There is a very broad range of crypto assets, including:
- “digital,” “crypto” and “virtual” currencies;
- “virtual” coins or tokens; and
- “traditional” equity or debt securities that have been “digitized” or “tokenized.”
You can find descriptions of the various sorts of crypto assets here. These descriptions have been taken not from technical textbooks, but from opinions and advisories issued by courts and regulators that have had occasion to discuss certain legal and regulatory issues surrounding crypto assets, as well as risks associated with investing in such assets.
Drawing distinctions between different types of crypto assets is important because the regulatory treatment of a particular crypto asset depends in large part on whether or not it is a security.
For example, as will be discussed in detail in subsequent posts on this blog:
- An investment adviser’s calculation of its regulatory assets under management may depend on whether crypto assets managed by the adviser are “securities” (or “cash or cash equivalents”).
- Crypto assets that are securities are subject to the pre-clearance and reporting (both holdings and transactional) requirements of Rule 204A-1 under the IAA, whereas crypto assets that are not securities are not subject to those requirements.
- To the extent that crypto assets are considered “securities or funds” of a client, an investment adviser must comply with Rule 206(4)-2 under the IAA—the so-called Custody Rule—if the investment adviser is considered to have custody over such assets pursuant to that rule.
So, when is a crypto asset a “security” for purposes of the federal securities laws? The answer:
- Traditional equity or debt securities that have simply been “digitized” are clearly securities. The fact that they are represented by records on a distributed ledger or blockchain clearly does not alter their status as securities.
- At the present time, certain high-ranking officials of the Securities and Exchange Commission (SEC)—but not the SEC itself—have concluded that two well-known “cryptocurrencies” or “virtual currencies”—namely, Bitcoin and Ether—are not securities for purposes of the federal securities laws. Unfortunately, that does not give us a lot of guidance on the status of “virtual currencies” in general, because Bitcoin and Ether are only two virtual currencies out of literally hundreds if not thousands currently in “circulation.”
So where does that leave us with respect to “virtual currencies” other than Bitcoin and Ether, and with respect to other crypto assets such as coins and tokens? Are they securities?
Although, as noted above, certain high-ranking SEC officials have conceded that two types of cryptocurrencies—namely, Bitcoin and Ether—are not securities, the SEC’s general attitude with respect to other crypto assets (including other cryptocurrencies) is that it is up to market participants to decide whether a particular crypto asset is a “security.”
Now that we are on our own, how do we determine whether a particular crypto asset is a security?
At the outset, the regulators have made it clear that simply calling something a “virtual currency,” “cryptocurrency,” “crypto asset,” “digital asset,” “coin,” “token,” etc. is not determinative of its status as a security for purposes of the federal securities laws. For certain statements made by courts and regulators on this point, see here.
What matters is substance, not form.
If, in substance, a crypto asset is a security, the fact that it consists of, or is represented by, records in a blockchain or distributed ledger clearly does not alter its status as a security. Again, for certain statements made by courts and regulators on this point, see here.
How do we determine whether a crypto asset is, in substance, a security? The answer:
Generally, we must apply the so-called “Howey test,” on a case by case basis, to determine whether a particular crypto asset is a security.
Under the three-part “Howey test”—which is named after a U.S. Supreme Court case, SEC v. W.J. Howey Co., 328 U.S. 293 (1946))—a financial instrument such as a crypto asset will be considered an “investment contract,” and therefore a “security,” where there is:
- an investment of money (which could include, for example, an investment of fiat currency or cryptocurrency)
- in a common enterprise
- with an expectation of profit derived from the managerial or entrepreneurial efforts of others.