Hot Takes

Good news: Ethereum’s CryptoKitties are probably not securities.

Ethereum just got overrun with cats; the cats are literally slowing down the network with their feline machinations, their idiosyncratic personalities, and yes, their breeding… lots of cat breeding… on Ethereum. The cats are called CryptoKitties. Just like bitcoins or ether, CryptoKitties are peer-to-peer tradeable, provably scarce digital items that are accounted for by an open blockchain network. Unlike those cryptocurrencies, each item (each kitty) is unique with its own set of attributes: striped, droopy-eyed, slow (yes, slow is one), and many more.

Rather like some of the ICOs you might have read about, there is a company that is selling some of these digital items and financing its operation from those sales. From their FAQ:

The CryptoKitties team releases a new “Gen 0” CryptoKitty every fifteen minutes (up until November 2018). The starting price of “Gen 0” CryptoKitties is determined by the average price of the last five CryptoKitties that were sold, plus 50%.

There are complicated and controversial legal arguments about why some ICOs might be unregistered securities issuance while other might not be. The SEC has yet to offer a bright line test but has identified a few specific projects as securities and indicated that it looks to the flexible test for an “investment contract,” the so-called Howey Test, in order to determine whether any particular token sale is securities issuance. Our framework for securities regulation of cryptocurrencies has outlined the nuts and bolts of that standard and advocated for an innovation friendly approach since 2015.

CryptoKitties look less like securities under that flexible test for a few reasons. One important prong of the test is whether buyers are relying on the managerial efforts of others for profits. First of all, CryptoKitties aren’t marketed as profit-making investments, and ownership of a Cryptokitty doesn’t give you a right to dividends or revenue streams from the Cryptokitty team or anyone else for that matter. Sure people might hope that they can flip a kitty for a profit but people feel that way about other non-securities like real estate, gold, or (appropriately) beanie babies. And sure you can breed two kitties to get more cats which you could of course sell, but that alone certainly doesn’t make them securities any more than real life purebred pets.

This is starting to sound a bit like an actual case about securities law and real life animals, the case was SEC vs. Weaver Beaver (yes, that’s the actual name). Here’s Bob Davenport, a regional director of the SEC back in the 1970s:

The beaver case was a case called SEC versus Weaver’s Beaver Association. One defendant appealed to the U.S. Supreme Court, which denied cert. A fellow in the Salt Lake area started a company called Weaver’s Beaver Association. They sold pairs of beaver, all over the United States and in foreign countries. These were purportedly domesticated beaver. You would buy a pair of beaver for several thousand dollars, and these beaver would have little beavers, called kits. Then these little kits would grow up, and they’d have more kits. And you would end up with this large herd of beaver. The beaver were to be sold to other purchasers. They had a marketing arm, where they would sell your pairs of beaver. There was going to be a tremendous demand for beaver pelts in coats, beaver hats, and everything—it’s coming back. So they sold millions and millions of dollars of these beaver. The salesmen represented that you could take possession of your beaver, and you can raise them in your own backyard, but if you don’t have the capabilities, we have beaver ranches all through the West—Montana, Wyoming, et cetera.

It didn’t end well:

We’ll take care of your beaver for you for a hundred and fifty or a hundred seventy-five dollars per beaver per year, until you can sell it. Nobody could take care of beaver; you can’t put it in your bathtub. The purchasers would have to leave the beaver on the ranches. What happened was that all these beaver and their kits that was being sold to people could not be re-sold, because the Association was too busy selling their own beaver to take time to sell your beaver.

So these people ended up with a large number of beaver, and they’re paying all these ranching fees. It was just a disaster. They really weren’t selling domesticated beaver; instead they were flying the beaver down from Canada and purchasing them from trappers in Canada at approximately twenty dollars a beaver. They’d fly them into Salt Lake, put tattoos in their back foot, in the web, and start selling them. They’d sell them for three thousand a pair and up.

The SEC came after Weaver Beaver because it was clear that the economic reality of the scheme wasn’t just beaver sales! Weaver was selling shares of a “profitable” beaver farm. You weren’t buying a beaver to take it home with you; you were buying it to get rich, and you relied on Weaver to take care of your beavers, breed them, sell the kits and give you the profits. Nobody actually took delivery of their beaver (you are shocked, I know).

So why are CryptoKitties different? Because you can and do actually take delivery of your CryptoKitty. You don’t have to keep them in your bathtub, you just connect to the open Ethereum network and check up on the blockchain to find your cats. You don’t have to rely on the CryptoKitty team to take care of your cats or breed them for you, the cats don’t eat and “breeding” is just an ethereum transaction that you (and only you) can make by using any free and compatible Ethereum software client and by signing the transaction with your Ethereum private keys. And you don’t rely on the CryptoKitty team to find buyers for your cats, or buy them back from you, all sales are peer-to-peer and any ethereum user in the world can find you and offer to buy your little bundles of kitty joy (or breed with it!). Also there’s no sad beaver relocation, caging, and tattooing, just happy little bits of digital fur ball coursing over the world’s increasingly renowned global computer, Ethereum. That last one isn’t part of the Howie Test but it makes me happy to live in the future we got.

Link/Tweet

Congress just sent a letter to the IRS about “urgent need for guidance” on crypto taxes.

Today, 21 members of Congress, led by Rep. Tom Emmer, sent a letter asking the agency to issue needed guidance on the tax consequences and basic reporting requirements for taxpayers that use virtual currencies. Congress has now sent four separate letters to the IRS about this issue.

In a statement, Rep. Emmer’s office said:

While initial guidance was provided, ambiguity around basic questions of how taxpayers should calculate and track the basis of their virtual currency holdings is unacceptable. According to a recent report from Coin Center, the 2014 guidance by the IRS failed to address fundamental tax questions, and repeated requests to the IRS for additional clarity have been made by a variety of entities. It also indicates that rather than providing clarity, the IRS has instead increased enforcement activities against taxpayers who “misreport” their cryptocurrency transactions.

Coin Center worked with Rep. Emmer to produce the bipartisan letter, which reflects several of the questions and concerns outlined in our recent report about cryptocurrency taxation, A Duty to Answer. The letter notes that the single piece of crypto tax guidance the IRS has released—the six-page “IRS Virtual Currency Guidance” from early 2014—fails to answer basic questions about crypto taxes, and that taxpayers deserve clarity from the agency. In other words, as the IRS Taxpayer Advocate put it a decade ago, “the IRS has a duty to answer all of the basic questions about transactions undertaken regularly by significant numbers of taxpayers, such as those involving virtual items.” In addition to describing these questions, our report provides common-sense recommendations on how the IRS should answer them.

In signing the letter, Rep. Emmer was joined by the other co-chairs of the Congressional Blockchain Caucus—Reps. Bill Foster, David Schweikert, and Darren Soto—as well as Reps. Patrick McHenry, James P. McGovern, French Hill, Terri Sewell, Warren Davidson, Stephen F. Lynch, Ted Budd, Eric Swalwell, Trey Hollingsworth, Ed Perlmutter, Greg Gianforte, Josh Gottheimer, Mark Meadows, Lance Gooden, Matt Gaetz, Ted S. Yoho, and Bryan Steil.

Link/Tweet

Congressional report on cryptocurrency cites multiple Coin Center resources.

Last week, the Congressional Research Service (CRS), which serves as nonpartisan shared staff to congressional committees and Members of Congress and operates solely at the behest of and under the direction of Congress, published “Virtual Currencies and Money Laundering: Legal Background, Enforcement Actions, and Legislative Proposals.”

We were pleased to see that the report cites Coin Center resources four separate times: “Bitcoin: A Primer for Policymakers” twice on the first page, as well as “The Bank Secrecy Act, Cryptocurrencies, and New Tokens: What is Known and What Remains Ambiguous” and “Bitcoin innovators need legal safe harbors.” We will continue to publish materials that advocate for good policy on issues related to public blockchain networks and are glad that they are being read by policymakers.

Link/Tweet

We held a briefing in Congress on open cryptocurrency tax questions.

Last week we released a report, A Duty to Answer: Six Basic Questions and Recommendations for the IRS on Crypto Taxes, which examines the state of crypto tax policy in the US and calls on the IRS to address the open issues.

Today we took that message to Congress with a briefing for policymakers on the Hill. Coin Center Senior Research Fellow James Foust presented some of the questions raised in the report, explained Coin Center’s recommended actions for the IRS to address them, and fielded questions related to the nature of UTXOs, forks, and more. For a top-line summary of the report you can read his blog post: It is time for the IRS to answer open questions about cryptocurrency

You can see his slides here:

Link/Tweet

Brookings has published a report by former CFTC Chairman Timothy Massad on cryptocurrency regulation.

In it, Massad calls for new regulatory authority from Congress for the SEC or CFTC to supervise cryptocurrency markets:

Congress should pass legislation providing the SEC (or alternatively the CFTC) with the authority to regulate the offering, distribution and trading of crypto-assets, including regulation of trading platforms, custodians (or wallets), brokers and advisors.

As we wrote last year, we would potentially support the creation of a new, unified federal regulator for trusted parties in the cryptocurrency ecosystem (exchanges, custodians, etc.) but it must come alongside full federal preemption of existing, vague, and innovation-chilling state money transmission licensing laws as they are applied to cryptocurrency activities. This is something the Massad report doesn’t mention, but that policymakers should consider. Trading fifty-three ill-suited and uncoordinated state regulators for a single specialist regulator is a good deal. It would encourage the growth of these technologies here in the U.S. rather than in other countries with already simpler regulatory regimes. Adding one more federal regulator on top of the existing state law soup is a recipe for pushing innovators overseas.

We also subtly disagree with Massad over which agency should be on point. The SEC should continue to police securities markets, including any issuance or trading of crypto-assets that fit the existing definition of a “security.” No new authority is needed from Congress on that subject. Decentralized cryptocurrencies, however, don’t fit the definition of a security and, owing to their public nature, they do not generate information asymmetries that a securities regulatory regime (focused on issuer disclosure) can efficiently correct. Instead, these assets are more like widely traded commodities, so it makes much more sense to have the CFTC on point, even if that means extending their supervisory authority from commodities derivative markets to commodities spot markets in the limited and special case of cryptocurrencies. Massad is right, though, only Congress through new law could create that authority, and we would support that law if it was reasonably calibrated, directed at the CFTC, and preempted state money transmission licensing.

As we wrote almost exactly a year ago,

These emergent investor protection issues are similar to those addressed by the SEC and CFTC with respect to securities exchanges and commodities futures exchanges. But, a digital currency is not a security and therefore it makes no sense to regulate digital currency exchanges as National Security Exchanges. Digital currencies are commodities, but the CFTC only regulates commodities futures markets, not commodities spot markets. All told, should investor protection issues in digital currency spot markets need to be addressed, they would be best addressed through a de novo regime crafted in legislation and seated within the CFTC. Much of that regime would be focused on investor disclosures, market transparency, and guardrails to prevent and police fraud, market manipulation, and insider trading (issues beyond the scope of this report), but the legislation should also deal with the more straightforward issue of licensing for exchanges that play a role as custodians and payment providers. The public policy goals of state money transmission regulators could thus be subsumed within a larger CFTC-administered investor protection regime. State money transmission laws would then be fully preempted for newly CFTC-regulated digital currency exchanges.

Link/Tweet

SEC Chairman Clayton just confirmed Commission staff analysis that found Ethereum (and cryptos like it) are not securities.

We’re often asked whether that policy, articulated mid-last year by Director of the Division of Corporate Finance William Hinman, truly represents the policy of the Commission or whether it’s just the opinion of SEC staff. So, a few months ago we worked with Rep. Ted Budd to send a letter co-signed by several colleagues to Chairman Clayton asking whether he agreed with Hinman’s approach. Now the Chairman has responded:

Your letter also asks whether I agree with certain statements concerning digital tokens in Director Hinman's June 2018 speech. I agree that the analysis of whether a digital asset is offered or sold as a security is not static and does not strictly inhere to the instrument. A digital asset may be offered and sold initially as a security because it meets the definition of an investment contract, but that designation may change over time if the digital asset later is offered and sold in such a way that it will no longer meet that definition. I agree with Director Hinman's explanation of how a digital asset transaction may no longer represent an investment contract if, for example, purchasers would no longer reasonably expect a person or group to carry out the essential managerial or entrepreneurial efforts. Under those circumstances, the digital asset may not represent an investment contract under the Howey framework.

We’re gratified to see that the SEC’s thoughtful approach to applying the Howey test to cryptocurrency comes from the top.

*The headline of this post has been changed from "SEC Chairman Clayton just confirmed Commission staff analysis that Ethereum (and cryptos like it) are not securities." to "SEC Chairman Clayton just confirmed Commission staff analysis that found Ethereum (and cryptos like it) are not securities."

A direct download of this Chairman Clayton's response is available here.

Link/Tweet

The Human Rights Foundation wants to help activists and journalists use Bitcoin to stay private.

Though often mischaracterized as “anonymous,” Bitcoin transactions do offer a much higher level of privacy for savvy users than traditional internet payment systems. Activists and journalists may want to add this ability to their toolkit as they make transactions in the service of their essential work.

But Bitcoin privacy is a complicated thing. In a new essay, software engineer Eric Wall examines cryptocurrency privacy and helps clarify the subject for those who need it most. As he explains:

The Bitcoin protocol itself evolves over time, which can lead to dramatic changes in its privacy properties. Changes to the core protocol are seldom simple choices between privacy and transparency alone, but more often come packed with changes to the security, scalability, and backward-compatibility of the software as well. Historically, the trend and ethos within the Bitcoin community has always favored privacy over transparency, but more conservatively so compared to other cryptocurrencies where privacy is the primary focus.

As a result, activists or journalists who are considering using bitcoin to escape the prying eyes of an authoritarian government or a corporation need to understand what type of traces they leave when they’re using it and whether the privacy nature of bitcoin is sufficient for their needs. However, achieving this understanding requires some amount of effort.

This is the first in a series of essays examining the practical applications of cryptocurrency for privacy. They will form the basis for a Coin Center report later this year. You can read the first in this important series here.

Link/Tweet

SEC and CFTC Commissioners to headline Coin Center Annual Dinner.

We are excited to announce that SEC Commissioner Hester Peirce and CFTC Commissioner Brian Quintenz will be the evening’s speakers during the Coin Center Annual Dinner!

Join us for a evening of food and drink with the best of the cryptocurrency industry, all while supporting Coin Center’s critical policy advocacy mission.

Monday, May 13, 2018 - 7:00 PM

The Plaza Hotel

768 5th Avenue, New York, NY 10019

Individual tickets are available here.

You can see pictures from past dinners here.

For table sponsorship opportunities contact antonie@coincenter.org.

Link/Tweet

Based in Washington, D.C., Coin Center is the leading non-profit research and advocacy center focused on the public policy issues facing cryptocurrency and decentralized computing technologies like Bitcoin and Ethereum. Our mission is to build a better understanding of these technologies and to promote a regulatory climate that preserves the freedom to innovate using permissionless blockchain technologies.