Should cryptocurrencies be regulated like securities? Financial regulators have been pondering this question for some time. In a Briefing Paper published today by the Cato Institute's Center for Monetary and Financial Alternatives, I suggest that securities regulation would only seem warranted in certain clearly circumscribed cases. For the most part, cryptocurrencies should be treated like commodities.
It has been nearly a decade since "Satoshi Nakamoto" laid the intellectual foundations for Bitcoin, the first cryptocurrency platform. Since then, more than 1,600 peer-to-peer networks have emerged to disrupt established intermediaries. Cryptocurrencies, even in the comparably bearish first half of 2018, have an aggregate market capitalization of nearly $300 billion.
While policymakers' attention has gradually turned to designing an appropriate regulatory framework for this emerging technology, policy uncertainty persists. On one hand, some policymakers recognize the potential for cryptocurrencies to increase competition, reduce transaction costs and improve capital formation opportunities for firms. On the other, statements from regulators at the SEC and CFTC, the two agencies most closely monitoring the development of cryptocurrencies, have been unclear, equivocal, and sometimes outright contradictory.
In April, former CFTC chairman Gary Gensler suggested that ether, the cryptocurrency of the Ethereum network, should be treated like a security. This designation would have forced onerous new registration requirements on platforms that hold ether in custody and for trading, while making access to Ethereum by retail buyers more difficult. Furthermore, because the Ethereum platform provides the infrastructure for many other cryptocurrencies, such a move would have compromised the viability of large parts of the cryptocurrency market.
Fortunately, these risks have receded into the background since William Hinman, Director of the SEC's Division of Corporation Finance, argued in a recent speech that ether, in its present form, wouldn't qualify as a security because the Ethereum platform is heavily decentralized. The SEC's classic test for a security defines it as (1) an investment of money (2) in a common enterprise (3) with the expectation of profits (4) from the efforts of others. In Hinman's opinion, developments since the launch of Ethereum in 2014 mean that the platform presently fails to meet criteria (2) and (4).
The next step is to give Hinman's welcome pronouncement regulatory heft. In the Briefing Paper released today, I propose that the SEC and CFTC formally establish a distinction between functional cryptocurrencies, such as Bitcoin and Ethereum, and promises of cryptocurrencies to be delivered in the future. Cryptocurrencies in the first category do not meet the criteria for a security and should be regulated as commodities. Those in the second category may be securities, depending on the individual circumstances of each issue.
The launch of cryptocurrencies is often preceded by what is, somewhat misleadingly, called an initial coin offering (ICO). An ICO involves the exchange of money today for the delivery of units of cryptocurrency in the future, where the funds are used to build a new platform. ICOs are a way for startups to raise capital, so in some circumstances they may tick the four boxes in the SEC's security test. In particular, when buyers in an ICO are able to trade their holdings before the launch of the application, the contracts could constitute securities. In other cases, however, ICO agreements may simply be advance purchases of a good or service and not tradable before the platform goes live. Those agreements more closely resemble forward contracts and should be regulated like them.
In the paper, I propose just such a two-tier regulatory structure for ICOs, recognizing that some of them may fall under the securities laws, but that this will be determined by the circumstances of each case.
Apart from being consistent with Director Hinman's position, the suggested approach balances consumer protection and the duties of financial regulators with an open environment for cryptocurrency innovation. It recognizes that most of the fraud about which the SEC has expressed concern happens at the ICO stage, so buyers might benefit from increased disclosures then. But it also takes account of the fact that excessive regulation of functional cryptocurrencies would stifle the market and throw a spanner in its further development, with few countervailing benefits in the form of market stability or consumer protection.
It is time for policy to catch up to the exciting development of cryptocurrency markets. But catching up shouldn't mean smothering the technology with regulation, nor crudely applying the securities laws to all cryptocurrencies. The reality of this emerging market favors a more judicious approach.