Is this the time for Indians to adopt crypto assets? - Part 1
In this four part article series, I will: 1) Break down the nature of crypto assets, 2) Analyse the nature of crypto trading, 3) Delve into the creation, existence, and role of Indian crypto trading intermediaries, and finally, 4) Opine on whether Indians should adopt crypto as an asset.
Let me paint you a picture. I'm really bored in quarantine. So I say, "Hey, you know what would be fun? If I made my own money." So I spend a few weeks designing and printing my own currency. Finally, I have it: 1 lakh Pranav Coins (PCD). I take it to the store and I try to buy a loaf of bread. I give him 45 PCD. The shopkeeper looks at me with the most puzzled look on his face as if this is some sort of a joke. I tell him, "No no, listen. This is PCD. Each PCD is worth 1 rupee." The shopkeeper boots me out of the store, and I'm stuck with worthless "currency".
What makes something a currency? There are a few accepted characteristics which are needed for something to be seen as currency, primarily arising from the 1875 paper, "Money and the Mechanism of Exchange" by William Stanley Jevons. They must be:
1. Generally Accepted - It must be widely accepted as a settlement of debt or as a discharge of obligation;
2. Durable - Its quality/value does not deteriorate over time, barring inflation;
3. Divisible - If you divide the currency in half, each half should be worth 50% of the whole. This is why artefacts and precious stones are not used as currency;
4. Stable/Consistent - The value does not fluctuate substantially with time;
5. Transportable - It is easy to move from one place to another, and retain its complete value. This is why we cannot adopt elephants as currency, no matter how badly we wanted to;
6. Scarce - It is difficult to acquire; and
7. Difficult to Counterfeit - This is primarily to maintain its scarcity and hold value.
I use the term crypto asset and not crypto currency as very few crypto assets have attained the characteristics of currency. Sure, you can call something a currency all you want. But what good is it if nobody else see it this way? Crypto currency is a small subset of crypto assets. But, it is a state of being. Any crypto asset could become a crypto currency, despite its primary intended purpose. One could argue that any asset could hypothetically fulfil the role of currency, and while that is a fair argument to make, the intrinsic decentralised nature of a crypto asset would allow it to attain the characteristics necessary of currency.
Thus, the term crypto currency used as a terminology to refer to all crypto assets is confused nomenclature, and this nomenclature is important from a regulatory standpoint. The RBI ban on all 'virtual currencies' aimed to protect the Indian economy from.. what? An entire system run on parallel currency? Flouters of anti-money laundering policies? It's still a little unclear even now after the Supreme Court has reversed the blanket ban on crypto adhering to the proportionality test.
Crypto assets can be divided into the following heads:
1) Cryptocurrencies like bitcoin; the most well known of all cryptoassets, are instruments of exchange, stores of value, and units of account. It was made for the purpose of being a decentralised currency and has largely been utilised that way. It does not have all the characteristics of currency but the goal is to reach a stable levels once all the coins are in circulation. However, there are some crypto currencies seeing adoption despite not being intended to be used as crypto currency, for example Ether. Any crypto asset should it gain the characteristics of a currency COULD be considered as a cryptocurrency.
2) Platform tokens like Ether of the Ethereum blockchain, the $40 billion mega-unicorn and Canada’s most successful start-up ever, are intrinsically designed to develop and support decentralized applications with various use case scenarios. Various crypto assets are built over the Ethereum platform and are traded subsequently.
3) Utility tokens are programmable blockchain assets that have utility in an application. Examples include Golem, which aims to aggregate the idle power of the world’s computing capacity into a decentralized supercomputer that anyone can use to run computations in exchange for Golem tokens. Essentially, Amazon Web Services, except being carried by individuals around the world, in exchange for said utility token.
4) Security tokens are equities, native digital bonds, and any other securities that trade peer to peer, unhinged; i.e, without the intervention of financial intermediaries. It aims to settle trades on T0 on a decentralised exchange, as opposed to the standard T0+2 of standard stock trade settlement. These are classified and issued as securities from the stage of initial offering. So there is little to no debate in this regard.
5) Natural asset tokens represent tangible goods like gold, oil, or carbon in peer-to-peer markets with real-time settlement.
6) Cryptocollectibles are entirely unique digital assets. Take for example CryptoKitties, a blockchain game on Ethereum that allows players to purchase, collect, breed and sell virtual cats. As of date, Cryptokitties has had over 600,000 individual sales of these digital cats resulting in sales worth $280 million.
Crypto trading platforms allow for users to purchase most of the above types of assets, and not just crypto currencies.
Part 1 of this series seeks to answer the impending question: Are crypto assets securities?
Section 2(h) of the Securities Contracts (Regulation) Act, 1956 defines securities. In relation to crypto assets, the cardinal extract reads as: securities include "shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate, any derivatives (which are securities derived from debt instruments, shares, secured or unsecured loans, risk instruments or contract for differences or any other form of security or a contract which derives its value from the prices, or index of prices, of underlying securities), or any such other instruments as may be declared by the Central Government to be securities."
Now the question that needs to be answered is that do crypto assets fall under the purview of this definition? The answer is not as simple as the question. Not only does it have to be a security, but furthermore, even if it is of like nature of a security, it must be issued by an incorporated company or body corporate.
In 1946, in the case of SEC v. W.J. Howey Co., the United States Supreme Court of developed a four-pronged test to determine whether an instrument would constitute an investment contract and therefore, be subject to securities regulations. Interestingly, the Indian Courts have looked upon this test favourably, as was seen in Sahara India Real Estate v. Securities & Exchange Board of India (SEBI). In order to satisfy the test, and constitute a security, there must be an:
- Investment of money,
- In a common enterprise,
- With an expectation of profits,
- Coming solely from the efforts of others.
SEBI used this test to determine that Optionally Fully Convertible Debentures would fall under the purview of a security. This test was accepted by the court. That's that then right? Initial Coin Offerings (ICO) would definitely satisfy this test? Well, yes and no. You see, Securities Exchange Commission (SEC) Director, William Hinman, built upon the Howey test, prescribing that if the network that was used to disburse tokens is sufficiently decentralized, such tokens would not constitute securities. To quote, "if the network on which the token…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." This was codified into the SEC framework in 2019. The importance of the addition of this element lies in the fact that it aligns with the objective of securities law: to balance out information asymmetry and eliminate misrepresentations and fraud in securities offerings. Two scenarios emerge from this categorisation.
The first is where the network on which the tokens are disbursed and functions is sufficiently decentralized. This leads to operational and managerial efforts being scattered across the network, largely disallowing information asymmetry and fraud. Thus sufficient decentralisation promotes transparency by way of its very functioning, thereby intrinsically not needing the regulation of securities law. In such decentralised networks, the absence of a central entity playing a pivotal role in the success of the enterprise fosters the implication that there no longer exists the material information asymmetry that securities law seeks to counter-balance. There would now no longer exist a single entity whose managerial efforts have been relied upon by investors.
The second type is where the network is not sufficiently decentralized and there exists a discernable third party/common enterprise upon whom investors rely for the expectation of profits. In such a case, as long as the other prongs of the test are satisfied, the offering would constitute a security. As a result, questions of Ponzi schemes and related risks to investors would all fall within the ambit of securities regulations, as these fears only arise when there is a central entity which has not yet been sufficiently decentralized, upon whom investors rely.
A number of observations can be made with regards to the factors which are of importance for a ‘sufficiency-of-decentralisation-test’ or the Hinman Test. Primarily, decentralisation should be measured on a gradual scale. Decentralisation is not binary, but instead a multidimensional concept that is a function of many factors, each of which has its own gradual scale of decentralisation. This is a however a post for another day.
In conclusion, if a utility token is issued on a sufficiently decentralised network, progressively or otherwise, it should not attract security law. The problem that now arises is that many ICOs are made as utility coins when in actuality they are security tokens, or utility tokens that are not on a decentralised platform, thereby triggering SEC intervention. This includes Telegram, Kik, and recently, Dropsil.
Back to the original question: Are crypto assets securities? Most crypto assets are not securities, and if tokens are issued properly, they are not securities either. Tokens are not securities so long as they have been issued on a sufficiently decentralised platform. The Hinman test builds on the existing Howey Test to give clarity to the role of security law in the cryptoverse, especially with regard to tokens.
Indian law however has not examined the Hinman test but has payed due regard to the Howey Test as stated above, and since the Hinman test has not been adopted by Indian courts yet, let us take a step back and logically put ICOs to the Howey test.
If the instrument fails on any one of the four criteria, it won’t be deemed as security:
1) Investment of money: This is the most important criteria and most common point of discussion for any token to be termed as security. It is essential to look at what the token is actually doing for investors and what happens to these tokens once the network is finally launched.
If the token is a utility token that will be used on a blockchain, then its chances of being deemed as investment security may be negligible. Thus, utility tokens are not investments per se, but think of it as a product launched on a crowd funding platform.
To circumvent this investment rule however, ICO issuers have historically used the word “contribute” than “invest” as they do not want their token to get termed as a security. However, these tactics no longer work as the SEC constantly blocks such ICOs that are portrayed to be utility tokens but are actually security tokens.
2) Common enterprise: Most ICO’s currently collect funds from various investors and pull it to a common cause that is highlighted in their white papers. This is where investors seem to be forming a “common enterprise.” Unless it is an open source platform that is solely not for profit, this criterion for the test is easily met.
3)The expectation of profit: While the token is expected to rise in value as its adoption increases, issuers work hard to prevent being labelled as an investment lest they attract regulators. For an ICO to bypass this criterion, it has to design its offering as a product or a service primarily being offered against the token held. As stated earlier, this would be similar to crowdfunding projects where the product or service is available against the initial investment made (e.g., Kickstarter). Kickstarter and similar platforms offer creators the opportunity to presell their goods, such as books, art, games, and tickets to films or plays to be produced. In general, such products are not securities, and would not pass the Howey test or fit within any of the statutory definitions. One merely pre-purchases a physical object, or a ticket to an event. These items can be resold free of restrictions on platforms like eBay, OLX, or Quikr. This does not grant them security status, as the general motivation for purchase is not investment but rather use and enjoyment. This is analogous to proof of concept platforms that issue utility tokens.
But, what happens when a utility token issued on a block chain that is yet to be launched rises in value? What if I invest in a platform taken solely to utilise the platform, but the interest and potential in the platform has driven up market sentiment? It all boils down to the nature of the platform.
In United Housing v. Forman [421 U.S. 837 (1975)], tenants of a massive New York City housing cooperative brought suit against the owners alleging securities fraud and the sale of unregistered securities, among other claims. Right of occupancy in the co-op apartments required the purchase of a number of shares in the co-op which were expressly called “stock.” No rights were conferred to the stock owners, other than occupancy; under the lease terms, stock could not be sold for more than their purchase price plus a fraction of the mortgage amortization paid during tenancy. Despite being labelled as stock, the US Supreme Court held that such shares were not securities and did not meet the conditions of Howey. Writing for the majority, Justice Powell stated that, when viewed in terms of their substance (the economic realities of the transaction) rather than their form, the instruments involved here were not shares of stock in the ordinary sense and conferred none of the normal rights associated with stock or other securities.
Following this logic, digital tokens sold for use in established networks that only have utility within those networks, such as Ether, Golem, or Ripple should not be considered as security.
4) Solely from the efforts of others: If the profit made by the token is entirely beyond the control of the token holder, then the token will meet this criterion. Most courts do not appear to take the “solely from the efforts of others” element of the Howey test in its literal sense, focusing instead on the degree of managerial control over an enterprise. This can be seen in a plethora of cases, landmark one being SEC v. Glenn W. Turner Enters [474 F. 2d 476 (9th Cir. 1973)]. This is where decentralisation comes into play. If there is no centralised control over the development of an enterprise, one could argue that it does not satisfy the test of common enterprise. Thus, this depends vastly on the nature of the ICO and the network. A democratic common enterprise which is sufficiently decentralised would not satisfy this test.
Thus, are crypto assets securities? A handful of them are, but most of them are not. Even if we apply the Howey test as accepted by the Indian courts, crypto assets will fail one or other of the test as illustrated above.
You see, hardly any crypto assets that are traded are issued from India. ICOs which are traded are primarily issued in the US, and some EU countries. That is why the SEC's classification of whether or not a token is a security is pertinent as without such clearance, they would not be allowed to be issued in the first place. In fact, the United States has the highest rate of issue of alt coins. 95% of all alt coins arise from USA, UK, Switzerland, Russia and Singapore; all of which have used decentralisation as a primary criteria for the determination of whether or not an ICO constitutes a security, and even if such crypto assets are securities, they have been issued the requisite clearance (such as Sia) in the origin country to be traded. There could arise a possibility where one country does classify a crypto asset as a security, while another country doesn't. Obscure alt coins don't make it to major trading platforms due to stringent ICO laws in their origin countries, making its second hand selling difficult, almost close to impossible.
So while Indian law doesn't have too much to offer, we have to take into account how these crypto assets make it to trading platforms in the first place, how they are classified in their origin countries, and how much their classification actually matters to us to trade. Even if we consider the Howey test in isolation and apply it to crypto assets, one could argue on the aforementioned grounds to say that the vast majority of them, barring a few exceptions (which are easy to isolate), are not securities.