SEC Chair Gary Gensler recently reiterated the SEC’s longstanding position that as far as they are concerned, Bitcoin is not a security, while most other digital assets are. Gensler didn’t say that BTC or BCH aren’t securities: he said that Bitcoin is not a security, specifically thanks to the unique circumstances of its creation and issuance.
Which of course begs the question: what is that original Bitcoin? And where does Gensler’s assessment leave the many forks that have branched off the original since its creation? Most importantly, why does any of this matter, legally or otherwise?
The term Bitcoin refers to a networking and database protocol described and published under the Satoshi Nakamoto pseudonym in 2008. The system which adheres to that description is Bitcoin: any system which does not, is not.
As Gensler acknowledged to NY Mag, Bitcoin is viewed differently from other digital asset networks because of its unique origin story. Satoshi Nakamoto issued all 21 million Bitcoin in January 2009, and specified a fixed algorithmic system that governs the circumstances under which coins are released ie Proof-of-Work mining by nodes. No coins were pre-mined and Satoshi, the issuer, has no input in the release of these coins beyond the initial design of the system. As soon as the entire issuance was complete Satoshi was only as able to get Bitcoin the same way anyone else was: by getting in line and mining.
Perhaps most importantly, the protocol underpinning Bitcoin was always designed to be fixed and not subject to revision (“The nature of Bitcoin is such that once version 0.1 was released, the core design was set in stone for the rest of its lifetime,” wrote Satoshi Nakamoto in June 2010).
These circumstances matter because of how securities are defined: whether or not a digital asset offering amounts to a security is governed by the Howey test. Under Howey, an offering will be a security if:
- There is an investment of money
- The investment is made into a common enterprise
- The investment is made with the reasonable expectation of profits
- That expectation of profits is reliant on the efforts of others
The lack of any pre-mine by Satoshi is important, because the courts have interpreted pre-mining as a signal to investors that the issuer ‘is motivated to work tirelessly to improve the value of its blockchain’ for itself and purchasers (see SEC v LBRY). In other words, it is taken as a sign that investment was made with a reasonable expectation of profits reliant on the efforts of the issuer. The algorithmic process governing the release of coins without input from the original issue matters because under those circumstances, it can’t be said that there is any common enterprise capable of investment: the nodes of the network are acting competitively.
That the protocol is fixed also matters: constant revisions to the protocol require centralized control that is exercised by some defined group. Absent centralization of that kind, it’s very difficult to argue that any sort of investment in Bitcoin was done with the expectation of profits reliant on the efforts of others. Add that control in, and not only is a given asset offering highly likely to amount to a security, but the developers are also likely to be acting as fiduciaries toward those using their blockchains: see recent commentary from the U.K. Court of Appeal in Tulip Trading v Van der Laan and Ors or Angela Walch’s much-cited paper, “In Code(rs) We Trust: Software Developers as Fiduciaries in Public Blockchains”.
So, when Gensler says that Bitcoin is not a security or refers to its unique history, this is what he is referring to. This was the legal character of Bitcoin as it existed in 2009 and continues to exist in 2023 as Bitcoin SV.
Where does that leave BTC, BCH and similar knock-offs?
The term Bitcoin can only refer to a system that adheres to the white paper. Any deviation from the protocol described by Satoshi Nakamoto in that document is no longer Bitcoin, because the original Bitcoin protocol was designed to be fixed and not subject to revision. The fixed nature of the protocol is a key pillar in Bitcoin’s ability to serve as peer to peer electronic cash and its ability to serve the needs of businesses: a protocol that is fixed can be embraced and relied upon by businesses and builders indefinitely, without the threat of regular changes to the fundamental protocol threatening to break all that relies on it. To illustrate, consider the TCP/IP protocol governing the internet: that protocol has remained fixed since inception, which has enabled the development and flourishing of the application level above it. If the underlying TCP/IP protocol were subject to constant revision, then the applications build atop it would need to be modified or even discarded each time. If that were the case, the world would not have been able to rely on, for example, email as the indispensable communications platform that it has remained for decades. The same can be said for Bitcoin: a fixed and unchanging underlying protocol is required if Bitcoin and all of its capabilities are to be relied on in business and everyday life.
Despite all this, Satoshi’s decision to hand off development to others in 2010 has led to attempts to change the underlying protocol of Bitcoin. This occurred despite the fact that Nakamoto remains the steward of the protocol and the issuer of all Bitcoin in existence. These changes have resulted in a number of ‘forks’ away from the original protocol, and though such forks have attempted to retain (illegally, it turns out) the Bitcoin name, they are not Bitcoin.
Chief among these offshoots is BTC, or Bitcoin Core. This offshoot was created by the core of developers who seized control of Bitcoin following Satoshi’s exit and implemented a number of centrally-planned changes to the protocol which break from the Bitcoin defined in the white paper.
The most radical of these early changes was the SegWit update in 2017, which took the extraordinary step of removing digital signatures from Bitcoin transactions and putting them in a separate data structure in order to (ostensibly) help Bitcoin scale alongside an ever-growing number of transactions without increasing the cap on block size. In reality, this didn’t help scaling at all (the so-called ‘problem’ of scaling is little more than a myth, as demonstrated by the original vision for Bitcoin which scales perfectly without any hard cap on block size) and only served the developers in charge, as it pushed users of the network off-chain and towards Lightning Network, a second-layer commercial solution owned by those very same devs.
The change was a radical departure from Bitcoin: the white paper makes clear both that signatures are an inextricable part of the system and that Bitcoin was always meant to scale on-chain via a fixed protocol. To move data off-chain in an effort to scale is to somewhat defeat the purpose of Bitcoin, which is to create a system of secure peer to peer electronic cash that is public. Moving that data onto a layer 2 network is a solution to a problem entirely of the devs own making (the imposition of an arbitrary block size) with the added benefit (to some) of obscuring the authors of transactions made with Bitcoin.
Each significant departure from that protocol has two related effects: the chain ‘forks’ so that newly changed protocol splits from the original Bitcoin protocol, and there is created a new coin issuance based on the new protocol whereby the new coins are ‘airdropped’ to holders of the original. So, for example, when the SegWit update created a fork and split off from Bitcoin, every Bitcoin holder was airdropped the new, covertly issued BTC coin. Attorney and tech commentator Zeming Gao put it best in his recent article, “Even BTC is a security according to the Howey test”:
“Every time when the actual underlying blockchain changes the base protocol that not only affects transactions but also affects the automated unilateral contract originally offered by Satoshi, the coin is no longer the original coin. From that point on, any coin that continues on the changed blockchain is materially a new coin offered under a new contract. Further, the continuous issuance of new tokens to miners is also under a new mining contract different from the original unilateral contract offered to miners by Satoshi. This makes the reissued tokens and new tokens both a security, collectively or separately, even though the original bitcoin was a nonsecurity. It does not matter what name or ticker it carries, nor what the market price it receives. This is because the market is not the factfinder for this matter; it simply votes according to whatever information it was fed, and in this case they were fed deceptive information.”
The most important implication here is that just as these changes fork away from the original definition of Bitcoin, so to do they fork away from the original, SEC-compliant issuance. In other words, none of the factors which ensured that Bitcoin is not a security apply to the forks. The consequence is that these subsequent issuances amount to illegal, unregistered securities offerings. Which means that at any point, these systems are liable to be hit with an SEC enforcement action the likes of which killed LBRY and XRP.
There’s another giant reason this should matter to anyone holding one of these forks: the taxman. BSV is the continuation of the original protocol, but the likes of BCH and BTC are forks. Each time a chain undergoes a hard fork in response to some network change, the forked coin is airdropped to all of the holders of the original. This airdrop is considered income by the IRS and is therefore taxable as such. This position was confirmed explicitly by the IRS in 2014 via Notice 2014-21. Which means holders of Bitcoin at the time it was forked into BTC (August 2017) and BCH (November 2018) owe income tax on the airdropped coins entailed by the fork:
“A hard fork occurs when a cryptocurrency undergoes a protocol change resulting in a permanent diversion from the legacy distributed ledger. This may result in the creation of a new cryptocurrency on a new distributed ledger in addition to the legacy cryptocurrency on the legacy distributed ledger. If your cryptocurrency went through a hard fork, but you did not receive any new cryptocurrency, whether through an airdrop (a distribution of cryptocurrency to multiple taxpayers’ distributed ledger addresses) or some other kind of transfer, you don’t have taxable income.”
Even ignoring the concerns of the SEC and IRS, those responsible for these drastic departures from the Bitcoin protocol and the continued misuse of the Bitcoin name are discovering that their actions have profound legal consequences. A number of individuals and entities who have been using the Bitcoin name to market these unrelated products have been hit with passing off claims in the U.K. potentially worth billions: those being sued include the individual developers of BTC but also those members of the broader ecosystem who enable the misuse of the Bitcoin name: companies like Coinbase and Kraken, who continually promote BTC as Bitcoin despite the fact that BTC bears little to no resemblance to the system described in the white paper. The developers are also discovering that their exercise of centralized control over their knock-off protocols have enormous legal consequences: they may well be proven to owe fiduciary duties to those who use their networks which would compel them to, among other things, return access to stolen digital assets to their rightful owners.
It must have seemed no big deal to hijack the original Bitcoin and transform it into something else entirely, but as Gensler and the deluge of lawsuits these hijackers are now facing demonstrate, such actions have severe legal consequences.
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