The regulatory picture for cryptocurrencies in the U.S. is gradually coming into focus, but Diego Zuluaga argues it must become much clearer for the sector to prosper.

Diego Zuluaga

A policy analyst at the Cato Institute’s Center for Monetary and Financial Alternatives, Zuluaga recently published a briefing paper suggesting a framework that expands on the landmark SEC v. Howey Supreme Court case that appears to be shaping regulators’ evolving thinking. He spoke with ThirtyK about the current landscape, the distinction between ICOs and the tokens they offer, and the connection between coffee beans and cryptocurrency.

ThirtyK: How would you characterize the current regulatory landscape for cryptocurrencies in the U.S.?

Zuluaga: The two key words are “confused” and “improving.”

We lack clarity among regulatory agencies and the outlook the individual regulatory agencies are taking toward cryptocurrency and distributed apps. That’s to be expected in an emerging sector.

They are improving to the extent that regulators have become more willing to contemplate the issues in more detail, though [recent statements] are non-binding. I’m hopeful there will be greater clarification.

“A lot of cryptocurrency investment will happen through investment funds that combine cryptocurrencies and intermediated services [and] give people access to diversified portfolios,” says Zuluaga.

ThirtyK: You’ve said you’re concerned that too much attention is being paid to ICOs by regulators. Why?

Zuluaga: ICOs [represent] only 10 percent of the total [cryptocurrency] market cap. It’s a rising issue, but it’s a small part of a market that’s still small. They have attracted a large number of scammers, but they haven’t been successful. You hear that 80 percent of ICOs are scams, but you’re talking about 80 percent of the total number, not the funds raised. The successful ones are more transparent and legitimate than the “HoweyCoins of the world.

It’s hard to judge [the extent] to which [ICOs] will become a capital formation tool in the future. But if we expect decentralized technology to become bigger than it is today, the ICO seems a better way to raise capital by giving [investors] a right to interact with the platform. They operate more like crowdfunding or a Kickstarter, which looks like a forward contract. Those are regulated by the U.S. Commodity Futures Trading Commission (CFTC), but are subject to less onerous disclosures [than securities].

By forcing securities laws on ICOs, you’re making it more expensive for startups to raise money in new ways and much more difficult for people to put their money into it.  Regulatory forbearance is important here. Some people are looking to raise money in good faith…. Many ICOs do have a speculative nature, but that doesn’t mean they always will.

ThirtyK: Do you think the Howey test is a relevant measure of whether cryptocurrencies should be treated as securities, as U.S. Securities and Exchange Commission (SEC) officials have recently suggested?  

Zuluaga: The motivation behind the Howey test is understandable. It’s an appropriate [definition] to take as a starting point. [But] the Howey test is limited, particularly in terms of addressing the main concern, which is regulatory protection. Its elements don’t capture the nuance of cryptocurrency networks.

ThirtyK: Your proposed model makes a distinction between cryptocurrencies marketed as investments or tradable on secondary markets before the associated applications are up and running, which could potentially be considered securities, and those marketed as an advance purchase of a token not tradable before the applications’ launch, which would be treated as commodities.

Zuluaga: There’s a difference between the promise to deliver a token in the future and the token itself. One may be a security, the other is a commodity. You’re resolving 80 percent of the problem.

[Regulators should focus] on the process between raising money and the working application, when people have given money and [token issuers] haven’t delivered on their promise.

ThirtyK: What would this look like in practice?

Zuluaga: Say I create a “HoweyCoin” and [tell people to] buy it because I’m going to build a platform for dog-sitting services, and you don’t have to care about dog-sitting services because you can sell it. Clearly you have something being marketed as an investment, where the profitable nature is highlighted and secondary trading is encouraged at the time of the issue.

Compare that to three developers without any funds trying to come up with a decentralized competitor to Amazon and hoping to raise $20 million. If they say that transactions will take place via their “junglecoin” and it will only be issued when the platform is live, or that you shouldn’t trade it in the meantime, or that they are looking for users who will stick with them, it’s an advance purchase. It’s similar to a farmer saying “I’m planting coffee. If you give me money now, I’ll give you coffee beans six months from now.”

ThirtyK: SEC officials recently argued that tokens that begin as securities could eventually shift to utility tokens once they show signs of being sufficiently decentralized. What do you think of that idea?

Zuluaga: I don’t think it’s a good way to operate. It neglects the distinction between an entitlement to a token and the token itself.

With Ethereum, you could make the case that when Vitalik [Buterin] and the other developers raised money in 2014, they were selling a contract to receive ether (ETH) in the future. The contract was the security. The ether wasn’t. If decentralization is the criteria, it’s prone to regulatory arbitrage. Who sets the standard? It would only bring back the regulatory uncertainty.

ThirtyK: How should regulators treat decentralized networks once they’re up and running?

Zuluaga: There’s plenty of scope for adequate regulation. The financial regulation can only be when there’s a financial element, which to me is when the capital formation comes in. When [the issue] is policing the quality of goods delivered on the platform, the relevant regulator would be the Federal Trade Commission on the federal level and state regulators for specific industries.

ThirtyK: What else should regulators do to encourage innovation in the space?

Zuluaga: The approach that applies to all regulators is cost vs. benefit. There’s a general environment of permissionless innovation. These two [themes] need to set the tone of the conversation.

We know very little about this technology. The only way to learn is to let it go. Unless you have freedom to let firms raise money this way and let people invest, we’ll never find out.

ThirtyK: How do you see the sector evolving?

Zuluaga: I think it will be much more institutionalized. A lot of cryptocurrency investment will happen through investment funds that combine cryptocurrencies and intermediated services [and] give people access to diversified portfolios.

But the real value will come to the extent that these platforms become goods and service providers. Whether the token is worth $1 or $1,000, it will be about the extent to which you reduce transaction costs and let people interact.

Mark Toner
Mark Toner is a Washington, D.C., writer and editor. He has covered business, technology, media, education, and healthcare for a wide range of trade and industry publications.