Right now, one of the biggest controversies in the news is the latest Securities and Exchange Commission (SEC) probe into Coinbase. Accusations of insider trading abound. With all of this, the biggest question is, “Are cryptocurrencies securities?”
Let’s look at the regulatory gray area around cryptocurrencies and consider why some agencies treat some cryptocurrencies as securities.
Currencies vs. Securities
First of all, it’s important to understand the difference between a currency and a security.
- A currency is a medium of exchange. It can be used to purchase goods and services. It can also be used to pay fees — including on a blockchain network.
- A security, on the other hand, is an investment contract. When you invest, you have a reasonable expectation of profit from a shared enterprise.
Basically, the SEC is looking at some cryptocurrencies and seeing that they function very similar to company stock.
One of the biggest examples is Ripple (XRP), which has been sued by the SEC. Ripple created 100 billion units in 2012. They are released in lots. Ripple controls most XRP — it’s very centralized.
On the other hand, the SEC ruled that Bitcoin (BTC) and Ethereum (ETH) are currencies. They are sufficiently decentralized. Additionally, you can pay fees with them, and the networks encourage their use.
Tax Treatment of Cryptocurrencies
Bitcoin and Ethereum are treated as property by the IRS — even though the SEC sees them as currencies. Well, sometimes.
That’s right, even the IRS doesn’t fully answer the question, “Are cryptocurrencies securities?”
If you receive a bitcoin for work completed, it’s treated as income. You have to report it as income on your taxes, based on its market value the day you receive it. However, once you have that bitcoin, it becomes property. If you sell it later, the market price on receipt is the cost basis.
Here’s an example:
- Receive 1/4 of a bitcoin in pay. That portion of a bitcoin is worth $5,750.
- You must report that as income on your taxes.
- You decide to sell that portion of a bitcoin a few months later. Your 1/4 bitcoin is now worth $8,000.
- You have a profit of $2,250.
- You must also report that as a capital gain. Because it’s a short-term gain (you haven’t had the 1/4 bitcoin for more than a year), you pay taxes at your regular marginal rate.
Regulations are evolving, but receiving crypto as payment can easily result in being taxed twice.
Some Cryptocurrencies Have Characteristics of Securities
In many cases, some cryptocurrencies really do function more like shares of stock than as mediums of exchange. This is especially true of tokens associated with decentralized autonomous organizations (DAOs). A DAO functions similarly to a company, even though it’s decentralized and trustless. Members often expect to receive profits as a result of the activities of the DAO.
Another consideration is how some consider staking a form of dividends. If you receive rewards for holding a token, that’s similar to receiving dividends from a stock.
The crux of the current Coinbase scandal around insider trading comes from token listing. When Coinbase lists a new token, it often jumps in price. One of the members of the listing team was buying tokens before they were listed. They had insider knowledge of the coins. They even shared the information with others so they could profit.
Frontrunning coins is an issue when people learn that they will potentially be listed. Now the SEC thinks it’s a major issue. Insider trading is illegal. And the SEC seems to be seeing more and more cryptocurrency tokens as securities rather than true currencies.
So, Are Cryptocurrencies Securities?
That’s the question. Cryptocurrencies have been a regulatory gray area almost from the beginning. The regulatory apparatus doesn’t seem to know what to do with them.
While some cryptocurrencies function as mediums of exchange, many also increase in value. They act like a stock or a commodity. Some aren’t very decentralized. Blockchains have specific purposes — similar to companies.
In fact, some investors evaluate cryptocurrencies the same way they would a tech startup. It’s difficult to pin down the exact nature of digital assets. Not all of them are the same. And don’t even get started on non-fungible tokens (NFTs). Are they more like stocks? Or more like collectibles?
Understanding how government agencies like the SEC and IRS treat these assets is important. Unfortunately, there hasn’t been much guidance. Lawsuits and fines might clear some of it up. However, there are more than 20,000 cryptocurrencies. Trying to classify each would be a monumental task.
At some point, regulation needs to keep up with developments so you can make better-informed decisions.