Last week, William Hinman, an official of the Securities and Exchange Commission (SEC) of the US, stated publicly that bitcoin and ether—the two mediums that have the most highly valued presence in the cryptocurrency market—are not securities, while initial coin offerings (ICOs) probably are.
Before launching into his analysis, Hinman was very complimentary about the blockchain technology behind bitcoin and ether. He was clear that many people believe that this technology, also known as distributed ledger technology, and which I have explained in simple terms in an earlier Mint column, will completely transform e-commerce. Information sharing, value transfer and the recording of transactions in a decentralised, secure, digital environment are what distinguish this technology from other clearing-house transactions, which require a trusted central clearing house like a bank or credit card issuer such as Visa or Mastercard.
Potential applications of blockchain include supply chain management, real estate contracts, intellectual property rights, degree/diploma verification and so on. As observed before, there is value for IT services firms in creating applications that can be executed electronically with a public, unchangeable record without the need for a trusted third party to verify transactions. Some of my friends disagree, though. They say the only worthwhile application of blockchain in its decade of existence has been cryptocurrencies, such as bitcoin.
Hinman’s argument on bitcoin and ether, available on the SEC’s website sec.gov, was based on previously established law as to what constitutes a security. Simply put, the test for an asset of any class to be considered a security or an “investment contract” requires an investment of money in a common enterprise with an expectation of profit derived from the efforts of others. Shares and debentures are securities, since we expect the promoters are toiling to increase their value.
Hinman quoted a seminal case, “SEC vs Howey”, which involved investors who had bought shares in an orange grove that “Howey-In-The-Hills Service Inc” owned, and as passive investors, expected Howey to increase the value of the orchard. Howey had recorded the contract as a real estate purchase. The US Supreme Court ruled that the purported real estate purchase was instead an “investment contract”—an investment in orange groves was in these circumstances an investment in a security as the company had made an implied promise to increase the investment’s value by servicing the orange groves.
With ICOs, Hinman said that promoters tout their ability to create an innovative application of blockchain technology. Like in “SEC vs Howey”, the investors are passive and efforts to market the investment widespread. At the outset, the business model and the viability of the technological application are still uncertain. The purchaser has no choice but to rely on the efforts of the promoter to build the network and make the enterprise a success. Therefore, the purchase of an ICO issue is a bet on the success of the enterprise and not the purchase of something like bitcoin, which is used to exchange goods or services on a wide network. ICOs look like investment contracts and are likely to be regulated as such.
Hinman goes on to say that learning material information about the third party—its background, financing, plans, financial stake and so forth—is a prerequisite to making an informed securities investment decision. Without a regulatory framework that promotes disclosure of what the third party alone knows of these topics and the risks associated with the venture, investors would be uninformed and are at risk.
However, in the case of bitcoin and ether, no single centralised seller is telling the people who buy the currencies that they will make money from doing so, hence there is no implied promise by a third party to increase the value of the asset. The trading platforms for these are highly decentralised and have been so since inception, especially in the case of bitcoin, or very soon after inception, as in the case of ether.
There is now news that price manipulation caused bitcoin’s enormous surge during 2017. Even if it isn’t a “security”, shouldn’t market manipulation worry regulating agencies? Real estate is not a “security” but is regulated in India. If cryptocurrency looms in our futures, then regulatory decisions now will impact us greatly. Watch this space.