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SEC’s Clayton: Use of a token can evolve toward or away from being a security

In recent remarks, the chairman took a pragmatic stance on token fundraising for decentralized networks.

SEC Chairman Jay Clayton discussed his perspective on cryptocurrencies and token sales at a recent event at Princeton University. He made two very important points that are worth highlighting:

  1. He stressed that open blockchain tokens are not all the same and will not all be regulated the same, and, according to CoinDesk, described a continuum from Bitcoin on the one side to tokenized securities on the other. SEC jurisdiction includes tokenized securities and some chunk of the continuum but likely doesn’t cover every crypto-project under the sun.
  2. He suggested that tokens can begin their existence as securities but become non-securities and vice versa, according to CoinDesk. In other words they can move around on the continuum depending on the economic realities of their sale and use.

It’s encouraging to hear this message coming from the Chairman. The question of SEC jurisdiction over open blockchain tokens is a complicated one that we’ve been analyzing since 2015. Over the past three years Coin Center has also stressed that a continuum exists, and we’ve characterized it with respect to technical and community variables surrounding any given token project. Our analysis is based on two key questions inherent in the flexible test that demarcates SEC jurisdiction over investment contracts, the Howey test. Those two questions boil down to:

  1. Is the token valuable primarily as an investment or as a useful item?
  2. Is there an issuer backing up that value or is the value the result of a network of unaffiliated participants in an industry and market?

Bitcoin is the most widely used token. It’s a tool for making payments on the internet and there are hundreds-of-thousands of transactions each day. Bitcoin is also the most decentralized token, there is no issuer backing up its value, and purchasers (to the extent they rely on anyone at all) are relying on thousands of unaffiliated individuals, among them miners, exchanges, market participants, and software developers. It’s heartening to hear the Chairman also describe Bitcoin as belonging on the far end of the spectrum away from securities. Regulating Bitcoin as a security simply doesn’t make sense because securities regulation is largely focused on issuers, of which bitcoin has none. As an approach it would fail to improve investor protection and it would also stymie the development of the technology in the U.S. by imposing complicated and ill-fitting compliance obligations on users.

Beyond Bitcoin, the answers to our two questions will generally be some mixture of the two alternatives. This token is a little bit useful and a little bit profitable. Its value is a little bit derived from the efforts of an issuer and a little bit derived from a massive network of strangers. And, as the Chairman said in his remarks, these qualities may change as the token network matures or comes to exist in differing contexts. According to CoinDesk, the Chairman said:

If I have a laundry token for washing my clothes, that’s not a security. But if I have a set of 10 laundry tokens and the laundromats are to be developed and those are offered to me as something I can use for the future and I’m buying them because I can sell them to next year’s incoming class, that’s a security. What we find in the regulatory world [is that] the use of a laundry token evolves over time. The use can evolve toward or away from a security.

If the token gets me access to a laundry machine today, then its value is primarily derived from the commercial goods or services to which it entitles the holder. If the washing machines are already in place, then I’m less reliant on any particular token promoter’s efforts; I can go to the laundry room and get the value of my token mostly without any further efforts of the seller. If, on the other hand, this promoter has sold me tokens that she promises will be useful for laundry in the future (even though there aren’t any machines that accept them now) and if I’m buying them because I expect she will only sell a few and that there will be big demand for them once the machines come online, then the token’s value is primarily as a speculative investment, and I’m relying on this promoter to deliver that promised profitable outcome.

It can be easier to think of this continuum as a graph with use-value to investment-value on one axis, and reliance on a network to reliance on an issuer on the other axis. Then we can characterize various tokens and their relation to potential SEC jurisdiction by looking at things geometrically. We can even distinguish between a token pre-sale (wherein you will rely on the seller to deliver the promised useful token, which may or may not be a security) and the delivered useful token (wherein you will rely on an open network of participants). We’ve previously used this graph to brief policymakers on the contours the token ecosystem and if you’re interested we even have a video version:

As the Chairman said, “The question is, where does our jurisdiction begin?” That question does not yet have an entirely unambiguous answer. And while there is much work left to be done to promote clarity, we’re encouraged that the SEC is focused on this issue and approaching it through common sense analysis.