Per Wikipedia, the earliest versions of the parable of blind men and elephant is found in Buddhist, Hindu and Jain texts, as they discuss the limits of perception and the importance of complete context. The parable has several Indian variations, but broadly goes as follows:
A group of blind men heard that a strange animal, called an elephant, had been brought to the town, but none of them were aware of its shape and form. Out of curiosity, they said: “We must inspect and know it by touch, of which we are capable”. So, they sought it out, and when they found it they groped about it. The first person, whose hand landed on the trunk, said, “This being is like a thick snake”. For another one whose hand reached its ear, it seemed like a kind of fan. As for another person, whose hand was upon its leg, said, the elephant is a pillar like a tree-trunk. The blind man who placed his hand upon its side said the elephant, “is a wall”. Another who felt its tail, described it as a rope. The last felt its tusk, stating the elephant is that which is hard, smooth and like a spear.
CRYPTO-CURRENCY – SECURITY? CURRENCY? or BOTH?
The multi-billion critical question is whether Crypto-currencies are to be deemed a Security or Currency, as defined by US state regulators, the SEC and the CFTC. From my perspective, the problem in solving this inquiry is simply the way the questions are being framed. Perhaps, and I believe, eventually the consensus answer will be that Crypto-currencies exist simultaneously as both a Security and Currency to be regulated appropriately for the benefit of investors and the general public. Essentially, on a empirical basis Crypto-currencies are equivalent to light. What do you mean, you may logically be asking, and my reply is that light has scientifically been proven to exist as both a particle and a wave simultaneously. Odd but true.
Generally, Crypto-currencies are created and distributed through a process known as an Initial Coin Offering (“ICO”). The ICO process is comparable to the Initial Public Offering (“IPO”). The IPO involves a Company which is created through incorporation with a State, as a legal fiction, and then follows the subsequent issuance and distribution of its shares through either private placements and/or IPOs. The distribution of an IPO requires the submission of regulatory filings with the SEC, which generally requires the preparation of a S-1 Initial Registration Statement. The S-1 provides numerous disclosures, including associated risks of investment, management discussion and analysis, as well as transparency about the corporations internal and external activities. As of date, no such requirements exists with respect to ICOs – as many operators of digital assets and currencies refuse to submit to the notion that ICOs constitute securities, but rather are argued to simply be the equivalent of minting fiat currency.
Now the truth is when Crypto-currency is being used directly to purchase goods or services, it is being used as traditional fiat money. It has a value for immediate exchange. When Crypto-currency is converted into Fiat currencies, it is no different than converting US Dollars into Euros, Pounds, or Yen. And similarly, such actions should be viewed through the lenses of Spot and FX currency trading, which are the well established regulatory purview of the CFTC. One of the problems with Crypto-currencies presently is the unavailability to easily convert them and receive Fiat currency at ATMs or banks. Additionally, most global merchants are unwilling to accept crypto-currency as a form of payment, nor do they seem willing to incur the costs to implement the necessary payment technology required to accept crypto-currency.
So now we turn our attention to Security implications of Crypto-currencies and one of the leading cases on what the definition “Security” means. The US Supreme Court in SEC v. W.J. Howey Co. provided the Howey Test stating that an investment contract is a transaction, scheme or contract where people invest their funds (pool) in a common enterprise and expect profits solely from the efforts of a third party or promoter. The Howey test is concerned with whether the investment’s profit is largely or completely outside the control of the investor. If yes, the investment can be considered as Security. But, if the investor has a critical influence on how the investment is managed, then it is not a Security. Here is the difference between Crypto-currencies use simply as a means of economic exchange for goods and services or Crypto-currencies use for potential appreciation based on no effort or contribution to its upside or downside value by the investor.
In fact, revealing such complexity of regulation I present the “Teucrium Commodity Trust”. The Fund product has been registered as a Security since it provides for the Trust to pool numerous investors money. According to the S-1, the Trust is designed to provide investors with a cost-effective means to gain price exposure to the Bitcoin market. The Fund issues shares that trade on the NYSE Arca stock exchange and that can be purchased and sold by investors through their broker-dealer. The Fund’s investment objective is for changes in the Shares’ NAV to reflect the daily changes of the price of the Benchmark Bitcoin Futures Contract… The Fund does not invest directly in bitcoin. In this situation, the SEC is regulating the Trust as a Security since it involves pooled investment, FINRA is regulating the Broker-Dealers selling Trust Shares, and the CFTC is regulating the Trust as a Commodity Pool Operator and Commodity Trading Advisor due to the utilization of derivative trading of Bitcoin Future contracts.
Based upon the above, it seems apparent to the author that in the words of SEC Chairman Clayton that “ICO’s are securities”. It is also akin to US Supreme Court Justice Potter Stewart explaining “hard-core” pornography, or what is obscene, by saying, “I shall not today attempt further to define the kinds of material I understand to be embraced… [b]ut I know it when I see it …”. With that being said, that does not not necessarily preclude ICOs from creating non-fiat currency, notwithstanding issues of intrinsic value or full faith and credit of such tokens.
CRYPTO LENDING – SECURITY OR NOT? BANKING MAYBE?
So now it gets a little more complex with Crypto lending. Crypto lending provides a Platform where investors lend their crypto to borrowers in exchange for interest payments. Crypto-backed loans are secured loans. Borrowers use digital assets as collateral for loans, similar to how a house or a car is used as collateral for a mortgage or auto loan. You may not intend to use or trade your cryptocurrency in the foreseeable future, so this allows you to get money for expenses you need to cover now without needing to make a transaction with your digital assets. This strategy of lending Crypto has been successfully implemented for shifting potential capital gains tax realizations to a future date since no actual sale has occurred to gain access to the Crypto-currencies trading value. The argument has been made that these activities are more akin to banking or making simple promissory notes (commercial paper) amongst parties that would not be subject to Security Regulation.
However, arguing that Crypto Lending is not a security product, is a losing proposition in my opinion. State regulatory agencies in Alabama, Kentucky, New Jersey, and Texas have increased their efforts to challenge digital asset-related products by issuing cease-and-desist or “show cause” orders against New Jersey-based cryptocurrency company, Celsius Network LLC (“Celsius”). Celsius — which provides a blockchain-based cryptocurrency lending and trading platform — became a target of these states’ regulatory enforcement efforts against cryptocurrency products.
Celsius — with the tagline “Unbank Yourself” as a means to differentiate it from engaging in Securities — advertises its mission as placing “unparalleled economic freedom in the hands of the people.” Celsius users buy, borrow, and trade various cryptocurrencies. Through its “Earn Rewards” program, Celsius encourages retail customers to place eligible cryptocurrency into interest-bearing accounts, which Celsius then pools to fund its lending operations and proprietary trading.
Although it is difficult to gauge, since there is no true transparency by Celsius, the fact that Celsius pools retail customers assets, or in other words comingles investor funds rather than having them placed in segregated custodied accounts, creates a Security, regardless of the underlying asset being Crypto-currency. The SEC holds that A pooled investment vehicle is an entity—often referred to as a fund and in Celsius’ case the “Earn Rewards Program” —that an adviser creates to pool money from multiple investors. The Program uses that money to make investments on behalf of the Pool. Investors generally share in the profits and losses in proportion to their interest in the fund, as would be demonstrated with ultra high interest yield payments of 8%-18%. Accordingly, until properly registered Celsius will be unable to offer their Program in the US without state and federal regulatory consequences. The simple solution is to simply comply in some negotiated fashion and factor regulation as a cost of business, or potentially create individual promissory notes that are segregated and treated as assets/liabilities of a banking institution under OCC scrutiny.
On the Federal level, Coinbase announced that after its month-long effort “to engage productively, the SEC gave us what’s called a Wells [N]otice about our planned Coinbase Lend program.” Coinbase had advertised “Lend” as “a high-yield alternative to traditional savings accounts” through which customers could lend cryptocurrency to Coinbase and “earn 8x the national average of high-yield savings accounts.” According to Coinbase’s Wells Notice, the SEC informed Coinbase that it would consider Lend as a security under the Howey and Reves standard.
Crypto lending products — particularly those tied to interest-bearing accounts — continue to come under regulatory scrutiny. The SEC’s Wells Notice to Coinbase was intended to send a clear message to other cryptocurrency companies to register their Crypto-lending products as securities within the meaning of Section 5 of the Securities Act. It is very likely that the SEC along with states will continue filing enforcement actions, against other cryptocurrency companies for offering alleged unregistered securities through ICOs and Crypto-lending programs and platforms.
In the meantime, state and various Federal regulators are actively challenging interest-earning cryptocurrency lending programs while trying to construct a fair regulatory scheme that will encompass understanding the large new elephant sitting in the SEC’s waiting room. And the best advice I can provide is for the Regulators to treat such regulation exactly as would be the case if the assets were not digital or crypto since traditional SEC, CFTC, FINRA, NFA and State regulatory schemes can be effectively applied.