It’s Been A Long December…For Crypto
December was an exhausting and hectic month for crypto. Statements from regulators, new proposed laws going to hearing, new tax bills, market swings, issues with exchanges, and a rash of prosecutions and enforcement actions have made for a bumpy and confusing ride, for crypto market participants and advisers alike. I was contemplating how to approach discussing all of the changes and activity in the sector over the last month, when a friend and client forwarded me this article. The tl;dr is given distributed ledger technology (“DLT”) has been around for ten years, and hasn’t produced any ‘killer apps’ or use cases beyond criminality, maybe there simply is no good use for the technology at all.
It’s a well thought out critique, but suffers from a problem that afflicts observers, within and without, of both crypto specifically and the tech sector(s?)* overall. To illustrate what I mean, let’s talk about use cases, computers, and quantum mechanics for a moment. (Bear with me, I swear this relates to crypto).
Quantum theory underlies the entire information age, from supercomputers to your cell phone and everything in-between. The groundwork for the application of quantum theory to practical problem-solving was laid at the beginning of the 20th century. It wasn’t an easy process; Einstein himself is supposed to have derisively remarked “God does not play dice” in response to the theory. Its first application was quite literally a ‘killer app’: nuclear weapons. Quantum mechanics didn’t get its wings until its marriage to another technology: digital computing. Although first invented in 1946, initial applications for digital computing were quite niche; it was decades before the first mass-use computers hit the market. The internet was similarly niche in its early days, and lets face it — the early internet was at least as much a den of criminality and socially-unacceptable behavior then as bitcoin is sometimes accused of being now. So, despite the extreme inherent value of quantum mechanical applications, it was a roughly a century to get from initial development to socially-acceptable use case.
Perhaps you see where I’m going with this.
Technological adoption, and determining its best application, is a drawn-out process that is driven as much or more by social considerations as anything else.** Finding the best ways to apply DLT, and developing its implementation to the point where it is sufficiently reliable will take time. More importantly, it will be a necessarily social process. It will require an open and ongoing dialogue between users, investors, developers, and yes, even regulators and governments. The last is important for a couple reasons beyond staying out of jail. First, they’re the best proxy we have for the will of entire social bodies (for now). Second, although technology changes and evolves quickly, human behavior generally does not.*** Speaking as a practitioner in the common law tradition, history gives us a pretty good guide to the types of social problems new technology both creates and solves; laws and cases tend to simply reflect that accumulated experience, and can help us avoid having to proverbially reinvent the wheel.
With all that in mind, let’s dive into some of the recent developments, and see what we can divine about the possible future for crypto from the ongoing dialogue between said parties.
Crypto Regulators, part deux
U.S. regulators — particularly the Securities & Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) — have been astonishingly active over the last several weeks. U.S. regulators continue to take a measured and nuanced approach to crypto markets. Rather than issue any kind of outright ban, as some other nations’ regulators have done, the SEC continues to signal its adherence to a case-by-case, fact-based approach to analyzing ICOs and other securities issued in crypto markets. Federal regulators have also confirmed the unusual level of inter-agency coordination and unified approach being taken in regards to this sector. As I’ve previously discussed, the importance of these facts cannot be overstated. It is rare enough to see this level of concerted effort and coordination across multiple regulatory agencies; it is much easier and simpler to simply ban the worrisome transactions.
Jay Clayton’s statement was informative. The comments were measured, and endorsed tokens as an innovative means for funding new projects, while repeating long-held concerns about fraud and investor protection. He directly addressed a long-standing concern of mine, that of the so-called ‘utility’ tokens and their characterization:
“Merely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security. Tokens and offerings that incorporate features and marketing efforts that emphasize the potential for profits based on the entrepreneurial or managerial efforts of others continue to contain the hallmarks of a security under U.S. law.” [emphasis added — keep that in mind when we get to Munchee, below]
I should note that he was firing a shot at my own sector, chastising attorneys and other professionals for not doing our jobs properly.
This ongoing, even-handed approach is emphasized by the recent enforcement actions. Like with the DAO, the recent proceeding against the Munchee ICO did not result in any punishment; rather, the promoters were simply required to unwind the deal. (They wisely complied). Conversely, actions against outright frauds, ponzi schemes, and other blatant bad actors have been more aggressive. It seems the SEC is acting on Jay Clayton’s prior concerns about fraud in the crypto sector. Specifically, this bifurcated approach is best understood as at least partially driven by regulators’ desire to see DLT develop free from public rejection due to pervasive fraud or lack of transparency.
The Munchee ICO order itself was pretty limited, and already covered well over at Coindesk. Here’s the short version: “if it looks like a duck, and it walks like a duck, and it quacks like a duck, it’s probably a duck.” Munchee explicitly emphasized the investment-like nature, opportunity for returns, and management activities to optimize those returns in its offering. Talismanic references to ‘utility’ and timing don’t shield an offering from the securities laws. If you market something as an investment opportunity and specifically engineer your management activities to treat it as such, guess what — you’re probably marketing a security!
While they’ve been particularly precocious, the SEC hasn’t been the only regulatory show in crypto over the last month. Bitcoin derivatives went live in the U.S., and despite a subsequent price correction, have not precipitated a financial crisis as some feared (yet, anyway). This has given investors a way to get exposure to BTC without having to exit fiat; a strange idea to many in crypto, but one that will help bridge the gap for many normal investors until the mechanics of custodianship and investment in crypto assets becomes more intuitive. And while many countries continue to crack down on cryptocurrencies and token offerings, Swiss cities are experimenting with blockchain-based identity systems, and French regulators authorized trading of unlisted securities over a blockchain.
That’s worth pausing on. They’re effectively regulating towards disintermediation and undermining the position of traditional intermediaries in those markets. This highlights an important point, one that U.S. regulators have also hinted at: some governments and their regulators see the inherent value in DLT. More importantly they are potential allies in the quest for disintermediation. Powerful ones. Ones that crypto will need.
“Gain not your friends by bare compliments, but by giving them sensible tokens of your love”
History tells us what happens with unsupervised ‘penny stocks’ and similar investment instruments; they are susceptible to pump-and-dump, fraudulent, and market manipulation schemes. Much of securities law derives from this baseline historical understanding. As the SEC put it, “[securities] laws provide that investors deserve to know what they are investing in and the relevant risks involved.” That’s eminently reasonable, and the serious misalignment of incentives in many projects conducting ICOs would be improved by adhering to that basic principle of disclosure. It seems regulators would also prefer if you didn’t actively defraud people. I think we can all agree this is a good idea.
The litany of ICO actions for age-old frauds emphasizes the historical continuity of human behavior; crypto is not going to change people’s propensity to lie, cheat and steal. The regulators have come because, on a basic level, they embody long-standing social understanding about how and why people misbehave, and protections against those behaviors.
Initial use cases for novel technologies are 1) often in socially vilified niches and 2) frequently don’t do anything new. The internet’s first great commercial use was adult entertainment. That’s normal; new technologies often provide services to market segments that are underserved or subject to high rents/inefficiencies, because that’s where they can compete and develop. However, to grow beyond these niches and prove the technology more than a refuge for criminals and hucksters requires a longer-term vision.
Building a new decentralized world will not banish leviathan; network protocols are rather like regulations, in that they effectively embody rules of social governance. The need to obtain buy-in from bodies politic was inevitable. Furthermore, the crypto goal of full disintermediation of information, identity, and financial systems faces powerful and entrenched incumbents, from Silicon Valley to Wall Street. The way for the crypto community to sate leviathan is to demonstrate a commitment to doing the right thing in the first instance: by being transparent, rejecting fraud, and recognizing that tokens which are intended to represent consumer services should not be designed, marketed, and managed like speculative investments. This won’t just improve the substance of the market; these are the tokens that will gain crypto the friendship of both government and the general public.
*Is there really one tech sector at this point? I mean, honestly, almost everything I own has a computer chip in it at this point.
** Case in point: all of the predicate technology for the industrial revolution existed in 3rd century B.C.E. Alexandria, but never took off because (amongst other things) the labor shortages of late-Enlightenment Europe didn’t exist. There was no need to apply steam technology and so forth to the purpose of saving labor because labor was already cheap and plentiful. It would be another two millennia before industrial technology came of age.
*** Anyone who doubts this point and is up on current geopolitics should familiarize themselves with the Thucydides Trap.