Regulators around the world treat cryptocurrencies in a variety of ways, sometimes categorising them not as currencies but as securities. When they do that, the regulations they apply can be considerably different from those applied to other types of currencies.
So what exactly are securities?
The US Securities and Exchange Commission (SEC) defines a security simply as “an investment instrument such as a stock or bond”. The UK’s Financial Conduct Authority goes into greater detail, describing it as an investment that could be represented by – among other things – a share, a debenture, a “certificate representing certain securities”, a stakeholder pension scheme or “rights to or interests in investments”.
The Street puts it in English that’s easier to understand: “A simple definition of a security is any proof of ownership or debt that has been assigned a value and may be sold.”
You can see from that last definition why securities law might be applied to cryptocurrencies, especially those that are issued via an initial coin offering (ICO) in which investors hope to see the value of their tokens rise along with the value of the company.
On the other hand, many other cryptocurrencies are not tied to investments in a particular company. Instead, these – Bitcoin in particular – were created as a digital alternative to fiat currency that would allow people to spend easily and securely online without the need for third-party validation and trust mechanisms.
However, cryptocurrencies in real life are rarely used in this way. More often, people tend to acquire cryptocurrencies in hopes of profiting when their value rises, or trade cryptocurrencies more frequently based on daily market movements – again with the goal of making a profit. So it’s not surprising that regulators often conclude that the rules applied to central-bank-backed currencies don’t apply to cryptocurrencies.
But does that mean they should be regulated like securities?
In a June 2018 briefing paper, Cato Institute analyst Diego Zuluaga argued that cryptocurrencies are unlikely to meet the US courts’ definition of a security. The key test, he said, is a 1946 ruling by the US Supreme Court – SEC v. Howey – that defined a security as “a contract involving (1) an investment of money (2) in a common enterprise (3) with the expectation of profits (4) from the efforts of others”.
Zuluaga concluded: “Regulators should provide clarity on how cryptocurrencies fit within existing laws by adopting a framework that makes a distinction between functional cryptocurrencies, such as Bitcoin, which are not securities, and promises of cryptocurrencies, which may in some cases be securities.”
In the case of The DAO, a decentralised autonomous organisation/venture capital fund that fell prey to smart contract vulnerabilities, the SEC found in 2017 that DAO tokens were securities.
The SEC’s report concluded that “issuers of distributed ledger or blockchain technology-based securities must register offers and sales of such securities unless a valid exemption applies. Those participating in unregistered offerings also may be liable for violations of the securities laws. Additionally, securities exchanges providing for trading in these securities must register unless they are exempt. The purpose of the registration provisions of the federal securities laws is to ensure that investors are sold investments that include all the proper disclosures and are subject to regulatory scrutiny for investors’ protection.”
Regulators in many other countries have taken a similar approach, deciding that some crypto assets are securities while others are not, the US Law Library of Congress found in its 2018 report on “Regulation of Cryptocurrency around the World”. As the Anguillan government noted in its attempt to create appropriate regulations, there is “a large swath of non-security tokens with no clear guidance as to where they would fit in the emerging blockchain economy. Therefore, we focused our efforts on creating a safe and effective regulatory framework for non-security token offerings, which appear to represent a majority of the current capital raising activity within the blockchain community.”