Cryptocurrency's classification conundrum

The classification of cryptocurrencies as securities or commodities has significant implications on their sale, listing, and potential legal status. However, categorisation, as either a security or a commodity remains uncertain and future regulatory decisions, could lack uniformity and vary on the specific tokens involved due to the diverse nature of the cryptocurrencies. While there is no explicit definition of cryptocurrencies under India’s existing regulatory framework, the focus has mainly been on investor protection, anti-money laundering measures, and financial stability.

Understanding the distinction

Securities and commodities are distinct financial instruments with unique characteristics and purposes. While securities are focused on ownership or debt in companies, commodities involve trading physical goods. Securities, such as stocks, bonds, and derivatives, represent ownership or debt in a company and are primarily used for investments. They are regulated by entities like the Securities and Exchange Commission (SEC) in the United States and the Securities and Exchange Board of India (SEBI) in India and provide individuals with opportunities to participate in a company's growth or receive fixed income through dividends or interest payments.

The Howey Test plays a crucial role in assessing the regulatory status of various financial arrangements, including token sales and initial coin offerings (ICOs). 

On the other hand, commodities are physical goods or raw materials like gold, oil, or agricultural products, traded on exchanges. Commodities serve various purposes, including portfolio diversification and hedging against price fluctuations. They are regulated by agencies such as the Commodities Futures Trading Commission (CFTC), and their prices are influenced by supply-demand dynamics, geopolitical events, and storage costs.

What constitutes security?

The Howey Test—derived from the SEC v. W.J. Howey Co. case, is a legal framework used in the United States to determine whether a transaction qualifies as an investment contract and falls under the definition of security. It consists of four essential elements: i) financial investment, ii) involvement in a common enterprise, iii) an expectation of profits, and iv) reliance on the efforts of a promoter or others for the generation of profit. If these conditions are met, the transaction is subject to securities regulations. The Howey Test plays a crucial role in assessing the regulatory status of various financial arrangements, including token sales and initial coin offerings (ICOs). 

Grey areas of cryptocurrency

At first glance, categorising cryptocurrency can be perplexing, as its classification is not immediately apparent. For instance, decentralisation is a strategy pursued by issuers to prevent the violation of securities laws. When a cryptocurrency lacks a centralised and coordinated entity accountable for influencing its value, its classification as a security becomes less probable. Decentralised finance (DeFi) projects utilise decentralised development, governance through decentralised autonomous organisations (DAOs), and proof-of-stake consensus mechanisms to accomplish this objective. By engaging participants as investors and contributors, allowing them to stake their holdings or participate in DAO decision-making through voting, dependence on external entities for returns is reduced, diverging from the requirements of the Howey test.

The classification of cryptocurrencies as securities introduces risks for exchanges, as they may opt against listing such assets to mitigate the potential fines imposed by regulators for trading unregistered securities.

In the event, that a cryptocurrency is categorised as security, issuers, and exchanges must acquire licences from securities regulators. Nonetheless, adhering to securities laws presents significant challenges, prompting the crypto industry to allocate substantial resources towards evading them. Moreover, the classification of cryptocurrencies as securities introduces risks for exchanges, as they may opt against listing such assets to mitigate the potential fines imposed by regulators for trading unregistered securities. Further ambiguities arise in the categorisation of cryptocurrency. Cryptocurrencies possess characteristics that make them easily comparable to commodities. They exhibit interchangeability on global exchanges and maintain consistent value across different trading platforms, much like commodities such as coffee. Regardless of whether Bitcoin is traded in India or the United States (US), its value and fungibility remain uniform on a global scale.

Regulatory Perspectives 

Given the multitude of stakeholders and complex dynamics, accurately envisioning the regulatory landscape in the near future, or even developing a regulatory framework at present, is challenging. Global debates and discussions have failed to reach a definitive consensus on this matter. For instance, the US congressional initiatives have centred on expanding the regulatory authority of the CFTC to oversee the spot trading of non-security tokens, with only Bitcoin is currently recognised. In 2021, India's Finance Ministry indicated that the proposed legal framework for cryptocurrencies would likely classify them more akin to commodities rather than currencies. However, no concrete developments have transpired. The SEC chair Gary Gensler believed his agency possessed the necessary jurisdiction to supervise cryptocurrencies, asserting that a majority of crypto tokens should be classified as securities. However, he changed his mind very soon. In May 2023, the SEC decided to eliminate the definition of “digital asset” from the final version of a hedge fund rule. This definition, which would have been the SEC's initial formal interpretation of the term, has been put under further consideration. This move potentially underscores the challenges encountered in coining a precise definition for cryptocurrencies. This uncertainty is present almost everywhere. The financial world has observed BlackRock CEO Larry Fink calling Bitcoin an  “index of money laundering” in 2017 to BlackRock filing for spot Bitcoin ETF in 2023.

The US congressional initiatives have centred on expanding the regulatory authority of the CFTC to oversee the spot trading of non-security tokens, with only Bitcoin is currently recognised.

An alternative perspective offers a different narrative. The CFTC has consistently asserted that cryptocurrencies like Bitcoin and Ether should be classified as commodities and regulated under the Commodity Exchange Act (CEA). Their argument is based on the notion that cryptocurrencies, being interchangeable on exchanges, hold equal value, similar to how identical sacks of corn are valued. The inherent ambiguities and diverse nature of cryptocurrencies suggest the possibility of certain cryptocurrencies being classified as securities, while others are considered commodities. Such a scenario could result in a complex regulatory landscape where distinct cryptocurrencies are subjected to varying rules and regulations. European regulators have acknowledged the complexities of cryptocurrencies and, as a result, chosen a distinct approach to establish regulations for cryptocurrencies as a separate asset class. The European Union's Markets in Crypto Assets (MiCA) regulation sets requirements for crypto issuers, wallet providers, and exchanges to protect consumers and ensure fair trading. These guidelines are tailored to the unique characteristics of crypto assets, distinct from traditional securities and commodities. 

In Search of Clarity 

The wide range of utility and technological frameworks exhibited by cryptocurrencies contributes to their complexity and challenges regarding understanding and categorisation. For instance, Bitcoin and Ethereum, two prominent cryptocurrencies, demonstrate significant distinctions. One notable difference lies in their consensus mechanism. Bitcoin relies on the Nakamoto consensus, utilising a proof-of-work system to validate transactions and add new blocks to the blockchain. In contrast, Ethereum employs a proof-of-stake system, which offers a more energy-efficient approach to transaction confirmation and block incorporation. It is important to note that proof-of-work cryptocurrencies carry certain risks associated with concentrated power. For instance, if an individual or group gains control over more than 50 percent of a blockchain's mining power, they potentially hold the ability to manipulate its records or render it ineffective. This vulnerability is commonly referred to as a "51% attack." The existence of subtle differences among cryptocurrencies raises the question of whether they should be uniformly characterised and regulated, but that would only add to regulatory complexity.

Bitcoin relies on the Nakamoto consensus, utilising a proof-of-work system to validate transactions and add new blocks to the blockchain.

Concerns arise regarding the paradoxical centralisation of decentralised technology. The recent centralisation in bitcoin mining raises significant concerns about the structural ambiguities of the technology. One possible question, purely speculative, arises from the presence of certain centralised elements that, in essence, satisfy the requirements of the Howey test, potentially leading to the categorisation of Bitcoin as a security. Conversely, since most cryptocurrencies are interchangeable on exchanges globally, they exhibit characteristics of commodities, like wheat and coffee. The diverse structural and technological aspects of cryptocurrencies make it extremely challenging to establish a clear definition or a definitive regulatory framework. Rapid technological advancements have outpaced regulatory efforts, but this does not imply that the sector will remain unregulated. Regulation is imminent and will be implemented once appropriate foundational principles are devised to classify different types of crypto assets. Europe's introduction of MiCA stands is a positive step. India is gradually progressing towards establishing a stable regulatory framework for cryptocurrency. The inclusion of crypto companies within the scope of anti-money laundering regulations introduces obligations and subjects them to penalties for any violations along with a 30 percent tax rate for cryptocurrencies. The exact shape and consequences of defining cryptocurrencies as security or commodity or a separate asset class and their regulation are uncertain, leaving questions about its impact on the broader ecosystem and potential innovation constraints. Regardless, it is crucial for regulation to adapt and keep pace with technological advancements.

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Sauradeep Bag is an Associate Fellow at Observer Research Foundation.

• Economics and Finance
• Cyber and Technology
• Digital Inclusion
• India
• USA and Canada
• Commodities
• cryptocurrency
• Financial Stability
• investor protection
• rapid growth
• regulatory framework
• SEBI

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