The Regulatory Debate: Why Cryptocurrencies Don't Meet the Definition of Securities

Cryptocurrencies and other crypto assets have become increasingly popular over the past decade, with the total market capitalization of these assets reaching over $2 trillion in 2021. However, an ongoing debate has been about whether crypto assets should be regulated as securities. The US Securities and Exchange Commission (SEC) has taken a strict stance on the matter, arguing that some crypto assets are in fact securities and should be subject to federal securities laws.

In this article, we will explore why some argue that crypto assets should not be considered securities and the implications of this debate for the crypto industry. We will also understand the factors the SEC considers when determining whether a crypto asset should be regulated as a security and the challenges of applying traditional securities laws to this emerging asset class.

Recent Event: The Collapse of FTX

FTX, a cryptocurrency exchange, recently faced a collapse, which has emphasized the need for comprehensive regulation of the crypto market. This regulation must have a solid legal foundation to protect investors and maintain stability in the market. One key aspect of such regulation is the ability to distinguish between different types of crypto assets, specifically those that are securities and those that are not.

The collapse of FTX has highlighted the need for a comprehensive regulatory framework to protect investors in the crypto market.

The SEC's Primary Theory on Whether a Cryptoasset is a Security

The Securities and Exchange Commission (SEC) has proposed that whether or not a cryptoasset is a security is based on whether the blockchain project associated with the cryptoasset is "sufficiently decentralized." This theory was first suggested in 2018 to address ICOs and was followed by more detailed staff guidance in 2019. However, this theory has not aged well and is impractical to apply to today's blockchain projects. Furthermore, it is not supported by existing judicial precedent, including the well-known Howey Supreme Court case. This approach has resulted in market distortions that harm market participants and innovation in the crypto industry.

The SEC's Decentralize-and-Morph Approach

In the wake of the 2014 ether ICO and the following ICO boom, the SEC staff provided the crypto industry with an analytical framework meant to clarify when and whether a cryptoasset is a security. The core idea is that where a blockchain project is sufficiently decentralized, the cryptoasset associated with the project will not be or represent an "investment contract" under the so-called Howey test, named after a 1946 Supreme Court case.?

This decentralization level of a project is determined based on approximately fifty factors that involve characteristics intrinsic and extrinsic to the project. These factors are evaluated at a particular point in time. However, this decentralization level could change over time, meaning a cryptoasset could start its life as a security and then morph into a non-security as the project becomes sufficiently decentralized.

The Right Path for Cryptoassets

A new paper, "The Ineluctable Modality of Securities Law: Why Fungible Crypto Assets Are Not Securities," analyses the relevant caselaw and concludes that there is a scant legalcapital-raising basis to treat fungible crypto assets as securities. The paper separates capital raising transactions by blockchain project sponsors or other insiders, in which a crypto assetcrypto asset may be sold - which are typically securities transactions - from the treat crypto assessment of the cryptoasset, which is not a security.?

crypto assetThis analytical framework addresses the challenges created by the SEC staff's approach and appropriately focuses the SEC's regulatory jurisdiction on asset crypto transactions. This approach should be taken by the US Congress as it considers legislation to regulate the crypto industry and by courts as they consider high-stakes cases that hinge on the securities law treatment of crypto assets capital-raising.

This paper's approach is the right one and should be taken into consideration by the US Congress and courts as they consider legislation to regulate the crypto industry and high-stakes cases that hinge on the securities law treatment of crypto assets.?

Doing so will avoid the flaws of the SEC's current approach and better protect market participants while supporting innovation in the crypto industry.

Key Takeaways

• Comprehensive regulation of crypto markets is needed, with a solid legal foundation, including a framework that distinguishes between crypto assets that are securities and those that are not.?
• Fungible crypto assets are not securities under existing US federal securities laws, while ICOs and similar token sales should be regulated as securities offerings.?
• The SEC's primary theory on whether a crypto asset is a security, based on decentralization, is impractical and has resulted in market distortions.?
• An analytical framework that separates capital-raising transactions from the treatment of the crypto asset is needed, with a focus on capital-raising transactions.?

Ultimately, striking the right balance between regulation and innovation is crucial for the long-term growth and sustainability of the crypto industry.