Cryptocurrencies are digital currencies that are secured using encryption techniques to secure and verify transactions, powered by a public ledger that records and validates all transactions chronologically, called a blockchain. These digital currency trades are executed on online trading platforms.

Online trading platforms have become a popular way investors can buy and sell digital assets, including cryptocurrency coins and tokens offered in Initial Coin Offerings (ICOs). The online trading platforms aim to give a wide range of investors the ability to quickly buy and sell cryptocurrencies.

Coins vs Tokens: Categorization of Cryptocurrencies

The terminology can be confusing and is still developing, but presently both coins and tokens can be referred to as cryptocurrencies, even if they do not function as a currency or medium of exchange.

The main difference between coins and tokens is in their structure; coins are generally intended to be used as a medium for exchange. For instance, you might electronically transfer coins to purchase a pizza as was famously done in the first transaction using Bitcoin. Tokens are generally electronic representations of ownership in a particular asset. Tokens can represent basically any asset that is mutually interchangeable and tradeable, from physical assets, such as commodities, to loyalty points and equity ownership, to even other cryptocurrencies.

Tokens are created and distributed to the public through an Initial Coin Offering, which is a means of crowdfunding, through the creation and sale of a digital coin or token to fund project development. It is similar to an Initial Public Offering (IPO) for stocks. A token issued in an ICO, however, may be designed in various ways. For instance, it may provide interest in the equity of a company, like a stock certificate, or it may provide the holder the right to purchase or obtain a good or service once a product is launched.

Controversy Regarding Classification and Regulation of Cryptocurrencies

In order to raise money to develop networks on which cryptocurrencies will operate, developers often sell coins or tokens. In many cases, the economic substance is the same as a conventional securities offering. Funds are raised with the expectation that the promoters will build their system and investors can earn a return on the instrument — usually by selling their tokens in the secondary market once the promoters create something of value with the proceeds and the value of the digital enterprise increases. Thus far the regulatory framework for cryptocurrencies or ICOs has not clearly defined the legal requirements, including the U.S. Securities Law that may apply.

A topic that has been watched closely is whether a cryptocurrency, as traded on online platforms or issued through an ICO, would be considered a security and therefore be subjected to U.S. securities laws. If a platform offers trading of cryptocurrencies that are securities and operates as an exchange as defined by the federal securities laws, the platform must register with the SEC as a national securities exchange. This would result in additional scrutiny, regulation, and a potential slow-down in trading or ICOs. In addition, the SEC can apply the U.S. Securities law retroactively to a prior transaction it deems would have been subject to the law. It was therefore with careful attention that affected parties considered the SEC's most recent position on the matter.

SEC Conclusion Whether Cryptocurrencies Are Securities

In a recent statement, the SEC concluded that in cases where a cryptocurrency represents rights that gives the holder a financial interest in an enterprise (e.g. certain tokens offered in an ICO), the answer is likely that the cryptocurrency would be considered a security.

The SEC further noted that a cryptocurrency that was originally offered in a securities offering (i.e. ICO with financial interest in an enterprise or project) could subsequently be sold in a manner that does not represent an offering of a security, if there is no longer a central enterprise being invested in, or where the cryptocurrency is only to be used to purchase a good or service available through the network on which it was created (e.g. trading of cryptocurrency coins or redeeming tokens). Cryptocurrencies can therefore be considered securities, depending on the facts and circumstances, but would not be securities in all cases. The substance of the transaction determines the conclusion, not the form; analysis of whether a coin or token is a security is not static and does not strictly relate to the instrument itself.

Notably the SEC's statement appeared to be narrowly focused on Bitcoin and Ether, two of the more popular and widely known cryptocurrencies, although application of the guidance to the crypto market in general, could have been implied.

Final Thoughts

Central to determining whether a security is being sold is how it is being sold and the reasonable expectations of purchasers. Under certain circumstances, a cryptocurrency that would typically not be considered a security can be offered in a way that results in classification as a security.

The cryptocurrency itself is simply computer code. But the way it is sold — as part of an investment to non-users by promoters to develop the enterprise can be a security if in substance it represents an investment contract. Conversely, if the network on which the cryptocurrency functions is sufficiently decentralized — where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts — the cryptocurrency may not represent a security.

While the cryptocurrency community certainly welcomed the clarity from the SEC with respect to the traded cryptocurrencies of Bitcoin and Ether, an amount of uncertainty lingers for the general cryptocurrency market where investors remain concerned that purchased cryptocurrencies could be deemed securities, and token issuers will need to pay retroactive fines on for non-compliance with SEC regulations. In addition, the continued lack of regulation and anonymity of cryptocurrency transactions makes it more difficult for the SEC to police the cryptocurrency space and protect investors, should they become a victim of fraud.

For More Information

If you have any specific questions, comments or concerns, please share them with Pieter Combrink at pcombrink@cbiz.com or 858.232.8681 or Mark Winiarski at mwiniarski@cbiz.com or 816.945.5614 of MHM's Professional Standards Group, or your MHM service professional.

Published on August 14, 2018 Print