Digital currency offerings are treated as securities offerings
The US SEC (Securities & Exchange Commission) views over 99% of digital currencies issued in the US as security digital currencies, with utility digital currency issuers being the exception. The SEC has issued over 400 subpoenas to digital currency issuers. The Howey test developed in 1948, still rules the day in determining whether it is a security or not. Unfortunately, the Securities Act (1933) could not have reasonably considered the prospect of digital currencies, and consequently, hasn’t adapted to this new, tokenized, digital asset trading environment. It’s clear that the SEC doesn’t see either blockchain or digital currency disappearing anytime soon. However, it is the overriding mandate of the SEC to ensure that enough investor protections are implemented from a public policy perspective.
High-risk digital currency jurisdictions are countries that are at a minimum not friendly to digital currencies and/or hostile to digital currencies via regulation or other punitive measures. High-risk countries that digital currency issuers should avoid include Indonesia, Bangladesh, and Nepal. Lower-risk countries that STOs (Security Token Offerings) should avoid include Macedonia, Algeria, Bolivia, Ecuador, and Libya.
On the other hand, the most STO-friendly jurisdictions are Singapore, Malta, Switzerland, Japan, and various Caribbean islands. These countries are digital currency friendly and receptive to STO marketing for the sale and distribution of digital currencies. We will continue to see more regulatory arbitrage, where STOs are marketed in jurisdictions that have the least path of regulatory resistance. This carries their own separate risks for digital currency holders.
Incidentally and unsurprisingly, none of these countries form part of the G-20, which is where the majority of either security or utility digital currency buyers are likely to be identified with serious interest. It’s the G-20 countries that matter in the final analysis. The biggest challenge in succeeding with this initiative will be regulatory coordination among the G-20 due to varying capital market structures, maturity, political imperatives, and liquidity preferences.
Does the extraterritorial reach of the SEC extend beyond US borders for STOs?
This is an issue of the SECs extraterritorial reach in other jurisdictions beyond its borders. As a lead statutory securities regulator, the SEC yields tremendous authority, ferocity, power, and enforcement that should never be underestimated. The SEC has been known to exercise its extra-territorial reach far outside its borders as far as Australia in the case of SEC v. National Australian Bank, for example. Unlike other, smaller securities regulators, the SEC has a $1.6B USD budget Such a budget allows the SEC to investigate, enforce, and prosecute for securities breaches both at home and around the world — the long arm of US securities laws. The SEC can and will prosecute non-resident companies that breach US securities laws. However, the SEC only has jurisdiction over breaches of its own rules under the Securities Act (1933) and Securities & Exchange Act (1934).
We’re also seeing a coordinated approach among securities regulators to fend bad actors in the digital currency space. In 2018, for example, there was a regulatory sweep between the OSC (Ontario Securities Commission) and SEC in cracking down on a few ICOs (Initial Coin Offerings) that were seen to be shady and suspect. This coordination should give comfort to digital currency investors and purchasers in Canada and the US, especially given how quickly both regulators reacted and investigated.
In fairness, although the SEC has taken a hardline approach to digital currency issuers generally, actual enforcement has not nearly been as harsh as the regulatory environment would predict. We’ve seen the start of a few class-action lawsuits filed against Paragon Coin on behalf of the investor class, and SEC enforcement action against Tezos and Munchee, for example. We should expect these actions considering the US being the largest and most powerful capital market globally.
How pervasive is regulatory arbitrage in exploiting differences in digital currency regulation?
Regulatory arbitrage is likely to be more nuanced and multifaceted. For example, a digital currency issuer has both digital currency securities regulation and tax regulation as major risks and concerns. It’s perfectly conceivable, for example, for a security digital currency issuer to select Switzerland for its banking jurisdiction, Panama for taxes, Malta for its exchange (e.g., Binance, the largest digital currency exchange in the world processing $5.6B USD in digital currency transactions, formerly based in Hong Kong, recently moved its operations to Malta), and Isle of Man for its gaming. In effect, this creates a form of “virtual jurisdiction” that takes regulatory arbitrage to new heights.
Japan is unequivocally leading the charge in digital currency exchange regulation by establishing firm and strict rules for all stakeholders in the exchange ecosystem – liquidity providers, third-party vendors, market makers, algorithm providers, and others. Nearly 60% of all digital currency trading is in Japan. This is clearly a market that views regulation as digital currency validation and a way to centralize controls for decentralized digital assets. Regulation provides exchanges with strict standards around the cold storage of digital currencies, for example. Customers that trade digital currency are increasingly concerned about the likelihood of digital currencies being stolen by outsiders for which they have no control over.
What does this mean for digital currency investors and issuers?
- STOs are unregulated and lack liquidity: The market for STOs is mainly unregulated, other than two national and regulated digital asset exchanges such as the JSE (Jamaica Stock Exchange) and BSE (Barbados Stock Exchange) that are onboarding STO issuers. The technological capability and regulatory approvals required for licensed securities dealers to list and integrate blockchain-native digital currencies into their offerings do not currently exist. This demonstrates there is a limited active secondary market for trading, and thereby limited liquidity. Although the JSE and BSE are slowly migrating from a traditional stock exchange to a digital asset exchange (retaining all traditional stock exchange capabilities), boards will need to carefully evaluate their secondary market needs and determine which jurisdiction(s) and the extent of regulation are required to best list their STO. Although regulatory arbitrage has yielded lower regulatory and surveillance costs for digital asset exchanges like Binance, for example, boards need to consider the absence of investor protections or insurance to mitigate against potential frauds, scams, or other malfeasance concerns.
- Director liability revisited: If issuers decide to raise capital via an STO, ICO, or IEO (Initial Exchange Offering), and list on decentralised and mainly unregulated exchanges, such exchanges do not provide investor protections nor deposit insurance for either issuers or investors. If issuers are sued for any type of fraud, scam, misrepresentation, or other malfeasance, existing D&O liability insurance may be insufficient. SEC enforcement actions listed above with various STO issuers is evidence that SEC enforcement actions are alive and well and directors need the required protections.
- Higher leakage costs: Blockchain powers digital currency. Issuers that raise capital via an STO, STO, or IEO must realize that shareholder dissemination of information is now instantaneous, giving rise to the efficacy of the efficient market hypothesis. Any internal leakage of material, non-public information of corporate events or transactions are likely to significantly increase leakage or slippage costs. This carries reputational, business, and director liability risks if certain shareholder groups are advantaged at the expense of others.
An article written by Jack J. Bensimon
Black Swan Diagnostics Inc