Gary Gensler, a former chairman of the CFTC and crypto expert, has been confirmed as the chairman of the Securities and Exchange Commission (SEC). He has been a member of the MIT Business School and teaches a course on blockchain and cryptocurrency, and has made several public statements that both bitcoin and Ethereum have clear securities characteristics, so his appointment is seen as a sign that the U.S. government will bring cryptocurrencies under full regulation.
Bitcoin trading has become more common in the United States, and products such as bitcoin futures and bitcoin options have emerged in the securities market. At the same time, the SEC has continued to prosecute other cryptocurrencies that it believes are in violation, such as Ripple and Telegram, showing a very firm stance on cryptocurrency regulation. With Gary Gensler as SEC chairman, it is likely that regulation will be further strengthened to include mainstream cryptocurrencies such as Bitcoin and Ethereum in the regulatory framework.
In the cryptocurrency market, bitcoin and Ethereum are generally considered to be a “virtual commodity” rather than a security product, and whether the SEC can regulate them under the securities law requires a determination of their securities properties. In this paper, we will take Bitcoin as an example and analyze its securities properties through the Howey test to explore the feasibility of regulation.
Bitcoin’s underlying relationships
In the external relationship of Bitcoin, there are three types of subjects: initiators, miners, and secondary market investors.
When an initiator develops a blockchain information system, miners invest in electricity and computer equipment to enhance their computing power and, with a certain probability, obtain a payment-based token, such as bitcoin, created by the blockchain system. The token can then be resold to other investors on the secondary market. The only internal relationship in Bitcoin is with the miner, who is a node on the blockchain and can verify, transfer and store information on the blockchain and create new tokens by “forking” the information on the blockchain under certain conditions. The secondary market investors do not enjoy any rights and interests in the internal relationship, but can only obtain proceeds through secondary market resale or use the tokens as payment instruments for goods and services. The initiator exits the blockchain system after completing its development and cannot intervene in subsequent token offerings and holders.
Howey Test Analysis
Under the Howey test, an “investment contract”, or security, exists when money is invested in a common enterprise with a reasonable expectation of profit from the efforts of others alone. Whether a particular cryptocurrency satisfies the Howey test when sold depends on the facts and circumstances of each case, which are analyzed below on a case-by-case basis for Bitcoin.
Investment of money
The element requires that the purchaser provide funds to the project sponsor through cash as a form of consideration. In response, the SEC has argued in several investigative reports that cash is not the only form of consideration under the Howey test, and that cryptocurrencies can be acquired for a fee or otherwise, whether in real money, another cryptocurrency, or some other form of consideration. The lack of monetary consideration for cryptocurrency distributed through a so-called “rewards program” does not mean that it cannot satisfy the monetary investment requirement.
As the Commission explained in The DAO Report, “[i]n determining whether an investment contract exists, the investment of ‘money’ need not take the form of cash” and “in spite of Howey’s reference to an ‘investment of money,’ it is well established that cash is not the only form of contribution or investment that will create an investment contract.”
Therefore, in the case of Bitcoin, both the mining machine and the electricity consumed by the miner that is purchased and incurs losses can be considered the consideration paid by the miner.
This element requires the existence of horizontal commonality, broad vertical commonality, and narrow vertical commonality. First, “horizontal commonality” requires the pooling of funds, while the mining equipment and power resources invested by bitcoin miners are decentralized and therefore do not meet the horizontal commonality requirement.
Second, “broad vertical commonality” requires that investors’ access to revenue depends on the efforts of the project initiator. Although the originator of Bitcoin withdrew from subsequent token issuance and trading after completing the development of the blockchain system, the entire circulation process is still carried out under the code agreement established by the originator, and the returns of miners and secondary market investors are always affected by the code agreement, which shows that Bitcoin has a more obvious broad vertical commonality.
Then, “narrow vertical commonality” requires that the returns of investors and the efforts of others are combined with the final operating results. From the perspective of a secondary market investor, the mining behavior of miners can be seen as the efforts of others, as the mining behavior of miners affects the investment behavior of the secondary market. In this way, it seems that Bitcoin can also fit into a narrow vertical commonality.
Reasonable Expectation of Profits
Generally, an investor may expect to receive a return through participation in a distribution or other means of realizing asset appreciation, such as selling a product in the secondary market at an appreciated price. This element is satisfied when the sponsor, organizer or other affiliated third party provides significant management efforts that affect the success of the undertaking and the investor has a reasonable expectation of receiving a return from those efforts.
In the case of bitcoin, if the holder has the right to share in the profits of the investment or to receive income from the appreciation of the token assets, or if the bitcoin is transferable or tradable through the secondary market or is expected to be transferable or tradable in the future, and the issue price of bitcoin and the market price of tradable goods or services do not correlate significantly, generally the number of transactions and the number of goods or services that the average consumer will purchase is not highly correlated, the holder is more likely to have a reasonable expectation of return.
Specifically, for miners, revenue expectations are generated for resale through the secondary market; for secondary market investors, given the extremely volatile price of bitcoin, few investors use it as a pure means of payment, and most choose to generate revenue expectations based on the volatility of the market price of bitcoin.
Profits from Efforts of Others
This element requires that the project originator, organizer, or other affiliated third party has made the necessary management effort and that the effort will critically affect the success of the undertaking, and that the investor pays only the specified fees and costs and is not actually involved in the operation and management of the project.
Bitcoin’s profits are primarily derived from fluctuations in trading prices in the secondary market, not from the efforts of the originator or third parties, and factors affecting the price of Bitcoin include the mining behavior of miners, macroeconomics, fiat currency prices, and regulatory policies, among which, except for mining behavior, all other factors are external market forces that affect the supply and demand of the underlying asset and result in price appreciation, which are not part of the Howey Test’s “profit”.
Therefore, from a secondary market investor, bitcoin can meet this element if miners are considered as others.
As seen in the above analysis, there is still some uncertainty as to whether bitcoin is a security, due to the complexity of the “common enterprise” element, which results in the same uncertainty as to whether the “profits are derived solely from the efforts of others”.
This is due to the complexity of the identity of the investor in bitcoin. While miners can be defined as investors in the broad sense, they are not dependent on the efforts of others, but secondary market investors are dependent on the mining behavior of miners for their returns, which makes it difficult to define “others”.
In practice, the SEC has made it clear that cryptocurrencies represented by bitcoin and Ethereum are not securities, but judicially courts have taken an evasive approach to this, such as in the Shavers case, where the court only analyzed the securities properties of the other cryptocurrency involved and did not respond to Bitcoin. I don’t know if this situation will change with Gary Gensler in office, and whether he will take action to bring tokens like Bitcoin into the regulatory system, so let’s wait and see what happens.
Article from Luo Tao
Translated by Yang(Mengyan Finance)