How are Cryptocurrency Investments Different than Securities Investments?
Attorney Jason Somensatto explains why investments in cryptocurrencies pose different risks and rewards and raise different policy concerns than investments in traditional securities.
The technology behind Bitcoin has led to a proliferation of new cryptocurrencies and, in turn, a proliferation of speculative investors purchasing those cryptocurrencies. Some of these investments share more similarities with an equity investment in a company than an investment in a traditional currency. Additionally, many of these new cryptocurrencies were initially distributed to early investors through a crowd sale similar to an IPO. As a result, the market for cryptocurrencies looks similar to the market for traditional securities. However, these limited similarities belie several important distinctions between the two.
Cryptocurrencies as an Investment
Although most people consider the dollars in their pockets as nothing more than a means for paying for goods and services, the truth is that those dollars are also an investment. The U.S. dollar fluctuates in value relative to other foreign currencies and relative to the goods and services that can be purchased with dollars. If today, you can buy more packs of gum, more light bulbs, or more Euros than you could have bought yesterday with the same amount of dollars, you have profited from your investment in dollars. The value of a U.S. Dollar investment fluctuates based on countless factors such as interest rate levels, trade deficits with other countries, and government policy. To some extent, an investment in the U.S. dollar is an investment in the U.S. economy relative to other countries’ economies.
Holding bitcoins is also an investment. But instead of an investment in a country’s economy, holding bitcoins can be seen as an investment in the network and technology behind Bitcoin. As more people recognize that the Bitcoin network provides a valuable service, they may increasingly sell dollars to obtain bitcoins in order to join the network. As a result, the price of bitcoins would be expected to rise relative to dollars, and everyone holding bitcoins would see their investment gain in value. This same paradigm applies to other cryptocurrencies.
The technology behind Bitcoin has led to a proliferation of a variety of new cryptocurrencies. These so-called altcoins or appcoins run on networks that function differently than Bitcoin. Whereas Bitcoin can be viewed as a general payments network in which users must use bitcoins to conduct transactions, there are now smart contracting platforms, cloud storage solutions, and social networking apps all with their own proprietary coins. To some extent, these coins function less like traditional currencies and more like frequent flyer miles because they only work within a limited network and may be redeemable for a particular product.
A key distinction, however, between frequent flyer miles and cryptocurrencies is that cryptocurrencies are freely transferrable at fluctuating values. Airlines usually prohibit their customers from transferring or selling their frequent flyer miles to other customers. But in the case of cryptocurrencies, the technology is designed so that no central authority (like an airline) controls the coins in circulation. As a result, there are already numerous exchanges where speculators buy and sell various cryptocurrencies like in traditional forex or securities markets.
Just ast the value of an individual bitcoin can be seen as tied to the value of the Bitcoin network, presumably, these alternative cryptocurrencies trade at prices based on the perceived value of the platforms and projects associated with each coin. For example, if there is no value in a smart contracting platform like Ethereum, presumably no one would pay to purchase Ethereum’s proprietary coin. In this context, purchasing an alternative cryptocurrency is less like an investment in a traditional currency and more like an equity investment in a company. Indeed, because some coins actually show less similarities to traditional currencies than to other assets like stocks, many prefer to refer to such coins as crypto-tokens or even crypto-equity to avoid confusion.
Crowdfunding New Cryptocurrencies
An added element that can make cryptocurrencies seem more like securities is how they are initially distributed.
Bitcoin introduced the idea of initially distributing bitcoins to users who provide some service that helps the network function. Bitcoin miners receive newly minted bitcoins in exchange for verifying the validity of transactions on the network and ensuring that no one is double spending their bitcoins. Mining is the only way new bitcoins come into circulation, so the only way to actually buy bitcoins is to purchase bitcoins already in circulation.
However, the more recent trend for distributing new cryptocurrencies is for the development teams behind a new coin to initially sell a portion of the coins in a crowd sale. In the past year, Maidsafe, Ethereum, Storj, and a host of other projects have all conducted crowdfunding campaigns. In addition, an industry of platforms, like Swarm and Koinify, which promise to promote and manage these crowd sales, has been created to assist development teams.
The purpose of conducting a crowdfunding campaign can be varied, but typically the goal is to raise money to pay the developers, initially distribute coins fairly amongst a large group, and entice early adopters by offering a new cryptocurrency at a perceived discount well-below its potential future value. The capital raised from a crowd sale is often used to fund some project associated with the new cryptocurrency. For example, in the case Storj, a proprietary coin was sold to help raise money to develop a unique cloud storage platform that relies on a network of users to rent out unused disk space on their hard drives. Investors purchasing Storj’s coin are betting that this platform will become widely adopted causing their coins to rise in value. As a result, these crowd sales share many similarities with traditional securities offerings where investors purchase stock as a bet on the future success of a company.
Differences Between Cryptocurrencies and Regulated Securities
Although cryptocurrencies can share characteristics with traditional securities and are increasingly being sold in a manner similar to a securities offering, to simply assume that cryptocurrencies should be subject to the same regulations as securities fails to understand the many differences between the two.
No management structure – One key distinction is that there is typically no traditional management structure behind a cryptocurrency. Indeed, most platforms that require users to transact with a proprietary coin are called decentralized applications because they operate not based on the decisions of a management team or central authority, but based on a defined set of protocols. (For context, a good analogy is to look at how email functions with no central authority behind it.) As a result, when purchasing a coin, unlike when purchasing a stock, an investor is not making the equivalent of a bet on a management team’s ability to operate a profitable company. Instead, an investor is often making a bet on how useful and popular a particular network application will become.
This distinction is not as clear cut when a development team sells a proprietary coin during a crowd sale. In that instance, investors can also be seen as making a bet on a development team’s ability to launch some related project or platform like Storj. It is still worth noting that a development team’s involvement may still be time-limited. For a truly decentralized application, the development team may play a role in supporting the new application after it launches, but will no longer be able to define how it functions.
Different information asymmetry – A similar distinction is that different information gaps exist between companies and stockholders than between development teams and coin holders. Securities laws are based primarily on a principle that full disclosure helps close information gaps between management and investors. As a result, companies planning to offer securities to the public are required to publicize certain defined information about their operations and financial health. Due to the fact that cryptocurrency investors are often investing in a decentralized application and not a management team, they are likely most interested in learning how the protocol behind that application works, not how the initial development team operates. And most popular decentralized applications are already open source, meaning that the protocol for how they will operate can be viewed by anyone. This is not to say that there is no information asymmetry between developers and cryptocurrency investors, just that the existing paradigm imposed by securities laws may be of little benefit to cryptocurrency investors. For example, investors may receive more protection from a technology audit of the proposed protocol than from a financial audit of the developer’s bank accounts.
No legal rights – Another key distinction is that cryptocurrencies do not grant their holders any traditional legal rights granted to securities holders. Holding a proprietary coin does not legally entitle one to share in profits realized by the project funded by the sale of that coin or to vote on key decisions that may need to be made about that project’s future. In cases in which cryptocurrencies are made to explicitly function like securities, the technology has progressed to the point that a network application can actually be programmed to perform tasks such as the automatic distribution of dividends. However, these are rights granted by computer code and are not backed by any actual legal obligation. It is unclear whether courts will, or even can, enforce such rights.
Consumption motive – In some jurisdictions, the law distinguishes between securities and products that a purchaser primarily intends to consume or use. Kickstarter functions on this understanding that pre-purchasing a product or obtaining a non-financial reward for contributing to a campaign is not a security interest. In some respects, ownership of a cryptocurrency may be similar. Many purchase a new cryptocurrency to actually use the coins, not just to speculate on their value. To the extent that purchasers are motivated primarily by a desire to use a cryptocurrency, the coin is distinct from a security under existing legal authority.
In the case of a cryptocurrency issued by a company that is backed by the profits of that company and sold in a crowd sale, we may all agree that the cryptocurrency is really just a security in disguise. However, most new cryptocurrencies do not follow this mold and, therefore, we should be reluctant to impose existing securities regulations that may not adequately address the differences between cryptocurrencies and securities.
Jason Somensatto is an Associate with Morovillo LLP where he specializes in financial and securities matters.