Cryptocurrencies call for the right regulatory fit

The very word “cryptocurrency” sounds suspicious. Although bitcoin caught the popular imagination after the 2008 real estate meltdown, the wild speculation of the past few years and the theft of $46 million in bitcoins from Mt. Gox, the largest bitcoin exchange, followed by its bankruptcy, injected a degree of skepticism that persists in regulatory circles.

Cryptocurrencies are essentially virtual tokens of exchange that are tracked, validated and verified by a decentralized peer-to-peer network of computers. The architecture and protocols of this peer-to-peer structure, known as blockchain, is being supported and advanced by leading IT companies such as IBM, Microsoft and Accenture.

Despite negative perceptions, cryptocurrencies are legitimate, thriving and evolving to meet diverse financial needs. Some 2,400 cryptocurrencies exist today. They include:

Litecoin, a decentralized peer-to-peer cryptocurrency similar to Bitcoin but developed with an eye toward eliminating Bitcoin’s drawbacks. There are more than 50 million litecoins in circulation.

XRP, a digital tool developed by San Francisco-based Ripple that supports instant, verified and low-cost international payments, allowing banks to settle cross-border payments in real time, bypassing intermediary transactions. While Ripple’s business solution uses the same distributed blockchain design as bitcoin and other cryptocurrencies, XRP can be better described as a digital token with a specific purpose.

Ethereum, more of a software platform for transactions than a currency, developers use it to create cryptocurrency applications. Ethereum’s key contribution was the ether, a digital token that can be used to purchase other cryptocurrencies. Ethereum made the first ethers available through an initial coin offering (ICO) in 2014. These ICOs, which start-ups are seeing as an attractive alternative to venture capital funding, have come under the SEC microscope.

Although the SEC chose not to act in the Ethereum case, the agency hasn’t closed the door on broader regulation either. Its mixed signals are a growing concern among developers.

It is true that some, but far from all, cryptocurrencies may fit the definition under the Supreme Court’s 1946 decision in SEC v. W.J. Howey Co. The test is that the instrument must involve an investment of money into a common enterprise with the expectation of profit to come solely from the efforts of others.

But the SEC should not have the last word in this matter. To treat all virtual currencies and digital tokens as securities would present their innovators with a difficult and expensive set of rules that runs outside the context of their business. It would be like forcing a railroad train to obey the speed limit of the highway adjacent to the tracks.

Instead, regulators and Congress should avoid attempting to shoehorn cryptocurrencies into an existing regulatory framework designed for centralized, institutional banking. Sound regulation will require new definitions and a new vocabulary first. This assures healthy development of both digital currency applications and blockchain as a whole.

Japan, where Mt. Gox was based, offers a good example of restraint. Instead of joining a rush to ban cryptocurrencies in the wake of the Bitcoin theft, the government moved forward with progressive regulation of cryptocurrency exchanges and became the first country to legalize ICOs. Since then, Thailand and Abu Dhabi have taken steps to liberalize digital currency platforms and applications. In the U.S., Wyoming passed a bill that specifically differentiates utility tokens from equity tokens, excluding the former from securities laws.

In the long run, effective regulation of cryptocurrency may require global standards — and a willingness by governments to recognize that traditional methods of centralized control of banking and finance will be upended. There will be far more benefits to consumers, commerce and international trade as a result. The goal is to curtail bad behavior, not halt progress.

Steven Titch is a technology policy analyst based in Texas. He is a policy advisor with the Heartland Institute.