Crypto mania has worn off a bit so far in 2018, with the price of bitcoin falling back from its stratospheric rise in 2017. Recent concerns that include exchange hacking episodes, adverse regulation in some foreign countries, and charges of price manipulation have cooled off the market for bitcoin and other cryptocurrencies. The U.S. Securities and Exchange Commission has gotten involved in the question of whether cryptocurrencies are securities, which would require further compliance measures from companies looking to make initial coin offerings or otherwise participate in the crypto boom.

Earlier this week, the SEC's William Hinman spoke at a summit on cryptocurrencies. Addressing the question of regulation of digital assets, the director of the SEC's Division of Corporation Finance made an interesting assertion that advocates for crypto tokens took as potentially opening the door to a new groundswell of support for the crypto market. Yet the statement raises major questions for investors, seemingly creating a distinction that will be almost impossible to define in exact terms.

Bitcoin symbol superimposed on candlepin chart showing ups and downs.

Image source: Getty Images.

What the SEC said

Hinman's talk centered on the idea of whether digital assets could ever not be considered a security subject to regulation. Under the framework that the SEC administrator laid out, just about every initial coin offering would potentially involve the need for securities regulation, because in his view, the fact that a central business entity was engaged in the ICO and that the token being offered would effectively give the buyer a business interest in that entity was enough to make securities laws apply.

Yet Hinman opened the door to the idea that at some point that situation might change. Specifically, if the crypto token itself became so decentralized that it no longer represented an implicit business interest in the entity promoting it, or if the token become solely a vehicle for commerce and trade of goods and services, then it might no longer be a security.

Indeed, the SEC administrator said that at least in his opinion, both bitcoin and ether had evolved to the point at which purchases and sales of the two high-profile tokens are no longer securities transactions. That initially boosted markets for those cryptocurrencies substantially, although prices have since fallen back.

Why variable regulation is unsustainable

For investors, whether something is a security plays a major role in determining how much and what type of information they'll receive about it when investing. Substantial protections apply to securities offerings, while offerings not covered by securities laws involve greater risk and uncertainty.

Just about the worst answer an investor can receive about a potential investment is that it could phase in and out of regulated security status. One might receive regular financial reports about an investment, only at some unspecified time in the future to stop getting any guidance whatsoever. The difficulty in determining that turning point would make cryptocurrencies uninvestable for those who demand the safety of regulatory protections under such a framework.

It might seem simple to establish whether a third party is driving expectation for returns in a given cryptocurrency. But even the guidelines that Hinman set forth as contributing to the discussion are too slippery to establish completely. Consider them, paraphrased for brevity:

  • Is someone sponsoring or promoting the digital asset who's important to its development?
  • Has the sponsor or promoter kept a stake in the asset?
  • Has the promoter raised additional funds beyond necessary establishment costs?
  • Do purchasers want a return?
  • Is disclosure of a promoter's activities important to investors?
  • Does anyone other than the promoter have influence or governance rights?

In any offering -- include the initial offerings of bitcoin years ago -- there'll be someone behind the digital asset who was responsible for its creation, and absent an act of charity, that person will always have some direct or indirect financial interest in the outcome of an offering. As for purchasers, they'll always want a return, and they'll always find the founder's actions to be valuable information to have.

Demand regulation

If you want to make money with cryptocurrencies, it's not enough just to sit back and buy into the philosophy behind a given crypto token as a matter of faith. The most successful cryptocurrencies should be regulated, as investors will benefit from the decentralization of proprietary information that would otherwise help promoters profit at their expense.

Those in the crypto industry who seek to avoid regulation have already made it clear how little they value the investors they should serve. Only by collectively expressing a preference for regulated investments can investors best ensure that illicit coin offerings won't take advantage of their demand for cryptocurrency opportunities. In that light, the SEC opening the door to deregulation is the worst news mainstream investors interested in crypto assets could get.

Neither Dan Caplinger nor The Motley Fool hold interests in any cryptocurrencies mentioned. The Motley Fool has a disclosure policy.