Ideas Made to Matter
Is a cryptocurrency a security? Depends.
As regulators wade through the thousand or so virtual currencies that have appeared in the last few years, they’re looking for answers to crucial questions. Is a cryptotoken, for example, an investment? Or is it a commodity?
“It’s both,” said Gary Gensler, who joined MIT earlier this year as a senior lecturer at MIT Sloan and a senior adviser at the MIT Media Lab. “I know that’s not an answer that a lot of people like, but that’s kind of where we are right now.”
As regulators play catch up, Gensler, the former chairman of the Commodity Futures Trading Commission, estimated that many cryptocurrencies, “probably well over a thousand,” are operating outside of U.S. law and will have to come into regulatory compliance. He said bitcoin is not a security, but that ether and ripple — two of the other most notable cryptocurrencies — likely are securities.
He made his comments at the April 23 MIT Business of Blockchain conference. On May 1, the Wall Street Journal reported that government regulators are trying to determine whether ether and other cryptocurrencies are securities.
The market for initial coin offerings (which allow entrepreneurs to bypass the traditional venture capital route and fundraise by selling virtual currencies) has proliferated. In the first quarter of 2018 alone, $6.5 billion was raised, by Gensler’s estimate.
“It’s no longer a small market,” Gensler said. “It surpasses a lot of the venture capital space and other ways of raising money.”
Citing MIT Sloan assistant professor Christian Catalini, Gensler warned that frauds and scams are common, affecting as much as 25 percent of the industry. “We’re not in a pretty good shape right now,” he said. “There really is significant non-compliance with respect to the laws, certainly in this country and in many, many other countries as well.”
What makes a cryptocurrency a security?
In his comments, Gensler explored crucial distinctions that could determine which companies are noncompliant. For instance, if a coin offering is designed to provide investors an ownership stake, then the company’s token should be treated like a security and be subjected to the applicable regulation. It doesn’t matter if there’s no dividend involved, nor the traditional features of equity or bonds. The absence of these features doesn’t make a company “home free,” Gensler said, referencing the Howey Test, which came out of a 1946 Supreme Court ruling to help determine whether certain transactions qualify as an investment contract.
“The investing public is clearly hoping for possible appreciation,” Gensler said. “When you quack like the duck, when you swim like the duck, when you walk like the duck, Riley, 100 years ago said, ‘I think the bird's a duck.’” (The “duck test” is often attributed to writer James Whitcomb Riley.)
Gensler said bitcoin — the first and most widely used virtual currency — cannot be classified as a security.
“Bitcoin came into existence as mining began as an incentive in validating a distributed platform,” he said, with no initial token offering, no pre-mined coin and no kind of common enterprise. That’s not the case for other companies, such as the cryptocurrency ripple, “which sure seems like a common enterprise,” he said.
Token design is another unknown that regulators will have to tackle. “Is there possibly a design that’s really about consumption and not about investment?” Gensler asked. “Can you put a packaging around a token, so the package is a security and so the token later on is not?”
Others in the industry are weighing in to help answer these questions and raise additional risks involved in cryptocurrencies. Speaking at an April 27 MIT conference in New York City, Bank of America CEO Brian Moynihan warned that digital currencies have the potential to move large sums of illicit money.
But if managed right, blockchain technology could be a boon for financial innovation, Gensler said.
“It could lower costs, and risks, and economic rents, but for broad adoption the technology needs to move forward in the public policy sphere,” he said. “We also need to adapt some of the rules of the road so that this new technology fits in.”
Starting this fall, Gensler will teach graduate classes at MIT Sloan that cover public policy, the private sector, and the functioning of global markets. Learn more about blockchain, crypotcurrencies, and initial coin offerings at the MIT Cryptoeconomics Lab.