The emergence of digital securities began in 2017, providing for blockchain-based assets that embrace global securities laws (in addition to other potentially applicable laws). If you’ve hung around the blockchain space since 2013, you’ve likely been exposed to terms like cryptocurrency, token, coin, security token, tokenized security, virtual currency, and digital assets. In this article, I provide a historical perspective on why the terms digital asset and digital security accurately map the facts and circumstances of a blockchain-based asset with the regulatory interpretation of it. Having a clear definition of the two categories that are often confused enables us, as we move forward as an industry, to have accurate and impactful conversations.
First some definitions:
Digital Asset — A digital representation of something of value, for which ownership is verified and recorded on a distributed ledger. A digital asset is most commonly regulated as currency or property. The thing of value represented by the digital asset may be any number of assets, including securities. And many digital assets themselves (regardless of what they represent) will be viewed by the SEC as securities, at least for a period of time.
Digital Security — A digital representation of an asset that happens to be a security, often an investment contract, for which ownership is verified and recorded on a distributed ledger. A digital security, which is subject to traditional securities laws, is often referred to as a security token. It could represent a share in a corporation, a portion of a note or other debt security, or a fractionalized interest in an underlying asset or bundle of assets (such as real estate, artwork or ETFs).
Just because you think you have a digital asset, doesn’t mean it won’t be considered a digital security.
The first known appearance of a digital representation of something of value, the ownership of which was verified and recorded on a distributed ledger, was on January 3, 2009. It was the same day The Times announced that the Chancellor of England was on the brink of a second bailout for banks. It was called Bitcoin.
As a new technology enters the space, one whose activity challenges existing regulations, it is common for regulators to release guidance slowly or take enforcement action to make their perspective clearer.
Five years after the launch of Bitcoin, the Financial Crimes Enforcement Network (FinCEN) began encouraging those engaging with Bitcoin to register as a Money Services Business (MSB)and to comply with the Bank Secrecy Act. Additionally, the NYDFS passed targeted regulation for MSBs interacting with digital assets (also known as virtual currencies) in the state of New York.
The first known enforcement action involving digital assets or securities by the SEC was against Erik Voorhees and his project FeedZeBirds. Although the act of fundraising online was seen as an unregistered securities offering by the SEC, Voorhees sold actual shares and not blockchain-based tokens (he received Bitcoin).
The first known exchange of a digital asset for a digital security was the launch of the Mastercoin protocol in 2013. The first major headline in the space occurred when The DAO raised $150 million through a crowdfunding campaign in 2016. Although the SEC took no action at the time, the act of crowdfunding in exchange for a digital asset or security began to take off in 2017 when various companies raised more than $100 million. Shortly after, the SEC began to provide meaningful guidance with its report on the Decentralized Autonomous Organization (DAO).
The most explicit guidance came with the Cease and Desist order of Munchee, a company which was selling digital assets that the SEC regarded as securities in an unregistered, non-exempt securities offering at the time. The cease and desist order laid out the particular actions that Munchee was taking, which were very similar to the “utility token” actions that were proliferating at the time. The SEC explained that these actions were in violation of US securities laws, thereby enhancing the clarity for companies seeking to undertake similar actions.
It's important to understand and use terminology that is clear; however, in most cases, digital issuances will be considered securities.
If seeking to launch a digital asset or digital security as part of your business initiative, you may be wondering how to classify your strategy and how to proceed. I recommend the following as a conservative approach:
It’s important to never launch a product without the blessing of experienced counsel. In 2014 I decided to close my first startup due to lack of regulatory clearance, even though it was a product I spent a whole year developing. It’s important to ensure your business and products operate within compliance of relevant regulations; after all, regulations are simply there to ensure no one gets hurt. Just like our roads have speed limits and parking lots have speed bumps, regulated activities are controlled because people, including regular investors, have been hurt and our government made the decision to create mechanisms that seek to ensure it doesn’t happen again.
We’re lucky to have such regulations in place to ensure a smooth entry into the greater economy. If you’re seeking to launch your product and are seeking assistance with complying with the relevant banking, securities and tax laws, feel free to reach out at https://www.tokensoft.io