Bitcoin has been around since 2009, but the SEC only recently clarified that this kind of digital currency may in fact be a security—which lays it bare to the federal securities law that governs traditional securities.
The agency’s note is a fairly straightforward compliance heads-up to those investing in initial coin offerings (ICOs), which are used to raise capital, but it comes at a time when the virtual asset sector remains a virtual free-for-all.
The SEC investor bulletin was issued July 25 in response to concerns about a growing trend to “entice investors” to buy virtual coins with the promise of big returns on what could be risky investments.
A virtual currency is a digital representation of value that can be digitally traded and functions as a medium of exchange, unit of account, or store of value, according to the SEC—but it “may represent other rights as well.”
Tracking the ‘DAO’
How did the SEC reach this conclusion? It used The Dao, a decentralized “virtual” for-profit organization that sold DAO Tokens to investors in 2016 in order to raise capital for projects, as a case study. The total amount raised was valued at $150 million. The DAO became the focus of public attention when a third of the funds were hacked before the investments could be moved into projects. The SEC concluded that the holders of DAO Tokens invested their money with the anticipated expectation of making a profit on their investment. Investors “could monetize their investments in DAO Tokens by re-selling DAO Tokens on a number of web-based platforms that supported secondary trading in the DAO Tokens.” The SEC said it applied existing U.S. federal securities law to “this new paradigm” and determined at the end of its investigation that DAO Tokens were in fact securities as defined under the Securities Act of 1933 and the Securities Exchange Act of 1934.
Is this really a far-reaching announcement? Maybe. The SEC announcement puts ICOs and the so-called blockchain token community (technology used to create and disseminate virtual coins) on notice that it must take appropriate steps to ensure compliance with U.S. federal securities law. It also serves as a warning to scammers looking to swindle investors.
But here are the catches. ICOs and virtual currency transactions and users can be located anywhere in the world, and while the SEC can obtain information from overseas ventures, it’s not an ironclad process. Add to that the fact that there is no central authority that collects virtual currency user information, and law informant officials can have difficulty freezing or securing investor funds that are held in a virtual currency—and it’s hard to see how this compliance effort will lead to significant change any time soon.
In an open letter to the SEC, venture capitalist Tim Draper said he agreed that “some (light) regulation might be in order with regard to ICOs” but not too much. The SEC’s goal should be to ensure that tokens being raised for capital for a company or for investment register with the SEC, according to Draper. But the venture capitalist thinks too much regulation can rein in this innovative financial vehicle. If the token is being used for societal transformation and all proceeds go to the support and development of the token, it shouldn’t need to register, Draper argued.
Although the SEC is clear that a system that meets the definition of an exchange must register as a national securities exchange or receive an exemption from such registration, a number of unanswered questions remain in the wake of the SEC’s notice, such as how much of a cascade effect may be felt from the notice, whether this announcement will simply move more activity outside the U.S. and beyond the reach of the SEC, and whether it will lead to more entities registering with the SEC and thereby improving the efficiency of the process along with investor protections.