Digital Assets and SEC Regulation
Released: 2020-01-30T00:00:00

What Are Digital Assets?

Digital assets are assets issued and transferred using distributed ledger or blockchain technology. They are often referred to as crypto-asset , digital token , or cryptocurrenc y , among other terminology. Digital assets can be securities, currencies, or commodities. Although market participants use different terms to describe them, financial regulators have stated thatâregardless of what they are calledâfinancial activities, services, and market participants must adhere to applicable laws and regulations. In the case of digital assets, depending on their characteristics, this can include securities laws and regulations. One key difference between digital and traditional assets is an asset's ownership and exchanges of ownership. Whereas traditional assets are generally recorded in private ledgers maintained by central intermediaries, digital assets' ownership and exchange are generally recorded on a decentralized digital ledger.

Digital Assets as Securities

The Securities and Exchange Commission (SEC) is the primary regulator overseeing securities offers, sales, and investment activities, including those involving digital assets. However, not all digital assets are securities. In general, a security is "the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others." When a digital asset meets the criteria defining a security, it would be subject to securities regulation. For example, most of the initial coin offerings (ICOs) are securities, but Bitcoin is not a security, mainly because it does not have a central third-party common enterprise.

Market intermediaries (e.g., investment advisers, trading platforms, and custodians) involved with digital asset investment, trading, and safekeeping could also be subject to relevant securities regulation. Securities regulations could apply if the intermediaries are directly engaged in the security-based digital asset transactions or if they use digital assets (including non-security-based digital assets) to facilitate securities transactions.

This report focuses on digital assets and activities that are subject to securities regulation. It discusses the objectives and policy rationale of securities laws and regulations; SEC initiatives to address specific regulatory challenges arising from certain unique digital asset features that raise questions concerning the adequacy of the existing regulatory framework; and policy issues for congressional and industry consideration in five selected areas: initial coin offerings, stablecoins, digital asset exchange-traded funds, digital asset custody, and digital asset trading.

Securities Regulation Background

Securities regulation generally applies to all securities and related intermediaries, whether they are digital or traditional. This section broadly discusses the objectives and policy rationale behind securities laws and regulations.

Congress established the SEC and the main framework for capital markets and securities regulation to restore market confidence after the stock market crash of 1929. The regulatory framework's key objectives are to promote disclosure of important market-related information, maintain fair dealing, and protect against fraud. As a result, the existing securities regulatory regime focuses on disclosure-based rules, an antifraud regime, and rules governing securities market participants (e.g., exchanges, broker-dealers, and investment advisors). The SEC's mission is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.

For example, one of the cornerstones of securities regulationâthe Securities Act of 1933âis often referred to as the "truth in securities" law. As the phrase suggests, disclosures allow investors to make informed judgments about whether to purchase specific securities by ensuring they receive financial and other significant information on securities offered for sale. The SEC does not make investment recommendations. The disclosure-based regulatory philosophy is consistent with Supreme Court Justice Louis Brandeis's famous dictum that "sunlight is said to be the best of disinfectants; electric light the most efficient policeman."

The current developments in digital asset trading and fundraising are not the first time securities regulators have had to accommodate new technology. Capital markets infrastructure has experienced continuous innovation since the securities regulatory framework was first formed in the 1930s. For example, securities trading platforms experienced a major revolution in the late 1960s and early 1970s, when trading processes shifted from paper and pen-based manual settlements in isolated markets to electronic platforms, which incorporate new data-processing and communications technologies that link all markets together. Congress responded to these advancements by amending Section 11A of the Securities Exchange Act to establish a national market system. The congressional objectives were to encourage efficient, competitive, fair, and orderly markets that are in the public interest and protect investors.

The SEC's Current Regulatory Approach

Although digital assets as a capital market innovation evolved quickly, the SEC to date has not been active in promulgating new digital-asset-specific rules. One rationale for this approach is that, because it is uncertain how the characteristics and use of digital assets will evolve, highly prescriptive regulations could become obsolete, and potentially inefficient.

The SEC's current regulatory framework that governs traditional and digital securities include the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1940. It has also used existing tools and a number of initiatives besides rulemaking to address specific regulatory issues arising from certain unique digital asset features. The SEC's approaches include the following:

Innovation office . The SEC created the Strategic Hub for Innovation and Financial Technology (FinHub) in 2018 to engage in financial technology ( fintech ), consolidate and clarify communications, and inform policy research. In 2019, FinHub conducted outreach meetings in multiple cities and published a framework for analyzing whether a digital asset is a security. Enforcement . The SEC has brought enforcement actions against securities token issuers and digital asset traders and asset managers, among others. The SEC established a new Cyber Unit and increased its monitoring of and enforcement actions against illicit cyber-based transactions. No-action letter s . The SEC uses no-action letters to provide relief for digital-asset-related businesses and to signal its regulatory intentions to capital markets. For example, the SEC issued a no-action letter to TurnKey Jet, a business-travel startup, stating that its issued tokens are not securities. This was the SEC's first no-action letter for an ICO. The letter triggered a wave of industry discussions and could set a precedent for future digital asset activities. Solicitation for public input . The SEC released a letter to the industry in March 2019 to solicit public input regarding digital asset custody. The comments may help the SEC understand the challenges the industry faces and assess investor-protection risks. New product approval . The SEC could approve or reject new digital asset products. For example, the SEC has reviewed Bitcoin ETF proposals in recent years and has consistently rejected such proposals as of 2019.

Issues Raised by Digital Assets in the Securities Regulation Context

Digital assets and their use in capital markets are a growing presence in the financial services industry's development. They raise policy questions, including whether new digital-asset-related practices have outgrown or are sufficiently overseen by the existing regulatory system; how the regulatory frameworks can achieve a level playing field where the same businesses and risks could be subject to the same regulation; and how to protect investors without hindering innovation.

A fundamental understanding of innovative trends and the appropriate timing of the related policy actions are also important for digital asset regulation. In analyzing technological changes, some commentators suggest that society tends to overestimate a technology's effects in the short run and underestimate its effects in the long run. This illustrates the delicate balance between social pressure for change and the appropriate timing for policy responses in the face of innovation.

This section explains key examples of digital asset developments and use cases, focusing on policy issues and legislative proposals in the securities regulation context. The most salient digital asset-related policy issues include regulatory oversight and investor protection.

Regulatory O versight . Digital asset issuers and investors face a steep learning curve in comprehending the regulatory landscape and determining how or if securities laws apply to them. It may not always be clear whether a digital asset is a security subject to SEC regulation. Multiple agencies apply different regulatory approaches to digital assets at the federal and state levels. For example, for certain digital assets, the SEC treats them as "securities," the Commodity Futures Trading Commission treats them as "commodities," and the Internal Revenue Service treats them as "property." State regulators oversee digital assets through state money transfer laws, and the Treasury Department's Financial Crimes Enforcement Network monitors digital assets for anti-money laundering purposes.

Investor Protection. Digital asset investorsâwhich may include less-sophisticated retail investors, who may not be positioned to comprehend or tolerate high risksâmay be especially vulnerable to new types of fraud and manipulation, leading to questions about investor protection. First, there appears to be high levels of scams and business failures. A 2018 study from Satis Group, a digital asset advisory firm, found that 81% of ICOs were scams and another 11% failed for operational reasons. Second, many digital asset companies offering securities do not comply with SEC registration and disclosure obligations, potentially affecting investors' ability to understand their risk exposures. Third, the high volatility of digital assets' valuations can potentially result in large gains and losses, the risk of which may not be well understood by less-sophisticated investors. Lastly, digital assets operate outside the traditional financial system and thus may not offer common types of transaction protectio ns. For example, banks may have the option to halt or reverse suspicious transactions and associate transactions with the users' identities, but a digital asset transaction is generally irreversible through such intermediaries.

Initial Coin Offerings

Businesses raise funding from capital markets through securities offerings, such as stocks, bonds, and digital assets. ICOs are a new fundraising mechanism in which projects sell their digital tokens in exchange for fiat currency (e.g., dollars) or cryptocurrency (e.g., Bitcoin). A typical ICO transaction involves the issuer selling new digital "coins" or "crypto tokens" to individual or institutional investors. Investors pay for these tokens with either cryptocurrencies or traditional currencies. ICOs are often compared with initial public offerings (IPOs) of the traditional financial world because both are methods by which companies acquire funding. The main difference is that ICO investors receive digital assets in the form of virtual tokens or the promise of future tokens, unlike IPO investors who receive an equity stake representing company ownership. These coins or tokens are new digital currencies each company creates and sells to the public. Coin purchasers could redeem the coins for goods or services from crypto enterprises or hold them as investments hoping the coins would increase in value. Although every crypto enterprise is different, they generally make transfers without an intermediary or any geographic limitation.

Industry practitioners are increasingly using the term security token offering s (STOs) to describe ICOs. This change of terminology reflects the industry's acceptance that many ICOs are securities offerings and thus subject to securities laws and regulations. Securities laws require all securities offers and sales to either be registered under their provisions (as a public offering) or qualify for an exemption from registration (as a private offering). ICOs can take many forms. They can be listed on national exchanges as public offerings or be issued pursuant to the private securities offering exemptions. Operational and regulatory conditionsâincluding investor access, maximum offering amounts, and filing requirementsâdiffer depending on the type of offering an ICO selects. Table 1 illustrates examples of ICO fundraising options. ICOs could potentially use all the existing securities offering venues. They have already reportedly been issued under several of the private exemptions (e.g., Regulation D, Regulation Crowdfunding, and Regulation A). Although public offering ICOs are possible, as of year-end 2019, no ICOs have yet issued under this method. The previously discussed policy issues relating to regulatory oversight and investor protection also apply to ICOs.

Digital Asset "Exchanges"

About 300 platforms are offering digital asset trading and referring to themselves as "exchanges," as of December 2019. A platform that offers trading in digital asset securities and operates as an "exchange" (as defined in the federal securities laws) must register with the SEC as a national securities exchange or obtain exemption. However, many such platforms are registered as money-transmission services (MTSs) instead of SEC-regulated national securities exchanges. MTSs are money transfer or payment operations that are mainly subject to state, rather than federal, regulations. Because MTS regulations were not designed with digital asset trading activities in mind, some argue that they are insufficient in regulating the transfer of digital assets. In addition, these services raise investor-protection concerns because they are not subject to the more rigorous oversight as national securities exchanges. The SEC issued a statement in 2018 clarifying that the online platforms for buying and selling digital assets that qualify as securities could be unlawful.

These digital asset trading platforms face problems with fraud and manipulation. Some think applying SEC regulation would help, but others are concerned that regulation could stifle financial innovation.

Digital Asset "Exchanges" Versus National Securities Exchanges

Although current technological advancements may seem to have blurred the terminology used, certain platforms trading digital assets that are securities appear to behave as functional equivalents to national securities exchanges. For example, these platforms bring together buyers and sellers, execute trades, and display prices. However, there are differences, such as the blockchain-enabled trading platforms operating without a central database and the fact that not all digital assets trading on platforms are securities.

The general consensus among domestic and international securities regulators regarding digital assets is that regulatory oversight should be balanced with the need to foster financial innovation. However, if digital asset trading platforms are buying and selling securities and fall within the SEC's regulatory regime, then securities regulation's basic objectives should arguably continue to apply. In addition, some international authorities believe that, although digital asset trading platforms may face issues similar to traditional exchanges, regulatory approaches may still need to be adjusted to account for particular operating models that may amplify risks differently. In general, policymakers contending with major financial innovations have historically focused on addressing risk concerns while tailoring their regulatory framework flexibly to accommodate evolving technology.

The differences between digital asset "exchanges" and the SEC regulated national securities exchanges could include transparency, fairness, and efficiency. These are principles guiding the national securities exchange regulation, yet they are perceived as lacking for digital asset "exchanges."

Many digital asset "exchanges" are reportedly exaggerating their volumes on a routine basis to attract more participation. Investors are perceived to have no idea whether the trading volume and prices reflect real activities or market manipulation. To take the more frequently studied digital asset Bitcoin for example, one study shows that 95% of Bitcoin's trading volume displayed on digital asset price and volume aggregator CoinMarketCap.com is either fake or non-economic in nature. Another widely cited academic study illustrates the scale of potential damage that digital asset market manipulations could create, underlining the investor-protection concerns in the digital asset space. The study argues that a single market manipulator likely fueled half of Bitcoin's 2017 price surge that pushed its price close to $20,000. The activities were reportedly carried out through the largest digital asset "exchange" at that time, Bitfinex, and used a stablecoin called Tether to boost the demand for Bitcoin. For this alleged manipulation, Bitfinex and Tether faced a class complaint seeking a total of $1.4 trillion in damages. Although Bitfinex and Tether rebutted the study, calling it "bogus," they are currently under investigation by federal and state regulators.

Given the scale of such issues, some have questioned whether digital asset trading warrants more regulatory safeguards that protect investors and promote more efficient market operations. It is difficult to predict the extent to which an SEC-regulated digital asset national exchange would have mitigated the market manipulations, or if the SEC's regulatory framework is the best fit for addressing all the digital-asset-trading-related policy concerns. Still, digital asset "exchanges" under the current operating environment appear vulnerable to misconduct. The Bitcoin price manipulation study's author, a finance professor with a background in forensics, said that "years from now, people will be surprised to learn investors handed over billions to people they didn't know and who faced little oversight."

Current State of Play

The SEC took its first enforcement action against an unregistered digital asset "exchange" in 2018. The SEC stated that the platform "had both the user interface and underlying functionality ofÂ an online national securities exchange and was required to register with the SEC or qualify for an exemption,"Â but was perceived to have failed to do so.

Some of the largest digital asset "exchanges" have developed a system to rate digital assets based on the probability that they could be defined as securities. These "exchanges" reportedly hope that by so doing they could exclude securities-based digital assets from their unregistered trading platforms, thus circumventing SEC securities regulation. This action is part of the digital asset industry's self-regulation discussion that is gaining momentum. For example, an international law firm's 2018 survey showed that the vast majority of the respondents thought the industry should formalize self-regulation and subject that self-regulation to regulatory oversight.

Many digital asset trading platforms also reportedly sought to obtain exemptions from the SEC to operate as alternative trading systems (ATS). ATSs are "dark pools" that do not publicly display the size and price of their orders. ATSs face fewer regulatory requirements than national exchanges, but they must register as broker-dealers and meet certain SEC and Financial Industry Regulatory Authority (FINRA) compliance and filing requirements, such as custody, books and records, and regulatory examinations. However, any ATS that transacts more than 5% of the trading volume of any security, which also trade on the national securities exchange system, could face stricter "order display" and "first access" rules that effectively integrate that ATS in part into the national market system.

A number of the largest digital asset "exchanges" (e.g., Coinbase, Gemini, Bitstamp, and ItBit) have obtained state-level regulatory licenses (BitLicense) from New York State's Department of Financial Services. The license requirements include certain investor protection, market fraud and manipulation prevention, and illicit activity prevention measures.

Digital Asset Custody

Custodians provide safekeeping of financial assets. They are financial institutions that do not have legal ownership of assets but are tasked with holding and securing assets, among other administrative functions. The SEC's custody rules impose requirements designed to protect client assets from the possibility of being lost or misappropriated. Custodians are important building blocks for the financial services industry. The custody industry for traditional assets is large and concentrated. In the past 90 years, financial custody has evolved from a system of self-custody to one in which major custodians provide asset custody for client accounts. Today, four banks (BNY Mellon, J.P. Morgan, State Street, and Citigroup) service around $114 trillion of global assets under custody.

Digital-asset custody has recently attracted regulatory attention because the SEC custody rules could pose unique challenges for custodians of digital assets. The custody rules were developed for traditional assets, which are easier than digital assets to secure and produce tangible tracks of physical existence or records. Digital assets generally lack physical existence or records produced by intermediaries, as seen in traditional assets such as gold or bank accounts. Common practice in the digital asset industry so far focuses on safeguarding private keys, unique numbers assigned mathematically to digital asset transactions to confirm asset ownership. This practice raises the question of how possession or control of a digital asset should be defined for regulatory purposes. The challenges include but are not limited to, for example, that a digital asset could have multiple private keys or that a single private key does not exist. As such, some believe the digital asset custody definition should go beyond the verification of the keys to incorporate holistic custody views.

Regulators are currently evaluating whether custody requirements should be adjusted to account for digital assets' unique operational characteristics. The SEC released a letter to the industry in March 2019 to solicit public input regarding digital asset custody. The SEC summarized a number of policy issues, including the use of distributed ledger technology (DLT) to record ownership, the use of public and private cryptographic key pairings to transfer digital assets, the ability to restore or recover digital assets once lost, the generally anonymous nature of DLT transactions, and the challenges posed to auditors in examining DLT and digital assets.

On July 8, 2019, the SEC and FINRA, a self-regulatory organization, issued aÂ joint statement to outline considerations for digital asset securities custody. They acknowledged the challenges of applying custody requirements to digital assets and stated that there are initiatives underway to solicit input from market participants that could help develop new ways to establish "possession or control" for digital asset securities.

Digital Asset Exchange-Traded Funds

ETFs are pooled investment vehicles that gather and invest money from a variety of investors. ETFs combine features of both mutual funds and stocks and can trade on national exchanges. Some industry practitioners hope that the ETF structure could incorporate digital assets. Individual investors typically buy digital assets, for example, Bitcoins, from other owners or through digital asset trading platforms and other intermediaries. Individual investors currently cannot directly purchase digital assets (e.g., Bitcoins) from the SEC-regulated national securities exchanges. Some have proposed allowing retail investors to buy or sell digital assets on regulated exchanges through the exchange-traded fund (ETF) structureâwhere, instead of directly trading digital assets, the investors would buy or sell publicly traded ETF shares with values linked to underlying digital assets. This section discusses potential Bitcoin ETFs' policy implications for the digital asset industry.

Bitcoin ETF Proposals

As mentioned previously, some digital assets are securities subject to securities laws and regulations. But digital assets could also be structured as securities products, even if the underlying assets are not securities. The proposed Bitcoin ETFs are the most prominent example. Although Bitcoin is not a security, Bitcoin ETFs would be securities products with value linked to the underlying Bitcoins and are subject to securities regulation, including the Investment Company Act of 1940 and Investment Advisers Act of 1940. The digital asset industry has submitted many Bitcoin ETF proposals with the hope of gaining access to more retail investors, but, as of the end of 2019, the SEC has not approved a Bitcoin ETF.

The SEC repeatedly stated in its rejections that Bitcoin ETF proposals did not meet standards governing national securities exchanges. Specifically, the SEC stated that the proposals have not met the requirements in Section 6(b)(5) of the Exchange Act that order national exchanges to be "designed to prevent fraudulent and manipulative acts and practices."

The agency articulated its rationale in a 2018 staff letter that listed challenges related to a Bitcoin ETF. In addition to market manipulation concerns, major Bitcoin ETF challenges included valuation and pricing, custody, and liquidity. For example, all ETFs must frequently value their portfolio assets. The valuation process determines what investors should pay for the ETF shares and how the ETFs perform. Some worry that the Bitcoin ETFs would not be able to obtain the information necessary to adequately value the digital assets given the high volatility and fragmentation of the markets.

Bitcoin ETFs also have supporters. One institutional investor argues that ETFs provide a familiar and convenient way for investors to invest in digital assets, enabling them to participate in digital asset trading and partake in the potential financial gains brought by technological advancements, despite the potential trade-offs with respect to investor protection. In a public statement about a dissenting vote on a disapproved Bitcoin ETF proposal, SEC Commissioner Hester Peirce stated that certain Bitcoin ETF proposals do satisfy the Section 6(b)(5) statutory requirements and that the disapproval may dampen innovation and inhibit institutionalization.

Stablecoins in Securities Markets

Stablecoins are a type of digital asset designed to maintain a stable value by linking its value to another asset or a basket of assets, typically collateralized by fiat currencies or facilitated by algorithms. The best-known example of a proposed stablecoin is Facebook's Libra proposal (see discussion below). Since it was first announced in mid-2019, Libra has generated many policy concerns, inspired new considerations for comparable use cases from the private and public sectors, and fueled discussions of other global stablecoins.

A stablecoin arrangement's individual components are complex, leading to many crosscutting policy discussions. The Financial Stability Board, an international financial authority, characterizes a stablecoin's components as the following:

Entities/structures involved in issuing stablecoins; entities/structures that manage assets linked to the coins; infrastructure for transferring coins; market participants/structures facing users (e.g., platforms/exchanges, wallet providers) and the governance structure for the arrangement, including the role and responsibilities of a possible governance body and the underlying stabilisation mechanism used for the stablecoin.

Stablecoin-related policy concerns vary; they include, market integrity, investor protection, financial stability, monetary policy, payments, and illicit activity prevention. Some of these concerns are outside of the scope of this report, which focuses on securities regulation. In addition to securities regulators, other regulatory authoritiesâcentral banks, payment system regulators, and financial crime enforcement entitiesâhave been involved in stablecoin monitoring and oversight.

Facebook's Libra Proposal

Facebook's planned stablecoin Libra attracted congressional attention after it was announced on June 18, 2019. At related congressional hearings, Facebook received multiple questions regarding whether Libra is an ETF and how it should be regulated. These questions arose because to create the stablecoin, Libra would be backed by reserve assets, including bank deposits and short-term government securities. New Libra tokens could only be created or destroyed by authorized sellers. Some industry practitioners argue that Libra's proposed operational structure is similar to the creation and redemption process used by ETFs. Facebook acknowledged at the House hearing that Libra uses operational mechanisms that are similar to ETFs, but stated its view that it is still a payment tool and not an investment vehicle.

If deemed an ETF, Libra must comply with the SEC's regulatory regime governing securities, investment advisors, and investment companies. SEC approval would be required to launch the project. The SEC is reportedly evaluating whether Libra's structure makes it an ETF.

Stablecoin-Related Legislative Proposals

The House Financial Services committee discussed three stablecoin-related securities proposals at an October 2019 House Committee on Financial Services hearing.

The Managed Stablecoins are Securities Act of 2019 ( H.R. 5197 ) proposes to subject stablecoins to securities regulation by amending the statutory definition of the term security to include a new category of securities called "managed stablecoins." The bill would define a managed stablecoin as a digital asset that has either (1) a market value that is determined, in whole or significant part, by reference to the value of a pool or basket of assets that are held, designated, or managed by one or more persons; or (2) holders that are entitled to obtain payment which is determined, in whole or in significant part, on the basis of the value of a pool or basket of assets held, designated, or managed by one or more persons. Because managed stablecoin issuers are generally perceived as not acknowledging their stablecoins as securities, this bill would remove regulatory uncertainty by stating that a managed stablecoin is a security and therefore subject to securities regulation. The second legislative proposal would limit public company executives' ability to own managed stablecoins. This draft proposal incorporates the same "managed stablecoins" definition, but would take a slightly different approach by delisting a public company if its directors and executives either (1) received compensation in managed stablecoin; (2) bought or sold a managed stablecoin; or (3) were affiliated with a person who bought or sold a managed stablecoin after the date of the security's registration. Lastly, the Keep Big Tech Out of Finance Act ( H.R. 4813 ) would prevent large technology firms like Facebook from offering certain financial services or issuing digital assets.