Cryptocurrencies are digital tokens built on blockchain technology. This allows for a product that is fully decentralized, with no need for a third-party intermediary like a government or financial institution. Cryptocurrency creators use initial coin offerings (ICOs) to raise capital to build their tokens. Cryptocurrency ICOs are problematic because they do not fit neatly within either of two traditional categories--securities or commodities. Each of these categories has their own regulatory agency: the SEC for securities and the CFTC for commodities. At first blush, ICOs seem to be a sale of securities subject to regulation by the SEC, but this is far from clear and creates regulatory difficulties. This is because the Howey test, which determines whether an asset is a security or not, does not cleanly apply to nontraditional assets, like tokens. This Note argues for a revised standard that reconciles Howey with cryptocurrencies. This standard would require cryptocurrency creators to show how essential blockchain technology is to their token if they pwant to fall beyond the scope of the Howey test, and consequently SEC regulation. This standard would still preserve regulatory protections from fraud, which the CFTC provides for investors, while loosening regulatory restrictions on the cryptocurrencies that leverage blockchain technology most usefully.
TABLE OF CONTENTS INTRODUCTION I. THE HISTORY OF BITCOIN AND ITS REGULATION A. The Basics of Blockchain Technology B. The Rise of Bitcoin C. Initial Coin Offerings and Regulatory Concerns II. CRYPTOCURRENCIES PRESENT CHALLENGES FOR HOWEY A. The SEC and the Howey Test B. The Vanishing Line Between Commodity and Security III. CRAFTING A STANDARD: HOW CRYPTOCURRENCY CREATORS CAN REBUFF HOWEY A. The Components of a Solution B. Is Blockchain Technology Essential to the Enterprise? C. Blockchain Examples: From Bitcoin to Bananacoin CONCLUSION INTRODUCTION
Cryptocurrencies expose a rift between the financial market regulatory schemes administered by the Securities Exchange Commission (SEC) and by the Commodity Futures Trading Commission (CFTC). Traditionally, the authority of each of these two regulators has been delineated by a clearly defined boundary separating securities and commodities. Bitcoin and other cryptocurrencies disrupt the securities/commodities dichotomy as they do not cleanly fit in either category. This Note examines the disruption through the lens of cryptocurrency initial coin offerings (ICOs). ICOs, a relatively recent phenomenon, allow entrepreneurs to raise substantial amounts of capital outside the existing framework of securities laws. (1) Although the SEC recently announced enforcement actions against these offerings, (2) reasoning that some cryptocurrencies are securities under the Securities Act of 1933, (3) the CFTC holds that cryptocurrencies (4) are commodities under the Commodities Exchange Act. (5)
The distinction between classifying cryptocurrencies as securities or commodities is critical. First adopted in SEC v. W.J. Howey Co., the investment contract test (Howey test) establishes four requirements that determine whether an agreement is an investment contract and therefore a security. (6) But cryptocurrencies do not neatly fit within the investment contract test. (7) The test distinguishes between commodities and securities, but the novelty of cryptocurrency strains that distinction. (8) If firms selling digital tokens to raise capital are found to be selling securities, they must comply with the registration requirement enforced by the SEC. (9) The registration requirement entails disclosing an exhaustive list of items to investors that is both costly and time-consuming to compile and, perhaps most critically, exposes the issuer to fraud liability under Rule 10b-5. (10) Additionally, "[t]he presence of a security also brings with it the monitoring and enforcement of the SEC and possible criminal sanctions for violations of the securities laws." (11)
Traditionally, commodities were distinct from securities because they were tangible and held inherent value. (12) Typical commodities include gold, livestock, and wheat. (13) These are nonfungible, are relatively nonmarketable, and require substantial care or attention. (14) In contrast, securities are intangible and have no inherent value; instead, they derive their value from the efforts of an enterprise. (15) Put simply, compared to securities, commodities indicate a higher dependence on the efforts of the seller to return a profit to the buyer. (16)
Contemporary finance has morphed these traditional commodities into financial instruments that can be used like securities. Commodities transactions now serve "essential functions of speculation, hedging, and price discovery." (17) The principal participants in commodities markets are sophisticated traders who use commodities in much the same way they use securities. (18) Furthermore, the modern legal definition of a commodity is much more expansive than the traditional view of tangible assets with inherent value. (19) Section 1(a)(9) of the Commodities Exchange Act defines "commodity" to include "all services, rights, and interests ... in which contracts for future delivery are presently or in the future dealt in." (20) This regime governs the largest financial markets in the world, including bets on interest rates, futures, swaps, and the currency exchange markets. (21) Where the capacious definition of commodity ends and where the definition of a security begins is not obvious.
Cryptocurrencies occupy an unclear place in this regulatory scheme. According to an SEC investor bulletin, some ICO transactions are securities while others are not. (22) But according to the CFTC, "[b]itcoin and other virtual currencies are ... properly defined as commodities." (23) As a result of this administrative split, an unclear rule has been established: cryptocurrencies that are structured like bitcoin are more likely to be commodities subject to regulation by the CFTC, while cryptocurrencies that are differently structured are more likely to be securities regulated by the SEC. This confounds regulated entities and provides little guidance on how firms should structure their offerings or tokens. Lawyers, too, are unsure of how to advise clients. (24) SEC Chairman Jay Clayton noted that the "most disturbing" feature of ICOs is lawyers providing "equivocal advice." (25) This uncertainty must be addressed for the benefit of all stakeholders: cryptocurrency firms, regulatory entities, and even the lawyers involved.
This Note provides a standard for evaluating cryptocurrency ICOs that is consistent with the Howey test but still provides room for the cryptocurrency market to grow. (26) Part I discusses the rise of cryptocurrencies, beginning with bitcoin. It examines the deeply factual problem that regulation of bitcoin and other cryptocurrencies gives rise to: whether or not a cryptocurrency is a security. Part II describes how cryptocurrencies present difficulties for the Howey test and raise the specter of regulatory arbitrage. Part III endorses a standard that a cryptocurrency is only a commodity if it is built on blockchain technology that provides sufficient utility.
THE HISTORY OF BITCOIN AND ITS REGULATION
The Basics of Blockchain Technology
Cryptocurrencies are made possible by a technological innovation: the blockchain. (27) Put simply, the blockchain, a decentralized ledger, is a connected list of encrypted transactions--like a database. (28) The blockchain is an improvement on conventional databases because it solves the problem of trusting intermediaries. (29) In typical transactions, "you have to believe the intermediary will store the data accurately." (30) In a cryptocurrency blockchain, transactions are funneled through coin "miners," who solve complicated cryptographic problems to securely verify them. (31) The ability for independent individuals to verify digital transactions through cryptography, without involving centralized institutions like a bank or government, is an innovation with huge potential. (32) The technology, though still new, enticed investors and drove up the valuation of cryptocurrencies like bitcoin, turning it into one of the most volatile assets traded today. (33) The law historically struggles with technological innovations because it relies on precedent and, therefore, does not reliably envision future developments. Grappling with technological changes is a continuing challenge for the legal community, and cryptocurrencies put that challenge into stark relief. (34)
The Rise of Bitcoin
Bitcoin is the most popular of available cryptocurrencies. (35) Bitcoin miners verify transactions on the blockchain by solving complicated cryptography problems and are rewarded with bitcoins. (36) Bitcoins can be used by whoever accepts bitcoin for payment, and their price depends on the market. (37) But, it remains unresolved "[w]hether bitcoin will ultimately be a store of value, akin to digital gold, or a means of payment." (38) Equally puzzling for lawyers, regulated entities, and regulatory agencies is the question of how the law should apply to bitcoin.
Viewing bitcoin as a commodity, as the CFTC suggests, (39) makes sense because its primary function is storing value. (40) This characterization places it in the same category as conventional commodities--most notably, gold. (41) Although there are clear distinctions between bitcoin and gold, such as gold's utility in creating other goods like jewelry and electronics, (42) any legal distinction disappears once they are both declared commodities. (43)
But if bitcoin is a commodity, what are other cryptocurrencies? Droves of cryptocurrencies have been created in the years since bitcoin's invention, but not all of them share bitcoin's "commodity" characteristics, such as nonfungibility, nonmarketability, and actual utility. (44) In the absence of these features...