Gary Gensler, the United States Securities and Exchange Commission (SEC) chairman, has consistently said that all digital tokens, except Bitcoin, falls within the jurisdiction of the SEC. Bitcoin, he says, is a commodity. In an interview with New York Magazine in February, Gensler said that “at the core, these tokens are securities because there’s a group in the middle and the public is anticipating profits based on that group.”
With this description, Gensler is referring to the Howey Test, based on a 1946 Supreme Court ruling in the case of the SEC v. W.J. Howey Co. Howey sold citrus groves to Florida buyers, who leased the groves back to the company, which then cultivated the trees and sold the oranges on behalf of their buyers, sharing the profits. Howey subsequently failed to register with the SEC, arguing that its transactions were not investment contracts. Howey lost the case when the court ruled that the leaseback arrangements were investment contracts after all, thus establishing the Howey test.
The Howey test has four criteria to determine whether something constitutes an investment contract:
- An investment of money
- in a common enterprise
- with the expectation of profit
- to be derived from the efforts of others
In a congressional hearing of the House Financial Services Committee in April, Gensler restated his position that “most crypto tokens are securities” and should be regulated by the SEC. In his opinion, the market is “rife with incompliance” and, in the name of investor protection, should be regulated in line with the standards applied to traditional finance: “It’s the law; it’s not a choice. Calling yourself a DeFi [decentralized finance] platform, for instance, is not an excuse to defy the securities laws.”
The SEC has ramped up its enforcement of the crypto industry, bearing down on companies and projects it alleges are hawking unregistered securities. The agency has reported about 50 separate enforcement actions against digital asset firms, and requested an additional $78 million in funds to expand its activity.
But his actions haven’t gone without criticism. At that hearing, committee chairman Rep. Patrick McHenry, R-N.C. said, “Your approach is driving innovation overseas and endangering American competitiveness. Regulation by enforcement is not sufficient nor sustainable. You’re punishing digital asset firms for allegedly not adhering to the law when they don’t know it will apply to them.”
Gensler seemed to show little sympathy, saying “We have a clear regulatory framework built up over 90 years” and that the exchanges are “just a bunch of intermediaries in this market that think they have a choice. They don’t have a choice. They’re noncompliant generally, and they need to come into compliance.”
Do we truly have “a clear regulatory framework” for digital assets in the U.S.? And should all digital tokens fall under SEC jurisdiction? Before we answer these questions, let’s first understand the legislative and regulatory structure and landscape in the U.S. and its implications on the digital asset space.
Regulation today
The U.S. has a ‘dual banking system,’ meaning that digital asset service provision can be regulated at the state or Federal level. In both cases, state and Federal regulatory and enforcement agencies have outpaced Congress and the White House in moving to regulate digital asset activity.
While regulatory agencies continue to discuss regulatory authority, policy makers have been drafting digital asset legislation proposals. For example, the bipartisan Responsible Financial Innovation Act (RFIA) would classify most digital assets as commodities, giving primary oversight responsibility to the Commodity Futures Trading Commission (CFTC) and establish requirements for stablecoins.
In March 2022, the Biden administration released an Executive Order outlining a whole-of-government approach to address risks stemming from the growth of digital assets and blockchain technology while supporting responsible innovation. In September 2022, initial findings have been reported, but questions remain as to which regulators in the U.S. hold the power and authority to govern digital assets.
The Financial Stability Oversight Council (FSOC), an interagency consultative body composed of state and Federal banking, commodity, securities, and consumer protection authorities, released a capstone report that concluded there is no comprehensive regulatory framework in the U.S. for digital assets.
In the absence of that framework, the regulation of digital assets is a function of their regulatory asset classification, which can overlap. Specifically, digital assets may qualify in several categories:
- Payments: These fall under the jurisdiction of Office of the Comptroller of the Currency (OCC) and Money Service Business (MSB)
- Commodity: These fall under the jurisdiction of the CFTC
- Security: These fall under the jurisdiction of the SEC
When Gensler says that all digital assets (except Bitcoin) fall under the jurisdiction of the SEC, this implies that digital assets cannot function as a payment or a commodity or have any utility other than trading as a security, like stocks on an exchange.
But we know that’s patently not the case. For example, meme coins like Dogecoin and Shiba Inu have no utility or economic merit, and are mainly traded and speculated. Despite that, some businesses have already begun accepting meme coins as payments; so even though these tokens may have no utility, they can still serve as a mode of payment. In such a case they resemble Foreign Currency (FX) rather than a security, and FX falls under the jurisdiction of CFTC.
Many also argue that Ether, the token used to facilitate transactions on the Ethereum blockchain, is a utility and not a security. Ethereum is a platform for developers to build decentralized applications, like iOS for the iPhone (iOS being a centralized platform), meaning that Ether should fall under the jurisdiction of CFTC.
The Chairman of the CFTC, Rostin Behnam, in a hearing from the Senate Agriculture Committee, called Ethereum a commodity and not a security. Behnam further argued that Ethereum had been listed on CFTC exchanges for quite some time, and that creates a “direct jurisdictional hook” for the agency.
Crypto exchange Coinbase filed suit against the SEC asking that the regulator be forced to publicly share its answer to a petition, filed in July 2022, on whether it would allow the crypto industry to be regulated using existing SEC frameworks. The SEC did not offer a specific public response to Coinbase’s petition, but in recent months has aggressively ramped up enforcement actions and warnings against crypto exchanges, including Coinbase.
Gensler responded to Coinbase lawsuit in a video to make the point that what crypto exchanges are doing is very obviously marketing and selling securities, even if the debate on the topic has been obscured, and again referenced the Howey test: “An investment contract exists when you invest money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others. Intermediaries for investment contracts, whether they’re exchanges, brokers, dealers, clearinghouses, they need to comply with the securities laws and register with the Securities and Exchange Commission.”
Do all digital assets meet the Howey test?
The Howey test is not quite clear, and using a 1946 case about orange groves to decide whether a digital asset is a security or not might need to be updated to account for the evolutions in technology, globalization, and financial instruments. For example, stablecoins, which are pegged to the U.S. dollar, might qualify as a security. But the purpose of a stablecoin is to be used as a payment method on digital and Web3 platforms and no profit or expectation of profit is involved.
And what about Central Bank Digital Currencies (CBDC)? What if the United States launched a digital currency that is a pure digital dollar – would that be a security?
There are tens or hundreds of thousands of tokens out there – anyone can create one. The real issue relates to the projects that accumulate significant capital through the issuance of tokens. It’s fair to say that at the time of the issuance process, most of them would meet the Howey test, but what does that mean years later, for ongoing trading and use of the tokens like in the case of Ether?
DeFi applications are another critical example. By construction, they are not an enterprise controlled by a centralized authority — no one controls a decentralized application (which is the whole point). Who would be responsible in this case? The developers? If you decide to regulate developers, that might deter innovators from building applications and significantly stifle innovation. Before we decide if and how to regulate DeFi, we might consider the approach taken by the Bank of France, which issued a discussion paper called “Decentralized or disintermediated finance: what regulatory response,” containing 38 questions and asking for responses from the public.
It’s clear that we do not have a clear regulatory framework for digital assets in the U.S. and that not all digital tokens and platforms (i.e., DeFi) should fall under SEC regulations.
How can we get more regulatory clarity?
Federal legislation would certainly create guardrails around the SEC and would help determine which federal agencies are tasked with regulating different types of digital assets. A clear framework by legislators would provide clarity to the industry. People who want to invest in digital assets will feel more confident if there is a clear framework, knowing that they are being protected, whether it’s the SEC or the CFTC, or if Congress came up with some new agency that was going to oversee digital assets.
Another potential outcome is a Supreme Court ruling, like the Howey case. Since the Howey test is a precedent established by a court decision, is it possible that the courts could set a similar precedent for digital assets?
In the absence of Congressional action, you could have a landmark case like the Ripple case that is currently playing out.
It is evident that more regulatory clarity on digital assets is needed, and sooner rather than later. It is vital that U.S. legislators take a more proactive approach to settle the confusion and ambiguity.
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