In How Blockchains and Decentralized ID Solutions Flip the Switch on Privacy, I explored decentralized identity (DID) and Web3, comparing 3 unique DID approaches to interoperability. Here I summarize how regulatory uncertainty affects blockchain development, what last week’s SEC commentary means for cryptocurrencies, and explain how decentralized applications are positioned within today’s regulatory landscape. This is the 3rd article in an ongoing series about Developing Blockchain Standards for the Decentralized Web. Next, I will focus on what KYC, AML and GDPR compliance mean for cryptocurrency, cryptoasset, and blockchain development.
Navigating Uncertainty In Pursuit of Compliance
Every day cryptocurrency and blockchain startups in the U.S. face a lingering regulatory question, “how do you fit a square peg in a round hole?” Today the Internal Revenue Service (IRS) treats Bitcoin like property; the Securities and Exchange Commission (SEC) believes that Bitcoin and Ether are not securities, essentially making them commodities, and the Commodity Futures Trading Commission (CFTC), which found that virtual currencies like Bitcoin are subject to oversight as commodities back in 2015 and recently issued guidelines for exchanges, has not yet specified which other virtual currencies will be regulated as commodities. To complicate matters further, just yesterday, US Representative Warren Davidson (R-Ohio) called for a “light touch regulatory framework that provides certainty for the ICO market.” So, while the 1st draft of his bill is in early-stage development and other regulatory bodies are inching towards more comprehensive oversight guidelines, what do existing businesses need to know about getting involved with blockchains, cryptocurrencies, and decentralized applications?
SEC Week in Review
Last week the biggest news in crypto was excitement over SEC commentary indicating that Bitcoin and Ether are not securities. As with most crypto news, it’s important to take a step back and distinguish fact from fiction and hype. Let’s first define what this commentary was not. This commentary was not a new SEC rule or change to existing securities laws. So, what was it, and what does this commentary mean for crypto regulation moving forward?
On June 14, 2018, William Hinman, Director of the Division of Corporation Finance, gave a speech at the Yahoo! Finance All Markets Summit: Crypto explaining his personal view of how digital assets, ICOs, and Utility Tokens interoperate with today’s securities laws. In the speech he opined on BTC and ETH, which made for great crypto headlines and rallied price valuations for the day.
Beyond the initial excitement, what struck me most about Hinman’s speech was not his view of BTC and ETH; it was how he outlined specific use cases, including “supply chain management, intellectual property rights licensing, stock ownership transfers,” and built an argument around what he believes might be a path towards future SEC compliance. In other words Hinman’s speech was also a nod to serious digital asset organizations, indicating that they ought to explore securities offerings as fundraising instruments with the opportunity to transition to “something other than a security” once the central enterprise is more fully decentralized. What might that transition look like and how could it affect existing blockchain and digital asset organizations?
Transitioning from a Security to Utility Token
Hinman’s speech started by reframing the premise of “whether a digital asset offered as a security can, over time, become something other than a security.” Changing tack, Hinman asks:
“Can a digital asset that was originally offered in a securities offering ever be later sold in a manner that does not constitute an offering of a security?” In cases where the digital asset represents a set of rights that gives the holder a financial interest in an enterprise, the answer is likely “no.” In these cases, calling the transaction an initial coin offering, or “ICO,” or a sale of a “token,” will not take it out of the purview of the U.S. securities laws.
But what about cases where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created? I believe in these cases the answer is a qualified “yes.”
After reviewing how SEC v. W.J. Howey Co. helped determine whether a transaction represents an investment contract and therefore a security, Hinman described a possible scenario wherein a blockchain startup that raises capital as a security (e.g. using investment contracts) might transition to a utility token model or alternative offering in the future:
If the network on which the token or coin is to function is sufficiently decentralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede. As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful.
In delineating a possible path from registered security to utility token compliance and offering a non-exhaustive list of factors to consider when assessing digital assets, Hinman sets up room for discussion and recommends that businesses seek SEC consultation to explore the particulars. Why does this distinction matter and to whom does it make a difference?
This is important because although dozens of ICOs never considered registering as a security, many others have followed compliance best practices. For ICOs that did not comply, there is talk of shakeup and reckoning. For those that have, there is still light at the end of the tunnel and regulatory hope for up-and-coming blockchain startups that wish to ICO and develop new decentralized applications with the capital raised.
What I love about the crypto community is our peer-to-peer mindset. I believe that the best ideas come from open collaboration and thoughtful feedback. As always, I’d like to hear from members of the community. Where do you stand on ICOs and regulatory compliance? What other avenues are worth exploring to foster decentralized innovation and comply with today’s laws and regulations? What does crypto compliance look like where you live and how does it compare to the U.S.?