Cryptocurrency and the SEC

Crypto coins surged in valuation after a top US Securities and Exchange Commission (SEC) regulator said crypto transactions aren’t subject to federal securities rules on the 14th of June. 

The SEC launched a crackdown on dozens of companies alleging fraudulent ICO (Initial Coin Offering) practices in the initial months of 2018. 

Background 

A cryptocurrency is a digital asset intended to work as a medium of exchange that uses cryptography to secure its transactions, to manage the creation of additional units, and to authenticate the transfer of assets. Cryptocurrencies are a form of digital currencies, alternative currencies, or virtual currencies. As it is not issued by any central authority, rendering it theoretically immune to government interference or manipulation. 

The first cryptocurrency to capture the public imagination was Bitcoin, which was launched in 2009 by an individual or group known under the pseudonym Satoshi Nakamoto. As of May 2018, there were over 17 million bitcoins in circulation with a total market value of over $140 billion. 

Cryptocurrencies make it easier to transfer funds between two parties in a transaction; these transfers are facilitated through the use of public and private keys for security purposes with minimal processing fees. Thus, it is more attractive for individuals and companies alike to use these decentralised cryptographic systems instead of central banks for basic transactions or for raising capital for projects. 

In the final months of 2017, the value of Bitcoins began to rise exponentially along with other cryptocurrencies. At one point it was trading at $20,000 thus sparking a slew of warnings from experts and analysts. Other cryptocurrencies like Ripple and Dogecoin have also performed incredibly well in the past year. However, after the SEC was expected to crackdown on Ether, launched by Swiss nonprofit Ethereal, the valuation of coins had dropped significantly. 

Analysis 

“Putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions,” William Hinman, who heads the Securities and Exchange Commission’s division of corporation finance, said in remarks prepared for a Yahoo Finance conference in San Francisco. “And, as with Bitcoin, applying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value.” 

United States follows the “Howey Test” to determine if whether an instrument qualifies as an "investment contract" for the purposes of the Securities Act which states "a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” 

For investor protection, promoters are liable if there is over or undervaluation of any given security. However, with crypto currency, the existence of third parties are negligible or ambiguous. The lack of centralised structures undercuts the assurance placed by investors on companies or entities carrying out future actions. 

An Initial Coin Offering is an event that usually extends over a period of one week or more and in which everyone is allowed to purchase newly issued tokens in exchange for established cryptocurrencies like Bitcoin (BTC) or Ether (ETH). In an ICO, there can be a specific goal or limit for project funding, meaning that every token will have a pre-designated price that will not change during the Initial Coin Offering period, which also means that the token supply is static. It is also possible for the token price to increase if the funding for the project increases based on the conditions of the ICO. 

Ethereum is complicated because of the circumstances of its ICO. Although the token currently has utility (say the ability to programme on widespread Ethereum servers for a small fee), there was some concern that its speculative nature might have caused the SEC to consider it a security. There was no ‘single’ third-party promoter as it was launched as a communal effort, unlike other ICOs. 

For the US, Ethereum presents itself as a political challenge as Russian President Vladimir Putin has publicly endorsed its use. According to Bloomberg, Putin was attracted to Ethereum as a ‘potential tool to help Russia diversify its economy beyond oil and gas’. 

Russia has been isolated by sanctions imposed by US and EU, but in the crypto world, an ambiguous dark underbelly of the regulated financial world of central banks and stock exchanges, digital transactions through crypto currencies are not hampered by sanctions or blockades. This particular feature has made it an attractive method of payment in the black market for drugs, arms, humans and more. 

Valuation of crypto currencies have wavered as countries, including India and South Korea, have set out laws that ban their use. Citizens continue to use crypto currencies as the laws for identification are incapable of encompassing features of transactions leaving domestic jurisprudence in a grey area. With no commission or regulatory authority to manage valuations and exchanges, most ICOs are left to the investors faith in the project’s capacity and future. 

Assessment 

Our assessment is that the cryptocurrencies are at the vanguard of change for the financial market. However, as stated previously, the cryptocurrency market is volatile and there remains some doubt over the real value that should be attributed to cryptocurrencies like Bitcoins. We believe that while states can attempt to ban their use, it is more viable to use regulatory processes.