Regulation Ramp-Up

Taking A Look At The SEC’s Approach To Crypto

by Ryan Shea

Key-Takeaways

• One of the most readily apparent consequences of last year’s collapse of FTX was that crypto regulation would be strengthened and accelerated. This is now happening.
• There are two primary methods for regulators to influence and shape the conduct of market participants. They can either introduce legislation (rule-making) or they can do so via enforcement of existing rules deemed by the regulator to be consistent with prohibited actions.
• By launching lawsuits against Binance and Coinbase for operating as unregistered securities exchanges the SEC is choosing the enforcement route.
• While this method of regulation is faster, it leaves considerable grey areas and can be seen as less legitimate because it relies on interpretation of existing legislation.
• In support of its enforcement approach, the SEC has labelled several leading cryptocurrencies as securities. However, determining where to draw the dividing line between security and commodity is hard for cryptocurrencies.
• Even SEC Chair Gensler, when repeatedly asked if Ethereum is a security in front of US House Financial Services Committee earlier this year, refused to be drawn. The recent law suits will do nothing to clear up the matter either.
• The best approach, one being followed by other nation-states, is to introduce legislation and then enforce those rules so that market participants comply. The SEC’s approach so far is the reverse and, as a result, the US risks being left behind.

One of the most readily apparent consequences of last year’s collapse of FTX was that crypto regulation would be strengthened and accelerated. The reason it was readily apparent is because that is the modus operandi of governments. In fact, the SEC, which is the global regulator uppermost in crypto investors minds right now, was created in June 1934 during the depths of the Great Depression, a period which also saw the establishment of the FDIC and the introduction of the Glass-Steagal Act separating commercial from investment banking. This latter legislation was gradually repealed over the next half century, but sections of it were subsequently reintroduced in the 2010 Dodd-Frank bill, which was itself a response to the Great Recession. This is just the nature of the beast. First the crisis, then come the cavalry in the form of government officials uttering what President Ronald Reagan once described as the nine most terrifying words in the English language:

“I’m from the government and I’m here to help”.

Rules vs. Enforcement

When I say regulation, I am using this word as a catch-all term to describe government efforts to influence and shape the conduct of market participants. Governments and their agents face a choice of options. They can either introduce legislation (rule-making) or they can do so via enforcement of existing rules deemed by the regulator to be consistent with prohibited actions. Both approaches have pros and cons.

Rule-making allows for extensive debate between various interested parties, including the opportunity for public comment. Once enacted, the result is clear rules and guidance and agreed upon definitions understood by all relevant parties. Rule-making provides both legitimacy, in the sense that people have the opportunity to shape the laws enacted, and clarity. The downside with this multi-step approach is it is slow, as evidenced by the fact that the Dodd-Frank Act was first proposed in June 2009 but wasn’t enacted until July 2010.

Enforcement, by contrast, is a much speedier process as it doesn’t involve extensive debate with numerous interested parties. It can also result in more targeted action against those deemed to have engaged in misconduct. The downside, however, is that adopting such a piecemeal approach leaves considerable grey areas and does little to foster goodwill between the regulators and market participants. It also could be deemed less legitimate because it is an action taken unilaterally by the regulator based on their interpretation of existing rules, a position others may disagree with.

Back in 2000, Richard Walker, Director of the Division of Enforcement at the SEC, gave a speech “Regulation vs. Enforcement in an On-Line World¹”, examining these two respective approaches in light of the emergence of the internet age. He concluded that in the SEC’s view just because an activity was done online, as opposed offline, did not invalidate the principles that have guarded US financial markets for the past 60 (now 80) years. Furthermore, given the speed of technological advancement far outpaces the ability of governments to implement new legislation (rule-making), he clearly favoured the nimbler enforcement approach (perhaps unsurprisingly given his role at the SEC). In light of the two lawsuits the SEC issued against Binance² and Coinbase³, it is clear their mindset hasn’t changed over the two decades since the speech was made. Enforcement is how the SEC has decided to respond to last year’s events in the crypto industry.

A Question Of Security

The common theme in the aforementioned lawsuits is that both companies have been charged with operating unregistered national securities exchanges (the Binance lawsuit contains other allegations including co-mingling of client funds and wash trading) after the SEC decided to classify several leading cryptocurrencies, such as Solana, Cardano, Polygon, Cosmos and Algorand as securities. Labelling these cryptocurrencies as such means they are subject to the same registration and legislative procedures as other securities (pre-clearance and reporting of holdings and transactions), which neither Binance nor Coinbase followed.

I readily admit I am no lawyer, but the idea you can be charged for operating an unregistered securities exchange at a time when there was no clear guidance as to whether a particular cryptocurrency was a security or not seems a tad unfair. Indeed, as Walker mentions in the aforementioned speech…

“...the Commission’s most important consideration in bringing an enforcement action addressing novel conduct is whether the defendant was on notice that his or her conduct was illegal. Market participants are put on notice of illegal behavior under Section 10(b) by several sources, including: judicial and SEC precedents, SEC staff guidance, and NASD guidance, such as Notices to Members.”

SEC Chair Gary Gensler has previously indicated that outside of Bitcoin, which he views as a commodity, pretty much all of crypto is a security because his agency views them as being an asset sold as an investment with the expectation of profit based on the efforts of others – the famous “Howey” test⁴. So does that mean that the SEC has given the crypto industry sufficient notice? Perhaps, but perhaps not.

In July last year, Coinbase filed a petition with the SEC⁵ requesting that the Commission propose and adopt rules to govern the regulation of securities that are offered and traded via digitally native methods, including potential rules to identify which digital assets are securities. The sought clarity because in their view:

“Digitally native securities are recorded and transferred using distributed ledger technology and do not rely on centralized entities or certificated forms of ownership that characterize traditional financial instruments. Transactions in these securities (henceforth “digital asset securities”) are executed and settled in real time, permanently recorded on blockchains, and visible with equal access to all market participants. This is a paradigm shift from existing market practices, rendering many of the Commission rules that govern the offer, sale, trading, custody, and clearing of traditional assets both incomplete and unsuitable for securities in this market.”

Some may view Coinbase’s petition as an attempt to muddy the waters and extend the period by which they could operate while ignoring the rules – which is what the SEC accuses Coinbase of in their press release detailing the lawsuit. However, determining whether a cryptocurrency is a security or not is far from straightforward. To appreciate this we have to look no further than the SEC themselves.

What Is Ethereum?

There was one glaring omission in the SEC lawsuits against Binance and Coinbase – Ethereum (ETH). After Bitcoin, which everyone agrees is a commodity, ETH is the second largest cryptocurrency by market cap so not exactly a minor token in the crypto space. It also shares many common features with other cryptocurrencies that the SEC has deemed are securities; unlike Bitcoin it uses Proof-of-Stake as its consensus mechanism meaning it relies on a network of ETH holders to work in concert to determine valid transactions in the Ethereum blockchain.

Back in April, before the US House Financial Services Committee, Gensler repeatedly refused to be drawn into saying whether he thinks ETH is a security or not. Does the fact that ETH was not included in the recent SEC lawsuits mean that by its omission the SEC does not think it is a security? It is impossible to tell because we have no specific reference to ETH in the lawsuits. This is what I meant earlier when I said the piecemeal approach of regulation by enforcement leaves grey areas.

Moreover, if the Chair of the SEC can’t decide whether ETH is a security or not, how are crypto companies seeking to comply with SEC rules supposed to decide where to draw the line? What Gensler’s actions make clear is that determining which cryptocurrencies are securities and which are not is far from easy.

Grill Time

Source: twitter

Degree Of Decentralization

The primary reason why ETH may not be considered a security, ie. fails the Howey test, is due to the decentralization of the Ethereum ecosystem. As I mentioned in an earlier research note⁶, this argument was first put forward in a 2018 speech by SEC Director William Hinman where he stated:

“If the network on which the token or coin is to function is sufficiently decentralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract.” [Ed note: my emphasis]

On the face of it this demarcation seems straightforward, decentralized cryptocurrencies should not be considered securities, but when you get to the nitty-gritty it is more complex. For example:

- How do you measure decentralization when cryptocurrencies are held in wallets and people/entities may hold multiple wallets?

- What happens if a cryptocurrency starts off life as a capital raising token, with pre-mines that would make them more-security-like, but which becomes more widely owned as the project evolves?

- When is a token decentralized enough to no longer be deemed a security?

These are difficult questions for regulators to address because regular securities do not often see their status change. Gold is a commodity and regulated by the CFTC, but gold ETFs are classed as a security just like equities and bonds and are regulated by the SEC. No matter how widely these financial assets are owned or used their classifications will be unchanged. The same does not appear to hold true for cryptocurrencies.

Moreover, it is not just crypto industry players - who could be viewed as talking their book - that think the SEC’s classification of almost all cryptocurrencies as securities is inappropriate. Last year, a paper was published, The Ineluctable Modality of Securities Law: Why Fungible Crypto Assets Are Not Securities⁷, which makes a robust case as to why the SEC’s approach is flawed.

First-Best Approach

Given that the SEC’s lawsuits against Binance and Coinbase in no way addresses these complex issues, it would seem pretty clear that the best approach for the US government when it comes to regulating crypto is to engage in the admittedly lengthy process of introducing new legislation specific to the sector. This is the approach adopted by many other states, including the EU, which after several years of back and forth between the various interested parties, introduced MiCA legislation to cover crypto-assets not regulated by existing financial services legislation. Similarly, the UK has been progressing towards introducing crypto legislation as have Hong Kong, Switzerland and the UAE.

The risk with the SEC enforcement approach is that crypto firms simply decide it is not worth operating within US borders and they set-up in more crypto-friendly jurisdictions. For the crypto doom-mongers this may be viewed as a step in the right direction, but it is hard to see the rationale for such a position.

The crypto industry is not going away. There are almost 8 billion people alive today and only 330 million of them live in the US . Too many people – including central banks and tradfi institutions in addition to millions of users – understand and appreciate the benefits of distributed ledger technology. This list includes BlackRock, the world’s larger asset manager, which just last week announced it had filed for a spot Bitcoin ETF (which unquestionably falls under the security category) to allow its clients to gain exposure to cryptocurrencies⁸. Given their impressive track record of getting ETFs approved by the SEC (575 accepted vs. 1 rejected), the omens for the US finally getting a spot Bitcoin ETF after numerous prior attempts failed, looks pretty solid.

Furthermore, blockchain are designed to operate in a geographically unbounded manner. This makes it impossible for the US to ban them. All US users seeking exposure to cryptocurrencies have to do is fire up a VPN service and magically they are “electronically” offshore. Worse, because they are interacting with entities offshore, which puts them beyond the reach of US regulators, they are effectively forcing US crypto users to operate in an unregulated environment, which is something the SEC is supposed to be tackling. Their stance, at least to me and many others, is all downside with next to no upside.

Cart Before The Horse

Let me end by making something very clear. I have been quite critical of the SEC’s approach to regulation but that does not mean I am against regulation. Regulation is needed in crypto. Indeed, as I pointed out in a research note published a year ago, regulation will be a powerful driver for increasing crypto-adoption because people feel more comfortable investing in something which is overseen by the government. However, regulation needs to be implemented in a thoughtful, inclusive manner generating clear guidance and rules so crypto projects and their users are well-positioned to leverage blockchain technology. The best approach, one being followed by other nation-states, is to introduce legislation and then enforce those rules so that market participants comply. The SEC’s approach so far is the reverse. It is putting the cart before the horses and the risk is that in doing so the US will be left behind.

Until next time.

Ryan Shea, Crypto economist

1See: https://www.sec.gov/news/speech/spch413.htm

2See: https://www.sec.gov/news/press-release/2023-101

3See: https://www.sec.gov/news/press-release/2023-102

4See: https://www.investopedia.com/terms/h/howey-test.asp

5See: https://www.sec.gov/rules/petitions/2022/petn4-789.pdf

6I first mentioned his speech in a previous research article examining crypto staking – see: https://trakx.io/interest-ing-times-part-iii/

7See: https://dlxlaw.com/wp-content/uploads/2022/11/The-Ineluctable-Modality-of-Securities-Law-DLx-Law-Discussion-Draft-Nov.-10-2022.pdf

8See: https://www.reuters.com/business/finance/blackrock-close-filing-bitcoin-etf-coindesk-2023-06-15/