We Must Distinguish Digital Commodities From ICOs
On March 14, 2018, the House Financial Committee held a hearing entitled “Examining the Cryptocurrencies and ICO Markets.” This was the first hearing in which members of the U.S. Congress, specifically a subcommittee on capital markets, securities and ICO markets, addressed cryptocurrencies and ICOs. Witnesses at the hearing included Dr. Chris Brummer, Professor of Law at Georgetown University Law Center; Mike Lempres, chief legal and risk officer at Coinbase; Robert Rosenblum, a partner at the Silicon Valley law firm Wilson Sonseni Goodrich & Rosati; and Peter Van Valkenburgh, the director of research at Coin Center.
The hearing addressed the economic efficiencies and potential capital formation opportunities that cryptocurrencies and ICOs offer to businesses and investors. It also reviewed the current approach by the SEC, CFTC and state regulators to administer laws which adequately protect investors. Because regulatory clarity so far has been difficult for businesses and investors, members of Congress also expressed interest in how to best monitor and oversee blockchain technology as it moves into the future.
Notable points asked of and addressed by the witnesses included the need for security and investor compliance for U.S. cryptocurrency exchanges; the need (or in Rosenblum’s case, lack thereof) for regulators to distinguish the difference between cryptocurrencies that are considered digitally scarce commodities and securities tokens; the need to establish a harmonization among the “patchwork” of regulatory agencies dictating how to move forward; and the policing of cryptocurrencies, all in such a way that won’t stifle domestic innovation by forcing investors and businesses to leave the country.
Digitally Scarce Commodities and Security Tokens
Distinguishing major cryptocurrencies from the majority of ICO tokens was the biggest topic of conversation during the hearing.
Van Valkenburgh noted that digital scarcity is a fundamental difference between ICOs and cryptocurrencies such as Bitcoin, Ethereum and Filecoin.
“The fundamental innovation of Bitcoin is digital scarcity. That digital scarcity can then be employed by innovative people for a variety of innovative purposes. A token that is scarce and transferable from person to person can be used just like money, just as any good throughout history from gold to seashells. A scarce token can also be automatically redeemable for a digital good or computing service provided by the same network of computing participants who verify the blockchain. These are projects like Ethereum, Filecoin and Blockstack and they are beginning to compete with competitors like Amazon, Facebook and Google. A scarce token can also represent a legal agreement.”
Van Valkenburgh went on to distinguish scarce tokens already put into practice from others that are merely theoretical, supported only by blockchain software that has yet to be built. Recently, new blockchain projects have raised money by selling the promise of future tokens to willing investors in ICOs.
From a regulatory standpoint there is a fundamental distinction that must be made between scarce tokens that exist on a blockchain and are used for payment or to obtain computing services and, on the other hand, promises of future tokens representing the hopefully profitable efforts of a developer.
He went on to state that the former scarce tokens are like digital commodities while the latter (ICOs) are securities, both having distinct risks that must be addressed by investors in different ways.
Rosenblum suggested a short– and long-term approach for the SEC and other agencies to modify the regulation rules around cryptocurrencies so that the industry does not get locked into a concrete regulatory system too early. He used the combination of blockchain technology with artificial intelligence to convey why imposing regulations at this time would not be a good idea:
It could potentially lead to new marketing, business opportunities, scientific and sociological advances. However, the opportunity to use that same technology for manipulative conduct, data breach and other nefarious conduct is really hard to predict right now.
On the subject of regulating ICOs, Brummer emphasized the need for standardized and precise promoter disclosures for investor protection. Speaking primarily about cryptocurrency white papers, essentially the business and technological plan behind each cryptocurrency, Brummer gave a list of recommended standardized disclosures:
- Location: Brummer cited one particular study which indicated that in 32 percent of ICOs it is not possible to identify the identity or origin of the ICO issuer or promoter. Without having this information it is very difficult for investors to understand the protection rights or authorities they can contact in case of fraud. Therefore, ICO promoters or issuers should establish a clear statement of where an issuer is located.
- Problem and proposed technology solution: The most important information for assessing the success of an ICO is understanding its proposed solution for how the technology will solve a problem: a plain-English explanation of the technology solution. More technical aspects of the white paper would be subject to the validation of a third-party technology audit. All code would be subject to a public repository such as GitHub.
- Token proposal: An ICO’s white paper should disclose legal rights of token holders as well as how the tokens will be traded and on what platforms.
Brummer concluded by saying that white papers should also disclose the basic principles of blockchain governance and risk factors, not only for the token itself, but also for the industry as a whole.
Brummer stated that one major point of contention for government regulators on cryptocurrencies might be the fact that “because digital things tend to be more abstract and they therefore tend to be harder to understand,” there is more tension and difficulty in defining them as commodities, unlike gold which is “shiny and universally identified as something that has value.”
Huizenga, in turn, acknowledged that “governmental bureaucracies tend not to view the world through those lenses. And I think that there is a certain governmental responsibility to protect investors.”
A Patchwork of Regulatory Agencies
While distinguishing between a digitally scarce commodity and a security appeared to be the most fundamental and pressing issue, all testifying witnesses acknowledged the need for clear lines in which regulatory agencies operate and monitor the industry. This confusing and often contradictory relationship between the SEC vetting cryptocurrencies, the CFTC policing cryptocurrencies on the spot market, and state regulators has already indicated a level of disorder that could potentially stymie further development within the domestic cryptocurrency and blockchain technology industry.
Again, Van Valkenburgh reiterated that if policymakers get the distinction between digitally scarce commodity tokens and security tokens wrong, they will cede leadership of the technology development to the rest of the world.
Rosenblum suggested that, moving forward, “regulation by enforcement, in an area that is as complicated and dynamic as this, is not the appropriate way to regulate. Enforcement is clearly necessary; however, we need clearer guidelines on the SEC’s registration, market trading and how investment rules should apply and do apply, and that is something that you cannot do through regulation and enforcement.”
Security and Compliance
Congressman Hultgren expressed concern over cybersecurity standards within cryptocurrency. Addressing these concerns, Lempres stated, “Approximately 99 percent of Coinbase cryptocurrency holdings are held in cold storage.” Furthermore, 20 percent of Coinbase’s employees are dedicated to compliance. Lempres also pointed out that the blockchain’s transparent ledger allows for Coinbase to glean insight into bad activity occurring within their system. Lempres also referred to the cybersecurity standards of the state of New York’s “BitLicenses.” So far these BitLicenses have only been administered to four cryptocurrency companies — including Coinbase — and that is the strongest evidence for the security standardization, according to Lempres.
Voices For and Against
Voicing disapproval of cryptocurrency, no one was more direct than Congressman Brad Sherman. “Cryptocurrencies are popular with guys who like to sit in their pajamas and tell their wives they are going to be millionaires. They help terrorists and criminals move money around the world. Tax evaders. They help startup companies commit fraud, take money, and one percent of the time they actually create a useful business.”
Sherman went on to suggest that cryptocurrency hurts the U.S. dollar, prevents the federal government from preventing tax evasion, and takes away from investment that could otherwise be used to develop the American economy. Chairman Huizenga noted that, despite Sherman’s comments, the hearing was to focus on cryptocurrency and blockchain technology and not Dodd Frank reform.
On the other hand, Rep. Tom Emmer, a member of the Congressional Blockchain Caucus, suggested that the potential for innovation from blockchain technology in American society is something both Republicans and Democrats should welcome.
I tend to trust people and believe that they’re in these things for good, and that they’re trying to improve their own lives and hopefully the lives of people around them — that old adage that a rising tide lifts all boats. And yet I hear elected officials who don’t have any concept of what we’re dealing with here and how exciting it is, talking about how we got to regulate and create more government infrastructure. I respectfully disagree that that won’t act as a wet blanket on this amazing new technology. I realize there has to be some regulation, but there’s got to be balance.