A cabal of the biggest companies in Bitcoin have come together to launch a system for measuring a coin’s likelihood to be caught up in U.S. securities regulations.
Coinbase, Kraken, Grayscale Investments, Bittrex, Poloniex parent company Circle and Anchorage custody services, among others, have established the Crypto Ratings Council (CRC). This council will rate specific cryptocurrencies on a scale of one to five based on the likelihood that they qualify as securities (1 being the least likely and 5 being the most likely).
This ratings system, as Blockchain.info lawyer Marco Santori noted on Twitter, is essentially “a Hot or Not for the Howey Test” — the litmus for classifying whether or not an asset is a security based on the Securities Act of 1933.
The Importance of Security Status
In the U.S. arena, the Howey Test has been the industry’s only touchstone for judging a cryptocurrency or token’s legal status as a security. Since the infamous DAO hack in 2016, the U.S. Securities and Exchange Commission (SEC) has been forthright that this age-old metric applies to the new-age asset class of cryptocurrencies, and the SEC has sued several token issuers, including messaging service Kik, for violating securities law with unregistered securities token sales.
Even so, some think that, more than being merely outdated, the Howey Test is not sufficient to address such a complex new beast as cryptocurrency. The CRC's legal counsel, for instance, think it isn't adequate.
“The SEC has provided guidance to help participants in the digital asset industry evaluate the status of digital assets under the U.S. federal securities laws, but evaluating digital assets remains an important challenge and uncertainty for the industry,” Eric Sibbit, chair of O'Melveny & Myers’ financial technology practice, told Bitcoin Magazine (O’Melveny is working with CRC to design the ratings). “The ratings system reflects an effort by members of the council to more systematically apply applicable case law and SEC guidance and utilize the collective expertise of council members.”
In the absence of any pre-rolled cryptocurrency regulation, Coinbase and co. are rolling their own rough guidelines. These ratings, though, are in no way endorsed by the SEC, which, among “other regulators are unlikely to adopt a rating system created solely by industry participants,” Sibbit told Bitcoin Magazine. Sibbit also expressed the hope that “the rating system may encourage further dialogue with the SEC.”
Instead, these ratings are meant to act as a guiding light for exchanges and cryptocurrency companies when evaluating which cryptocurrencies to support (even though the exchanges involved have already listed most of the coins in question).
The criteria for the ratings are based on dozens of yes or no questions. Crafted with the help of law firm O’Melveny & Myers, “these questions are derived directly from SEC guidance and case law and are designed to address important characteristics that inform whether an asset is or is not a security,” the Coinbase post claims.
The first batch of ratings are as follows:
Hedera Hashgraph (3.5)
Loom Network (3.5)
Writing about the methodology in correspondence with Bitcoin Magazine, Sibbit explained: “Considerations relating to ‘decentralization’ are important to the question of whether any expectations of profits may result from the efforts of a founding project team or others, but other important factors in evaluating the status of a digital asset include how a token was sold and marketed, the existing utility of the token and ongoing role of the project team behind a token, whether holders of the token receive some sort of return or payment by holding the token and a number of other factors.”
In the midterm future, the council will review more assets and may even extend its reach to other jurisdictions. Additionally, projects that are rated may provide feedback, though this will not necessarily influence the ratings.
What’s the Point?
Community reactions to the news have been mixed so far, both between lay observers and lawyers in the space.
Marco Santori, for example, decried the lack of clear framework for industry participants. “It's just a series of legal conclusions, devoid of reasoning. A scattershot blast of facts aimed haphazardly out of Howie's four short barrels,” he wrote in a Twitter thread.
This “scattershot” guidance by enforcement means cryptocurrency teams have to sink substantial time and capital into figuring out whether or not supporting an asset might end in a lawsuit. Lacking focused legislation from Congress or clear regulations from the SEC, this ratings system is “basically the best we’ve got,” Santori argues, qualifying that the industry “absolutely and without a doubt can do better.” Working with its back against the wall, the industry’s biggest players came together to broker a de facto solution to a persistent problem and this should be applauded, he concludes.
Robert Cornish Jr., a partner at the Anderson Kill law firm with experience in securities law, sees the news less favorably. What Santori views as an imperfect-but-necessary solution, Cornish views as crypto’s most powerful companies overplaying their hands.
“A ‘council’ of financial services industry participants making affirmative determinations on how and when federal and state securities and commodities laws apply to products in which they are transacting business is troubling on several levels,” Cornish told Bitcoin Magazine over email. “The SEC and CFTC rules on the formation and approval of self-regulatory organizations (FINRA, etc.) are written so that applicants actually inform the regulatory bodies of the steps they are taking to have putative members operate within the bounds of the law. This seems to me more of an ad-hoc declaratory judgment forum of a cartel without any judicial or regulatory oversight. Taking the model to extremes, such a ‘council’ could also act as a cartel and ignore rulings from courts and arbitration panels to foster anti-competitive conduct. Clearly, this is something that needs to be thought out more carefully by industry participants.”
Whether or not you buy that the council will disregard court action, the underlying anxiety with the biggest names in cryptocurrency trying to guide regulation is that these companies aren’t vested with any of the legitimacy that give real self-regulatory organizations (SROs) like the Financial Industry Regulatory Authority (FINRA) clout in their decision-making and legal actions.
Unsurprisingly, the law firm that’s advising the initiative sees it as a positive step toward correcting the currently inadequate framework.
“Because lawmakers designed legacy financial regulation that did not envision these technological advances, industry participants have struggled when applying existing laws to the unique nature and characteristics of digital assets,” O’Melveny partner Eric Sibbitt said, according to a press release from the firm. “The CRC seeks to improve this process by creating a standardized framework that takes into account available facts, relevant U.S. securities law statutes, court cases, enforcement actions, and applicable SEC regulations and guidance, while accommodating the potential for that determination to change as the law and facts and circumstances around a particular asset evolve.”
Sibbitt was not immediately available for comment, but we will update this article if and when we hear back.