A top US official has provided some clarity about how crypto assets should be regulated. Bitcoin and ether are not securities, according to a senior Security and Exchange Commission official, meaning they don’t have to comply with strict US requirements on registration, disclosure, and accreditation of investors. The regulator made no direct mention of XRP, a crypto token that money-transfer company Ripple has promoted.
Digital assets have been in a bear market this year—bitcoin has fallen some 50%—but ether and bitcoin jumped yesterday (June 14) around the time reports emerged (paywall) on the SEC’s stance. XRP, which like all virtual assets tends to be highly volatile, diverged from bitcoin and ether, according to CoinDesk prices.
“Today is going to be looked back at as somewhat of a momentous day,” said Adam White, general manager at crypto exchange Coinbase, in an interview with podcast host Laura Shin. Guidance that ether isn’t a security gives the crypto industry the confidence to move forward on projects, he said.
One of those projects could be ether futures at Chicago-based derivatives exchange Cboe. The exchange has been considering futures—which give traders a way to speculate or hedge prices of an asset at some later date—for the crypto asset since it started a contract for bitcoin last year, according to president Chris Concannon. “This announcement clears a key stumbling block,” he said.
As for XRP, Ripple CEO Brad Garlinghouse said in an interview earlier this month that “it’s very clear XRP is not a security.” He argued that it exists independently of Ripple the company, which has built technology that uses XRP to facilitate cross-border payments. He said owning XRP doesn’t provide ownership or equity in his firm, which itself it sitting on a large amount of the crypto asset. “It’s quite different than what a security looks like,” Garlinghouse said.
The SEC may feel differently. An important consideration is whether a third-party—a person, entity, or group–is driving the expectation for a return, according to a speech yesterday by William Hinman, director of the corporation finance division at the SEC. For some investors, the rationale for buying the XRP crypto token is the hope that the company Ripple will succeed at convincing banks and other financial institutions to use Ripple, and the crypto token, as a transmission mechanism for payments.
What would make a digital asset a security, according to the SEC
Here are six factors that the SEC suggests considering when determining whether a digital asset is an investment contract, and therefore a security:
- Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?
- Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
- Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
- Are purchasers “investing,” that is seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
- Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?
- Do persons or entities other than the promoter exercise governance rights or meaningful influence?
How virtual tokens differ
There are ways to structure virtual tokens so that they function more like consumer items rather than a security, Hinman said. For analysis, he suggested this list of considerations:
- Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
- Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading?
- Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?
- Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?
- Is the asset marketed and distributed to potential users or the general public?
- Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?
- Is the application fully functioning or in early stages of development?
Hinman pointed out that the US Securities Act is meant to give investors essential information known by promoters of assets, so that people buying into projects can make informed decisions. This is why promoters can be held liable for misstatements.
Factors such as a project’s financing and background are vital for an investor to be able to make sound decisions. While ether and bitcoin don’t qualify as securities in Hinman’s view, initial coin offerings (ICOs)—a kind of crowdfunding that’s been turbocharged by crypto-token speculation—often do qualify and may be better off adhering to those regulations.