At the Medici Conference held on May 2, 2018, SEC Commissioner Hester M. Peirce delivered a speech outlining the challenges that arise with innovation in the cryptocurrencies and blockchain sector.1 Commissioner Peirce argued that regulators should take the role of a "lifeguard" when approaching the new world of crypto-technology, as opposed to the "sandbox" approach adopted by securities regulators in other sectors or jurisdictions.2 In her view, the regulator as lifeguard watches over what is happening and takes action when spotting dangerous activity, but does not monitor every decision made by the innovator.
Commissioner Peirce further asserted that cryptocurrency regulation requires an assessment based on the currency's form and function. For example, "tokens" in form may not resemble money, but may in fact function like a currency. In contrast, such "tokens" may support multiple functions, each of which may implicate different regulatory regimes.3 Given these complexities, she argued that defining the function of a product or transaction is essential to determining the proper way to regulate it.
Commissioner Peirce then described certain categories of tokens currently available in the marketplace, including (i) bitcoin, (ii) utility tokens, and (iii) tokens used in initial coin offerings (ICOs). She acknowledged that bitcoin, on its own, is unlikely to be a security, whereas utility tokens may function as a means of executing a transaction. She then discussed tokens used in ICOs, which "look the most like securities."4 In the context of ICO tokens, Commissioner Peirce submitted the following questions:
- Are the coins used in ICOs securities?
- Are ICOs offerings of securities?
- To comply with the law, do offerings have to be registered with the SEC or qualify for an exemption?
- Does the Securities Exchange Act govern trading in the coins after they have been sold by their creator?
To answer these questions, Commissioner Peirce initially turned to the Howey test, which defines a security "as an investment in a common enterprise with the expectations of profits solely through the efforts of another."5 She further indicated that the Howey test requires analysis of function rather than form when determining whether something is a security. In terms of the functional analysis, Commissioner Peirce analogized the Howey case's orange grove investment contracts to ICO tokens. In that regard, she stated that an ICO involving the "sale of tokens to investors seeking to realize a profit from the increased value of their coins once the environment is created . . . starts to look like a securities offering."6 However, she acknowledged that innovation may be deterred if all ICO tokens are treated as securities and, moreover, not all ICOs need to be deemed securities offerings. Instead, in her view, the best approach for now is to evaluate the facts and circumstances of each offering.
Commissioner Peirce cautioned against certain traps in devising an appropriate regulatory structure for ICOs, tokens, and other new technologies. First, she argued that regulators need to understand the underlying technologies when applying the Howey test. Second, lack of familiarity with a new technology should not cause regulators to focus only on the harms associated with innovation, which can result in an agency leading with its enforcement powers.7 Third, regulators should avoid inserting themselves inappropriately into the creative process, which Commissioner Peirce fears may occur with the "sandbox" approach. In her words, the "law deserves respect, but technological progress should not be bound by the limits of the regulator's lawyerly imagination."8
In closing, Commissioner Peirce encouraged those with concerns or questions about the regulation of ICOs to meet with the staff in the Division of Corporation Finance. She also expressed an interest in understanding (i) whether conducting ICOs as private placements under Reg D work, and (ii) whether other exemptions are being used, and if so, whether they work. Commissioner Peirce expressed her hope that regulators will not "lose sight of the benefits new technology can provide in the area of capital formation, market efficiency, economic growth and overall societal well-being."9
The answers to all of these questions will affect innovation and regulation in the months and years ahead. The regulatory landscape is shifting rapidly, as it attempts to catch up to recent innovations. Whether orange groves or tokens, beaches or sandboxes, regulators are focused on this evolving area. Industry participants need to carefully evaluate whether to play in the sandbox and how to navigate the waters patrolled by the lifeguards.
The full speech by Commissioner Peirce can be found here.