Does the SEC Have Authority under Howey to Regulate Cryptocurrencies?

The cryptocurrency market experienced major growth in recent years and whether the U.S. Securities and Exchange Commission (SEC) should regulate cryptocurrency has become the center of attention.1Rakesh Sharma, How SEC Regs Will Change Cryptocurrency Markets, INVESTOPEDIA (Nov. 7, 2021), https://www.investopedia.com/news/how-sec-regs-will-change-cryptocurrency-markets/. Senator Warren wrote to the SEC’s chairman Gary Gensler questioning if the SEC has authority to regulate cryptocurrency exchanges.2Id. With the volume of cryptocurrency trading growing tenfold on the popular exchange platform Coinbase in the last year, Warren warned about the potential danger for investors in the absence of any regulatory protections.3Id. The potential dangers include market manipulation, faking high volumes of trading, and cryptocurrency scams exploiting the platform’s anonymity.4Id. The SEC’s regulation could reduce volatility in the crypto market, but imposing compliance costs could also risk taking down the entire market, given the decentralized nature of cryptocurrency. How to protect the interests of potential investors without destroying the market became a major question for institutional regulators. 

It is important first to discuss the nature of cryptocurrency. Cryptocurrency is “a peer-to-peer electronic cash system,” which acts like “a public ledger that functions as a decentralized system for recording ownership and value transfers.”5Omri Marian, A Conceptual Framework for the Regulation of Cryptocurrencies, 82 U. Chi. L. Rev. 53, 54–55 (2015). The only public feature of cryptocurrencies is the documentation of ownership and transfers, which is identified by a set of letters and numbers representing their public cryptocurrency address.6Id. The owner proves ownership with the private key, which together with the public address constitutes the owner’s cryptocurrency wallet.7Id. Anyone can create as many wallets as they desire without providing any identifying information.8Id. While this innovative technology can potentially reduce transaction costs and create access to nontraditional financial institutions, this anonymity could allow potential criminal activity to go undetected. Moreover, the traditional financial-regulation system relies on regulating intermediaries like banks, securities exchanges, and other financial institutions to protect customers and investors.9Id. The anonymous and decentralized feature of cryptocurrencies by design makes it particularly difficult for governments to regulate the cryptocurrency market.10Id.

One of the most important questions around cryptocurrency exchanges regulation is whether they should be considered as securities, which is within the SEC’s regulatory authority.11SEC, Statement on Digital Asset Securities Issuance and Trading (2018). In S.E.C. v. W.J. Howey Co., 328 U.S. 293 (1946), the Supreme Court defined the term “security” under Section 2(1) of the Securities Act of 1933, 15 U.S.C. § 77b(1), to “include the commonly known documents traded for speculation or investment.” 12Howey 328 U.S. at 298. The Court further stated that “this definition also includes ‘securities’ of a more variable character, designated by such descriptive terms as ‘certificate of interest or participation in any profit-sharing agreement,’ ‘investment contract’ and ‘in general, any interest or instrument commonly known as a ‘security.’”13Id. The Court defined investment contract as “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….”14Id. at 298­–99.

Cryptocurrency transactions would classify as investment contracts under conventional interpretation,1515 U.S.C. § 78c(a)(10) as they likely satisfy the test outlined in Howey. The Howey test established the three necessary elements for a transaction to be considered as an investment contract: if there is (1) a capital investment in (2) a common enterprise (3) expecting profits from solely the efforts of others or third parties.16Howey 328 U.S. at 298­–99; see also In re BitConnect Sec. Litig., No. 18-CV-80086, 2019 WL 9104318, at *6–9 (S.D. Fla. Aug. 23, 2019) (applying the Howey test to a cryptocurrency exchange Ponzi scheme). Investment in cryptocurrency satisfies all three elements since investors use money to purchase cryptocurrencies with expectations of return, and cryptocurrency is a common enterprise. Furthermore, the SEC applied the Howey test to an Initial Coin Offering (ICO) in a DAO report and found that the DAO violated the registration requirements adopted in securities laws.17SEC, RELEASE NO. 81207, REPORT OF INVESTIGATION PURSUANT TO SECTION 21(A) OF THE SECURITIES EXCHANGE ACT OF 1934: THE DAO (2017). Subsequent district courts have also upheld this ruling in Sec. & Exch. Comm’n v. Shavers,18No. 4:13-CV-416, 2014 WL 12622292, (E.D. Tex. Aug. 26, 2014) where the court held that an ICO constituted a security and the use of Bitcoin as “money” was sufficient under the Howey test.19Id. at *6­–8. Thus, it is quite clear that ICOs, a cryptocurrency exchange transaction, can fall within the authority of the SEC regulations. 

Outside of the ICO context, the SEC provided guidance in 2018 on “Investment Vehicles Investing in Digital Asset Securities” and “Trading of Digital Asset Securities.”20SEC, Statement on Digital Asset Securities Issuance and Trading (2018). It stated that under the Investment Company Act of 1940,2115 U.S.C. § 80a-1 et seq. parties holding digital securities or advising customers on them are subject to registration, regulatory and fiduciary obligations under the Act.22Id. Moreover, the Statement noted that parties that advise customers on digital asset securities and operate as exchanges in trading them are subject to federal registration requirements with the SEC.23Id. Thus, cryptocurrencies likely fall under the scope of SEC’s regulatory authority. How the SEC will set to regulate cryptocurrencies may become the next big inquiry. 

Given the anonymous and volatile nature of cryptocurrencies, there are two types of regulatory frameworks the SEC may adopt. First, the SEC can require all cryptocurrency exchanges to obtain broker-dealer registration pursuant to Section 15 of the Securities Exchange Act of 1934, 15 U.S.C. § 78a, Sec. 15.24See also SEC, Statement on Digital Asset Securities Issuance and Trading (2018). Broker-dealers help execute transactions for their clients and also may transfer clients’ assets to third parties.25See Sarah Jane Hughes & Stephen T. Middlebrook, Advancing a Framework for Regulating Cryptocurrency Payments Intermediaries, 32 Yale J. on Reg. 495, 499–500 (2015). Second, the SEC can require all cryptocurrency exchanges to register as national securities exchanges under Section 6 of the Act.2615 U.S.C. § 78a, Sec. 6. The registration requirements will provide a vehicle for the SEC to monitor the cryptocurrency market to provide protection to the investors and customers. Although requiring registration will likely increase compliance costs, it will not completely destroy the market. Requiring registration only creates a small barrier for exchanges of cryptocurrencies and gives SEC more control over the trading of cryptocurrencies. The downside will likely be fewer ICOs as the entry barrier is higher given the registration requirements. However, both registrations will allow the SEC to balance the interests of the investors and at the same time allowing the market to function.  

Danyang Li

Class of 2023, The University of Chicago Law School

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