There has been a lot of discussion about crypto in the news recently. El Salvador made global headlines last month as the first nation to accept a crypto as legal tender, while other countries, like China, are banning them outright. In the United States, the state of crypto is much more in flux. In a recent statement, Federal Reserve Chairman Jay Powell said that the United States has no intention of banning cryptos, but he did indicate that they should be regulated. If the United States were to regulate cryptos, the agency responsible for such regulations would be the Securities and Exchange Commission (SEC).
SEC Chairman Gary Gensler also believes that cryptos should be regulated. Gensler has expressed his concern about crypto digital assets, likening the space to the “Wild West” and reminiscent of the private currencies of the “wildcat banks” of the past. Chairman Gensler’s recent statements do not represent the SEC’s first foray into crypto. In fact, on February 6, 2018, then-SEC Chairman Jay Clayton said that he believed that crypto offerings were securities and the SEC had jurisdiction over them.
This all begs the question: If the current and preceding SEC chairs believe that cryptos are securities and should be regulated, why hasn’t the SEC regulated them?
Why would the SEC have jurisdiction over cryptos?
The SEC was created by Congress in 1934 to enforce the federal securities laws of 1933 and 1934. Amid the Great Depression, the U.S. legislature passed the federal securities laws to ensure the “full and fair disclosure” of securities and to regulate securities’ markets to “prevent inequitable and unfair practices.” The hope of these acts was to build trust in the markets and protect investors from fraudulent promoters of investments. The federal securities laws require that all securities that are offered or sold are registered (or exempted from registration) and all information in the registration is complete and not materially misleading. The registration disclosures further the purpose of the federal securities laws by ensuring that investors have the information necessary to make informed investment decisions.
While many people equate stocks with securities, the term has a more expansive definition, which extends, among other things, to “investment contracts.” Investment contracts often capture instruments or assets that are sold in order for the promoter to raise money rather than selling shares. The question that federal securities laws raise is whether digital assets like crypto coins or tokens are “investment contracts.”
To analyze whether the sale of an asset qualifies as an investment contract, the U.S. Supreme Court devised what has come to be known as the “Howey test.” As outlined in the 1946 case SEC v. Howey Co., there are three prongs that must be satisfied for an “investment contract” to exist: 1) there must be an investment of money, 2) in a common enterprise, and 3) with a reasonable expectation of profits to be derived from the efforts of other.
The first two prongs of the Howey test are typically satisfied by buyers of digital assets because the assets are purchased or acquired in exchange for value and because the fortunes of the purchasers are linked to each other or to the success of the promoter’s efforts. The main question when analyzing cryptos under the Howey test is whether there is a reasonable expectation of profits from the efforts of others. As stated above, the most essential question for this prong is whether a purchaser reasonably expects to rely on the efforts of a promoter, sponsor, or other third party, rather than a decentralized network.
What is crypto and how does it work?
Crypto is a form of a digital asset. Often cryptos are referred to as cryptocurrencies because the digital assets are denominated in “coins” or “tokens.” This “currency,” however, is neither issued nor controlled by a government. Rather transactions with cryptos are validated by the blockchain on which the crypto was created.
A blockchain is a system for recording information, like transactions, across a network of computers. It functions similarly to a bank’s ledger; however, rather than being controlled by a single bank, a transaction on a blockchain is verified by other participants in the blockchain’s network, making it difficult, if not impossible, to manipulate the system. These peer-to-peer transactions create an entirely new financial system concept called “decentralized finance,” of DeFi. The concept of DeFi is to establish a global, peer-to-peer financial system that removes the “middle men,” i.e., financial institutions, with the aim of achieving a more efficient and secure system of financial transactions. The establishment of DeFi was one of the founding principles of crypto; in 2008, Satoshi Nakamoto–which may be the person’s real name or a pseudonym for a person or group–published the first paper about Bitcoin, stating “I’ve been working on a new electronic cash system that’s fully peer-to-peer, with no trusted third party.”
There are two prominent mechanisms that enable users to ensure the integrity of the blockchain underpinning their chosen crypto–“proof of work” and “proof of stake.” Proof of work is the older mechanism and is used by most blockchains, including Bitcoin’s and Ethereum’s current blockchains. Proof of work requires virtual “miners” to compete to verify transactions by solving complex math problems, which requires immense computing power as these problems can only be solved through trial and error. As an incentive, the verifying miners are awarded coins. The proof of work mechanism requires a vast amount of computing power because the miners are competing with each other to place the transaction on the blockchain. Because many miners are competing to solve the math problem first, but only one miner gets to place the transaction on the blockchain, much of the work is duplicative, resulting in wasted processing power and energy. According to Coinbase, verifying a transaction in October 2019 required 12 trillion times more computing power than it did when the first blocks were mined in January of 2009. The need for processing power makes it difficult to scale blockchains using this mechanism.
In the proof of stake, the newer of the two mechanisms, network participants “stake” or place their own coins on the line for a chance to validate the transactions on the blockchain. These “validators” are selected based on how much and how long their coins have been staked. Once a validator places a transaction on the blockchain, other participants verify the transaction until a threshold number of validators have agreed the transaction is correct. If a validator is inaccurate, the validator can lose their staked coins. Because the validators are chosen rather than competing, proof of stake requires less energy and is more scalable. Proof of stake blockchains are beginning to roll out and the Ethereum 2.0 blockchain is likely to be completed sometime in 2022.
How has the SEC treated crypto to date?
Thus far, crypto has largely evaded the SEC’s regulation because of its decentralized mechanisms. Despite the recent Chair’s comments that crypto’s coin offerings are securities, the crypto space has generally relied on comments made in 2018 by William Hinman, then-director of the SEC’s Division of Corporate Finance. At the Yahoo Finance All Markets Summit: Crypto in San Francisco, Hinman indicated that two of the most well-known cryptos, Bitcoin and Ethereum, were not securities. Hinman said:
“When I look at Bitcoin today, I do not see a central third party whose efforts are a key determining factor in the enterprise. The network on which Bitcoin functions is operational and appears to have been decentralized for some time, perhaps from inception. Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value. And 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, applying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value. Over time, there may be other sufficiently decentralized networks and systems where regulating the tokens or coins that function on them as securities may not be required.”
Notably, Hinman’s comments make clear that decentralization is a critical component when determining whether crypto is a security; “[p]rimarily consider whether a third party–be it a person, entity or coordinated group of actors–drives the expectation of return.”
However, Hinman made clear that when a digital asset is not “sufficiently decentralized” the SEC has the power and responsibility to regulate the offering and sale of that digital asset because it would evidence an investment contract. In fact, the SEC initiated an action against a digital asset promoter for violating federal securities laws in 2020. Under Chair Jay Clayton, the SEC took aim at Ripple Lab Inc. and its XRP coin. According to the SEC, the cofounders of Ripple raised funds through the sale of a digital asset, XRP, “in an unregistered securities offering to investors in the U.S. and worldwide.” In the complaint, the SEC said that Ripple and its co-founders constituted an identifiable entity responsible for the efforts associated with XRP because at one point Ripple and its founders controlled 100% of XRP; thus, it was not a decentralized system. The SEC’s complaint described legal memos that said XRP was distinguishable from Bitcoin for purposes of federal securities laws because there was “‘a specific entity,’ Ripple, ‘which was responsible for the distribution of [XRP] and the promotion and marketing functions of the Ripple Network.’” The complaint also states that employees of an equity investor in Ripple distinguished XRP from Bitcoin and were concerned that XRP would be treated differently by the SEC; “Ripple is controlled by [one] entity rather than through a distributed entity like Bitcoin.” The SEC v. Ripple case is still undecided, but the case shows that the SEC is not permitting every digital asset to evade its jurisdiction.
Why does the SEC’s treatment of crypto matter?
The future of the SEC’s regulation of crypto is still unclear, but it is likely that there will be a great deal of activity in coming months. This activity is bound to continue because the crypto space is continuing to grow, having exceeded a total market value of $2 trillion in August 2021, and because the SEC seems unwilling to let the crypto space continue unregulated.
In Gensler’s remarks at the Aspen Institute in August, he said that that crypto space was “rife with fraud, scams, and abuse of certain application.” As reported by The New York Times in August, there are close to 70,000 cryptos and there are thousands of “dead coins” most of which were casualties of scams or abandonment. Additionally, Gensler said that “investors aren’t able to get rigorous, balanced, and complete information,” which is one of the primary objectives of the federal securities laws. With new cryptos entering the market, older cryptos evolving into more advanced systems, and new mechanisms like Ethereum 2.0’s proof of stake mechanism launching, the SEC will have abundant opportunities to find ways to assert its jurisdiction over cryptos.
Ultimately, as Gensler stated at the Aspen Institute, if the SEC doesn’t address the issues in the crypto space, he worries “a lot of people will be hurt.”
