Recent events regarding FTX and other failed crypto enterprises amplify the need for the 118th Congress to take action by passing legislation to provide holistic federal oversight of the virtual currency market.
This includes regulating market participants that engage in a virtual currency business from the US or with US persons.
The Commodity Futures Trading Commission should be appointed the federal regulator responsible for overseeing this industry. The CFTC already has express authority under law to prosecute malfeasance in connection with transactions involving any commodity in interstate commerce, including virtual currencies.
And such a lead role for the CFTC was contemplated by three legislative proposals introduced on a bipartisan basis in Congress last year.
However, any new legislation must confirm a few details. Even if a virtual asset is regarded as a security in connection with its initial offering, it may not be a security in connection with secondary market transactions.
Any new law should provide a clear path for such transformation. Otherwise, whether a virtual currency is a security or not will continue to be unclear, at least under some circumstances, and so will the potential for regulatory arbitrage and malfeasants to fall through the cracks.
The recognition that a financial asset may change its essential nature as a security to a non-security or vice versa is nothing new for the CFTC and the Securities and Exchange Commission.
In passing the Commodity Futures ModernizationAct in 2000, Congress determined that certain futures contracts based on broad-based security indices—considering the number of component securities and their weighting, among other numeric characteristics—should be regarded solely as futures contracts under the exclusive oversight of the CFTC.
However, if the number of component securities was too low—nine or less—or the weighting of one or more component securities of such indices was too high—for example, one security comprised more than 30% of the index’s weighting—among other numeric tests, such indices should be regarded as “narrow-based.”
That meant futures on such indices should constitute a type of security termed a “security future” and be subject to joint CFTC and SEC oversight.
Moreover, the CFMA recognized that the characteristics of a security index could change over time. Congress addressed this by providing a clear path, including a timeline, for the transformation of such products from one regulatory scheme to another.
With some bumps, the methodology for futures and security futures has worked well for over 20 years.
SEC staff has similarly recognized that virtual currencies may change their characteristics over time. In a well-known June 2018 speech, William Hinman, then-director of the SEC’s Division of Corporation Finance, explicitly recognized that a digital asset initially offered in a manner to render the offering an investment contract—and thus a security under applicable law—may at some point “no longer represent an investment contract.”
Is it a Security?
According to Hinman, if the “network on which the token or coin is to function is sufficiently decentralized—where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts—the assets may not represent an investment contract.”
In April 2019, the SEC’s Strategic Hub for Innovation and Financial Technology expanded on Hinman’s comments. It enumerated several indicia of decentralization that could be considered in assessing whether a crypto asset had morphed from a security to a non-security.
These included whether the efforts of persons who initially or later provided “essential managerial efforts”—so-called “active participants”—remain “important to the value of an investment in the relevant digital asset.”
However, these characteristics, unlike the measures for security futures, generally were subjective and not numerically objective. Moreover, SEC staff provided no definitive timeline for when a digital asset might be regarded as a non-security—even if it should meet the SEC’s amorphous standards of decentralization.
One version of crypto legislation proposed in the last Congress by Senators Kirsten Gillibrand (D-NY) and Cynthia Lummis (R-Wyo.) creatively attempted to address the morphing potential of crypto assets by labeling digital assets that, after initial issuance, benefit from the efforts of active participants but do not represent traditional debt or equity type financial instruments, as “ancillary assets.”
Although issuers of ancillary assets would be required to provide certain disclosures to consumers under SEC rules, such assets ordinarily would be deemed commodities that are not securities, and thus subject to plenary oversight by the CFTC.
In addition to the Gillibrand-Lummis proposal, there are likely other potential ways to address the prospective morphing of crypto assets—just as Congress dealt in 2000 with the potential changing nature of futures based on security indices.
However, there must be certainty for markets and market participants in knowing whether a crypto asset is a security or not to avoid other potential calamities for crypto asset traders and investors.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Daniel J. Davis, former CFTC general counsel, is a partner at Katten Muchin Rosenman.
Gary DeWaal is special counsel to Katten Muchin Rosenman.