Crypto Rating Council

What Is The Crypto Rating Council?

If a digital asset is deemed a security by government regulators, that determination can have major implications for the asset's creators, investors and network. Over the last several years, the U.S. Securities and Exchange Commission (SEC) has sued several companies that issued digital assets, alleging that they sold unregistered securities.[1]

While regulators have previously released guidance on what defines a security, many digital assets are highly complex, so it is not always clear whether they would qualify as securities based on this information. To help provide some clarity to this situation, several cryptocurrency industry participants formed the Crypto Rating Council, a member-operated organisation set up specifically to assist market participants involved in either the trade or support of crypto assets to adhere to U.S. federal securities laws.[2]

When it was announced, the council consisted of eight founding members: Coinbase, Kraken, Anchorage, Grayscale Investments, Bittrex, Genesis, Circle and DRW Cumberland.[3] In announcing the creation of the council, the members emphasised that while the SEC has provided some helpful guidance, determining whether any crypto asset is a security requires the input of both technical and legal experts, who may not always have the same point of view.[2]

The members came up with a framework that can be used to determine whether a crypto asset is a security by answering questions that have either a "yes" or "no" answer.[2] By applying this framework, the members can arrive at a score between "1" and "5," with the former score meaning that a digital asset has either few or zero similarities to a security. The latter score, however, would indicate a crypto asset that has numerous similarities to a security.

The Howey Test

The SEC has traditionally used something called The Howey Test to determine whether an investment is a security. This test, created following a 1946 U.S. Supreme Court case, considers several factors in evaluating whether a specific investment is a security.[3]

Under this test, a digital asset is a security if:

  • It requires an investment of money in some kind of common enterprise
  • There is some expectation the enterprise will generate profits
  • The profits are created primarily by the efforts of others

Council's Points-Based Rating System

With considerations like these in mind, the members of the Crypto Rating Council created a points-based rating system, in which any digital asset can be given a numeric rating after answering several "yes" or "no" questions.[5] The members of the council focused on creating "objective, repeatable, fact-driven questions" that were created after perusing SEC and case law.[5]

The council noted that outside legal experts work with the technical experts of member firms to conduct factual analysis. The legal experts work together to create a numerical rating, and then member firms discuss this potential rating and then vote on whether they will agree to accept it.[5]

Kristin Smith, director of The Blockchain Association, weighed in on the council and its complex rating system, telling CoinDesk that the council was "an effort by the industry to comply with the incredibly complex [U.S.] securities laws."[6]

Eric Sibbit, a partner in the law firm O'Melveny & Myers who collaborated with the council to create the ratings, told Bitcoin Magazine that "the ratings system reflects an effort by members of the council to more systematically apply applicable case law and SEC guidance and utilize the collective expertise of council members."[1]

Example Ratings

The Crypto Rating Council proceeded to evaluate 20 digital assets, including well-known cryptocurrencies like Bitcoin, Litecoin, EOS and XRP.[7] The council gave both Bitcoin and Litecoin a rating of 1, stating that both had "decentralized development and usage" and an "absence of a marketed token sale and corresponding marketing efforts."

The council gave the XRP token a rating of 4, noting its "marketing of the token suggesting an opportunity to earn profits," "usage of securities-like language" and "sale of tokens or token interests prior to the existence of token utility."[8] At the same time, the council referenced the token's "decentralized development and usage."

Considerations

The council's announcement stated that its ratings do not represent legal advice.[8] Further, the council said that these ratings are not endorsed by the SEC, U.S. Commodity Futures Trading Commission (CFTC) or any other third party. The SEC, along with "other regulators," "are unlikely to adopt a rating system created solely by industry participants," Sibbit told Bitcoin Magazine.[1]

Summary

The Crypto Rating Council was announced in September 2019, and it was designed to provide guidance on which digital assets represent securities. The framework provided by the council, while not endorsed by government agencies like the SEC or CFTC, was designed to help industry participants determine which digital assets will likely be subject to the laws surrounding securities.

The council developed a series of fact-based, "yes" or "no" questions for evaluating digital assets in an effort to establish an objective methodology. After analysing a digital asset, members of the council can give a crypto asset a rating between 1 and 5, depending on how many characteristics it has the make it similar to a security.