Coin Center Director of Research Peter Van Valkenburgh has prepared a report regarding the regulation of various cryptocurrencies within a traditional securities framework. Although the report found cryptocurrencies attached to public blockchains, such as bitcoin and ether, should not be regulated as securities, the team behind the document did find that the definition of a security may apply to some of the more centralized crypto-assets currently on the market.
Most of Coin Center’s report provided a general overview of Bitcoin and related technologies for regulators, but the end of the report mainly focused on the Howey test. The Howey test is a way to figure out whether something should be defined as a security and is defined by the following parameters in the report:
“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, [excluded factors] it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.”
Bitcoin and many altcoins are not well-suited for the Howey test, which is why the report recommends regulators do not treat these cryptocurrencies as securities. The Howey test becomes a bit more viable when talking about blockchain initiatives that have low transparency, involve a pre-sale of tokens, or a more centralized approach to transaction validation (such as a permissioned ledger).
The Coin Center report on treating cryptocurrencies as securities went through all four prongs of the Howey test to determine which types of crypto-assets should be regulated.
Investment of Money
According to Coin Center’s report, the way a cryptocurrency is distributed to its users should be the first variable to consider when analyzing that token in the eyes of the Howey test. The report claims altcoins that offer any sort of pre-sale of their tokens are more likely to qualify as an investment of money, which is the first prong of the Howey test. Pre-mined coins are also included in this group, especially when combined with a minimum price floor guarantee (as was the case with Paycoin).
Coin Center’s report says tokens issued via a mining process, such as Bitcoin, do not constitute as an investment of money. Tokens issued via proof-of-burn, a sidechain or as a reward for contributing resources in some other manner (Storj for example) are also lumped into this category of cryptocurrencies that do not involve an investment of money by users.
Creating a Common Enterprise
The next aspect of the Howey test covered by the report is whether an investment counts as a common enterprise. This prong of the test is defined in the report:
“Briefly, horizontal commonality can be defined as the pooling of investor funds such that the fates of all investors rise or fall together, often — though not always — through a pro-rata sharing of profits. Vertical commonality requires that the ‘fortunes of the investor are interwoven with and dependent upon the efforts and success of those seeking the investment or of third parties.’”
While horizontal commonality in Bitcoin is easy to prove — everyone’s bitcoin will rise and fail in value together — vertical commonality is another story. The report notes there are many companies that promote bitcoin as a currency or commodity, but the profits for these companies are tied to internal factors rather than a simple increase in the U.S. dollar value of bitcoin.
Paycoin is pointed out as one possible situation where the requirements of vertical commonality are met. The altcoin’s parent company, Geniuses at Work, held the majority of all paycoin, which means their profits and losses were closely tied to the success or failure of the cryptocurrency. Although not mentioned in the report, Rippleholds a large amount of XRP and falls under similar consideration.
Coin Center’s report also mentions token scarcity, decentralization and developers holding a large percentage of all tokens as troubling signs for investors. In general, altcoins that involve vertical commonality are noted as high-risk investments.
Expectation of Profits
Nearly every altcoin that has been launched up to this point has come with an expectation of profits, and speculation is still one of the main use cases of bitcoin today. Coin Center’s report only pointed out two possible cases where an altcoin does not meet this prong of the Howey test: sidechains and appcoins.
The reasoning behind Coin Center’s exclusion of sidechain-based altcoins is clear — the value of a sidechain token is pegged to bitcoin — but some may say the decision to include appcoins as tokens that don’t come with any expectation of profit is questionable. For example, the Satoshi Nakamoto Institute ’s Daniel Krawisz has referred to appcoins as snake oil.
The final prong of the Howey test covered in Coin Center’s report involves the level of trust required in the transaction validators. Although these systems are oftentimes referred to as “trustless,” the reality is that all blockchains, even Bitcoin, have some trusted entity (or entities) processing transactions on the network. According to Coin Center, the risks for users are higher when these entities are more centralized.
While Bitcoin’s proof-of-work system was praised for its level of decentralization, Coin Center’s report was not as kind to proof-of-stake and permissioned ledger systems. The report cites often-discussed flaws of proof-of-stake systems that could lead to more centralization than originally intended, but it also notes research in this area is still ongoing. When it comes to permissioned ledgers, the report claims:
“A Permissioned distributed ledger system will always lead to the reliance of users upon the class of enumerated transaction validations. This group effectively controls the ledger and can issue new tokens at will. All access to the network is mediated by this group, and the total value of the network would therefore be predicated on the faith or trust that users choose to place in that group.”
The final portion of the report covers specific advice for regulators. These innovations are presented as having a lower risk profile for investors and users:
- Highly decentralized cryptocurrencies (Bitcoin, Litecoin )
- Sidechained cryptocurrencies (Rootstock, Bitcoin Hivemind)
- Cryptocurrencies with a distribution model based on open, competitive mining or proof-of-burn (Bitcoin)
- Appcoins (Ethereum, Storj)
Alternatively, Coin Center’s report states investors (or users) may need more protection from the following types of cryptocurrencies:
- Closed-source or low-transparency cryptocurrencies
- Cryptocurrencies with a pre-sale that involve a small and non-diverse mining and developer community
- Cryptocurrencies with permissioned ledgers or some other form of highly centralized transaction validators
These are simply recommendations made by Coin Center, so no government agency has any responsibility to follow them. Having said that, this report has been able to make a clear distinction between open, decentralized cryptocurrencies and their more centralized, and perhaps riskier, counterparts.
Kyle Torpey is a freelance journalist who has been following Bitcoin since 2011. His work has been featured on VICE Motherboard, Business Insider, RT’s Keiser Report and many other media outlets. You can follow @kyletorpey on Twitter.