Monday, February 01, 2016

Decentralization, Transparency Should Dictate Whether a Cryptocurrency Is a Security, Group Says

By Amy Leisinger, J.D.

A research firm has issued a report detailing a framework for regulation of cryptocurrency and related technologies. According to Coin Center, a non-profit research center focused on policy issues facing this ever-evolving industry, some cryptocurrencies should be treated as securities and some should not, based on the application of longstanding Howey test for investment contracts and the underlying policy goals of securities regulation.

Software and operational variables among cryptocurrencies affect their status and potential risks, the group explains, and a governing framework may need to depend on a determination of whether a cryptocurrency resembles a security. Larger, decentralized cryptocurrencies like Bitcoin do not readily fit the definition of a security and do not present risks generally addressed by securities regulation, but smaller and more uniquely designed ones may fit the definition and present risks that can and should be addressed, according to the report.

Howey test application. Under the Supreme Court’s Howey test, an investment contract means a contract or transaction where a person invests money in a common enterprise and is led to expect to profit from the efforts of a third party. While there may be a “provocative argument” that investments in Bitcoin and similar cryptocurrencies fall within the SEC’s jurisdiction, Coin Center states, several variables exist within these types of currencies and others with different software and operational structures. Specifically, the report explains, coin supply and distribution processes and network transaction recording, centralization, and transparency may vary greatly among cryptocurrency types, and the rights of holders and potential profits to developers differ in accordance with individual systems.

Recommendations. To avoid stifling innovation, the report opines, regulators should avoid limiting highly decentralized cryptocurrencies like Bitcoin because they lack general commonality and discernible third parties to be relied on by investors. In addition, sidechained cryptocurrencies connected with Bitcoin and those acquired for use-value or specific rights and privileges do not necessarily involve an expectation of profits.

Likewise, Coin Center continues, cryptocurrencies distributed through competitive mining involve no investment of money or potential loss of a “purchase” and provide limited opportunity for profit to developers. Transparency also plays a crucial role in relation to these particular cryptocurrencies, according to the report, and regulation may be unnecessary in light of the ability of participants to monitor, control, and/or object to potential risks.

However, regulators should take action to protect investors against cryptocurrencies that fit within the Howey test and present increased risks to users, according to Coin Center. Closed-source cryptocurrencies should be regulated because profits may come only from promoter’s hype and may be usurped by the promoter before development is complete, the report states. Further, those with heavily marketed pre-sales and a small mining and developer community should be treated as securities when indications exist that profits come primarily from the efforts of a discrete, profit-motivated group. In addition, cryptocurrencies with permissioned ledgers or a highly centralized group of transaction validators lead to user reliance upon transaction validations and the value of the network is based on faith in that group.

Finally, the report emphasizes that Bitcoin and related cryptocurrencies lacking indications of a security are less likely to pose significant risks, while smaller, less-transparent cryptocurrencies may require additional focus. The proposed framework “will hopefully enable regulators to more easily delineate between these inevitable scams and the legitimate innovations that will improve our lives, ensuring that a few bad apples do not spoil the bunch,” Coin Center concludes.