ethereum and ICO tokens with regards to securities legislation, including legal eagle Preston Byrne who argued earlier this year that Ether would be considered a security under current legislation. Byrne came to this conclusion, in part, through analysis of the unusual nature of the presale process that was used as the initial fundraising mechanism for the Ethereum project. The dynamics of the presale are analysed in more depth in this Medium article. Crypto-industry advocates Coincenter took an opposing view, arguing that the decentralisation now established across the network is sufficient for Ether to no longer be considered a security.

A particularly important facet of securities legislation is that it defines the acceptable arenas for trading in securities. If the SEC ultimately took a negative approach, this could be hugely detrimental to US access to the emerging crypto-markets. US regulations strictly control the venues in which securities may be traded, and US-based cryptocurrency exchanges could be forced to remove any potential security tokens, until such time as they could obtain licensing from the SEC as a “national securities exchange” under Section 6 of the Securities Exchange Act of 1934.

As reiterated by Hinman, whether or not a token can be thought of as a security is ultimately down to “how it is being sold and the reasonable expectations of purchasers”. This focus on expectations of investors can be traced to the Securities Act 1933, or “Truth in Securities Law” which as summarised by the SEC website is:

Primarily focussed on eliminating fraud in securities, this act ensures the legal requirement of a certain amount of transparency

• require that investors receive financial and other significant information concerning securities being offered for public sale; and
• prohibit deceit, misrepresentations, and other fraud in the sale of securities

Many ICOs have tried to avoid falling foul of securities law by implying that their offering is simply a utility token, but this approach is far from sufficient in Hinman’s view; “simply labeling a digital asset a “utility token” does not turn the asset into something that is not a security.”

The stated opinion of an important SEC official such as Hinman, makes it pretty clear that many ICOs have been conducted in such a manner, that they are almost certainly securities:

The digital asset itself is simply code. But the way it is sold – as part of an investment; to non-users; by promoters to develop the enterprise – can be, and, in that context, most often is, a security – because it evidences an investment contract.

However, until now the SEC and fellow regulatory bodies have taken a relatively tentative approach when it comes to making any serious judgment on the more prominent assets within the space. Hinman has now expressed that in his view, both Ethereum and Bitcoin are not securities. The exact wording of his speech is still somewhat ambiguous, in that he focuses on the “present state of Ether”, but appears to acknowledge that the initial fundraising mechanism behind Ethereum was somewhat dubious in relation to current regulations:

“putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.”

The dialogue could appear to suggest that the commission are not concerned with current sales of Ether, as it is now sufficiently decentralised, and purchasers do not have any realistic expectation of gains coming from the efforts of the initial third-party promoter/issuer. This argument of decentralisation has been strongly supported and developed by CoinCenter, an organisation that has been actively engaging in regulatory advocacy for the nascent cryptocurrency technologies.

Hinman’s statement appears to indicate that it is the initial issuance of some tokens which may be the primary concern of the SEC with regards to potential breaches of securities law. It has been reasonably common knowledge that many ICOs have been flouting the regulation with regards to their public offerings, and there have even been cases of outright fraudulent behaviour. The staggering amounts of money being raised by teams with no discernible product are unheard of, and this sort of speculative mania is fertile ground for just the unscrupulous actors that the SEC exists to protect investors against. There has certainly been activity directed towards the ICO trend from the Commission this year, with a series of subpoenas and information requests supposedly hitting the desks of companies involved with the industry earlier this year. The SEC recently created a spoof website offering HoweyCoins for sale, with many of the hallmarks of many ICOs that have clearly been in breach of the spirit of the existing regulations. The site linked to an investor information site which helped to inform would-be investors of some of the potential signs that an ICO project isn’t legitimate.

This latest dialogue could cause some significant headaches for a number of exchanges and OTC desks based within the USA that are enabling trading in ICO tokens, as Hinman has gone further than before in outlining that most ICO tokens can be deemed securities in the eyes of the SEC. This means that the exchanges and OTC brokers are essentially breaking the law by allowing these assets to be traded without being registered as either a “national securities exchange” or an “ATS” (Alternative Trading System). Coinbase appear to be making moves to ensure compliance already, with the company recently attempting to obtain a broker-dealer license (B-D), an alternative trading system license (ATS), and a registered investment advisor (RIA) license, through the acquisition of a handful companies; Keystone Capital Corp., Venovate Marketplace, Inc., and Digital Wealth LLC.

As much as many of the more Libertarian-leaning cryptocurrency users see all legislation impacting the space as negative, in the current paradigm they are still essential and will have an important role to play as the world of cryptocurrencies continues to mature and integrate further with traditional finance.