As we’ve previously written, the Token Taxonomy Act (TTA) is an ambitious and potentially impactful piece of legislation that, by exempting digital tokens from the securities laws, might remove regulatory inhibitions from the maturing digital token industry. The bill is not without fault, however. As it stands, the language of the bill requiring that a digital token’s consensus be inalterable is ambiguously written and the SEC could use a strict interpretation to preclude many digital assets from qualifying as digital tokens.
The proposed additional language of Section 2(a)(20)(B) of the Securities Act of 1933 reads that to qualify for the exemption, a digital token:
(i) must be 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.
In other words, a digital token must use an inalterable and objectively verifiable process. This language is designed to include in the definition only those digital tokens that are or will be in widespread enough use so that no one single party can influence the nature of the outstanding tokens in a way that adversely affects digital token holders.
The proposed language creates the possibility that the SEC could strictly apply the requirement that a token “cannot” be materially altered. As it stands, proof-of-work and even proof-of-stake digital assets are susceptible to a 51% attack, which could alter the digital token’s consensus. “Proof-of-work” and “proof-of-stake” refer to different systems used to verify and process transactions on a blockchain.
A “51% attack” is an event in which a party takes control of the requisite computer power underlying a token’s blockchain such that the party can control the token platform’s operation. Typically, a party seeking such control needs to possess 51% of the outstanding tokens, but the threshold amount can be lower for individual digital assets. A party that has successfully executed a 51% attack can change the ledger history so that it can, for example, double-spend tokens.
The SEC could negate the potential application of the TTA because the recent 51% attack against Ethereum Classic shows that the risk of attack against proof-of-work digital assets, especially those with a low market capitalization, is real. And although the proof-of-stake system makes a 51% attack prohibitively expensive, the SEC could justifiably claim that it is theoretically possible. An irrational, non-economic actor could still stage a 51% attack against a proof-of-stake digital asset with an intent to destroy it rather than to make profit.
In the end, the ambiguity in the bill’s language might not have a deleterious effect. It is hoped that a regulator would not strictly interpret the bill’s language to exclude the intended beneficiaries because of a hypothetical possibility of a 51% attack. So, too, the digital asset industry will likely continue to innovate new and more secure protocols that could potentially eliminate the threat of 51% attacks, making potential exclusion from the bill’s benefits a moot point. Nonetheless, as the TTA undergoes revision, the potential ambiguity in the proposed language should be remedied.