The Token Taxonomy Act has gotten a lot of media attention in the cryptocurrency industry over the past few weeks. Here I will describe what the Token Taxonomy Act is, as well as what it means for the cryptocurrency industry. Please keep in mind that I am not a lawyer, nor a politician, nor a financial advisor, and this post is my opinion/interpretation of the Token Taxonomy Act. This is not legal or financial advice.
What Is The Token Taxonomy Act?
The Token Taxonomy Act is a bill that aims to distinguish cryptoassets/cryptocurrency as their own asset class entirely and thereby require its own rules and regulations. This would set it apart from securities, real estate, cash, bonds, mutual funds, etc.
It is bipartisan and was proposed by two congressmen: Warren Davidson (Republican from Ohio) and Darren Soto (Democrat from Florida). In its opening paragraph, it states its purpose:
“To amend the Securities Act of 1933 and the Securities Exchange Act of 1934 to exclude digital token from the definition of a security, to direct the Securities and Exchange Commission to enact regulatory changes regarding digital units secured through public key cryptography, to adjust taxation of virtual currencies held in individual retirement accounts, to create a tax exemption for exchanges of one virtual currency for another, to create a de minimis exemption from taxation for gains realized from the sale or exchange of virtual currency for other than cash, and for other purposes.”
The Token Taxonomy Act has four tenets that describe a Digital Token:
- Is created: (i) in response to the verification or collection of proposed transactions; (ii) pursuant to rules for the digital unit’s creation and supply that cannot be altered by a single person or group of persons under common control; or (iii) as an initial allocation of digital units that will otherwise be created in accordance with clause (i) or (ii).
- Has a transaction history that: (i) is recorded in a distributed, digital ledger or digital data structure in which consensus is achieved through a mathematically verifiable process; and (ii) after consensus is reached, cannot be materially altered by a single person or group of persons under common control.
- Is capable of being traded or transferred between persons without an intermediate custodian.
- Is not a representation of a financial interest in a company, including an ownership or debt interest or revenue share.
Why do we need a Token Taxonomy Act?
The intention of this bill is to provide regulatory guidance/clarity on the subtleties of what differentiates a cryptocurrency from a security. During the ICO frenzy of 2017, there were numerous dubious projects that under ordinary circumstances would likely be considered as a security and thus fall under the purview of the Security and Exchange Commission (SEC). The vast majority of those ICO projects were either plain scams or very poorly managed and doomed to fail from their inception.
Jay Clayton, SEC Chairman, has said on record that every crypto ICO he has read about this year has been an unregulated security offering. This is because people have given money with the expectation of a return due to the actions of a third party. The Securities Act of 1933 and the Securities Exchange Act of 1934 were designed to protect the “little guy” – aka the retail investor (98-99% of everyone who invested in ICOs). Not registering and meeting the strict requirements of the SEC to make security offerings is against US law.
What Is A Security?
A security has a broad definition that includes notes, stocks, bonds and investment contracts. In order to create a security (i.e. shares in a company), it must meet certain standards set out by the SEC. These regulations were set in order to protect retail investors. There are a set of 4 rules that are used as a test to determine if something is a security, known as the Howey Test.
The Howey Test parameters are:
- It is an investment of money
- There is an expectation of profits from the investment
- The investment of money is in a common enterprise
- Any profit comes from the efforts of a promoter or third party
Over the past few years, there has been a lot of contention as to whether or not a cryptocurrency fails the Howey Test and thus, falls under the definition of a security. This is important because it would mean a huge difference in taxation, as well as expected results from organizations associated with different cryptocurrencies.
Finally, the Token Taxonomy Act hopes to provide clarity on this. The bill does not propose to strictly regulate cryptocurrencies. Politicians are carefully wording the bill so as to provide enough clarity to allow for the legal development of cryptocurrency projects and at the same time, not stifle innovation and fintech development. Many other countries have already provided the green light for cryptocurrency development, including Sweden, Switzerland, Canada, South Korea, Spain, Thailand, the UK, Norway, Luxembourg, Iceland, and a few others. The United States does not want to be left behind.
Given how different cryptocurrencies are from securities it makes sense that different laws should be developed to regulate them. You cannot exchange stocks or bonds directly peer-to-peer, nor can you build digital infrasture (applications) on top of a stock or bond, where as you can on Ethereum and Bitcoin. In a truly decentralized cryptocurrency such as Bitcoin, Ethereum and XRP there is no one single common enterprise, and a cryptocurrency does not pay a dividend.
Apparently, there was a similar effort made in the early days of the Internet, where US Congress passed legislation that provided clarity on what was legal/illegal in the internet industry, yet it was broad enough to not stifle innovation, thereby allowing the internet economy to grow. This seems to be a parallel effort.
Previously, the only two cryptocurrencies that received an exemption from securities laws were Bitcoin and Ethereum, which as of now are regulated as commodities by the Commodities Futures Trade Commission. I personally believe that this may change, as they do not seem to fit neatly into a commodity structure. Bitcoin and Ethereum are protocols for distributed ledgers, that allow applications to be built on top of them. This seems very different from a commodity such as oil, gold, or corn.
What Can We Expect Looking Forward With The Token Taxonomy Act?
This proposal of the Token Taxonomy Act is very exciting; however, it is still a bill being proposed. It has not yet passed, and the US government is still under a shutdown that began late December 2018. Additionally, over the past 12 months, the cryptomarket has significantly dropped from about an $850 Billion USD market capitalization to about $125 Billion USD market capitalization. However, I am not deterred.
There have been significant developments in the cryptocurrency industry despite the dropping value (institutional investors [University Endowments, Circle, Galaxy Digital Holdings, Fidelity, Intercontinental Exchange], custodian solutions, development of different blockchains’ scaling such as Bitcoin lightning network, Ethereum Raiden alpha testing, the opening of institutional exchanges [Bakkt, Stuttgart Exchange] and much more).
Factors in favour of the Token Taxonomy Act passing are multifold:
- It is a bipartisan bill, meaning support from both Republican and Democrat parties.
- There is a Cryptocurrency Lobby Group, titled “Blockchain Association” whose purpose is to advocate and push for pro-cryptocurrency laws and regulations.
- The United States of America will not want to be left in the wake of the rest of the world with regards to the development of cryptocurrencies and blockchain technology, so there is an incentive to have light regulation and legal clarity for crypto companies and projects.
Regarding when we can expect it to pass… I wouldn’t hold my breath. Governments are notoriously slow, and even with the lobbying group and bipartisan support, I think it could take anywhere from 6 to 18 months AFTER the government shutdown is resolved. It might be 6 months only. It might be 10 months, 14 months, even 24 months if I am wrong. I hope it is sooner rather than later though.
Let us know what your thoughts are on the Token Taxonomy Act below in the comments!