Crypto Law TL;DR
Hi all 👋
Oof.
Crypto. It’s a regulatory quagmire.
To keep this short, this TL;DR assumes you know the basics of crypto.
As always, if you want a topic covered, or have questions, feel free to DM me.
Let’s start with some fundamentals…
What Is Crypto, Legally?
Crypto regs are still evolving, but two options1 have emerged depending on what the token is: securities and commodities. You should start by asking…
Is It A Security?
Section 2(a)(1) of the Securities Act defines what counts as a “security.” It lists instruments like stocks, bonds, CDs, swaps, puts, calls, etc.
And, of course, it doesn’t include crypto (...since it was written in 1933). But it does include a catchall for “investment contracts.”
Whether something counts as an investment contract depends on the four-part Howey test2:
There’s an “investment,”
In a “common enterprise” (aka, some mutual endeavor of people working together),
Investors expect profit, and
The profit would come from the efforts of others.
The common enterprise prong is nuanced. Some courts say you need “horizontal commonality” (a bunch of investors pooling $$ together), while other courts say you need “vertical commonality” (a relationship between someone promoting the security and an investor).
BTC
Let’s apply the Howey prongs to BTC:
Investment: buying BTC with USD or other crypto qualifies.3
In a common enterprise: maybe? There’s no vertical commonality because there’s no issuer promoting the securities. But maybe there’s horizontal commonality? People pool their money together in BTC...kind of? This prong is not entirely clear for BTC.
Investors expect profit: yes, a lot of people buy BTC with the hope of making $$.
From the efforts of others: not really? There’s not really a person or small group that controls Bitcoin (that’s the point…).
BTC probably fails the second and fourth prongs. The consensus is BTC isn’t a security.
ETH
What about ETH? That’s less clear:
Investment: yup, same as BTC.
In a common enterprise: probably? When ETH was launched, the creators issued a crowd sale, so people pooled their capital together, and they pooled it together for the then-small group that promoted ETH.
Investors expect profit: yup, many buyers expected to profit.
The profit comes from the efforts of other people: initially, yes. The success of ETH depended on the efforts of the creators to grow the user-base, develop the blockchain, etc.
ETH gets interesting over time, though. The consensus4 suggests that ETH has become sufficiently decentralized (because it has so many developers and users) that it’s not a security anymore.
Generic ICO
Let’s take an example of a generic ICO from the 2017 craze:
Investment: yup.
In a common enterprise: yup; buyers pooled their capital together for a cause driven by a promoter.
Expectation of profit: yup, many (most?) investors expected profit.
From the efforts of other: for most (all?) 2017 ICOs, yes. They were usually driven by a small group of entrepreneurs who wanted to circumvent traditional fundraising. They often had significant control over the development, supply, and node operations.
It’s safe to say most 2017 ICOs were unregistered securities offerings. Examples: Telegram, Kik, and Munchee, which were all hit with SEC charges for violating the securities offering registration requirements.
ICO Factors
The SEC has listed some additional factors it considers when determining if an ICO involved securities:
How much managerial authority developers and promoters had over the token and blockchain.
How the tokens were marketed.
How functional the blockchain was and how practically usable the token was.
How much correlation there is between the token purchase price and market price of the good/service it can be used for.
How many ways the token can be used as a payment instrument.
The prospects of price appreciation (e.g., XRP vs. a stablecoin).
Commodities
If a token isn’t a security, then it’s a commodity. But what is a commodity, conceptually?
Traditional commodities are goods like silver, gold, beef, oil, and natural gas. They’re goods that are practically useful and don’t typically have cashflow like a business would.
The CFTC regulates not just commodities, but commodity derivatives, swaps, and other non-security instruments.
Commodity tokens are frequently referred to as “utility tokens.” (Of course, calling something a utility or commodity token doesn’t change whether it’s actually a security).
Now that we’ve laid out the security-commodity framework, let’s dig into the key regs…
Key Crypto Regs
Securities Registration
If a token is a security, you need to either register the sale of it with the SEC or fall under an exemption.
Registration with the SEC is, uhh, expensive (think: IPO costs in the millions). And you have to show them a lot of info about your business (audited financials, etc.).
If you offer non-security tokens (commodities), though, you don’t need to register the offering with the SEC or CFTC. Other CFTC laws will apply, though.
Securities Exemptions
There are a few key securities registration exemptions that token issuers could use:
Private offerings (Rules 506(b) and (c))
Reg CF
Reg A+
For more details on these options, check out the TL;DR on crowdfunding.
Section 12(g) Registration Limits
One under-appreciated limit on private offerings is Section 12(g) of the Securities Exchange Act.
Section 12(g) says that, for private offerings, you must register the security offering with the SEC if:
You have more than $10M of total assets, and
You have more than 2,000 investors or more than 500 unaccredited investors.
So private offerings of securities tokens with many investors may need to register with the SEC, even if they fit under an exemption.
Transmutation & SAFTs
As mentioned above with ETH, some tokens may start as securities, and “transmute” into commodities. The Simple Agreement for Future Tokens (SAFT) has evolved as an investment instrument for this option.
SAFTs are investment instruments that basically say: hey we’re going to invest in securities now, but they’ll turn into commodities later.
In a typical SAFT:
The initial token sale is made to accredited investors under a private offering securities exemption.
The blockchain is built and grows until it’s decentralized enough that the tokens are no longer securities.
At that point, the tokens are commodities so the sale of tokens doesn’t need to be registered with the SEC, restricted to accredited investors, etc.
Whether the SEC will respect SAFTs generally is an open question and will depend on the circumstances of each token.
Antifraud Authority
Both the SEC and CFTC have authority to take action against securities and commodities fraud, respectively.
Wallets
Crypto wallets aren’t quite the same as your CashApp wallet, right? So how exactly are they regulated?
Broker-Dealers
If the wallet is for security tokens, the operator is a broker-dealer and may need to register with the SEC and FINRA.
Broker-dealers have obligations like the Customer Protection Rule. That rule requires broker-dealers to safeguard customer assets and keep them separate from their own assets. This means that wallet operators need to keep records of digital wallet holdings.
If you want a better sense of how broker-dealers are regulated, a TL;DR on them is coming soon…
Transfer Agents
Crypto wallet operators may be deemed “transfer agents” if they involve security tokens.
A “transfer agent” is anyone that’s designated by a securities issuer to hold records and account balances of securities.
Transfer agents must register with the SEC, and are subject to rules like: minimum standards for issuing securities certificates, recordkeeping, reporting rules, and SEC examinations.
Additionally, trying to put securities ownership on a blockchain can also trigger transfer agent considerations. For example, Securitize registered as transfer agent with the SEC.
Clearing Agents
There are two types of clearing agents: clearing corporations and depositories.
Clearing corporations receive orders from exchanges and facilitate settling securities transactions. Typically, they settle the transaction orders T+2 (two business days later). The National Securities Clearing Corp (NSCC) is probably the best example.
Once a trade is settled by the clearing corp, it sends instructions to a “depository.”
Depositories hold the ultimate records of securities ownership. When a clearing corp sends instructions, the depository updates its securities ownership records. The Depository Trust Company (DTC) is probably the best example.
Wallet operators that handle securities tokens and have centralized ownership tracking, clearing, and settlement mechanisms may be deemed a clearing corp or depository by the SEC.
If that happens, they must register with the SEC, and meet financial, operating, and other requirements.
Central Bank Currencies
What would a Central Bank Digital Currency (CBDC) require? Two starting considerations are: (1) AML and BSA compliance for user accounts and (2) Congress would likely need to give the Fed additional authority to issue a digital currency.
AML and BSA
Many crypto operators (e.g., exchanges) are subject to anti-money laundering and Bank Secrecy Act requirements.
The state of crypto AML/BSA laws is very much in flux, but you can read about key crypto AML considerations in the AML TL;DR.
About
Any views expressed are my own (well, sort of? I mean, they’re laws and regulations, so they’re not really “mine”). Nothing here is legal or financial advice.
Caveat: crypto is protean. This framework could change next week.
The test comes from a Supreme Court case (SEC v. Howey) where a guy sold “interests” in his company’s orange-growing land and services. Investors would get a share of the $$ when the oranges were later sold. Howey argued “look, there’s nothing financial about this! There’s no stock or bonds, just oranges!” The Supreme Court didn’t buy it. There’s also another, less common test, “Reves,” that looks at an instrument’s duration, seller/buyer motives, distribution plan, retail investors’ expectations, and availability of alternative regulation
The investment doesn’t need to be made with cash; investing with goods, services, or other crypto, counts. See the SEC’s DAO Report.
SEC Director Hinman, in 2018, made public statements that he believed ETH had probably transitioned from security to commodity. A previous SEC Chairman (Jay Clayton) later supported this view.