Crypto Rating Council
While there are many hurdles that need to be cleared in the world of blockchain, there continues to be a recurring question that has plagued companies big and small.
What makes a token/coin a security?
This is not a simple question to answer, despite the SEC’s continuing stance that the existing regulations are clear.
In an effort the help both, companies and investors alike, a group of industry leaders have formed, what they are calling, the ‘Crypto Rating Council’. This council has taken it upon themselves to create a framework designed to ‘objectively assess whether any given crypto asset has characteristics that make it more or less likely to be classified as security in the U.S. federal securities laws’.
The ‘Howey Test’, which refers to a set of rules determining if an asset is a security, was long ago established by the SEC.
As this test is still the primary basis, to this day, for determining an asset’s status, the Council has structured their own framework around it. The council indicates that this developed framework, as a whole, looks at these assets through the same lens as the SEC. In doing so, they state that there are dozens of yes/no questions that they apply when determining asset classification.
Various noteworthy companies involved with blockchain form the founding members of the Crypto Rating Council. The following are only a few, listed by Coinbase, to be taking part.
- Grayscale Investments
While the list of assets evaluated will continue to grow, the Council has launched their initial ratings with of 20 popular tokens/coins already evaluated.
Once looked at through their developed framework, the assets are given a rating, which indicates the likelihood of the asset being deemed a security. These ratings range from 1-5 (5 being the most likely to be deemed a security). In their initial 20 ratings, there were a few noteworthy assets living on the extremes.
A few assets at the other end of the spectrum (most likely a security), receiving a 4.5, include POLY, XRP, and Maker.
Unsurprisingly, the SEC has stated in the past that they do not view Bitcoin as a security, justifying the 1/5 it received. Also unsurprisingly, assets such as XRP received a 4.5/5. This is not unexpected, as Ripple is in the midst of an ongoing lawsuit which would see XRP deemed a security.
Why it is Needed
Clearly, despite the SEC saying otherwise there is still industry confusion with regards to what constitutes a digital security. If this were not the case, we would not see nearly as many instances of these assets being improperly distributed. It is also important to note that it is not just ‘mickey-mouse’ companies being caught doing this – there are also well funded teams still falling into the trap.
While the council does not hold any true authority, hopefully, they will be able to at least provide some level of guidance moving forward to companies looking to distribute a digital asset.
On behalf of themselves, and the others joining them in the Council, Coinbase commented in a blog post on their announcement. The following is what they had to say on the importance of legal characterization, along with expected growth moving forward.
“The proper legal characterization of a crypto token — as a currency, a commodity, a security, or something else — can have a meaningful impact on how crypto businesses operate. Whether a token is a security under U.S. federal securities laws, in particular, will significantly impact registration, licensing, and operating obligations for financial services firms that offer crypto services like exchange, investment management, or trading.”
“In the coming months, we expect to add more members, review more assets, and publish more and revised asset scores. As we continue to grow, we may develop similar tools for non-U.S. jurisdictions.”
In the past year, we have reported on various events entailing the SEC laying charges upon companies. These have primarily stemmed around the improper issuance of what the SEC believes are securities. The following are a few examples of this, along with companies that could have very well benefited from a service now being created by the Crypto Rating Council.
Commissioner Hester Peirce Awarded 2nd Term at SEC
From now until 2025, the world of blockchain can look forward to at least one friendly face residing at the Securities and Exchange Commission. Earlier this week, Commissioner Hester Peirce was successfully voted into a subsequent term at the regulatory body.
The vote, which took place on August 6th, 2020, was completed by the U.S. Senate. While no outcome is ever assured, this decision had been anticipated for months now, as the initial nomination was put forth six months prior, on February 6th.
A History of Dissent
While there are a variety of reasons that the blockchain and cryptocurrency community have become enamored with Commissioner Peirce – earning her the moniker of ‘Crypto Mom’ – the most obvious is her previous statements of dissent.
A statement of dissent simply refers to the expression of a belief, contrary to those of others, and their actions made. In the past few years, Commissioner Peirce has voiced her dissent on multiple occasions.
Winklevoss Bitcoin Trust, 2018
The first statement of dissent, issued by Commissioner Peirce, revolved around the denial of a Bitcoin based exchange traded fund (ETF) application in 2018. While the main mandate of the SEC is to protect investors, Commissioner Peirce felt their actions did just the opposite. She stated, “…I am concerned that the Commission’s approach undermines investor protection by precluding greater institutionalization of the bitcoin market. More institutional participation would ameliorate many of the Commission’s concerns with the bitcoin market that underlie its disapproval order.”
Exchange Traded Funds (ETF), 2020
In early 2020, Commissioner Peirce reiterated her opposing stance regarding cryptocurrencies and ETF type products. In the time between her initial statement on the Winklevoss fund in 2018 and now, the SEC had gone on to deny various applications – essentially doubling down on their stance. She stated, “…I warned that the Commission’s hesitancy to embrace new products and technologies impedes innovation in this country and threatens to drive entrepreneurs, and the opportunities they create, to other jurisdictions. The Commission’s actions in this area over the past eighteen months confirm these concerns. Meanwhile, investor interest in gaining exposure to bitcoin continues to grow.”
This example is the most recent of the three. Taking place in July of 2020, during a speech at Blockchain Week Singapore, Commissioner Peirce touched on why she thought the SEC’s actions against Telegram were flawed. While her stance was not divulged in an official statement of dissent, it was clear nonetheless. She stated, “Telegram chose to end its legal battle by settling with us. I did not support the settlement because I did not support the underlying action. I do not support the message that distributing tokens inherently involves a securities transaction.”
While it may be easy to disagree with one’s peers, Commissioner Peirce has ensured that she has provided more than just criticisms. Most notable is Commissioner Peirce’s ‘Safe Harbor Proposal’. In the Safe Harbor proposal, companies would benefit from “a three-year grace period within which they could facilitate participation in and the development of a functional or decentralized network, exempted from the registration provisions of the federal securities laws, so long as the conditions are met.” This is an interesting and important approach; time has proven that while many blockchain based assets may begin their lives as securities, they can later transform into a different class of asset. One such example is the wildly popular, Ethereum.
Ethereum, which held an ICO early in its lifecycle, has since become a functional decentralized platform and token. This simple transition, which was always planned, allowed for Ethereum to transform from being a security to simply a token.
By implementing a proposal such as this, innovative and well-intentioned companies would have more leeway to produce next-gen products, without the fear of repercussions from the SEC (providing the companies meet all the conditions). Commissioner Peirce’s Safe Harbor Proposal can be read in detail here.
Despite the SEC retaining a familiar face in Commissioner Peirce, the regulatory body may soon look quite different.
Although talk has died down for the moment, current SEC Chairman Jay Clayton is being floated as a candidate for a position as the U.S. Attorney for Southern New York. If this departure were to occur, Commissioner Peirce would, no doubt, be an exciting prospective replacement for the position of Chairman.
Such a move would, no doubt, be accompanied by differing approaches to blockchain and crypto markets, as Commissioner Peirce has made it clear that she believes the markets are here for the long run. Time will tell if Commissioner Peirce finds herself filling these shoes.
Securities and Exchange Commission
The Securities and Exchange Commission (SEC), is a U.S. based regulatory body, tasked with ensuring fair and transparent markets. This is done through the creation, and enforcement, of various laws surrounding the usage of securities.
Chairman, Jay Clayton, currently oversees operations at the SEC.
In Other News
In early 2020, we were fortunate to have completed an exclusive interview with Commissioner Peirce, herself. In this discussion, we learned more about her approaches to crypto and blockchain, as well as that of the SEC. For those interested in learning more about Commissioner Peirce, this interview can be found in its entirety, HERE.
Commissioner Hester Peirce Dissents on SEC Telegram Ruling and Settlement
Commissioner Hester M. Peirce of the Securities and Exchange Commission (SEC) delivered a June 21 speech at Blockchain Week in Singapore where she expressed her dissent regarding the recent settlement between the SEC and Telegram.
It is unsurprising to hear Commissioner Peirce disagree with the recent court ruling barring the release of Telegram tokens to all investors, and subsequent settlement with the SEC. Commissioner Peirce has made it clear that she did not agree with the originating October 2019 emergency order filed by the SEC against Telegram.
Timeline of Telegram Raise and Court Case
|February 2018||Popular messaging app Telegram raises $850M using the SAFT (Simple Agreement for Future Tokens) structure|
|March 2018||Telegram raises an additional $850M using SAFT structure|
|October 2019||Distribution of Telegram Tokens to Investors scheduled for October 31, 2019|
|October 2019||SEC files an emergency action and temporary restraining order against Telegram to prevent the distribution of Telegram tokens to investors.|
|March 2020||The court orders that Telegram may not distribute tokens to any investor, American and foreign|
|June 2020||Telegram settles with the SEC and agrees to return $1.2Bn to investors, close operations, and pay $18.5M fine|
Synopsis of Telegram Raise
- $1.7Bn raised from investors ($424.5M from American investors)
- 171 investors (39 Americans)
- Accredited investors only
- A minimum investment of $1M per person or entity
- The invested money was to be used to develop the Telegram Open Network (TON) blockchain and grow and maintain Telegram Messenger.
What Issues Does Commissioner Peirce Raise?
The court sees “one single scheme”. Commissioner Peirce takes issue with the court treating the investment agreement between Telegram and the accredited investors, the delivery of the tokens to the investor, and the resale of the tokens, as one single scheme. She laments, “gone is the distinction between the investment contract (the agreement between Telegram and the accredited investors) and the token (the asset to be created and delivered under the agreement)”. Commissioner Peirce believes that the initial investments in the company are to raise capital to build the platform, and that those initial investments are separate from the resale of a functional token “… such tokens, once they have a consumptive use, should be able to be sold to purchasers outside of a securities transaction”. She believes the Howey test supports the idea that the resale of the tokens does not constitute as a security simply because the tokens were initially acquired as a part of a securities transaction.
What is a requirement for success, is deemed an illegal securities offering by the SEC. What the SEC sees as an illegal securities offering (widespread global distribution of the token), Commissioner Peirce sees as a necessary element for a successful blockchain. “I do not support the message that distributing tokens inherently involves a securities transaction…. I see [widespread distribution of tokens] as a necessary prerequisite for any successful blockchain network.”
The SEC is overreaching. Commissioner Peirce also takes issue with the fact that the SEC, asked and was granted, enforcement against a corporation that is not incorporated or based in the US, and only a quarter of the investors and total investment were US-based. She reminds us that the American way is not the only way in a global economy “This willingness of the SEC to ask for, and of the district court to grant, such sweeping injunctive relief against a non-US company, in a case where one-quarter of the funds came from US investors, reasonably might raise some concerns among our international colleagues… we would do well to recall that our way is not the only way. We should be cautious about asking for remedies that effectively impose our rules beyond our borders.”
At Your Own Risk – No Clear Path
Interestingly, Commissioner Peirce notes that Telegram employed sophisticated counsel, “made good faith efforts to comply with federal securities laws” and “engaged extensively with SEC staff”. It begs the question – what went wrong? Did the SEC give improper guidance? Did Telegram choose not to follow the SEC’s guidance? Did the SEC change its mind once Telegram was due to distribute tokens to investors? These questions do not have clear answers and continue to leave companies in risky and unknown waters when conducting token offerings in the United States and/or with American investors.
It is clear that Commissioner Peirce believes that the SEC is not doing enough to help guide companies in the right direction, she notes “rather than provide useful guidance on safety standards and functional braking technology… [leaving] the industry to guess at the path to compliance”. Companies should not have to assume the risk of guessing at the correct path to compliance.
Who Did the SEC Protect?
The case of SEC v Telegram Group Inc. and Ton Issuer Inc. was petitioned by three investors; seven investors are listed as interested parties. All the investors would have had to qualify as “accredited investors” under the federal definition to invest in the Telegram raise. The minimum threshold for investing in Telegram was USD$1,000,000.
At the end of her speech, Commissioner Peirce asks, “who did we protect by bringing this action?”. It is a good question – one would assume that an investor with the capital to invest $1M in the Telegram raise is a reasonably sophisticated person or entity that understands the inherent risks of investing in new technology and early stage start-ups. So, who did the SEC really protect in this case? It appears that the only people protected were a handful of sophisticated investors who were unhappy with the risk they knowingly took.
Since 2018 the crypto industry has witnessed a growing trend of companies refusing to accept American investors. It is likely that this trend of barring American investors will continue until there is clear guidance from the SEC. Due to the SEC’s enforcement actions and lack of guidance, most companies simply deem it too risky to allow American citizens, residents, or entities to invest in capital (token) raises.
In February of this year, Commissioner Peirce announced her proposal to bridge the gap between regulation and decentralization. She calls this proposal a safe harbor that gives companies a three-year grace period to develop a functional network. At the end of the three years, the tokens would not be deemed securities providing there is a functioning network where the token can actively be used for goods and services. Additional details about Commissioner Peirce’s safe harbor proposal can be found in the link above.
While Commissioner Peirce’s safe harbor proposal is well thought out and appears to be a great way to move forward, unfortunately, it is still simply a proposal. Given the ongoing refusal of the SEC to provide clear written guidance, rules, or regulation, we do not expect that Commissioner Peirce’s safe harbor will be adopted any time soon by the SEC. We expect to see other global markets take the lead in decentralized projects if clear guidance or regulations are not set out by the SEC.
Ontario Securities Commission Alleges Coinsquare Committed Various Securities Violations
The Ontario Securities Commission (OSC), a Canadian regulatory body tasked with ensuring fair and transparent markets, has released a detailed set of allegations against Coinsquare.
In its allegations, the OSC purports that Coinsquare knowingly took part in ‘wash trading’ for an extended period. In doing so, Coinsquare was knowingly in clear violation of various securities laws.
What is Wash Trading?
Wash trading is an illegal practice that refers to the purposeful manipulation of trading markets, by way of buying and selling shares to artificially inflate the trading volume and pump up the share price. Trading volume is important to traders, as high-trading volumes typically align with asset liquidity and value.
By taking part in wash trading, the offender is intentionally misleading traders. Exchanges often choose to do it regardless, as they attempt to attract new business to their platforms. More volume = greater liquidity = enticing to traders.
While not as prevalent as in past years, wash-trading has unfortunately been a common practice among many cryptocurrency exchanges. Much of this was due to the unregulated nature of these exchanges in the early days of the industry.
Statement of Allegations, The Details
In its ‘Statement of Allegations’, the OSC provides a detailed breakdown of the various violations by Coinsquare. In addition to simply wash-trading, the OSC indicates that the practice of wash-trading was well known among those in charge at the company. More specifically, the OSC names the following individuals as being responsible for the practice.
- Founder, Virgile Rostand
- CEO, Cole Diamond
- CCO, Felix Mazer
If the act of market manipulation was not enough, the OSC also indicates that an employee who brought forward knowledge of the wash trading to company executives was told by those same executives to continue wash trading. Coinsquare is believed to have then taken reprisal against this employee.
A Timeline, According to the OSC
- March 2018
- Cole Diamond orders wash-trading to commence
- July 2018
- Coinsquare representatives publicly deny practices on various online forums
- March 2019
- Employees raise concerns about wash-trading practice to management
- December 3, 2019
- OSC completes unscheduled visit to inspect Coinsquare headquarters
- December 4, 2019
- Wash-trading is halted
During the time period when the wash-trading occurred, the OSC states that 90% of Coinsquare’s volume was faked.
CEO, Cole Diamond, currently oversees company operations.
Ontario Securities Commission
The OSC is a regulatory body based in Ontario, Canada. The OSC is tasked with ensuring fair and transparent markets for companies and investors by enforcing compliance with the governing rules and regulations.
Grant Vingoe is the current Acting Chair and CEO of the OSC.
In Other News
Coinsquare and QuadrigaCX represented, arguably, the most well-known Canadian cryptocurrency exchanges. Unfortunately, each has dealt with its own share of controversial issues, with only Coinsquare remaining operational to date.
For those interested in an alternative, the upcoming cryptocurrency trading through WealthSimple has the potential to become a leader in the space. WealthSimple has developed a positive reputation in its time operating as a financial service provider, and is expected to deliver a polished, and transparent service. To learn more about this upcoming service, make sure to read our recent article detailing what it will entail.