Security or Not a Security, A Crucial Regulatory Question
Securities regulators in the U.S. and Canada continue to wrestle with many issues as they consider how best to oversee the emerging realm of blockchain-based digital tokens. Offshoots of blockchain technology, which underlays Bitcoin and other cryptocurrencies, digital tokens reside in a regulatory twilight zone.
A concern among blockchain developers is that the U.S. Securities and Exchange Commission and its Canadian counterparts may attempt to classify all digital tokens as securities, regardless of crucial differences in rights and functionality embedded in the tokens.
Though some regulation will help to boost investor confidence in public token sales, a one-size-fits-all approach to defining digital tokens as securities would be a mistake that would raise legal costs and potentially stifle innovation.
In North America, the Howey Test provides regulators with a guide to defining and instrument as a security. A 1946 Supreme Court ruling in SEC v. W.J Howey & Co., sets out criteria for a security in today's marketplace:
1. There is an investment of money.
2. It is an investment of money in a common enterprise.
3. There is an expectation of profit.
4. Any profit comes from the efforts of the promoter or third party.
While the test covers a lot of ground, it does not explicitly address the status of digital tokens or other digital assets and consequently doesn't take into account differences in the actual uses of digital tokens.
A source of worry for some token developers is that in the absence of a clear definition, U.S. regulators have been defining tokens as securities through enforcement actions against certain Bitcoin entrepreneurs.
"It is important to foster an environment where potentially transformative innovations that make for safer, better markets can flourish, but as the saying goes, with power comes responsibility," former SEC Chair Mary Jo White said in a speech in November.
"Entrepreneurs should recognize that they are not only innovators, but also market participants with important duties and obligations," she said.
In Canada, the Ontario Securities Commission (OSC), the country's largest securities regulator, is stepping up its interaction with financial technology entrepreneurs to refine its approach to blockchain technology.
In a statement in March, the OSC warned developers of products rooted in the blockchain, or distributed ledger technology, that their activities may fall within the commission's jurisdiction.
"Because this is a novel area, businesses may not be aware that some uses of this technology could trigger securities law requirements," said Pat Chaukos, chief of the commission's LaunchPad interface between the Toronto-based commission and fintech product developers.
At The Vanbex Group, we believe that whether a digital or blockchain-based token is a security or not should hinge on the types of rights or privileges embedded in the digital asset at the time of purchase. We propose an addendum be made to the current Howey Test that specifically deals with digital tokens, something akin to a digital securities test.
The Vanbex Group believes tokens related to equity ownership, dividends, profit sharing or voting rights should be categorized as securities and be subject to regulatory oversight because of the need to protect investors.
On the other hand, digital tokens with rights associated with membership or access to a platform, or so-called fuel to run an application, should not qualify as securities as these companies are, at point of purchase, are just selling a service, which fails to comply with the Howey Test's third criterion, that is, the expectation of profit.
For example, in the case of Ethereum, the world's second-largest public blockchain, the ether tokens that power it were sold to provide access to the Ethereum platform or as "gas" for computing power. Ethereum is structured to allow users to build smart contracts and decentralized applications on top of its platform.
Similarly, developers of Steemit, one of the most successful blockchain social media platforms, sold its STEEM digital tokens to provide an incentive for site users who write and post articles, videos, or comments.
And then there is Spells of Genesis, a Switzerland-based blockchain-based game developer, which has also issued access tokens called BitCrystals, which grant access to the game and to unlock in-game features.
In all three examples above the tokens function as a means of gaining access to a platform and, in our view, negate their definition as a security under the Howey Test.
"There are many "digital" items that have value or can be bought or sold without being classified as a security," said Boris Mann, co-founder of Vancouver-based Frontier Foundry, a venture creation studio. "The real test is utility: can the tokens be used on the platform for a purpose other than funding the platform?"
One only has to look to the Domain Name System and the international market for domain names being bought, sold, and speculated on for an example of digital real estate that have real value, but are not securities.
To further cement a digital token as non-security, blockchain-based projects would be well advised to include a disclaimer that token buyers should have no expectation of profiting from their purchase.
In recent discussion with the OSC, I have emphasized the willingness of blockchain risk takers to develop constructive and collaborative relationships with market regulators for the ultimate safety and benefit of investors.
That said, more needs to be done to protect the fate of the blockchain industry. The prospect of heightened regulatory interest in digital tokens should be a wake-up call to more aggressively educate regulators about the diversity of token functionality and the risks of unnecessary oversight.
Blockchain technology is a fundamental computer science innovation that is powering new innovation and for the first time instilling trust in the Internet without the need of intermediaries.
Everything from Bitcoin as a digital currency to Ethereum's promise as a world computing engine are possible, with fintech and non-fintech innovations arising from these ventures.
Fintech-centric applications should be regulated as such, while leaving open the opportunity for the many other use caeses that are being unlocked.