Are Bitcoin and Other Digital Currencies Securities?

Anyone who has tried to explain bitcoin around their kitchen table knows that it is not easy to put your finger on what exactly the technology is.  Because of their innovative nature, digital currencies don’t have obvious analogs or fit easily into existing categories.  Bitcoin is part currency, part digital payment system, and part immutable ledger. This confusion is not merely academic.  How digital currencies are defined determines how they are regulated.  For instance, the Internal Revenue Service (IRS) determined that bitcoin is a form of property, not currency, for tax purposes.  The Commodity Futures Trading Commission (CFTC) labeled bitcoin a commodity.  Could the Securities and Exchange Commission (SEC) decide that bitcoin is a form of security? Coin Center recently released a thorough and thoughtful report examining this question and proposing guidelines for determining when a digital currency should be treated as a security. The guide, a “Framework for Securities Regulation of Cryptocurrencies,” draws on the Supreme Court’s famous Howey test.  SEC v. W.J. Howey Co. held that an investment contract—for the purposes of securities regulation—is a “contract, transaction or scheme whereby a person [1] invests his money [2] in a common enterprise and [3] is led to expect profits [4] solely from the efforts of the promoter or a third party.”  The report’s framework identifies seven key variables that distinguish different digital currencies and maps them onto the four factors of the Howey test.  A recent Coin Center blog post identified “seven key variables that might differ from one cryptocurrency to another:

• Scarcity (what are the economics of the coin’s supply?)
• Distribution (how do new coins reach users?)
• Consensus (how does the network agree on supply and transaction history?)
• Permissions (what does possession of the coin allow the user to do?)
• Decentralization (how centralized is the network and developer community?)
• Profit-Development Linkage (how linked are developer profits to coin sales?)
• Transparency (how transparent is the network and developer community?)”

Different variables map onto different factors of the Howey test.  For example, the distribution variable maps onto the “invests his money” factor of the test—if coins are purchased, instead of mined competitively, the cryptocurrency starts to look more like a traditional security. The framework concludes that several types of digital currencies do not fit the definition of a security.  First, highly-decentralized cryptocurrencies, including bitcoin, do not have a third-party promoter that investors rely on.  Sidechain projects have no expectation of profit because the value of a sidechain coin is pegged to pre-existing bitcoins.  Similarly, platforms that create and use tokens for a particular use or application, such as Ethereum, do not create an expectation of profit.  Finally, cryptocurrencies distributed through competitive mining or similar processes do not involve the investment of money, and should not be treated as securities. On the other hand, securities regulation may be appropriate where a digital currency is distributed through pre-sales from a small and non-diverse developer group.  Oversight is particularly important where the cryptocurrency is not transparent, because the trust of investors is based mostly on a promotor’s actions.  Permissioned ledgers are also a better fit for the Howey test because the central authority may play the role of a third-party promoter. Coin Center believes this approach aligns with the purpose of the securities laws and would lead to positive policy outcomes.  The proposal would protect investors by regulating the cryptocurrencies that pose the greatest risk, while avoiding unnecessary regulation on relatively safer options. With a framework instead of a bright-line rule, it won’t always be clear whether a cryptocurrency is a security or not.  Still, Coin Center has articulated a comprehensive view of how digital currencies interact with securities laws, which will be useful as federal and state regulators think about how to approach bitcoin and other digital currencies.