As Facebook continues to unveil plans for Project Libra, everyone from global central bankers and regulatory agencies to Wall Street and Silicon Valley are asking the same question: What would qualify a token or cryptocurrency to be the subject of regulatory scrutiny?
For better or worse, we have seen this movie before. Investment advisers, as well as platform and software providers, have been very excited about getting into the crypto space, but don’t know whether their token of choice is considered a “security” and, therefore, subject to the rules of trading securities.
Many investment banks exploring the cryptocurrency space are well-equipped to mitigate and work through the regulatory issues and, at times, opaque boundaries presented by the shifting crypto landscape. However, smaller private funds or companies that never needed to take these factors into consideration may not be as prepared or well positioned to tackle the upcoming regulatory challenges that they may face.
Just as Facebook will likely do, any new “crypto” fund, investment firm or trading platform must perform the “Howey Test” to determine if their token is subject to Securities and Exchange Commission regulations.
The Howey analysis, which looks at an investment’s substance rather than its form to decide whether the investment consists of an investment contract and therefore qualifies as a security, is predicated on three critical questions any issuer of a token would need to ask:
- Is the investment in the form of money?
- Is the investment of money in a common enterprise?
- Is there an expectation of profits from the investment derived from the efforts of others (i.e., a third party)?
Since cryptocurrencies were borne out of the idea of creating a decentralized monetary environment, the most important questions for a firm to focus on are two and three: (2) is there a common enterprise in which to invest; and (3) is there an expectation of profits via a third party?
SEC Chairman Jay Clayton has said that most tokens and initial coin offerings—particularly those that include aspects and marketing efforts that highlight the potential for profits obtained from a third party—are, in fact, securities and should be regulated as such.
However, some cryptocurrencies, like Bitcoin and Ethereum, have been deemed to not be securities, as they are viewed as purely exchange instruments.
According to Facebook, the Libra will function a bit differently than most other tokens and cryptocurrencies in that it will be backed by a basket of liquid assets and, therefore, provide holders with a certain level of price stability.
The Token Is a Security—Now What? Compliance Considerations for Registered Firms
Once a firm has performed the “Howey Test” and concluded that the token in question is deemed to be a security, the firm will likely be required to register with the SEC as an investment adviser or with the SEC and FINRA as a broker-dealer depending on the context in which the token will be invested or traded. In the context of anti-money laundering, the firm may need to adhere to the regulatory requirements of FinCEN.
In addition to federal requirements, many rules and regulations related to tokens differ substantially from state to state. Understanding the purpose and goals of any token are paramount in creating a compliance-based strategy that allows the token in question to succeed while satisfying all applicable regulatory requirements.
Given the volatility and trends of the crypto market, many fund managers who initially explored cryptocurrency investment strategies have begun searching for relief through alternative strategies, including exploring exchange-related opportunities as broker-dealers. It is not uncommon for firms to begin the registration process and slam on the breaks when they begin to more fully understand the regulatory hurdles that can arise prior to, and after, Form BD is submitted.
Regardless of the chosen registration and regulatory route, it is important to develop a comprehensive understanding of the token and its long-term plan during the registration process.
It’s also important to consider the differences between your token and tokens that are currently not deemed securities. While the differences may seem obvious, conducting an analysis that can substantiate the individual “Howey Test” results could be pivotal during the registration process.
Once the initial analysis that determined the token to be a security is completed, one may elect to do the following:
- Obtain confirmation from counsel or regulatory experts that registration is required.
- Identify necessary steps to registration and compliance.
- Conduct the registration process and implement a compliance program in stages to ensure the program is fully functional by the time registration is approved.
- Obtain registration approval and live your best regulatory life.
The Token Is Not Currently Deemed a Security—Now What?
Firms who have tokens not deemed to be securities are safe from the regulatory hurdles previously mentioned; however, they aren’t in the clear just yet. It is imperative to evaluate the token’s function by way of the “Howey Test” on a periodic basis because circumstances can change, either within the business or from an industry or regulatory perspective.
Depending on how close the firm is needing to register, it may be advisable to begin implementing certain aspects of a comprehensive compliance program with the support of both internal and external resources and expertise.
For example, as a precautionary measure, a firm might consider developing internal processes and marketing guidelines to ensure that the promotion of the token is carried out in such a way that it is not seen as an investment.
Like many “exempt reporting advisers,” it may be appropriate to adopt certain compliance policies and procedures now that are not required at this time, not only as a matter of best practice, but also in an attempt to be prepared for an eventual registration.
As demonstrated by the uptick of guidance from regulators, including its citation in the SEC’s Office of Compliance Inspections and Examinations 2019 exam priorities and the topic of the April 2019 CFTC and SEC Investor Alert, cryptocurrency is a priority. The next six months will be very telling as it relates to the regulatory repercussions of Facebook’s Libra and, to a certain extent, the viability of cryptocurrencies, tokens and other FinTech investing issues.
The non-conformist thinking of millennials has, in large part, allowed cryptocurrencies to flourish, while the world of regulators is primarily led by GenX. The crypto space is proving to be just another chapter in the challenge of two generations trying to speak the same language and it will be fascinating to see how that language barrier is overcome as products such as Libra continue to shake up the market.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Fizza Khan is founder and CEO of Silver Regulatory Associates, a firm specializing in compliance for the investment industry.
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