Blockchain-based applications and investment products are all the rage these days. Each week, cryptocurrency news grabs headlines and inflames interest. The U.S. Securities and Exchange Commission (SEC) recently outlined a procedure by which initial coin offerings (ICOs), like an Initial Public Offering (IPO) for a crypto-asset, may be legally undertaken. Nations have joined in; Estonia is considering issuing an ICO for citizens, while the Singaporean Central Bank released a plan to peg its currency to a distributed ledger. And of course, the price of bitcoin, the first cryptocurrency, seems to always inch upwards.

With all of this coverage, it’s easy for those uninitiated to the cryptocurrency space to feel some combination of excitement, skepticism and being overwhelmed. While it is true that blockchain applications represent one of the most significant disruptions in computer science and finance in decades, there are also reasons to look before one leaps head first into the world of crypto-finance.

For one, cryptocurrency technologies can be perplexing. Then there are the uncertainties that come with any new institutional development. Of chief concern is the need to distinguish among legitimate ventures with a reasonable chance of success, honest but incompetently executed schemes destined to become “vaporware,” and full-on scams.

Furthermore, various regulators have made it known they are taking the regulation of cryptocurrencies and their uses seriously, though those pronouncements range from fairly well-defined to worryingly opaque.

Yet these are not reasons to write off involvement in crypto-finance forever. On the contrary, it merely requires due diligence and active education on the part of anyone looking to get involved in this exciting space. This article aims to outline the basics of crypto-finance, describing the most promising applications and regulatory concerns relevant to modern investors and policymakers alike.

First, you will need to do your homework. It is helpful to have a good understanding of the history of cryptocurrency, how it works, and what problems the technology sets out to solve.

Cryptocurrency is best understood as a method of coordinating exchange online without the need to rely on a trusted third-party, like a bank, to reconcile accounts and make transfers. The early days of the internet faced a bit of a “chicken and egg” problem when it came to online transfer. There was no obvious way for users to send money directly to each other online.

Users could not simply send a digital token to another user – say, in an email attachment – because a recipient could “copy and paste” the token, thereby undermining scarcity. This was called the “double spend problem” in computer science. Furthermore, there was no guarantee that some malicious party would not intercept and change the transaction before it reached the recipient, which is known as the “Byzantine general’s problem.”

E-commerce was thus relatively slow to develop because the internet lacked a credible third-party to perform the necessary bank-like functions. Companies like PayPal made billions by eventually providing this service, and today people can easily use all of the major payment methods that they employed offline.

There was still no way for people to make direct payments online. This means that we had to trust that third-party payment processors would not improperly block transactions or turn over sensitive financial information to governments or hackers – incidents that unfortunately happen with some frequency.

Computer scientists had been at work trying to find a solution to the double-spend and Byzantine general’s problems to allow direct online payments for years. In 2008, an unknown programmer or group of programmers known under the pseudonym Satoshi Nakamoto cracked the code: his creation of bitcoin introduced the world to the innovation of distributed blockchain technology. Now, rather than relying on a trusted third-party, users could employ a network of computers running code to process transactions in a secure and verifiable manner.

Computers essentially “mine” for bitcoin by running the code on the bitcoin network process transactions and solving very difficult math problems. The processing power expended from these computations allows the network to verify how many currency units, or bitcoins, each user owns, and to which users they are transferred. All of this information is recorded in the blockchain, or the distributed ledger of all transactions.

Computers are rewarded for this “mining” by randomly earning newly-created units of bitcoins or receiving bitcoins from users as fees. The system is protected by cryptography and processing power, which ensures that no hacker can falsify the blockchain and makes it very difficult to attack the network.

Bitcoin is a fascinating enough development in its own right. It has generated interest among civil libertarians for its capacity to allow frictionless, censorship-resistant transfers across the world. As long as the internet is running, individuals now have the technology to exchange value regardless of borders, laws, or institutions. (This also generates concern from regulators, which we will later discuss.) Many in the finance community are interested in bitcoin’s qualities as an investment vehicle or store of value.

But blockchain is much bigger than bitcoin, and its applications range far beyond currency.
The innovation of blockchain technology led to a veritable Cambrian explosion in distributed ledger applications. First, innovators sought to replicate the cryptocurrency model, tweaking monetary properties and protocol characteristics to reach new audiences. Niche coins dedicated to fast transactions, conservation, scientific research, and even Internet memes have come and gone.

Eventually, people began to realize that the underlying distributed ledger technology could apply not just to currency, but to other kinds of information. At its heart, a blockchain is simply a distributed ledger of data. That data could represent physical property, or shares of a company, or any kind of financial instrument.

For example, blockchain technology has expanded from competing with fiat currencies to facilitating their movement, with firms like Ripple seeking to use blockchain to address the burdensome process of foreign currency exchange and cross-border remittance. Another popular blockchain technology is the ethereum protocol, which aims to provide a general purpose “smart contracting” platform to program complex functions into transactions and even corporate governance.

Moving farther afield, the use of distributed ledger tokenized systems has found some significant traction with companies looking to access capital, at least for the time being. So far in 2017, ICOs or token sales have raised over $1.2 billion. While token sales were initially viewed by some as unregulated, recent moves by regulators – including the SEC, the Canadian Securities Administrators, and the Monetary Authority of Singapore – have made clear that the mere use of a token does not move a transaction outside the scope of the regulations governing the sales of securities.

Instead of issuing tokenized securities, some firms are seeking to fund themselves by preselling the product or service they plan to offer via an “appcoin” sale. In this scenario, the firm is not selling a corporate security. Instead it is preselling access to the product or service it intends to offer and is using tokens as a receipt to indicate that, when the firm is up and running, the holder of the token is entitled to the good or service. This is conceptually similar to firms preselling products via crowdfunding websites like Kickstarter before they are made to help fund their creation.

The key regulatory point to remember is that the economic reality of the transaction, not the vehicle or form factor, will determine how a transaction is regulated. For example, the transfer of digital tokens that are used as currency is subject to currency regulation. This includes issues like anti-money laundering and know your customer (AML/KYC) requirements. Failure to comply with those requirements can have significant consequences, as demonstrated by the recent arrest of Alexander Vinnik, the operator of BTC-e, for allegedly failing to comply with AML/KYC requirements imposed on currency exchanges by U.S. law.

Likewise, in the securities context, it does not matter that an ICO does not give the purchaser a traditional stock certificate. What matters is whether the firm performing the ICO gives the impression to potential purchasers that the firm is offering an object that meets the legal definition of a security. As the SEC makes clear, whether an object constitutes a security is a fact-specific question, but there are general rules.

Particularly relevant in this context is whether the instrument meets the definition of an “investment contract.” The test for whether an item is an investment contract was enumerated by the Supreme Court in the case of SEC v. W.J. Howey Co. As the court in Howey laid out, a transaction that involves a person spending her money in a “common enterprise” with the expectation that she will obtain “profits solely from the efforts” of a third-party constitutes a security. Subsequent court decisions broadened the criteria so that even in cases where the investor puts in some work the contract can still be a security, provided the essential work is done by others.

If these criteria sound broad and vague, that’s because they are. As the court in Howey said:
“It [the definition of an investment contract under federal law] embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”

This means that firms participating in a token sale need to be cautious that they are not violating securities laws. The mere presence of some non-investment utility to the investor is not enough to avoid constituting a security. For example, in Howey the security in question was ownership of orange groves, but because the underlying economics of the transaction relied on the pooling of independently owned land into a common scheme relying on the work of people other than the owners to make the groves profitable, it was considered a security.

Further, tokenized securities also pose a risk to cryptocurrency exchanges. As the SEC points out in its analysis, exchanges that facilitate the transfer of tokenized securities are regulated as securities exchanges. Failure to properly register and comply with the relevant rules could result in significant regulatory penalties.

Even if the token isn’t a security, that doesn’t mean the token sale is unregulated. The sale of goods and services is highly regulated in its own right and the relevant regulators have jurisdiction.

This discussion is just a start. Numerous questions still exist regarding how governments will tax cryptocurrencies, the extent to which previous money transmitter rules will apply, and how central banks will proceed given the monetary implications of such technologies.

However, we believe that blockchain technologies should be allowed to scceed or fail based on their merits or lack thereof – not based on inapt regulatory constraints. A policy environment that provides appropriate protections while allowing the greatest possible space for collaboration and innovation will yield the highest probabilities that these emerging technologies can be as revolutionarily as expected.

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Brian Knight

Senior Research Fellow. Mercatus Center, George Mason University

Andrea O'Sullivan

Program Manager. Technology Policy Program, Mercatus Center, George Mason University

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