Deconstructing the SEC’s Cryptocurrency-Suppression Program: Part Three | Arnall Golden Gregory LLP
What Do We Mean by Private Digital Money?
This article is the third in a multi-part series that explains how the SEC has structured its anti-cryptocurrency campaign and over-reached its regulatory authority in shutting down cryptocurrencies or private digital money (“PDM”). Part I discussed some of the sleights of hand the SEC has used in its anti-cryptocurrency efforts and the sources for its claim of jurisdiction. Part II reviewed the SEC’s early history with PDM and steps taken in its suppression-by-regulation program. Part III revisits the term “private digital money” (“PDM”), explores the relationship between PDM and tokens, and, finally, compares and contrasts PDM and tokens with securities.
Private Digital Money
As digital assets increase in popularity, a vocabulary emerges to distinguish one type of asset from another. For this reason, we think it is helpful to reiterate what we mean by the term private digital money,1 or PDM. We define PDM as all types of non-governmental digital2 assets3 that do not create and constitute liabilities or ownership of the producer of the digital asset; in other words, PDM does not include a digital security token.
PDM Is a Financial Product
Like securities and government-authorized or government-produced currencies—so-called fiat currencies4—PDM is a financial product. It is not, however, both a financial product and a financing product. A financing product is a security, which has no function other than to create, constitute, and convey a set of rights to the issuer’s assets, including rights to the residual assets of the issuer, to the holder of the security. The issuer creates and sells a security in exchange for capital or money for the purpose of its investment and operating activities. A security may have an active secondary market, as with publicly traded companies, but the value of that security is a function of, among other things, the issuer’s present and anticipated financial condition.
Not All Investments Are Securities
Accordingly, being a financial product is not a sufficient condition to make PDM a security. So long as PDM has value, it is also a financial asset to its holder.5 As a financial asset, it has features of and can function as money insofar as it has a named unit of value (such as a unit of Bitcoin, Ether, etc.) that can be multiplied or fractionalized, and it can act as a store of value that can be transferred or used in a transaction.6 When used in a sale-and-purchase transaction or a loan-and-borrow transaction, PDM constitutes a medium of exchange; it may even be used to pay existing financial obligations to individuals and organizations.7 The greater the number of possible transactions and markets in which it can be a medium of exchange, the more likely it will become a store of value. Stability or volatility of value is a different matter.
As a financial asset, a buyer may buy and hold units of a PDM as an investment—that is, with the hope or expectation that the resale price will exceed the purchase price.8 A buyer’s or many buyers’ intent to hold the PDM as an investment, whenever and however that intent is formed, and the possibility that PDM will increase in value do not make PDM a security. This is because holders of financial assets can use them in different ways; the psychology of the holder bears no necessary connection to the source of the financial asset’s value. First, the buyer of a financial asset need not be an investor. Day traders of securities are not investors in the common sense of the term; they engage in flipping operations to realize profits on price movements of publicly traded securities over brief holding periods. A buyer’s intention to invest, therefore, is not a condition necessary to make a financial asset a security. Also, a buyer’s decision to retain an asset to realize a gain—to treat the asset as an investment—is not a condition sufficient, by itself, to convert that asset into a security.9 This is true even if the asset is a financial product or financial asset. In short, the status of a particular asset as an investment is neither a necessary nor sufficient condition for it to constitute a security.
Private Digital Money and Tokens
A “token” can be defined as an instrument (tool) that is (1) perceptible using one or more senses, (2) representative of a stored value and useful as a medium for exchange in a particular market or system of markets, and (3) exchangeable, at some fixed or changeable ratio, for other value, such as a good or service, within that market or system of markets.
In the first part of the definition, (1) above, the token can be perceptible as a tangible object, such as a coin, stamp, ticket, coupon, gambling chip, or only visually, as on a computer monitor or in a company’s ledger.
The second prong, (2) above, includes tokens that have stored value that is either “intrinsic” in that the value derives solely from the token’s acceptability in transactions in the system of markets or “extrinsic” insofar as the token’s value is pegged or linked to another specific asset. A token’s perishability and replicability obviously impact its value. A banana makes for a poor token because it will decompose over time. Although the weight of a cylindrical piece of metal will diminish through abrasion over time, coins are perhaps the optimum token.10 The ability to create more units of value creates a fear and possibility of inflation,11 which creates more units even though the inventory of items that can be purchased has not increased.
Under the third part of the definition, (3) above, the number and types of transactions and markets within which the token’s value is recognized can be used to determine the scope and value of the token. The key difference between a token, as defined, and money is the scope of the transactions and markets—the micro-economy—in which each is accepted and used. This is a difference in degree, not in kind.
Distinctions Among Digital Tokens
A distinction can be made between currency tokens and utility tokens, based on the scope of the transactions and markets in which they can be used, and between cryptocurrencies and crypto-tokens, based on their relationship to a blockchain. As noted above, the difference between a currency token and a utility token can soon break down, as the latter can become the former; in some sense, they both constitute money. Some tokens have their own blockchains, and other tokens use others’ blockchains.
A digital asset, however, need not be a financial product generally or a cryptocurrency specifically;12 it can be a digital collectible—a blockchain-tracked, non-duplicable digital item or image. Digital collectibles are becoming a popular product in an emerging industry;13 such a product may become a digital asset and also an investment if a secondary market demand for it develops and grows. One such item, the non-fungible token (“NFT”), is a digital collectible, a unique item that remains the only such “object” or token and the blockchain “effectively gives each NFT a unique and non-hackable certificate of authenticity.”14 This is simply a digitized form of the collectible sports card, such as a baseball or football card, with much better record-keeping and tracking. Perhaps not surprisingly, demand for NFTs is growing as it has been for cryptocurrencies: in fact, on February 28, 2021, CNBC reported on the NBA’s “Top Shot” blockchain-based trading card system, which has generated gross revenue of $230 million.15
The emergence of NFTs and similar digital collectibles raises an important question: does or will the SEC equate a digital collectible to a “digital asset” as in the Ripple Complaint and treat NFTs, too, as “investment contracts?” If the answer is “yes,” then one must either distinguish a hard collectible,16 such as a baseball card made of cardstock, from the digitized version, or treat a baseball card as a security, too. If the answer is “no,” then an NFT and other digital collectibles must be distinguished from digital currency in a way that identifies the peculiarity of the currency. If the differences are insignificant, the question is why hard collectibles are not also securities under the federal securities laws? What makes a coin or paper valuable, whether in hard or digital form, is the same: market demand, both primary and secondary, for that type of “object” and the scarcity of that “object.” This is true for fiat currency as well.
All items of value are social constructs, including digital tokens, securities, and money, whether private digital money (“PDM”) or fiat currency issued by governments.17 Although not tangible, each “unit” has its own origin and history. Hard collectibles, digital collectibles, and digital currency or digital assets are all investments in the sense that—if a secondary market exists—one may, upon resale, be able to recover one’s purchase price and a profit as part of the total resale price. Also, these items are all usable in the same way as any asset is usable. They may be flipped for a quick gain, held to increase in value, used to secure loans, or traded for other assets of the same class or otherwise.
Is a token’s identity irrelevant? The inability to detect or the indifference to the user of a particular token distinguishes the non-collector from the collector. But each token, non-digital or digital, is different in fact or concept. Every metallic coin, even if “fungible” in the sense of having been created in a certain denomination and time period, is a unique product with its own history of production, transfers, use, and ownership.
A share of stock is a legal construct: tracing the individual, unique, yet fungible units sold is essential to any legal action that asserts violations of the registration mandates of Sections 5(a) and 5(c) of the Securities Act. A collectible digital token usually has an accompanying image. With respect to securities, the image or concretization of the “object” cannot be material, as old stock certificates, each one unique, is giving way to digitized stock. On a preliminary analysis, one can conclude that tokens of digital collectibles are no different from tokens of digital currency.
Private Digital Money and Securities
Having briefly discussed PDM and tokens, we compare and contrast the properties and elements that a unit of PDM and a security share and do not share.
Both Are Financial Products
The SEC defines a financial product to include, but not be limited to, “stocks, bonds, derivatives, and currency,”18 and this definition includes both a unit of PDM and a security. As discussed above, PDM functions as a currency, either as its sole function or in a limited capacity as a token within a micro-economy. The PDM producer may be formally organized (as a corporation, partnership, limited liability company) or organized informally. Often, the producer of PDM is also the seller of the PDM. Similarly, any entity, whether a formally or informally organized enterprise, may issue a security, such as a unit of stock (a share) or a dollar-denominated bond, and the security will be sold by the issuer.
Incentives: For Sellers, Profit and Capital Differ; For Buyers, It Is Gain
Profit is certainly an incentive of PDM producers, and the gross profit from selling (or distributing) currencies or coins is called seigniorage. Seigniorage in the context of PDM is the difference between the selling price per token sold and the cost of producing each token. With United States coinage, for example, the profit or loss is the face value of a metallic coin—a multiple, unit, or fraction of one United States Dollar (“USD”), which is the “selling price” of the coin, less the cost of producing the coin (the cost of revenue), also measured in United States dollars.19 As metals—the raw materials of coins—increase in price, the quality and amount of metals in non-virtual coins diminish.
Private producers of virtual currencies and coins—PDM—can generate significant profits because a unit of PDM can be “sold” or exchanged for US dollars or other currencies and the cost of “producing” a virtual unit of PDM, not including the blockchain, is negligible. As with any enterprise, revenue may be used in perpetuating business operations and profits of such revenue may be reinvested in new projects or distributed as dividends to the owners of the enterprise.
If a security producer—an issuer—seeks “profit” from the sale of a security, the issuer is engaging in fraud. This is because money paid to an issuer for a security is considered capital invested in the entity, not revenue from its business operation. A security is not produced for and sold to a customer. Although money paid for a unit of PDM is revenue, and money paid for a security is capital, in both cases, the money may be used for the enterprise’s operations and investments. Proceeds received from sales of PDM—a product of business operations—generates taxable income; proceeds from sales of a security—a product of financing operations—are not taxable.20
The buyer’s incentive for purchasing a unit of PDM or a security is the same: gain. As noted above, PDM can be a store of value and may be used to purchase goods or services or traded for another currency. Because PDM is a non-perishable financial product and may have value, it can be considered an investment, meaning that the holder may recover not only the original purchase price but an additional amount—the gain. Gain from PDM is typically realized when one “sells” or exchanges the PDM on a secondary market for PDM. Gain from a security, however, can come from the secondary market for that security, but it also can come directly from the issuer in the form of interest payments or dividends.
Durations of Transactions Differ
The contract between the PDM producer and buyer is a contract of sale. Upon performance of the contract— the seller’s delivery of PDM to the buyer and the buyer’s delivery of payment to the seller—the transaction typically ends. The PDM buyer seldom has post-delivery rights to future performance from the PDM-producer. However, the PDM-producer may create a separate contract right, such as a commitment in the form of a warranty to expend the purchase price on a blockchain buildout.
The contract between the security issuer and buyer is not a contract of sale but one of subscription. As with PDM, the buyer’s delivery of payment for the security completes the buyer’s obligations under the contract. Unlike the sale of PDM, however, the sale of a security is the beginning of the security producer’s obligations to the buyer or subsequent holder of the security. This is a critical difference.
The PDM Buyer Is a Customer—Not a Creditor or Owner of the PDM Producer
Buying PDM does not give the PDM buyer any direct rights against the PDM producer. Going back to the world of collectibles, PDM is like any collectible product, such as baseball cards or baseball cards that are simply unreproducible digitized icons. Both PDM and baseball cards lack “intrinsic” value: what they are “made of” has no value. One may buy the cards to trade, resell, or keep with the hope that they will increase in value. The buying of baseball cards does not make the customer a creditor or owner of the card-producer, and the value of the cards is largely not dependent on the card-producer’s performance. The value of the cards is wholly dependent on the secondary market of collectors. Similarly, PDM is typically dependent solely on the secondary market.
With some exceptions, PDM does not provide the owner-holder with contract-based or statutory-based rights against the assets of the PDM producer. If the latter engaged in fraud in procuring the sale of PDM or failed to comply with a collateral promise and obligation, not unlike a warranty, the buyer may be able to seek recovery in a fraud action or breach-of-contract action.
Having examined the similarities between PDM and digital collectibles and compared the digital token to the concept of a “security,” some of the dangers inherent in the SEC’s ongoing campaign to regulate cryptocurrencies become apparent. Because there is so little to distinguish PDM from other types of digital tokens and because the SEC has chosen to disregard the numerous differences between PDM and securities, any form of digital token risks being swept into the SEC’s regulatory scheme and regulated as a security. In Part IV, we will discuss the standardized definition of “security” and its evolution over time.
 Private currency is non-governmental money that exists in instrument form (paper, metal, or other material). Generally, private currency is not held in demand deposit accounts.
 A digit refers to a finger, thumb, or toe. Because we may use our fingers and thumbs to count, a digit metaphorically refers to any numeral from 0 to 9—the tenth phalange being represented by numerals 1 and 0. These two numerals, the binary numerals, are used to represent data—digital data—which, in turn, can be translated into pieces of information. Whereas analog-based information is non-countable and continuous, digital information is made of non-continuous, countable pieces.
 Digital assets are based on blockchains, which are chains of transaction blocks. They include cryptocurrencies, which use their own blockchains, and “crypto tokens [that] are built on an existing blockchain.” Cryptopedia, Digital Assets: Cryptocurrencies vs. Tokens (Mar. 23, 2021) (“Digital Assets”), https://www.gemini.com/cryptopedia/cryptocurrencies-vs-tokens-difference.
 A fiat currency is money that exists in instrument form (paper or cloth banknotes and metallic coins) that a particular government has deemed to be legal tender. Legal tender is currency or coin that must be accepted as payment of an existing debt obligation. It need not be accepted as payment in transactions not involving credit. In the United States, the legal tender provision is found at 31 U.S.C. § 5103, which reads: “United States coins and currency (including Federal reserve notes and circulating notes of Federal reserve banks and national banks) are legal tender for all debts, public charges, taxes, and dues. Foreign gold or silver coins are not legal tender for debts.”
 We do not use the term financial asset here in a financial accounting sense.
 Money includes that represented by an instrument (tool), such as paper or metal, and immediate rights to such instruments as with demand-deposit accounts at banks.
 For clarity, the word “finance”—based on the French word for “end” (fin)—refers to that which can be used to satisfy or “end” an outstanding obligation. See, e.g., Merriam-Webster Dictionary, finance: History and Etymology (“from finer “to pay by way of settlement, make a payment” (derivative of fin “final agreement, payment”)), https://www.merriam-webster.com/dictionary/finance. Such items would include, of course, currency and coins.
 A security, however, can generate a return on the price paid that comes directly from the issuer, typically in the form of interest or dividend. PDM does not offer the holder this type of return.
 Many things can be treated as investments: paintings, automobiles, stamps, old certificates, and so on.
 If the coin is made of precious metal and the market value is greater than the coin’s face value, it will likely cease to function as a medium of exchange and become solely an investment in metal, as Gresham’s Law posits.
 In the United States, the federal reserve banks can increase the number of units (USDs) by buying securities. Commercial banks can collectively increase that number by ten-fold based on the governmental privilege of fractional reserve banking.
 In its Complaint in SEC v. Ripple, the SEC asserted that “[t]he term ‘digital asset’ or ‘digital token’ generally refers to an asset issued and transferred using distributed ledger or blockchain technology, including assets sometimes referred to as ‘cryptocurrencies,’ ‘virtual currencies,’ digital ‘coins,’ and digital ‘tokens.’” Complaint, SEC v Ripple Labs, Inc., Case No. 1:20-cv-10832, ¶ 32 (SDNY Dec. 22, 2020), https://www.sec.gov/litigation/complaints/2020/comp-pr2020-338.pdf (“Ripple Complaint”).
 Reality Gaming Group, What are Digital Collectibles?, https://realitygaminggroup.com/blog_post/what-are-digital-collectibles/.
 Jabari Young, People have spent more than $230 million buying and trading digital collectibles of NBA highlights, CNBC (Feb. 28, 2021), https://www.cnbc.com/2021/02/28/230-million-dollars-spent-on-nba-top-shot.html?__source=sharebar|email&par=sharebar.
 By “hard collectible,” we refer to tangible tokens such as coins, bank notes, and stamps that are assets, stores of value, media of exchange, and investment-worthy.
 We have previously defined cryptocurrency, virtual currency, digital tokens, or digital coins collectively as PDM. See Part I of this series of articles, at note 4.
 SEC, Introduction to Investing: Glossary, https://www.investor.gov/introduction-investing/investing-basics/glossary/financial-product. In the federal banking laws governing the Consumer Financial Protection Bureau, a “financial product or service” is defined under 12 U.S.C. § 5481(15) and a “consumer financial product or service” is defined in 12 U.S.C. § 5481(5).
 David Kestenbaum, Planet Money: What Is Seigniorage?, NPR (Jan. 9, 2009), https://www.npr.org/sections/money/2009/01/what_is_seigniorage_1.html (“In the old days, seigniorage was the revenue the government earned because it costs less than a dollar to print a dollar. Say it costs 2 cents to print a $1 dollar bill. Then, poof, the government has gained something like 98 cents when it prints that dollar and uses it to buy something. That’s overly simple, but it’s a good starting place.”).
 However, the SEC does collect fees from issuers for registration of their securities. See, e.g., SEC, Fee Rate Advisory #1 for Fiscal Year 2021 (Aug. 26, 2020), https://www.sec.gov/news/press-release/2020-196.