[House Hearing, 115 Congress]
[From the U.S. Government Publishing Office]
CRYPTOCURRENCIES: OVERSIGHT OF NEW ASSETS IN THE DIGITAL AGE
=======================================================================
HEARING
BEFORE THE
COMMITTEE ON AGRICULTURE
HOUSE OF REPRESENTATIVES
ONE HUNDRED FIFTEENTH CONGRESS
SECOND SESSION
__________
JULY 18, 2018
__________
Serial No. 115-14
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Printed for the use of the Committee on Agriculture
agriculture.house.gov
______
U.S. GOVERNMENT PUBLISHING OFFICE
30-893 PDF WASHINGTON : 2018
-----------------------------------------------------------------------
For sale by the Superintendent of Documents, U.S. Government Publishing
Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800;
DC area (202) 512-1800 Fax: (202) 512-2104 Mail: Stop IDCC,
Washington, DC 20402-0001
COMMITTEE ON AGRICULTURE
K. MICHAEL CONAWAY, Texas, Chairman
GLENN THOMPSON, Pennsylvania COLLIN C. PETERSON, Minnesota,
Vice Chairman Ranking Minority Member
BOB GOODLATTE, Virginia, DAVID SCOTT, Georgia
FRANK D. LUCAS, Oklahoma JIM COSTA, California
STEVE KING, Iowa TIMOTHY J. WALZ, Minnesota
MIKE ROGERS, Alabama MARCIA L. FUDGE, Ohio
BOB GIBBS, Ohio JAMES P. McGOVERN, Massachusetts
AUSTIN SCOTT, Georgia FILEMON VELA, Texas, Vice Ranking
ERIC A. ``RICK'' CRAWFORD, Arkansas Minority Member
SCOTT DesJARLAIS, Tennessee MICHELLE LUJAN GRISHAM, New Mexico
VICKY HARTZLER, Missouri ANN M. KUSTER, New Hampshire
JEFF DENHAM, California RICHARD M. NOLAN, Minnesota
DOUG LaMALFA, California CHERI BUSTOS, Illinois
RODNEY DAVIS, Illinois SEAN PATRICK MALONEY, New York
TED S. YOHO, Florida STACEY E. PLASKETT, Virgin Islands
RICK W. ALLEN, Georgia ALMA S. ADAMS, North Carolina
MIKE BOST, Illinois DWIGHT EVANS, Pennsylvania
DAVID ROUZER, North Carolina AL LAWSON, Jr., Florida
RALPH LEE ABRAHAM, Louisiana TOM O'HALLERAN, Arizona
TRENT KELLY, Mississippi JIMMY PANETTA, California
JAMES COMER, Kentucky DARREN SOTO, Florida
ROGER W. MARSHALL, Kansas LISA BLUNT ROCHESTER, Delaware
DON BACON, Nebraska
JOHN J. FASO, New York
NEAL P. DUNN, Florida
JODEY C. ARRINGTON, Texas
______
Matthew S. Schertz, Staff Director
Anne Simmons, Minority Staff Director
(ii)
C O N T E N T S
----------
Page
Conaway, Hon. K. Michael, a Representative in Congress from
Texas, opening statement....................................... 1
Prepared statement........................................... 3
Peterson, Hon. Collin C., a Representative in Congress from
Minnesota, opening statement................................... 4
Witnesses
Fairfield, J.D., Joshua A.T., William Donald Bain Family
Professor of Law, Washington and Lee University School of Law,
Staunton, VA................................................... 5
Prepared statement........................................... 7
Baldet, Amber, Co-Founder and Chief Executive Officer, Clovyr,
New York, NY................................................... 11
Prepared statement........................................... 13
Submitted questions.......................................... 97
Kupor, J.D., Scott, Managing Partner, Andreessen Horowitz, Menlo
Park, CA....................................................... 15
Prepared statement........................................... 18
Gorfine, J.D., Daniel, Director and Chief Innovation Officer,
LabCFTC, Commodity Futures Trading Commission, Washington, D.C. 20
Prepared statement........................................... 22
Submitted questions.......................................... 97
Gensler, Hon. Gary, Senior Lecturer, Sloan School of Management,
Massachusetts Institute of Technology; Senior Advisor to the
Director, MIT Media Lab, Brooklandville, MD.................... 27
Prepared statement........................................... 30
Ness, J.D., Lowell D., Managing Partner, Palo Alto Office,
Perkins Coie LLP, Palo Alto, CA................................ 47
Prepared statement........................................... 48
CRYPTOCURRENCIES: OVERSIGHT OF NEW ASSETS IN THE DIGITAL AGE
----------
WEDNESDAY, JULY 18, 2018
House of Representatives,
Committee on Agriculture,
Washington, D.C.
The Committee met, pursuant to call, at 10:01 a.m., in Room
1300 of the Longworth House Office Building, Hon. K. Michael
Conaway [Chairman of the Committee] presiding.
Members present: Representatives Conaway, Thompson,
Goodlatte, Lucas, King, Gibbs, Austin Scott of Georgia,
Hartzler, LaMalfa, Davis, Yoho, Allen, Bost, Rouzer, Abraham,
Kelly, Comer, Marshall, Bacon, Faso, Arrington, Peterson, David
Scott of Georgia, Costa, McGovern, Vela, Lujan Grisham, Kuster,
Nolan, Plaskett, Adams, Evans, Lawson, O'Halleran, Panetta,
Soto, and Blunt Rochester.
Staff present: Darryl Blakey, Mindi Brookhart, Paul
Balzano, Rachel Millard, Matthew MacKenzie, Patrick Delaney,
Troy Phillips, Nicole Scott, and Carly Reedholm.
OPENING STATEMENT OF HON. K. MICHAEL CONAWAY, A REPRESENTATIVE
IN CONGRESS FROM TEXAS
The Chairman. Good morning, everyone. This hearing of the
Committee on Agriculture entitled, Cryptocurrencies: Oversight
of New Assets in the Digital Age, will come to order. Please
join me in a quick prayer.
Heavenly Father, we ask you, Lord, for blessings on this
meeting this morning. We have some things to understand that
are new and different, and we have great panelists to visit
with us this morning. I also want to lift up Collin Peterson
and his family during these times, bittersweet, and your
thoughts and prayers with him as well. Help us to do your will
and be the kind of people that will honor you. We ask these
things in Jesus' name. Amen.
Just a quick word. Collin Peterson's 98\1/2\ year old
father passed this week, and this is bittersweet. But he was
telling me a wonderful story that his dad apparently had his
faculties right up until the very end, which is pretty darn
good. Our thoughts are with you, Collin.
Mr. Peterson. He was hanging in there. He could remember
the crop prices from 1952. He knew everything.
The Chairman. Yes, all right.
Well good morning. We have a terrific panel this morning. I
see a lot of new faces in the audience today. One of the big
questions on a lot of folks' mind is what is the Agriculture
Committee doing with cryptocurrency, and the distributive
ledger technology, but we are here to find that out this
morning.
For those of you who have not joined us before, welcome. We
are happy to have you as we discuss an emerging policy area
that is of deep interest to our Members, to the emerging
crypto-industry, and, we hope, to Americans of all stripes.
Digital assets like Bitcoin and Ether, but also hundreds of
other token-based projects that are being developed, represent
a new way for people to interact and exchange in commerce with
one another. While digital assets are often thought of as
payment systems or digital gold, I believe the promise that
token networks hold is more universal and more exciting, quite
frankly, than that.
For the first time, we have a tool that enables individuals
to reliably exchange value in a digital realm without an
intermediary. We can have assets that exist and can be created,
exchanged, and consumed in digital form. The promise of being
able to secure property rights in a digital space may
fundamentally change how people interact with one another. This
technology holds the potential to bring enormous benefits to
each of us, if we are willing to give it the space to grow.
Providing a strong, clear, legal and regulatory framework
for digital assets is essential. To that end, there are several
questions before us about how laws should govern the issuance,
trade, and utilization of these digital assets.
Perhaps no question has generated greater uncertainty than
how to determine if a particular token is a security. What to
do if a commonly traded asset is, in fact, deemed a security.
We simply apply the securities laws. If it is not a security,
there is a good chance it is a commodity, which would be
subject to the requirements of the Commodity Exchange Act.
The problem seems to be in making that determination. The
Howey Test, which concerns the sale of orange groves and
service contracts in the 1940s, is often presented as the
standard test to determine if the securities laws govern a
token, yet they have proved challenging to analyze under this
test.
A related question is whether or not current laws are
appropriate for these new digital assets. If a token is
determined to be a security or a commodity or something else,
our regulatory regime need not be static. If it is necessary,
Congress and regulators may want to consider developing a new
framework that takes into account the diverse characteristics
and unique economic relationships embedded in many of the types
of digital assets that can be represented by tokens.
Providing clear guidance to enable developers to determine
the nature of their token and then suitable rules to enable
them to develop their project, is essential to both protecting
the public and promoting innovation. How we regulate these
products and those who develop them won't determine if they are
developed or used, but it will determine where they are
developed and used, and we want that innovation done in our
country.
As we consider changes to the laws or new regulations, the
Committee on Agriculture will be a part of that conversation.
Within the House, we have a vested interest in the definition
of a security, because it directly impacts the definition of a
commodity.
Similar to our work in agricultural commodities, as well as
futures and swaps markets, the Committee has a strong interest
in promoting safe, efficient and transparent markets for those
who use these new token markets. Properly regulated markets
promote innovation and foster economic growth, and I don't
believe that will be any different with respect to digital
assets. Of course, proper regulation does not mean intrusive
regulation. It means regulation appropriate to the nature of
the activities and the participants, and in some cases, it
might mean no regulation at all.
Before I turn to our Ranking Member, I want to thank all of
our witnesses for making the time to prepare and testify. We
have an incredibly qualified panel to present all sides of a
fascinating and complex set of issues. I am pleased to welcome
each one of you here today for this conversation.
[The prepared statement of Mr. Conaway follows:]
Prepared Statement of Hon. K. Michael Conaway, a Representative in
Congress from Texas
Good morning. I see a lot of new faces today as we tackle a
cutting-edge topic for the Committee: digital assets.
For those of you who have not joined us before, welcome. We are
happy to have you as we discuss an emerging policy area that is of deep
interest to our Members, to the emerging cryptocurrency industry, and .
. . we hope . . . to Americans of all stripes.
Digital assets like Bitcoin and Ether, but also like hundreds of
other token-based projects that are being developed, represent a new
way for people to interact and engage in commerce with one another.
While digital assets are often thought of as ``payment systems'' or
``digital gold'' I believe the promise that token networks hold is more
universal--and more exciting--than that.
For the first time, we have a tool that enables individuals to
reliably exchange value in the digital realm, without an intermediary.
We can have assets that exist--and can be created, exchanged, and
consumed--in digital form. The promise of being able to secure property
rights in a digital space may fundamentally change how people interact
with one another. This technology holds the potential to bring enormous
benefits to each of us, if we are willing to give it the space to grow.
Providing a strong, clear legal and regulatory framework for
digital assets is essential. To that end, there are several questions
before us about how laws should govern the issuance, trade, and
utilization of digital assets.
Perhaps no question has generated greater uncertainty than how to
determine if a particular token is a security. We generally know what
to do if a commonly traded asset is deemed a security--we apply the
securities laws. And if it is not a security, there is a good chance
it's a commodity and subject to the requirements of the Commodity
Exchange Act.
The problem seems to be in making that determination. The Howey
Test, which concerns the sale of orange groves and service contracts in
the 1940s, is often presented as the standard test to determine if the
securities laws govern a token, yet they have proved challenging to
analyze under the test.
A related question is whether or not the current laws are
appropriate for these new digital assets. If a token is determined to
be a security or a commodity or something else, our regulatory regime
need not be static. If it's necessary, Congress and regulators may want
to consider developing a new framework that takes into account the
diverse characteristics and unique economic relationships embedded in
the many types of digital assets that can be represented by tokens.
Providing clear guidance to enable developers to determine the
nature of their token and then suitable rules to enable them to develop
their project, is essential to both protecting the public and promoting
innovation. How we regulate these products and those who develop them
won't determine if they are developed and used, but it will determine
if they are developed and used in our country.
As we consider changes to the law or new regulations, the Committee
on Agriculture will be a part of the conversation. Within the House, we
have a vested interest in the definition of a security, because it
directly impacts the definition of a commodity.
Similar to our work in agricultural commodities, as well as futures
and swaps markets, the Committee has a strong interest in promoting
safe, efficient, and transparent markets for those who use these new
token markets. Properly regulated markets promote innovation and foster
economic growth, and I don't believe that will be any different with
digital assets. Of course, ``proper regulation'' does not mean
``intrusive regulation.'' It means, regulation appropriate to the
nature of the activities and the participants, and in some cases, it
might even mean no regulation at all.
Before I turn to our Ranking Member, I want to thank all of our
witnesses for making the time to prepare and testify. We have an
incredibly qualified panel to present all sides of a fascinating and
complex set of issues. I am pleased to welcome you all, and I look
forward to our conversation today.
The Chairman. With that, Collin, I will turn to you for any
comments that you might want to add.
OPENING STATEMENT OF HON. COLLIN C. PETERSON, A REPRESENTATIVE
IN CONGRESS FROM MINNESOTA
Mr. Peterson. Thank you, Mr. Chairman, and thanks to all of
you for joining us here today.
I am happy that we have a chance to review this new
technology in our role to oversee the CFTC regulation of it, if
appropriate.
As a CPA and someone who spent a career helping folks run
the numbers on their finances, I am still having a hard time
getting my hands around this, and I have some real concerns.
One aspect of cryptocurrency that we need to pay special
attention to is its volatility. There are some of you that will
tell us that the fluctuations in cryptocurrency are a good
thing, and part of its appeal. But the increased speculation
and the fact that regular investors stand to lose their shirts
gives me a great deal of concern.
As one study found, over 80 percent of the initial coin
offerings are scams. While regular investors stand to lose, a
very small amount stand to gain. For example, 97 percent of
Bitcoin is held by just four percent of addresses.
There are a lot of things here that don't make much sense
to me, and who knows? Maybe some type of this technology will
come along and really make a difference after these starts and
fits, but as it stands right now, I am skeptical. It is our job
to be the adults in the room and to ensure that in these early
days, there is enough oversight of this new frontier to ensure
that it can grow responsibly.
With that, I look forward to your testimony, and I yield
back.
The Chairman. Thank you, Mr. Peterson.
The chair would request other Members submit their opening
statements for the record so that our witnesses may begin their
testimony, and to ensure there is ample time for questions.
I now would like to welcome our witnesses to our table.
First off we have Mr. Joshua Fairfield, the William Donald Bain
Family Professor of Law, Washington and Lee University School
of Law in Staunton, Virginia.
We have Ms. Amber Baldet, Co-Founder and CEO of Clovyr in
New York, New York.
We have Scott Kupor, Managing Partner of Andreessen
Horowitz, Menlo Park, California.
We have Mr. Daniel Gorfine, Director, LabCFTC and Chief
Innovation Officer at the CFTC here in Washington, D.C.
We are welcoming back for another round of conversations
the Honorable Gary Gensler, who currently is a Senior Lecturer,
MIT Sloan School of Management, and then we have Mr. Lowell
Ness, Managing Partner, Perkins Coie, Palo Alto, California.
We have a terrific panel, and with that, we will go to Mr.
Fairfield.
Everybody will have 5 minutes to pitch your wares, and we
also have your full statements for the record.
So with that, Mr. Fairfield, you are recognized.
STATEMENT OF JOSHUA A.T. FAIRFIELD, J.D., WILLIAM
DONALD BAIN FAMILY PROFESSOR OF LAW, WASHINGTON AND LEE
UNIVERSITY SCHOOL OF LAW, STAUNTON, VA
Mr. Fairfield. Thank you, Chairman Conaway, Ranking Member
Peterson, and Members of the Committee for the opportunity to
address you today.
My remarks are going to try to set some context, and they
are organized around two questions. We have heard a lot about
securities and commodities, but how are people actually using
cryptocurrency tokens? And given that, how should regulators
proceed?
On the first question, blockchain, which is the technology
underlying the current rash of cryptocurrency and tokens, is a
new decentralized database technology. Many communities have
formed just to see what the technology can do, and they are
trying different experiments. The potential value in these
experiments is considerable. Collaborative communities of
artists, new forms of corporations, fast and low cost check
settlement, digitization of securities, open and low cost
electronic mortgage and secured transactions filing systems,
secure international remittances, voting systems, and many more
are possible applications of the technology.
My testimony today will focus on potential for blockchain
technology to expand personal property rights online. This is
my primary area of research, and my conclusions are--and I will
continue them below--that first, citizens need and want an
expansion of personal property rights online. The
cryptocurrency tokens are helping them do that by solving
important problems in building markets for digital property and
that we need to be cautious when regulating overlapping spaces
and use cases, such as systems in which most people hold a
token to use it or consume it, and that few hold it to
speculate on the price.
On the second question, how do we go about conducting
oversight? Common sense construction of how groups are using
the technology, a so-called duck test, will help regulators
begin to sort out whether and where to engage. Rough agency
consensus can handle these conflicts, and hearings such as this
one are critically important for regulators to start working
out the overlaps because many, many more applications of this
technology are coming.
In the body of my remarks, I would like to discuss how this
technology represents a badly needed expansion for personal
property rights online. We should really care about good
property rules for intangible electronic digital assets. Good
property rules preserve citizen independence. Property
institutions build individual wealth and social welfare by
reducing transaction costs, and property permits us to express
ourselves by changing and arranging our environment to reflect
what we want. Here you might think of your own home or your
wedding ring, for example.
But personal property rights like this have had serious
trouble coming online. We just don't own that much personal
property online. Consider that people used to have record
collections. Now they have a subscription to Spotify. People
used to have bookshelves. Now they have Kindle accounts. This
is because early in the history of the Internet, intellectual
property holders were worried about illegal copying. It took
several decades to develop a technology, blockchain, the
database technology underneath cryptocurrency tokens, that can
be traded, held, bought, and sold but not duplicated. So far
until now, property institutions haven't really gotten the
benefit of Internet technologies because it is too costly to
record all the transactions. We can't have a database of
ownership for every Barbie doll in the entire country, right?
It is too costly. However, token systems can and will reshape
all of these ways of owning if they push price points low
enough the way the Internet did for basic Internet
communications.
In sum, blockchain technology is not just used as a
security. It is not just used as a commodity. It is used as a
way to unstick personal property law for all of us online. But
it is only going to do it if we let it.
What is the path to successful oversight? Responsible
regulation has to rest on a frank and common sense
determination of how people are using this technology. Working
out the jurisdictional questions is going to be time consuming,
but it is not particularly harder than for network
communications technology. Generally we have just had to hand
these things out and figure it out.
Tokens do present some challenge. Specifically, they may be
used in different ways by different members of a community.
They may be used at different times in different ways, but most
importantly, the nature of the use by a community can shift. A
community can be trying to do something entirely legitimate and
have speculators come in and begin to disrupt the purpose of
the original community.
The current hot characterization debate is whether token
sales ought to be deemed regulable under the Howey test. I
believe instead the Howey test represents the outer bound of
where we should look. We should look inside that outer bound to
figure out what the beneficial and damaging uses of the
technology are. If a community is using cryptocurrency tokens
like securities, then they should be regulated as securities.
But if they are not, they shouldn't, and that is the most
important addition.
In conclusion, blockchain technology has enabled new
communities and new business forms. It has also provided the
technological basis for a badly needed expansion of personal
property rights online, and for purposes of regulatory
jurisdiction, a rough common sense sorting into buckets will do
more good in the near term than precise definitions of what a
cryptocurrency token is. That is a lost cause. A cryptocurrency
token wears as many hats as humans give it. It is an entry in a
database. It is a technological entry and nothing more.
In the current characterization debate, what this means is
that a token should be deemed a security when it operates like
a security, a commodity when it operates like a commodity, a
currency when it operates as a currency, and as a simple
property interest when it operates as a simple property
interest.
Thank you so much.
[The prepared statement of Mr. Fairfield follows:]
Prepared Statement of Joshua A.T. Fairfield, J.D., William Donald Bain
Family Professor of Law, Washington and Lee University School of Law,
Staunton, VA
Mr. Chairman Conaway, Ranking Member Peterson, and Members of the
Committee. Thank you for the opportunity to address you today.
Introduction
My remarks are organized around two questions:
How are people actually using this new technology? And: How should
a regulator best proceed in light of how the technology is being used?
I will briefly summarize my conclusions before returning to the body of
my testimony.
First, blockchain, the technology underlying the current rash of
cryptocurrencies, is a relatively new database technology that permits
communities to self-organize and build trustworthy decentralized
databases. Many communities have formed just to see what the technology
can do, and are attempting different experiments, often with each
offering its own ``coin.'' (To be sure, scam artists have also flocked
to the development scene.) The potential value in these experiments is
considerable: collaborative communities of artists, new corporate
forms, distributed autonomous organizations, fast and low-cost check
settlement, digitization of securities, open and low-cost electronic
mortgage and secured transactions systems, secure international
remittances, voting systems, and many more are possible applications of
the technology.
The Committee will hear about a range of these applications today.
The specific area in which I would like to focus is the potential for
blockchain technology to act as a catalyst for expansion of online and
electronic personal property rights. This is my primary area of
research. My conclusions, as below, are that citizens need and want an
expansion of personal property rights online; that cryptocurrencies and
cryptocurrency tokens can help solve important problems in building
markets for digital property; and that caution may be advisable when
regulating overlapping spaces and use cases, such as systems in which
most people hold an asset to consume it, and a few hold it to speculate
on the price.
On to the second question, how to best proceed? Agencies have
already for several years found themselves faced with the potential for
overlapping jurisdiction over blockchain-based businesses, products,
and services, precisely because the technology can support so many
different uses. Because blockchains are just databases, their use must
determine the oversight response.
Uses of cryptocurrency tokens can be complex. Not all people who
hold a cryptocurrency token do so for the same reasons. Some people
hold cryptocurrency tokens to consume, some simply to possess, some to
speculate, some to trade, and some change their minds from time to
time. Thus, tokens have a fundamentally multi-use nature. There is also
a time component. Until the owner takes action (consume or trade), the
owner's reason for holding the token may not be knowable. The use and
holding of the token as personal property should be generally
unproblematic, at least by default. Only the trade and speculation
components should trigger regulatory concern, and even then, only if
the structure of the transaction looks like an attempt to circumvent
some established regulatory mandate.
There are solid paths forward that can protect investors from fraud
and permit entrepreneurs and communities to develop new business
models. Common sense construction of how groups are using the
technology--a ``duck test''--will help begin to sort out whether a
regulatory structure is needed at all, and if so, which law governs.
Rough agency consensus and even active and agile cooperation between
regulators can handle these conflicts, and are good for regulators to
start working out: more applications of this technology are coming.
There is indeed every reason to believe this is how regulation in this
space will actually evolve. More concerning is the risk of chilling
innovation through incautious overlapping or conflicting regulation.
Carefully overlapping jurisdictional claims need not cause
contradiction, but it may take time until the contours of how people
use the technology become clear. And when those contours do become
clear, good rules can draw workably clean lines between shifting uses
of a product or service within a community that weaves across a legal
boundary.
B. Cryptocurrencies and the Future of Property *
---------------------------------------------------------------------------
* Editor's note: the testimony is published as submitted, there was
no section labeled A.
---------------------------------------------------------------------------
In the body of my remarks I would like to discuss how this
technology represents a badly needed expansion of personal property
rights online. We should care about good property rules for electronic
assets. Good property rules contribute to human thriving, or as Nobel
Laureate Amartya Sen expressed it, good property rules expand the range
of human capabilities. Property matters because it lets people do
things. Thus, good property rules are those that expand what people can
do. There are three primary ways good property institutions positively
impact society.\1\ First, good property rules can preserve citizen
independence. Property draws an important line between private and
state power.\2\ Second, property institutions build individual and
social welfare by reducing transaction costs, permitting resources to
flow to higher-valuing users.\3\ And third, property permits humans to
express themselves by changing and arranging their environment to
reflect themselves.\4\ Here, examples might be the property interest in
a home, wedding band, detailed automobile, and so on.
---------------------------------------------------------------------------
\1\ See Jedediah Purdy, The Meaning of Property: Freedom,
Community, and the Legal Imagination 19 (Yale University Press 2010).
\2\ Joshua A.T. Fairfield, Owned: Property, Privacy, and the New
Digital Serfdom 18 (Cambridge University Press 2017) (``His first
stream is `libertarianism,' or negative liberty: the idea that property
means a kind of liberty from government interference.'') (citing
Jedediah Purdy, supra, at 19).
\3\ Id. (``His second stream is efficiency, or what he calls
`welfarism': property is an institution that helps to ensure the free
flow of goods for minimum transaction costs, such that it allows people
to get what they want at the lowest price.'') (citing Jedediah Purdy,
supra, at 20).
\4\ Id. (``Purdy identifies a stream of human personhood, or
identity. The identity view of property requires that we have some
stability in our environment so that we can build a home, a family, an
identity. Property allows us to surround ourselves with reminders of
who we are or wish to be.'') (citing Jedediah Purdy, supra, at 20); see
also Margaret Jane Radin, Property and Personhood, 34 Stan. L. Rev.
957, 957 (1982) (``The premise underlying the personhood perspective is
that to achieve proper self-development--to be a person--an individual
needs some control over resources in the external environment. The
necessary assurances of control take the form of property rights.'').
---------------------------------------------------------------------------
Despite these advantages, personal property rights have had serious
trouble transitioning from offline to the online environment. We don't
own much personal property online. Instead, we license everything.\5\
If you question whether this is true, consider that people used to own
record collections; now they license iTunes, or simply have a
subscription to Spotify. People used to have bookshelves; now they have
Kindle collections. This modern license framework is in place because,
early in the history of the Internet, intellectual property holders
were worried about illegal copying. It took several decades to develop
a technology, blockchain, which operated like a digital object. Slots
in a blockchain--cryptographic tokens--can be traded, held, bought, and
sold, but not duplicated. Cryptocurrency tokens cannot be double-spent,
because they would be rejected by both the protocol and the other
``players.'' \6\
---------------------------------------------------------------------------
\5\ See Aaron Perzanowski & Jason Schultz, The End of Ownership:
Personal Property in the Digital Economy (MIT Press 2016).
\6\ Joshua A.T. Fairfield, BitProperty, 88 S. Cal. L. Rev. 805, 841
(2015).
---------------------------------------------------------------------------
As a result, cryptocurrency tokens let us own an intangible
electronic asset just like we own a hat. Blockchain technology appears
poised to un-stick personal property law online by strongly reducing
transaction costs for tracking transactions in digital property rights,
and by creating rivalrous (that is, non-copyable) digital assets.
Already, cryptocurrency tokens are appearing in court decisions on
inheritance, wills and trusts, and other routine treatment of personal
property under the common law. It may soon become as routine to own
digital tokens as it is to own dollars in a bank account.
Property institutions will deeply benefit from this technology-
driven drop in transaction costs. Carol Rose notes: ``It costs
something to define rights, to monitor trespasses, and to expel
intruders.'' \7\ As property rights become more complex and harder to
define, property systems cost even more. The difference in expense is
why we currently have title registries for big items like houses, cars,
boats, and airplanes, but not for smaller pieces of personal property.
Cryptocurrency tokens can keep track of minute changes in ownership of
property interests at strongly reduced costs. Rose predicted that
``when there are changes in the technological or administrative costs
of establishing, monitoring and trading property, there may well be
changes in property regimes as well.'' \8\ Her advice: look for drops
in those costs. There we will find the future of property. And this is
precisely what cryptocurrency tokens represent.
---------------------------------------------------------------------------
\7\ Carol M. Rose, The Several Futures of Property: Of Cyberspace
and Folk Tales, Emission Trades and Ecosystems, 83 Minn. L. Rev. 133
(1998).
\8\ Id. at 139.
---------------------------------------------------------------------------
These cost drops can fuel further innovation. Just as
communications technologies proliferated when the cost of communication
went nearly to zero, so a range of property interests will flourish
when the costs of transfer go nearly to zero. This is, after all, the
model of the broader Internet, which, for all of its ``free'' price
points, is extraordinarily expensive to maintain.\9\ Internet
technologies scale most disruptively at near-zero transaction
costs.\10\ For each drop in transaction costs, a new range of widely
scaled and potentially disruptive uses becomes possible.
---------------------------------------------------------------------------
\9\ See Joshua A.T. Fairfield, BitProperty, supra, at 815.
\10\ See Kevin Werbach, The Centripetal Network: How the Internet
Holds Itself together, and the Forces Tearing It Apart, 42 U.C. Davis
L. Rev. 343, 347-48 (2008) (``The Internet fosters innovation by
eliminating transaction costs, enabling new services to emerge.'').
---------------------------------------------------------------------------
So far, property institutions have not yet fully realized the
benefits of the last 3 decades' advances in information technology
because of the cost needed to record transactions and vet trusted
intermediaries to maintain and protect records.\11\ Token systems can
and will reshape property law if they push price points low enough to
unleash disruptive and scalable applications.
---------------------------------------------------------------------------
\11\ See Joshua A.T. Fairfield, BitProperty, supra, at 813.
---------------------------------------------------------------------------
C. A Path to Successful Oversight
In this section, I turn to the second question, and discuss
features of a successful oversight strategy. I derive these principles
from experience with several prior analogous regulatory moments: the
IRS determination as to when to tax financial gains on virtual objects;
the IRS determination as to whether cryptocurrency ought to be taxed as
currency or commodity; and the deliberations by FinCEN, CSBC, and other
stakeholders in the state and Federal banking systems over whether
cryptocurrency exchanges ought to be deemed money transmitters under
the Bank Secrecy Act.
Responsible regulation must rest on a frank and common-sense
determination of how people are using the technology. A primary benefit
of close attention to how the technology is actually being used will be
to reduce the number of overlapping oversight claims. Almost every
regulator will soon be able to claim jurisdiction over some application
of blockchain technology, but of course they will not have jurisdiction
over all uses.
Working out jurisdiction over actions or business models that cross
several different regulatory boundaries will be time-consuming, but no
harder for blockchains than they were for network communications
technology generally. SEC, CFTC, FinCEN, IRS, and state banking
regulators have spent several years sorting out their various roles in
regulating the various uses of cryptocurrency, and there has been
measurable progress in determining which regimes and what terms govern.
Tokens do present some interesting problems. First, tokens may be
used in different ways by different members of a community. Second,
even a single owner may buy, hold, consume, sell, trade, or destroy
tokens for different reasons at different times. A community may shift
to use products or services in illicit ways that the product creator or
service provider did not predict. Illicit uses may make use of a licit
support layer. This is precisely what happened when the SEC warned in
July of 2017 that The DAO, an Ethereum-based investment and governance
platform had likely violated securities regulations.\12\ Contrast this
with SEC Division of Corporation Finance Director William Hinman's
recent announcement that transactions in Ether are unlikely to be
deemed securities transactions.\13\ Agencies are already beginning to
sketch out the important distinctions that will help preserve
beneficial applications of the technology (investors in Ether were
justifiably relieved by the announcement) while permitting oversight of
bad practices at the application layer (such as another DAO).
---------------------------------------------------------------------------
\12\ See generally SEC, 81207, Report of Investigation Pursuant to
Section 21(a) of the Securities Exchange Act of 1934: The DAO (2017).
\13\ See Trevor M. Dodge, SEC Director William Hinman: ``Current
offers and sales of Ether are not securities transactions,'' The
National Law Review, June 18, 2018, at 1.
---------------------------------------------------------------------------
The currently hot characterization debate is whether token sales
ought to be deemed regulable under the Howey test.\14\ I find that
discussion unhelpful. Howey marks in a sense one of the deepest reaches
of the SEC into regular ownership behavior. The case is a placeholder,
there to preserve SEC's right to make further and more in-depth
determinations. As such, it is not a particularly good guide to how
things should end up. Instead of the rule of Howey, a better approach
is to look at how the technology is actually being used. If a community
uses cryptocurrency tokens functionally like securities, then they
ought to be regulated as such. But if not, they shouldn't. There should
be a well-regulated market for blockchain-traded securities. Companies
are working now to legally list and trade securities through blockchain
databases, and Delaware has been working to make that possible. There
is a legal path for companies wishing to list and trade securities on a
blockchain, and some companies are moving to do so. This is the duck
test as applied to securities: ``if it quacks like a security,'' and
everyone knows the rest.
---------------------------------------------------------------------------
\14\ SEC v. Howey Co., 328 U.S. 293 (1946).
---------------------------------------------------------------------------
The harder question is how to characterize token sales when the
issuer and majority of purchasers can credibly show that their purpose
in buying, holding, selling, and consuming cryptocurrency tokens is not
to profit from the efforts of others, but in fact to order rights and
relationships in some new way. For example, most community members
might use a given token system for clearly non-securities related
purposes, but some tokens may be bought, held, and traded by
speculators. Further, different actors within the community may take on
different positions at different times, and the community as a whole
may shift its use of the token. In these cases, the trick is to catch
the fraudulent ducks without killing a goose who may lay the golden
egg--new and powerful communities and business models. Only a deeper
dive into how the asset is promoted, used, and traded can begin to
provide an answer.
Entities charged with oversight should be cautious not to squash
new arrangements of rights merely because there is an arguable
conceptual overlap with the broad language of cases such as Howey.
However, they must not fail to recognize systems that walk, quack, and
waddle like ducks merely because of some shiny new cryptocurrency
feathers. Many token sales transparently attempt to bilk the public by
selling and supporting junk tokens.\15\ Some token sales are a
transparent attempt to raise money for business ventures that wish to
circumvent securities regulation. But just as clearly, many companies
and communities are building communities that have nothing to do with
securities, although some users may speculate with the tokens. Part of
this is unavoidable. Entities tasked with oversight are reasonably
reluctant to overcommit to the legality of some cryptocurrency business
models, because they are concerned with lending a false sense of
credibility to business practices that may turn out in the end to be
fraud. But reasonable common-sense guidance is necessary so that
innovators can move plans for businesses from the kitchen table to the
garage.
---------------------------------------------------------------------------
\15\ See, e.g., Nathaniel Popper, In the World of Cryptocurrency,
Even Good Projects Can Go Bad, New York Times (May 30, 2018), available
at https://www.nytimes.com/2018/05/31/technology/envion-initial-coin-
offering.html (last visited on July 13, 2018).
---------------------------------------------------------------------------
During this shakedown period in token technology, regulators will
best be able to decide jurisdictional questions, and citizens will best
be able to predict how the law will respond to their attempt to create
new business models and new communities, by reasoning from past
business practices. This new technology permits us to do new things
technologically, not legally. This is not a permanent state of affairs,
however. The demand for cryptocurrency tokens also demonstrates that
there is serious untapped demand for new and cheaper ways to manage and
trade certain kinds of rights, and that people want to be able to
directly invest by making cryptocurrency purchase decisions--whether
this is wise or not. In the end, regulators may determine that certain
kinds of transactions simply cost us all too much in terms of defrauded
investors, broken promises, emptied bank accounts, and subsequent
claims that regulators should have better insulated consumers from
harm. But they should not do so lightly, and should take every
precaution to avoid stepping on legitimate novel forms of organizing
human productivity while they make a determination of how people are
using this technology, and what to do about it.
Conclusion
Blockchain technology has enabled new communities and new business
forms. It has also provided the technological basis for a badly needed
expansion of personal property rights online. An agency exercising
oversight must therefore be sure that the use it observes fits in its
regulatory wheelhouse--many new uses will not. In determining what law
applies to blockchain technology, the legal regulatory regime must rest
on an informed and common-sense determination of how the technology is
being used. That simple test has some advanced wrinkles, because
cryptocurrency tokens are built for overlapping, shifting, and multiple
uses. As a result, regulatory agencies have done best with
cryptocurrency technologies when they use a common-sense functional
analysis, followed by engagement with the industry or community.
In considering regulatory jurisdiction, common-sense sorting into
rough buckets will do more good in the near term, as applications begin
to come online, and regulators see which applications are likely to
impact society the most. In the current characterization debate, a
token should be deemed a security when it operates like a security, a
commodity when it operates as a commodity, a currency when it operates
as a currency, and a simple property interest when it operates as a
simple property interest.
The Chairman. Thank you, Mr. Fairfield.
Ms. Baldet, 5 minutes.
STATEMENT OF AMBER BALDET, CO-FOUNDER AND CHIEF EXECUTIVE
OFFICER, CLOVYR, NEW YORK, NY
Ms. Baldet. Chairman Conaway, Ranking Member Peterson, and
Members of the Committee, thank you for the opportunity to be
here this morning. I am Amber Baldet, Co-Founder and CEO of
Clovyr, a company building tools that make it easier to build
decentralized applications on top of both publicly accessible
blockchain networks, and access-controlled distributed ledgers.
Previously, I led the blockchain program at JPMorgan,
though I would like to note that my comments today do not
represent my former employer. I also currently sit on the Board
of the Zcash Foundation, a nonprofit organization seeking to
advance the state of the art for privacy technology as applied
to Internet infrastructure and privacy preserving
cryptocurrencies.
These are a variety of disparate hats, all of which lead me
to the same message. My commentary today concerns the
importance of a cautious and thoughtful regulatory approach to
innovative technologies, even--and especially--those that might
disrupt business as usual or add to the complexity of
regulating the Internet, as both critical infrastructure and a
shared public good.
We must determine how to balance the enormous potential
value of this technology with the need for consumer protections
and national security, and how to achieve this while respecting
human and constitutionally protected rights.
So far, money seems to be the killer app for blockchain.
Much as the early Internet's killer app, e-mail, continues to
be a cornerstone for how we communicate online, peer-to-peer
payments will likely grow into and persist as a ubiquitous part
of our personal and professional daily lives. In fact, the
ability to spend, trade, rent, or license other sorts of unique
digital bearer assets could be applicable to many things we
own, mortgages, securities, collectibles, intellectual property
rights, personal data, et cetera.
Imagining this mature, interconnected global ecosystem of
such markets feels like standing in the 1990s and imagining
Netflix streaming on your phone; and yet, my concern is not the
speed with which we reach that end stage, it is the choices
that we make along the way, which stand to be as hotly
contested and impactful as net neutrality, the DMCA, FOSTA/
SESTA, or the on again, off again discussion of state-mandated
weak cryptography continues to be.
While we struggle to overlay existing regulatory frameworks
onto new technology that is useful precisely for its fluidity,
other areas of the world are embracing that ambiguity and
learning by doing. In Afghanistan, for example, Code to Inspire
helps train young women for technical careers and pays them in
Bitcoin, which they can use in local shops as well as global
marketplaces. In a place where women's banking and even
physical agency is limited, financial autonomy and digital
inclusion is a powerful force for equality and democracy.
In some African countries and places with less legacy
financial infrastructure, companies are using crypto-assets to
enable farmers to properly track and register their
commodities, and increase their bargaining power in downstream
market pricing. Not only can end consumers tip their farmer in
support of fair and sustainable working conditions, but every
other factory or wholesale retailer along the way can make more
informed decisions about the providence of inputs to their
products.
In the United States, Square, whose business strategy is
already based on disrupting traditional payments processors,
has added the ability to buy, sell, and transfer Bitcoin into
its mobile app, and there are many products targeting
cryptocurrency investors and early adopters.
There are also several more experimental projects that are
interesting. For example, using economic incentives to battle
fake news, cryptocurrency micropayments as an alternative
business model to data-hungry online advertising, and fluid
marketplaces for unused disk space on your home computer as a
disruptive force to centralized Cloud storage. These projects,
all launched as initial coin offerings, ICOs, either on a new
single purpose blockchain network or as a token on top of an
existing network, like Ethereum, are often compared to the
Internet startup boom of the 1990s.
The ability to ``code oneself out of business'' is a novel
property of these decentralized blockchain applications, but
most experiments today invoke a variety of human-controlled
workflow checkpoints and escape hatches to allow intervention
if necessary.
Along with understanding who controls access to the network
and who can modify the rules of the system, identifying who
controls these escape hatches might be helpful in sorting
tokens into various asset classes once a sensible taxonomy has
been established.
As a counterpoint, blockchain is not the answer to every
problem. For example, I recommend extreme caution with
exploration of blockchain-based e-voting. Ensuring one person
one vote while keeping ballot selections private is an
incredibly complex computer science and human coordination
problem that we are not ready to tackle yet. Internationally,
it is no surprise that some of the central banks most
aggressively investigating cryptocurrency as an alternative or
enhancement to their existing currencies are in Venezuela,
Russia, and China.
Going forward, as there is inevitably more discussion of
the potential for a digital dollar, I encourage strongly
encrypted, privacy-preserving design choices coupled with opt-
in selective disclosure, as opposed to options like mandatory
cryptographic back doors or golden keys, which could make the
U.S. financial system a very attractive target for nation-state
sponsored cyberattacks and hackers. As that conversation
matures, we must clarify how FinCEN, OFAC, and other relevant
rules can be applied, modified, or interpreted to balance many
competing interests.
In conclusion, even--and hopefully if--this Committee's
guidance is simply a strong commitment to non-interventionism,
safe harbors for innovators, and work towards resolution of the
patchwork fabric of state laws, the time it takes to come to
such a commitment may have the unfortunate effect of eroding
America's early mover advantage in technical innovation and
entrepreneurism.
Thank you.
[The prepared statement of Ms. Baldet follows:]
Prepared Statement of Amber Baldet, Co-Founder and Chief Executive
Officer, Clovyr, New York, NY
Chairman Conaway, Ranking Member Peterson, and Members of the
Committee, thank you for the opportunity to be here this morning. I'm
Amber Baldet, co-founder and CEO of Clovyr, a company building tools
that make it easier to build decentralized applications on top of both
publicly accessible blockchain networks and access-controlled
distributed ledgers.
From 2015 to April of this year, I led the blockchain program for
JPMorgan's Corporate & Investment Bank, though I'd like to note that my
comments today do not represent my former employer. I also currently
sit on the Board of the Zcash Foundation, a nonprofit organization
seeking to advance the state of the art for privacy technology as
applied to Internet infrastructure and privacy-preserving
cryptocurrencies.
Technical tooling, corporate and financial industry transformation,
digital privacy and public cryptocurrency advocacy: these various hats
might sound incongruous, but I see them as interconnected pieces of a
larger puzzle. The puzzle we are trying to solve is the design for the
next-generation fabric of both macro and micro-economies.
E-mail allows you to send a digital version of a birthday card to a
grandchild instantly. Cryptocurrency like Bitcoin gives you the ability
to put the digital equivalent of $10 inside that card. No need to
attach a code for a gift card redeemable at a single retailer or buy a
clunky prepaid cash card from a credit card company. Whereas you might
attach the same family photo to three different birthday cards, you
can't send the same $10 more than once. The revolutionary proposition
of cryptocurrency--or more broadly, crypto-assets--is the ability to
send something you own across the Internet and then irrefutably not
have it anymore, without relying on a third party to intermediate or
otherwise witness the event. So far, money seems to be the killer app
for blockchain, but you can imagine that the ability to spend, trade,
rent, or license unique digital bearer assets could be applicable to
many things we own: mortgages, securities, collectibles, intellectual
property rights, unused disk space on your home computer, personal
data, etc.
Imagining a mature, interconnected global ecosystem of such markets
feels like standing in the 90s, looking at a pre-World Wide Web
electronic bulletin board system and trying to imagine Netflix
streaming on your phone. The prospect seems so fanciful as to be
impossible, but here we are. And yet, my concern is not getting to that
end state, it's the choices that we make along the way. As evidenced by
the debate around, and impact of, legislation like the DMCA (Digital
Millennium Copyright Act), Net Neutrality, FOSTA/SESTA (Fight Online
Sex Trafficking Act/Stop Enabling Sex Traffickers Act), or sporadic
discussion of state-mandated weak cryptography since the 1990s (e.g.,
Compliance with Court Orders Act of 2016), the government greatly
impacts how we are all able to use Internet and communications
utilities which are inexorably woven into the vast majority of
Americans' daily lives.
The peer-to-peer protocols which underpin crypto-asset networks are
not much different than those that underpin the Internet; they are just
rules for how to route bits and bytes. They do not care about the
legality or morality of what crosses the wire and can be used in
service of business as usual, political action, commission of crimes,
facilitating human rights, or sharing funny photos of cats.
Everything old is new again, and we are at the precipice of the
same choices for crypto-asset networks as for the Internet. The
difference, of course, is that we did not previously need to decide if
every email was possibly a security with taxable profit and loss. The
discussion today concerns the financial classification of the assets
that cross the wires, which is important, but cannot be completely
decoupled from the treatment of the Internet any more than litigation
about a car crash can be divorced from observations about the condition
of the road, timing of traffic lights, speed limit signage, and driver
compliance with traffic laws.
It's not just about our banking sector, not just corporate supply
chains, not just consumer payment rails, but how all these things might
be connected both here and abroad to reduce friction and open new
possibilities for economic growth. It is recognition that we are
building next-generation systemically important infrastructure for the
American economy. It's also about learning how to balance the enormous
potential business value of this technology with the need for consumer
protections and national security, and how to achieve this while
respecting human and Constitutionally-protected rights.
There are many stakeholders in this emerging universe who sometimes
have fundamentally divergent philosophies. Yet, they are in near
unanimous agreement that when it comes to cryptographically unique
digital bearer assets, the genie is out of the bottle. As science
fiction author William Gibson said, ``The future is already here, it's
just not very evenly distributed.'' While we struggle to overlay
existing regulatory frameworks onto new technology that is useful
precisely for its fluidity--sometimes it may act like a medium of
exchange, sometimes a store of value, a commodity, a security, etc.--
while we wrestle with that flexibility, other areas of the world are
embracing the ambiguity and learning by doing.
In Afghanistan, for example, Code to Inspire helps train young
women for technical careers and pays them in Bitcoin, which they can
use in local shops as well as global marketplaces. In a place where
women's banking and even physical agency is limited, financial autonomy
and digital inclusion is a powerful force for equality and Democracy.
Another example is that in places with less legacy financial
infrastructure, companies are using crypto-assets to enable farmers to
properly track and register their commodities, enhance supply chain
transparency and increase their bargaining power in downstream
commodities market pricing. Not only can end consumers ``tip their
farmer'' in support of fair and sustainable working conditions, but
every other factory or wholesale retailer along the way can make more
informed decisions about the provenance of inputs to their products.
The sticking point in such registries might be the perfection of
these crypto-assets, in that while we can represent a real-world good
on a blockchain, processing of claims in the case of a default requires
enforcement practices external to the network. Relatedly, while
tokenized physical assets have been proposed as a response to
government corruption (for example, forced re-allocation of land rights
during a change in leadership), credible threat or use of physical
violence still holds more sway over allocation of resources than any
ledger ever will. Ironically, then, these sorts of token registries
might work best in places that want to leapfrog a generation of banking
technology, but already have well-functioning rule of law.
In the United States, several more experimental projects are also
interesting, whether it's using economic incentives to battle fake
news, cryptocurrency micropayments as an alternative business model to
data-hungry online advertising, or fluid marketplaces for unused disk
space on home computers as a disruptive force to centralized cloud
storage. These projects, all launched as initial coin offerings (ICOs)
either on a new single-purpose blockchain network or as a token on top
of an existing network like Ethereum, are often compared to the
Internet startup boom of the 1990s. Because these are ``blockchain
native'' assets rather than tokenized representations of real-world
assets, it may be possible to more closely approximate today's dispute
resolution frameworks entirely as programmatic rules within ``smart
contracts,'' but only if explicitly coded to do so, and only assuming
there are no bugs in the code which cause unintended and possibly
irreversible outcomes.
The ability to ``code oneself out of business'' is a novel property
of decentralized blockchains, but most experiments today invoke a
variety of human-controlled workflow checkpoints or escape hatches to
allow intervention if necessary. Along with understanding who controls
access to the network and who can modify the rules of the system,
identifying these escape hatches and who controls them might be helpful
in sorting tokens into various asset classes once a sensible taxonomy
has been established.
Of the myriad applications currently under development, it's hard
to tell what's going to take off and what will be most transformative.
Nonetheless, the sheer number of people globally working on these
projects make it likely that it's only a matter of time until they are
no longer considered experimental. The question is how long it will
take for distributed ledgers of various incarnations to be considered a
legal system of record in enough places that interacting with them is
the norm rather than a novelty. Clarity around legal and regulatory
treatment in various jurisdictions is, perhaps, the most important
factor in the speed of that evolution.
As a counterpoint, and to temper what might sound like unbridled
enthusiasm, I recommend extreme caution on engaging with blockchain
based e-voting for real-world ballot measures. Ensuring one-person-one-
vote while keeping ballot selections private, is both a non-trivial
computer science and human coordination problem we're not ready to
tackle yet. It is one thing to experiment with making decisions about a
blockchain network's governance processes using the network itself, it
is quite another to talk about electronic voting processes for
something like U.S. elections, where even traditional electronic voting
machines are continually demonstrated to be vulnerable to being hacked.
But when it comes to more promising near-term use cases, the oft-
referenced regulatory position of Do No Harm is a helpful signal but is
perhaps not strong enough. Recently, new entrants Coinbase and Gemini
launched cryptocurrency custody solutions for retail and institutional
investors, and this week Coinbase made further strides in SEC approval
to list on its exchange tokens which are considered securities. As more
traditional assets become tokenized, they may be able to challenge
incumbents not because the incumbents are too outdated to understand
the technology or unable to develop new products and services quickly
enough, but because they are held back from competing due to regulatory
uncertainty.
Similarly, as the Federal Reserve and commercial banks take a wait-
and-see approach to exploring tokenized representations of the U.S.
Dollar, we risk missing the larger picture of what a next-generation
Internet of Value means for geopolitics and the future of nation-state
economic competition and power projection. It's no surprise that some
of the central banks most aggressively investigating cryptocurrency as
an alternative or enhancement to their existing currencies are in
Venezuela, Russia, and China. As we begin to explore domestic strategy
in this area, it will be important to clarify how existing FinCEN,
OFAC, and other relevant rules can be applied, modified, or interpreted
to not stifle innovation.
Interestingly, the anonymous, censorship resistant features of open
blockchain currencies may not prove to be a threat to U.S. financial
system at all, but rather turn out to be foundational to creation of a
digital U.S. Dollar equivalent that is as well regarded around the
world as the physical dollar is today. Going forward, I encourage more
discussion of strongly encrypted, privacy-preserving digital currencies
coupled with opt-in selective disclosure, as opposed to more naive
options like so-called cryptographic backdoors or ``golden keys,''
which are attractive targets for nation-state sponsored cyberattacks
and hackers.
In conclusion, even--and hopefully if--this Committee's guidance is
simply a strong commitment to non-interventionism, safe harbors for
innovators, and work toward resolution of the patchwork fabric of state
laws, the time it takes to come to such a commitment may have the
unfortunate effect of eroding America's early mover advantage in
technical innovation and entrepreneurism. We take for granted that much
of the Internet as we know it was developed here at home, and the
immense benefits accrued to us because of it. I appreciate your ongoing
work to come to consensus on a way to repeat the successes of the early
Internet era while learning from the things we could have done better.
Thank you for your time.
The Chairman. Thank you, Ms. Baldet.
Mr. Kupor?
STATEMENT OF SCOTT KUPOR, J.D., MANAGING PARTNER, ANDREESSEN
HOROWITZ, MENLO PARK, CA
Mr. Kupor. Thank you, Chairman Conaway and Ranking Member
Peterson for the opportunity to be here today to talk about
this very important new technology. My name is Scott Kupor. I
am the managing partner for a firm called AH Capital
Management, which manages about $7 billion worth of venture
capital assets, and very recently also for a group called CNK
Capital Management, which is a $300 million registered
investment advisor fund focused exclusively on investing in
crypto-related assets.
I would like to spend my time today to focus on why we
believe as investors that crypto-technologies make a very
compelling investment opportunity, particularly for members of
the venture capital community, and I want to start with a
definition that is different from the definition that we often
hear about. If you focus on a lot of the public narrative today
about crypto-technologies, there are two kind of dominating
narratives. One is certainly around Bitcoin and price
fluctuations and volatilities, which we heard certainly from
the Ranking Member today as well, as well as what are called
initial coin offerings, ICOs, for capital fundraising.
As investors, though, we are interested in the broader
ecosystem and we use the term crypto-networks to describe what
we think about as that ecosystem. Very specifically, crypto-
networks for us means a new way to build digital services, and
by digital services, we mean any Internet application that
obviously may exist today, so ridesharing applications, social
media applications, and probably a whole host of things, of
course, that we haven't even thought about, but where those
digital services are owned and operated by a community of
network participants rather than by a centralized corporation.
Now, I realize at first blush that when you think about
community ownership and management of an asset, that may seem
odd, but in fact, if you look at the technology industry, there
is actually significant precedent for the existence and success
of community-based networks in the development of a significant
portion of technology.
First is what is known as the open source software
movement. This started back in 1983 actually at MIT by a
professor named Richard Stallman, and at the time, it was a
very, very radical notion. The idea was that a community of
developers would publish and then freely offer their software
to others who could modify that software, who could incorporate
it into various other projects. It was really, in many
respects, a very liberal movement around opening up and
reducing copyright initiatives in software.
If you fast forward to today, though, open source is the
predominant method of software development and software
utilization today in the world. For any data center you go to,
which is obviously where major corporations run their Internet
applications, Linux, which is a major operating system, is by
far the dominant operating system in play, and for all of you,
like myself, who walk around with your cell phones all day
long, the vast majority of components in your cell phones are
what are called android and essentially open source software.
The history of open source software is relevant for how we
think about the potential for what Bitcoin and crypto-networks
can be.
The second important historical analogy is around what we
call open protocols, which really form the foundation of the
modern Internet that we all use today. An example of this is
something called SMTP, which is the protocol that we all use
for e-mail transmission. It is an open protocol. It was
governed, in many cases, by open communities, by networks, by
academics, and in many cases, with government funding, and many
people built applications on top of these open networks
precisely because they knew that the nature of that protocol
would not change. They could rely on the steadiness and the
consistency of that protocol on which to build applications.
If we look at technology, the open protocols that are well-
developed and well-maintained can become the building blocks on
which massive customer utility and economic growth can be
built. It is also the case, however, as you look at the start
up world that many start up companies have failed by relying on
what we call platform risk, which is building on other
platforms that are governed by centralized corporations and
then finding that the rules of the road change over time, and
that really does significantly handicap their efforts.
As a result of this, what we now see in our business is
many developers are hesitant to take on this platform risk and
are instead looking at things like crypto-networks as a new and
innovative way for developers to create new digital services
without the attendant risk that comes from depending upon
centralized platforms. In many ways, crypto-networks borrow it
from the nearly 50 years of history in the technology industry,
which shows that communities of developers can share their work
openly and properly govern a network without centralized
authority.
But crypto-networks also introduce a very powerful economic
incentive that didn't exist in these prior generations. The
presence of what we call a token, which creates a direct
financial incentive for members of the communities to, in fact,
develop and govern the network appropriately. The token really,
in a sense, is the glue that binds the various players in the
ecosystem and provides the appropriate economic incentives for
all market participants.
Understandably so, this creates a whole new set of
challenges for regulators. Consistent with recent statements
that we have heard from the director of corporate finance at
the SEC, we believe that the regulatory nature of crypto-
networks varies with the stage of development of a particular
project. Briefly, when a centralized sponsor is seeking to
raise capital from investors prior to the functional
development of the network, this is probably what is known as
an investment contract and therefore properly regulated as a
security. However, the nature of the tokens that are delivered
on that contract can ultimately be regulated as commodities
once the fulfillment of that investment contract has occurred.
As stated by the CFTC, some tokens are not securities. Once
the network is functional, and in particular cases where the
network is decentralized from an ownership perspective, we
believe the nature of the tokens looks more like commodities
than securities, and therefore probably rightly should be
governed by the CFTC. This is precisely because there is no
centralized sponsor on which the efforts of the value of the
token are largely dependent. Instead, the tokens have value
based upon the utility of the service to participants. This
actually looks much more like the way commodities trade.
In conclusion, the U.S. has long enjoyed the fruits of
innovation in the form of economic growth, job growth, and
consumer utilities stemming from many of the great technology
companies of our time, and we believe that crypto-networks
present a new and exciting opportunity for us to continue on
that trajectory. Doing so, however, will require that we
develop a regulatory framework that encourages risk taking and
capital formation, provides clarity and certainty to market
participants, and of course protects individual investors and
the integrity of the markets.
Thank you for the opportunity to be here today.
[The prepared statement of Mr. Kupor follows:]
Prepared Statement of Scott Kupor, J.D., Managing Partner, Andreessen
Horowitz, Menlo Park, CA
Chairman Conaway and Ranking Member Peterson, thank you very much
for the opportunity to speak with the Committee regarding crypto-
technology and its implications for American technology innovation. I
applaud this Committee for your efforts to take a closer look at what
we believe is a foundational area of technology development, one that
is critical to the health of our capital markets, entrepreneurship and
the American economy.
By way of background, I am the Managing Partner for AH Capital
Management, which manages approximately $7 billion in venture capital
funds focused principally on early-stage IT-related investments. We
have been operating this business for just over 9 years and some of the
companies in which we have invested and with which you may be familiar
include Facebook, Lyft, AirBnB, Instacart, Pinterest and Github. I am
also the Managing Partner for CNK Capital Management, a registered
investment adviser that manages a $300 million venture capital fund
dedicated solely to investing in crypto-related technologies.
Background on Crypto-networks
I'd like to focus my time here today on what we believe is the
foundational importance of crypto-related technologies and why we
believe they make a compelling investment opportunity for the venture
capital community.
In doing so, I think it's important to define the space precisely.
The public narrative around crypto-related technologies tends to
focus primarily on two areas: (i) Bitcoin itself as a potential store
of value and the high levels of volatility inherent in the price of
Bitcoin and (ii) the proliferation of initial coin offerings (ICOs) to
unaccredited, retail investors, many of which have been rightly
criticized by the SEC as inconsistent with U.S. securities laws. While
these are no doubt currently significant aspects of the industry, the
almost exclusive public focus on these areas obscures the exciting
technological innovation that drives our interest in crypto-networks.
Specifically, we define the term ``crypto-networks'' as:
a new way to build ``digital services,''
where those services are ``owned and operated'' by a
``community of network participants,'' rather than by a
centralized corporation, and
where the repository of activity on the network (i.e., the
database) is decentralized and maintained by the community.
What are ``digital services''? They are simply Internet-based
applications, such as many of the ones we enjoy today--ride sharing,
messaging, grocery delivery, enterprise applications, to name a few. We
believe that developers will create a whole new set of digital services
utilizing the principles of crypto-networks, many of which are likely
beyond our imagination today but will also yield enormous consumer
utility.
And what are those principles of crypto-networks? That they are
both owned and managed by the community that develops, maintains and
utilizes the networks. This is distinct from the large digital services
that we utilize today, where the ownership and management of those
services are governed by a centralized corporation.
At first blush, this may sound crazy--that there may be value in
community ownership and management of an asset that exceeds that of
centralized corporate control? But, in fact, there is well-established
precedent for this in the history of the technology industry.
First, is the open source software movement. This started in 1983
as a movement to create free software, led by an MIT researcher named
Richard Stallman. Understandably, this was a radical concept at the
time--that a community of developers would publish their software
freely for others to modify and incorporate into various other open
projects. But over time, this work morphed into the mainstream
development of open source software, which today is the predominant
method by which software is developed. Examples of open source software
that have experienced widespread adoption include Linux, an operating
system that governs most data center servers today and is a major
component in virtually all smartphones and tablets, and Git, an open
source software development system used by millions of software
engineers globally.
Second, is the development of the very Internet protocols that have
given rise to the tremendous job and economic growth and consumer
utility that we all currently enjoy from existing digital services.
These protocols--which include, for example, SMTP (the protocol for
email transmission), HTTP (the protocol to exchange structured text on
the Internet) and TCP/IP (the protocol for end-to-end data
communication)--derived largely from academic or government-funded
efforts and have been maintained in most cases by communities of
academics and developers. They are ``open'' protocols in the sense that
they are the well-established foundations on which many very exciting
for-profit businesses have been built (e.g., Facebook, Amazon, Google),
knowing that the protocols themselves cannot be changed by a
centralized corporation.
Why should we care about this?
Because as the history of the Internet has shown us, open protocols
that are well-built and well-maintained can become the building blocks
on which massive consumer utility and economic growth can be built.
And why is that? Because for-profit enterprises are willing to take
on all of the market risks of building a new company--and venture
capitalists are willing to provide the funding for such endeavors--when
they know that the foundations on which they are taking that risk
cannot be changed at the whim of a centralized corporation.
In contrast, the technology world is also riddled with startup
companies that have failed as a result of having taken on platform risk
that depends on the rules of the road as defined by centralized, for-
profit platforms (in contrast to open protocols). That's not because
centralized, for-profit platforms are inherently bad, but rather
because over time their economic incentives require that to remain
viable as independent businesses they capture more of the gains
associated with their proprietary platforms, often causing them to
change the nature of the relationships they once encouraged with other
companies who were in fact building on and improving their platform.
What does any of this have to do with crypto-networks?
As we noted previously, crypto-networks enable a new way for
innovative developers to create new digital services without the
attendant risk of building on centralized platforms. In many ways,
crypto-networks borrow from the nearly fifty years of history in the
technology industry that enabled the initial Internet protocol
development and the open source movement; that is, the idea that
communities of developers can share their work openly and properly
govern a network without centralized authority. As my partner, Chris
Dixon, has written about, crypto-networks essentially replace the
requirement to rely on trust from a centralized corporation with the
requirement only that you trust the software itself to do what it has
been built to do (and for which the fundamental code is open sourced
for you to confirm on your own).
But, at the same time, crypto-networks introduce a very powerful
economic incentive that did not previously exist in the development of
prior technologies--the presence of a token that creates a direct
financial incentive for the community members to in fact develop and
govern the networks appropriately. ``Tokens'' in the crypto-networks
world perform a series of functions: (i) they are the method of value
exchange between network participants--that is, consumers ``pay'' for
services using the token and sellers ``receive'' tokens in exchange for
the services and (ii) they provide the financial incentive to reward
developers and other maintainers of the network--that is, people may
receive tokens for ensuring the authenticity of the transactions
completed on the network.
The Importance of Regulation in Crypto-networks
Thus, the token plays a very important role in the functioning of
crypto-networks--it is the glue that binds the various players and
provides the appropriate economic incentives for all market
participants. And, recall that because all of the software in these
networks is open sourced, meaning that anyone who wants to create a
competing network can simply take all of the existing software and
stand-up a rival network, the competitive incentives for the market
participants are designed to be fair and responsive to the user
community.
But, the token itself and the decentralized nature of many of these
networks create a new set of challenges for regulators.
I want to first be very clear that we believe appropriate
regulation in crypto-networks is very important and we welcome the
opportunity to work with you, other Members of the House and Senate and
the various agencies who are interested in creating a regulatory
framework that both encourages innovation and protects consumers and
well-functioning capital markets. There is an important role for the
regulatory community to play and we believe that role is one of the
reasons why the U.S. has long been a leader in the commercial
development of so many breakthrough technologies.
In fact, the work that CFTC Chairman Giancarlo has done in setting
up LabCFTC is a great example of how the regulatory community is trying
hard to balance the needs of encouraging technological innovation with
those of protecting consumers. Such collaborative engagement between
regulators and innovators is precisely the type of activity that is
required in such fastmoving markets as are crypto-network-related
activities. Thank you as a Committee for your support and sponsorship
in these initiatives.
Consistent with recent statements from the Director of Corporate
Finance at the SEC, we believe that the regulatory nature of crypto-
networks varies with the stage of development of a particular project.
Briefly, if a centralized sponsor is seeking to raise capital from
investors prior to the functional realization of the network itself,
the contract between the sponsor and investor is likely an ``investment
contract'' and thus properly regulated under the U.S. securities laws
by the SEC. The nature of the to-be-delivered tokens under that
contract, however, may not be securities; they need to be evaluated
using the same Howey test as do all potential securities.
As stated by the CFTC, some tokens are not securities. Once the
network is functional and, in particular in cases where the network is
decentralized, we believe that the nature of the tokens looks more like
commodities than securities. This is because there is no centralized
sponsor on whose efforts the value of the token is largely dependent.
Rather, the tokens will have value that represents the utility of the
service to its participants; the value will not be derived from the
coordinated activities of a centralized sponsor.
Obviously, these are not easy determinations and will require the
efforts of this Committee, among others, and the various regulatory
agencies. But, we believe this framework is consistent with early
pronouncements from both the SEC and the CFTC.
Regardless of the jurisdictional boundaries, we believe that
investor protection, well-functioning capital markets and support for
innovation should be the hallmark of the regulatory focus.
Summary
In summary, I would offer the Committee the following observations:
The U.S. has long been a leader in technology, in large part
due to a favorable regulatory and financial environment that
has fostered risk taking and innovation.
While we have enjoyed the fruits of this innovation in the
form of economic growth, job growth and consumer utility
stemming from many of the great technology companies of our
time, we believe that crypto-networks presents a new and
exciting opportunity for us to continue on that trajectory.
This is why you see venture capitalists and other financial
professionals increasing their investment focus in this area.
Just like other areas of technology development, our job is to
provide risk capital to the areas of innovation that we believe
can support long-term, self-sustaining enterprises. We believe
crypto-networks is one such area.
But, to ensure that the U.S. continues to be the favored
haven for such technological innovation, we need to develop a
regulatory framework that encourages risk-taking and capital
formation, provides clarity and certainty to market
participants and protects individual investors and the
integrity of the markets.
I thank you for your time and look forward to the opportunity to
work with the Committee on this important topic.
The Chairman. Thank you, Mr. Kupor.
Mr. Gorfine, 5 minutes.
STATEMENT OF DANIEL GORFINE, J.D., DIRECTOR AND CHIEF
INNOVATION OFFICER, LabCFTC, COMMODITY FUTURES TRADING
COMMISSION, WASHINGTON, D.C.
Mr. Gorfine. Thank you, Chairman Conaway, Ranking Member
Peterson, and Members of the Committee for the opportunity to
testify before you today. I am Chief Innovation Officer and
Director of LabCFTC at the U.S. Commodity Futures Trading
Commission. The testimony presented here reflects my own views
and does not necessarily reflect the opinions or the view of
the Chairman or the Commission.
In May of last year, Chairman Giancarlo announced with
bipartisan Commission support the launch of LabCFTC, the
agency's effort to help create a model for regulatory
engagement and modernization in light of the ongoing
digitization of our markets. Its mission is to facilitate
market enhancing innovation, inform policy, and ensure that we
have the technological and regulatory tools and understanding
to keep pace with inevitable change. The building blocks of our
effort are engagement, testing and experimentation, and
education.
Shifting to the primary topic of today's hearing, we are
interested in both private or permission-distributed ledger
technologies that can improve market infrastructure and in
public blockchains that require the use of a virtual currency.
Developments across this spectrum have society rethinking the
nature of money, how people transact, and how we can more
efficiently engage in regulatory, economic, and market
activity.
With respect to public blockchains, proponents note that
they unlock digital scarcity, enable efficient transfer of
ownership, and power the execution of applications, and all of
this can be done without the need for a trusted central
intermediary that was traditionally needed to verify that each
party has and does what it promises. Many, however,
appropriately worry that virtual currencies and tokens may be
used for illegal activities and are prone to fraud, manias, and
bubbles driven by potential misunderstandings and myths
regarding their scalability, utility, and intrinsic value.
With recent hype around this space, there has also been a
proliferation of ICOs, which may be intended to raise capital
for a venture and may bear the hallmarks of a securities
offering. Our colleagues at the SEC have been thoughtfully
addressing related challenges, and providing additional clarity
to the marketplace. And from the CFTC's perspective, given the
potential to tokenize a broad range of economic assets, it is
important to remind the public that digital assets can also be
commodities or derivatives, depending on their terms and how
they are structured.
Given the potential and the challenges of this space,
Chairman Giancarlo has made clear that the proper response by
regulators is not to dismiss the entire movement as misguided
or foolish, but rather, to take the time to learn, facilitate
the promise, and guard against risks and bad actors. As part of
this effort, LabCFTC published its first FinTech primer on the
topic of virtual currencies in October 2017. The primer
explains that the agency determined in 2015 that certain
virtual currencies, such as Bitcoin, are commodities and
therefore implicate our jurisdiction. The CFTC has regulatory
oversight authority over futures and swaps markets based on
commodities, and then has anti-fraud and manipulation
enforcement authority over these and the underlying commodity
markets. It is important to note, however, that we do not have
oversight authority over these underlying markets. Additional
details regarding CFTC oversight of crypto-related markets and
enforcement and education efforts since the self-certification
of Bitcoin futures in December 2017 can be found in my written
testimony.
Moving forward, one thing is certain. None of us are able
to predict exactly where this innovation is heading. It is
accordingly incumbent upon us as a 21st century regulator to
continue studying, learning, and keeping pace with change. We
look forward to ongoing close collaboration with our regulatory
peers, including through the FSOC digital asset working group.
We all have the shared goal to educate market participants,
target bad actors, and ensure an efficient and effective
regulatory framework. We are also focused on bringing clarity
and certainty to the market, but need to be sure that we are
thoughtful in our approach and do not steer or impede the
development of this area of innovation.
While some may seek the immediate establishment of bright
lines, the reality is that hasty regulatory pronouncements are
likely to miss the mark, have unintended consequences, or fail
to capture important nuance regarding the structure of new
products.
In the late 1990s during the early days of the Internet,
senior government policy advisor Ira Magaziner made the
following observation, that given ``the breakneck speed of
change and technology, the government attempts to regulate are
likely to be outmoded by the time they are finally enacted.''
Given this dynamic, the government largely avoided a
prescriptive approach in favor of principles, focused on
educating and empowering law enforcement, and allowed this area
of innovation time and space to develop all while maintaining
the ability and careful vigilance to act to ensure market
integrity. This approach generally seems like the right one
when dealing with new technologies, which are largely agnostic
as to how they are used. The role of the regulator is to
facilitate use of new technologies that can benefit markets and
the public more broadly, while deterring and pursuing those who
seek to use technology to do harm.
Thank you, and I am happy to answer any questions you may
have.
[The prepared statement of Mr. Gorfine follows:]
Prepared Statement of Daniel Gorfine, J.D., Director and Chief
Innovation Officer, LabCFTC, Commodity Futures Trading Commission,
Washington, D.C.
Thank you Chairman Conaway, Ranking Member Peterson, and Members of
the Committee for the opportunity to testify before you today on
FinTech innovation, Blockchain, and new assets in the digital age. I am
Chief Innovation Officer and Director of LabCFTC at the U.S. Commodity
Futures Trading Commission (CFTC). The testimony presented here
reflects my own views and does not necessarily reflect the opinions or
views of the Chairman, Commissioners, or the Commission.
The mission of the CFTC is to foster open, transparent,
competitive, and financially sound markets.\1\ The agency oversees
markets vital to supporting the transfer of risk between market
participants and by extension to the stability and reliability of real-
world economic activity, ranging from the production and provision of
gasoline for our cars, to the availability of credit for our purchases,
and the offering of produce in our grocery stores.\2\
---------------------------------------------------------------------------
\1\ See CFTC Mission Statement, Commodity Futures Trading
Commission http://www.cftc.gov/About/MissionResponsibilities/index.htm
(last visited July 16, 2018).
\2\ Many of my introductory remarks here derive from my prior
publication: See Daniel Gorfine, FinTech Innovation: Building a 21st
Century Regulator, Georgetown University Law Center Institute for
International Economic Law (IIEL), Issue Brief 11/2017 (November 2017),
https://www.law.georgetown.edu/iiel/wp-content/uploads/sites/8/2018/01/
LabCFTC-Chris-Brummer-Dan-Gorfine-IIEL-Issue-Brief-November-2017-
Accessible.pdf; see generally, Bruce Tuckman, Derivatives:
Understanding Their Usefulness and Their Role in the Financial Crisis,
J. of Applied Corp. Fin. Vol. 28, No. 1 (Winter 2016).
---------------------------------------------------------------------------
As one might expect, the agency's work has always included a focus
on agricultural products like wheat and corn, and even precious metals.
It is worth asking how do we now find ourselves here making the jump
from traditional commodities and risk transfer to FinTech topics like
DLT and Bitcoin?
The answer is that our financial markets are fast-evolving due to
technology-driven innovation and this has changed the way market
participants interact, trades are formulated and processed, risk is
assessed and hedged, and business operations are executed. No longer do
market participants rely on face to face interactions and telephones.
Instead, markets have become increasingly electronic, digital, and
interconnected. This new world in turn creates new market and
regulatory opportunities, challenges, and risks.
Much of this dynamic derives from three identifiable threads around
FinTech innovation. The first centers on speed, both in terms of
innovation and subsequent adoption. The speed phenomenon derives from
the profound impact of increased computing power in the development of
products, services, and markets, and the Internet in their adoption.
The concept of Moore's Law \3\--which roughly suggests that computing
power will expand exponentially over time--has allowed for the
development of increasingly powerful, and low cost, computer systems
that enable rapid iteration and development of new business models, as
well as the capability to do more with increasingly available data.
This means that markets and regulators are faced with a constant
barrage of innovations and not much time to grasp their implications
before interconnected computers permit their ready adoption.
---------------------------------------------------------------------------
\3\ See Harald Bauer, et al., Moore's Law: Repeal or Renewal?,
McKinsey & Company (December 2013), http://www.mckinsey.com/insights/
high_tech_telecoms_internet/moores_law_repeal_or_
renewal.
---------------------------------------------------------------------------
The second is that innovation largely seeks to either
disintermediate traditional gatekeepers or change the way they operate.
Current financial regulatory frameworks are centered on the
intermediaries or gatekeepers that manage the access to our markets or
financial services activity. To the extent that innovators are seeking
to disintermediate or substantially transform traditional models in
order to increase efficiencies, regulators will need to proactively
identify how rules and regulations conform or will need to change.
Finally, the increasing complexity of technology-driven business
models requires significantly more focus on technological literacy at
all levels of leadership, including within business and government. It
is simply not enough to all agree to high level platitudes that items
like cybersecurity are of great importance--instead it is imperative
that we have deep understanding of the details of security protection
in order to avoid bad outcomes, including cyber breaches. Indeed, I
would suggest that a key emerging risk in our markets is a potential
lack of required literacy in the face of increasingly technology-driven
business models and processes.
LabCFTC: Building a 21st Century Regulator
Given these market dynamics, and related emerging regulatory
challenges, we believe thoughtful 21st century regulatory approaches
are needed. This is why last summer, CFTC Chairman Chris Giancarlo
announced with bipartisan Commission support the launch of LabCFTC.\4\
---------------------------------------------------------------------------
\4\ Address of J. Christopher Giancarlo to the New York FinTech
Innovation Lab, ``LabCFTC: Engaging Innovators in Digital Financial
Markets,'' (May 17, 2017) Commodity Futures Trading Commission, http://
www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo-23.
---------------------------------------------------------------------------
LabCFTC is the CFTC's effort to help create a replicable model for
regulatory engagement and modernization. The mission of LabCFTC is to
facilitate market-enhancing innovation, inform policy, and ensure we
have the technological and regulatory tools and understanding to keep
pace with changes to our markets. LabCFTC was launched out of our
Office of General Counsel so that it can leverage its deep bench of
expertise to help manage the interface between technological engagement
and innovation, regulatory modernization, and existing rules and
regulations.
The building blocks of the effort are engagement, testing and
experimentation, education, and collaboration. The core LabCFTC team
works closely with subject matter experts from the Agency's operating
divisions, who form the LabCFTC liaison network. Through this approach,
we can gain a better understanding of emerging risks, technologies, and
trends, modernize our regulatory tools and operations, engage with
innovators early in the development of new business models, and support
better informed policymaking that facilitates market-enhancing
innovation.
The effort seeks to involve both internal and external stakeholders
through three primary work streams. First, `Guide Point' provides a
dedicated point of contact for FinTech innovators to engage with the
CFTC, learn about the CFTC's regulatory framework, and obtain feedback.
Such feedback and discourse may provide innovators with valuable
information that can help them save time and resources, or allow for
the identification of potential friction or uncertainty in existing
rules.
Since the beginning of its formation, LabCFTC has met with
approximately 200 organizations and discussed a range of technology-
related issues, including those involving machine learning and
artificial intelligence, DLT and capital markets infrastructure,
virtual currencies, smart contracts, RegTech, cloud, and algorithmic
trading. LabCFTC `office hour' meetings have been held in Silicon
Valley, Chicago, New York, Boston, and Washington, D.C. And in response
to common questions raised through these sessions, LabCFTC published
its first FinTech educational primer in October 2017. The primer,
leveraging a format which will be applied to a range of innovations
going forward, involved discussion of technology use-cases, CFTC
jurisdiction, and potential risks and challenges.
Second, `CFTC 2.0' fosters the testing, understanding, and
potential adoption of new technologies that can improve markets or make
the Commission a more effective and efficient regulator. We are
currently crowdsourcing ideas for future innovation competitions,\5\
which may involve, for example, novel ways to visualize CFTC published
data, develop market surveillance tools, make our rules more readily
machine-readable, or build a more dynamic, digital, and ``smart''
notice-and-comment platform.
---------------------------------------------------------------------------
\5\ CFTC Asks Innovators for Competition Ideas to Advance FinTech
Solutions, (Apr. 24, 2018) Commodity Futures Trading Commission,
https://cftc.gov/PressRoom/PressReleases/7717-18.
---------------------------------------------------------------------------
We further believe that it is through developing proofs of concept
and truly kicking the tires on new innovations that agency staff can
properly understand the application of new technologies, which will
subsequently drive more informed policymaking and technology
strategies. In some instances, existing law may be an obstacle to
participation in this type of testing, research, and proofs of concept.
For this reason, the Chairman appreciates the current efforts of
Members of this Committee to suggest ways to provide the CFTC with the
authority to fully engage with, research, and test emerging
technologies.\6\
---------------------------------------------------------------------------
\6\ See, e.g., Commodity Futures Trading Commission Research and
Development Modernization, H.R. 6121, 115th Cong. (2018), https://
www.congress.gov/bill/115th-congress/house-bill/6121/text?r=1.
---------------------------------------------------------------------------
Finally, `DigitalReg' is designed to support the Commission's
effort to build a 21st century regulator and regulatory approach.
Internally, DigitalReg serves as a CFTC-wide resource to help inform
the Commission and staff on FinTech-related developments. Externally,
DigitalReg acts as a hub to help the Commission collaborate with other
U.S. and international regulatory authorities in order to share best
practices around FinTech engagement. We were accordingly pleased
earlier this year to enter into a CFTC-first FinTech cooperation
arrangement with the UK's Financial Conduct Authority (FCA),\7\ and
look forward to ongoing constructive engagement with our domestic and
international regulatory peers.
---------------------------------------------------------------------------
\7\ U.S. CFTC and UK FCA Sign Arrangement to Collaborate on FinTech
Innovation, Commodity Futures Trading Commission, (Feb. 19, 2018)
https://www.cftc.gov/PressRoom/PressReleases/pr7698-18.
---------------------------------------------------------------------------
DLT, Blockchain, and Digital Assets
The topics of DLT, blockchain, and digital assets \8\ have been
prominent areas of engagement and exploration for the CFTC over the
past year. When LabCFTC views the space, we are interested both in
private or permissioned ledger networks (also sometimes considered
``blockchain-inspired'' technologies) that can be deployed by market
participants to improve market infrastructure and in public blockchains
that require use of a virtual currency to incentivize participation in
maintaining the ledger system.
---------------------------------------------------------------------------
\8\ `Digital assets' is a broad category that includes `virtual
currencies' or `cryptocurrencies.' For purposes of this testimony and
consistent with CFTC past use, I use the term `virtual currencies.'
---------------------------------------------------------------------------
Developments across this spectrum have society re-thinking the
nature of money, how people transact, and how we can more efficiently
engage in regulatory, economic, and market activity.
On the private or permissioned side of the spectrum, new
innovations hold promise in improving clearing and settlement
processes, facilitating regulatory reporting and compliance, and even
transforming information capture, delivery, and analytics capabilities.
The CFTC is also very interested in better understanding their
potential ability to power smart (or self-executing) contracts, which
can incorporate compliance provisions and potentially decrease
execution risks. To be clear, however, this area of innovation is quite
distinct from the realm of public distributed ledgers and virtual
currencies, and has its own unique set of challenges including around
security, scalability, and broader adoption.\9\
---------------------------------------------------------------------------
\9\ CFTC Primer on Virtual Currencies. Commodities Future Trading
Commission, (Oct. 17, 2017), http://www.cftc.gov/idc/groups/public/
documents/file/labcftc_primercurrencies
100417.pdf (hereinafter ``LabCFTC Primer'').
---------------------------------------------------------------------------
On the public distributed ledger side of the spectrum, it may be
helpful to level-set. Virtual currencies are a digital representation
of value and may function as a medium of exchange, a unit of account,
and/or a store of value. Virtual currencies generally run on a
decentralized peer-to-peer network of computers, which rely on certain
network participants to validate and log transactions on a permanent
public distributed ledger visible to all. The virtual currency serves
as the required incentive for miners or validators.\10\
---------------------------------------------------------------------------
\10\ See generally LabCFTC Primer.
---------------------------------------------------------------------------
Proponents note that these virtual ecosystems unlock digital
scarcity, enable the efficient transfer of ownership, and power the
execution of relatively autonomous application platforms all without
the need for a trusted, central party that was traditionally needed to
verify that each party to a transaction has--and does--what it
promises.\11\ In addition to providing new ways to transact over the
Internet, these advancements could allow for decentralized platforms or
applications that provide consumers with desired goods and services
absent a central gatekeeper.\12\ Some further note the potential
inspiration that virtual currencies may provide Central Banks in the
future creation of digital fiat currencies.\13\
---------------------------------------------------------------------------
\11\ See Jerry Brito, Executive Director, Coin Center before the
New Jersey Assembly Financial Institutions and Insurance Committee
Hearing on digital Currency, Coin Center (Feb. 5, 2015) https://
coincenter.org/wp-content/uploads/2015/02/
NewJerseyLegislatureWrittenTestimony.pdf.
\12\ Steven Johnson, Beyond the Bitcoin Bubble, New York Times,
(Jan. 16, 2018) https://www.nytimes.com/2018/01/16/magazine/beyond-the-
bitcoin-bubble.html.
\13\ Qin Chen, Next Stop in the Cryptocurrency Craze: A Government-
Backed Coin, Consumer News and Business Channel, (Dec. 29, 2017)
https://www.cnbc.com/2017/11/29/federal-reserve-starting-to-think-
about-its-own-digital-currency-dudley-says.html.
---------------------------------------------------------------------------
Many, however, appropriately worry that virtual currencies and
tokens are prone to fraud, manias, and bubbles driven by
misunderstandings and myths regarding their scalability, utility, and
intrinsic value.\14\ Indeed, over time bad actors have commonly invoked
the concept of innovation in order to engage in fraudulent activities
that target the general public.\15\ Additionally, as we are reminded by
recent events,\16\ concerns regarding the use of cryptocurrencies to
facilitate illegal activity are well-founded and require government
efforts to ensure that Anti-Money Laundering (AML) and Know Your
Customer (KYC) requirements are effectively applied.
---------------------------------------------------------------------------
\14\ CFTC Customer Advisory: Use Caution When Buying Digital Coins
or Tokens, Commodity Futures Trading Commission, (July 16, 2018),
https://www.cftc.gov/PressRoom/PressReleases/; see also Shane Shifflett
& Coulter Jones, Buyer Beware: Hundreds of Bitcoin Wannabes Show
Hallmarks of Fraud, Wall Street Journal (May 17, 2018) https://
www.wsj.com/articles/buyer-beware-hundreds-of-bitcoin-wannabes-show-
hallmarks-of-fraud-1526573115; Angela Monaghan, Bitcoin Biggest Bubble
in History, says Economist who Predicted 2008 Crash, The Guardian,
(Feb. 2, 2018) https://www.theguardian.com/technology/2018/feb/02/
bitcoin-biggest-bubble-in-history-says-economist-who-predicted-2008-
crash.
\15\ CFTC Charges Nicholas Gelfman and Gelfman Blueprint, Inc. with
Fraudulent Solicitation, Misappropriation, and Issuing False Account
Statements in Bitcoin Ponzi Scheme, Commodities Futures Trading
Commission (Sept. 21, 2017) https://www.cftc.gov/PressRoom/
PressReleases/pr7614-17.
\16\ Gabriel T. Rubin, How Bitcoin Fueled Russian Hacks, Wall
Street Journal (July 13, 2018), https://www.wsj.com/articles/how-
bitcoin-fueled-alleged-russian-hacks-1531517907.
---------------------------------------------------------------------------
With recent hype around virtual coins and tokens there has also
been a proliferation of so-called ``Initial Coin Offerings'' or ICOs,
which frequently refers to the sale of virtual tokens to the public
that are intended to raise capital for a venture and may bear the
hallmarks of a securities offering.\17\ Our colleagues at the
Securities and Exchange Commission (SEC) have been thoughtfully
addressing related challenges,\18\ and providing additional clarity to
the marketplace.\19\ And from the CFTC's perspective, given the
potential to tokenize a broad range of economic assets, it is important
to remind the public that digital assets can also be derivatives or
commodities, depending on their terms and how they are structured.
---------------------------------------------------------------------------
\17\ Jay Clayton & J. Christopher Giancarlo, Regulators Are Looking
at Cryptocurrency, Wall Street Journal, (Jan. 24, 2018). https://
www.wsj.com/articles/regulators-are-looking-at-cryptocurrency-
1516836363.
\18\ The SEC Has an Opportunity You Won't Want to Miss: Act Now!,
(May 16, 2018) Securities And Exchange Commission, https://www.sec.gov/
news/press-release/2018-88; see also Pre-ICO Sale is Live, Howeycoins
(2018), available at https://www.howeycoins.com/index.html; Investor
Bulletin: Initial Coin Offerings, Securities and Exchange Commission
(July 25, 2017). https://www.sec.gov/oiea/investor-alerts-and-
bulletins/ib_coinofferings.
\19\ William Hinman, Director of the Division of Corporation
Finance, Director Digital Asset Transactions: When Howey Met Gary
(Plastic), Yahoo Finance All Markets Summit: Crypto, San Francisco, CA,
Securities and Exchange Commission (June 14, 2018) https://www.sec.gov/
news/speech/speech-hinman-061418.
---------------------------------------------------------------------------
Given the potential and challenges of this space, CFTC Chairman
Giancarlo has made clear that the proper response by regulators and
policymakers is not to dismiss the entire movement as misguided or
foolish, but rather to take the time to learn, facilitate the promise,
and guard against risks and bad actors.\20\
---------------------------------------------------------------------------
\20\ Written Testimony of Chairman J. Christopher Giancarlo before
the Senate Banking Committee, Washington, D.C., Commodity Futures
Trading Commission (Feb. 6, 2018) https://www.cftc.gov/PressRoom/
SpeechesTestimony/opagiancarlo37; see also Testimony of Chairman J.
Christopher Giancarlo before the Senate Committee On Appropriations
Subcommittee on Financial Services and General Government, Washington,
D.C. Commodity Futures Trading Commission (June 5, 2018) https://
www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo47.
---------------------------------------------------------------------------
As part of this effort, LabCFTC published its first FinTech primer
on the topic of virtual currencies in October 2017.\21\ The goal of the
primer was to help educate the public about potential use-cases of the
technology, CFTC jurisdictional considerations, and relevant risks,
including around investment speculation, cybersecurity, and platform
operations.
---------------------------------------------------------------------------
\21\ CFTC's LabCFTC Releases Primer on Virtual Currencies Commodity
Futures Trading Commission (Oct. 17, 2017), https://www.cftc.gov/
PressRoom/PressReleases/7631-17.
---------------------------------------------------------------------------
After the self-certification and launch of Bitcoin futures in
December 2017, LabCFTC was then able to continue providing support in
the areas outlined below to the Commission and operating divisions
based on our engagement and study of DLT and virtual currencies.
Digital Assets and CFTC Jurisdiction
In 2015, the Commission determined that certain virtual currencies,
such as Bitcoin, met the definition of ``commodity'' under the
Commodity Exchange Act (CEA). This means that the CFTC's jurisdiction
is implicated from an oversight perspective if a commodity-based future
or swaps product is offered to the market and from an enforcement
perspective if there is fraud or manipulation involving such products
or their underlying commodity markets.
In December 2017, two CFTC regulated futures exchanges self-
certified and launched Bitcoin futures products.\22\ Under the CEA and
Commission regulations and related guidance, futures exchanges may
self-certify new products on twenty-four hour notice prior to trading.
This type of framework encourages market-driven innovation and has made
America's listed futures markets the envy of the world. Both CME and
CBOE worked with the CFTC for months before launching Bitcoin futures
in December 2017. As detailed in our Chairman's prior Congressional
testimony, due to the complexity of issue, the CFTC conducted a
``heightened review'' of CME's and CBOE's responsibilities.
---------------------------------------------------------------------------
\22\ The following discussion is largely based on: J. Christopher
Giancarlo Testimony Before the U.S. Senate Agriculture, Nutrition, and
Forestry Committee (Feb. 15, 2018), Commodity Futures Trading
Commission https://www.cftc.gov/PressRoom/SpeechesTestimony/
opagiancarlo38.
---------------------------------------------------------------------------
Chairman Giancarlo has outlined six elements regarding CFTC
oversight of the virtual currency-related futures and swaps markets.
These elements include: (1) staff competency; (2) consumer education
through our Office of Customer Education and Outreach; (3) interagency
cooperation including with the SEC, the Department of Treasury's
Financial Crimes Enforcement Network known as FinCEN, and through the
Financial Services Oversight Council (FSOC); (4) CFTC exercise of its
regulatory oversight authority; (5) strong enforcement efforts to deter
and prevent fraud and manipulation; and (6) heightened review of
virtual currency-related product self-certifications.
With respect to heightened review, in May of this year, our
Division of Market Oversight and Division of Clearing and Risk issued a
joint staff advisory that gives exchanges and clearinghouses registered
with the CFTC guidance for listing virtual currency derivative
products. The advisory highlights key areas that require particular
attention in the context of listing a new virtual currency derivatives
contract, including: enhanced market surveillance; close coordination
with CFTC staff; large trader reporting; outreach to member and market
participants; and, Derivatives Clearing Organization risk management
and governance.
Commission staff further noted at the time that since the Agency
found virtual currencies such as Bitcoin to be commodities in 2015, it
has taken action against unregistered Bitcoin futures exchanges;
enforced the laws prohibiting wash trading and prearranged trades on a
derivatives platform; issued proposed guidance on what is a derivative
market and what is a spot market in the virtual currency context
through an interpretation of `actual delivery' \23\; issued warnings
about valuations and volatility in spot virtual currency markets; and,
addressed a virtual currency Ponzi scheme.
---------------------------------------------------------------------------
\23\ CFTC Issues Proposed Interpretation on Virtual Currency
``Actual Delivery'' in Retail Transactions, Commodity Futures Trading
Commission (Dec. 15, 2017), https://www.cftc.gov/PressRoom/
PressReleases/7664-17.
---------------------------------------------------------------------------
On the topic of enforcement, it is worth mentioning that the CFTC
is working closely with the SEC and other fellow financial enforcement
agencies to aggressively prosecute bad actors that engage in fraud and
manipulation regarding virtual currencies. The more cops we can have on
the beat, the better.
Moving Forward
One thing is certain: none of us are able to predict exactly where
innovation is heading, and, accordingly, it is incumbent on us as a
21st century regulator to continue studying, learning, and keeping pace
with change. For our part, LabCFTC looks forward to ongoing engagement
with a broad range of innovators, including the likes of those on
today's panel, to be sure we are skating to where the puck is heading.
We can best facilitate market-enhancing innovation and ensure sound
policy through sound understanding.
Additionally, we look forward to ongoing close collaboration with
our regulatory peers, including through the FSOC digital asset working
group spearheaded by our colleagues at the Treasury Department. We all
have the shared goal to bring clarity and certainty to the market, but
also need to be sure that we are thoughtful in our approach and do not
steer or impede the development of this area of innovation. Indeed,
while some may seek the immediate establishment of bright lines, the
reality is that hasty regulatory pronouncements are likely to miss the
mark, have unintended consequences, or fail to capture important nuance
regarding the structure of new products or models.
In thinking about the future of a broad range of emerging
technologies, it is perhaps informative to harken back to the policy
approach that helped facilitate the development of the Internet and the
rise of new Internet-based business models. Noting the rapid pace of
innovation and technological transformation, then senior policy adviser
Ira Magaziner stated in 1997 that given ``the breakneck speed of change
in [] technology . . . [g]overnment attempts to regulate are likely to
be outmoded by the time they are finally enacted.'' \24\
---------------------------------------------------------------------------
\24\ Steve Lohr, Policing the Internet: Anyone But Government, New
York Times (Feb. 20, 2000), https://www.nytimes.com/2000/02/20/
weekinreview/ideas-trends-policing-the-Internet-anyone-but-
government.html?nytmobile=0&pagewanted=print&src=pm&referer=.
---------------------------------------------------------------------------
Given this dynamic, the government largely avoided a prescriptive
approach in favor of principles, focused on educating and empowering
law enforcement to target bad actors, and allowed this area of
innovation time and space to develop, all while maintaining the ability
and vigilance to act to ensure market integrity. While particular areas
of innovation may require different treatment, generally this approach
seems like the right one when dealing with new technologies, which are,
of course, agnostic as to their use. The role of the regulator is to
facilitate the use of new technologies that benefit markets and the
public more broadly, while deterring and pursuing those who seek to use
technology to do harm.
Thank you. I am happy to answer any questions that you have.
The Chairman. Thank you, Mr. Gorfine.
Mr. Gensler, 5 minutes.
STATEMENT OF HON. GARY GENSLER, SENIOR LECTURER, SLOAN SCHOOL
OF MANAGEMENT, MASSACHUSETTS
INSTITUTE OF TECHNOLOGY; SENIOR ADVISOR TO THE
DIRECTOR, MIT MEDIA LAB, BROOKLANDVILLE, MD
Mr. Gensler. Thank you. Good morning, Chairman Conaway,
Ranking Member Peterson. My condolences on your dad's passing.
It is good to be with you all here today. I have testified in
front of you a dozen or two dozen times in some previous
capacities, but since I was last with you, I took on a new role
at MIT where I am engaged, yes, in researching, teaching,
lecturing, and advising on digital currency and blockchain
technology. Now I say that, but for those who don't know
because some are new, I also chaired the Commodity Futures
Trading Commission for 4 or 5 years, and before that, long ago,
I was 18 years at Goldman Sachs. I bring from my years in
finance, my years in public policy, and now, I guess, as an
academic, some perspective of what I have learned. And with the
Chairman's permission, one thing I have learned as an academic
is to ask the audience a little bit about their engagement in
Bitcoin. Again, with the Chairman's permission, if I could just
ask, how many Members of this Committee have invested in
cryptocurrencies? And I am going to ask the audience, too.
The Chairman. By show of hands?
Mr. Gensler. We have one. The audience, show of hands?
The Chairman. Same with the audience.
Mr. Gensler. Yes, we have about half the audience. That is
an interesting split. There we go.
I would say the other thing that splits the community in my
discussions usually is this is not a community that splits
normally like right and left, Republican, Democratic. This is a
community that splits more about Bitcoin maximalist and Bitcoin
pessimist, or skeptics on one end and by the way, some of those
skeptics and pessimists are Republicans and some are Democrats.
Some are Nobel laureates, some are in finance. Whether it is
Jamie Diamond or Warren Buffett, and then some of the
maximalists can be adventure capitalists like at Andreessen
Horowitz and elsewhere. It is interesting the split in the
community.
I am probably a little bit center maximalist, if I can say
that. I am an optimist on the underlying technology. You will
also hear some people say, ``Well, not that Bitcoin but the
blockchain technology is good,'' and they kind of split their
views that way.
Again, what have I learned? Blockchain technology, I
believe, has a real potential to transform the world of finance
because it is about money. It is about moving value on the
Internet. This new technology could lower costs and risks in
the financial sector. Second, to reach its potential, I feel
strongly that for public confidence to reach its potential, we
need to bring it inside the world that we know, the long held
public policy frameworks. Now what are those frameworks?
Congress has a role to play to tinker about with these
frameworks. I will just say what are our historical frameworks
about technology and finance: We guard against illicit activity
like tax evasion or money laundering. We insure for financial
stability, and we protect investors and consumers. Those are
the three big ones. We protect against illicit activity, we
insure for financial stability, and we protect investors.
Everything else is debatable and we need to adjust the details
underneath that.
Third, the SEC and CFTC do have a role to play. Both of
them have roles to play. They have released numerous notices
and enforcement actions and so forth; however, there is a lot
of noncompliance. I mean, there are thousands of entrepreneurs
out there that probably right now are not complying with SEC
guidance, and there are fewer that are not complying with CFTC
guidance, but that is just because the CFTC doesn't have
oversight of this thing called the initial coin offering
market, and that is where there is a lot going on. And this
thing is going large and big. It is about a $250 billion
market, $\1/4\ trillion is getting some size. I mean, the
overall capital markets in the world are about $250 trillion or
$300 trillion, so it is not threatening that. But thousands of
ICOs have been raised, $20 billion of capital formation. I am
here to say nearly all of them, I don't know if it is 98
percent or 97 percent, but nearly all of them are probably
securities under our securities laws because they are being
offered in a pre-functional time. This ICO market is rife with
scams and frauds.
Fourth, bad actors have figured out how to use this new
currency. Sometimes it is state actors. We learned last Friday
it was the alleged, I should say, but the alleged 12 Russian
spies. Venezuela tried to raise it off of their oil and outrun
U.S. sanctions policy.
Fifth, while Federal agencies are engaged, current laws
apply to this activity, there are gaps. If I can mention a few
of the gaps. First, I think that there are gaps around the
crypto-exchanges themselves, either where you can buy and sell.
Why? Because they are right now being regulated through state
money transmission laws. This approach, regulating them like
Western Union or MoneyGram is not satisfactory because crypto-
activity is more complex and it is harder to trace, and it
doesn't build on top of the traditional banking system. It is
built on something that we can't see that is out there in other
countries, like in China and Russia. Second, the crypto-
exchanges lack brokered access. They don't have brokers, so
there are no brokers, by the way, sending 1099-Bs and my
detailed testimony says that maybe the IRS should do something
about that so you can just have reporting of the gains. Third,
the issuers of securities, the crypto-space, are only slowly
coming into the SEC remit. This is going to take 2, 3, 4 years
before the SEC really cleans up this space, can they go faster,
can we do it right, but it is going to take some time. Fourth,
crypto-derivatives are being handled by the CFTC. They are
doing it well, but there are two things that worry me about the
technology, and one is that the unregulated underlying crypto-
cash market is a mess.
The corn and wheat markets that you oversee, the gold and
the oil markets, we have a lot of history. We have some
confidence about that, and then the CFTC can do their job
layering over those underlying commodities. The CFTC is
regulating derivatives, but they are referencing an underlying
market where it is just, at best, the Wild West and at worst,
it is pretty bad.
About that underlying market: The CFTC has general anti-
fraud and anti-manipulation authorities with regard to it, but
I think that Congress will be debating it. Probably not in this
Congress, but I suspect in the next session, the next Congress,
you all will be debating should you give the CFTC additional
authority, or maybe some other agency. Maybe it will be the
SEC, somebody else, but the CFTC needs to have additional
authorities about that underlying what I would call cash
crypto-market, it is 70 percent of the market. The SEC has
securities. The CFTC has derivatives. You will want to debate
whether to do something about the underlying market. And last,
I think you will need to give them resources along with your
friends over at the Appropriations Committee, because these
agencies will need that.
Thank you.
[The prepared statement of Mr. Gensler follows:]
Prepared Statement of Hon. Gary Gensler, Senior Lecturer, Sloan School
of Management, Massachusetts Institute of Technology; Senior Advisor to
the Director, MIT Media Lab, Brooklandville, MD
Good morning, Chairman Conaway, Ranking Member Peterson, and
Members of the Committee. I thank you for inviting me to testify
regarding the world of crypto-finance birthed by blockchain technology.
As is often the case when innovations in finance occur, this
Committee's oversight of commodities and derivatives markets is
implicated.
On a personal note, it is good to be with you once again.
I'm honored to be testifying in my new role at Massachusetts
Institute of Technology (MIT), where I am engaged with a talented team
researching, writing and teaching about digital currency, blockchain
technology, and the ethics and governance of artificial intelligence.
As Senior Advisor to the Director, MIT Media Lab and Senior Lecturer,
MIT Sloan School of Management, I have spoken at numerous regulatory,
research, or investor conferences related to blockchain technology and
will be teaching a graduate course this fall entitled `Blockchain &
Money.' I coauthored of an upcoming Center for Economic Policy
Research-Geneva Report entitled `The impact of blockchain technology on
finance: a catalyst for change' (Casey, Crane, Gensler, Johnson, and
Narula, 2018)
I also am honored to be Chairman of the Maryland Financial Consumer
Protection Commission which reports to the General Assembly, Governor
and Congressional delegation of Maryland about matters related to
financial consumer protection. We held a public hearing in Annapolis
last month on cryptocurrencies, initial coin offerings, crypto-
exchanges and other blockchain technologies.\1\
---------------------------------------------------------------------------
\1\ Maryland Financial Consumer Protection Commission; http://
dls.maryland.gov/policyareas/maryland-financial-consumer-protection-
commission#.
---------------------------------------------------------------------------
With the benefit of this experience, I would like to share some
thoughts about blockchain technology and more particularly the public
policy issues raised by the burgeoning markets for the trading of
cryptocurrencies, initial coin offerings and other related crypto-
tokens.\2\
---------------------------------------------------------------------------
\2\ Though the research herein builds upon joint work with
colleagues, the views expressed are mine alone, and do not represent
the views of any of my academic colleagues or fellow MD Commissioners.
I have no financial interest in any digital currency, or any blockchain
related business.
---------------------------------------------------------------------------
Executive Summary
Blockchain technology has real potential to transform the world of
finance. Though there are many technical and commercial challenges yet
to overcome, I'm an optimist and want to see this new technology
succeed. It could lower costs, risks and economic rents in the
financial system.
To reach this potential and for public confidence, blockchain
technology and the world of crypto-finance it has birthed has to come
within the norms of long-established public policy frameworks.
As with other aspects of finance or other emerging technologies, we
must guard against illicit activities, such as tax evasion, money
laundering, terrorism finance and avoiding sanctions regimes. We must
continue to ensure financial stability. And we must ensure investors
and consumers are protected.
As things currently are, though, there is significant non-
compliance with respect to many initial coin offerings (ICOs), other
crypto-assets and crypto-exchanges.
The question then is how do the crypto-finance markets, this new
technology, Congress and regulators go forward? While many U.S.
agencies are engaged, and current laws clearly cover much of this new
activity, there may be gaps to consider.
To date, crypto-exchanges and digital wallet providers generally
have not been registering as banks, exchanges, broker dealers or
futures commission merchants. This leaves the only regulatory
safeguards--to guard against illicit activity and protect investors--to
state-administered money transmission regulations. This approach--
regulating exchanges' duties in the same manner that Western Union and
MoneyGram are regulated--is not satisfactory. Illicit activity is hard
to track, billions of dollars have been lost to hacks, and manipulative
behavior is unchecked.
Crypto activities are more complex, inherently harder to monitor
and less traceable than straightforward money transfers. Crypto
exchanges and digital wallet providers lack the same natural
connections to the regulated banking system that money transmission
companies have when transferring fiat currencies. Regulated banks help
protect customers funds by compliance with the bank secrecy act. As
crypto-exchanges lack intermediated access, tax compliance is also
compromised as there are not brokers to regularly report crypto-
transactions through form 1099-Bs.
Furthermore, though both the Securities and Exchange Commission
(SEC) and Commodity Futures Trading Commission (CFTC) have released
numerous public advisories, notices and enforcement actions, most
crypto-exchanges remain unregistered and operate with limited investors
protections. Thousands of ICOs have occurred, most being investment
contracts under the securities laws, but only a fraction have recently
started complying. Studies repeatedly report that the ICO market and
crypto-exchanges are rife with scams, frauds and manipulative
practices.
The current patchwork approach to addressing these issues--to guard
against illicit activities, protect investors & their funds, and
promote market integrity--would be better accomplished through
application of commodities and securities laws. As outlined below,
while issuer based crypto is slowly being brought under securities laws
and crypto-derivatives are clearly under the CFTC and commodities laws,
there may be a gap Congress considers filling related to
cryptocurrencies not subject to securities laws, such as Bitcoin,
herein called `crypto-cash commodities.'
While the CFTC has general anti-fraud and anti-manipulation
authorities with regard to spot transactions in crypto-cash
commodities, such as Bitcoin or Ether, the agency does not currently
have express registration or plenary rule writing authorities with
regard to cash commodities. Furthermore, as the CFTC staff recently
said in an advisory letter, ``virtual currencies are unlike any
commodity that the CFTC has dealt with in the past.'' \3\
---------------------------------------------------------------------------
\3\ CFTC Staff Advisory No. 18-14 (May 21, 2018) https://
www.cftc.gov/sites/default/files/idc/groups/public/%40lrlettergeneral/
documents/letter/2018-05/18-14_0.pdf.
---------------------------------------------------------------------------
Congress may wish to consider providing the CFTC--or another
agency--with general authorities to write rules for these markets,
including possibly requiring registration for trading on crypto-
exchanges solely dealing in cryptocurrencies, aka crypto-cash
commodities. Doing so may best protect investors, limit illicit
activity and enhance underlying reference markets for crypto-
derivatives and exchange traded funds (ETF). It also is critical that
the CFTC, SEC and other agencies have sufficient budgetary resources to
adequately oversee crypto-markets, especially as these markets have
continued to grow.
Clear rules of the road also would allow firms--both incumbents and
start-ups--to more fully explore investing in blockchain technology or
crypto-assets. Start-ups have had an advantage over incumbents as they
generally differ on how they evaluate taking reputational and
regulatory risks regarding uncertain regulatory treatment.
Bringing the crypto-world within the long-established public policy
frameworks, though, will promote greater innovation and competition,
allowing blockchain technologies to be explored to their fullest
potential.
Comprehensive Review
Blockchain Technology Potential
Blockchain technology and cryptocurrencies are an innovative tool
for creating and moving value on the Internet (digital assets) using
blockchains, distributed consensus algorithms, cryptography, and peer
to peer networking. Regardless of whether Bitcoin and other
cryptocurrencies adequately exhibit the three classic characteristics
of money--a store of value, a medium of exchange and a unit of
account--they do provide a means to move value and run computer code on
the Internet without relying upon a central intermediary such as a
bank.
That ties blockchain technology and cryptocurrencies directly to
the essential plumbing of the financial sector, which at its core
performs the role of efficiently moving and allocating money and risk
within the economy.
Though there are many technical and commercial challenges yet to
overcome, blockchain technology has the potential to transform the
world of finance by creating open protocols to which everyone has
access, but nobody has control--to do for finance what the web did for
information.
The technology could reduce the ``cost of trust''--the costs borne
by transacting parties because they have to rely on their
counterparties or a trusted intermediary to honestly record completion
of the transaction. These costs range widely--from those associated
with vault doors, cybersecurity, settlement procedures, user
identification, compliance teams, security guards, and anti-fraud
regimes, to the excess amounts that centralized institutions can charge
customers.
Potential use cases include cross-border payments, clearing and
settlement for financial transactions, digital identities, trade
finance and supply chain management. Open permissionless blockchain
applications such as Bitcoin have also inspired permissioned or private
blockchains. The term ``distributed ledger technology,'' or DLT, is
often used to describe this field in broader, generic terms.
With increased competition and innovation in the financial system,
DLT--both permissionless and permissioned--offers a catalyst for change
by incumbents or as an opportunity for entrepreneurial start-ups,
potentially lowering costs, risks and economic rents in the financial
sector which represents 7.5% of the U.S. economy.\4\
---------------------------------------------------------------------------
\4\ Value added by private industries: Finance, insurance, real
estate, rental, and leasing: Finance and insurance as a percentage of
GDP; Federal Reserve Bank of St. Louis (reviewed on July 15, 2018)
https://fred.stlouisfed.org/series/VAPGDPFI.
---------------------------------------------------------------------------
To reach its potential, though, blockchain technology and the world
of crypto-finance, must come fully within long established public
policy frameworks.
Crypto Finance
Blockchain technology has given rise to the latest addition to an
ever-evolving global financial system. The world of crypto-finance--
with total market capitalization of $250 billion,\5\ its innovative
forms of crowdfunding and trading on crypto-exchanges--has so far
operated largely outside established investor protection frameworks.
---------------------------------------------------------------------------
\5\ CoinMarketCap (as of July 14, 2018) https://coinmarketcap.com.
---------------------------------------------------------------------------
To date, 3800 ICOs have launched \6\ and 200 crypto-exchanges are
operating \7\ with tens of millions of customers worldwide. About 55
percent of the crypto-market value is now in tokens other than
Bitcoin.\8\
---------------------------------------------------------------------------
\6\ Stats and Facts; ICO Bench (as of July 13, 2018) https://
icobench.com/stats.
\7\ 24 Hour Volume Rankings (Exchange); CoinMarketCap (as of July
13, 2018) https://coinmarketcap.com/exchanges/volume/24-hour/.
\8\ Market Cap by Cryptocurrency (as of July 13, 2018); Coin Dance;
https://coin.dance/stats.
---------------------------------------------------------------------------
Cryptocurrencies by Market Cap
coin.dance
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
The market is volatile but has grown significantly over the years
as shown in the following figure of historical market capitalization.
Cryptocurrency Market Caps (Historical)
coin.dance
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Tokens and Initial Coin Offerings
Burgeoning investor interest in crypto-assets along with the
potential for token-based economies, has led to a new means of raising
capital for blockchain-based projects: initial coin offerings (ICOs)
and similar token sales.
By their very nature and design, ICOs and similar token offerings
mix economic attributes of both investment and potential consumption.
Marketing documents describe utility-like qualities for the token's
stated purpose on a decentralized network, but there is almost always a
strong investment component to token sales as they fund development of
underlying software and a network. Thus, ICOs are quite different from
tokens for a neighborhood laundromat, tickets to the theatre or
donation-based crowdfunding platforms such as Kickstarter or GoFundMe.
ICO investors bear economic risk related to the success or failure
of the network in which the token is to potentially circulate.
Investors lose if the network isn't completed or falls short of hoped
for public adoption, but they may gain if the network widely succeeds.
ICOs are typically marketed online with the release of a whitepaper
prior to the launch of a new blockchain-based decentralized
application.
ICO tokens are structured with attributes to promote marketability
and potential appreciation. They usually include a so-called `monetary
policy' which is encoded in the software, defining the future supply of
tokens and introducing an element of scarcity. They are fungible or
interchangeable which enhances liquidity. They are often listed on
crypto-exchanges, boosting marketability and transferability.
Development and support of the network, though often open-sourced,
tends to be largely concentrated around the issuing company or
foundation and other closely aligned developers. The selling company,
related foundation and founders usually retain a meaningful portion of
pre-issued tokens and are motivated to increase the value of the
tokens.
Nearly every ICO token's economic realities--its risks, expectation
of profits, monetary policies, manner of marketing, and capital
formation--are attributes of investment schemes.
Issuance has ballooned in the last 12 months, with CoinDesk
reporting total ICO issuance of nearly $20 billion through June 30.
There are no authoritative data sources, however, and most data
aggregators are relying on ICO issuers to self-report the amount they
raised. EOS raised $4.2 billion through a year-long ICO and Telegram
Group raised $1.7 billion in two private offerings. CoinDesk reports
$14 billion raised so far in 2018 versus just over $5 billion in all of
2017.\9\
---------------------------------------------------------------------------
\9\ All-Time Cumulative ICO Funding; CoinDesk (as of July 13, 2018)
https://www.coindesk.com/ico-tracker/.
---------------------------------------------------------------------------
All-Time Cumulative ICO Funding
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Many start-ups are turning to this market to raise capital as there
are significant valuation differences versus traditional venture
capital funding. The valuation disparity may be due, amongst other
things, to the public's speculative interest, the potential to share in
the network effects of token economies, the token's greater liquidity,
reduced transactions costs or regulatory arbitrage.
There is a high failure rate for ICOs. One study in February of
2018 found that 59% of a sample of 2017 ICOs had already failed or
semi-failed.\10\ There also is a considerable amount of fraud and scams
in this field, with numerous ICOs targeting retail investors, using
celebrity endorsers, and promising short-term gains. Estimates vary
considerably with 25 percent \11\ to 81 percent as scams.\12\ A recent
Wall Street Journal analysis of over 1400 ICOs found ``rampant
plagiarism, identity theft and promises of improbable returns.'' \13\
---------------------------------------------------------------------------
\10\ Nearly Half of 2017 Cryptocurrency `ICO' Projects Have Already
Died; Forbes (February 25, 2018) http://fortune.com/2018/02/25/
cryptocurrency-ico-collapse/.
\11\ Initial Coin Offerings: Can Regulators Curb the Risks? How
Many ICOs Are Scams?; ValueWalk (March 30, 2018) https://
www.valuewalk.com/2018/03/initial-coin-offerings-regulators-curb-risks/
\12\ ICO Quality: Development & Trading; Sherwin Dowlat & Michael
Hodapp of Satis Group (March 21, 2018) https://medium.com/satis-group/
ico-quality-development-trading-e4fef28df04f.
\13\ Hundreds of Bitcoin Wannabes Show Hallmarks of Fraud; Wall
Street Journal (May 17, 2018) https://www.wsj.com/articles/buyer-
beware-hundreds-of-bitcoin-wannabes-show-hallmarks-of-fraud-1526573115.
---------------------------------------------------------------------------
As cheap money, though, will always displace expensive money (from
an entrepreneur's perspective), if valuation disparities continue, it
is possible that ICO funding will grow further to displace a
significant portion of the $160 billion venture capital raised annually
around the globe.\14\ This changing venture funding landscape
highlights the need for investor protection to keep pace with market
developments.
---------------------------------------------------------------------------
\14\ Venture Capital Funding Report 2017; CB Insights https://
www.cbinsights.com/research/report/venture-capital-q4-2017/.
---------------------------------------------------------------------------
Crypto-Exchanges
Once Bitcoin developed as the first cryptocurrency, it was only
natural that secondary markets and exchange trading would develop.
In aggregate, crypto-exchanges now have tens of millions of
customers. Coinbase, alone, has over 20 million accounts, almost as
many as Fidelity Investments, more than twice brokerage firm Charles
Schwab and nearly as many as Vanguard has investors.\15\
---------------------------------------------------------------------------
\15\ Move deliberately, fix things: How Coinbase is building a
cryptocurrency empire; Washington Post (May 17, 2018) https://
www.washingtonpost.com/business/economy/move-deliberately-fix-things-
how-coinbase-is-building-a-cryptocurrency-empire/2018/05/17/623d950c-
587c-11e8-858f-12becb4d6067_story.html?utm_term=.a18c45536e2b.
---------------------------------------------------------------------------
Trading appears to be significant, with over $12 billion in daily
volume reported last week.\16\ There are now approximately 200 crypto-
exchanges and many others have failed. By 2015, one list already had at
least 36 failures.\17\ In 2018, after the Japanese Financial Services
Agency (JFSA) conducted business reviews of exchanges, at least nine
suspended their operations.\18\
---------------------------------------------------------------------------
\16\ 24 Hour Volume Rankings (Exchange); CoinMarketCap (as of July
13, 2018) https://coinmarketcap.com/exchanges/volume/24-hour/.
\17\ 36 bitcoin exchanges that are no longer with us, Brave New
Coin (October 23, 2015) https://bravenewcoin.com/news/36-bitcoin-
exchanges-that-are-no-longer-with-us/.
\18\ Nine Japanese Crypto Exchanges Have Suspended Operations So
Far, Bitcoin.com (April 13, 2018) https://news.bitcoin.com/nine-
japanese-crypto-exchanges-have-suspended-operations-so-far/.
---------------------------------------------------------------------------
In reviewing exchange volume figures, some caution is in order as
market data from crypto-exchanges generally is not audited or
regulated. Furthermore, exchanges may use wash sales (i.e., trading
involving no change in beneficial ownership that is intended to produce
the false appearance of trading) to inflate their volume statistics in
an effort to report greater market share. One recent study suggests up
to 95% of OKex's reported volume may be nonexistent and 82% of Huobi's
may be as well.\19\
---------------------------------------------------------------------------
\19\ Chasing fake volume: a crypto-plague; Sylvain Ribes (March 10,
2018) https://medium.com/@sylvainartplayribes/chasing-fake-volume-a-
crypto-plague-ea1a3c1e0b5e.
---------------------------------------------------------------------------
These exchanges also have some significant differences from
traditional securities, derivatives and retail fiat currency exchanges.
Crypto exchanges offer direct access to customers rather than access
through regulated intermediaries, such as broker dealers or future
commission merchants. Centralized crypto-exchanges also take custody of
customers crypto and some fiat funds. For instance, Coinbase reports to
have custody of over $20 billion in customer crypto-funds.\20\
---------------------------------------------------------------------------
\20\ Announcing the Coinbase Suite of Institutional Products; The
Coinbase Blog (May 15, 2018) https://blog.coinbase.com/coinbase-
institutional-deea317d23af.
---------------------------------------------------------------------------
Crypto-exchanges have had significant problems protecting
customers' funds held in custody, usually in digital wallets rather
than at a bank, broker dealer, or future commission merchants. Numerous
hacks have led to significant stolen customer funds. Mt. Gox lost $473
million in Bitcoin in 2014.\21\ Coincheck lost $530 million in NEM
tokens in 2018.\22\ A South Korean exchange, Coinrail, was hacked in
June of 2018, losing $40 million, or fully 30% of customer tokens held
in custody.\23\
---------------------------------------------------------------------------
\21\ 12 Biggest Cryptocurrency Hacks In History, Benzinga (November
24, 2017) https://www.benzinga.com/fintech/17/11/10824764/12-biggest-
cryptocurrency-hacks-in-history.
\22\ Coincheck: NEM Foundation Stops Tracing Stolen Coins, Hackers'
Account At Zero, CoinTelegraph (March 23, 2018) https://
cointelegraph.com/news/coincheck-nem-foundation-stops-tracing-stolen-
coins-hackers-account-at-zero.
\23\ South Korean Exchange Coinrail Hacked, $40 Million in Crypto
Reported Stolen; Bitcoin Magazine (June 11, 2018) https://
bitcoinmagazine.com/articles/south-korean-exchange-coinrail-hacked-40-
million-crypto-reported-stolen/.
---------------------------------------------------------------------------
Also acting as counterparties to their customers, crypto-exchanges
currently have limited guardrails against front running, fraud, or
other manipulative practices. For instance, there are no assurances
that order book or sales price information posted on these exchanges
are current or accurate or that the cryptocurrency held by exchanges in
custodial wallets is fully backed with coins on the relevant
blockchain.
There are no rules for best execution or order routing amongst
crypto-exchanges. There are no rules limiting conflicts of interest or
for fair and orderly markets. There are no standards for price
transparency--either pre-trade or post-trade. There are no cops on the
beat to protect against manipulative practices. In summary, investors
have little basis for confidence in crypto-exchanges' order books or
price discovery function.
There have been repeated reports of manipulative behavior on these
exchanges. A study last year reviewed how a trader using two trading
bots on the Mt. Gox exchange may have manipulated the price of Bitcoin
up eight-fold in 2013.\24\ In January of 2018, there were reports of an
investigation into whether Bitcoin might have been manipulated on the
Bitfinex exchange in a scheme using the token Tether.\25\
---------------------------------------------------------------------------
\24\ Price Manipulation in the Bitcoin Ecosystem; Neil Gandal, J.T.
Hamrick, Tyler Moore, and TaliOberman (June 22, 2017) https://
tylermoore.utulsa.edu/jme17.pdf.
\25\ Worries Grow That the Price of Bitcoin Is Being Propped Up;
New York Times (January 31, 2018) https://www.nytimes.com/2018/01/31/
technology/bitfinex-bitcoin-price.html?dlbk.
---------------------------------------------------------------------------
The Futures Industry Association (FIA) expressed its apprehension
about the reference markets for Bitcoin futures. As it stated: ``We
remain apprehensive with the lack of transparency and regulation of the
underlying reference products on which these futures contracts are
based and whether exchanges have the proper oversight to ensure the
reference products are not susceptible to manipulation, fraud, and
operational risk.'' \26\
---------------------------------------------------------------------------
\26\ Open letter to CFTC Chairman Giancarlo regarding the listing
of cryptocurrency derivatives; Futures Industry Association (December
7, 2017) https://fia.org/articles/open-letter-cftc-chairman-giancarlo-
regarding-listing-cryptocurrency-derivatives.
---------------------------------------------------------------------------
The volumes, millions of customers, repeated hacks and ample
potential for manipulative behavior, suggest that oversight is worthy
by securities, commodities and derivatives regulators around the globe.
To date, however, this trading activity has largely taken place outside
of investor protection and market integrity regimes.
Public Policy Frameworks
As with the emergence of new technologies in the past, from
railroads in the 19th century to the Internet in the late 20th century,
there have been debates on how blockchain technology and crypto-finance
might best fit within existing public policy and legal frameworks.
Operating within policy frameworks, though, has helped foster
traditional capital markets for decades and are just as important for
crypto-finance, even if the details for achieving the goals may be
adapted to accommodate new technologies.
The public broadly benefits when we:
Ensure tax compliance.
Guard against money laundering or terrorism financing.
Enforce sanctions regimes.
Promote financial stability.
Protect investors and consumers.
Promote market integrity and efficient capital markets.
Foster economic inclusion and growth.
Achieving these broad public policy goals fosters economic growth
and is consistent with promoting innovation.
When investing in any form of financing, whether initial coin
offerings, other crypto-assets, or in traditional forms, such as stocks
or bonds, the public benefits from full and fair disclosure from
issuers.
The investing and hedging public benefits from prohibitions against
fraud and deceptive sales practices.
Investors, hedgers, and issuers all benefit from secondary market
trading that promote transparency and prohibit manipulative practices
such as price manipulation, front running, wash sales, and spoofing
(i.e., bidding or offering with the intent to cancel the bid or offer
before execution.)
The investing and hedging public benefits when conflicts of
interest are disclosed and minimized.
Such core principals of investor protection and market integrity
are embodied in U.S. securities and commodities laws regardless of the
form of investment. Such common-sense rules of the road bolster
confidence in markets and enhances our economy.
Securities Laws, Howey Test & Duck Test
Despite issuers' claims that the intended utility function of their
tokens should place them in a different category from securities,
there's no getting away from ICOs' investment contract attributes which
means they should be subject to securities laws.
In essence, as Indiana poet James Whitcomb Riley wrote over 100
years ago: ``When I see a bird that walks like a duck and swims like a
duck and quacks like a duck, I call that bird a duck.''
An important early test of securities laws' statutory construct
related to the Florida orange groves of William Howey, whose company
sold land with an option to lease the land to an affiliated service
company and participate in the profits of the crop. Even though not
stocks or bonds, the U.S. Supreme Court in 1946 ruled that Howey's land
sale agreements satisfied the definition of `investment contracts'
under the 1933 Securities Act and thus should be regulated as
securities.
The so-called `Howey Test' from this case states that: ``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.'' SEC v. W.J. Howey Co., 328 U.S.
293, 299 (1946).
The Securities and Exchange Commission (SEC) has now repeatedly
spoken out about the application of securities laws to initial coin
offerings and crypto-exchanges offering ICOs for sale. Sounding like
poet Riley, SEC Chairman Clayton stated in February that ``I believe
every ICO I've seen is a security. You can call it a coin but if it
functions as a security, it is a security.''
At a Congressional hearing on April 26, 2018, Chair Clayton divided
crypto-assets into two areas, those which represent ``a pure medium of
exchange'' and ``tokens, which are used to finance projects.'' He said
that a ``pure medium of exchange . . . as a replacement for currency''
such as Bitcoin would not be regulated as a security.
As for tokens, Chair Clayton said: ``Then there are tokens, which
are used to finance projects. I've been on the record saying there are
very few, there's none that I've seen, tokens that aren't securities.''
He added ``To the extent something is a security, we should regulate it
as a security, and our securities regulations are disclosure-based, and
people should follow those and provide the information that we
require.'' \27\
---------------------------------------------------------------------------
\27\ Bitcoin is Not a Security SEC Chairman; BlockExplorer News
(April 27, 2018) https://blockexplorer.com/news/bitcoin-is-not-a-
security-sec-chairman/.
---------------------------------------------------------------------------
Commodities Laws & Crypto Derivatives
The CFTC has exclusive jurisdiction over the trading of crypto-
derivatives on exchanges, i.e., ``designated contract markets'' (DCMs)
and ``swap execution facilities'' (SEFs) for both futures contracts and
swaps as well as the trading of over-the-counter crypto-swaps. The CFTC
also has general anti-fraud and manipulation authority for spot
transactions in commodities traded in interstate commerce.
Thus, the CFTC has direct jurisdiction for crypto-derivatives. If
an exchange offers derivatives on cryptocurrencies, then that exchange
must register with the CFTC. Crypto-exchanges that offer to U.S.
persons `retail commodity transactions' as defined in statute, could
also be subject to the authority of the CFTC.
The CME Group and CBOE Global Markets started trading Bitcoin
futures in December 2017. Nasdaq \28\ and Intercontinental Exchange
\29\ have both said that they are investigating offering cryptocurrency
or crypto-derivative trading. Overseas, Germany's largest exchange,
Deutsche Borse, has said it is considering offering Bitcoin futures on
its Eurex derivatives exchange.\30\ A UK start-up, Crypto Facilities,
launched an Ether futures contract in May 2018.\31\
---------------------------------------------------------------------------
\28\ After Nasdaq CEO Blesses Cryptocurrency, Investors See Bigger
Future for Bitcoin, Others; Forbes (April 25, 2018) https://
www.forbes.com/sites/kenrapoza/2018/04/25/nasdaq-ceo-bitcoin-trading-
cryptocurrency/#556c526613f4.
\29\ Bitcoin Sees Wall Street Warm to Trading Virtual Currency; New
York Times (May 7, 2018) https://www.nytimes.com/2018/05/07/technology/
bitcoin-new-york-stock-exchange.html.
\30\ German market weighs Bitcoin futures, Handelsblatt Global
(December 13, 2017) https://global.handelsblatt.com/finance/german-
market-weighs-bitcoin-futures-865045.
\31\ Ethereum Futures Go Live on UK Trading Platform; CoinDesk (May
11, 2018) https://www.coindesk.com/ethereum-futures-go-live-uk-trading-
platform/.
---------------------------------------------------------------------------
The CFTC in its ``Coinflip Order'' determined that Bitcoin and
other virtual currencies are commodities under the CEA in 2015.\32\ A
U.S. District court subsequently concurred with a latter similar
determination.\33\ Accordingly, the CFTC has general anti-fraud and
anti-manipulation authority for spot transactions in the underlying
reference cryptocurrencies, whether traded on exchanges or over the
counter. The CFTC has brought a number of actions under this authority,
one related to the trading of Bitcoin and Litecoin \34\ and another
with regards to the trading of My Big Coin.\35\ My Big Coin, though, is
challenging the jurisdiction of the CFTC contending that their token is
not a commodity.\36\
---------------------------------------------------------------------------
\32\ In the Matter of Coinflip, Inc., d/b/a Derivabit, and
Francisco Riordan; (Sept. 17, 2015), https://www.cftc.gov/sites/
default/files/idc/groups/public/@lrenforcementactions/documents/
legalpleading/enfcoinfliprorder09172015.pdf.
\33\ Bitcoin and Cryptocurrencies Are Commodities, Federal Court
Rules, Bitcoin.com (March 7, 2018) https://news.bitcoin.com/bitcoin-
cryptocurrencies-commodities-federal-court-rules/.
\34\ Federal Court in NY Enters Preliminary Injunction Order
Against Patrick K. McDonnell and his Company CabbageTech, Corp. d/b/a
Coin Drop Markets in Connection with Fraudulent Virtual Currency
Scheme; CFTC (March 6, 2018) https://www.cftc.gov/PressRoom/
PressReleases/pr7702-18.
\35\ CFTC Sues Obscure Crypto Scheme for Fraud; CoinDesk (January
24, 2018) https://www.coindesk.com/cftc-sues-crypto-scheme-big-coin-
fraud/.
\36\ My Big Coin Tells Court Tokens aren't Regulated by CFTC
Because they are Not Commodities; Crowdfund Insider (April 5, 2018)
https://www.crowdfundinsider.com/2018/04/131518-my-big-coin-tells-
court-tokens-arent-regulated-by-cftc-because-they-are-not-commodities/.
---------------------------------------------------------------------------
The Path Forward
How do the markets, this new technology, Congress and regulators
move forward?
I will review some considerations organized around the three broad
public policy goals of: (1) guarding against illicit activity; (2)
ensuring for financial stability[;] and (3) protecting the investing
public.
Guarding Against Illicit Activity
On balance, though, blockchain technology and cryptocurrencies have
given the official sector new challenges in guarding against illicit
activities. The crimes aren't generally new. The means and methods,
though, particularly of payment, may be.
The pseudonymous nature of blockchain-based records obscures the
identity of actors, raising concerns for law enforcement authorities
tasked with guarding against illicit activities. At the same time, the
private sector has had legitimate concerns about the privacy of data
shared on Bitcoin and other open permissionless blockchain
applications.
Interestingly, Bitcoin and other blockchain applications while
often referred to anonymous, are more accurately what security experts
would call pseudonymous. Bitcoin transactions do not include names of
individuals or companies, but they do provide Bitcoin addresses, which
if found to be linked to any personal data, such as your e-mail or ISP
address, may allow for some transparency. Thus, blockchain technology
allows some information about participants to be gleaned from patterns
in the transaction records, balances in the unspent transactions
outstanding and blockchain forensics.\37\
---------------------------------------------------------------------------
\37\ Stealing bitcoins with badges: How Silk Road's dirty cops got
caught; arsTechnica (August 17, 2016) https://arstechnica.com/tech-
policy/2016/08/stealing-bitcoins-with-badges-how-silk-roads-dirty-cops-
got-caught/. Also see: A Fistful of Bitcoins: Characterizing Payments
Among Men with No Names; Meiklejohn, Pomarole, Jordon, Levchenko,
McCoy, Voekler, & Savage (2013) https://cseweb.ucsd.edu/ smeiklejohn/
files/imc13.pdf.
---------------------------------------------------------------------------
Given the pseudonymous nature of Bitcoin, it was only a matter of
time and technological innovation before a number of cryptocurrencies
would be developed promoting more anonymity. These anonymity-focused-
crypto-assets have specific designs that make their transactions harder
to track on their underlying blockchains. Monero, Dash and Zcash are
the three with the largest market capitalization, totaling about $5
billion, but many more exist and are marketed to the public.\38\ It has
been reported that Japan this spring has been encouraging crypto-
exchanges to halt listings of trading anonymity-focused-crypto-
assets.\39\ On the other hand, it has been recently reported that
Coinbase is considering listing Zcash for the first time.\40\
---------------------------------------------------------------------------
\38\ 9 Anonymous Cryptocurrencies You Should Know About; Coinsutra
(February 2, 2018) https://coinsutra.com/anonymous-cryptocurrencies/.
\39\ Japan's Financial Regulator Is Pushing Crypto Exchanges To
Drop `Altcoins' Favored By Criminals; Forbes (April 30, 2018) https://
www.forbes.com/sites/adelsteinjake/2018/04/30/japans-financial-
regulator-is-pushing-crypto-exchanges-to-drop-altcoins-favored-by-
criminals/#22d47e3e1b8a.
\40\ Coinbase Considering Cardano, Stellar Lumens, Zcash, 0x & BAT
Token Listings; Bitcoin Exchange Guide News (July 13, 2018) https://
bitcoinexchangeguide.com/coinbase-considering-cardano-stellar-lumens-
zcash0x-bat-token-listings/.
---------------------------------------------------------------------------
Dark Markets
One of the most harmful activities has been on so-called dark
markets. These markets operate with anonymous communications through
the Tor network, a free and open network which provides users anonymous
and censorship resistant means of communicating on the Internet.\41\
Dark markets have generally used Bitcoin for escrowed payments. They
list for sale illegal drugs, weapons, stolen credit card details, and
forged documents offered by hundreds or sometimes thousands of vendors.
---------------------------------------------------------------------------
\41\ Tor https://www.torproject.org.
---------------------------------------------------------------------------
U.S. and international enforcement authorities have successfully
taken down a number of dark markets trafficking in illegal activities,
but other markets keep popping up in their place. When the U.S.
Department of Justice shut down AlphaBay in July of 2017, it was
estimated to be ten times larger than the notorious Silk Road web site
which was shut down in 2013. Dutch authorities, working along with U.S.
authorities successfully shut down another large dark market, Hansa,
just 2 weeks later.\42\
---------------------------------------------------------------------------
\42\ Forget Silk Road, Cops Just Scored Their Biggest Victory
Against The Dark Web Drug Trade; Forbes (July 20, 2017) https://
www.forbes.com/sites/thomasbrewster/2017/07/20/alphabay-hansa-dark-web-
markets-taken-down-in-massive-drug-bust-operation/#72702fd15b4b.
---------------------------------------------------------------------------
Beyond use on the darknet, there are those around the globe who
seek to use these new technologies to thwart government oversight of
money laundering, tax evasion, terrorism financing, or evading
sanctions regimes.
State Actors
Two high profile uses of cryptocurrencies in efforts to thwart U.S.
policy were by foreign government actors. In January of 2018, Venezuela
announced a $5 billion oil-backed ICO called Petro. In response,
augmenting previously established sanctions, the President signed an
Executive Order in March prohibiting U.S. persons from purchasing or
dealing in any digital currency, coin or token of the Government of
Venezuela.\43\
---------------------------------------------------------------------------
\43\ Executive Order on Taking Additional Steps to Address the
Situation in Venezuela; White House (March 19, 2018) https://
www.whitehouse.gov/presidential-actions/executive-order-taking-
additional-steps-address-situation-venezuela/.
---------------------------------------------------------------------------
On July 13, 2018, the U.S. charged 12 Russian military intelligence
officers with conspiracy to interfere with the 2016 elections. Amongst
the charges, count ten alleges conspiracy to launder money. It reads,
in part: ``the defendants conspired to launder the equivalent of more
than $95,000 through a web of transactions structured to capitalize on
the perceived anonymity of cryptocurrencies such as bitcoin.'' It is
alleged that: ``they principally used bitcoin when purchasing servers,
registering domains, and otherwise making payments in furtherance of
hacking activity.'' The indictment states that: ``The use of bitcoin
allowed the Conspirators to avoid direct relationships with traditional
financial institutions, allowing them to evade greater scrutiny of
their identities and sources of funds.'' \44\
---------------------------------------------------------------------------
\44\ U.S. v. Netyksho, et al., Indictment; Count ten, paragraph 57
(July 13, 2018) https://assets.bwbx.io/documents/users/iqjWHBFdfxIU/
rs96.XUFx2Gw/v0.
---------------------------------------------------------------------------
Tax Compliance
The U.S. Internal Revenue Service issued guidance in 2014 on the
use of what they called `virtual currencies', such as Bitcoin and other
crypto-assets. In determining that all virtual currencies are treated
as property for U.S. tax purposes, the IRS said that general tax
principals applicable to property transactions apply to virtual
currencies. Taxpayers receiving virtual currencies for payment of goods
and services must include their fair market value in their reported
gross income.
Taxpayers also are required to include in income any gains or
losses upon a sale or exchange of virtual currencies.\45\
---------------------------------------------------------------------------
\45\ IRS virtual currency guidance: Virtual currency is treated as
property for U.S. Federal tax purposes; General rules for property
transactions apply; IR-2014-36; IRS (March 25, 2014) https://
www.irs.gov/newsroom/irs-virtual-currency-guidance.
---------------------------------------------------------------------------
One open question that investors and tax practitioners had had was
the appropriate treatment under the tax laws of crypto to crypto-
exchanges. The law was clear that tax could be deferred by treating
these trades as so-called `like-kind exchanges' under IRS section 1031.
If that was even possible prior to 2018, it no longer is now, with
amendments to Section 1031 included in the Tax Cut and Jobs Act to make
like-kind exchanges only applicable to real estate transactions.\46\
---------------------------------------------------------------------------
\46\ The Truth About Cryptocurrency And Like-Kind Exchanges; Forbes
(February 19, 2018) https://www.forbes.com/sites/tysoncross/2018/02/19/
the-truth-about-cryptocurrency-and-like-kind-exchanges/#33c7cdc26fd1.
---------------------------------------------------------------------------
One challenge for tax compliance is that crypto-exchanges have not
yet been sending form 1099-B, reporting on transactions, to their
customers and the IRS. The IRS requires brokers to do so with regard to
all broker or barter exchange transactions.\47\ As discussed elsewhere,
though, the current model for crypto-exchanges does not generally
include brokers, leaving a significant gap in tax reporting. The U.S.
Internal Revenue Service had to win in Federal court before the crypto-
exchange Coinbase was willing to share information on their most active
customer accounts--approximately 13,000 accounts--with the IRS.\48\
---------------------------------------------------------------------------
\47\ 2018 Instructions for form 1099-B; IRS https://www.irs.gov/
pub/irs-pdf/i1099b.pdf.
\48\ Coinbase Notifies Customers That It Will Turn Over Court-
Ordered Data; Forbes (February 28, 2018) https://www.forbes.com/sites/
kellyphillipserb/2018/02/28/coinbase-notifies-customers-that-it-will-
turn-over-court-ordered-data/#390113ca1431.
---------------------------------------------------------------------------
The IRS, if need be working with Congress, should close this gap
and require crypto-exchanges lacking intermediated brokered access to
provide customers and the IRS with form 1099-B for their crypto and
other property transactions. In addition, the IRS should close gaps
with regard to requirements for taxpayers with offshore crypto-accounts
on filing a report of foreign bank and financial accounts (FBAR).\49\
This has been a gray area which could undermine tax compliance.\50\
---------------------------------------------------------------------------
\49\ Report of Foreign Bank and Financial Accounts (FBAR); IRS
https://www.irs.gov/businesses/small-businesses-self-employed/report-
of-foreign-bank-and-financial-accounts-fbar
\50\ Bitcoin, FBAR, and the Offshore Voluntary Disclosure Program:
A Primer for Expats; Greenback Expat Tax Services (March 22, 2018)
https://www.greenbacktaxservices.com/blog/expat-taxes-on-bitcoin-fbar/.
---------------------------------------------------------------------------
First Line of Defense--Money Transmission Laws
There is a widely held view amongst most policy officials globally
that we must guard against such threats--whether by state actors or
private-sector actors--though how best to do so has been up for debate.
The first line of defense has been through money transmission laws
and bank secrecy laws requiring compliance with anti-money laundering
(AML), combating financing of terrorism (CFT), and know your customer
(KYC) laws. The U.S. Treasury's Financial Crime Enforcement Network
(FinCEN) put out guidance on this regard starting in 2013 \51\ and most
recently in a letter to Congress.\52\
---------------------------------------------------------------------------
\51\ FIN-2013-G001; Application of FinCEN's Regulations to Persons
Administering, Exchanging, or Using Virtual Currencies; Department of
Treasury (March 18, 2013) https://www.fincen.gov/sites/default/files/
shared/FIN-2013-G001.pdf.
\52\ Letter to Senator Ron Wyden, FinCEN (February 13, 2018)
https://coincenter.org/files/2018-03/fincen-ico-letter-march-2018-coin-
center.pdf.
---------------------------------------------------------------------------
More could be done, though, directly overseeing the crypto-
ecosystem and at the intersections of the traditional financial
sectors, e.g., banking and payments networks, to perform KYC and to
minimize the risk of the illicit use of blockchain networks.
Crypto-Exchanges and Wallets--Critical Gateways
Crypto-exchanges and digital wallet companies, if properly
regulated, may provide one of the most critical gateways to protect
against such illicit transmissions of value. Both crypto-exchanges and
digital wallets provide customers the ability to store crypto-assets
and transact electronically. (Many provide fiat currency services as
well.)
This gateway to effect public policy is particularly important as
crypto-exchanges allow for direct public access. In contrast,
traditional securities and derivatives exchanges are accessed through
intermediaries such as banks, broker-dealers or futures commission
merchants (FCM), giving authorities important gateways to monitor and
enforce the law. Thus, in the crypto-world, tax authorities and
financial crimes enforcement will have to look to exchanges,
custodians, investors or blockchain forensics companies, for reporting
on crypto-transactions, taxable gains or losses, and any illicit
activity.
In the U.S., in the absence of Federal registration, crypto-
exchanges are required to comply with money transmission laws and to
register in each state according to those individual state laws. This
is a cumbersome and inconsistent process even for those well-meaning
companies seeking to comply. Few exchanges have done so in all
jurisdictions, raising questions of possible noncompliance. New York
State, through its BitLicense, has acted to bring exchanges within
enhanced money transmission laws.\53\ Federal registration and
oversight--through commodities and securities laws--would be a better
public policy solution than this current patchwork approach.
---------------------------------------------------------------------------
\53\ Department of Financial Services BitLicense Regulatory
Framework; New York State (June 24, 2015) https://www.dfs.ny.gov/legal/
regulations/bitlicense_reg_framework.htm.
---------------------------------------------------------------------------
Japan moved in 2017 to regulate crypto-exchanges primarily for
money transmission and their custodial duties. Korean authorities
banned exchanges from trading for anonymous accounts \54\ and
subsequently began investigating numerous exchanges for fraud and other
misconduct.
---------------------------------------------------------------------------
\54\ S Korea bans anonymous cryptocurrency trades; BBC News
(January 23, 2018) http://www.bbc.com/news/business-42784384.
---------------------------------------------------------------------------
As many jurisdictions around the globe, however, do not yet have
specific regulatory regimes governing crypto-exchanges it puts an even
greater burden on U.S. authorities, financial sector and laws. ``There
are significant challenges to investigating foreign virtual currency
businesses, because most jurisdictions do not regulate and supervise
virtual currency businesses,'' a Treasury official wrote in the letter
FinCEN sent to Congress in February 2018.
Decentralized Crypto-Exchanges--Challenges Ahead
Decentralized crypto-exchanges, still only a modest portion of the
crypto-markets, may present even greater challenges. These exchanges
provide for peer-to-peer trading based upon open-source algorithms with
no centralized platform and no custody of funds. Thus, decentralized
exchange protocols, might help provide a solution for the security of
customer funds, if they truly don't hold those digital assets. On the
other hand, though, they may pose additional challenges to authorities
trying to guard against illicit activities, particularly for crypto-to-
crypto trading.
If decentralized exchanges facilitate trading of fiat currency vs.
cryptocurrency, regulators might be able to implement policy by
restricting regulated intermediaries or their customers in transacting
with such platforms.
Ensuring for Financial Stability
It is important to ensure that blockchain technology,
cryptocurrencies and crypto-exchanges do not undermine financial
stability, in normal times or in stressful economic times.
Financial Stability Board--Initial Assessment
The Financial Stability Board (FSB), an international group that
makes recommendations about the global financial system, stated in its
open letter in March 2018 to the G20 heads of state, that ``The FSB's
initial assessment is that crypto-assets do not pose risks to global
financial stability at this time.'' \55\ They noted that even at their
peak earlier this year, the overall market value was less than 1% of
global GDP.
---------------------------------------------------------------------------
\55\ To G20 Finance Ministers and Central Bank Governors; Financial
Stability Board (March 13, 2018) http://www.fsb.org/wp-content/uploads/
P180318.pdf.
---------------------------------------------------------------------------
The current market value of all crypto-assets is approximately $250
billion relative to global equity markets of approximately $80 trillion
as of 2017 year-end \56\ and global debt outstanding as of March 31,
2018 of approximately $250 trillion.\57\ The world's 190,000 tons of
gold \58\ are worth about $7 trillion in aggregate at recent market
prices of $1,243 per ounce.
---------------------------------------------------------------------------
\56\ Market capitalization of listed domestic companies; The World
Bank (as of December 31, 2017) https://data.worldbank.org/indicator/
CM.MKT.LCAP.CD.
\57\ Global debt monitor; Institute of International Finance (July
9, 2018) https://www.iif.com/publication/global-debt-monitor/global-
debt-monitor-july-2018.
\58\ World Gold Council (as of July 13, 2018) https://www.gold.org/
about-gold/gold-supply/gold-mining/how-much-gold-has-been-mined.
---------------------------------------------------------------------------
The FSB noted, however, that their assessment could change if
crypto-finance became more interconnected with the core of the
regulated financial sector. In that regard, it is worthwhile to
consider three areas worthy of monitoring: (1) leverage in crypto-
markets; (2) market infrastructure blockchain initiatives; and (3)
central bank digital currencies.
Leverage in Crypto-Markets
Given the high volatility of crypto-assets, significant leverage
could add to instability and stress, particularly during down markets.
While Bitcoin futures listed at CME and CBOE require nearly 50% margin,
most crypto-exchanges allow for much lower margin (and thus higher
leverage) when trading Bitcoin and many other crypto-assets. BitMEX
provides 100:1 leverage (only 1% margin) for Bitcoin trading. Many
other exchanges allow offer leverage above 10:1.\59\ Furthermore, given
that many exchanges lack transparency and remain unregulated, it may be
challenging for central banks and others responsible for financial
stability to influence the amount of leverage in crypto-markets or get
an accurate window into these markets.
---------------------------------------------------------------------------
\59\ The Best Bitcoin and Cryptocurrency Trading Platforms;
BitReview (as of July 12, 2018) https://bitreview.com/trade/bitmex/.
---------------------------------------------------------------------------
Market Infrastructure--Blockchain Initiatives
Blockchain technology and other forms of distributed ledger
technology raise the possibility of replacing various centralized
market infrastructures. This could lower costs, limit counterparty
risks, promote innovation and economic inclusion. It may also lower the
systemic risks associated with centralized market infrastructures for
payments, clearing, settlement and other shared functions. Though
Bitcoin is now nearly 10 years old, these technologies are still
untested in any economy-wide (or even enterprise-wide) production. Any
widescale use of blockchain technology within the financial sector will
need to be considered in light of their potential resilience to various
risk vectors--economic, cyber, operating and otherwise.
Possibly most relevant to this Committee's work, there are efforts
underway to use blockchain smart contracts to help automate post trade
event management for uncleared swaps. The International Swaps and
Derivatives Association (ISDA) is working with Regnosys to produce a
digital version of ISDA's Common Domain Model for numerous swap
transaction and life cycle processes. The goal is to provide the market
with a standard set of digital definitions and smart contracts to
reduce costs and counterparty risk.\60\
---------------------------------------------------------------------------
\60\ ISDA Publishes Digital Iteration of the Common Domain Model;
ISDA (June 5, 2018) https://www.isda.org/2018/06/05/isda-publishes-
digital-iteration-of-the-common-domain-model/.
---------------------------------------------------------------------------
There are other clearing and settlement use cases of note, though
as stated, none are live at this time. The Depository Trust and
Clearing Corporation's (DTCC) has delayed its initiative, working with
IBM, to implement a permissioned blockchain for credit default swap
clearing and record keeping at its Trade Information Warehouse.\61\
Nasdaq, partnering with blockchain startup Chain, is experimenting with
a number of blockchain applications, including for clearing and
settlement for private securities transactions for non-listed
companies.\62\ Overseas, the most noted initiative is that of the
Australian Stock Exchange which announced last year that it would
replace its entire clearing and settlement infrastructure with a
permissioned distributed ledger-based solution developed by Digital
Asset Holdings.\63\
---------------------------------------------------------------------------
\61\ Enterprises Building Blockchain Confront Early Tech
Limitations; CoinDesk (March 23, 2018) https://www.coindesk.com/
enterprises-building-blockchain-confront-tech-limitations/.
\62\ Nasdaq Exec: Exchange Is `All-In' on Using Blockchain
Technology; TheStreet (April 23, 2018) https://www.thestreet.com/
investing/nasdaq-all-in-on-blockchain-technology-14551134.
\63\ CHESS Replacement, ASX is replacing CHESS with distributed
ledger technology (DLT) developed by Digital Asset; ASX (December 2017)
https://www.asx.com.au/services/chessreplacement.htm.
---------------------------------------------------------------------------
Central Bank Digital Currencies
Last, Bitcoin and cryptocurrencies has led to healthy debates
within the central banking and economics communities on the pros and
cons of central banks issuing retail central bank digital currencies
(CBDC) and if so, the effects that might have on payment systems and
the commercial banking system.\64\ Central banks already issue digital
currency, but only to commercial banks, in the form of bank reserves.
The public--merchants and consumers alike--can only access paper
currency or bank deposits. In the U.S. that is in the paper form is
Federal Reserve Notes.
---------------------------------------------------------------------------
\64\ Central bank digital currencies; Bank for International
Settlements, Committee on Payments and Market Infrastructures (March
2018) https://www.bis.org/cpmi/publ/d174.pdf.
---------------------------------------------------------------------------
The debate is whether to utilize blockchain technology to give
greater access to either central bank payment systems and/or reserves
to merchants or the wider public. In part this is being considered by
central banks in an effort to stay abreast of rapid changes in payment
methods and means of commerce, such as mobile payments, digital wallets
and in some countries, the decline in the use of paper notes. In
addition, central banks may find that they will be reacting to private-
sector initiatives to issue so-called `stable value' tokens designed to
have stable prices or values and tied to or backed by fiat currency.
Though stable value tokens to date, such as Tether, have had many
challenges, some observers think that such an effort has potential.\65\
---------------------------------------------------------------------------
\65\ Stable Coins Analysis: Is There A Viable Solution For The
Future?; Cointelegraph (May 14, 2018) https://cointelegraph.com/news/
stable-coins-analysis-is-there-a-viable-solution-for-the-future.
---------------------------------------------------------------------------
Thus, the question CBDC raises for financial stability is with
direct access to central bank digital currencies what portion of
consumer deposits would move away from commercial banks and what
effects would such migration have on lending and the overall economy?
Furthermore, in times of stress or financial uncertainty, the public
might move a significant portion of their money away from commercial
banks to the central bank, potentially aggravating instability in the
financial sector.
Protecting the Investing Public
As noted above, the $250 billion crypto-markets currently operate
largely outside of traditional investor protection norms. This is in
spite of the SEC repeatedly publishing advisories and making public
statements that most ICOs and the crypto-exchanges trading in such
tokens must comply with U.S. securities laws.
Thus, it is not surprising that the crypto-markets are now known
for high levels of fraud, scams and manipulative behavior. I will now
review the need for investor protection in each of the three segments
of the crypto-markets: (1) crypto-tokens--ICOs or issuer or based, (2)
crypto-derivatives[;] and (3) cryptocurrencies (aka crypto-cash
commodities). Following this, I will touch upon the critical need to
address crypto-custodial functions.
Crypto-Tokens--ICOs or Issuer-Based
The burgeoning market and the economic realities of ICOs or issuer-
based tokens has led to robust debates around the globe over the
appropriate regulations to apply to their issuance and trading. The
International Organization of Securities Commissions (IOSCO) board
expressed its concerns in a statement stating that: ``ICOs are highly
speculative investments in which investors are putting their entire
invested capital at risk. . . . the increased targeting of ICOs to
retail investors through online distribution channels . . .--raises
investor protection concerns. There have also been instances of fraud,
and as a result, investors are reminded to be very careful in deciding
whether to invest in ICOs.'' \66\
---------------------------------------------------------------------------
\66\ AIOSCO Board Communication on Concerns Related to Initial Coin
Offerings (ICOs); IOSCO (January 18, 2018) http://www.iosco.org/news/
pdf/IOSCONEWS485.pdf.
---------------------------------------------------------------------------
Individual countries' securities regulators have also been active
in releasing statements regarding ICOs, cryptocurrencies, and
exchanges. IOSCO lists statements from 40 countries regarding ICOs.\67\
---------------------------------------------------------------------------
\67\ Regulators' Statements on Initial Coin Offerings; IOSCO
https://www.iosco.org/publications/?subsection=ico-statements.
---------------------------------------------------------------------------
In the U.S., it is now the case that most ICO related tokens, and
the crypto-exchanges that list them must comply with securities laws.
Unfortunately, though, most are not yet doing so. The SEC's effort to
date has yet to bring this market into compliance.
We've already seen high levels of fraud and loss of funds in these
markets. Currently, a growing and potentially significant portion of
the capital markets--crypto-finance--is not benefiting from basic
investor protections.
When determining what is an investment contract under their
securities laws, Canada has a similar approach to that of the U.S.
Howey Test.\68\ Provincial regulators from Canada joined with state
regulators in the U.S. in May 2018, in a coordinated action against
ICOs named ``Operation Cryptosweep'' with nearly 70 open investigations
and 35 enforcement actions.\69\
---------------------------------------------------------------------------
\68\ CSA Staff Notice 46-307, Cryptocurrency Offerings; Ontario
Securities Commission (August 27, 2017) http://www.osc.gov.on.ca/en/
SecuritiesLaw_csa_20170824_cryptocurrency-offerings.htm.
\69\ State and Provincial Regulators in U.S. and Canada Target
Initial Coin Offerings; the Wall Street Journal (May 21, 2018) https://
www.wsj.com/articles/state-and-provincial-regulators-in-us-and-canada-
target-initial-coin-offerings-1526918512.
---------------------------------------------------------------------------
The SEC to date has used public advisory statements, speeches,
testimony and enforcement actions against some of the most obvious
offenders but has a great deal of work ahead of them to bring the
issuer-based crypto-market into compliance.
The SEC's Director of the Division of Corporate Finance, William
Hinman, sought to give additional direction in a speech on June 14,
2018. He noted that ``a digital asset transaction may no longer
represent a security offering [where] 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.'' In explaining that
decentralization may reduce information asymmetries, he said: ``[W]hen
the efforts of the third party are no longer a key factor for
determining the enterprise's success, material information asymmetries
recede.'' Moreover, ``[a]s a network becomes truly decentralized, the
ability to identify an issuer or promoter to make the requisite
disclosures becomes difficult, and less meaningful.'' \70\
---------------------------------------------------------------------------
\70\ Digital Asset Transactions: When Howey Met Gary (Plastic);
William Hinman, SEC (June 14, 2018) https://www.sec.gov/news/speech/
speech-hinman-061418.
---------------------------------------------------------------------------
While the number of ICOs being sold under exempt securities
offerings (i.e., Reg D filings) is increasing, many ICOs are still
sidestepping these requirements. Furthermore, while there are reports
that a number of crypto-exchanges are in discussions with the SEC about
registering as broker dealers and complying with Reg ATS, none have yet
fully done so. That means that these exchanges are currently likely
operating in the breach.
To bring greater clarity to these markets, the SEC must also
determine how best to bring into compliance the over 1000 ICOs and
numerous crypto-exchanges still in operation in the U.S. What
remediation and possible penalties are appropriate? One petitioner
recommended retroactive registration along with investor rescission
rights. Some requirements, such as satisfying requirements to track
beneficial ownership may be difficult for these past ICOs.
Another challenge is that though SEC Chair Clayton has been clear
that nearly all of the ICO market need comply with securities laws,
until more enforcement actions are brought, potentially litigated and
upheld in court, many issuers and exchanges will possibly continue to
skirt their obligations. As the SEC stated in its Munchee Order, it
will take more than semantics and more than a token being functional on
a network to be exempt from securities regulation.\71\
---------------------------------------------------------------------------
\71\ Order Instituting Cease-and-desist Proceedings Pursuant to
Section 8A of the Securities Act of 1933, making Findings, and Imposing
a Cease-and-desist Order (Release No. 10445) (December 11, 2017)
https://www.sec.gov/litigation/admin/2017/33-10445.pdf.
---------------------------------------------------------------------------
The crypto-markets have gotten some clarity with the SEC stating
that the two largest coins, Bitcoin and Ether are not currently
securities. There are strong cases to be made, though, that a number of
the other large market cap tokens are noncompliant securities. If large
market cap tokens, such as XRP (sold by Ripple) or EOS (sold by
Block.one), are concluded to be non-compliant securities--there are
strong arguments that they pass the Howey Test and are--exchanges
offering trading in these tokens will need to comply with SEC
regulatory requirements or cease offering these products.
Also, the SEC will need to decide if they might issue rules and
interpretations specific to the crypto-space. To date, they have chosen
not to do so, but with the advent of the Internet and electronic
trading in the 1990s, the SEC issued a number of new regulations for
those novel market developments. A similar approach could be adopted
here.
Crypto-Derivatives
If an exchange offers derivatives on cryptocurrencies, then that
exchange must register with the CFTC either as a DCM or as a SEF.
Exchanges that offer leverage or margin for the purchase of
cryptocurrencies may come under the definition of offering `retail
commodity transactions' and thus also be required to register.
The CFTC has yet to finalize a proposed interpretation that may
help determine the breadth of crypto-exchanges that will need to
register.\72\ Under the CEA, the CFTC has jurisdiction over any retail
commodity transaction entered into on a leveraged or margined basis
that does not result in actual delivery of the underlying commodity
within 28 days. Under a proposed CFTC interpretation, ``actual
delivery'' occurs if within 28 days of execution, only if a full
transfer of the cryptocurrency is transferred between the seller and
buyer as recorded on the relevant blockchain (not merely on the
exchange's data base or wallet), whether it is reflected on the
recipient's private wallet and whether the recipient has control of the
private key.
---------------------------------------------------------------------------
\72\ Retail Commodity Transactions Involving Virtual Currency--80
FR 60335.
---------------------------------------------------------------------------
Given how crypto-exchanges' transactions are currently being
conducted for levered or margined cryptocurrency, many exchanges may be
holding cryptocurrencies for retail customers that do not satisfy the
``actual delivery'' exemption. These crypto-exchanges therefore might
be offering trading of a form of a retail commodity transaction subject
to CFTC regulations.
Thus, the CFTC's final interpretation with regard to the definition
of `actual delivery' will be important. At one end--nearly all of the
crypto-exchanges offering margin to the retail public would need
register with the CFTC. At the other end for the final interpretation--
gaps in crypto-exchange market integrity and custodial duties oversight
will persist.
The CFTC issued an advisory in May 2018 with respect to crypto-
derivatives listings. The CFTC staff expressed guidance on enhanced
procedures for exchanges and clearinghouses listing derivatives
contracts on virtual currency. These enhancements include an
expectation that exchanges, and clearinghouses enter into information
sharing arrangements with the underlying crypto-spot market(s).\73\
---------------------------------------------------------------------------
\73\ CFTC Staff Advisory No. 18-14 (May 21, 2018).
---------------------------------------------------------------------------
Another challenge for regulators is that blockchain technology
provides for new algorithmic means to structure binary options and
contracts for differences, all of which are derivatives under the
jurisdiction of the CFTC. The bitcoin scripting language and smart
contracts used on other networks provide ways to structure peer-to-peer
derivatives which execute and settle automatically based upon pre-
arranged conditions. These blockchain based derivatives could reference
any commodity--agricultural, metals, energy or financial. The CFTC and
other regulators will want to ensure that this new technology does not
presage a new and growing unregulated or dark swaps market.
Cryptocurrencies (aka Crypto-Cash Commodities)
Gaps in investor protection also have developed for crypto-
exchanges solely trading cash cryptocurrencies. As previously
discussed, crypto-exchanges currently have limited guardrails against
front running, fraud, or other manipulative practices. There have been
repeated reports of manipulative behavior on these exchanges. There
have been repeated reports of stolen customer funds through cyber
hacks. As mentioned, the FIA expressed its apprehension about the lack
of transparency and regulation of the crypto-cash commodities markets
underlying Bitcoin futures.
Currently nearly 70% of the crypto-markets' $250 billion total
capitalization is represented by the five cryptocurrencies which have
either been designated by the SEC as not securities (Bitcoin and Ether)
\74\ or were forks off of Bitcoin or Ether (Bitcoin Cash in 2017,
Litecoin in 2011, Ethereum Classic in 2016).
---------------------------------------------------------------------------
\74\ Digital Asset Transactions: When Howey Met Gary (Plastic);
William Hinman, SEC (June 14, 2018) https://www.sec.gov/news/speech/
speech-hinman-061418.
---------------------------------------------------------------------------
The CFTC has general anti-fraud and anti-manipulation authorities
with regard to spot transactions in these crypto-cash commodities, such
as Bitcoin or Ether. This authority is critical for cryptocurrencies
referenced in the derivatives markets but may be increasingly important
as well for retail investors in crypto-cash commodities. The agency,
though, does not currently have express registration or plenary rule
writing authorities with regard to cash commodities.
One troubling recent development highlights the need for such
authorities. The CME was unable to get underlying transaction data from
the four crypto-exchanges upon which they rely for the Bitcoin index
referenced by their Bitcoin futures contract. It's been reported that
these four exchanges (Bitstamp, Coinbase, Itbit, and Kraken) refused to
provide the data until the CFTC stepped in with subpoenas.\75\ It is
critical to the functioning of any crypto-derivatives markets that both
self-regulatory organizations and government regulators have ready
access to trading data for the underlying referenced crypto-cash
commodities.
---------------------------------------------------------------------------
\75\ What Do We Know About the CFTC Price Manipulation Probe;
Cointelegraph (June 15, 2018) https://cointelegraph.com/news/what-do-
we-know-about-the-cftc-price-manipulation-probe.
---------------------------------------------------------------------------
The SEC is grabbling with similar issues with regard to its review
of possible crypto-related ETFs and crypto-investing by mutual funds.
The SEC has rejected a number of filings for Bitcoin ETFs, starting
with the Winklevoss Bitcoin Trust (COIN ETF) in March 2017. The SEC
stated two requirements that the exchanges had not must satisfied in
order to list a Bitcoin ETF: ``the exchange must have surveillance-
sharing agreements with significant markets for trading the underlying
commodity or derivatives on that commodity. And second, those markets
must be regulated.'' It further cited ``concerns about the potential
for fraudulent or manipulative acts and practices in this market.''
\76\
---------------------------------------------------------------------------
\76\ SEC Release No. 34-80206; File No. SR-BatsBZX-2016-30; March
10, 2017 https://www.sec.gov/rules/sro/batsbzx/2017/34-80206.pdf.
---------------------------------------------------------------------------
In a subsequent staff letter published in January 2018, the SEC
raised a series of questions regarding, amongst other things,
appropriate valuation methods available for crypto-assets, liquidity of
crypto-markets, custody of crypto-funds and potential manipulation in
these markets.\77\
---------------------------------------------------------------------------
\77\ Staff Letter: Engaging on Fund Innovation and Cryptocurrency-
related Holdings; SEC (January 18, 2018) https://www.sec.gov/divisions/
investment/noaction/2018/cryptocurrency-011818.htm.
---------------------------------------------------------------------------
Failing to better oversee the crypto-cash commodities markets also
leaves investors vulnerable, illicit activity hard to control and
custodial responsibilities to vagaries of state enforcement of money
transmitter laws. The volumes, millions of customers, repeated hacks
and reports of manipulative behavior, suggest that oversight of crypto-
exchanges trading solely in crypto-cash commodities is worthy of
consideration.
Furthermore, as the CFTC staff discussed in their recent advisory,
there are differences between crypto-cash commodities and other
commodities. They said:
``To date, virtual currencies have gained prominence as they
are bought and sold for investment, speculative, or financial
purposes. Those transactions greatly predominate over
commercial uses of virtual currency--such as to purchase goods
and services--which are still developing. Thus, virtual
currencies differ from commodities like oil and gold where
commercial uses predominate or at least provide points of
comparison. At the same time, virtual currencies differ from
financial indices and other commodities for which robustly-
regulated markets facilitate price verification and provide
insight into the reasons for price changes.'' \78\
---------------------------------------------------------------------------
\78\ CFTC Staff Advisory No. 18-14 (May 21, 2018).
Gemini Trust Company (Gemini), the crypto-exchange founded by
Cameron and Tyler Winklevoss, recently proposed setting up a self-
regulatory organization (SRO) for crypto-exchanges dealing in crypto-
cash commodities or what they call `virtual commodities.' In the medium
post calling for the SRO, Cameron and Tyler Winklevoss articulate a
view that virtual commodities should have an additional layer of
oversight beyond that which other cash commodities have stating: ``Cash
markets for virtual commodities, however, are unique inasmuch as: (a)
the commercial use-cases for virtual commodities are still developing,
(b) there is strong speculative interest, (c) these marketplaces
involve a large number of individual participants, and (d) technology
makes individual transaction costs exceptionally low (on a relative
basis) as compared to other physical commodity spot markets.'' \79\
---------------------------------------------------------------------------
\79\ Proposal for a Self-Regulatory Organization for the U.S.
Virtual Currency Industry; Cameron Winklevoss (March 12, 2018) https://
medium.com/gemini/a-proposal-for-a-self-regulatory-organization-for-
the-u-s-virtual-currency-industry-79e4d7891cfc.
---------------------------------------------------------------------------
It is a logic for additional oversight of crypto-cash commodities
somewhat consistent with the recent CFTC staff advisory discussion.
Though the logic is directional sound, I believe that a Federal
oversight regime is appropriate if we are to achieve the public policy
goals for crypto-exchanges of guarding against illicit activity,
ensuring stability, protecting investors and promoting market
integrity, with SROs playing an important supportive role as they do in
securities and derivatives markets.
Given frauds and other concerns in the retail foreign exchange
markets, Congress, in the 2008 Farm bill, included provisions for the
first time for CFTC registration and regulation of retail foreign
exchange dealers (RFEDs). Similarly, the CFTC and Congress might wish
to consider allowing retail cryptocurrency exchanges to register as
RFEDs, though cryptocurrencies are not foreign currency, and while
ensuring that cryptocurrencies remain distinct from fiat currencies for
other parts of the commodities law.
Or Congress may wish to consider if it would be more appropriate to
provide the CFTC--or another agency--with general authorities to write
rules for crypto-cash commodities markets, including possibly requiring
registration for trading on crypto-exchanges solely dealing in
cryptocurrencies, aka crypto-cash commodities.
Custodial Functions
The Wall Street Journal reported this week: ``Regulatory gaps and
insufficient levels of defense have made some exchanges simple to
breach.'' \80\ Seven hacks to date in 2018 have led to $800 million in
customer funds being stolen from crypto-exchanges. Over $1.6 billion
has been stolen in 56 reported hacks since 2011. No doubt, more has
been lost to unreported thefts and cyber-attacks.
---------------------------------------------------------------------------
\80\ Cryptocurrency Exchanges Are Getting Hacked Because It's Easy;
Wall Street Journal (July 16, 2018) https://www.wsj.com/articles/why-
cryptocurrency-exchange-hacks-keep-happening-1531656000.
---------------------------------------------------------------------------
Though Bitcoin and many blockchains themselves have been generally
resistant to hacks, with the integrity of their ledgers preserved,
there are significant weaknesses in other areas and layers within the
crypto-ecosystem.
Unlike traditional exchanges, crypto-exchanges hold significant
customer funds in digital wallets--a state of affairs that directly
contradicts the principles of decentralized user-based control of
digital assets upon which Bitcoin was initially built. The aggregate of
these customer crypto-assets is then represented on a particular
token's blockchain associated with the public keys of the exchange, not
the individual customers. As mentioned previously, Coinbase reports to
have custody of over $20 billion in customer crypto-funds.
In contrast, customers trading on traditional securities exchanges
with intermediated access have their securities recorded at a transfer
agent, and held by a broker or dealer, not the exchange. Customers
trading on derivatives platforms, have their trades recorded and margin
posted at regulated clearing houses and FCMs.
Exchanges are exploring whether new approaches, such as multi-
signature wallets, might aid in protecting the security of customer
funds.\81\ But for now, the existing system is operating with a glaring
gap in investor protection. With well over 90% of daily trading volume
in Bitcoin occurring through crypto-exchanges rather than being
recorded as a transaction directly within the blockchain, and with the
public accessing these exchanges without the benefit of regulated
intermediaries, it is critical to put in place Federal requirements for
the custody of crypto-assets.
---------------------------------------------------------------------------
\81\ The sad state of crypto custody; Techcrunch (February 1, 2018)
https://techcrunch.com/2018/02/01/the-sad-state-of-crypto-custody/.
---------------------------------------------------------------------------
In the U.S. to date, the only regulatory safeguards have been
through state-administered money transmission regulations. This
approach--regulating exchanges' custodial duties in the same manner
that Western Union and MoneyGram are regulated--is not satisfactory.
In some countries, particularly Japan, authorities have required
crypto-exchanges to register and meet certain custodial duties to
protect customer funds stored in an exchange's digital wallets.
The public policy goals should be the same, whether the asset is
crypto in nature or a more traditional security or derivative.
Exchanges should fully segregate customer funds and ensure that they
not lose those funds and not use those funds.
When considering existing custodial rules, the specifics of
blockchain technology, public keys and cryptography will need to be
considered. New technologies, such as multi-signature controls might
protect customers or fulfill certain custodial responsibilities. Added
safeguards, need be considered for the private keys associated with
exchanges', asset managers', banks' or regulated intermediaries' public
keys. Additional cyber-security and other safeguards might be
appropriate, particularly given the numerous losses and hacks that have
occurred in the past.
Conclusion
In conclusion, blockchain technology has a real potential to
transform the world of finance. Though there are many technical and
commercial challenges yet to overcome, I'm an optimist and want to see
this new technology succeed. It could lower costs, risks and economic
rents in the financial system.
For broad adoption--both as a technology solution and as part of
the capital markets--the technology and its various applications need
to come within existing public policy frameworks. Basic norms and
principles to guard against illicit activity, ensure for financial
stability, and protect investors and market integrity, while promoting
innovation, should consistently guide public policy.
Clear rules of the road also will allow firms--both incumbents and
start-ups--to more fully explore investing in crypto-assets or
blockchain technology. Today, start-ups have an advantage as incumbents
do not take the same reputational and regulatory risks that startups
generally are willing to take. Startups, so to speak, are more willing
to beg for forgiveness while incumbents more often need ask for
permission.
Bringing clarity and compliance will have its challenges. There are
numerous crypto-exchanges and thousands of ICO launched tokens in
significant non-compliance. Congress and this Committee have a role to
play as well, monitoring developments, overseeing compliance, and, when
appropriate, updating laws. It also will be critical that sufficient
resources be provided the CFTC, SEC and other agencies to adequately
oversee crypto-markets, especially as these markets have continued to
grow.
Market participants, the investing public, entrepreneurs,
technology developers, regulators and Congress all will play a role. In
particular, crypto-exchanges and ICOs should now seek to comply with
the law to fullest extent possible.
The public, blockchain technology, and the financial system will
all reap the benefits.
Thank you again for inviting me today, and I look forward to your
questions.
The Chairman. Thanks, Mr. Gensler.
Mr. Ness, 5 minutes.
STATEMENT OF LOWELL D. NESS, J.D., MANAGING PARTNER, PALO ALTO
OFFICE, PERKINS COIE LLP, PALO ALTO, CA
Mr. Ness. Thank you all for inviting me to testify this
morning.
I certainly agree with everybody that has gone before me
that this technology does have the potential to be
transformative.
One of the questions I get asked a lot is why don't we just
call these things securities? We have securities regulations.
We could create a scenario where these things get registered
and then become freely tradable, so why not just call them
securities, deal with the existing laws? The problem with that
is they exhibit some characteristics of securities during
certain phases and not in others; especially when we get to
full functionality when it is a truly completed product that is
being sold, the intention of that product is to be used in a
network, and that really can't happen--at least not at the
speed of software, which is really the fundamental principle
here behind these decentralized protocols is to allow for value
transfers truly at the speed of software. You can't do that if
everybody has to be a broker-dealer and all the intermediaries
have to interact in a way that would be appropriate for
securities.
We need to come up with a fairly novel and pragmatic
approach to dealing with the fact that there needs to be some
investor protections, particularly in the early stages while
the things are a PowerPoint deck and an idea in somebody's
mind. But find ways to create some clarity around how and when
it goes from being sold as a security to being sold as a
commodity. And that is a very important imperative right now
because we are seeing so much activity, frankly, and the threat
of people going offshore for lack of clarity is a very real
one.
I will say in my 25 years in Silicon Valley, I have not
seen circumstances where you go to a meet-up in places like
Palo Alto or even San Jose and you see regulators from Zug,
Switzerland; Singapore; Hong Kong; and Bermuda et cetera. To
avoid any kind of race to the bottom, I do think that there is
a serious imperative about getting something done before we
have a situation where we are trying to entice people back into
the country, because then the standards would really have to be
lowered to do that. I think we have an opportunity now if we
get ahead of the true flight, but that is an important idea
around why we need some of the bright lines.
To that end, I did in some of my written testimony include
some materials and a proposed regulatory framework that both
talk about what the existing laws and how the existing laws
treat these so-called utility tokens, and there is a 50-page
memo on how the existing laws work. To avoid having to go
through that 50-page memo type analysis with each and every one
of these, I think the bright lines are really what is
necessary.
There is a regulatory framework that we have been thinking
a lot about how that would create that set of bright lines that
would enable the regulators and the companies going out there
to really know how to sort the good ones from the bad ones. I
do think that starts with this test around how we in the
investment contract analysis for regulating securities as
securities in the primary offering, if they are being sold pre-
functional--before they are fully functional. But coming up
with ways to say that once they are fully functional, how do we
let them now trade as commodities effectively, and the trading
is important because as I said, this is the movement of value.
To have value, it needs a price and the markets really are a
necessary part of this. The fact that there are secondary
markets is a key part of this. They need to be able to trade in
those markets to establish price. They also need to be able to
be used in their networks as non-securities, and so we need to
come up with ways to say when they are being sold to investors
as investments, let's treat them like securities. When they are
being used in the network or they are being traded in the
secondary markets, let's call them commodities.
Thank you.
[The prepared statement of Mr. Ness follows:]
Prepared Statement of Lowell D. Ness, J.D., Managing Partner, Palo Alto
Office, Perkins Coie LLP, Palo Alto, CA
U.S. Regulatory Framework for Digital Assets
Introduction
We support the regulatory mission of investor protection and full
and fair disclosure. We also support aggressively dealing with
fraudulent actors in the blockchain technology industry. We believe it
is essential to both market participants and the regulatory community
that bad actors are dealt with through targeted strikes and regulatory
action. We also believe it is equally essential to provide clear
guidance beyond enforcement actions to allow continued development and
innovation around what many believe to be potentially transformational
technology development. It is in that spirit that we welcome this
engagement with the regulatory community toward defining a regulatory
framework that best addresses market participant protection and
continued growth and development of blockchain technologies.
Blockchain technology (also called ``distributed ledger
technology'') allows the creation of a software ledger that is
distributed, meaning many copies of the ledger exist and are
automatically kept in sync such that no one actor can alter the ledger
without employing a defined consensus mechanism among the actors. This
technology allows assets to be traded on a ledger that is not
maintained by a centralized ``trusted'' actor. Blockchain technology
allows ledger transactions to occur immediately, immutably and
transparently, without the need for reconciliation of multiple
proprietary ledgers. This is, arguably, the most fundamental change to
ledger technology since double-entry accounting. Double-entry
accounting helped trading counterparties trust each other. Blockchain
technology removes the need for centralized trusted intermediaries to
act as the go between for trading counterparties. While the Internet
enables the free flow of information, blockchain technology enables the
free flow of value. More specifically, blockchain technology enables
the creation of many types of digital assets, including digital
currencies, digital goods and services, software tokens and digital
securities (e.g., tokenized debt or equity).
This memorandum addresses the regulatory framework for the
application of U.S. securities laws and commodities laws to these
various types of digital assets, with a focus on the treatment of
utility tokens. Tokenized goods and services are non-fungible tokens
that are merely intended to represent specific goods or services, so
their regulatory status should simply follow from the regulatory status
of the good or service they represent. Other digital assets require
somewhat more complicated analysis to determine their regulatory
status.
Digital Currencies, Digital Securities & Utility Tokens
At one end of the spectrum, digital currencies are fungible tokens
that have no other marketed functionality than use as a medium of
exchange or stored value. These types of tokens (e.g., Bitcoin) are
subject to various U.S. Federal and state as well as foreign money
transmission laws, are treated as property under U.S. tax laws, and are
treated as commodities under U.S. commodities laws. Offers and sales of
digital currencies should not be viewed as securities under the Howey
test, absent unusual facts (such as promising efforts to maintain
secondary market liquidity or token architectural features like burning
tokens intended to reduce supply and increase the value).
At the other end of the spectrum, digital securities are tokenized
traditional securities (e.g., debt or equity) or investment contract
type securities that offer a direct financial return from an
identifiable issuer. These types of tokens would clearly be securities
and would generally not be subject to commodities laws or money
transmission laws per se.
Utility tokens are intended to be used by users of a software
network and do not represent an equity interest (or any other corporate
obligation), but they do attract speculative resellers, which
implicates the Howey test. The Howey case law is highly nuanced and,
therefore, challenging to interpret, leading to uncertainty. As a
general matter, U.S. Federal securities laws were developed and have
evolved primarily for and around equity securities (and other corporate
obligations). There is much less clarity around investment contract
type securities, particularly investment contract type securities that
offer no direct financial return, but nevertheless enjoy robust
secondary markets.
The Howey test requires a reasonable expectation of profits. A
purchaser may be led to expect profits either from a direct financial
return (e.g., an ownership interest in a business or a promise of
payment) or from a rising price in secondary markets. Ordinarily, if
there is no direct financial return, and the object being sold has
never been sold before, there would be no reasonable expectation of
profits. This is because a reasonable purchaser would not expect a
novel product to have any secondary market liquidity. The fact that
every team, every time, seems to be able to general an immediate
secondary market for its newly minted utility token, is astonishing,
but has become a fact of life. At this point, the expectation of
profits from secondary market activity has become a given. It would be
difficult to point to another phenomenon where this was the case. This
is the first factor in the utility token analysis that is arguably
unique.
An expectation of profits is not, however, sufficient to form an
investment contract. The expectation of profits must be based on the
efforts of others. Most investment contracts, including Howey itself,
involve the promise of direct financial returns. When a promoter offers
a financial return to the purchaser, the efforts of others continue for
the life of the financial return, which would mean indefinitely in the
case of an ownership interest in a going concern. When no direct
financial return is offered, however, and the only expectation of
profits comes from the hope of a rise in price in secondary markets,
the efforts of the promoter are only relevant so long as the product is
being developed by the promoter. This temporal qualification is the
second factor in the utility token analysis that is unique and leads to
the concept of mutability, discussed in our memorandum to the SEC dated
March 26, 2018 regarding the Investment Contract Analysis of Utility
Tokens. As discussed in that memorandum, the token itself is never a
security, but the facts and circumstances surrounding the sale of the
token likely constitute an investment contract while the token is in
the development stage because the buyer's expectation of profits are
based on the seller's efforts to complete development of the token.
Once the token has been fully developed and the facts and circumstances
no longer support an investment contract conclusion, the offer and sale
of the token should be treated as the sale of any other commodity
trading in spot markets. As a result, under the Howey test, token sale
agreements could constitute investment contracts under some
circumstances but not others.
Some would prefer to resist the implications of mutability by
simply treating all tokens as securities forever. Treating all tokens
as immutable securities, however, (i) would not be analytically
consistent with existing law and (ii) would not allow tokens to be used
for their intended purpose--access to products and services on a
network, which would inevitably cause development to relocate
abroad.\1\ China, whose securities laws arguably are not as nuanced,
took a binary approach to regulation and banned all token sales in
China instead of adopting tailored protections that would enable the
development of the technology to continue in China. We believe the law
and guidance around what constitutes an investment contract should be
clarified. We believe that the industry's and the regulators' interests
are aligned in establishing clear rules and appropriate investor
protections so that capital formation in blockchain technology is not
derailed and development can continue to flourish in the United States.
---------------------------------------------------------------------------
\1\ For example, a social network that uses a token as a micro
payment for a micro task like submitting a blog post, would be engaged
in the unregistered and, presumably, non-exempt sale of a security if
the token were a security.
---------------------------------------------------------------------------
Proposed Regulatory Framework for Utility Tokens
To remedy the uncertainty and confusion in this space, we are part
of a group of academics, venture capital firms and law firms practicing
in this area that has proposed the following regulatory framework to
serve as the basis for a more detailed non-exclusive safe harbor that
would help provide guidance to the industry on what constitutes an
``investment contract'' and how the investment contract law and
guidance should apply to utility tokens with respect to primary sales,
resales and use of the tokens for their intended purposes. Similar to
the steps the SEC took by putting in place Regulation D, a non-
exclusive safe harbor to address the uncertainty caused by SEC v.
Ralston Purina in the private placement arena, we believe the proposed
framework outlined below could be codified in a no-action letter or
series of no-action letters that could ultimately lead to a rulemaking
around a safe harbor that will assist in relieving the regulatory
uncertainty around utility tokens. The goals of the proposed framework
are to (i) establish clarity for the industry, (ii) permit use of
tokens for their intended purposes (i.e., on their software platform)
and (iii) establish appropriate investor protections for both primary
sales and resales of tokens, with emphasis on eliminating trading
manipulation.
The industry's need for clarity is obvious. Currently, the vast
majority of token sales are smaller token sales that have not been
reviewed by counsel or that are merely attempting to follow precedent
transactions in a highly nuanced area with varying models and no bright
line rules. The regulators would also benefit from clarity. The
proposed framework would require affirmative consent to jurisdiction,
which has been challenging in light of the global and distributed
nature of token sales. The proposed framework allows regulators to (i)
define the contours of jurisdiction (and therefore responsibility),
(ii) avoid the incongruent result of defining all tokens as securities
(while tokens have security-like characteristics at one stage, the
regulatory scheme must also permit use of tokens for their intended
purposes) and (iii) provide an efficient structure for continued
capital formation.
The proposed framework is largely based on the application of
existing case law and regulatory principles, such as Rule 144 and Rule
701, to tokens, but proposes bright lines to clarify existing case law
and regulation in a way that is practical and useful for all
constituents. The proposed framework has been vetted by, and has the
support of, many of the key players in the industry. We believe the
proposed framework works well from the perspective of both industry and
the regulators by balancing market participant protections and capital
formation.
In general, offers and sales of tokens meeting the specified
conditions would not be deemed securities transactions (except for
purposes of application of general anti-fraud and manipulation rules,
such as Rule 10b-5) once the tokens have achieved either full
functionality or full decentralization (as described below) and may be
exchanged as non-securities in secondary markets subject to the general
anti-fraud and manipulation rules of each of the CFTC and the SEC.
Token sellers would, however, impose certain investor protection
requirements tailored to each stage. The no-action letter(s) and any
eventual safe harbor would be non-exclusive as there will be tokens
clearly purchased for consumptive purposes, such as non-fungible
tokenized goods and services. The principles of the proposed framework
are as follows:
Pre-Functionality--Until the token achieves full functionality,
offers and sales of tokens would generally constitute investment
contract type securities under Howey, unless a reasonable purchaser is
purchasing with consumptive intent.\2\ In this case, the token should
generally be treated as a security unless use of the token (as opposed
to resale) is reasonably certain. As such, this stage would include the
following features:
---------------------------------------------------------------------------
\2\ Consumptive intent, as opposed to investment intent, would
generally be established if the purchaser is only able to use the token
for its intended purpose and is not able to resell the token for
profit. The existence of consumptive intent was a key determinant, for
example, in United Housing Foundation, Inc. v. Forman, 421 U.S. 837
(1975).
---------------------------------------------------------------------------
Primary sales--Existing securities laws would apply to primary
sales of the token. Primary token sale agreements would continue to be
generally treated as securities based on the investment contract
analysis under Howey. Primary sellers of tokens would be able to rely
on available exemptions from registration (e.g., Rule 506(b), Rule
506(c), Regulation S, Rule 701) and the SEC would retain full
regulatory authority to enforce violations under existing Federal
securities laws.
Resales--Any resales or assignments of the primary token purchase
agreement, which is the security under Howey, by purchasers or
affiliates of the token creator would also need to rely on existing
resale exemptions under the securities laws. Resales of the token would
also be subject to the special resale lockup and resale volume
restrictions described below.
Use for Intended Purpose--Tokens would be able to be earned or used
as intended through the network, so long as either (i) resale is not
possible,\3\ or (ii) the network on which the tokens can be used will
be shut down within some reasonably finite period, say 6 months (i.e.,
these are testnet tokens that have no resale value).
---------------------------------------------------------------------------
\3\ During this stage of token development, we believe that resale
should either be extremely unlikely (i.e., in the case of testnet
tokens) or effectively impossible. More practical (i.e., less
stringent) resale lockup mechanics may be more appropriate for tokens
that achieve full functionality.
---------------------------------------------------------------------------
Full Functionality--Once the token achieves full functionality,
offers and sales of tokens would generally not constitute investment
contracts under Howey. Software networks, however, generally require
ongoing updates and upgrades, so it may be appropriate to create
limited but ongoing investor protections.\4\ As such, this stage would
include the following features:
---------------------------------------------------------------------------
\4\ Ongoing software updates and upgrades constitute ongoing
efforts of others under Howey, but they are not likely to rise to the
requisite level of efforts to form an investment contract. The case law
is particularly challenging to apply to the facts in this area, which
makes it difficult to determine whether investor protections should
apply. Nevertheless, we believe that limited ongoing investor
protections, even at this stage of token functionality, are essential
in ensuring that capital raising is not derailed in this industry by
pump and dump or get rich quick schemes taking advantage of immediate
liquidity in secondary trading markets for tokens.
---------------------------------------------------------------------------
Primary Sales--Primary sales of tokens below the Per Purchaser
Limit (described below) would be able to be made without being subject
to lockup or volume restrictions. Larger purchasers, however, would
need to be accredited investors and are subject to the special resale
lockup and resale volume restrictions described below. Tokens would be
able to be gifted or otherwise distributed to users, service providers,
strategic partners and other participants without an exchange of money,
including mining, also without being subject to lockup or volume
restrictions.\5\
---------------------------------------------------------------------------
\5\ For equity securities, we would typically consider many of
these non-monetary issuances of stock to be ``sales.'' For tokens,
there are strong policy objectives around bolstering the use of the
tokens for their intended purposes. As such, non-monetary transfers of
tokens for the purpose of seeding potential users to drive network
adoption or for purposes otherwise related to the token's usage should
be permitted. To the extent a so-called ``airdrop'' is announced in
advance as a way to drive up the trading price of the token associated
with the blockchain on which a new token is being airdropped, we would
consider this a marketing practice inconsistent with the safe harbor.
---------------------------------------------------------------------------
Resales--Tokens would be able to be traded on exchanges or resale
platforms as non-securities, other than for purposes of the general
anti-fraud and manipulation rules, such as Rule 10b-5.\6\
---------------------------------------------------------------------------
\6\ There are many variations in the market on token trading
platforms, from true peer-to-peer to decentralized exchanges that
provide information supporting peer-to-peer trading or, in some cases,
matching engines, but that do not take custody of tokens, to hosted-
wallet exchanges running full services as an exchange. How to handle
exchanges and the mechanics of our proposal will need significant
further discussion with the Staff. We do not believe, however, that it
would be appropriate to require all exchanges trading fully functional
tokens to be registered as Alternative Trading Systems. We believe it
is essential to apply general anti-fraud and manipulation rules to
these open exchanges, but it would be counterproductive to treat them
as ATS's with inapposite rules developed around equity securities and
other corporate obligations.
---------------------------------------------------------------------------
Use for Intended Purpose--The token would be able to be earned or
used on the network for its intended purpose (i.e., on their software
platform) without being subject to lockup or volume restrictions.
Full Decentralization (Protocol Tokens) \7\--If a token achieves
full decentralization (not all will), the token would fall entirely
outside of Howey since there is no longer an issuer or promoter
delivering ongoing software updates or upgrades that could potentially
constitute the requisite efforts of others under Howey. As such, a
token that achieves full decentralization would be not be deemed a
security for any purposes other than the general anti-fraud and
manipulation rules, such as Rule 10b-5.
---------------------------------------------------------------------------
\7\ ETH is a good example of this type of protocol token that has
become so decentralized it should not be deemed a security. For
clarity, ETH is the protocol token for the Ethereum network, so this
safe harbor provision would apply to ETH, but not necessarily to all
ERC20 tokens running on top of the Ethereum network unless an ERC20
token is itself a protocol token. Also, for clarity, a protocol token
may qualify as a token with full functionality irrespective of whether
it has achieved full decentralization.
---------------------------------------------------------------------------
Key Defined Terms
Full Functionality--A token achieves full functionality when a
token holder can use the token for its intended purpose (marketing
test), or a token holder can use the token in some meaningful way
(qualitative use test), or the network in which the token is to be used
is fully functional in accordance with its whitepaper (operational
test), or the token's consensus mechanism is working and blocks are
being published (layer 1 protocol token test). The foregoing are
examples of functionality criteria, but there may be other indicia of
functionality that require further discussion in the context of a
specific no-action letter. Protocol tokens (i.e., tokens that allow
other developers to build application tokens on top of the protocol
token network) should be deemed to have immediate full functionality
when the protocol tokens can be used for their intended purpose by
developers even if the applications have not been developed yet, while
application tokens would require their marketed features to be built
before achieving full functionality.
Per Purchaser Limit--This could be a dollar limit akin to
crowdfunding concepts, but would make more sense under Howey as a limit
that indicates consumptive intent. Each primary token seller could
establish a limit based, for example, on the number of tokens a user
might use within a given period of time. In some cases, tokens are
meant to be purchased by developers who are building other applications
that will make use of the tokens and will need a larger quantity of
tokens for their separate development project than would a typical
user.
Full Decentralization--A token achieves full decentralization when
the token creator no longer has control of the network based on its
ability to make unilateral changes to the functionality of the tokens,
or based on the number of network nodes controlled by the broader
community, or based on the code being forkable and open source, or
based on it being a permissionless network (any node can join), or
based on affiliated hashpower (proof of work), or based on affiliated
holdings (proof of stake). Again, these are just examples of indicia of
control criteria that require further discussion in the context of a
specific no-action letter.
Primary Token Seller Conditions for Safe Harbor
Special Resale Lockup and Resale Volume Restrictions--Primary sales
other than for fully decentralized protocol tokens (i.e., for either
Pre-Functionality or Full Functionality tokens), would need to include
a lockup that permits use but not resale for the period ending on the
later of (i) 6 months following purchase, and (ii) achievement of full
functionality. In addition, purchasers and affiliates of the token
creator would need to agree to resale volume limitations.
Consent to Jurisdiction--Primary token sellers would need to
consent to jurisdiction of the applicable regulators.
Consent to Anti-Fraud Rules--The primary token seller would need to
also agree to the application of the general anti-fraud and
manipulation rules, such as Rule 10b-5 under Federal securities laws
with respect to any tokens sold under all circumstances.
Public Disclosure--Any information that the primary token seller
provides regarding features and use of the network would need to be
made publicly available. To achieve full functionality, a white paper,
superseding any prior white paper, would need to be published detailing
present functionality and would need to focus on present features with
only limited and very generalized discussion of future features, if
any. Other disclosures may be appropriate and would need to be
discussed in the context of a specific no-action letter.
Public Marketing--The token seller would not be permitted to market
the token as an investment, but would be able to provide disclosures
consistent with Rule 506(c) and Rule 134. Any marketing materials made
public would only be able to relate to the token's functionality, not
its resale value.
Legends/Smart Contracts--Primary token seller would need to enforce
lockups.
Token Features--The tokens would not (i) have one or more features
that make them a ``security'' under one of the other concepts in the
definitions under the 1933 Act or 1934 Act, or (ii) constitute an (a)
ownership interest, (b) equity interest, (c) a share of revenue, profit
and/or loss, or assets and/or liabilities, (d) status as a creditor or
lender, (e) claim in bankruptcy, (f) holders of repayment obligations,
or (g) right to convert into an investment interest, all with respect
to the token project or network application, or any legal entity.
Exchange Conditions for Safe Harbor
The conditions for an exchange to list a utility token as a non-
security requires further discussion in the context of a specific no-
action letter, including with respect to (i) the exchange's role
regarding FinCEN KYC/AML regulations; (ii) the exchange's role relating
to resale limitations on tokens; and (iii) consent to jurisdiction for
enforcement of general anti-fraud and manipulation rules.
Reseller Conditions for Safe Harbor
Resellers would need to comply with any lockup and volume
limitations.
Resellers would need to be subject to the general anti-fraud and
manipulation rules, such as Rule 10b-5.
Conclusion
We believe that the above regulatory framework ensures the goals of
investor protection, clarity for market participants and support for
blockchain technology. While the SEC retains significant jurisdiction
under the proposal, the CFTC would also retain the ability to regulate
fraud and market manipulation in the token spot markets, in addition to
its full authority to regulate any derivative token markets. FinCEN
remains the primary regulator with respect to all KYC/AML requirements,
and the FTC would also have jurisdiction for any consumer protection
actions associated with misleading advertising.
Attachment
March 26, 2018
To: William Hinman, Director, Division of Corporation Finance
Amy Starr, Chief, Office of Capital Markets Trends
Valerie Szczepanik, Assistant Director, Head of the SEC
Distributed Ledger Technology Working Group
From: Perkins Coie LLP
Re: Investment Contract Analysis of Utility Tokens
This memorandum discusses whether and under what circumstances so-
called ``utility tokens'' would be securities as defined under the
Securities Act of 1933, as amended (the ``Securities Act'').\1\
---------------------------------------------------------------------------
\1\ While other U.S. securities laws have slightly different, and
in some cases broader, definitions of a security, the most immediate
concern for utility tokens is whether a token sale to the general
public may constitute a violation of Section 5 of the Securities Act.
Outside the United States, except for Canada, we have not run into a
jurisdiction where the securities laws would apply the investment
contract test discussed in this memorandum according to local counsel.
So far, utility tokens have been deemed non-securities in places like
Switzerland, Singapore, Hong Kong, Bermuda, the Cayman Islands, and the
British Virgin Islands, among others.
---------------------------------------------------------------------------
Executive Summary
In Howey \2\ and its progeny, including the cases discussed in the
DAO Report,\3\ the Securities and Exchange Commission (the ``SEC'') and
the courts have laid out the characteristics of an ``investment
contract,'' emphasizing that the analysis of what is and is not an
investment contract can be based on the facts and circumstances
surrounding each offer and sale. Inherent in any analysis based on
facts and circumstances is the reality that the analysis may yield a
different conclusion at different points in time as circumstances
change. In the case of tokens, and the underlying blockchain
technology, the market dynamics have, in fact, changed over time, as
market participants have adjusted to a better understanding of both the
technology and the applicable regulatory requirements. Currently, it is
widely accepted that a pre-functionality sale of tokens may well
constitute an ``investment contract,'' and hence a security, within the
meaning of Section 2(a)(1) of the Securities Act. This conclusion flows
from the likelihood that a reasonable purchaser expects to profit in
the secondary market for the tokens based on the efforts of the token
seller to build the network or application in which the token is used.
Accordingly, most market participants are initially purchasing a pre-
functionality token sale agreement, which is offered and sold in
accordance with Rule 506(b), Rule 506(c) or Regulation S, and which
represents a right, at a future time, to delivery of utility tokens. In
this context, the pre-functionality token sale agreement is the
security, and it is subject to the resale restrictions imposed by
Regulation D or other applicable exemptions, under the Securities Act.
At the point at which the utility tokens achieve a sufficient level of
functionality, such that their value is no longer dependent on the
efforts of others, the pre-functionality token sale agreement is
effectively extinguished and the holder thereof receives delivery of
the tokens. A token by--itself is never an investment contract--
Dogecoin \4\ is simply a meme that can be transferred via blockchain
operations. The investment contract arises from the understanding as to
how the token will be developed into something of useful value. In this
memorandum we discuss the legal analysis supporting our views with
respect to the legality of these transactions and the legal status of
the tokens, both pre- and post-functionality. We also discuss more
broadly the legal framework in which token sales take place.
---------------------------------------------------------------------------
\2\ SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (hereinafter,
``Howey'').
\3\ Report of Investigation Pursuant to Section 21(a) of The
Securities Exchange Act of 1934 (Exchange Act Rel. No. 81207) (July 25,
2017) https://www.sec.gov/litigation/investreport/34-81207.pdf
(hereinafter the ``DAO Report'').
\4\ http://dogecoin.com/.
---------------------------------------------------------------------------
The key difference between (i) an equity offering or the forward
sale of an extant commodity and (ii) an offering of utility tokens is
the fact that equity is inherently a security by its nature and extant
commodities are non-securities by their nature and that nature never
changes. Equity fundamentally represents a right to a share of the
profits of the issuer, so equity securities never ``transform'' from a
security to a non-security because their fundamental nature does not
change. The treatment of a contract as an investment contract, and
hence as a security, however, is entirely based on a test that is
driven by the facts and circumstances at the time of the offer and
sale. Thus, it is possible for a contract for the sale of tokens to be
an investment contract under one set of circumstances, while a
subsequent contract for the sale of the same tokens is not an
investment contract when sold under different circumstances. In this
case, the transformation is not de jure, but arises from a change in
the facts and circumstances, i.e., ipso facto. Since one of the key
facts underpinning the efforts of others element set out in Howey is
the promoter's efforts to build functionality, there may well be a
different result with respect to an offer and sale made at a time when
functionality exists, versus at a time when it does not. Indeed, if
tokens are delivered to the pre-functionality token purchasers after
full functionality has been created, the efforts of others element
would no longer be met under Howey, and any subsequent resale of the
tokens should not constitute an investment contract.
If we assume that the expectation of profits prong under Howey is
always met based on today's frothy secondary markets, and if we ignore
the other prongs of the test, the only remaining question is whether
the expectation of profits is sufficiently based on the efforts of
others. The courts use objective criteria to determine when a
reasonable purchaser expects to profit on the efforts of others, not
the subjective mind set of each purchaser. Thus, even if token
purchasers currently may be described as irrationally exuberant,
meeting the Howey test is within the control of the token seller
because the test is objective not subjective. It follows that there is
a ``right way'' for token sellers to construct tokens and conduct token
sales, initially as a security, but once the token has achieved full
functionality, it should be treated as a non-security that will
ultimately trade on spot markets regulated under the anti-fraud rules
administered by the CFTC.
In addition to being analytically inconsistent with existing law,
categorizing tokens immutably as securities will mean that tokens
cannot be used for their intended purposes in the United States.
Securities cannot be used in the way utility tokens are intended to be
used (e.g., as micro payments for micro tasks on a social network).
From a policy perspective, it is important that we apply our securities
laws in such a way that inapposite regulation does not cause today's
highly mobile workforce to develop these technologies abroad (as many
already have) if utility tokens cannot be used for their intended
purposes in the United States. While regulators must be mindful of
containing the highly speculative and frothy market that currently
exists, in which resale motives may predominate, use motives are
gaining traction. As use of tokens grows, and as the novelty wears off,
we expect that circumstances may well change again to the point where
the irrational exuberance has subsided and there is a more balanced
view of tokens as merely tools for interacting with various software
platforms and applications.
Policy objectives aside, and whether or not a less frothy future
state comes to pass, this memorandum addresses the analytical basis for
the appropriate treatment of token sales under existing law.
Detailed Analysis
A. Definition of Utility Token
In October 2008, the Bitcoin whitepaper \5\ introduced a new
currency based on distributed ledger technology, also known as the
Bitcoin Blockchain. Currency was the first use case for this underlying
technology. Other use cases include using cryptographically secure
distributed ledgers to track and trade traditional debt and equity
securities, or any other tangible or intangible asset, good or service.
This memorandum does not cover:
---------------------------------------------------------------------------
\5\ Satoshi, Nakamoto, Bitcoin; A Peer-to-Peer Electronic Cash
System, www.Bitcoin.org, available at https://bitcoin.org/bitcoin.pdf.
(last visited March 22, 2018).
(1) Digital Securities--meaning (i) any token that represents or
otherwise enables a blockchain transfer of a share of
stock, note or other type of security explicitly included
in the definition of ``security'' in the Securities Act and
(ii) any token that would constitute an (a) ownership
interest, (b) equity interest, (c) a share of revenue,
profit and/or loss, or assets and/or liabilities, (d)
status as a creditor or lender, (e) claim in bankruptcy,
(f) holders of repayment obligations, or (g) right to
convert into an investment interest, all with respect to
the token project or network application, or any legal
---------------------------------------------------------------------------
entity;
(2) Digital Currencies--meaning fungible tokens that have no other
marketed functionality than use as a medium of exchange or
stored value; \6\ or
---------------------------------------------------------------------------
\6\ Digital currencies, like Bitcoin, would generally not be
securities unless there are somewhat unusual facts and circumstances
causing the coin to fall within the definition of a security (e.g., if
the coin's promoter builds certain features into the coin like
diminishing supply or promises significant actions that would make the
coin more valuable in the future). Typically, digital currencies are
complete and useful as currency immediately upon creation of the first
coin and do not promise any further development of features or
functionality or actions to make them more valuable in the future. Even
if the coin is marketed as an investment (as physical gold coins often
are, for example), it would not be a security unless the expectation of
profits is based on the efforts of others.
(3) Tokenized Goods and Services--meaning each token represents the
right to a specific good or service that would often not be
perfectly fungible with any other token.\7\
---------------------------------------------------------------------------
\7\ Non-fungible (or less fungible) tokenized goods and services do
not pose the same trading issues and easy resale profit opportunities
as fungible utility tokens. By definition, the consumptive intent of
the purchaser is patently obvious with respect to this type of token.
In this case, the token can be abstracted away and its status as a non-
security simply follows the non-security status of the underlying good
or service. If the presale of a Tesla, for example, had used
distributed ledger technology to track the identity of holders of the
presale rights to the Tesla, the token purchasers would have had such
clear consumptive intent that the tokens should not have been deemed
securities even if such rights had been traded on an exchange while the
car was under development. In this case, the token could either
represent a customized car (i.e., a nonfungible token), or it could
represent a fungible currency value only redeemable for a car to be
selected by the token holder in the future (akin to a gift card).
Either way, the consumptive intent is clear. Tokenized concert tickets
would be another example of this type of token, where there is a fixed
supply of tickets and initial sales are likely to be virtually
exclusively to and between resellers, but the tickets will ultimately
be purchased, for the most part, by the end users who go to the
concert. In the case of concert tickets, of course, it is also possible
for the tokens to be perfectly fungible if the concert is all open
seating, for example, so the touchstone for this type of token is the
clarity of the consumptive intent of the ultimate end use purchasers.
Of course, as with digital currencies, the offer and sale of this type
of token could still meet the investment contract test if, for example,
the tokens are coupled with a management contract like the one present
in the Howey case.
This memorandum covers utility tokens, defined as fungible tokens
that have some software-based functionality beyond mere use as a medium
of exchange or stored value, although typically the tokens also have
those currency-like properties. The value of these utility tokens
should be derived from their use in a smart contract or other
application automating the payment and delivery of goods or services,
including access to decentralized networks.
B. Token Sale History and Evolving Model
A large number of token sales of so-called ``alt coins'' occurred
in 2014 and 2015. These were typically coins, based on the software
code for Bitcoin, which is open-source software accessible to anyone.
Many of these early tokens were digital currencies, although over time
these tokens were used in more novel ways as part of a software network
or application and became utility tokens (as defined for purposes of
this memorandum). In 2014 and 2015, market participants believed that
as long as these alt coins did not pay any sort of financial return,
and did not represent a share of any company, similar to Bitcoin, they
should not be treated as securities. Over time, the market cooled as
appetite faded for new tokens that offered little in true functionality
other than use as a currency, and use began to rise for the alt coins
that included significant functionality in addition to use as a
currency. In 2017, there was a resurgence of token sales based on the
advent of more capable token technology. The ERC20 token protocol, as
well as several others, now embed executable code into each token
(often referred to as smart contracts), which allows developers to
tokenize anything that software can create. These second-generation
tokens can be said to be tokenized software products or APIs
(application programming interfaces) that perform a function in
addition to acting as a medium of exchange or stored value.
Initially, these new utility tokens were thought of by market
participants as the sale of products in development that could follow
the Kickstarter crowd sale model, so long as they continued to avoid
paying any sort of financial return or share of ownership of a company
or project. The offers and sales were made at a time when the market
for tokens was untested and it could not be said that there was a
built-in reasonable expectation of profits associated with resale
because secondary markets were not assured.\8\ Participants in the
offers and sales tended to be technologists, developers, software
users, and innovators. A reasonable amount of technological know-how
was required just to be able to participate in a token sale. Means of
holding tokens became more user friendly, including in online wallets,
and means of exchanging one token for another, including on token
exchanges, were made more reliable and simplified.
---------------------------------------------------------------------------
\8\ Generally, when a new team markets a new product or service, it
is extremely unlikely for any sort of secondary market to develop on
its own. It normally requires promotional efforts over a long period of
time to gain any sort of traction and most projects fail to ever get a
secondary market to develop. It cannot be said that a reasonable
purchaser was expecting to profit in secondary markets at this point in
the history of token sales.
---------------------------------------------------------------------------
Over time, as the development of robust secondary markets became
more and more of a given, market participants began to evolve the model
to take into account the changing market conditions. Specifically, it
became apparent that the offer and sale of tokens potentially
implicated the Federal and state securities laws and market
participants started to apply the Howey test to determine whether the
tokens might properly be viewed as securities. This in turn led to
delivering increasingly functional tokens at the time of a public token
sale to offset the increasingly apparent expectation of profits
associated with secondary trading (as opposed to use of the token) that
began to emerge.
Today, as discussed below, while there are many token sales that do
not follow best practices, market participants seeking to follow best
practices generally follow a model where, before the tokens are fully
functional, the sale of the tokens is conducted under an exemption from
the registration requirements of the Securities Act and the proceeds
are used to build functionality into tokens that will later be
distributed to the pre-functionality purchasers. Typically, this is
effected through the use of a pre-functionality token sale agreement
that is not transferable and must be held indefinitely. The tokens are
not delivered to the pre-functionality purchasers (and, therefore, do
not begin trading on any exchanges or in peer-to-peer wallets) until
the system for using the tokens becomes fully functional. Once full
functionality is achieved, the token seller delivers the tokens to the
pre-functionality purchasers and often conducts a second sale of the
fully functional utility tokens to the public as a non-security.
C. Overview of Securities Law Analysis
The Securities Act regulates the offer and sale of securities. Once
it is established that an instrument is a security within the meaning
of the Securities Act, this transactional regulatory regime requires
that each offer and sale of a security be registered or exempt from the
registration requirements of the Securities Act. For current purposes,
the threshold question is whether the instrument or arrangement meets
the Securities Act's wide-ranging definition of ``security.'' As
discussed in the Dao Report, the applicable test then is whether the
instrument or arrangement by which the offers and sales of utility
tokens are made would constitute an ``investment contract'' under
Howey. This is a multi-factor test based on facts and circumstances
that must be analyzed with respect to the instrument or arrangement as
of the time of each offer and sale. Facts and circumstances can and do
change over time, so the results may be different, even for the same
token, depending on when the offer and sale is made.
In most cases, under present market conditions,\9\ the pre-
functionality sale of tokens may well be a securities transaction under
the Securities Act based on the investment contract analysis under
Howey.\10\ Once full functionality has been incorporated into the
technology underlying the token, the token is a commodity trading on
spot markets accessible to the public, which are subject to the anti-
fraud rules enforced by the CFTC described below. For these purposes,
``full functionality'' is not intended to mean that merely some utility
exists but rather that the requisite quantum of functionality exists
such that the efforts of the promoter or others to deliver additional
functionality do not form the basis for a reasonable purchaser's
expectation of profits in purchasing the token. The requisite quantum
of functionality is further discussed below.
---------------------------------------------------------------------------
\9\ Present market conditions for utility tokens include the
presence of robust secondary markets trading the rights to the tokens
being developed primarily among resellers with speculative intent
rather than users with consumptive intent. To continue the analogy to
event ticket sales, the market for utility tokens is still in the early
days after initial launch of ticket sales where resale is the primary
intent of buyers who are attempting to gauge the ultimate price the
end-user will be willing to pay for this fixed-supply good.
\10\ The Kickstarter pre-functionality crowd sale model likely
doesn't apply under present market conditions for utility tokens.
Kickstarter campaigns do not have secondary markets trading the rights
to the goods being developed, which calls into question consumptive
intent.
---------------------------------------------------------------------------
Of course, the circumstances could change again in the future, as
the novelty wears off, and a pre-functionality crowd sale structure
could work again, if and when it becomes clear that purchasers have
switched back to purchasing primarily for consumptive purposes rather
than resale (as is the case with Kickstarter campaigns). In addition,
even under present market conditions, token sellers may decide to take
certain steps to ensure use rather than resale, which would also change
the analysis. In such a case, the Howey test would arguably not be met
if either there is not sufficient expectation of profits because the
token is generally being purchased for consumptive purposes or the
expectation of profits is predominantly based on variables exogenous to
the efforts of the promoter(s) of the token.
D. Description of the Pre-Functionality Token Sale Agreement
Although pre-functionality token sale agreements may be executed
with differing characteristics, for purposes of this memorandum, we
assume the pre-functionality token sale agreements will have the
following common characteristics:
The purchaser pays to the seller the purchase amount (which
may be denominated in fiat currency, such as U.S. dollars, or
digital currency, such as Bitcoin) on or about the date on
which the pre-functionality token sale agreement is executed.
In consideration of the purchase amount, the seller agrees
to deliver to the purchaser a number of tokens equal to the
purchase amount divided by a certain price on or about the time
the seller conducts a public sale of the tokens or otherwise
publicly launches the system or application on which the token
may be used. In either case, the delivery does not occur until
full functionality is achieved.
The pre-functionality price may be stated as a fixed
value, in which case the quantity of tokens to be delivered
can be determined at the time the pre-functionality token
sale agreement is executed. This is always the case when
the trigger for token delivery is network launch.
Alternatively, the pre-functionality price may be
stated in terms of a percentage of the eventual public sale
price.
The pre-functionality token sale agreement is a separate
instrument from the tokens and terminates upon the seller's
delivery of tokens to the purchaser.
The pre-functionality token sale agreement generally
contains certain other standard representations, including, for
instance, representations from the purchaser that it is an
accredited investor purchasing the rights to the token embodied
in the agreement for its own account and not with a view to
distribution.
A pre-functionality token sale agreement frequently will not define
the specific function of the token or the timeframe for its development
and completion, or require the seller to conduct a sale before a
specified time or at all. The seller's whitepaper and other information
provided to the pre-functionality purchasers typically addresses such
matters, often in very general terms. When analyzing a potential
investment contract, the ``[d]ecision will necessarily turn on the
totality of the circumstances, not on any single one.'' SEC v. Aqua-
Sonic Products Corp., 687 F.2d 577 (2nd Cir. 1982), cert. denied, sub
nom Hecht v. SEC, 459 U.S. 1086 (1982). Thus, it would be the totality
of the circumstances relating to the use of the proceeds from pre-
functionality token sale agreements to develop and launch a token that
may give rise to an investment contract under Howey, rather than the
pre-functionality token sale agreement itself. Nevertheless, to
facilitate the discussion, this memorandum will analyze a pre-
functionality token sale agreement as though it incorporated all of the
reasonable understandings and expectations of the purchaser that would
arise under the total circumstances.
Because of the risk that a pre-functionality token sale agreement
may be deemed to constitute an investment contract, as discussed below,
pre-functionality token sale agreements are frequently sold in
compliance with an exemption from the registration requirements of the
Securities Act. This would include provisions prohibiting any transfer
of the pre-functionality token sale agreement except in compliance with
such exemption, or more typically, a standard prohibition on transfer
or assignment of the agreement without consent.
E. Circumstances in Which a Pre-Functionality Token Sale Agreement May
Create an Investment Contract
A pre-functionality token sale agreement to deliver a specified
amount of an asset at a specified price on a future date has many of
the characteristics of a forward contract for the underlying future
tokens. It is established that a forward or futures contract for non-
securities, in fact any type of sales contract, normally does not
entail an investment contract. For example, in SEC v. Commodity Options
Intern., Inc., 553 F.2d 628, 632 (9th Cir. 1977), the Ninth Circuit
stated that:
Commodity futures contracts are considered not to be
securities per se. [Citation omitted] They are investments to
be sure. The investment, however, is not in an enterprise but
is in the underlying commodity, and we may assume, arguendo,
that a conventional option to buy or sell a futures contract
takes on the character of the contract that is the subject of
the option and is no more a security than is that underlying
contract.\11\
---------------------------------------------------------------------------
\11\ The court distinguished standard commodity futures and options
from the ``naked double options'' that were offered by the defendant.
Defendant collected and pooled the premiums for these options ``and put
out to speculation with the expectation that the seller's expertise in
speculation will produce a profit in which the buyer and seller will
share,'' thus creating an investment contract. Commodity Options
Intern, 553 F.2d at 633. See also, cases cited at 15[a] of Stephen G.
Christianson, What is ``Investment Contract'' within Meaning of 2(1)
of Securities Act of 1933 (15 U.S.C.A. 77b(1)) and 3(a)(10) of
Securities Exchange Act of 1934 (15 U.S.C.A. 78c(a)(10)), Both
Defining Term ``Security'' as Including Investment Contract, 134 A.L.R.
Fed. 289 (1996).
A pre-functionality token sale agreement differs from conventional
forward contracts in an important respect: it typically involves a to-
be-created novel product or service with no established market or
value. In the words of the Ninth Circuit, such agreements are often
``investments in the enterprise'' of creating an operating token rather
than an investment in just the token.
Most other products and services have a market value determined by
general supply and demand where prices are bounded by the price of
competing goods or services. Even if the seller in a typical forward
contract engages in significant promotional efforts, such efforts
should be expected to have only a marginal impact on the product's
price and any resulting profits from the forward contract. Such
promotional efforts would not be ``undeniably significant [efforts],
those essential managerial efforts which affect the failure or success
of the enterprise.'' SEC v. Glenn W. Turner Enters., Inc., 474 F.2d
476, 482 (9th Cir. 1973); see e.g., Bender v. Continental Towers Ltd.
P'ship, 632 F. Supp. 497, 501 (S.D.N.Y. 1986) (``Here, plaintiffs
allege that Continental influenced the value of the condominium units
through its marketing efforts and its own buying and selling
strategies. But these efforts by Continental would have at most only a
marginal effect on the value of the condominium units''). Thus,
expected profits from any appreciation in the value of the asset
underlying a typical forward contract should not be derived from the
efforts of the seller.
In contrast, the future tokens underlying a pre-functionality token
sale agreement have yet to be fully developed or to demonstrate their
functionality and typically are associated with an entirely novel
application where the ultimate ranges of prices to be paid by end users
is speculative. Any eventual profits from the pre-functionality token
sale agreement may therefore depend on the successful development of
the application using the tokens and on the seller's success in
launching the application. In some circumstances, this may elevate the
seller's efforts to the ``undeniably significant'' level required under
Glenn W. Turner.
Real estate provides an example of circumstances in which an asset
not generally regarded as a security may become the basis of an
investment contract based on promises of future development. Although
the SEC has stated that ``[t]he offer of real estate as such, without
any collateral arrangements with the seller or others, does not involve
the offer of a security,'' Guidelines as to the Applicability of the
Federal Securities Laws to Offers and Sales of Condominiums or Units in
a Real Estate Development, Securities Act Release No. 5382, 38 FR 9587
(1973), courts have found allegations ``that defendants encouraged
investment purchases by promising the lots would increase in value
because of defendants' activities in developing and providing
amenities, and that defendants led purchasers to believe a trust would
be established to construct and operate facilities for their common
benefit,'' sufficient to establish an investment contract. Aldrich v.
McCulloch Properties, Inc., 627 F.2d 1036, 1039 (10th Cir. 1980); see
also, Fogel v. Sellamerica, Ltd., 445 F. Supp. 1269, 1277-78
(S.D.N.Y.1978) (``the developers did represent that a variety of
residential services and recreational facilities would be developed so
as to increase the value of plaintiffs' property along with all of the
lots in the development''); Anderson v. Grand Bahama Dev. Co., 384
N.E.2d 981, 985 (Ill. App. Ct. 1978) (``[P]laintiffs allege that the
land will become `valuable and salable to tourists' and others solely
[original emphasis] by virtue of defendants' efforts. They also allege
that purchasers of the land could not, nor were they expected to, do
anything to increase the value of their investments. These allegations
fulfill the final two requirements for an investment contract as stated
in Howey.''). Similarly, an undertaking to develop and launch an
application for a token may create a collateral arrangement that would
cause an agreement to buy a utility token to qualify as an investment
contract, even though the token itself will be a commodity.
As more fully discussed in Section I.1 below, the manner in which a
token is offered is also relevant to its status as an investment
contract. Offering materials that emphasize the potential profits from
purchasing a token may create an expectation of profit that satisfies
the third prong of the Howey test. Because the purchasers of the pre-
functionality token sale agreement will not receive tokens until
completion of the project, and many purchasers may not intend to use
the tokens, there is pressure on the seller to discuss the potential
market value of the tokens in its offering materials. The materials
also commonly explain the anticipated timeframe for development, the
development team and their relevant experience. Under these
circumstances, the offering materials could be viewed as ``emphasizing
the economic benefits to the purchaser to be derived from the
managerial efforts of'' the seller which, according to the Munchee
Order, could factor into finding that the pre-functionality token sale
agreements are investment contracts.
The purchasers of the pre-sale functionality token sale agreement
may also require assurances that the seller intends to conduct a public
sale of the future tokens at a higher offering price than the pre-
functionality price, reflecting the fact that the early money is being
paid to take the risk that functionality may not be achieved or that
the expected use may command a lower price than anticipated. Although
the purchasers do not generally offer their tokens in the public sale,
and may not receive unrestricted access to the tokens until the sale is
completed, their ability to profit from the sale of their tokens
generally depends on the success of the public sale. In the case of a
token used for a new or unique software application, the public sale
will establish the initial value of the token, so the seller's efforts
may have more than a marginal effect on the potential profits of the
purchasers who decide to sell their tokens.
Under such circumstances, which are different from those of a
typical forward contract, the SEC or a court may find that the efforts
of a seller are ``undeniably significant'' with respect to the expected
profits of the purchasers. The development of a successful application
for a token may be comparable to the efforts required to develop the
infrastructure and amenities of a resort, which courts have found to
satisfy the final element of an investment contract. Moreover, unlike
an asset (such as a commodity or condominium) with an established
market, the developer of a new or unique application may have
significant influence over the related token's initial market value.
Consequently, the seller's efforts in conducting the public token sale
and launching the network application may have a significant impact on
the purchaser's expected profits from selling, rather than using, the
tokens. Circumstances such as these create a heightened risk that the
pre-functionality token sale agreements may be classified as investment
contracts.
Different circumstances may reduce the risk of a pre-functionality
token sale agreement being considered an investment contract. For
example, a seller may be converting an already developed application
into a blockchain format using the future tokens. This might be the
case for a video game which already has an ``in-game'' token that can
be earned by playing the game and spent to acquire virtual assets used
in the game. The game developer may want to convert the in-game token
to a blockchain token so as to allow players to purchase tokens rather
than earn them (saving hours of game playing), and to permit other
games to incorporate the tokens, so players can move their virtual
wealth from game to game. In this instance, the token's ``ecosystem''
is largely developed; the developer only needs to pay for the
programing and other costs of moving the in-game token to a blockchain.
To fund this cost, the developer may offer pre-functionality token sale
agreements for the blockchain tokens to current players of its game who
would benefit from the ability to acquire and transfer the tokens
outside of the game. The materials marketing these pre-functionality
token sale agreements could emphasize the established functionality of
the future tokens, the value of which would depend on the appeal of the
gaming community created by the players (including the purchasers),
rather than the entrepreneurial or managerial efforts of the seller.
These purchasers would resemble someone buying a condominium in a
nearly completed resort, which ``is not under normal circumstances
treated as purchasing a `security.' '' Rodriguez v. Banco Cent. Corp.,
990 F.2d 7, 10 (1st Cir. 1993); see also, cases cited in Christianson,
supra note 2, 134 A.L.R. Fed. at 12[c]. Under circumstances such as
these, a pre-functionality token sale agreement may resemble a standard
forward contract more closely than an investment contract.
F. Why Tokens Delivered Pursuant to an Investment Contract May Not
Qualify as Investment Contracts
The foregoing analysis shows how a pre-functionality token sale
agreement might be regarded as an investment contract due to
circumstances unrelated to whether the future tokens are securities. If
the circumstances have changed materially by the time of the delivery
of tokens to the pre-functionality purchasers (which is often
accompanied by a public sale of the utility tokens), any new offer or
sale of those same tokens should not necessarily be construed to
represent investment contracts. This would be the case if development
of the token's functionality is completed by the time of the public
sale. So long as there are no other efforts of others involved either--
i.e., (i) marketing materials are focused primarily on present
functionality and use of the token, (ii) the seller has not built
features into the token intended to provide an investment return or
support the price of the token in secondary markets, and (iii) the
seller does not promise to take steps to support secondary trading of
the token--then, at this stage, the seller's efforts would be limited
to supporting the use of the tokens with the network or software
application and any further increase in the value of the token should
not be derived from the efforts of the seller. Once the tokens are
delivered to the purchasers, each purchaser would have unfettered
control over the tokens, and would have no reasonable expectation that
the seller will take future steps intended to increase the market value
of the tokens. Generally, ``[T]the courts will find a security is not
present where the investor retains unfettered discretion over the
distribution and marketing of the product.'' Wabash Valley Power
Ass'n., Inc. v. Public Service Co. of Ind., Inc., 678 F. Supp. 757, 767
(1988) (added emphasis). At this point, unlike the DAO Token, which
promised returns from projects undertaken by the DAO, any reasonable
expectation of profits the purchaser might have should depend primarily
on the market's demand for the functioning application and the
purchaser's own efforts to find buyers and negotiate a favorable price
for the tokens (akin to general expectations of appreciation in the
demand for a commodity or real estate).
Such changing circumstances--the completion of the full
functionality of the token--also allow the seller to take a different
approach to marketing its network or software application at the time
of the public token sale. The completion of the network or software
application allows the seller to focus on selling the tokens to
potential users, so any marketing materials would emphasize the value
in using the goods and services accessible through the token. In
addition, unlike pre-functionality purchasers, the purchasers in a
public sale do not expect the seller to hold a future sale of the
tokens at a higher price. In fact, if the public sale is conducted to
distribute the tokens at approximately their market clearing price,
purchasers should not have a reasonable basis to anticipate any future
appreciation in their value.
These circumstances: (i) completion of the network or software
application in which the token is used, (ii) a corresponding emphasis
on selling the token based on its use and the value of its application
and (iii) a public sale price that approximates such value, all serve
to separate the public sale of the tokens from the circumstances
existing at the time the pre-functionality token sale agreements are
privately placed. These changed circumstances should prevail at the
time the pre-functionality purchasers receive delivery of their tokens
and have an opportunity to sell them. If the tokens are not digital
securities by design, and if all the other facts and circumstances
support the conclusion that the token sale agreements entered into at
the time of the public sale should no longer be viewed as investment
contracts, then tokens received and, if applicable, sold by pre-
functionality purchasers under those same circumstances should not be
viewed as investment contracts either. The characteristics of the pre-
functionality token sale agreement by which the tokens were originally
purchased should not be determinative of the status of the tokens as
``investment contracts'' with respect to the subsequent offer and sale
transaction occurring under changed facts and circumstances.
Instead, we would argue that the pre-functionality token sale
agreement was the instrument that was deemed a security under the Howey
test, but that it is distinguishable from the underlying token. The
pre-functionality token sale agreement is subject to the applicable
private placement restrictions for the duration of its existence and
may not be offered or sold except pursuant to appropriate registration
or exemption. At the point of full functionality, however, and delivery
of the tokens, the tokens take on a separate regulatory existence and
their status as securities should be independently determined at that
time.
From Howey (oranges) to Edwards (pay phones),\12\ the case law is
replete with products that provide the basis for an investment contract
without qualifying as securities themselves. See, Christianson, supra
note 2, 134 A.L.R. Fed. at 10[b] (citing cases involving dental care
products, foxes, beavers and master tapes) and 14[a] (citing cases
involving whisky, personal and home care products, oil, chinchillas and
earthworms). In these cases, a critical element was the promoter's
promise to either purchase or arrange for the sale of the underlying
product at a profit, regardless of its current market value. A seller's
undertaking to conduct a public sale of future tokens at a price above
the pre-functionality price might be considered analogous to the
promoters' promises in these cases. In that context, the promise of an
opportunity to sell the tokens at a profit after delivery makes the
pre-functionality token sale agreement an investment contract, not the
character of the tokens (or any of the products in the cited cases).
---------------------------------------------------------------------------
\12\ SEC v. W.J. Howey Co., 328 U.S. 293 (1946); SEC v. Edwards,
540 U.S. 389 (2004).
---------------------------------------------------------------------------
Critical, and unique to tokens and this analysis, is the mutability
of the token--it can be both initially representative of an investment
opportunity and subsequently a functional tool for use on the
blockchain application. Thus, one of the reasons it may seem
appropriate to treat both pre-functionality token sale agreements and
their underlying tokens as investment contracts may stem from the fact
that a token directly issued and marketed under the same circumstances
as a pre-functionality token sale agreement may be considered an
investment contract for the same reasons as a pre-functionality token
sale agreement. A pre-functionality token in this sense, has the same
security-like characteristics as a pre-functionality token sale
agreement. This was the case in the Munchee Order, where the utility
tokens were created and delivered to purchasers prior to full
functionality. The Munchee Order involved several practices (such as an
undeveloped application) commonly associated with pre-functionality
token offerings.
So long as utility tokens are not created or delivered to the pre-
functionality purchasers prior to full functionality, the financial
instrument that is the proper subject of the analysis is the pre-
functionality token sale agreement itself, not the future token, which
does not yet exist.
G. Deemed Underwriter Status and ``Coming to Rest'' Analysis
The adage ``once a security, always a security'' is alive and well,
in light of the fact that the ``security'' is the investment contract
(or, more precisely, the right to future tokens evidenced by that
contract) not the asset underlying the investment contract. The pre-
functionality token sale agreement never loses its character as a
security and in practice these contracts are non-transferable on the
part of the purchaser. Thus, the right to future tokens represented by
the pre-functionality token sale agreement, which is a security, stays
a security, and comes to rest in the hands of that initial purchaser.
The best way to think about this is to change one fact from the Howey
case itself--suppose the purchasers were paid in oranges instead of
cash. If all the other facts remained the same, we would undoubtedly
still consider the contract to be an investment contract (it would
still be a contract to share profits, just denominated in oranges), but
we would never conclude that the oranges, once fully grown and
delivered, had somehow transformed into a security that could not be
immediately sold by the purchasers upon receipt.
H. Jurisdiction Over Hybrid Instrument
When a contract involves an asset that is a commodity being sold
under circumstances that cause the transaction to be a securities
transaction under the Securities Act, Section 2(f) of the Commodity
Exchange Act (the ``Hybrid Instrument Exclusion'') guides the analysis
of jurisdictional boundaries.\13\ By acknowledging and relying on the
distinctions outlined within that provision, the SEC retains its
inherent discretion and latitude to address potential security law
violations at the point of token issuance, in addition to, and
potentially independent of, pre-functionality token sale violations.
This has the systemic benefit of maintaining clarity for responsible
actors within the industry, ensuring utility tokens are treated in
accordance with their inherent fungible characteristic, not negatively
impacting the wider pre-funding model for the rest of the industry, and
maintaining consistency with existing law designed to address these
dilemmas. A pre-functionality token sale would need to satisfy the
enumerated requirements of the Hybrid Instrument Exclusion in order to
meet the definition, although such requirements could be met through
appropriate documentation and marketing restrictions, for example a
legend that confirms the pre-functionality token sale agreement is
subject to SEC oversight and not an instrument subject to the
provisions of the Commodity Exchange Act.
---------------------------------------------------------------------------
\13\ Section 2(f) Exclusion for qualifying hybrid instruments of
the Commodity Exchange Act provides:
(1) In general
Nothing in this chapter (other than section 16(e)(2)(B) of this
title) governs or is applica-
ble to a hybrid instrument that is predominantly a security.
(2) Predominance
A hybrid instrument shall be considered to be predominantly a
security if--
(A) the issuer of the hybrid instrument receives payment in
full of the purchase price
of the hybrid instrument, substantially contemporaneously with
delivery of the hybrid in-
strument;
(B) the purchaser or holder of the hybrid instrument is not
required to make any pay-
ment to the issuer in addition to the purchase price paid under
subparagraph (A), wheth-
er as margin, settlement payment, or otherwise, during the life
of the hybrid instrument
or at maturity;
(C) the issuer of the hybrid instrument is not subject by the
terms of the instrument
to mark-to-market margining requirements; and
(D) the hybrid instrument is not marketed as a contract of
sale of a commodity for fu-
ture delivery (or option on such a contract) subject to this
chapter.
(3) Mark-to-market margining requirements
For the purposes of paragraph (2)(c), mark-to-market margining
requirements do not in-
clude the obligation of an issuer of a secured debt instrument to
increase the amount of
collateral held in pledge for the benefit of the purchaser of the
secured debt instrument to
secure the repayment obligations of the issuer under the secured
debt instrument.
---------------------------------------------------------------------------
Section 1(a)(29) of the Commodity Exchange Act defines a ``hybrid
instrument'' as ``a security having one or more payments indexed to the
value, level, or rate of, or providing for the delivery of, one or more
commodities.'' Section 1(a)(31) of the Commodity Exchange Act defines a
``security'' by reference to Section 2(a)(1) of the Securities Act of
1933 and Section 3(a)(10) of the Securities Exchange Act of 1934, both
of which in turn define a security to mean, in pertinent part, an
investment contract.
The guidance provided by the Hybrid Instrument Exclusion is
agnostic as to what is ultimately delivered pursuant to the pre-
functionality token sale agreement in question:
in the event that the ultimate utility token delivered does
not bear the hallmarks of a security and thus can be properly
categorized as a commodity the SEC retains jurisdiction and
regulatory oversight of the pre-functionality token sale
agreement qua an investment contract, with the CFTC taking over
jurisdiction and enforcement oversight of the delivered utility
token in the spot market, as outlined in Section I.1 below.
in the event that the ultimate utility token delivered does
bear the hallmarks of a security and thus can be properly
categorized as a security the SEC retains jurisdiction and
regulatory oversight of the pre-functionality token sale
agreement qua an investment contract, and also retains
jurisdiction and enforcement oversight of the delivered utility
token as a security qua a commodity. This result, although
slightly counter-intuitive, arises because under the
definitions applicable to the Commodity Exchange Act, a
security is a type of commodity, albeit an excluded commodity
which is subject to exclusive SEC oversight.
The history and interaction between the SEC and the CFTC on shared
instruments is consistent with this result, and the Hybrid Instrument
Exclusion is a direct result of consideration of products that escaped
clear classification. The SEC and the CFTC have considered questions
relating to hybrid instruments since the 1980s (of particular note is
the report of the President's Working Group on Financial Markets in
1999).\14\ Since that time, the Hybrid Instrument Exclusion (formerly
the hybrid instrument exemption) has been an appropriate method of
determining which agency should have appropriate oversight over a
legally awkward instrument.
---------------------------------------------------------------------------
\14\ Report of the President's Working Group on Financial Markets,
Over-the-Counter Derivatives Markets and the Commodity Exchange Act,
November 9, 1999. Available at: https://www.treasury.gov/resource-
center/fin-mkts/Documents/otcact.pdf.
---------------------------------------------------------------------------
Given the unique and novel nature of utility tokens, conceiving a
pre-functionality token sale agreement as a hybrid instrument is a
pragmatic and common-sense approach to a scenario that can exhibit the
characteristics of both a security and a commodity for all the reasons
discussed above in Section E. This position is also consistent with the
legislative history and general position of both the SEC and CFTC that
products should generally be regulated by a single agency. It also
results in the maintenance of the inherent fungibility of the utility
tokens in question--an outcome that from a commodity law perspective is
sensible (the characteristics of a commodity should not be affected by
its means of delivery), as well as from a securities law perspective
(the utility token can be assessed on its own merits as a potentially
distinct security).
On balance, treating the underlying token as a `commodity' is an
outcome consistent with the fundamental legislative intent of the
Hybrid Instrument Exclusion (bearing in mind that for these purposes, a
security can also be a type of commodity) and is also consistent with
statements of CFTC Commissioner Brian Quintenz that [digital
currencies] ``may actually transform at some point from something that
starts off as a security and transforms into a commodity'' and that
``they may start their life as a security from a capital-raising
perspective but then at some point--maybe possibly quickly or even
immediately--turn into a commodity''.\15\
---------------------------------------------------------------------------
\15\ Coincenter.org, CFTC commissioner: tokens that start as
securities may ``transform'' into commodities. October 20, 2017.
Available at: https://coincenter.org/link/cftc-commissioner-tokens-
that-start-as-securities-may-transform-into-commodities.
---------------------------------------------------------------------------
I. Quantum of Functionality
The real question we need to address is not about transformation,
it is whether a utility token can ever achieve the status of a
commodity that is not also a security. This goes to the issue of the
quantum of functionality required and whether and when variables
exogenous to the promoter become predominant as the reason for the
purchaser's expectation of profits.
Since utility tokens do not represent a share of the promoter, the
main ties back to the promoter once full functionality has been
achieved would seem to be any residual belief that the promoter is
likely to continue to support and update the software underlying the
tokens and/or the network on which the tokens can be used. Of course,
all software products have updates and upgrades, so it would be
surprising indeed if tokenized software must always be treated like a
security while non-tokenized software is not. Tokenized software is a
novelty but the analytical framework underlying the case law requires a
determination of what predominates as the underlying driver of price
changes that a reasonable purchaser would expect. In a post-
functionality trading market for a fully completed piece of tokenized
software, the ongoing updates and upgrades from the promoter would only
represent a very small driver of price changes, if any. The state of
the industry, competing novel trends, competing goods and services, and
fundamental supply and demand issues that drive the price of the access
or service provided by the token should predominate the value
attributed to a token. The recent volatility in the digital currency
markets demonstrates this very clearly. It cannot be said that
someone's promises of updates to the Bitcoin protocol, for example, had
anything to do with the recent price swings. The real price swings
occurred after the fork to the protocol was completed. These market
moves were unrelated to any promises by a promoter to update the
software as a driver of price, but instead reflected exogenous views of
the market as to the value of Bitcoin.
1. Whose Perspective Counts?
In Teague v. Bakker, the Fourth Circuit affirmed that ``[t]he
subjective intention of a given purchaser cannot control whether
something is a `security' '' for purposes of the Howey test, otherwise
``some might have purchased securities while others did not.'' 139 F.3d
892, 892 (4th Cir. 1998). Rather, ``[t]he proper focuses of the inquiry
are on the transaction itself and the manner in which it is offered.''
which would tend to place emphasis on objective evidence and
considerations such as marketing materials, communications and
transaction documents. Id.
The manner of offering was paramount in the recent Administrative
Order against Munchee, Inc., Sec. Act Release No. 10445 (Dec. 11, 2017)
(the ``Munchee Order''), which found an investment contract based on
the promoter ``emphasiz[ing] the economic benefits to the purchaser [of
a token] to be derived from the managerial efforts of the [token's]
promoter.'' The tokens in the Munchee Order (``MUN'') were intended for
use in an application to advertise, review and buy meals from
restaurants, although ``no one was able to buy any good or service with
MUN'' at the time of their sale. Munchee Order at 10. ``In the MUN
White Paper, on the Munchee Website and elsewhere, Munchee and its
agents . . . emphasized that the company would run its business in ways
that would cause MUN tokens to rise in value.'' Id. at 12. The SEC also
found that ``Munchee primed purchasers' reasonable expectations of
profit through statements on blogs, podcasts, and Facebook that talked
about profits.'' Id. at 14. Munchee also undertook to list MUN on
exchanges, so that purchasers could realize profits through secondary
trading, regardless of whether they ever used MUN in the application.
Id. at 13. These findings led the SEC to conclude that MUN tokens were
investment contracts, id. at 30, insofar as, ``[b]ecause of the conduct
and marketing materials of Munchee and its agents, investors would have
had a reasonable belief that Munchee and its agents could be relied on
to provide the significant entrepreneurial and managerial efforts
required to make MUN tokens a success.'' Id. at 34 (added emphasis).
Notwithstanding its emphasis on the manner of offering, Teague
allowed that in some cases, ``where most intended purchasers share a
common understanding of, and have similar motives stoked by, an
offering, the `subjective' understanding and motives are powerful
evidence of the objective intent and effect of the offering.'' Teague,
139 F.3d at 892. Teague set a high bar for reaching this conclusion: it
looked to ``the subjective feeling of the vast majority of
purchasers,'' and not merely the particular plaintiffs in question, as
likely indicative of the seller's objective intention despite other
evidence. Id. It should also be noted that the motives must still be
``stoked by the offering,'' rather than a general enthusiasm for all
things associated with a blockchain. It follows that a token seller
that implements safeguards and constructs a token and conducts a token
sale the ``right way'' will ultimately be able to sell a utility token
as a non-security even if some purchasers have wildly unrealistic
expectations of profit akin to beanie baby mania.
2. Who are the ``Others'' in Efforts of Others?
The original formulation of the Howey test stated that the profits
must have been expected ``solely from the efforts of the promoter or a
third party.'' This test has been subsequently modified with respect to
the requisite amount of efforts as discussed below. Some courts \16\
have focused on the efforts of the promoter as satisfying the common
enterprise prong of the Howey test as discussed below, with other
courts noting that this treatment would conflate the common enterprise
prong with the efforts of others prong. Putting aside the common
enterprise conflation and focusing again on the efforts of others
prong, most cases focus on either the promoter's efforts or the
purchaser's efforts. It would appear from the original formulation that
reliance must be placed on the efforts of some identifiable person or
persons. The clause would be overbroad if ``others'' were interpreted
to include anyone other than the purchaser. All investment assets would
be securities if efforts of others included the efforts of unspecified
persons contributing to market dynamics and supply and demand. This
element of the test will be relevant to many utility token sales since,
unlike traditional enterprises, typically, the projects involve the
development of open-source software that can be maintained by anyone
and not just the original promoter of the project. Even for those who
subscribe to the broad vertical commonality interpretation of the
common enterprise prong of the Howey test, however, that interpretation
has focused on the efforts of the promoter, so the entire community of
open source software developers would need to be considered part of the
promoter in order to satisfy that interpretation. While the original
promoter is the most likely party to provide updates and upgrades to
the code, the fact that there is a large community of developers who
could easily decide to step in and do so further minimizes the amount
of reliance a reasonable purchaser would objectively have on the
efforts of the promoter as compared to the far weightier price drivers
in a trading market that have nothing to do with the original token
seller.
---------------------------------------------------------------------------
\16\ Revak v. SEC Realty Corp., 18 F.3d 81, 87-88 (2d Cir. 1994),
relying on Long v. Shultz Cattle Co. Inc., 881 F.2d 129, 140-41 (5th
Cir. 1989); SEC v. Comcoa, Ltd., 855 F. Supp. 1258 (S.D. Fla. 1994)
(finding vertical commonality with regard to service to assist
application and development of FCC licenses). These courts can be said
to subscribe to the broad vertical commonality interpretation of the
common enterprise prong of the Howey test.
---------------------------------------------------------------------------
3. Requisite Amount of Efforts of Others
As discussed, the original Howey formulation was modified by
subsequent case law that recognized the word ``solely'' was too narrow.
It is clear that at one end of the spectrum, if either the purchaser's
efforts are significant in the success of the enterprise,\17\ or the
promoter's efforts are de minimis in assuring the success of the
investment, the Howey test is not satisfied. Beyond that, courts have
stated the requirement as ``primarily'' or ``substantially'' from the
efforts of others.\18\ As discussed above, in Glenn W. Turner, the
court stated the test as ``whether the efforts made by those other than
the investor are the undeniably significant ones, those essential
managerial efforts which affect the failure or success of the
enterprise.'' The context for this test was a business enterprise that
included both efforts of the promoter and efforts of the purchaser. The
court was clearly focused on ensuring that promoters could not avoid
the securities laws by merely building in some perfunctory efforts of
the purchaser into their business schemes. When the context is about
determining when the promoter's efforts are displaced by variables
entirely exogenous to (and beyond the control of) both the promoter and
purchaser, the test is better understood to be a simple predominance
test. For that reason, we have used predominance as the test throughout
this memorandum, but we would also expect that if a court applied a
test more like the Glenn W. Turner test, the efforts associated with
software updates and upgrades would still not rise to the level
described by that test. It can hardly be said that providing ongoing
software updates and upgrades constitute those essential managerial
efforts which affect the failure or success of the secondary market
price,\19\ particularly compared to the other market dynamics affecting
price in the trading market post-functionality.
---------------------------------------------------------------------------
\17\ E.g., Steinhardt Group v. Citicorp, 126 F.3d 144 (3dCir. 1997)
(limited partnership interest in a securitization transaction was not a
security where limited partner's retention of ``pervasive control''
meant that he was relying extensively on his own efforts).
\18\ See, e.g., United States v. Leonard, 529 F.3d 83 (2d Cir.
2008) (the court considered whether, under all the circumstances, the
scheme was being promoted primarily as an investment).
\19\ This illustrates the problem with applying Glenn W. Turner to
tokens. There is no enterprise on whose success or failure the token
holder's investment depends. The closest analog might be to substitute
the secondary market for the ``enterprise'' in that test.
---------------------------------------------------------------------------
Since the test is objective, and because use of tokens for their
intended purpose is gaining traction, some courts might well conclude
that purchasers are not merely passive and that the purchaser's
collective efforts are significant because use of the token for its
intended purpose is a strong driver of demand for the token and,
therefore, the price of the token. Many applications permit, and some
require, token holders to participate in the operation of the
application. A crowdsourcing application will not work unless enough
users vote or otherwise record a view on the crowdsourced question.
These applications frequently use tokens to regulate the crowdsourcing
process, assign and weight votes and reward the most accurate
predictions. Networked services are another common example of
applications that require active participation by token holders.
Network participants must download the service application on their
computers and accept tokens in exchange for performing the service.
Holders of tokens for such applications may be active contributors to
the token's success, rather than passive investors. Many courts have
found that an arrangement does not constitute an investment contract
when it involves significant efforts of the purchaser. See Cordas v.
Specialty Restaurants, Inc., 470 F. Supp. 780, 788 (D. Ore. 1979)
(``[i]t is undeniable here that the plaintiff's managerial efforts were
intended to have an important effect on her own success. Her efforts
would also have some effect, however slight, [added emphasis] on the
success of the enterprise as a whole. [Citation omitted.] These factors
are sufficient to preclude her from coverage under the Howey
analysis.'' ``To hold otherwise would put the courts in the position of
judging where along the continuum a manager's efforts become
`significant' in the success of a larger enterprise.'') Id. at 788. The
Cordas court chose to apply Howey based on the quality of the
plaintiff's participation, rather than its impact on the broader
enterprise. Other courts have also taken this approach to the final
prong of the Howey test, particularly in cases involving franchises.
For example, Boldy v. McConnell's Fine Ice Creams, Inc., 904 F.2d 710
(9th Cri. 1990) (``In focusing on `the extent of participation the
franchisee has under the franchise agreement' in this case, it is clear
that `each franchisee's active management was essential to the success
of his retail restaurant.' '' [Citation omitted.]); see also, cases
discussed in What is an ``Investment Contract'' within Meaning of
2(1) of Securities Act of 1933 (15 U.S.C.A. 77b(1)) and 3(a)(10) of
Securities Exchange Act of 1934 (15 U.S.C.A. 78c(a)(10)), Both
Defining Term ``Security'' as Including Investment Contract, 134 A.L.R.
Fed. 289, 17[a]-[c] (Cum Supp. 2017).
Whether or not a court finds substantial efforts of token holders
are involved, it seems likely that once full functionality has been
achieved, the efforts of the promoter would not rise to the level
required by the efforts of others element of the Howey test to consider
post-functionality sales of the token to constitute investment
contracts.
4. Gary Plastic
The Gary Plastic case has special relevance to utility tokens given
the robust secondary markets that have developed. In an ordinary case,
most of the elements of Gary Plastic can be distinguished--token
exchanges do not negotiate the terms of the tokens, do not promise to
find buyers for the tokens and are not exclusive venues for purchase
and sale of the tokens. The key element, however, that would be
applicable is any promise by the promoter to establish or maintain a
trading market for the tokens. This can be described as a special type
of ``efforts of others'' that obviates the need for analysis of trading
dynamics as the driver of price since the expectation that the market
will exist in the first place is based on the promised efforts of the
promoter. It follows that any promises by the promoter to support an
active trading market for the token would, by itself, be sufficient to
satisfy the efforts of others prong of the Howey test. The same would
not be true, however, if the token seller were to cooperate with token
exchanges in the qualification process without publicizing in advance
any promise of such cooperation. Without a promise of supporting
trading in advance of a purchase, the purchaser cannot reasonably
expect it, as token exchange qualification requirements are significant
and evolving rapidly. While outside the scope of this paper, we note
that some exchanges are currently requiring token sellers to provide a
securities law analysis and some token creators are declining to
provide this for fear of being seen as facilitating exchange activity.
As a result, many tokens perversely wind up being traded only on the
less rigorous (often foreign) exchanges that do not require
interaction. Discouraging cooperation with the qualification process,
may negatively impact the ability of exchanges to properly discriminate
between tokens that are securities, which the exchange is not licensed
to list, and utility tokens. Similarly, merely providing links to token
exchanges contained on a token seller's website should not be viewed as
efforts of the promoter to support an active trading market, so long as
these links are merely included to assist users of the platform in
obtaining tokens for use on the platform.
5. Full Functionality
In light of the above, it is clear that merely some utility is not
sufficient under present market conditions. A reasonable approach to
defining how much functionality is sufficient under present market
conditions would be to say that the token must have at least as much
functionality as any other non-tokenized good or service being sold. To
that end, we would propose an 80/20 rule of thumb whereby the marketing
materials focus on the present functionality of the token with much
less attention paid to the potential future upgrades or additional
features (i.e., 80% focused on present functionality and 20% on future
functionality). This roughly approximates what other sellers of non-
tokenized goods and services have historically put into their marketing
materials. While virtually all products with embedded software come
with free updates, the seller will focus on the present functionality
of the product to entice the purchaser with the features the purchase
can presently enjoy. The seller might also mention planned future
enhancements that will be delivered for free to induce the purchaser to
buy now rather than wait because the purchaser will get the update for
free when available without having to wait to enjoy all the present
features of the product. Stereo equipment is a good example of this
where the marketing materials will focus on the present features, but
will also include some mention of the ``future proof'' nature of the
purchase by discussing other codecs (i.e., digital music formats) that
will be supported on the equipment after a firmware update that will be
provided for free when available.
Once a token has achieved its full functionality under this
proposed standard, any purchaser that purchases the token with an
expectation of profits is relying primarily on market dynamics
affecting the value of the goods and services accessible through the
token (not the promoter) for price changes. So long as the token seller
did not promise to support secondary trading on any exchanges, the sale
of a utility token with full functionality should not be the sale of a
security.
J. Consumptive Intent vs. Resale
As discussed, the Teague court focused on objective criteria in
determining the purchasers' intent. Other Federal courts have expanded
on Teague, concluding that marketing materials indicating an actual
subjective investment-related purpose established by the plaintiff
could not override a contractual representation and merger clause
affirming that a purchase was for consumption.\20\ As such, even under
current market conditions where resale intent appears to be more
prevalent than consumptive intent, there are certain practices that
could be employed by token sellers to establish sufficient consumptive
intent, although these are not common features of a token sale. Here
are a few examples:
---------------------------------------------------------------------------
\20\ Demarco v. LaPay, No. 2:09-CV-190 TS, 2009 WL 3855704, *8-*9
(D. Utah Nov. 17, 2009) (holding that plaintiffs could not ``disclaim
the contents of the contract which were clearly laid out and duly
acknowledged by them'' in real estate transaction); see also Alunni v.
Dev. Res. Group, LLC, No. 6:08-cv-1349-Orl-31DAB, 2009 WL 2579319, *8
n. 12 (M.D. Fla. Aug. 18, 2009) (same).
Establish limits on the number of tokens any individual
purchaser may purchase to approximate the number likely to be
---------------------------------------------------------------------------
used in a reasonable amount of time;
Exclude purchasers who fit the profile of an investor (e.g.,
venture funds or hedge funds);
Include lockups on the tokens that preclude resale but
permit use for some period of time;
Include representations as to intended use of the token; and
Include covenants of the purchaser to login and use the
tokens in the network on some prescribed periodic basis.
Since an offering must meet each prong of the Howey test to be
considered an investment contract, if sufficient consumptive intent
were to be established, the token sale would not be an investment
contract even if the sale occurred prior to the development of full
functionality.
It is also important to consider when the appropriate time to
measure consumptive intent vs. resale intent is. In the case of event
tickets, resale intent predominates the first few days following ticket
launch as resellers attempt to speculate on the ultimate price that
users will be willing to pay. This is because the tickets are generally
not released until shortly before the event takes place. Because there
is a fixed date for use, the seller is able to ensure that the time for
resale is arbitrarily short. With utility tokens, there is no fixed
date for use so it is possible that resale will go on for a relatively
long time and only gradually shift to use as the project gains adoption
and traction among users. As that happens, the price would be expected
to converge on the ultimate price that end users are willing to
pay.\21\ If we measure consumptive intent today for a utility token
launched last week, it is likely we will conclude that resale intent
predominates over consumptive intent presently. That doesn't mean there
never will be consumptive intent or that the utility tokens have no
inherent consumptive purpose. The same would be true of event tickets
if measured at a time when resale was prevalent. Anecdotal evidence
suggests that there have been a number of earlier token offerings from
the 2014 and 2015 vintage with respect to tokens that are now routinely
used for their intended purpose. This is why the Kickstarter model was
considered best practices for the early utility token sales in 2017.
This inevitable change in circumstances, i.e., mutability, at least for
those tokens with truly useful functionality, is also why it makes
sense under existing case law to only consider pre-functionality token
sale agreements to be securities, and not the tokens themselves in
perpetuity.
---------------------------------------------------------------------------
\21\ In many cases, the use price of a utility token is entirely
independent of the secondary market price, in which case the secondary
market speculation is really about currency value which is commodity
speculation having nothing to do with the project or promoter. These
types of utility tokens are much more akin to digital currencies in
their relationship to securities laws.
---------------------------------------------------------------------------
K. Characteristics of a ``Compliant'' Token Sale
As the DAO Report found, and as many commentators and regulators
have observed, many token sales are currently running afoul of U.S.
securities laws. In this sense, the DAO Report sounded an important
cautionary alarm to the market. However, the offer and sale of tokens
can be affected in a manner that complies with the requirements of the
Federal and state securities laws. Here are the key characteristics
that must be present in a token sale that complies with the
requirements of the U.S. securities laws:
The token cannot offer or be packaged with a financial
return or share of ownership;
Prior to achieving full functionality, the offer and sale of
tokens will almost always be deemed to be the offer and sale of
an investment contract that must be registered or exempt under
U.S. securities laws;
Once full functionality is achieved, there should be no
expectation of profit from the efforts of others, and value
should instead be driven by exogenous market factors. At such a
point, the token should no longer be deemed an investment
contract, as the transaction no longer meets the Howey test,
and the offer and sale of tokens should no longer be subject to
the requirements of the Securities Act;
The requisite amount of functionality needed is fact-based,
with marketing being an important determinant--if buyers would
not buy the token for its present functionality, the token
seller must build more present functionality before
distributing the token to the public as a non-security;
Marketing materials must focus on present functionality and
use of the token, not on future features or resale
opportunities, although a short description of any planned
upgrades is permissible; and
The token seller cannot promise to support secondary market
trading of the token on any exchanges.
We believe the following facts tend to push the securities analysis
one way or the other but are not by themselves dispositive (good facts
push the analysis toward a non-security):
Fixed or automatically increasing supply of tokens is
generally a good fact. A fixed or automatically increasing
supply is not characteristic of most traditional product sales,
but it is also not characteristic of most securities offerings
either.\22\ It is a currency-like characteristic and generally
stems from the Bitcoin model and the fact that most utility
tokens are used as currencies even if they have additional
functions and features. A fixed or automatically increasing
supply also helps the analysis around efforts of others in the
sense that the promoter has no control over supply, which is a
key element of price in the trading market.
---------------------------------------------------------------------------
\22\ Once again, event tickets are an example of a traditional good
that does have a fixed supply.
Diminishing token supply, either automatic or periodic,
tends to indicate an intent on the part of the token seller to
drive up the price of the token in the secondary markets. If
this feature exists, there should be important structural
reasons for this feature having nothing to do with the desire
to influence price. This feature represents efforts of the
promoter in structuring the token that not all courts would
recognize as satisfying the Howey test to the extent the court
applies the Life Partners test focusing on post-sale efforts
rather than pre-sale efforts, but since this conclusion is in
question, it is still considered to be a bad fact for purposes
---------------------------------------------------------------------------
of utility token sales.
Publicly announced discounts that diminish over a set
schedule are problematic during a post-functionality token
sale, especially if not accompanied by resale lockups. While
this may be a practice used by conventional sellers of goods
and services, in the context of utility tokens, it does tend to
create an expectation of profits based on the efforts of the
promoter to structure the token sale in this manner. Once
again, these would be pre-sale efforts of the promoter, but it
would still be considered a bad fact for a utility token sale.
Also, the same practice would be appropriate during the pre-
functionality token sale, because the purchasers are investors
with a profit motive participating in a securities offering
with the requisite protections in place.
Allocations of a substantial number of tokens to the token
seller team as well as to advisors, strategic partners and
others for compensatory purposes, especially without any
significant resale lockups in place, clearly puts tokens in the
hands of persons with resale intent, not consumptive intent.
This may not matter to the extent we have already assumed that
most purchasers are purchasing with resale intent. At a
minimum, if these allocations are granted pre-functionality,
the grant must comply with Rule 701 or Regulation D or
otherwise comply with U.S. securities laws. The real reason
this could be a bad fact is that this practice may result in
fraudulent ``pump and dump'' Ponzi-like schemes on the part of
the persons receiving the allocations.
Each of the factors discussed above in Section J that tend
to establish consumptive intent rather than resale intent are
good facts, particularly lockups that prohibit resale but not
use for a significant period of time after purchase, which are
an excellent way to curb ``pump and dump'' tendencies and to
emphasize intent to use rather than resell.
L. Existing Regulations Applicable to Token Exchanges--CFTC Anti-Fraud
Rules
The CFTC is responsible for enforcement actions against wrongful
conduct in spot markets for digital currencies.\23\ Historically, the
CFTC has exercised that enforcement authority when there is a nexus to
an actively traded commodity interest,\24\ and, consistent with that
approach, since the recent launch of digital currency-related
derivative products, the CFTC has stepped up its enforcement actions
against spot market abuses, although its initial digital currency-
related actions began in 2015.\25\ ``Bitcoin and other virtual
currencies'' have already been deemed within the scope of `commodities'
under CFTC enforcement jurisdiction, and given the wide scope of the
definition (the term commodity means ``all other goods and articles [.
. .] and all services, rights and interests [. . .] in which contracts
for future delivery are presently or in the future dealt in''), any
utility token with fungible characteristics falls within this
scope.\26\
---------------------------------------------------------------------------
\23\ The term digital currency means the same thing as virtual
currency for purposes of this memorandum. In its enforcement order
against Derivabit in September 2015, the CFTC confirmed that ``Bitcoin
and other virtual currencies are encompassed in the definition and
properly defined as commodities.'' United States of America Before the
Commodity Futures Trading Commission In the Matter of Coinflip Inc., d/
b/a Derivabit, and Francisco Riordan, Respondents. Order Instituting
Proceedings Pursuant to Sections 6(c) and 6(d) of the Commodity
Exchange Act, Making Findings and Imposing Remedial Sanctions. CFTC
Docket No. 15-29, September 17, 2015. Available at: http://
www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/
legalpleading/enfcoinfliprorder09172015.pdf.
\24\ CEA Sections 6c, 9a(2) and Part 180 of the CFTC's regulations
give the CFTC the authority, in relevant part, over violations with
respect to ``any commodity in interstate commerce.'' 7 U.S. Code 9,
13, and 17 CFR 180, 76 FR 41398. There are two particular provisions
of the CEA that grant the CFTC broad authority to take action against
persons engaged in forms of market abuse, including manipulation and
fraud, or attempted manipulation and fraud, Sections 6(c) and 9(a)2.
Commission Regulation 180 (i.e., Part 180) codifies Section 6(c).
\25\ In addition to the Derivabit action outlined above, the CFTC
has also taken action against TeraExchange in 2015, and the spot
exchange Bitfinex in 2016, for CEA violations associated with virtual
currencies. See United States of America Before the Commodity Futures
Trading Commission In the Matter of TeraExchange LLC Respondent. Order
Instituting Proceedings Pursuant to Sections 6(c) and 6(d) of the
Commodity Exchange Act, as amended, Making Findings and Imposing
Remedial Sanctions. CFTC Docket No. 15-33, September 24, 2015.
Available at: http://www.cftc.gov/idc/groups/public/
@lrenforcementactions/documents/legalpleading/
enfteraexchangeorder92415.pdf. See also United States of America Before
the Commodity Futures Trading Commission In the Matter of BFXNA Inc. d/
b/a BITFINEX, Respondent. Order Instituting Proceedings Pursuant to
Sections 6(c) and 6(d) of the Commodity Exchange Act, as amended,
Making Findings and Imposing Remedial Sanctions. CFTC Docket No. 16-19,
June 2, 2016. Available at: http://www.cftc.gov/idc/groups/public/
@lrenforcementactions/documents/legalpleading/enfbfxnaorder060216.pdf.
\26\ CEA Section 1a(9), 7 U.S. Code 1.
---------------------------------------------------------------------------
In September 2017, in its complaint against Gelfman, the CFTC took
action against alleged abuses in the Bitcoin spot market and charged
operators of an alleged Ponzi scheme with fraud, misappropriation and
issuing false account statements in violation of Section 6(c) of the
CEA.\27\ In January 2018, the CFTC brought three digital currency
enforcement actions: (i) My Big Coin Pay Inc., which charged the
defendants with commodity fraud and misappropriation related to the
ongoing solicitation of customers for a digital currency known as My
Big Coin; \28\ (ii) The Entrepreneurs Headquarters Limited, which
charged the defendants with a fraudulent scheme to solicit Bitcoin from
members of the public, misrepresenting that customers' funds would be
pooled and invested in products including binary options, making Ponzi-
style payments to commodity pool participants from other participants'
funds, misappropriating pool participants' funds, and failing to
register as a Commodity Pool Operator; \29\ and (iii) CabbageTech,
Corp., which charged the defendants with fraud and misappropriation in
connection with purchases and trading of Bitcoin and Litecoin.\30\
---------------------------------------------------------------------------
\27\ Commodity Futures Trading Commission v. Gelfman Blueprint,
Inc. and Nicholas Gelfman, Case Number 17-7181, United States District
Court, Southern District of New York. Complaint filed September 21,
2017. Available at: http://www.cftc.gov/idc/groups/public/
@lrenforcementactions/documents/legalpleading/
enfgelfmancomplaint09212017.pdf.
\28\ Commodity Futures Trading Commission v. My Big Coin Pay, Inc.,
Randall Crater, and Mark Gillespie, Case Number 18-10077-RWZ, United
States District Court, District of Massachusetts. Complaint filed
January 16, 2018. Available at: http://www.cftc.gov/idc/groups/public/
@lrenforcementactions/documents/legalpleading/
enfmybigcoinpaycomplt011618.pdf.
\29\ Commodity Futures Trading Commission v. Dillon Michael Dean
and the Entrep[r]eneurs Headquarters Limited, Case Number 18-cv-00345,
United States District Court, Eastern District of New York. Complaint
filed January 18, 2018. Available at: http://www.cftc.gov/idc/groups/
public/@lrenforcementactions/documents/legalpleading/
enfentrepreneurscomplt01
1818.pdf.
\30\ Commodity Futures Trading Commission v. Patrick K. McDonnell,
and CabbageTech Corp. d/b/a Coin Drop Markets, Case Number 18-cv-0361,
United States District Court, Eastern District of New York. Complaint
filed January 18, 2018. Available at: http://www.cftc.gov/idc/groups/
public/@lrenforcementactions/documents/legalpleading/
enfcdmcomplaint011818.pdf.
---------------------------------------------------------------------------
The CFTC also appears to be closely monitoring digital currency
spot exchanges as part of these efforts. As part of the self-
certification process for Bitcoin futures products by certain
Designated Contract Markets (``DCMs''), the CFTC expects information
sharing agreements to be in place with underlying spot exchanges in
accordance with the second core principle for DCMs.\31\ On February 15,
2018, the CFTC once again reminded market participants in a customer
protection action that it ``maintains general anti-fraud and
manipulation enforcement authority over virtual currency cash markets
as a commodity in interstate commerce.'' \32\ It has also apparently
(i) requested information from GDAX in relation to an alleged `flash
crash' which occurred on June 21, 2017,\33\ and (ii) issued subpoenas
regarding alleged conduct at the Hong Kong-based exchange Bitfinex.\34\
---------------------------------------------------------------------------
\31\ See CFTC Backgrounder on Self-Certified Contracts for Bitcoin
Products, December 1, 2017. Available at: http://www.cftc.gov/idc/
groups/public/@newsroom/documents/file/bitcoin_fact
sheet120117.pdf. See also CFTC Statement on Self-Certification of
Bitcoin Products by CME, CFE and Cantor Exchange, December 1, 2017.
Available at: http://www.cftc.gov/PressRoom/PressReleases/pr7654-17.
\32\ CFTC Customer Advisory: Beware Virtual Currency Pump-and-Dump
Schemes, February 15, 2018. Available at: http://www.cftc.gov/idc/
groups/public/@customerprotection/documents/file/
customeradvisory_pumpdump0218.pdf.
\33\ Lily Katz and Matt Robinson, Cryptocurrency Flash Crash Draws
Scrutiny from Watchdog, Bloomberg.com, October 2, 2017. Available at:
https://www.bloomberg.com/news/articles/2017-10-02/cryptocurrency-
flash-crash-is-said-to-draw-scrutiny-from-cftc.
\34\ Matthew Leising, U.S. Regulators Subpoena Crypto Exchange
Bitfinex, Tether, Bloomberg.com, January 30, 2018. Available at:
https://www.bloomberg.com/news/articles/2018-01-30/crypto-exchange-
bitfinex-tether-said-to-get-subpoenaed-by-cftc.
---------------------------------------------------------------------------
Reinforcing the inherent scope of the CFTC's enforcement authority
is the possibility of aiding and abetting violations that act to
restrain certain industry service providers or other market
participants associated with any alleged violations.\35\ The efficacy
of this regulation by proscription is further reinforced by the ability
of private litigants to take actions under the above provisions,
subject to certain additional requirements.\36\ For a private actor to
make a claim, they must demonstrate, inter alia, that they purchased or
sold a derivative contract referencing a digital currency and prove
actual damages resulting from the proscribed conduct. Although this
right of action therefore relies on a nexus to the digital currency
derivative market, as the number and diversity of digital currency
based derivative products continues to grow so too does the number of
potential plaintiffs.
---------------------------------------------------------------------------
\35\ To prove an aiding and abetting violation under the CEA (7
U.S. Code 25(a)(1)), it must be shown that the defendant ``in some
sort associate himself with the venture, that he participate in it as
in something that he wishes to bring about, that he seek by his action
to make it succeed.'' CFTC v. Amaranth Advisors, L.L.C., 554 F. Supp.
2d 523 (2008) stating the appropriate standard for aiding and abetting
under the CEA, quoting Learned Hand J. in United States v. Peoni, 100
F.2d 401, 402 (2d Cir.1938).
\36\ 7 U.S. Code 25(a)1(D) provides that a private litigant can
take action for fraud, attempted fraud or if the violation constitutes
``a manipulation of the price of any such contract or swap or the price
of the commodity underlying such contract or swap.''
---------------------------------------------------------------------------
M. Conclusion
The Howey test is fundamentally based on facts and circumstances--
the economic realities--of the offer and sale of the underlying product
or service.\37\ As circumstances change, the results of the test should
change as well. Specifically, when the circumstances under which
parties agree to enter into a pre-functionality token sale agreement
have changed by the time the underlying tokens are delivered, an
analysis which concluded that the pre-functionality token sale
agreement constituted an investment contract may no longer apply to the
tokens. On the other hand, if circumstances have not changed
materially, new token sale agreements may constitute investment
contracts in their own right, even after delivery under the initial
pre-functionality token sale agreement.
---------------------------------------------------------------------------
\37\ Howey, supra note 2 at 299. (The Howey test ``embodies a
flexible rather than a static principle, one that is capable of
adaptation to meet the countless and variable schemes devised by those
who seek the use of the money of others on the promise of profits.'')
---------------------------------------------------------------------------
A pre-functionality token sale agreement may be found to constitute
an investment contract even if the future tokens will not qualify as
investment contracts or other securities at the time of their delivery.
When a seller offers and sells the pre-functionality token sale
agreements by emphasizing the potential value of the future tokens,
uses the proceeds of the pre-functionality token sale agreements to
complete development of an application for the tokens and undertakes to
conduct a public sale of the tokens with a target price above the pre-
functionality price, these circumstances may provide a basis for the
SEC or a court to conclude that the pre-functionality token sale
agreements are investment contracts. Once the network or software
application for the tokens is developed, these circumstances would no
longer apply and, thus, could no longer provide a basis for concluding
that further sales of tokens would constitute investment contracts.
Even if the pre-functionality purchasers reasonably anticipate that a
token will appreciate above its public sale price, any such
appreciation should result from general market forces rather than the
efforts of the seller. Therefore, once the investment contract implied
by the pre-functionality token sale agreement has been completed (i.e.,
at the time of tokens are delivered), the tokens should no longer
involve a common enterprise in which the seller's efforts are
reasonably expected to produce profits for the token purchasers.
N. Epilogue
While not directly related to the above conclusion, here are some
additional thoughts worth considering.
1. Relevant Disclosure
Ultimately, the Securities Act is a disclosure regime. One
important way to look at this situation is to ask what the relevant
disclosure would be post-functionality. Existing disclosure rules
assume the security represents either equity or debt, neither of which
would be appropriate disclosure rules for utility tokens. It would not
be wise, for example, to include disclosure about the token seller, or
we would confuse the purchasers into believing they have some interest
in the token seller, which they do not. Perhaps some disclosure would
be appropriate about the real risk here, namely that the market price
is extremely volatile, but that is now patently obvious to anyone
sitting in front of a computer and is not something about which the
token seller has any special information or expertise to provide. Maybe
some disclosure about overhang would make sense, especially if the
token seller happens to be aware of any large purchasers, but this
disclosure again risks providing false comfort to the market since the
token seller, unlike an equity issuer, has no way of knowing who holds
any particular percentage of the tokens from time to time. We have to
ask ourselves, if there is no relevant disclosure that could possibly
be provided by the token seller post-functionality, are we really
dealing with a securities transaction that is appropriately regulated
under a disclosure regime, or are the regulatory concerns really about
trading price manipulation covered by the CFTC's anti-fraud rules for
spot trading?
2. Common Enterprise
We have not considered the common enterprise prong of the Howey
test in the above discussion because the courts are fractured over the
best way to interpret this prong of the test. This fact, however, cuts
both ways. It is not prudent for a token seller to rely on this test as
the sole prong to hang its hat on, or for regulators to assume it will
be easy to prove (and the regulator must prove it to win in court).
Indeed, the most commonly applied interpretation of this prong
involves horizontal commonality, which doesn't appear to be the case
once tokens have achieved full functionality and are sold to purchasers
as a product. There are no contractual commitments on the part of the
token seller surviving the post-functionality token sale. The proceeds
of a post-functionality token sale cannot be said to be pooled in any
enterprise of which the token holders own a share or interest. It is
true that narrow vertical commonality will often exist in the sense
that the token seller's fortunes are often tied to the same market
dynamics as the token holders to the extent the price of tokens rises
and the token seller has retained an inventory of tokens for future
sale. Perhaps for the very reason that this type of commonality would
apply to every seller of a good or service that is hoping for the
prices of its goods to go up, very few courts have held that narrow
vertical commonality is sufficient by itself to satisfy the common
enterprise prong. Broad vertical commonality, meaning that the fortunes
of the token holder are tied to the efforts of the token seller would
be subsumed within the efforts of others prong, so it would not be
sufficient for merely some efforts of the promoter to satisfy the Howey
test for all the reasons described above with respect to the efforts of
others prong showing that those efforts must predominate the
expectation of profits. From the regulator's perspective, at best, the
common enterprise prong adds nothing to the analysis, but in all
likelihood, it represents a very significant hurdle to overcome in
court.
3. Fraudulent Sales Tactics--Pump and Dump
We have pointed out in several instances above that, if we apply
existing case law with analytical consistency, the mere marketing of a
post-functionality token (or any commodity, such as gold coins) as an
investment should not, by itself, cause the offering to satisfy the
Howey test. Nevertheless, we leave open the possibility that the
presence of abusive marketing tactics or running a so-called ``pump and
dump'' scheme can satisfy the efforts of others prong in that
purchasers would expect to profit on the continuation of those abusive
promotional efforts. In any market environment, that would be
sufficient basis for satisfying Howey if the other prongs were also
satisfied. Moreover, token sellers would be unwise to ever refer to the
token as an investment, whether pre- or post-functionality, because
those statements will live on and be discoverable with an Internet
search even at some future time when the token seller would like to be
able to conclude that the efforts of others prong is no longer the only
prong available to avoid satisfying the Howey test (e.g., if the token
seller wants to market future features after the market has cooled down
and the tokens are being used instead of resold for the most part). As
such, we do not expect this technical point--that commodities may be
marketed as investments--to lead to problematic behavior in the context
of token sales.
4. Reves Test
It is important not to confuse the Reves test with the Howey test.
Some of the Reves factors are similar to some of the Howey prongs. The
first Reves factor examines the transaction in order to assess the
motivations that would prompt a reasonable lender (buyer) and creditor
(seller) to enter into it. For example, was the transaction in question
an investment transaction or a commercial or consumer transaction? This
factor might be confused with the expectation of profits element of the
Howey test. In Reves the satisfaction of any one factor, if strong
enough, can cause the note to qualify as a security. This confusion may
lead to the incorrect application of Howey which requires every prong
to be satisfied, regardless of how clearly any one factor may be
satisfied, for the arrangement to qualify as an investment contract.
Again, it is not sufficient for an expectation of profits to exist with
respect to an asset that may even be marketed as an investment, if the
expectation is not based on the efforts of others. Analytically, it
just doesn't matter in how many ways and how clearly the expectation of
profits prong is satisfied if those expectations are not based on the
efforts of others.
In addition, some of the Reves factors would appear relevant to
utility tokens, especially the second factor, which is the plan of
distribution used in the offering and selling the instrument--for
example, is the instrument commonly traded for investment or
speculation? While it may be tempting to consider the trading markets
for utility tokens to be dispositive of the issue of whether a utility
token is a security, that is not the case. As discussed above, it is
merely one more fact tending to establish the expectation of profits
element of the Howey test, which may be overridden by the other prongs.
5. Policy Considerations
Blockchain technology is as transformative as the Internet. While
the Internet was about the movement of information (and set off lots of
new legal concerns around privacy and data security), blockchain
technology is about the movement of value. The key innovation, as with
the Internet, is found in the frictionless nature of the movement. It
has already led to important new business models never seen before. It
will ultimately lead to rapid frictionless liquidity for every asset
class and every good and service. Wherever possible, it will be
important to regulate based on looking through the token to the thing
being tokenized for the right regulatory treatment. But, it will mean
things like novel software applications suddenly have unprecedented
trading characteristics that need to be evaluated under existing law.
Fortunately, the Howey test is based on facts and circumstances and
focuses on the economic substance of the transaction, so it should
stand the test of time as this disruptive technology changes our daily
norms.
Blockchain technology is expanding at a rapid pace. Other
jurisdictions like China have taken a very stilted binary approach to
regulating token sales by simply banning them because their laws are
not developed enough to be useful as a means of preventing bad actors
while permitting good actors. Other jurisdictions have aggressively
embraced blockchain technology and have instantly become magnets for
blockchain entrepreneurs as today's workforce is more mobile than ever.
Over time, this recent spate of irrational exuberance associated
with this novel technology will subside and consumptive intent will
predominate once again. In that future state, it would not make any
sense to have taken a position that all tokens are securities in
perpetuity. This would be tantamount to following China's lead as this
would shut down the entire ecosystem, at least here in the United
States. Fundamentally, utility tokens are intended to be used as non-
securities in a network or application. They could not be used for
their intended purpose (e.g., micro payments for micro tasks, or
loyalty rewards) if they are categorized as securities under U.S. law,
so all of this innovation would need to move offshore and the United
States would be one more jurisdiction added to the list of disqualified
jurisdictions along with China and New York (because of the overbroad
BitLicense). It makes more sense to draw a line today that is grounded
in intellectual rigor and analytical consistency, which uses the
flexibility of Howey to regulate the bad actors while permitting the
good actors to continue to innovate with Blockchain technology here in
the United States.
The Chairman. Thank you, Mr. Ness.
The chair reminds Members that they will be recognized for
questioning in the order of seniority for Members who were here
at the start of the hearing. After that, Members will be
recognized in the order of arrival. I appreciate Members'
understanding, and I will recognize myself for 5 minutes.
Mr. Ness, I agree with you that if we don't get this right
and we flush the innovators offshore into other countries, that
getting them back is a lot more difficult. We are at the start
of the process with this hearing so that we can get to an
answer that doesn't do that.
Ms. Baldet and Mr. Kupor, you each noted that tokens in
crypto-networks have the potential to create next generation
open Internet protocols. Can you flesh that out a little bit
for the laymen and myself that understand the words, but if you
can tell us what those actually mean, that would be a little
helpful.
Ms. Baldet. Sure, thank you.
When we say open, open means a couple things. In this case,
we mostly mean open access when we say public blockchains,
which means that anyone can join the network. It has to do with
the degree of gatekeeping, which is not necessarily an all or
nothing kind of a decision. If we start thinking of public
blockchains as being more like a public commons, it is a lot
more like the Internet wherein you have a lot of choice as to
how you access that sort of network.
We also usually mean open source, as Mr. Kupor mentioned,
so that we are allowing auditing of that code which increases
trust of the code, and most of the core technology that powers
the backbone of the Internet is open source.
Mr. Kupor. I agree with all that. I would just to give you
a very specific example, imagine in the future a social
network. Today, as users of social networks, of course, you
have an intermediary, in many cases, a company like Facebook
who obviously is taking and utilizing the consumer data, and
then obviously developing relations with advertisers and others
as a way to monetize that data. That is their business model.
In the future, utilizing a crypto-network, you can imagine
a world where you as the user own your data. That data is
cryptographically secured, and you choose which data you want
to expose to various advertisers or other promoters, and the
flow of economic value in that case, as opposed to going
through an intermediary, might be going directly from an
advertiser or a promoter of products to you as an individual as
you have kind of governed the use of that data. That would be,
in very broad terms, a kind of expansive view of what this
could look like.
The Chairman. All right. Mr. Fairfield, you talked about
the Howey test, which seems to be the gold standard among
securities lawyers who can spell that last name. Can you talk
about that being maybe the outer edges?
One of the questions we are trying to answer is are they
securities or commodities, and where does that transition
occur? Can you talk to us better about this Howey test and why
you think that is the outer edge, and just how should it apply
to distinguishing between commodities and securities?
Mr. Fairfield. Certainly. There are two questions. The
first is lawyers are inventive. They can rework the formal form
of a transaction to make it into anything. Howey describes the
outer limit of the kinds of legal forms that can be turned into
investment contracts, that can be turned into this sort of
exchange. I give you money now, and I wait and I reap the
benefit of your labor on the other end.
But the difficulty with that is that while courts must be
able to look to the economic realities of the transaction, look
underneath the form because if we just look at the form, if we
just look at what it is called, then anyone can title the asset
whatever they want at the top of a piece of paper and escape
whatever regulation they want.
Courts have to look past the formal titling of the asset to
the economic realities of it; however, they also have to
understand that the very flexibility of these tools, both the
flexibility of legal forms and the flexibility of this database
technology means that it is very possible for people to be
using a product for one entirely legitimate purpose and have
other people begin to use it for different purposes.
An example of this from outside of the cryptocurrency area
entirely would be the discussion we had several decades ago on
VCRs. The question was some people use them to make illegal
copies. Many people don't. How far are we willing to go in
rooting out bad uses that we are beginning to cut away healthy
tissue? And that is why I believe Howey is the outer circle. It
is necessary that it be there so that SEC, in this particular
case, can reach cases in which people are labeling something
one formal legal form, but are actually engaging in an
investment contract. That is what it is there for, but it
doesn't really tell us anything about what the regulatory
landscape should actually look like at the end of the day. In
fact, the regulatory landscape, in my estimation, should and
will look like something substantially different. It will look
like a bit of a handoff, like a relay race in which for certain
functions and for certain conditions, one overseer may have
authority. Under [audio malfunction in hearing room].
The Chairman. Sorry, I lost your microphone. Thank you, Mr.
Fairfield.
Ranking Member Peterson, 5 minutes.
Mr. Peterson. Thank you, Mr. Chairman. I don't know where
to start.
I am somebody that believes we should still be on the gold
standard, and we should audit the Fed because I don't really
trust them.
What worries me about this is that you say there are $250
billion of capitalization here or whatever, how much money is
actually here. This just seems like a Ponzi scheme to me. I
think the stock market is a casino, so that is where I am
coming from.
If I am going to send $100,000 to somebody through one of
these deals, who is going to stand behind it? I give the money
to one of you guys and then you turn around and create these
things and send it to somebody else. Well, in the meantime,
what if you went broke? I was involved when we found out about
credit default swaps and figured out that everybody was trading
these things and there was nothing there, and if we wouldn't
have stopped them the whole economy would have collapsed. I
don't know if we have a similar situation going on here with
this, but what is behind this? If there is no money at the end
of the day, who is going to make up for this? Can anybody
explain that to me? Mr. Gensler?
Mr. Gensler. Could I take a shot?
I think that I would split it in two buckets. In this field
where venture capitalists, entrepreneurs are developing an idea
and asking people for money, they publish a White Paper, they
build up a following, Reddit posts--these are different
communities, social network posts, a medium and so forth--and
they build a following and then they sell it and raise money.
And sometimes it is small, just like a crowdfunding on
Kickstarter. But most of them aren't. There have been 3,800 of
them to date. Over 50 percent of them fail within 4 months, and
there are different estimates how many are scams and frauds.
There are good faith actors in the middle of it, too, a lot of
good faith actors, but there are a lot of frauds and scams.
Right now, if they fail, the only thing you could do is try
under the securities laws to say they were an unregistered,
noncompliant security and try--under the private rights of
actions under securities law--to get something back; or do
nothing.
And the second category is digital gold. The digital gold,
which is Bitcoin, and while there is nothing behind it, I would
say, Mr. Ranking Member, there is really nothing behind gold
either. All of this, we have what is behind it is a cultural
norm that for thousands of years we like gold. The worldwide
value of gold is $7 trillion, by the way, just to give you a
little sense, but only about ten percent of the annual
production of gold is used in manufacturing. The rest of it is
because we think it is kind of nice to have gold necklaces and
jewelry, or we do it as a store value. Bitcoin is a modern form
of digital gold and it is a social construct.
Mr. Peterson. They are just creating this money out of
nowhere.
Mr. Gensler. In the first category, the investor type that
would be under the SEC.
Mr. Peterson. No, I get that.
Mr. Gensler. But in the second category, you are right,
which was under this Committee. You are going to be grappling
with this for a while.
Mr. Peterson. No, I know.
Mr. Gensler. It is digital gold.
Mr. Peterson. In the first category, I assume those people
are sophisticated enough to realize they are going to get
fleeced potentially?
There are people that get into that area that don't realize
what they are getting into. They think they are going to get
rich and they are going to get into this deal ahead of
everything else and they are going to make 10,000 percent on
their money and whatever else, and some guy is selling them on
this. I don't know where the protection is here for people.
Mr. Gensler. Some are very sophisticated like Andreessen
Horowitz and they manage $7 billion. There are many like that,
but there are others that aren't. But you are right. The
Securities and Exchange Commission has a lot of work ahead of
them to sort of bring this market into--the first part of the
market. Seventy percent of the market is commodities, but the
first part, this ICO marketplace, is the SEC's--they are
working at it, but they have a lot of work ahead.
Mr. Kupor. If I could just add, Mr. Ranking Member, you
raise this concept of a kind of trust, right, which is who do I
trust? What is the trusted intermediary?
The beauty, at least, certainly from the perspective of an
investor and as a consumer, the beauty of these crypto-networks
is what you are trusting is you are trusting cryptography, you
are trusting math, you are trusting software as opposed to a
centralized intermediary, and you have a community that is
governing the interest there. In other words, if the community
tries to do something that is inappropriate, all of the
software is open source. All of the software can be basically
what is called forked and literally taken over and recreated in
a new community. There is a norm of community governance that
exists in these areas that really substitutes trust from a
centralized intermediary to trust to a community that is
responsible for government.
Mr. Peterson. Thank you, but I am still skeptical.
The Chairman. Mr. Lucas, 5 minutes.
Mr. Lucas. Thank you, Mr. Chairman, and along with the
gentleman from Georgia, Mr. Scott, I have the privilege of
sitting both on this Committee and the Financial Services
Committee, so I welcome this discussion by the panel when it
comes to the next regulatory frontier as it impacts the two
Committees.
First, Mr. Kupor, how should regulators think about the
function of the token when choosing to apply regulatory
requirements? Should regulators look to the functioning of the
token at all, or only the issuing activity?
For example, say there is a cryptocurrency. We will call
it, for the sake of discussion, Bitcoin 2.0, and say it
functions identically to Bitcoin in every way except that a
small portion of the total tokens were pre-mined and
distributed in token sale. It is possible to issue Bitcoin 2.0
through ICO and not have it be a security, or is the
functioning of the token irrelevant because of the manner in
which it is issued?
I am asking what my folks back home would define as geek
questions, but this is where we are.
Mr. Kupor. Yes, sir.
Mr. Lucas. What say you?
Mr. Kupor. Yes, to a couple of things.
The issuance of those tokens and the sale of those tokens
in exchange for money before a network exists, I do believe is
what is called an investment contract and should be regulated
as such.
If I develop a white paper and I tell you I am going to
build this thing and you give me money for it before it exists,
if I fleece you, absolutely the SEC has jurisdiction to bring
me up on securities fraud charges. You have private cause of
action. No question about it there.
Once the network is functional and therefore, the tokens
are doing what they were intended to do, whether that is
storage or other things, the value of that token now really is
not a function of the efforts of the developer, it is really
the question of what is the utility of that token, much like
any other commodity. Therefore, certainly my view is that in
that case, the underlying token itself should be regulated as
if it were a commodity because that is actually kind of the
nature of what it is actually doing.
Mr. Lucas. Thank you.
Mr. Ness, the last prong of the Howey test identifies an
investment contractor transaction in which an individual
expects profits solely from the efforts of the promoter or the
third party. Yet, for almost every token project, there are
multiple avenues for a holder to come into possession of a
token. When a network is fully functional, tokens can be
purchased through promoter, traded on a secondary market
exchange within a network, or earned by performing work to
support the network. In each of these cases, the efforts of the
holder vary and can implicate the Howey test differently. How
should regulators think of an asset that has multiple methods
of delivery, an asset that can be both purchased and earned, or
should the method of delivery determine the regulatory regime
governing an asset?
Mr. Ness. Fortunately, it is a relatively simple answer,
which is that it really comes down to the same test, which is
pre-functionality versus post-functionality, or whatever we end
up deciding is the trigger point for determining the different
status.
It seems to me that however you come by this, I suppose
there are two fundamentally different ways. One is to get it
from the issuer directly, the other is to get it from some
third party. And if it is in pre-functional--the pre-functional
stage and you are obtaining it from the issuer, I would argue
that is a primary offering of an investment contract, even if
it is essentially earned on a network, because at that point
there is a lot of case law out there if you do work for a
security, you have paid for the security. There is
consideration there in the services.
I wouldn't say that there is a difference between earning
it versus buying it. It going to be a security, based on its
characteristics as we end up defining them, pre-functionality
versus post-functionality.
Mr. Lucas. Mr. Gorfine, in your testimony you mentioned the
new working group set up by FSOC and the Commission's work with
the SEC and other regulators. This Committee cares a lot about
coordination between financial regulators when it comes to
these sorts of matters. Can you talk more about how the
regulators, including the CFTC, are working together, I should
say, to understand and clarify their overlapping jurisdictions
and how it affects the virtual currencies?
Mr. Gorfine. Yes, thank you. It is a great question and we
agree that coordination and collaboration with our sister
agencies is very important on this type of a topic.
One thing about this space that is common across a lot of
areas of financial technology is that it inherently cuts across
geographic and jurisdictional boundaries. It is very important
to make sure that we are coordinated in sharing information
with each other.
Certainly, on the topic of cryptocurrencies, we are working
closely with the SEC to make sure that we are coordinated. And
just to step back and explain how we view our rule set, the
definition of commodity under our statute is very broad. A lot
of things are commodities and we are soon after the World Cup,
so think about soccer balls. Those are commodities. Just
because something is necessarily a commodity doesn't mean that
we have a direct regulatory interest. It is only when we start
to see the rise of futures or swaps products built on those
commodities that we have direct oversight.
But when the SEC applies the Howey test and determines
whether something fits within a securities law framework, that
certainly matters to us because then that is something that
would fall under their jurisdiction. Hence the need for us to
be in close communication with the SEC.
Mr. Lucas. Mr. Chairman, if you would indulge me for one
last thought.
For a number of years, I sat next to Ron Paul on the
Financial Services Committee, so when Mr. Peterson brought up
his observations about gold standard, I can't help but think
about Mr. Paul's story noting that when the Roosevelt
Administration took us off the gold standard in 1933, they
sealed every safe deposit box in every financial institution in
America and before you could open it, you had to have Federal
official of appropriate nature or state designee to be with you
so they could make sure you didn't have any gold coins, gold
bars, or gold certificates in those safe deposit boxes. The
Ranking Member brings up some interesting observations. Even
gold wasn't safe in 1933.
I yield back, Mr. Chairman.
The Chairman. The long reach of government. Thank you.
David Scott, 5 minutes.
Mr. David Scott of Georgia. Thank you, Mr. Chairman.
There is a good amount of very serious and legitimate
concerns about coins that are being offered. I am not sure we
realize it, but there are over 1,600 coins currently and
growing every day. And we have to look closely and watch how
these coins are being used, and if it is appropriate for them
to be regulated, to make sure that they are not being used
improperly. I am not sure that the panelists or the audience or
those who may be watching via television know, but I find it
very concerning that in the indictment of the 12 Russian
hackers that hacked the DNC's servers, did you know that they
included in those charges within the indictment was the fact
that the Russian hackers used principally Bitcoin when
purchasing the servers, when registering the domains, and
otherwise making payments in furtherance of illegal hacking
activity on the United States elections?
What I am saying is that with every new tool, our
technology is moving fast. It is growing at a rapid rate, and
we have to grab hold on what we are doing to make sure that we
do everything we can to ensure that these new coins are not
being used illegally or for illicit activities, like when the
Russians attacked our election system.
Now, I also have read in some news coverage studies that
are out there that think that not all of these ICOs are a
positive thing. There is a lot of debate on that, and our
Ranking Member, Mr. Peterson, expressed it best of all.
For example, a recent Statis group study found that over 80
percent of initial coin offerings are scams. In fact, they
broke ICOs into six groups, scam ICOs, failed ICOs, gone dead
ICOs, dwindling ICOs, promising ICOs, and then successful ICOs.
And on the basis of these above six classifications, they wrote
that they found that approximately 81 percent of our ICOs were
scams. Six percent were failed. Five percent had gone dead, and
eight percent went on to trade on the exchange.
I want to ask the panel, with this evidence, does this seem
right to you? Is 80 percent high? Are the risks being blown out
of proportion for these studies?
Let's start with Mr. Gorfine. You mentioned in your
testimony that LabCFTC published in its first FinTech primer on
virtual currency late last year. What more can we do to protect
investors? And I want to get each of you in my last minute
here. Just say yes or no, are we in trouble? Is this thing
serving us or are we serving it?
Mr. Gorfine. I will try to be brief, and we share your
concern. And you mentioned the LabCFTC primer which we
published in October of last year, and the way that the primer
is structured is that it concludes with a discussion of risks
and challenges that we believe market participants need to be
aware of. Just this week on Monday, and I would encourage the
public that is viewing this today to take a look at a customer
advisory that we published through our Office of Customer
Education and Outreach where we are tackling exactly this
issue, which is that it is a very speculative, risky space,
especially for retail participants to be participating, and we
encourage them to really do their research and ask themselves
important questions about the value of a lot of the different
types of offerings that are out there. It is an area that we
think education is a key component. I will also add that from
an enforcement perspective, the CFTC, as well as a lot of other
agencies, are looking to target bad actors that are trying to
take advantage of a lot of the enthusiasm around this space.
The combination of education, enforcement, and then
proactive engagement as LabCFTC is doing are important
regulatory tools for us to deploy.
Mr. David Scott of Georgia. Thank you, Mr. Chairman.
The Chairman. The gentleman's time has expired.
Austin Scott, 5 minutes.
Mr. Austin Scott of Georgia. Thank you, Mr. Chairman.
We are a long way away from peanut fields in Sycamore,
Georgia, and I can't help but wonder if somebody who, prior to
getting elected to Congress, actually had a series 7, what
would a prospectus on coin offering look like? I don't know if
it would be one page or 10,000 pages or more, but one thing
that is clear to me is that you can certainly create a coin for
anything. You can create a coin for any color. You can create a
coin for any opposite color. There is an infinite number of
coins that can be created.
I see no way to regulate every coin offering that is out
there, but I would also tell you that when you turn on CNBC and
they show the Dow, the S&P, and the Nasdaq on one side of the
screen and on the other side of the screen is a value for
Bitcoin, then certainly it has reached the level where we need
to have some sort of regulatory certainty in this area.
Most of my questions are for Mr. Gorfine. You run LabCFTC,
and you have held office hours around the country where you
have met with many people in the industry. Can you tell us
about the interesting concerns of the developers who are
working on token-based projects, and how sensitive they are to
the regulatory environment?
Mr. Gorfine. Yes, thank you for the question, and in fact,
I am heading this afternoon up to New York to have another
round of office hours with innovators.
We have had an incredible opportunity to go to various
cities and meet with folks that are heavily involved in a lot
of projects across the spectrum that you have heard about
today, and it strikes me that it is a new generation that is
really looking through a technology lens as to how we can
transform markets, make markets more efficient and effective.
But there are a lot of questions that they have, and that is
the reason we have the engagement function of LabCFTC. A lot of
folks are trying to get a lay of the land and start to
understand the alphabet soup of regulators in D.C., so through
LabCFTC, we do try to establish some guideposts and educate as
to how our framework applies. And in some situations, we will
explain, ``Well, this is where the CFTC fits and then there are
questions that you may need to look at securities laws to
understand the interplay there.''
But in response to a lot of common questions we were
getting, that is why we published the FinTech primer. It is our
way of facilitating conversation with the community to make
sure we are being responsive, and where possible, providing as
much clarity as we can.
Other efforts of CFTC have been around things like actual
delivery is a question that comes up a lot in the
cryptocurrency realm, so our Division of Markets and Oversight
has put out a draft interpretation that deals with actual
delivery. All of these are efforts to start enhancing and
providing as much clarity as we can.
Mr. Austin Scott of Georgia. Mr. Gorfine, you suggest in
your testimony that the Commission has an interest in this
technology being used for capital markets infrastructure. Many
of us on this Committee, including myself, have introduced a
piece of legislation, the CFTC Research Modernization Act. Have
you had a chance to review that legislation, and do you think
it could help the Commission understand the emerging financial
technologies and help us better understand how we need to
regulate, or in some cases, not regulate certain areas?
Mr. Gorfine. Yes, thank you. One of the things that we are
really focused on doing is making sure that we are engaging
with technologies and fully understanding them. What you are
raising is the ability to give the CFTC authority to research
and test new technologies.
I will give one example of how that may work in this space.
We talked a little bit about private and permissioned
distributed ledger technologies, which could impact and improve
capital markets infrastructure. There is a lot of interest for
market participants who are saying there may be more efficient
ways for us to do, for example, regulatory reporting, in a
lower cost way for them and in a way that for the regulator is
more consumable. If we can receive standardized data without
the traditional push process, that could be very valuable. What
you are pointing out, Congressman, is that authority that is
proposed in your legislation would allow us to actually work
with a consortia of folks that are trying to create that type
of infrastructure, and that way from a CFTC perspective we
could better understand how can this technology benefit our
markets? How would regulatory reporting be facilitated, and
lift the hood and really understand the technology instead of
having the high level conversation.
Those types of authorities would be very, very helpful to
us.
Mr. Austin Scott of Georgia. Thank you very much.
The Chairman. The gentleman's time has expired.
Ms. Kuster, 5 minutes.
Ms. Kuster. Thank you very much, Mr. Chairman, and thank
you witnesses. This has been a very enlightening hearing, and I
appreciate all the wisdom.
Mr. Gorfine, picking up on the CFTC regulation, such as it
is; do you have sufficient resources at the CFTC, or what would
you recommend that you need from Congress, going forward?
Mr. Gorfine. Thank you. Well, I will harness the Chairman
on this. Our Chairman has been very vocal about the need for
the CFTC to have the right resources to be able to keep pace
with our markets and regulate our markets most effectively. I
believe he has asked for $281 million for our budget, and a lot
of those resources would be utilized, not only with bringing in
economists, but also making sure we have the technologists in
house to be able to keep pace.
I am a lawyer. I know a couple layers deep of the onion
when you are talking about technologies, but we really need to
be able to get to the core of technology to make sure that we
are ascertaining where new risks are arising. Certainly, with
greater resources, our agency would be able to even scale up
some of those activities.
Ms. Kuster. I would just say for the record one obvious
place to look for those resources would be to get the IRS on
top of how to tax the benefits and the gains that are being
made, because one of the most troubling comments today is that
the IRS is not on top of how to capture those gains. That is
something that we need to look at, but it is also something on
your side with some conversations with your counterparts at the
IRS.
I want to quickly turn to the two professors and get a
sense of a very troublesome aspect of this, and if anyone else
wants to comment. Analysts last year identified that four
percent of the addresses hold 97 percent of the Bitcoin in the
world, and the philosophical goal of Bitcoin is to replace
government-backed fiat currency. But if that goal is achieved,
you would have an unprecedented amount of wealth and power
concentrated in the hands of a very small number of people. Is
this concerning to you, and what should lawmakers be doing in
this regard?
There are couple of minutes left, and----
Mr. Gensler. To some extent it is not surprising, because
most small economics ends up with some centralization. An irony
is that the technology is supposed to be a decentralized peer-
to-peer----
Ms. Kuster. That was why the statistic struck me, because
all the commentary has been this is all----
Mr. Gensler. And so it is one of the natural ironies,
because all humans tend towards clusters and clumps and
centralization.
Ms. Kuster. And taking into account with the indictment
that some of these addresses are in Russia with people that
want to do harm to our country.
Mr. Gensler. More specifically to your question, some of
that concentration is because it is the large exchanges, the
crypto-exchanges, like Coin Base has 20 million accounts. They
may not all be active, and they hold $20 billion of crypto-
funds. I should have said the market went up in the last day,
so it is now about $290 billion. But just one exchange has a
big chunk of it. I don't know if that----
Ms. Kuster. Is that then owned by multiple parties?
Mr. Gensler. I will speak a little bit like an accountant,
which I know the Chairman can appreciate, but it is that Coin
Base has several accounts, but they are only there at Coin
Base. But if I wanted to trade, then I have an account at Coin
Base. These addresses would be in Coin Base's name, not in my
name. I only have a right to Coin Base. Coin Base has whatever
you want to call a right on this ledger. And part of----
Ms. Kuster. Part of my question is that not very many
people end up controlling and influencing, and if the long-term
goal is to cut out state-sponsored currency, that is
problematic in my view.
Ms. Baldet. Yes, you are right to be concerned about the
centralization of power, but when it is not necessarily so that
a single address equates to a single legal entity in any way.
Any one person can generate any number of addresses that have
smaller or larger amounts, and we don't really have a proper
way to be able to tie that----
Ms. Kuster. How would you describe to the public watching
today the distribution of influence?
Ms. Baldet. There certainly are loci of power, but also if
you look at the movement in some of those earlier addresses or
larger addresses, it is commonly accepted that about 25 percent
of something on a network like Bitcoin have not moved or
basically been lost at this point, and so you will see funds
sitting in places and simply not moving, and the common
consensus is that the private keys or the access to those
addresses have simply been lost.
Ms. Kuster. My time is up and I will yield back, but just
to make a plea for democracy somewhere in this process. I
appreciate the Chairman for scheduling the hearing. Thank you.
The Chairman. The gentlelady yields back.
Mr. Allen, 5 minutes.
Mr. Allen. Thank you, Mr. Chairman, and this has been very
interesting. The gig economy is moving at light speed, and the
rest of us are just kind of dragging us along. But it is
exciting.
I guess the problem that we are having, from a regulatory
standpoint is throughout the gig economy is obviously the
reason it is doing so well is because there is lots of freedom
and very little regulation, but we do know that there are lots
of problems, as far as connectivity, as far as security, and
that sort of thing.
How do we reach a balance with this, what we are doing is
we are creating another money supply here as I see it. In other
words, it is global. It is a global currency. I just don't know
how that works, like where we have our basis. Our dollar, I
believe, kind of sets the mark for the world right now.
Explain how this is going to work across the world. I mean,
you mentioned Afghanistan. I don't know what their currency
base there is, but I am just going to open it up. I can't
visualize how this could possibly work.
Mr. Gensler. Can I get one real quick shot?
Mr. Allen. Yes.
Mr. Gensler. Sound governments like the U.S., if we have to
maintain our fiscal discipline and all the things we need to
do----
Mr. Allen. Yes, if you can keep it, right.
Mr. Gensler. But sound governments have certain advantages,
because of the stability, and also because we allow our
currency, fiat currency, it is legal tender for all debts
public and private, and you can use it to pay taxes. And so
there are some just natural advantages.
I think that how this might play out, I could see a country
that is in distress, the Venezuela's of the world, where in the
future one of these currencies will be a better thing for their
public than in that----
Mr. Allen. For the individual citizen?
Mr. Gensler. For the individuals, for the merchants----
Mr. Allen. Because they are not dealing through their
government, they are dealing through this global currency?
Mr. Gensler. Yes, I could see that.
Second, even in a stable economy like ours, that our
Federal reserve, with all respect, has a little bit of
competition for the payment system. We Americans spend between
$100 billion and $200 billion a year for our payment system.
That is only \1/2\ percent to one percent of our economy, but
it is still $100 billion to $200 billion a year. And so
startups and entrepreneurs have a chance to chip away at that
and get inside of that. That is competition to the commercial
banks and the central bank on our payment system.
Mr. Allen. Other feedback? We have about 2 minutes.
Ms. Baldet. Yes, I just wanted to add to that around the
Venezuela point, that there was some interesting usage of Zcash
in Venezuela over the last year as a sort of bridge currency to
the dollar so that citizens that could not have traditional
access to get to the dollar were using a cryptocurrency as an
intermediary. Given the volatility of cryptocurrency, you
wouldn't necessarily want to stay there, but as a bridge and a
censorship resistant bridge at that, it is somewhat important.
While censorship resistance can be seen as a double-edged
sword, we might not necessarily like the way that people are
doing bad things with the network, the ability to project into
places where they also would prefer people to not be doing
things should not be underestimated.
Mr. Allen. I can see where like a business located in a
country where the government is unstable, the business
community could really benefit from this.
Then you have this competition between nations, right now
the biggest competition is between United States and China. The
end seems to want to be the basis. Which nation would run this
thing and ultimately be responsible for it?
Mr. Gensler. See that is the thing. It is decentralized so
no nation does, but you mentioned China. I don't know that
there has been public reports, but there are a lot of people in
the community that say that though China, the government, has
said we are clamping down, the reality is there is a lot of
activity. The Bitcoin, this is how it is developed. Two of the
three largest mining pools are in China. The third one is in
Russia, and that combined is about 50 percent of the mining
pools.
But beyond that, the Bank of China is very actively engaged
to do research----
Mr. Allen. But the government is not fond of this?
Mr. Gensler. Well, they are of two minds.
Mr. Allen. Yes.
Mr. Gensler. They say publicly they are not fond of it
because their currency is not convertible, so they are worried
about people running around their currency. That is the public
face of it, but underneath it, they are doing a lot of work on
it. The Bank of China particularly is looking at it very
closely because they are worried. They want to get their
payment system right and they want to use it maybe.
Mr. Allen. Okay.
Ms. Baldet. There is also a bit of a land grab going on
when it comes to enterprise distributed ledger projects where
countries, like China, can go into emerging economies and do
essentially free work for them using their technology, which is
impacting the adoption of specific protocols backed by various
countries in those regions.
Mr. Allen. Okay. All right, I yield back, Mr. Chairman.
The Chairman. The gentleman yields.
Mr. Allen. Thank you very much.
The Chairman. Mr. Soto, 5 minutes.
Mr. Soto. Thank you, Mr. Chairman.
Cryptocurrency, blockchain technology all have tremendous
potential, and I am bullish on the prospect. But we are in a
bizarre position here. Satoshi Nakamoto, an unknown person or
people who developed Bitcoin, and this person or persons has
980,000 Bitcoins and an estimated worth between $19.4 billion
to $17.9 billion. Can any of you today, and just raise your
hand, verify that Mr. Satoshi Nakamoto is, in fact, a person or
persons?
Ms. Baldet. I don't believe that we have all agreed that it
is a male.
Mr. Soto. All I asked--okay.
Ms. Baldet. Satoshi is female.
Mr. Soto. Satoshi is female, great. None of you can verify
who founded or owned Bitcoin is my point, which puts us in a
strange position, because normally we have industries and new
currencies where we know who created it. That puts us in a
weird position.
In addition, you mine to develop new currency, a process by
which transactions are verified and you add it to the public
ledger. You compile recent transactions into blocks and try
solving computationally difficult puzzles, and you get a
reward, either a transaction fee or newly released Bitcoin. I
guess gold is the only thing that we could even parallel to
where we have mined in such a way. Have we ever had a currency
online like this where you mine via transaction algorithms and
solving puzzles on the Internet?
Mr. Gensler. That is the novel creation of--yes, somebody
we don't know who she is--Satoshi Nakamoto, or he or
collection. But that is the novel thing. When the Internet was
created----
Mr. Soto. My time is limited, so we have an unknown person
and a bizarre way of mining Bitcoin to get it together.
I am more concerned, though, about being able to void money
laundering for terrorism, drug trafficking, human trafficking,
tax evasion. I would love to hear from each of you in one
sentence on what we could do to stop money laundering and
having Bitcoin and other cryptocurrencies be the choice of
terrorists, drug traffickers, and those evading taxes. We will
start from the left and go on back. One sentence, because my
time is limited.
Mr. Fairfield. Trust FinCEN to do their job.
Ms. Baldet. Rely on other law enforcement mechanisms that
work around strong cryptography. We do not weaken roads and add
potholes to them.
Mr. Soto. That is two sentences, but thank you. My time is
limited. I apologize.
Mr. Kupor. Bitcoin is actually the worst tool to money
launder because every transaction is registered and fully
reportable, so it is actually law enforcement's best friend.
Mr. Soto. Okay.
Mr. Gorfine. While the technology can be peer-to-peer, most
activity takes place through a new type of intermediary where
you can apply AML/KYC rules.
Mr. Soto. Okay.
Mr. Gensler. On top of that, rigorously require crypto-
exchanges to register, and you may need to pass a law to do
that, but to make sure they register and that all the AML,
anti-money laundering and know your customer is being done
there.
Mr. Soto. Run-on sentence, but helpful. Thank you.
Mr. Ness. The alleged Russian hackers were caught because
they used Bitcoin.
Mr. Soto. Thank you.
I am also concerned about two practices, spoofing and wash
trading. Spoofing being flooding markets with fake orders to
trick other traders into buying or selling, and wash trading,
which is where cheaters trade with his or herself to give a
false impression of market demand that lures others to dive in,
too. Can anybody give us any insight into how to stop spoofing
and wash trading? We will start from the right to the left now.
Mr. Ness. That is a tough one. I don't have a good answer.
Mr. Soto. Okay, next.
Mr. Gensler. Register the exchanges and cops on the beat.
Mr. Gorfine. We are a markets regulator. That is something
that we are able to police for within our regulated futures and
swaps markets, and so worth a look at the underlying market to
ensure that the right types of regulations are in place.
Mr. Soto. And are you all doing that right now?
Mr. Gorfine. The CFTC does not have direct oversight
authority over underlying markets.
Mr. Soto. We would have to give you jurisdiction to help
with spoofing and wash trading?
Mr. Gorfine. It would be something Congress would have to
look at in terms of authorities.
Mr. Soto. Okay. Next, Mr. Kupor?
Mr. Kupor. Yes, I agree. Either between the SEC or the CFTC
you would have to grant appropriate authority.
Ms. Baldet. Agree, broker dealers need to be treated like
broker dealers.
Mr. Fairfield. I would agree with that.
Mr. Soto. All right, thanks, and I yield back.
The Chairman. The gentleman yields back.
Mr. Faso, 5 minutes.
Mr. Faso. Thank you, Mr. Chairman.
I am wondering if, for the benefit of our viewers at home
across the country who are watching this hearing and are trying
to understand the impact of the cryptocurrencies and what the
future holds, if perhaps Ms. Baldet and Mr. Kupor could tell us
where you think from a 5 to 10 year viewpoint where this is
going to be, the role that these currencies are going to have
in our economy, and how might this affect average consumers?
Right now the market participants are mostly very sophisticated
people. Do you see this insinuating itself into the broader
economy?
Mr. Kupor. Sure, thank you. Yes, we believe that this
really is going to create a whole new set of infrastructure on
which all kinds of new applications are going to be built, some
of which we don't even know about today. If you think about all
the benefits we have reaped from Facebook and Google and all
the Internet properties----
Mr. Faso. And negatives from----
Mr. Kupor. And negatives, too. What the beauty of this
technology is, is it gives us a new set of platforms, and
again, very critically those platforms are not controlled or
governed by centralized corporations, they are controlled and
governed by a community. And so you can imagine all the utility
that we have today, but where the consumer actually has
ownership of data. The consumer has the ability to actually
ensure that data is shared in a manner in which they want to be
shared, and a consumer can also capture the economic rents from
use of that data, so we think the opportunity in that respect
is endless.
Mr. Faso. Yes.
Ms. Baldet. Sure, I would say that there are two very
different sides of the spectrum.
On the enterprise blockchain and distributed ledger side,
we are seeing mutualization of work flow come to pass, and that
is a way for companies who trust each other to do things in a
more coordinated way that drives down operating costs.
On the public side, to tag onto the gig economy statement
earlier, we can see a further kind of micro-gig economy is
happening wherein if people were to have more access and
control over their own data--this goes for businesses as well--
we might be able to monetize that in new ways.
Alternative business mechanisms to the current data hungry
surveillance capitalism that we see arising from centralized
companies, we might be able to challenge that kind of hegemony.
Mr. Faso. And Mr. Fairfield, you referenced personal
privacy issues. How do you see that coming into play here?
Mr. Fairfield. Well there are a few. The first would be if
we were to follow through on the suggestion that KYC and AML,
that is Know Your Customer and Anti-Money Laundering,
requirements be imposed on many more actors in this space. The
initial reaction of many people who held cryptocurrency was
that they did not particularly want those data revealed, and
they built products to try to keep that data from being
revealed.
At least as far as the major exchanges, and I have heard
exchanges used a few different ways today, but here I am
talking about the way you onboard. You spend dollars, you get
Bitcoin, for example.
I think that giving those exchanges the requirement under
the Bank Secrecy Act to have KYC and AML requirements at the
same time that they have fairly strict financial privacy
requirements was a moderately decent fit. For national security
purposes, we need to know when people can make a couple million
dollars disappear in one country and reappear in another. But
at the same time, there is some degree of constraint over where
that information can go once it is kept within financial
institutions. That is a good example of a mix that seems to
work, and maybe that would be a model we could spread out from.
Mr. Faso. And just generally, Mr. Gensler or Mr. Gorfine,
as we look at the development of this, it does seem that there
is an issue that is going to affect government, which is right
now we know, because we have a paper trail, we have electronic
trails and documentation of transactions for which taxation
applies, for which government oversight and reporting applies.
How does government address this from the standpoint of its
interest to try to make sure that taxation and other compliance
issues are resolved that currently, with our existing financial
transactions we have mechanisms to have that reporting?
Mr. Gensler. It is really about knowing all the accounts.
This technology has what is called public keys and private keys
and Zcash, which Ms. Baldet is involved in is even more secret
than that, but it is really knowing who owns the accounts
behind that. It is know your customer, beneficial ownership,
and then trying to do that through some of the central
mechanisms like crypto-exchanges.
It is not going to be perfect. This is going to be like a
whack-a-mole, the IRS and the CFTC will work hard and then 3
years from now the technologists will have a new way to get
around it.
Mr. Faso. Mr. Chairman, could Mr. Gorfine respond to that
as well?
The Chairman. Yes, very quickly.
Mr. Gorfine. Yes, if I may. One observation, too, is
remember the most anonymous form of transaction is actual cash,
right, people transacting cash. There is very little record of
that taking place. Most virtual currencies, cryptocurrencies,
are pseudonymous, so there is actually the ledger, which is a
fairly transparent mechanism to be able to pursue potential law
enforcement, as well as AML and KYC, so I just want to point
that out, but it is something that needs to be figured out by
government.
Mr. Faso. Thank you, Mr. Chairman.
The Chairman. Mr. LaMalfa, 5 minutes.
Mr. LaMalfa. Thank you, Mr. Chairman. I am a little sorry I
missed part of this hearing here, but it might be--well, I am a
flip phone guy in a Bitcoin world anyhow, there is no pretense
here.
But, Mr. Ness, I come from the flip phone part of NorCal,
as you say down there in the Bay area. I will ask a question
and I will try and narrow down to, it was talked about earlier
in the Committee about crypto-networks and the Internet
protocols on tokens, so would you touch upon what it would look
like if that token is determined to be a security? Can you hit
that for us?
Mr. Ness. Yes. The issue really comes down to friction, and
while we can get to a status of free trading securities by
registering them, even when you do get to that status, there
are all sorts of ancillary friction in and around the transfer
of a security. You need to have broker dealers involved, and
you need to have suitability requirements met, and other
potential disclosure issues and so forth that are ongoing.
And so when we are talking about trying to create the next
generation of decentralized protocol layer kind of apps on top
that are all interoperable and interacting with each other and
transferring value at the speed of software to deliver a
service to a consumer. It may be all transparent to the
consumer. This is all happening under the hood, but you can't
have fundamentally the transfer of value at the speed of
software if it is a security.
Mr. LaMalfa. You are talking with the middle man of a
typical financial institution, right?
Mr. Ness. That is right.
Mr. LaMalfa. All right, and again, please touch on the
importance of increasing the access to the speediness of those
types of transactions. Why is that important?
Mr. Ness. Well, to get a little philosophical, ledger
technology is fundamental to commerce, right, and double entry
accounting was an amazing innovation in ledger technology that
pulled Europe out of the Dark Ages. And the same thing can
happen in an amazingly more robust way when we start to
literally not just allow parties to trust each other through
standard mechanisms of reconciliation, but when we remove the
reconciliation or the need for it altogether, and that is
simply a philosophical point of view, I suppose, but it goes to
this issue that we are at early stages of this. We don't know
where it is going to go, but speed is probably a good thing.
Mr. Gensler. Can I just say, I am an optimist. I agree with
what Mr. Ness says, but maybe it is the MIT in me now. I think
that the beneficial ownerships will be able to be tracked in a
matter of milliseconds and nanoseconds. Not yet, it might take
5 years, but we will get there. Technology is pretty neat, how
it grows and helps us.
Mr. LaMalfa. Well, it is amazing. Thank you, and Mr.
Chairman, at the risk of looking senatorial at a Zuckerberg
hearing, I am going to yield the rest of my time.
The Chairman. Thank you, Mr. LaMalfa.
Ms. Plaskett, 5 minutes.
Ms. Plaskett. Good morning, gentlemen and gentlewoman.
Thank you all for being here.
Of course, this is something that we are all really
learning about. I try and say that I am woke, but you know,
that always doesn't work and this is one area where my 20+ year
old children would find me really out of date. I am happy, Mr.
Chairman, that we are having this because you all are correct.
There is a balance, right? We don't want to over-restrict
something that we don't even really understand or that is still
developing, but at the same time, ensuring that that
development, while it is developing, bad actors are not
utilizing and gaming the system so that really terrible things
can go on.
One of the main things that I am concerned about, people
think of the Virgin Islands as really just being a beautiful
paradise, but we have an enormous amount of drug trafficking
that goes through the Virgin Islands, and we also, along with
other Caribbean islands--other islands more so than ours--have
the ability to be used as a filter for hiding money, and
particularly ill-gotten gains. And so I was wondering if anyone
on the panel can really talk about how we can or law
enforcement can really act as a deterrent for the use of
Bitcoins, the marriage now between Bitcoins and blockchain to
be able to really accelerate the use of these types of
currencies in a manner that does not cause individuals in other
places to really take advantage of this.
Mr. Gensler. It is ultimately a bit of an arms race because
technology is new----
Ms. Plaskett. I love it. We are having an arms race with
electronic money, right?
Mr. Gensler. We are, we are. But the arms race in this is
basically against societal norms and bad actors. There is
always going to be crime and technology is just a new way to do
it.
One thing that the panel has all said is Bitcoin actually
is more traceable than the public thinks. It is not anonymous.
It is what is called pseudonymous, but we need ways to connect
those public keys, which are like 24 or 32 digits to real
people and real companies, and that is why I have recommended
you need to have gatekeepers or gateways to do that, the
exchanges, the crypto-exchanges or one set of gateways for law
enforcement then to track the way that law enforcement now uses
banks to track things. That would be one way I would say.
Ms. Plaskett. Right. I saw some others wanted to respond.
Mr. Fairfield. If I could also respond.
The way we catch criminals often is through traffic
analysis. Blockchains are quite good sources for traffic
analysis.
Ms. Plaskett. Yes.
Mr. Fairfield. There are----
Ms. Plaskett. Can you tell me, how does the blockchain
facilitate that?
Mr. Fairfield. Sure. One thing to do would be to go online
and simply Google the blockchain.
Ms. Plaskett. Right.
Mr. Fairfield. You will find a website that will list each
transaction as it comes across, and if you spend 30 seconds
watching every transaction in the world that happens in
blockchain and you think to yourself if I were a police
officer, I would find this flow of money around the world very
interesting. We also have computer programs, though, that don't
require a person sit there but can comb these databases, find
patterns, and kick bad patterns up to somebody to take a look
at it.
There are ways of circumventing this. Blockchains are
pseudonymous. I don't put too much stock in it because tumblers
and dark wallets can essentially--you and I might agree I will
pay your debts, you pay mine, that way your debts aren't
traceable to you and my debts aren't traceable to me. That is
essentially what a tumbler does. We pay each other's debts, and
so we hide where the money is coming from.
Ms. Plaskett. Right.
Mr. Fairfield. But, with traffic analysis and standard
artificial intelligence runs combing across the database, we
can do a pretty good job of kicking up where bad actors are
stirring the water.
Ms. Plaskett. Mr. Gorfine, we talk about law enforcement
doing this. All of us here are concerned with what is our role.
What do you see CFTC in dealing with this as well?
Mr. Gorfine. Yes, and I want to kind of step back and
compliment the way you framed this initial set of questions
because it is exactly right that when I mentioned earlier in my
testimony about thinking about principles and making sure we
are giving--you can regulate based on principles, and then as
you identify areas where there are particular harms to solve
for, that is where more prescriptive rules might fit in.
Certainly, in this area of anti-money laundering and know your
customer, that is an area where you would want to make sure you
are enforcing rules.
But to your more specific question, the CFTC has now had a
lot of experience dealing with some of these markets and the
technologies, but again, our role is as a primary regulator of
futures and swaps markets, and then we do have that enforcement
authority that is a look-back authority to police for fraud and
manipulation, either in our futures and swaps markets or in the
underlying market as well.
But because of our experience, we have a lot to offer at
this stage in terms of informing the discussion around this
space, given our enforcement experience, the role of our
division and market and oversight in regulating the actual
exchanges, monitoring some of the clearing and risk issues
associated with cryptocurrencies, customer education, and then
LabCFTC outreach. I think we are playing a very important role,
and then hopefully can help inform these efforts.
Ms. Plaskett. Thank you, and I yield back. I just want to
make sure that the regulations that we are doing, while we give
time for this to grow, we also make sure we don't end up like
Facebook where it has outpaced us in terms of being able to do
damage in the general good.
The Chairman. The gentlelady's time has expired.
Mr. Davis?
Mr. Davis. Thank you, Mr. Chairman.
Mr. Gorfine, I am going to go right back to you. Obviously
we have talked a lot about jurisdictional issues and how to set
up the proper regulatory structure that many in the industry
are asking us to do. Obviously, with many of the commodities
and different products, we have an SEC portion that is
regulated in many cases, and then we have the CFTC which falls
under our jurisdiction, and you get to see some of the humorous
anecdotes from Members of Congress here who I am sure have had
similar things to say when that new thing the Internet was
taking place, and how are you ever going to buy things off of
the Internet? Well Jeff Bezos showed us very well that anyone
can do that now. And as cryptocurrencies continue to grow in
usage, they are going to become less and less intriguing and
more and more used.
I am going to get into the demographics of many of the
crypto-users, but I am want to ask you a quick question, sir.
Based on the way current law is written, it is not cut and dry
whether cryptocurrency should be regulated by the SEC or the
CFTC. If Congress attempts to come up with a workable
definition for cryptocurrencies that are more similar to
commodities, call them, as we have heard, blockchain
commodities, what should we be looking to guide us?
Mr. Gorfine. Yes, thank you for the question. You know
what? The one thing I would say is, and I mentioned this in my
opening statement, that it is important that we are not hasty
in terms of figuring out what the right contours are of
applying securities laws and then the commodities framework. I
do think that the SEC has in due course been providing
additional clarity. Mr. Hinman over at the SEC gave a well-
received speech outlining some of the SEC's thinking as to how
they would apply the securities law framework, and some of the
things that you have heard are factors around decentralization,
are there expectations of return based on meaningful work of
others? These are important elements that, of course, I am not
saying that these are the only elements, but these are some of
the things that you start to look at in terms of figuring out
well, when does it make sense to be applying the securities
laws framework that includes things like required disclosures,
it requires regulations around the offering of securities and
the intermediaries involved in securities, and when does that
perhaps not fit the product?
This discussion is ongoing, and in due course and being
thoughtful, you are starting to see additional clarity and
certainty coming out. But certainly those are some of the
factors that we have heard talked about a fair amount.
Mr. Davis. Thank you.
Ms. Baldet and Mr. Kupor, and I am sorry I wasn't here at
the beginning of the hearing so if I mispronounced a name,
forgive me. I always try to mispronounce my colleague, Ted's,
on purpose, but not yours.
Now Ms. Baldet, this is an industry that you are getting
into in the infancy, and you have actually done something that
we don't see a lot around here. You have come to us to actually
ask for a stricter regulatory environment to stop some of the
fraud and abuse that was mentioned by some of my other
colleagues today.
But I want to ask for those of you who are in this
business, what demographic usually utilizes Bitcoin here in the
United States, what age?
Ms. Baldet. It is pseudonymous, so----
Mr. Davis. What----
Ms. Baldet. Based on Twitter, it is probably people in
their 20s to 40s.
Mr. Davis. The millennials?
Ms. Baldet. It is millennials.
Mr. Kupor. Institutionally there is a very different skew
towards the size of transactions and the types of people that
are playing and the larger dollar values. And there is a
developing institutional market as well, right, so yes, it
started there, but if you look at some of the major financial
institutions, there are institutional markets and large private
equity groups that are heavily transacting in this as well.
Ms. Baldet. Yes, and to tie on to the last question, but
also the concern about regulatory framework. What I was
mentioning is about a need for more clarity, not so much the
bright lines that we are talking about security versus
commodity as much as more interest in safe harbors for
innovators, especially because we are seeing the market adapt
to this in that new disruptors are at an advantage versus
incumbent institutions who are waiting for regulatory clarity
to engage. And so in a way, in absence of that, it is not
necessarily that incumbents are incapable of innovating or they
don't understand the technology, but they have to take a
sidelines approach because they have traditional businesses to
lose.
Mr. Davis. Well thank you, and Mr. Chairman, my time is
about ready to expire, but we want to make sure that we devise
a regulatory structure that allows this industry to continue to
grow, but allows us to address many of the law enforcement
problems that have been brought up here by many of my
colleagues.
I can't wait to continue to work with you. Thanks for your
time.
The Chairman. Mr. Yoho for 5 minutes.
Mr. Yoho. Thank you, Mr. Chairman. I appreciate you all
having the patience to be here. This is something that is
really confusing to me. My wife and I, we watched a documentary
on Bitcoins and when we were done, we were more confused. I
have not invested in any, as you asked.
With that said, Mr. Gensler, in your testimony you
mentioned recent SEC staff determination that Ether is not a
security, although it might have been at its issuance. If the
SEC had determined Ether was a security in 2015, what
regulatory requirements would Ether be subject to today? And I
have two follow-ups, and anybody else that wants to weigh in on
this.
Mr. Gensler. If they had determined that way back in 2015,
at the time they would have had to give some full and fair
disclosure. The SEC at that time would have probably said,
``Well, it is probably not 3 years of financials and things
like that because it was a new startup,'' and this is something
the SEC is grappling with even now for current initial coin
offerings. What is full and fair disclosure? Director Hinman at
the SEC said it right. It is about information asymmetry. Give
an investor enough information so they can take the risk. It is
not a nanny government. The investors can take the risk as long
as they get enough information.
Mr. Yoho. Okay, and how might such a regulatory regime
affect the functionality of the Ethereum network?
Mr. Gensler. Mr. Ness raised this question earlier. There
is friction right now because we don't have the beneficial
ownership. Securities laws say we have to have full and fair
disclosure and we have to keep track of anybody who owns the
security. It is that second one that is the friction Mr. Ness
mentioned. I am an optimist. I think technology can solve for
this. It is not going to be in 2018. It would slow down some of
these token economies, but I believe that it is important to
track beneficial ownership for all the reasons about illicit
activity and taxing.
Mr. Yoho. I agree with that. Anybody else?
Ms. Baldet. At the risk of confusing you more about
Ethereum----
Mr. Yoho. I was going to say, that name Ethereum is apropos
because it is just out there.
Ms. Baldet. In the Ether, yes.
Mr. Yoho. It is like where is it?
Ms. Baldet. Yes. Whereas some systems like Bitcoin were
initially meant for peer-to-peer value transfer, the Ethereum
network does, well it is more like a distributed world
computer, in a way. Don't think about it too much. But what you
can do is you can use the native token of the system, this
Ether, which may or may not have been a security issuance as
you mentioned, to pay for what is called gas in that network.
And that gas is used to buy computational cycles on a shared
computer. If something like gas ends up looking a lot like a
security, that is generating PNL just as you are running a
general computer, it would be incredibly cumbersome, if not
impossible, for normal humans to figure out what their balance
sheet should look like. We need to be careful in not just
applying a one size fits all solution on that.
Mr. Yoho. Well, the important thing is that we don't want
to stifle the imagination, the entrepreneurship, the
development of this, but yet we want to have the safeguards in
place. Whether it is the CFTC or the SEC, we just want to make
sure that when people get involved in it, that their monies or
their investments are protected.
You were going to add something?
Mr. Fairfield. I was going to make a rough analogy. Because
these are databases, it is like the database in your computer,
and applying securities regulation to these databases would
have the same impact as having the SEC regulate your computer
at the internal level, which is just simply going to gum up the
works.
Mr. Yoho. Right. We don't want that, but I mean, we want
the safeguards there.
My other question is, and I sit on the Foreign Affairs
Committee, and we deal a lot with North Korea and the sanctions
and all that, and we see countries changing companies,
funneling money, breaking sanctions or skirting sanctions, and
a lot of we see is being done over electronic currency like
this.
What are the safeguards that you guys can help us with on
that so that we can follow it? When that cash transfers, it is
easier to track that. We can block and sanction those banks or
those entities, but when they are transferring things like this
or any other nefarious activity, drug deals and things like
that, what are the safeguards that you guys can put in place
that we know we can follow that stuff?
Mr. Kupor. We talked a little bit about this earlier, but
the idea behind these networks is all the transactions are, in
fact, traceable and immutable, and so in fact, in most cases
that you have seen, for example, in the recent Russian hacking
investigation, they really create a trail and a presence that
actually really is a data mine for, in many respects, law
enforcement. If you fast forward a few years, this will look,
in many respects, like GPS and cell phones have become for law
enforcement as well, which is it really creates an immutable
record that----
Mr. Yoho. I appreciate your time. I am out of my time, and
thank you, Mr. Chairman.
The Chairman. Well I want to thank the panel.
Mr. Gorfine, you may have to slip out to catch a plane, but
I would like to give each of you probably no more than a minute
for any closing comments you think you wish you would have said
during your opening or a question that didn't get asked that
you thought would be helpful for the record to have it.
So we will start with Mr. Fairfield. Any closing comment
quickly?
Mr. Fairfield. Only that it is a wonderful idea to begin
with these kinds of conversations because it is here that we
are able to look at the different communities that are using
the technology in different ways, and perhaps craft legislation
or other rules that will permit us to not only capture the bad
guys, not only get them cleaned out of the system, but to leave
intact what is good behind.
Ms. Baldet. Sure. Thank you for having me.
I would say that it is certainly important that we are
having these conversations and moving towards some right-sized
frameworks. At the same time, and possibly this is just our
general American sensibility. We are focusing on the private-
sector kind of business. How does this look like a business?
How does this look like a financial system angle, whereas there
is a whole other conversation to be had about what does this
look like if it becomes systemic infrastructure similar to the
Internet, and what does that mean globally?
At the same time, it should not be an either/or
conversation. We need to be thinking about how rather than just
defensively we regulate, how we can proactively make sure that
we are frontline innovators in the way that we were for the
Internet as well globally.
Mr. Kupor. Yes, I just want to echo a little bit, Mr. Yoho,
what you said, which is to be very clear, I speak for myself.
None of us are suggesting here that there shouldn't be
appropriate regulation in this market. There is actually a very
good framework between definitions of security laws that apply
to the SEC, and then things that actually, rightly so look more
like commodities. There is also FinCEN as we have talked about,
right, in terms of KYC and AML, so there is quite a patchwork
out there, certainly in our business were we sit, a lot of what
we are seeking is, quite frankly, just regulatory clarity so
that we ensure that companies who are good actors actually
understand what the rules of the road are, and we fully
support, obviously, the activity that the SEC and CFTC and
others are doing to make sure that the bad actors are rooted
out of the system.
Mr. Gorfine. Yes, thank you. I just want to thank the
Committee for taking an interest in this area and allowing us
and the CFTC to help inform and support the effort to strike
the right balance. It is a promising and very new area of
innovation that, as I said earlier, we don't know where a lot
of these different threads will lead. But it is important for
us to be vigilant and make sure that we are targeting bad
actors and making sure there are appropriate guardrails in
place, and that we have an efficient, effective regulatory
framework in place and look forward to helping support that
effort.
Mr. Gensler. First, it is just so good to be with you, Mr.
Chairman, and this Committee again after 5 years.
Two, promoting innovation and promoting competition means
also bringing this inside the public policy sphere. I don't
think they compete. I think it is together. If you recall, in
this Committee that there is the issuer-based crypto, which is
kind of the SEC and these ICOs. There is derivative crypto,
which the CFTC has but it is going to have some challenges. And
then there is the whole cash commodity crypto, which is 70
percent of this world. That is where Congress has a role, a
real role to think about is there more authorities?
I say incumbents versus startups. Startups feel that they
can beg for forgiveness after they mess up with the law
enforcement. Incumbents feel they have to ask for permission.
And so right now there is an imbalance right now where
incumbents aren't in this space and startups are, and you might
want to address that. MIT and I are available any time if you
need any help on any of this.
Thank you.
Mr. Ness. I guess I will echo that. I think probably Uber
taught us all that for better or for worse, if you build
something that is incredibly popular, the laws will change to
conform to that new technology.
Technology is moving at a very, very fast pace. We have
heard today about some of the pitfalls of these new
technologies that get out ahead of the legislators, and so I
want to compliment you guys for being on top of this, and the
SEC as well has been incredibly on top of it and working
closely with us and open to dialogue, and that is what is
really needed is a kind of free flow of information and
communication between those of us who are on the frontlines
dealing with the day-to-day fact patterns and you guys who need
to think about the actual policymaking aspects.
The Chairman. Well thank you. It has been a terrific couple
of hours. It was well spent for us. I hope you consider it the
same. You clearly elucidated some issues, not only just with
regulation of these issues, but also the tangential impact of
taxable transactions being captured in a way that folks can
comply with our Tax Code and the revenues there, the law
enforcement piece. Ms. Baldet, you may be involved with a group
that is trying to find a way to create a currency that is not
pseudonymous but would be anonymous. That is what innovators do
is they see something that needs to get changed, and they will
do that. And so that just speaks to how dynamic the process is.
As long as the stupid criminals keep using Bitcoin would be
great, but then the smart ones will pivot to something that
allows them to hide better behind that.
It has been a terrific eye-opening session, and will not be
the last because our folks at the CFTC who are our partners in
making this happen, and their partners at the SEC really want
to do the same thing, and that is regulate where it needs to
and give the certainty so that the incumbents don't have to
worry about asking for permission while the innovators are
asking for forgiveness. That is an unlevel playing field. And
we also want this action going on within the United States.
Thank you all very much. Under the Rules of the Committee,
the record of today's hearing will remain open for 10 calendar
days to receive additional material and supplementary written
responses from the witnesses to any question posed by a Member.
This hearing of the Committee on Agriculture is adjourned.
Thank you all.
[Whereupon, at 12:03 p.m., the Committee was adjourned.]
[Material submitted for inclusion in the record follows:]
Submitted Questions
Response from Amber Baldet, Co-Founder and Chief Executive Officer,
Clovyr *
---------------------------------------------------------------------------
* There was no response from the witness by the time this hearing
was published.
---------------------------------------------------------------------------
Submitted Questions by Hon. Vicky Hartzler, a Representative in
Congress from Missouri
Question 1. Illicit Activity--Over the past few years, one of the
things that's caused me and my constituents a great deal of concern is
the rise of illicit activities being facilitated by the dark web, such
as drug and sex trafficking. Congress is continuing to address the
opioid epidemic, and I've turned my attention to sex trafficking as
well. Last year, I sponsored a bill, known as the Empowering Law
Enforcement to Fight Sex Trafficking Demand Act, that passed the House
to address this issue.
Ms. Baldet, Mr. Gensler brought up the use of certain
cryptocurrencies to purchase illegal goods and facilitate criminal
activity. As you sit on the board of the Zcash Foundation, which is a
non-for-profit dedicated to enhancing financial privacy, I'd like to
get your perspective on how we can fight against illegal activities
being facilitated through cryptocurrency.
How should we weigh the value of financial privacy against the
value of law enforcement access to financial information?
Answer.
Question 2. Is it possible to have a truly anonymous cryptocurrency
and still protecting against bad actors using it to launder money,
purchase illegal goods, or evade taxes, or does the public have to
choose one or the other?
Answer.
Response from Daniel Gorfine, J.D., Director and Chief Innovation
Officer, LabCFTC, Commodity Futures Trading Commission
Submitted Questions by Hon. John J. Faso, a Representative in Congress
from New York
Question 1. Commissioner Brian Quintenz has stated that a virtual
currency can start as a security and become a commodity. What is that
transition point in your mind?
Answer. The Securities and Exchange Commission (SEC) interprets and
applies the securities laws, and has been providing further guidance on
how it would apply the ``Howey Test'' to crypto-asset offerings. To the
extent that a crypto-asset is a security, the CFTC would generally not
exercise regulatory authority over the instrument.
Within the above context, it is conceivable that an enterprise
would seek to raise capital through an investment contract and help to
build a decentralized network predicated on a crypto-coin or token that
takes on attributes similar to Bitcoin or Ether. In this case, the
crypto-coin or token may be a commodity, akin to oranges or Bitcoin,
while the initial investment contract is deemed a security. Of course,
whether a particular offering or crypto-asset is a security or
commodity is subject to a facts and circumstances legal test and
accordingly is highly dependent on the details of the offering.
Question 2. In the hearing you cited SEC Director Hinman's comments
on decentralization. At what point are a central actor's efforts no
longer key to the success of an enterprise, or sufficiently
decentralized, to no longer be classified as a security?
Answer. I defer to the proper jurisdiction of the SEC in
determining the outer boundaries of the securities laws, but given our
ongoing collaboration with the SEC and observation of its public
comments the factors of decentralization, control, public expectations
of profits from ongoing work of others, information asymmetries, and
crypto-asset use cases all appear to be relevant to the analysis.
Again, the securities and commodities laws are subject to facts and
circumstances tests that eschew over-simplified definitions in order to
accommodate evolving markets and offerings.
With respect to decentralization, one might consider how many
nonaffiliated individuals or entities contribute to the success of the
network and whether the network remains significantly reliant on a
founding team of creators or developers. As crypto-asset fact patterns
continue to evolve, we at the CFTC will strive to continue providing
clarity to market participants, as appropriate.
Question 3. How many independent users confirming transactions or
changes to a blockchain are sufficient for effective decentralization?
Answer. I do not believe a bright-line number of users or
transactions should be dispositive as to the classification of a
crypto-asset. Instead, the CFTC utilizes a facts and circumstances test
in determining application of the CEA. To be sure, the number of users
confirming transactions and breadth of participation are likely
relevant to such a test, but not dispositive. As noted above, a
relevant consideration may be whether the network remains significantly
reliant on the work or efforts of a core team or group of developers as
compared to gaining such widespread adoption that it can continue to
run largely autonomously.
[all]