For the crypto market, regulation continues to be a large gray area. As the crypto market continues to grow, so too does the attention being paid to it by governments and regulating agencies. ??In the US, crypto is at the mercy of the Financial Services Oversight Council (FSOC) and its ten voting members. There’s the Federal Reserve (Fed), the Department of TreasuryCommodities and Futures Trading Commission (CFTC), the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Commission (FDIC), the Consumer Financial Protection Bureau (CFPB), and.....the Securities and Exchange Commission (SEC). The SEC is headed by (now) crypto-infamous, Gary Gensler. Mr. Gensler's apparent favorite past times are bullying crypto projects, not protecting investors, and shouting "security" at least a few dozen times a day. So, let's talk security and what it means for a crypto project should it be designated a security.
The Howey Test
The Howey Test, the primary case law on the features of a security, remains the best measuring stick despite its many shortcomings when applied to cryptoassets. For this analysis, understand that the degree of decentralization of a protocol is a significant factor in determining which, if any, United States securities regulations apply.
“When a promoter, sponsor, or another third party (or affiliated group of third parties) (each, an “Active Participant” or “A.P.”) provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts, then this prong of the [Howey] test is met.
There are essential tasks or responsibilities performed and expected to be performed by an A.P., rather than an unaffiliated, dispersed community of network users(commonly known as a “decentralized” network).”
-SEC guidance “Framework for ‘Investment Contract’ Analysis of Digital Assets
Increased speculation of crypto assets is leading to an attempt by agencies like the SEC to separate what’s considered a currency and what’s considered a security. Cryptocurrencies can be deemed a security if it satisfies specific properties based on the standard definition and interpretation of the Howey Test, the standard legal test applied to assets to determine if they're securities. The four-component questions of the test are:
- Is there an investment of money?
- Is there an expectation of future profits?
- Is the investment of money in a common enterprise?
- Do any profits come from the efforts of a promoter or third party?
In October 2021, the Commodity Futures Trading Commission (CFTC) chairman “nearly 60% of cryptocurrencies are commodities” and that his team is positioned to lead regulations over the market. Meanwhile, SEC chairman Gary Gensler has continually commented that many cryptocurrencies, including stablecoins, are no different than securities and, as such, should fall under his sphere of influence in the name of “consumer protection.”
Rulings on Comparable Launches
Other tokens created by large centralized companies have recently run into opposition from the US regulators, such as Telegram abandoning its project entirely after a multi-year battle with the SEC. Several landmark cases by the SEC set a precedent for them to evaluate ICOs as securities retroactively, while a recent November 2022 ruling against LBRY tokens further strengthens the SEC’s case against many altcoins.
In 2022, SEC Chairman Gary Gensler made comments on CNBC’s Squawk Box about being prepared to label only Bitcoin a commodity, meaning the Commodities Futures Trading Commission (CFTC) would be able to regulate it. However, Gensler also said that many other tokens on the market have ‘’key attributes’’ of securities. Gensler has called for full and fair disclosure in the crypto market while stating ‘’the U.S. is open to having hundreds, if not thousands of tokens on its market if they complied with SEC laws.’’
What a Security Designation Means for a Crypto Asset
In the world of cryptocurrencies, the term "security" can have significant impacts on three main stakeholders: the token issuer, the crypto exchange, and the investor. For the token issuer, being labeled as a security can mean having to navigate a complex set of regulations and guidelines that vary based on jurisdiction. This includes limitations on the amount of capital raised and who it can be raised from, as well as restrictions on selling to accredited investors or a defined number of non-accredited investors.
The compliance requirements can be tedious and expensive, with documents and disclosures such as a prospectus, pitch deck, KYC, token subscription agreement, marketing restrictions, and an anti-money laundering compliance manual, to be prepared and submitted to the regulatory body. Failure to comply can result in heavy fines for the token issuer.
Crypto exchanges that want to list a security token must secure a broker-dealer or similar capital markets license in their respective jurisdiction, which is expensive and comes with rigorous compliance requirements and regulatory oversight. Those that do not have the necessary license may be forced to delist the token after it is deemed a security by the regulator.
Finally, securities laws are intended to protect investors by placing limits on who is allowed to invest in securities. This means that tokens classified as securities are typically out of reach for most investors, going against the core tenets of crypto, which advocate for indiscriminate and decentralized access to financial markets.
Overall, the designation of a cryptocurrency as a security can have far-reaching implications for the project or ecosystem associated with it, affecting compliance, costs, and investor access.
February 2023 Crackdown on Centralized Staking in the U.S.
In February 2023, as part of a settlement with the Securities and Exchange Commission, the centralized crypto exchange, Kraken, was forced to discontinue its crypto staking program in the United States and pay a $30 million penalty. The SEC accused the company of selling unregistered securities through its "crypto asset staking-as-a-service" program.
It has been evident that the SEC was planning to enforce regulations on crypto yield programs for some time now. In 2021, the SEC had a disagreement with COINBASE regarding the exchange's intention to introduce a lending feature in the U.S. Also, in the previous year, the SEC, along with several states, reached a settlement with BlockFi for $100 million over the company's interest-bearing accounts.
The full extent and ramifications of this ruling have yet to be realized at the time of writing. Currently, the only way to stake on Aptos is to run a full node, which is a gated, permissioned endeavor. The project has plans to enable users to delegate votes. After this ruling by the SEC, the question for Aptos is, “Can you run a validator and accept delegation in the U.S.?” If not, this will certainly shake up the validator distribution on the network.
In the world of cryptocurrencies, the term "security" can have significant impacts on three main stakeholders: the token issuer, the crypto exchange, and the investor. For the token issuer, being labeled as a security can mean having to navigate a complex set of regulations and guidelines that vary based on jurisdiction. This includes limitations on the amount of capital raised and who it can be raised from, as well as restrictions on selling to accredited investors or a defined number of non-accredited investors.
The compliance requirements can be tedious and expensive, with documents and disclosures such as a prospectus, pitch deck, KYC, token subscription agreement, marketing restrictions, and an anti-money laundering compliance manual, to be prepared and submitted to the regulatory body. Failure to comply can result in heavy fines for the token issuer.
Crypto exchanges that want to list a security token must secure a broker-dealer or similar capital markets license in their respective jurisdiction, which is expensive and comes with rigorous compliance requirements and regulatory oversight. Those that do not have the necessary license may be forced to delist the token after it is deemed a security by the regulator.
Finally, securities laws are intended to protect investors by placing limits on who is allowed to invest in securities. This means that tokens classified as securities are typically out of reach for most investors, going against the core tenets of crypto, which advocate for indiscriminate and decentralized access to financial markets.
Overall, the designation of a cryptocurrency as a security can have far-reaching implications for the project or ecosystem associated with it, affecting compliance, costs, and investor access.
