Article Highlights
- The importance of a clear token classification system.
- The applied logic of the Howey test, acknowledging the possibility of investment contract termination.
- Practical implications for innovators, intermediaries, and investors.
Introduction
Ladies and gentlemen, good morning. I want to express my deep gratitude for your kind introduction and the gracious invitation to be here today. Together, we will continue to explore how America can lead the next era of financial innovation. In my recent remarks on America’s leadership in the digital finance revolution, I described “Project Crypto” as the regulatory framework we have built to match the dynamism of American innovators (Note: The SEC launched the Project Crypto initiative on August 1st of this year, aiming to update securities rules and regulations to enable US financial markets to become blockchain-based). Today, I would like to provide an overview of the next step in this process. At the heart of this step lies a commitment to fundamental fairness and common-sense principles in applying federal securities laws to crypto assets and related transactions. In the coming months, I anticipate the SEC will consider establishing a token classification system based on the long-standing Howey investment contract securities analysis, while acknowledging the applicable boundaries of our laws and regulations. What I am about to explain is largely based on the pioneering work led by Commissioner Hester Peirce’s crypto asset working group. Commissioner Peirce has constructed a framework that aims to regulate crypto assets cohesively and transparently under securities laws, based on economic substance rather than slogans or panic sentiments. I want to reiterate here that I agree with her vision. I value her leadership, hard work, and unwavering dedication to promoting relevant issues over the years. I have worked with her for a long time, and I am very pleased that she has agreed to take on this task. My remarks will revolve around three themes: first, the importance of a clear token classification system; second, the applied logic of the Howey test, acknowledging the fact that investment contracts can terminate; and third, what this means in practice for innovators, intermediaries, and investors. Before starting, I also want to reiterate: although the SEC staff is diligently drafting rule amendments, I support Congress’ efforts to support the comprehensive crypto market structure framework in legislative law. My vision is consistent with the bills currently being considered by Congress, which aim to supplement rather than replace Congress’ critical work. Commissioner Peirce and I have prioritized supporting Congress’ actions, and we will continue to do so. Working with Acting Chairman Pham has been very pleasant, and I wish President Trump’s nominee for Chairman of the Commodity Futures Trading Commission (CFTC), Mike Selig, a smooth and rapid confirmation. My experience working with Mike over the past few months has convinced me that we are both committed to helping Congress quickly promote bipartisan market structure bills and submit them to President Trump for signing. There is nothing more effective in protecting against regulatory abuse than sound legal text passed by Congress. To reassure my compliance team, I would like to make the usual disclaimer here: my remarks represent my personal views as chairman and do not necessarily reflect the individual positions of other commissioners or the overall position of the SEC.
A Decade of Uncertainty
If you are tired of hearing the question “Is a crypto asset a security?”, I understand completely. This question is confusing because “crypto asset” is not a term defined in federal securities law. It is a technical description that only explains the method of record-keeping and value transfer, but it says almost nothing about the legal rights attached to a particular instrument, or the economic substance of a particular transaction, both of which are essential for determining whether an asset is a security. I believe that most cryptocurrencies traded today are not securities in themselves. Of course, a particular token may be sold as part of an investment contract in a securities offering. This is not a radical view, but a direct application of securities law. The legislative law that defines securities lists common instruments such as stocks, bonds, and securities, and adds a broader category: “investment contracts”. The latter describes the relationship between parties, not a permanent label attached to a particular item. Unfortunately, an investment contract is also not defined in legislative law. Investment contracts can be performed or terminated. An investment contract cannot be considered to be in effect forever just because the underlying asset of the investment contract continues to be traded on the blockchain. However, in the past few years, too many people have claimed the view that if a token was ever the subject of an investment contract, it will always be a security. This flawed view has gone even further in presuming that every subsequent transaction of the token (regardless of where or when) is a securities transaction. I find it difficult to reconcile this view with legal text, Supreme Court rulings, or common sense. At the same time, developers, exchanges, custodians, and investors have been stumbling in the fog, facing obstacles rather than guidance from the SEC. They see tokens that act as payment tools, governance tools, collectibles, or access keys, or mixed designs that are difficult to place into any existing category. However, the regulatory stance has long treated all these tokens as securities. This view is unsustainable and unrealistic. It brings huge costs, but achieves few results; it is unfair to market participants and investors, does not comply with the law, and also leads to the emigration of entrepreneurs overseas. The reality is: if America insists that every innovation on the chain must pass through a minefield of securities laws, these innovations will move to jurisdictions more willing to distinguish between different types of assets and more willing to set rules in advance. Instead, we will do what regulators should do: delineate clear boundaries and explain them in clear language.
Core Principles of Project Crypto
Before explaining my views on the application of securities laws to cryptocurrencies and transactions, I would like to explain some basic principles that guide my thinking. First, whether a stock is presented in the form of a paper certificate, an account record at the Depository Trust and Clearing Corporation (DTCC), or a token on a public blockchain, it is still essentially a stock; bonds do not stop being bonds just because their cash flows are tracked through a smart contract. Securities are always securities, regardless of the form in which they are presented. This is easy to understand. Second, economic substance trumps labeling. If an asset essentially represents a claim on the profits of a business and its offering comes with a promise to rely on the core management efforts of others, then calling it a “token” or “non-fungible token (NFT)” does not exempt it from current securities laws. Conversely, the fact that a token was part of a financing transaction does not mean that it magically turns into shares in an operating company. These principles are not novel. The Supreme Court has repeatedly emphasized that when determining whether the Securities Act applies, attention should be paid to the substance of the transaction rather than its form. The new change is the scale and speed of the evolution of asset types in these new markets. This pace requires us to be flexible in responding to the urgent needs of market participants for guidance.
A Coherent Token Classification System
Based on the above background, I would like to provide an overview of my current views on various categories of crypto assets (please note that this list is not exhaustive). This framework was formed on the basis of months of round table meetings, more than one hundred meetings with market participants, and hundreds of public written comments. First, with regard to the bills currently being considered by Congress, I believe that “digital commodities” or “network tokens” are not securities. The value of these crypto assets is inherently related to and arises from the programmed operation of a “fully functional” and “decentralized” crypto system, rather than stemming from the expected profits brought about by the key management efforts of others. Second, I believe that “digital collectibles” are not securities. These crypto assets are designed for collection and use, and may represent or grant holders the right to digital expression or reference to works of art, music, videos, trading cards, in-game items, or online memes, characters, current events, or trends. Purchasers of digital collectibles do not expect to profit from the daily management efforts of others. Third, I believe that “digital tools” are not securities. These crypto assets have practical functions, such as membership, tickets, vouchers, proof of ownership, or identity badges. Purchasers of digital tools do not expect to profit from the daily management efforts of others. Fourth, “tokenized securities” are now and will always be securities. These crypto assets represent ownership of financial instruments listed in the definition of “securities”, which is maintained on a crypto network.
Howey Test, Promises and Termination
Although most crypto assets are not securities in themselves, they may be part of an investment contract or subject to an investment contract. These types of crypto assets often come with specific statements or promises, under which issuers are required to fulfill management responsibilities, thereby meeting the requirements of the Howey test. The core of the Howey test is: investing funds in a common enterprise and reasonably expecting to earn profits through the core management efforts of others. The purchaser’s expectation of profits depends on whether the issuer has made statements or promises to carry out core management efforts. In my view, these statements or promises must explicitly and unambiguously state the core management efforts that the issuer will carry out. The next question is: How can non-financial crypto assets be separated from investment contracts? The answer is simple and profound: either the issuer has fulfilled the statement or promise, or failed to fulfill it, or the contract has been terminated for other reasons. To make it easier for everyone to understand, I would like to talk about a place in the rolling hills of Florida. I am very familiar with the place that was once home to William J. Howey’s citrus empire. In the early twentieth century, Howey purchased more than 60,000 acres of undeveloped land and planted orange and grapefruit groves next to his mansion. His company sold plots of farmland to individual investors and was responsible for planting, picking, and selling the fruit for them. The Supreme Court reviewed Howey’s arrangement and established the test standard that defines investment contracts, which has influenced generations of people. But today, Howey’s land has undergone earth-shattering changes. His mansion, built in Lake County, Florida in 1925, still stands a century later and is used to host weddings and other events, while the citrus groves that once surrounded the mansion have mostly disappeared and have been replaced by resorts, tournament golf courses, and residential areas. This has become an ideal retirement community. It is hard to imagine that anyone standing on these fairways and cul-de-sacs today would think that they constitute a security. However, over the years, we have seen the same test being rigidly applied to digital assets that have
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