The Future of Payments

67 BANKING PERSPECTIVES QUARTER 4 2018 Blockchain was first developed in 2008 as the technology underlying what is widely agreed to be the world’s first and best-known cryptocurrency, bitcoin. As set forth in the bitcoin white paper, bitcoin was intended to provide a means for peer-to-peer payments. However, due to the high level of price volatility of bitcoin and many other cryptocurrencies (for example, Ether, Ripple, Zcash, etc.), many believe that cryptocurrencies’ use ultimately will be confined primarily to investment purposes rather than to use as stores of value or means of exchange. We think, however, that this vastly oversimplifies the cryptocurrency landscape and how financial institutions and other service providers should evaluate cryptocurrencies when determining whether or not to provide services with respect to this new asset class. THE CRYPTOCURRENCY LANDSCAPE Cryptocurrencies are not a homogeneous asset class; rather, they come in many varieties. For example, there are what can be described as truly decentralized cryptocurrencies, such as bitcoin and Ether, which, as we discuss below, the Securities and Exchange Commission (SEC) has stated are so decentralized that they no longer should be deemed to be securities. Tokens are another variety of cryptocurrency offered in initial coin offerings (ICOs) as a means of raising capital for a business or blockchain project. A shared characteristic of many truly decentralized cryptocurrencies and many ICO tokens is that they generate their values intrinsically – their values are what everyone agrees their values to be. In contract, there is another variety of cryptocurrencies called asset-backed cryptocurrencies, which, as the name suggests, generate their values through a pool of collateral (e.g., real estate, fiat currency, precious metals, other cryptocurrencies). One example of an asset-backed cryptocurrency is called a “stablecoin.” Stablecoins are a class of cryptocurrencies that seek to maintain price stability with respect to an asset with a stable value, such as U.S. dollars. There are two main varieties of stablecoins: collateral-backed coins and algorithmic coins. Collateral-backed coins rely on collateral to back the value of the coins. Collateral can be U.S. dollars, gold, euros, or any other “stable” asset. The collateral is placed in an account, with a bank or other financial institution, and is subject to audit to ensure that the collateral truly exists and is sufficient to cover the amount of the outstanding obligations. The Gemini Dollar and the Paxos Standard are both examples of collateral-backed stablecoins. Both are pegged to the U.S. dollar at a one-to-one ratio. Algorithmic stablecoins rely on a liquid market of digital bonds to expand and contract the stablecoin supply, thus creating price stability in the stablecoin. 1 Algorithmic stablecoins substitute monetary supply policy dynamics for collateral as the mechanism for maintaining a stable coin value. The potential benefits of the algorithmic approach include a scalability and automation that may not be feasible with the collateral approach. Examples include Basis, which pegs its value to the U.S. dollar by controlling the supply of the stablecoins in circulation. CRYPTOCURRENCY: THE SECURITIES LAW PERSPECTIVE Given the variety of cryptocurrencies, it is important for financial institutions and other service providers to understand how regulators view cryptocurrencies and what those views mean from a risk perspective. In considering the truly decentralized cryptocurrencies and ICO tokens, the SEC has applied the investment contract test set forth in SEC v. W. J. Howey Co ., 328 U.S. 293 (1946) (“ Howey ”). The factors of the Howey case are: (1) whether purchasers of the instrument contributed money (or valuable goods or services); (2) whether purchasers invested in a common enterprise; (3) whether purchasers reasonably expected to earn profits through that enterprise; and (4) whether the expected profits are to be derived from the efforts of others. Most of the analysis to date under the Howey case as applied to cryptocurrencies has focused in particular on whether token purchasers rely on the efforts of others with A shared characteristic of many truly decentralized cryptocurrencies and many ICO tokens is that they generate their values intrinsically; their values are what everyone agrees their values to be.