Gary Gensler's confirmation Wednesday, April 14, as chairman of the Securities and Exchange Commission marks a significant moment in the development of the digital assets and blockchain industry. Digital assets and blockchain technology hold significant potential for human advancement.
As now-Chairman Gensler acknowledged in his March 2 hearing before the Senate Banking, Housing, and Urban Affairs Committee, powerful use cases exist — including financial resources for the unbanked, increased and more immediate access to medical records, and reduction in the costs of international transactions between small-business owners in the developing world and consumers worldwide.
Of course, these are just a few of the unlimited theoretical applications of this technology. Because of its massive potential to transform the economy and meaningfully shape our collective future, investors to date have poured billions of dollars into the development of digital assets.
But the U.S. legal landscape in which these assets operate is still largely emerging and is in a constant state of change.
As the U.S. market has a significant influence on the overall economic potential of these assets, this ever-changing legal landscape creates substantial market uncertainty for industry participants.
To be clear, regulatory oversight plays an indispensable role in creating a safe market for mainstream market participants, as evidenced by the countless security breaches and hacks and criminal misuse of this technology over the years. However, equally critical for allowing this nascent industry to reach its potential is regulatory clarity.
The truth of this principle is no more apparent than in the SEC's recent enforcement action filed against Ripple Labs, the primary promoter of the digital asset XRP. On Dec. 22, 2020, the commission filed a complaint against Ripple Labs, alleging a continuous securities offering from 2013 through the present of over 14.6 billion units of XRP tokens.
Ripple contends that XRP is a medium of exchange and not a security. Since the complaint was filed, XRP has experienced significant price volatility and trading has largely been halted. If there is one takeaway from this story, it is this: Regulatory clarity matters.
Clarity from SEC
Of pivotal importance is regulatory clarity from the commission, which is responsible for overseeing U.S. market activity involving securities. Specifically, as we discuss below, the Commission should build on the breadcrumbs of clarity SEC leadership has offered in prior speeches in which they have recognized that bitcoin is not a security.
Building on this foundation, the SEC has the opportunity to offer meaningful clarity to the industry by making clear that a digital asset does not qualify as a security if it operates as a currency equivalent with an existing marketplace for everyday transactions and is distributed by a mining network responsible for validating transactions.
Presently, there is no categorical classification for all digital assets as either commodities or securities under U.S. law. Depending on the digital asset, it may be deemed either a commodity or a security.
If a digital asset meets the definition of a security under U.S. law, it is subject to all requirements under the U.S. securities law regime. For example, digital assets that are securities must be sold only in offerings that comply with the registration and disclosure requirements of Section 5 of the Securities Act of 1933, unless the assets or sale qualify for an exemption.
Further, exchanges that allow trading in securities must likewise follow registration and disclosure requirements under the Securities Exchange Act of 1934. Failure to comply can result in stiff penalties.
The Howey Test
In determining whether a given instrument qualifies as an investment contract — and therefore a security — U.S. courts apply a test developed by the Supreme Court known as the Howey test.
Under this test, a transaction or series of transactions may qualify as an "investment contract" when the following elements are present: (i) an investment of money; (ii) in a common enterprise; (iii) with a reasonable expectation of profits (iv) based on the entrepreneurial or managerial efforts of a third party. The Howey test was first applied to digital assets by the SEC in its July 2017 Section 21(a) report concerning tokens issued by The DAO.
Since then, the SEC has provided significant guidance to market participants on how it evaluates digital assets under Howey. Namely, in 2019, the Strategic Hub for Innovation and Technology (FinHUB) in the Division of Corporate Finance provided the most extensive guidance to date to market participants in its Framework for "Investment Contract" Analysis of Digital Assets (the Framework).
The Framework identifies 38 separate considerations, listing sub-points under many of them. However, the Framework is not an official commission rule, does not qualify as formal guidance, and is not binding on the SEC or its divisions. Moreover, the Framework stresses that "[w]hether a particular digital asset at the time of its offer or sale satisfies the Howey test depends on the specific facts and circumstances."
The fact-specific nature of the Howey test, coupled with the SEC's lack of binding guidance on what kinds of digital assets do not qualify as securities, has created enormous uncertainty in the market. This has a very consequential impact in the real world. It hinders innovation.
This problem, of course, is solvable. There is hope that with the change in administration, new FinHUB leadership will provide clearer guidance to the digital asset and blockchain industry. In this article, we propose one modest form of guidance that could go a long way toward providing that much-needed clarity.
