The question of whether tokens are securities or not has huge implications for todays crypto companies. Fascinatingly, the lack of clarity may be becoming a bigger problem for companies than whatever regulation might result from their identification as such.
In the mid 1930s, physicists were grappling with the implications of quantum theory. Until the turn of the 20th century, classical physics had neatly organized energy separately into particles or waves. Quantum theory upended that simple “this-or-that” classification, instead suggesting, paradoxically, that every particle could also be observed and described as a wave, and vice-versa. Einstein wrote:
“We have two contradictory pictures of reality; separately neither of them fully explains the phenomena of light, but together they do.”
What’s more, it wasn’t just individual particles but entire systems that were subject to this duality. A 1935 article known as the EPR article after its authors described the strange situation of quantum superpositions, in which systems can exist in multiple states corresponding to different outcomes simultaneously. In effect, the paper argued that there wasn’t only one but in fact multiple “true” realities. Each of these realities would remain valid until they were interacted with or observed by the external world. At that time, the superposition collapses in upon a single of the possible states.
To better visualize this idea, Austrian physicist Erwin Schrödinger proposed a thought experiment that would eventually become engrained in culture. Imagine a cat in a box with a flask of poison and a monitor that will smash the flask and release the poison if a single atom decays. After a while, quantum theory dictates that the cat is simultaneously dead and alive at the same time. It is only once we open the box to observe the cat to be either dead or alive that the multiple states cease to be simultaneously true. It is our actions that determine, ultimately, which reality prevails.
Currently, tokens exist in their own sort of legal quantum superposition, in the “box” as both security and not security simultaneously. To paraphrase Einstein…we have two contradictory pictures of reality between those who view tokens as securities and those who view them as something else; separately neither of them fully explains the phenomena, but together…they might.
The answer to that question will have a deterministic effect on the development of blockchain economies, from how companies are formed to how they resource themselves to who gets to participate.
How We Got In The Box
First, how did we get here?
A security is a tradable financial instrument with monetary value. Securities regulations have been a key part of the American financial landscape for more than 100 years. As consumer wealth grew around the turn of the 20th century, the public became targets for schemes where “companies” primarily formed of promotors and marketers would form simply to sell “shares” of themselves and then take off with the profits. The first regulations came in the nineteen-teens with the “Blue Sky Laws” which required at least basic financial disclosures. In 1934, in the wake of the Great Depression, these laws were given real enforcement teeth with the creation of the Securities & Exchange Commission.
In 1946, a landmark case created the standards we still apply today for determining whether an investment offering is a security. W.J. Howey Co was a Florida citrus company. To help fund operations, it sold a portion of its land to investors and then leased the land back, promising profits on the fruit grown on that land. The SEC took the company to court arguing that they should have registered the leases as securities, with the Supreme Court ultimately ruling in their favor.
The result was “The Howey Test,” a heuristic that 72 years later still shapes policy. As articulated most recently in the SEC’s December 2017 “Statement on Cryptocurrencies and Initial Coin Offerings,” a security is:
“an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”
Blockchain was born in the wake of the 2008 financial crisis that, for many, represented the last straw of faith in centralized financial intermediaries. For regulators, interest in the crypto space has increased proportional to the growth of token sales.
Starting in 2013, “initial coin offerings” (ICOs) offered an alternative to traditional financing that also doubled as a mechanism for providing people with the currency to participate in a company’s economy. 2014 saw Ethereum’s ICO, a watershed moment that crypto investor Eric Meltzer called “arguably the best publicly available investment of all time.”
Ethereum’s impact would be transformational to ICOs in more than just as inspiration as the blockchain’s smart contracts provided a mechanism to further simply the crowd funding process. Because of that, some have called fundraising and ICO’s Ethereum’s “Killer App.”
Crowd token sales have a few dynamics that make them quite different from previous forms of startup fundraising.
The first is liquidity. Unlike the equity bought in venture capital, tokens are able to be bought and sold on various exchanges virtually immediately (depending only on whether the buyer bought in a private pre-sale or after public sale). This means that if the value of the token appreciates meaningfully in a short period of time, the investor can quickly make back their principle investment.
The second difference is a democratization of who can invest that results directly from the change in liquidity profile. As Bancor founder Eyal Hertzog points out in this conversation with Kevin Rose, before token sales, the only capital available for new startup ventures was capital that could afford to be locked up for 10 years — a tiny fraction of the world’s resources. The compression of the liquidity timeline has created a massive expansion in the diversity of capital and people that get to participate. In June of last year, his decentralized exchange project became the best funded ICO to date (although it has since been eclipsed), raising $153 million from more than 40,000 individuals.
The third difference is the one most likely to cause challenge for regulators. Tokens are not an ownership stake like stock, but a mechanism for exchanging value within the community of the company that create the token. This means that when companies sell tokens, in addition to the benefit of raising capital that they can use on developing the project, they are also empowering the community with the resource they need to be autonomous economic economic actors within their ecosystem. They are a utility necessary for participation.
By 2017, ICOs were outpacing traditional seed & venture capital, eventually hitting more than $4 billion raised for the year. Some individual projects like Bancor mentioned above and Filecoin raised more than $100 million. The sheer increase in the volume of capital and attention set the stage for the increased regulatory scrutiny that is shaping the industry today.
Is The Cat Alive Or Dead?
Voluminous digital ink has been spilled exploring where the SEC is likely to land on securities regulation, as well as what will happen based on where they land.
A ‘Howey Test’ for Blockchain? Why the SEC’s ICO Guidance Isn’t Enough
ICOs, Take Note: Did the SEC Just Throw Away the Howey Test?
Passing the Howey Test: How to Regulate Blockchain Tokens
Introducing the Blockchain Token Securities Law Framework
Summarizing much too simply, to the extent there is consensus it is that:
There are a set of tokens that explicitly understand themselves to be securities. They are designed from the ground up to behave like securities like stock or bonds and anticipate being regulated as such.
On the other end of the spectrum, there are an array of projects that seem highly unlikely to be treated like securities. These tend to be crypto infrastructures like Ethereum and Bitcoin that operate in a fully decentralized manner, which promise no profit for holding, which in some cases have no “common enterprise” and which enable people to get the currency without buying it through some form of mining. (Although this recent piece argues that these too should be considered securities).
Where things get tricky is with so-called “utility tokens,” in which the token is designed to have a specific purpose relative to the projects core activity.
Utility tokens have varying degrees of how important the token is to their actual core activity. There are many projects that have seemingly had a token bolted on to their enterprise to take advantage of the swirl of excitement for fundraising purposes. As the community of investors and interested parties around crypto grows, however, it gets harder and harder for this approach to carry muster.
On the other hand, many of the projects generating the most attention are those whose core function couldn’t actually happen without the token; where the opportunities opened up by the micro transacting or smart contracts or some other aspect of tokenization and blockchain represent not only a change in scale but a change in kind.
On the face of it, these companies appear to pass the Howey Test because the tokens are used not primarily as a means of investment in an enterprise that someone else runs, but rather as a means of exchange for the active participants in a community or economic ecosystem.
The problem is that — like particles that are also waves and waves that are also particles — these tokens don’t only function as a utility for the ecosystem. By their very nature, they also represent an investable asset. No matter how much a company tries to argue that they’re only selling tokens as a way to give the community the tools to participate, if there is any possibility of appreciate, there will be speculation.
This highlights another key challenge of trying to regulate an industry based on decentralization; even the semi-centralized startups have far more distributed stakeholders and far less control than traditional corporations. There is a good argument that blockchain projects are more like entire online economies than they are like for-profit companies. They have a different set of motivations, a different set of stakeholder relationships, and as such, they likely need a different regulatory framework.
Speaking of “different regulatory frameworks,” as if this weren’t complicated enough already, the SEC isn’t the only regulatory body involved. So far, pretty much every regulatory body seems to think that cryptocurrency looks a lot like the thing they happen to regulate.
For the IRS, cryptos are a form of property, and subject to taxation
For the U.S. Commodity Futures Trading Commission (CFTC), cryptos are a commodity and subject to their regulation
For FinCEN, the Financial Crimes Enforcement Network, cryptos are money and crypto companies should be require to register as money transmitters or face felony charges.
The paradox at the heart of the quantum state of crypto is they’re all right, just incompletely. Tokens are, in some ways, all of the things they think they are — property, currency, securities — they’re just not all the way those things, and not only those things.
So, where does the SEC land? Other bodies be damned: ultimately, this cat is going to be alive or dead when the SEC decides to fully open the box.
Three communications show the evolution of the SEC’s thought:
Last July, the SEC released the findings of an investigation around an ICO. While the investigation declined to ascribe blame or pursue further legal action, it determined that the token sale did, in fact, meet the standards of the Howey Test to classify the token as a securities offering.
In December, SEC Chairman Jay Clayton released a “Statement on Cryptocurrencies and Initial Coin Offerings” where the body simultaneously affirmed that token sales could be good ways to fundraise, even suggesting that in some cases they wouldn’t be securities offerings, but that investors should be wary around any sort of new offering like this and take precautions. The statement had the effect of demonstrating that, if nothing else, the SEC was approaching the issue with considered thoughtfulness and wasn’t about to make snap pronouncements.
The recent “Statement on Potentially Unlawful Online Platforms for Trading Digital Assets” took a somewhat more aggressive tone, especially with regard to exchanges, saying: “If a platform offers trading of digital assets that are securities and operates as an ‘exchange,’ as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration.” Many legal experts, including Morrison Cohen partner Jason Gottlieb who has set up an database to track cryptocurrency litigation, feel the message behind the rhetoric is clear:
“I think it’s one more message from the SEC that they view coins as securities and they encourage everyone in the space to … follow securities laws”
Does It Really Matter If The Cat Is Dead Or Alive?
It’s reasonable to ask whether, ultimately it really matters whether all or some portion of cryptocurrencies are declared to be securities.
The argument for the “no it doesn’t matter” camp is that, entrepreneurs being entrepreneurs, they will simply adapt to whatever the new regulations are, working within the system when it works for them and finding new cracks where it doesn’t.
The last six months have seen a massive influx of the professional millennial entrepreneur class into the blockchain space, and the prevailing assumption there within this group is that there will be some amount of regulation around token sales, at least. Indeed, for many of this cohort, it is the regularity uncertainty — not whatever the regulations ultimately end up being — that is the biggest concern and deterrent to action today.
This is almost certainly true, to an extent. Regardless of what happens with regulation, the space will persist and entrepreneurs will adapt. With big chunks of the world lining up to create more favorable legal environments for crypto, part of that adaptation may be to move business away from the U.S., but regardless, things will go on and the space will continue to develop.
At the same time, regulation could have a significant impact on the industry in negative ways that don’t reveal themselves immediately.
One risk is regards functionality. A token that is classified as a security but that has day-to-day need for an online economy could create a significant challenge. Last week, KODAKCoin — a new token to help photographers manage the digital rights around their photos and get paid for usage, issued a warning to investors about potential SEC regulation. Caitlin Long, a multi-hyphenate in the crypto community who was most recently involved in Wyoming’s landmark legislation, tweeted: “If the SEC deems every utility token a security, does it really expect a photographer to open a brokerage account to sell a photo on #KodakCoin?”
The other risk is around the risk around who gets to participate in the creation and funding of new ventures. Power & capital around startups has been largely concentrated on the West Coast of the US. Through the mechanism of token sales, that monopoly was beginning to break. As regulatory concerns increase, however, more and more of the entrepreneurial energy is being concentrated back around private sales that tend to have a significant emphasis on institutional investors who represent that old power structure (or even a slightly updated version of it).
This is not, in and of itself, a bad thing. The old cohort of investors bring amazing skills and expertise with them. And great entrepreneurs tend to find be able to figure out how to break into closed circles.
As a new technology movement takes shape, however, with all of its immense implications for how the world organizes itself, its worth taking a moment to ask what our responsibility is to extend the benefits of those changes. Do we want a new, slightly-more distributed version of Silicon Valley that is still fundamentally organized around small enclaves of capital? Or do we want a true scaled global market, safe for people from all types of backgrounds, where the ability to both create and invest in the future is actually democratized?
Ultimately, these are the stakes of regulation. What’s for sure is that blockchain is not going anywhere as a force reshaping technology, commerce and society as a whole. No matter what the regulation, this cat is out of the bag (or the box, as it were) and it will have impact. The questions are what barriers shape the innovation and disruption that comes next, and how they determine who gets to be involved.
Whatever happens, we’re likely to see more happen soon. The SEC has reportedly sent out more than 80 subpoenas, and Congress held its first open hearings on blockchain this week. Wyoming just passed extremely pro-blockchain legislation, including a bill that recognizes utility tokens as a new asset class distinct from securities.
More than anything, and entire cohort of entrepreneurs are waiting with baited breath to know just what situation they’re dealing with. In this case, it is the paradox of multiple realities rather than the possibility of regulations creating the tension.
Entrepreneurs are starting to doubt that crypto tokens can be used at all in the U.S. In fact, according to Simar…www.coindesk.com
A story today on Coindesk describes how one project — a payment token for video and streaming content creators — has delayed an intended airdrop (a strategy for distributing tokens directly to a community who can then use them in a company’s ecosystem)
It seems unlikely that the SEC doesn’t push for any regulation. If nothing else, however, they seem to be approaching it thoughtfully and diligently. Will they simply default to the easy classification that all token sales constitute securities offerings? Will they resolve the Schroedinger’s Securities paradox with something like a convertible debt instrument that allows tokens to be securities when they’re acting like investment instruments but not when they’re being used by a community as a utility?
Right now, all the realities are possible, and only time will tell.