This problem, of course, is solvable. There is hope that with the change in administration, new FinHUB leadership will provide clearer guidance to the digital asset and blockchain industry. In this article, we propose one modest form of guidance that could go a long way toward providing that much-needed clarity.
The SEC leadership has already made clear their view that Bitcoin is not a security. In April 2018, in a hearing before the House Appropriations Committee, then-SEC Chairman Jay Clayton stated that Bitcoin does not qualify as a security. He reasoned that Bitcoin functions as a replacement for currency.
Clayton later added in a media interview that digital assets that “are replacements for sovereign currencies, [which] replace the dollar, the euro, the yen … [are] not a security.” In other words, he reasoned that any digital currency whose primary function is to serve as a substitute for fiat currency would not qualify as a security.
Subsequently, in a July 2018 speech, William Hinman, then director of the Division of Corporation Finance, likewise opined that Bitcoin is not a security under Howey. He reasoned that there no longer seemed to be “a central third party whose efforts are a key determining factor in the enterprise.”
Importantly, now-SEC Chairman Gensler similarly recognized in his Senate confirmation hearing that Bitcoin “has been deemed” a commodity. Further, in a 2018 speech before an MIT blockchain conference, he distinguished Bitcoin from tokens accompanied by initial coin offerings and/or pre-mined coins, explaining that “bitcoin came into existence as mining began as an incentive in validating a distributed platform.”
Two key features highlighted by the commission’s leadership merit further comment. First, SEC leaders have flagged the importance of a digital asset functioning as a currency equivalent. This, of course, makes perfect sense. Those who acquire digital assets that can readily be used as a currency equivalent in the existing marketplace may reasonably be assumed to have acquired those assets with the intent to spend them, rather than to hold them for their investment potential. Such a showing defeats the required element of an expectation of profits.
Second, SEC leadership has likewise highlighted the importance of a digital asset with a diversified control structure, so that the success of the enterprise does not hinge principally on one private operator alone. Many have misconstrued this emphasis on “decentralization” to suggest the misplaced notion that a digital asset cannot have a central entity or coordinated group responsible for maintaining the blockchain code.
Such an expectation would create an impossible and counterproductive standard. At a minimum, blockchain code — as with any software code — requires constant maintenance to protect it from hackers and other security risks. Such maintenance cannot be achieved effectively and efficiently without centralized leadership guiding that effort.
A more intuitive reading of these comments leads to the obvious conclusion that decentralization does not require the absence of centralized maintenance of a digital asset’s blockchain, but rather a structure that places responsibility for the success of the enterprise across a diverse array of market participants. Bitcoin does this by design. Specifically — a central and defining aspect of Bitcoin — that transactions must be processed by miners, who are independent market participants from those who maintain the blockchain code — distinguishes Bitcoin from an array of other digital assets whose distributions are controlled directly by the issuer. Indeed, Gensler himself highlighted the importance of mining as a distinguishing feature of Bitcoin in his 2018 speech at MIT.
Among other reasons, the mining structure is important because it naturally defeats the required showing under the Howey test that investors’ reasonable expectation of profits turn principally on the managerial or entrepreneurial efforts of a central third party. Indeed, without miners willing to operate nodes and process transactions, the Bitcoin network could not function. Accordingly, these services, provided by a diverse array of unrelated entities central to the success of the network, are undeniably significant.
Thus, the commission’s leaders can provide meaningful and much-needed clarity to the digital asset industry by building on their prior remarks and formalizing those remarks into binding guidance. Specifically, the SEC should, through its rulemaking authority, make clear that a digital asset does not qualify as a security if it operates currently (or from inception) as a currency equivalent with an existing marketplace for everyday transactions and is distributed by a decentralized mining network responsible for processing and validating transactions.
Such clarity would significantly reduce the investment risk for market participants to make the costly upfront investment in powerful and innovative technology that builds on those digital assets that have these critical attributes. Indeed, these modest assurances have the power to unleash unlimited, large-scale innovation that can transform our everyday lives. The Biden administration has a unique opportunity to provide the foundation for this transformational technology. We hope it won’t miss the moment.
Chris Bellini and Kara Kapp are attorneys at Cozen O’Connor.
