The Securities and Exchange Commission of Nigeria has proactively defined virtual digital assets under its regulatory purview in a statement issued on its platform on September 14, 2020.
This is a rather impressive step as the Commission has been understudying several ways to leverage innovative products deployed in its emerging economy and is a clear cut deviation from its previous No-Action position on crypto-currency which is still being held by other regulators.
Although the current SEC intervention has been looming, it is perceived that Nigerians piqued interest in crypto for the last 5 years would have been a major propellant in driving SEC to quickly rein in this budding market. According to Google Trends, Nigeria consistently ranks first worldwide in online searches for “Bitcoin” (the largest blockchain crypto network) tripling the traffic of Ghana or South Africa. Chainalysis also reports that Nigeria, alongside South Africa and Kenya, lead the continent in monthly crypto transfers, totaling about $316 million as of June.
While the statement may raise certain bitter-sweet concerns for incumbent crypto-asset market players (still early-stage companies), it would also serve as a springboard for previously inhibited traditional capital market operators (CMOs) to approach and access an otherwise burgeoning crypto market.
However, whichever part of the value chain an entity would fall, it appears that SEC has applied a broad interpretation of its regulatory oversight powers on crypto-asset related activities. According to the statement, “The position of the Commission is that virtual crypto assets are securities unless proven otherwise.”
SEC two-prong approach; a grand slam to other watching Regulators
A further review of the statement indicates that the SEC would take a two-prong approach as the parties (issuer or sponsor) dealing in crypto-asset would have to make an initial assessment filing with the sole obligation of convincing the SEC, that their digital asset is not a security, and if unsuccessful would be required to register same with SEC, most likely as security, following SEC’s absolute or strict classification that all virtual asset is considered as securities.
It would appear that this broad classification of crypto-asset as securities by SEC is to primarily emphasize its regulatory position amongst other competing regulators on issues relating to Crypto-asset whilst other secondary usage or adoption of crypto-asset would be left for debate and grappling by relevant regulators.
Legally, this classification also reinforces SEC’s oversight responsibilities on investment and securities as the Apex Regulator of the capital market and all forms of securities. This power or responsibility of the SEC is derived from the provisions of the Investment and Securities Act (ISA) 2007.
Putting it more succinctly, section 8 (a) & (b) of ISA provides that “the Commission shall be the apex regulatory organization for the Nigerian capital market and shall carry out the functions and exercise all the powers prescribed in this Act and, in particular, shall – (a) regulate investments and securities business in Nigeria as defined in this Act…” To accentuate this point section 315 of the ISA 2007 further defines the term ‘securities’ to include commodities, futures, contracts, options, and “other derivatives”.
Consequently, the conflated reading of the statement and ISA cements SEC oversight powers on perceived crypto-asset (now) stamped as securities which would help provide some regulatory certainty amongst market participants. A challenge however would be the fact that considering SEC has loosely used the term Virtual digital asset (which may include other digital assets other than crypto-asset i.e. mobile airtime, mobile money, electricity token, etc.) and virtual crypto assets, there may arise some hassling amongst the relevant regulator says there is a clear difference between the two and the market players may vary significantly.
Perhaps a fitting classification would have been to term a digital asset as a financial product either as a securities (commodities, options, security or investment contracts) which would fall under the scope of SEC or as a means for the exchange of value (product, non-cash payment facilities, crypto-asset payment gateway platforms, wallets, etc.) which would fall under the scope of the CBN. Although as an aside this current approach may be a fair win for the SEC considering the CBN’s full swoop of the FinTech (particularly payment) space and the expansion of its scope by creatively classifying interested payment service company’s (TELCOs inclusive) with intention to hold cash as a Bank (Payment Service Bank).
Determining SEC Regulatory Scope for Crypto-Activities
It can also be gleaned from the statement, that SEC has attempted to make two distinctions on related crypto-asset activities, namely activities relating to an offering (such as Initial coin offering (ICO), STO, Initial Exchange Offering) and those dealing in crypto-asset activities particularly in the secondary market.
In relation to the former, the statement states that “Similarly, all Digital Assets Token Offering (DATOs), Initial Coin Offerings (ICOs), Security Token ICOs and other Blockchain-based offers of digital assets within Nigeria or by Nigerian issuers or sponsors or foreign issuers targeting Nigerian investors, shall be subject to the regulation of the Commission.”
As an aside, it is also important to note that existing digital assets offerings prior to the implementation of the Regulatory Guidelines will have three (3) months to either submit the initial assessment filing or documents for registration proper, as the case may be.
Market Player under the SEC Crypto-Asset Regime
The Statement provides that “any person, (individual or corporate) whose activities involve any aspect of Blockchain-related and virtual digital asset services, must be registered by the Commission and as such, will be subject to the regulatory guidelines. Such services include, but are not limited to reception, transmission and execution of orders on behalf of other persons, dealers on own account, portfolio management, investment advice, custodian or nominee services.”
Again from the above exhaustive, it is clear that other regulators would be left to scurry and cherry-pick from the left-overs of other would-be digital market players to regulate, as SEC has stamped its oversight powers not only crypto-asset (which could include utility token, ICOs, crypto-currency) but also on all “Blockchain-related and virtual digital asset services” as they must be required to register with SEC.
It seems that although these entities may succeed in showing that they fall under any of the exempted class to be stated by SEC, or that they are not exchange or securities they would still be required to register with SEC. I would avoid the urge to streamline what I would consider as the virtual digital asset value chain in SEC’s current statement but would state that SEC would have to collaborate with other Regulators to avoid regulatory overlap which affects the current FinTech landscape.
A classic consideration would be an instance where a bank decides to offer custodian (safe-keeping of private keys or crypto-currencies) services or other payment gateways providers due to widespread adoption of cryptocurrency or other blockchain-enabled product utility token decide to provide crypto asset payment or merchant service providers alongside other existing fiat currency options to consumers, would they then be required to register with SEC as well as the CBN assuming they decided to join in this regulatory trailblazer?
It would also appear that SEC had considered this by stating that all cryptocurrency and utility token would be considered as commodities and only be subjected to its regulation if traded in an exchange, however, this would conflict with the earlier classification that all blockchain-related services must be registered with SEC. Another query would be whether existing market-place dealers/brokers (e.g. luno, buycoinafrica, etc.) in cryptocurrency would fall under this blurred exception or be regarded as exchanges dealing in securities (commodities)?
Bearing in mind that crypto-assets are already considered securities it would infer that existing P2P platform, wallet, and exchange services which aid the purchase and sale of crypto-asset would have to be registered with the SEC and are deemed as exchanges considering that the crypto-asset they offer are classified as securities (commodities).
The challenge then would be whether this native start-up crypto-exchange like bitcoins, luno, etc., can fulfill the requirement or standard set for traditional exchanges as stated in Part E of SEC Rules and Regulations, and perhaps the SEC may want to grant them certain regulatory exemptions i.e. pairing or being sponsored by existing exchanges or intermediaries.
Another consideration would be that in the event that they do serve as a platform for crypto offering (ICO, IEO, STO) but simply for the sale and purchase of cryptocurrency (commodities) with no underlying investment or security features, they should not be classified as an exchange in the traditional sense and could merely be classified as those providing blockchain-related services and subject to mandatory registration with SEC.
This would be a reasonable consideration as it would reduce SEC’s burden and divided attention in tackling bad-actors or black market traders, after all, SEC’s claims in the statement that the regulation “is not to hinder technology or stifle innovation, but to create standards that encourage ethical practice”
A Regulation beyond Borders;
Interestingly, SEC has not limited their approach to indigenous crypto market players as the SEC statement has blurred the effect of borders and jurisdiction by making it applicable to foreign market players who seek to offer the same in Nigeria. This was an approach taken by Australia which became a haven for the US blockchain network.
The statement provided that all Blockchain-based offers of digital assets within Nigeria or by Nigerian issuers or sponsors or foreign issuers targeting Nigerian investors, shall be subject to the regulation of the Commission” The SEC also states that it may require Foreign or non-residential issuers or sponsors to establish a branch office within Nigeria, however, foreign issuers or sponsors will be recognized by the Commission where a reciprocal agreement exists between Nigeria and the country of the foreign issuer or sponsor or the country of such foreign issuer is a member of the International Organization of Securities Commissions (IOSCO).
Ultimately, this is a step in the right direction considering the significant level of involvement of Nigerians in cryptocurrency, the country would serve as a major haven or dedicated space for crypto dealers which would invariably boost the foreign direct and portfolio investment in the Nations economy, particularly during this looming bearish market. I am aware of the amount of opinion that we have prepared for existing market participants who had shown early teething signs to reiterate their product offerings in Nigeria.
But all that glitters is not gold considering that this would further expose Nigerian investors both retail and wholesale to bad-actors and fraudulent activities thereby requiring SEC and other relevant regulators to take stricter measures, adopt strategic and targeted compliance regime for the crypto-market participant as well as develop creative ways to sanction foreign sponsors and issuers.
Who can be exempted from the requirement to Register
Following the steps of Canada and Australia, the statement by SEC has classified crypto-Asset non-fiat virtual currency like (bitcoin, monero, ether, etc.) and utility tokens as a commodity which if not traded in a recognized exchange would fall outside the scope of SEC. Also, SEC has stated that as an exception to securities Issuers or sponsors are expected to satisfy the burden of proving that the virtual assets do not constitute securities by making an initial assessment filing.
The referred assessment link does not provide parameters on how the SEC would determine this exception principle. If the proposed guideline does not provide clear grading systems/ parameters, it may be that SEC has empowered itself to choose as it deems fits on a case by case basis and ultimately this may lead to abuse. Hence, it is recommended that the guidelines provide clear criteria for this.
Without putting the cart before the horse, as the SEC is yet to release the applicable guidelines, it would seem that there is an intersection between what SEC would consider as a crypto offering (i.e. ICO) not classified as a security or requiring registration and a utility token (commodities).
For clarity in an ICO, the issuer sells a pre-functional cryptocurrency. That cryptocurrency itself is a smart-contract that is activated when a deposit of a more established cryptocurrency such as Bitcoin or Ether has been received a popular example is Dawn Dickson’s PomCom. From the Statement, all forms of Security token would be classified as falling under SEC regulatory ambit whether classified as an ICO or STO provided that it is considered as a form of securities.
The sad reality of this is that despite the aim of a blockchain network to attain the classification of a utility token (network functionality and decentralization), its initial network offering would have been classified as an ICO/STO falling under the regulatory purview of SEC.
Also, after this initial crypto offering in order to attain the utility token yardstick (network maturity through the widespread usage of the token and decentralization) this token would have to be sold in the secondary market (which directly falls under SEC’s ambit as seen in the Statement), whichever ways whether this would be done solely through crowdfunding portals (which seems to be another exemption in the Statement) or crypto marketplace in order to fall outside the securities requirement of SEC ought to also be considered.
The application of SEC securities laws to these transactions may frustrate the network’s ability to achieve maturity and prevents the transformation of the token sold as a security to a non-security token functioning on the network. Although there are arguments that Nigerian entrepreneurs may not have the relevant skill to build and develop a blockchain network to attain token functionality and decentralization or to become a utility token, as such SEC’s limited focus on such initial blockchain-related network offering is not misplaced, but yet again such observations would lack the regulatory proactiveness required for a modern regulator as incidents need to be considered before they occur.
SEC may however consider adopting the US safe harbor approach which gives issuers whose end goal is to develop a decentralized and functional blockchain network as opposed to raising security an exemption period where their offering whether made in the primary or secondary market would not be subject to regulation or classified as a security. In the alternative SEC may recognize and approve a utility token network which although previously may have been considered as security having attained network maturity can be classified as a utility token and not security.
Also, while SEC has not created parameters for determining when a crypto-asset would be granted an exemption from being classified as a security offering, it is important for those who intend to leverage on this exception to understand the granular details of a security or investment contract and the expectation attached to it which would then classify it as a security or not.
Even when there is a substantial argument that an ICO involves a utility token, Issuers should be aware that token offerings that attempt to lure investors with the promise of extraordinary returns may likely be considered as a security. If the token is offered to investors for its potential for appreciation, it is likely subject to SEC regulation.
For example, if the value of a token is not tied to the profitability of a venture, it would not satisfy the requirement that the investor “expects profits.” However, if the sales materials describe the token as having profit potential, it would be offered in a way so that the investors would “expect profits.”
Another method through which selling of token may fall under SEC’s regulatory waterloo may be a bifurcated process of selling tokens without registration through a Simple Agreement for Future Tokens (SAFT). In the first stage, investment contracts promising future delivery of tokens are sold to sophisticated investors without registration in private placements.
In the second stage, after the project has reached a stage where the token is “functional,” the enterprise will sell utility tokens to the general public. It is unclear however whether SEC broad classification of crypto-asset as security may subject this method to its regulatory ambit or whether this private placement mechanism would essentially be regarded as falling under the purview of the Companies and Allied Matters Act. A disadvantage of this method would also be that unlike the alternative mode of financing which crypto-asset issuance provides, the issuer/company may have to cede significant control to early investors of the SAFT.
Providing an unsolicited two-cent to SEC
“We are witnessing a time of significant innovation in the securities markets with the use and application of distributed ledger and Whichever way we choose to look at this statement issued by SEC, it definitely would offer profitable opportunities for the Nigerian economy, indeed Santa clause came visiting early.
However, considering this innovation in order for SEC to protect investors, the emerging guidelines should be thoughtfully crafted bearing in mind the peculiarities of digital markets and enforcement of existing laws.” Though it has the power to regulate ICOs and other crypto-related offerings, SEC must act with care in regulating entrepreneurship.
The SEC must weigh competing policy goals; protecting investors while promoting capital raising. Its recent cautious enforcement approach may reflect the need to navigate both concerns at once. However, in the event of a risk of harm to retail investors, the SEC should enforce the securities laws more decisively.
The SEC needs to be aware that the traditional form of regulatory reporting and compliance would not suffice in their new supervisory role of the digital asset as certain bad actors have innovative ways of reinvesting illegally obtained funds into funds by circumventing KYC (Know Your Customer) and AML (Anti Money Laundering) procedures.
For utility tokens or products being offered in the primary market, there should be stricter measures of reporting and disclosure by the exchange or issuer requirement. Depending on the features of the blockchain ought to be offered, such public disclosure could include information about how tokens are generated or mined, the process for burning tokens, the process for validating transactions, and the consensus mechanism. The team also would have to explain the governance mechanisms for implementing changes to the protocol.
Also, in creating these exemptions on utility token not directly regarded as securities or commodities traded in the secondary market, perhaps other crypto exchange platforms may be able to show that they only offer for sale the crypto-currency and as such are not trading in securities to be considered as an exchange in the real sense.
What this would mean is that they would be unable to act as brokers or use the cryptocurrency to offer derivative or financial instruments such as CFD, options, etc. More so they may also consider registering as a Crowdfunding portal or intermediary for the purpose of conducting crowdsourced funding for entities or issuers who are able to scale through the rare exceptions of their crypto-asset being classified as securities by the SEC for their initial coin offering.
All these are considerations which the SEC should also consider in determining when a crypto-asset (whether it is an interest in a managed investment scheme, security, derivative, or commodities) trading platform become that enables consumers to buy (or be issued) or sell these crypto-assets may be deemed as an exchange.
The SEC should however create a clear distinction between crowdfunding (crowd-sourced funding) regulation and the new crypto regulation as ICOs are sometimes referred to by the industry as a form of crowdfunding, however, crowdfunding using an ICO is not the same as ‘crowd-sourced funding’ with the relaxed regulatory requirement for public fundraising.
I am also of the opinion that with this current movement, there may be further involvement of SEC invalidating the FOREX trading and regulating such space as the trading of some of these digital currencies either as a commodity or securities would further open up that market.
While we anticipate SEC’s guidelines, the law enforcement agencies and the Nigerian court must also be technologically sensitive as there would be several cases to be considered ranging from the dispute of when an investment contract would be classified as a security, particularly for the exempted crypto asset or token offered to investors which have failed to meet network maturity and token functionality or where such crypto asset fluctuates due to a combination of managerial and market efforts
Lastly, a key take out is that although cryptocurrencies raise incredibly complex and interesting questions about the nature of securities, SEC’s Statement has provided some perspective on the SEC’s position and raises the possibility that some blockchain projects could eventually sell utility tokens without registration.
Regulators in other countries ensure that the regulatory requirements or definition are technology-neutral and apply irrespective of the mode of technology used to perform a regulated service. Therefore whether it is issuing tokens to be used in a network, launching an exchange-traded product based on bitcoin (cryptocurrency exchange/forex platform), providing custody for crypto assets, operating a broker-dealer that handles crypto transactions, or setting up an alternative trading system where people can trade crypto assets, the relevant market participant namely, crypto-asset intermediaries, miners and transaction processors, crypto-asset exchanges and trading platforms, crypto-asset payment and merchant service providers, wallet providers and custody service providers, and consumers regulatory obligations must be determined by the relevant financial service regulator.
Authored by Ugo Nwaokike