Why the future of the crypto industry rests on whether digital tokens are securities or commodities

WASHINGTON – Cryptocurrency traders have been put on notice that the United States Securities and Exchange Commission (SEC) considers a range of widely traded digital assets to be securities, a position that could impose regulatory requirements that many boosters say could be crippling.

But figuring out what does or does not make a coin a security is a complicated question.

1. What is the SEC doing?

Its chairman, Mr Gary Gensler, has said that many digital assets have the hallmarks of securities.

Mr Gensler warned that the agency was planning to take a hard line in enforcing its rules on those tokens.

Anxiety among crypto traders grew when, in July 2022, the market regulator took the unusual step of identifying nine crypto assets that it considered to be securities as part of an insider trading case.

Seven of them were traded on Coinbase, the biggest crypto trading platform in the US.

In March, Coinbase said it had received a notice from the SEC signalling the agency’s intent to bring an enforcement action against the company.

The notice identified several products or offerings that it considered to be securities, including Coinbase’s staking service and a portion of its listed digital assets.

2. What does it mean for something to be a security?

In its most simple form, whether something is or is not a security under US rules is basically a question of how much it looks like shares issued by a company raising money.

To make that determination, the SEC applies a legal test, which comes from a 1946 Supreme Court decision.

Under that framework, an asset can be under SEC purview when it involves investors kicking in money with the intention of profiting from the efforts of the organisation’s leadership.

In December 2020, the agency sued Ripple Labs for allegedly raising money by selling the XRP digital token without registering it as a security.

The SEC claimed that the company was funding its growth by issuing XRP to investors betting that its value would rise.

The case is now a massive legal battle, with Ripple having hired a former SEC chair, Ms Mary Jo White, as an attorney.

3. Why does calling a token a security matter?

For starters, such designations would make running a cryptocurrency exchange more expensive and complex.

Under US rules, the label carries strict investor-protection requirements for platforms and issuers.

Exchanges would face continuous scrutiny by regulators, which could lead to fines, penalties and, in the worst case, prosecutions if the criminal authorities ever got involved.

It could also mean losing future funding from investors who may be skittish of those increased compliance burdens and regulatory scrutiny.

Supporters of more regulation believe designating cryptocurrencies as securities would result in more information and transparency for investors because of the SEC disclosure requirements that would apply.

4. What does the crypto community want?

The crypto crowd desperately wants the Commodity Futures Trading Commission (CFTC) to be their regulator and not the SEC.

The CFTC – and the US’ rules around commodities and their financial derivatives – are widely seen as a less onerous regulatory regime.

There have been efforts to give the CFTC more power to regulate crypto assets directly.

Currently, it primarily oversees crypto futures and has the ability to take enforcement action if there is fraud or manipulation in the underlying market, as it has in dozens of crypto cases.

Crypto executives joined an industry push behind a Bill from lawmakers that would give the derivatives watchdog more turf – at the expense of the SEC.

Opponents of that approach say that the SEC’s securities-focused rules offer more protections for mom-and-pop investors.

The industry-backed effort stalled after the collapse of crypto exchange FTX, which was one of the most vocal companies backing the effort.

5. What coins are or aren’t considered a security?

The short answer is that beyond the very biggest cryptocurrency, there is a lot of ambiguity.

US regulators, including the SEC, agree that Bitcoin, which is by far the largest digital asset, is not a security.

It was started by an unknown person or persons going by the pseudonym Satoshi Nakamoto and does not exist as a way to raise money for a specific project.

The second-biggest token, Ether, was deemed not to be a security during the Trump administration by a senior SEC official who signalled that while Ether may have started out qualifying as a security – the Ethereum Foundation used it to raise money – it had grown into something sufficiently decentralised that it probably no longer was one.

But after Ethereum changed to a system in which coins that are “staked” play a role in recording transactions, the SEC said that the fact that staked coins can earn interest might lead regulators to start treating it as a security.

The CFTC deems Ether a commodity, and the CME lists futures on it, as well as Bitcoin.

6. What’s next?

SEC’s Mr Gensler has said the agency could waive some of its rules to better suit digital assets, while also ensuring investors are protected, if exchanges work with the agency to register.

But he has not provided a road map of how exactly that could be accomplished.

The SEC also ramped up enforcement against crypto companies after the failures of several in 2022, including FTX, which is now at the centre of a criminal investigation over misuse of customer funds.

Meanwhile, some lawmakers have pointed to 2022’s turmoil as reason for needing clear-cut rules for the industry, though it is unclear if a Republican-led House and Democrat-led Senate can find enough common ground to reach an agreement.

Pending litigation, including the Ripple case and the SEC’s insider trading case, could also help shed light on some of the murkier legal questions surrounding the industry, including which tokens are securities and which are commodities.

7. Is this an issue elsewhere?

Yes. Globally, different regulators have taken a range of positions on whether to treat cryptocurrencies as securities.

Britain’s Financial Conduct Agency regulates digital assets it considers investments that come with rights to repayment or a share in profits, while “payment tokens” like Bitcoin or “utility tokens” that provide access to a service are unregulated.

Singapore regulates both types but under different laws. It considers coins that are digital representations of other assets, such as unlisted shares, to be securities.

In June, the European Union reached a provisional agreement to impose common cryptocurrency rules across all 27 member states and to develop a new legal framework to regulate public offers of crypto assets. BLOOMBERG