Is Bitcoin a Security?

Strange bunch of things right? Mink, bullion, golf course, diamond, worm farm, chinchilla, orange grove, beaver? Aside from the anomalous prevalence of furry mammals, what can we say about this random grouping of. . . things?

They can all be classified as securities when sold as investments.

And yes, in those cases, the U.S. Securities and Exchange Commission can regulate investment contracts for these odd things—just like they would regulate AAPL, GOOG, or MSFT.

With that context in mind, it should be less surprising to learn that, yes, there’s a provocative argument that Bitcoin investment might also be within the SEC’s jurisdiction (if mink, then why not doge!?). To address these open questions, today we are releasing a new Coin Center Report, ourFramework for Securities Regulation of Cryptocurrencies. In it we lay out the case for treating some cryptocurrencies as securities—and some not.

The framework is based on the Howey test for an investment contract—which comes from a famous case about orange groves—as well as the underlying policy goals of securities regulation. We find that several key variables within the software of a cryptocurrency and the community that runs and maintains that software are indicative of investor or user risk. These variables are explained in depth—we manage to discuss everything from proof-of-burn to sidechains to pre-mining to GitHub—and then these variables are mapped to the four prongs of the Howey test in order to create a framework for determining when a cryptocurrency resembles a security and might therefore be regulated as such.

We find that larger, more decentralized cryptocurrencies (e.g. Bitcoin), pegged cryptocurrencies (i.e. sidechains), as well as distributed computing platforms (e.g. Ethereum), do not easily fit the definition of a security and also do not present the sort of consumer risk best addressed through securities regulation. We do find, however, that some smaller and questionably marketed or questionably designed cryptocurrencies may indeed fit that definition.

The framework is actually pretty simple, and there’s a summary of it below.

Howey has four prongs:

An investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person . . .

• invests his money in
• a common enterprise and is led to
• expect profits
• solely from the efforts of the promoter or a third party

And we explain some seven key variables that might differ from one cryptocurrency to another:

• Scarcity (what are the economics of the coin’s supply?)
• Distribution (how do new coins reach users?)
• Consensus (how does the network agree on supply and transaction history?)
• Permissions (what does possession of the coin allow the user to do?)
• Decentralization (how centralized is the network and developer community?)
• Profit-Development Linkage (how linked are developer profits to coin sales?)
• Transparency (how transparent is the network and developer community?)

And then these variables are mapped to the Howey test to determine when a given cryptocurrency sale would look like investment contract, and might be wisely regulated as such. That matching looks like this:

And after discussing these variables, we offer the following policy recommendations:

1. Avoid chilling promising innovations that are ill-fitted to the Howey test, presenting less risk to users:
   • Highly decentralized cryptocurrencies (e.g. Bitcoin, Litecoin) because of a lack of vertical commonality or a discernible third party or promoter upon whose efforts investors rely.
   • Sidechained Cryptocurrencies/Blockchains because there is no expectation of profits on the part of participants who hold coins with a value pegged to their existing bitcoin holdings.
   • Cryptocurrencies where initial distribution is made through open competitive mining or proof-of-burn because there is no investment of money, i.e. no risk capital is provided to an issuer or promoter.
   • App-Coins or Distributed Computing Platforms (e.g. Ethereum) because participants seek access to these tokens for their use-value rather than an expectation of profits.
2. Take action necessary to protect investors against cryptocurrencies well-fitted to the Howey test, presenting greater risks to users:
   • Closed-source or low-transparency cryptocurrencies because without visibility into the operation of the technology there is no reason to believe that profits come from anything other than a promoter’s hype.
   • Open but heavily marketed pre-sales or sales of pre-mined cryptocurrencies with a small and non-diverse mining and developer community when the facts indicate that profits come primarily from the efforts of this discrete and profit-motivated group.
   • Cryptocurrencies with permissioned ledgers or a highly centralized community of transaction validators.

So, if this is an area of law that you’re interested in—or if you are developing ChinchillaCoinz—you’ll probably want to read the full report to get a good sense of how it all works.