The Fight Over the Fate of Cryptocurrencies (Part 2)
What the Future Holds
In case you missed it, check out part 1
What to Expect in the Next Few Rounds
Despite the uncertain future for ICOs, nothing will stop the growth of blockchain technology. The advent of cryptocurrencies represents an opportunity for improved efficiency, transparency, and democratization. It represents the opportunity to not only change the way we do business, but the way that we live in tomorrow’s global world.
The SEC may have won round 1, but it won’t win this fight. The SEC stepped into the ring against ICOs in exactly the same shape with the exact same fighting style it has employed for the past 85 years.
From my vantage point, it’s clear the agency brought a knife to a gunfight.
Meanwhile, ICOs are younger, hungrier, and ultimately, more powerful. Like Marciano, the cryptosphere has power, grit, heart, and it is unpredictable. ICOs used round 1 to read their opponent, and now they know what they’re up against. They know the SEC’s power and its limitations.
The SEC will do what it’s always done. As with any governmental agency, it is reactive, not proactive. And, at the pace the cryptosphere is going, the SEC can’t possibly keep up.
For starters, any ICO being launched internationally that cares about what the SEC might do will take further steps to protect themselves from SEC reprisal. One way of doing this is by asking users to certify that they are not US citizens or blocking the donation addresses from US based IP addresses. These attempts are easily skirted, although they’d help an organization concerned about SEC action.
While some cryptocurrencies tout the transparency of their blockchain, there is an increasing demand for privacy of transactions and fungibility of crypto-assets being met by cryptocurrencies like Monero, PIVX, ZCash, and others. An update coming soon to Ethereum will include enhanced privacy. It’s easy to envision a future where transfers of value from an investor to an organization go from pseudonymous to anonymous. Regulation at that point will be close to impossible, particularly if the organization is open-sourced, decentralized, and exists on a borderless governance platform like Aragon.
And, the cryptosphere isn’t a snake. Even if the SEC manages to cut off its head, like the hydra, two more will grow back. Except not two heads, but 20 or 100 or 1000. Just look at any decentralized or peer-to-peer network in the history of the Internet. First, there was Napster, then Limewire, Kazaa, BitTorrent, Pirate Bay, then Pirate Bay again, and on it goes. Attempt after attempt to eliminate the sharing of information (legal or not) was met with an even more capable platform. We are witnessing the same innovation, only this time the tech community is moving faster, and it will revolutionize finance, information, privacy, community economics, and the intermediaries that facilitate them. Regulation will come, but so will the metamorphosis to sidestep it if it stifles progress.
It’s easy to forget that we are talking about a globally accessible network of easily transferrable funds. Trying to pinpoint where jurisdiction begins and ends, and who is held accountable for a decentralized organization’s actions, puts us back in murky waters. This is a fast moving new world, and the traditional regulatory agencies of yesterday move about as fast as, well, governmental agencies.
This burgeoning industry is vast and complex, and the use case of each of the hundreds of tokens and coins varies wildly from one to the next. The attraction of cryptocurrency to many is the low barrier to entry and the lack of gatekeepers stifling innovation from small players. It should not go understated that a group of individuals with some experience, an idea, whitepaper, and alpha product can raise millions of dollars of capital in a matter of hours. Never before have we seen such a radical shift of capital liquidity across borders. The system is being primed with the hopes of affluent return by easy investment, and you can count on losses. The one-two punch of speculative greed and significant investor losses screams for SEC oversight. And, while those two things aren’t necessarily positive in a vacuum, shaking existing power structures and disrupting the millennia old coupling of nation and currency is a pretty darn good thing in my book.
Sure, some blockchain tech is partnering with institutions and will, without a doubt, revolutionize fintech, distribution channels, cross-border payments, and more. Look at the Ethereum Enterprise Alliance or Ripple’s partnership with banks for a glimpse at how private institutions are recognizing the power of this technology. Partnering with existing, established players in saturated industries means that these endeavors are years and years away from viability. Moreover, it feels like a feeble attempt by established industry players — whether they are in finance, energy, or other industries — to rein in a growing threat to their very existence.
The SEC won the first round against cryptocurrencies, but it will eventually be outpaced by the rate of innovation in this space. And, in the next round, the questions will only get harder. When a future DAO 2.0 exists only in code, with no proclaimed owner or CEO, how will the SEC respond? Decentralized exchanges already exist and will only become more popular. Cryptocurrencies will become more private and secure. Then where does the organization exist, who has jurisdiction over this DAO 2.0, who is held accountable for violating the SEC’s definition of securities? Is it everyone that holds The DAO 2.0 token? How would that be tracked or enforced? What is it going to take to stop a US citizen from sending cryptocurrencies to an address during the contribution phase utilizing a private transaction?
In the end, regulatory agencies like the SEC, the nation-states they regulate, and the idea of borders will begin to crumble as its ability to control currencies and patrol its citizens’ wallets does as well.
How Will We Possibly Manage Without All That Regulation?
We’ll be just fine. I don’t say that because I think the SEC is irrelevant. The SEC still matters. For now. Like most of the U.S. regulatory framework, the SEC’s days were already numbered because its version of regulation is less effective than new versions rolling out. We’re seeing a paradigm shift from Regulation 1.0, which describes how the federal government operated before the digital age as well as how it continues to lag behind in the digital era, to Regulation 2.0, when the market itself provides the regulation. To understand what I mean, let’s take a brief walk back to the 1940s when W.J. Howey was peddling citrus grove leases.
Back then, it was difficult to get information on anyone. The world was just about to see the invention of the computer, although we were three decades away from the mass marketing of them. You couldn’t look someone up. Police departments weren’t networked online. There was no Google search. No Yelp. Mass communication was hitting its stride courtesy of the radio and telephone. Newspapers, of course, had been on the scene for quite some time. Those means of communication are only good for spreading a small sliver of relevant stories and information. You can’t inform the general public about the quality of a certain doctor’s work via the radio. You can’t call everyone and tell them he stinks. Any information passed along is done orally on the phone. The friction of transmitting information via means like these is much higher than those available today, thus limiting their reach and impact.
In our modern, globally connected village, you are the sum of your digital identities. Your LinkedIn skills are vetted by prior connections, business performance rated on Google, Yelp and the like, and credit score rated by centralized agencies (a whole other area ripe for innovations in efficiency). In other words, increasing aspects of your persona and reputation are more efficiently catalogued and communicated by digitally accessible means.
The information can shared so readily and easily accessed. A post online, for example, reaches exponentially more people and is permanent — so permanent, in fact, that the European Union has laws labeled The Right to be Forgotten.
My point is that there is so much information out there that a consumer who makes a buying decision without performing due diligence is being willfully ignorant. The information is out there — even for major financial investments. While it is the responsibility of the seller to not misrepresent their product, the responsibility of research and due diligence lies squarely on the investor in the case of potential investments. I am reminded of the purpose of the Securities Act of 1933 — disclosure, not merit-based review. When the 73rd United States Congress passed the ’33 Act they couldn’t envision the level of disclosure we have today.
Admittedly, the rapid entrance of new actors provides few heuristics on which to gauge the reputation of potential investments. In a burgeoning industry without regulatory recourse, there is concern for potential loss of investment and fraudulent activity by bad actors. And, that is, after all, the stated aim of the SEC: to force disclosure so that the public can vet offerings and protect themselves to the extent within their control to do so. But, there are a number of more efficient ways to mitigate this counterparty risk and visibly audit potential investments (see the proposed Topl protocol), especially in the crypto-verse.
Is every regulatory entity worthless? Of course not. But, the cost-benefit calculus is shifting daily. The opportunity lost to US based investors and blockchain startups due to overreaching regulations will only deprive us of an inevitable wave of innovation and wealth transfer. We need the paternalistic oversight of federal agencies less and less, meanwhile the offsetting cost of their regulatory hand grows daily. Regulation is meant to be a balancing test, and Regulation 1.0 is overweighted. It fails what my friend, Scott Mylin, calls “the blank sheet of paper test.”
All this change scares the bejesus out of modern day regulators — partly because they are well meaning and believe in their mission, and more partly because they don’t understand the future and are heavily invested in perpetuating the existing structure.
While cryptocurrencies are not an investment for the average, risk-averse individual, its power is yet to be realized. Scams, buggy wallet UIs, fragmented and lacking services, stalling transaction capacity, and lack of accountability for stolen funds — all these problems and more need to be sorted out before bitcoin or a similar coin is ready for mainstream use.
These issues, however, are being sorted out at a rapid pace. There is a breakneck race among hundreds of cryptocurrencies and blockchain projects to lead the space, and failures are all part of the process. We shouldn’t be afraid or surprised when projects inevitably fail — failure is a step on the path of progress.
Benefits of the End of the SEC’s Reign
I’m not an anarchist and I don’t want to level every facet of the government. Perhaps if we did away with licensing laws and securities regulation, we would need to regulate information and reputational portals, which would become that much more important.
And, it’s not that I don’t think the SEC brings any value to the table. It certainly does. They have played an important role in regulating our capital markets, which are among the largest and most sophisticated in the world. Throughout the years, the SEC has ebbed and flowed, tightened and relaxed, as needed to account for developments and innovation in society. As a recent case in point, look at the Jobs Act and the changes allowing companies to raise money with more general solicitation and through crowdfunding from non-accredited investors.
Regulation has benefits. For example, increasing regulation of ICOs will weed out some scammy offerings and increase the perception of legitimacy. That, in turn, may encourage more risk-averse investors to participate in ICOs. It would also allay the concerns of investors who don’t want to partake in what some describe as “Ponzi schemes.”
However, regulation also carries tradeoffs, and in the digital world we have alternative options for vetting investment opportunities that far exceed the limits of Regulation 1.0. These other options are often more effective than the SEC-style status quo, which carries plenty of deficiencies.
1It’s expensive to hire lawyers to wade through murky waters and comply with constantly-evolving securities regulations. Registering securities comes with a whole lot of hoops to jump through. Not all companies have the resources and wherewithal to comply with the SEC rules.
2 Regulation 1.0 can chill innovation by increasing barriers to entry, thereby raising costs of innovating. If every new method of raising capital requires registering with the SEC or spending a lot of money on lawyers, cryptocurrency startups may be stifled. Of course, federal agencies are aware of the stifling effect of overregulation, but sometimes a particular administration or leadership of an agency prioritizes enforcement over encouraging innovation, particularly if that regulation favors the already entrenched institutions that stand to lose from said innovation. We are, after all, talking about how people make money and survive in the world — regulators regulate. We shouldn’t be surprised when they err on the side of over-regulation.
In the digital economy, there are far fewer “gatekeepers,” and the ones that exist keep the gates up to allow both entrepreneurial innovation and a wave of wealth moving from traditional institutions and currencies to digitally native, decentralized platforms and stores of value. In contrast, Regulation 1.0 carries a healthy dose of paternalism, where an arm of the government says, “We know what’s best for you, trust us,” while still playing catch up to the whirlwind of advancement happening in the cryptosphere.
3In a world of increasing transparency, with so much feedback and information available online, the need for disclosure regulation under federal securities law is decreasing. I think about this as a licensed lawyer. At this point, is licensure primarily about helping consumers or about protecting the licensees? I’ve heard arguments that we should do away with law licensing. Let people learn the trade and practice. With online reviews, there is a deterrent for poor performance. And, it’s caveat emptor for the purchaser or services that doesn’t perform some level of diligence. This argument gains steam every day. It’s not that a law degree has zero value; it’s that what the degree says about your lawyer is much less important than their online reviews and general reputation. That’s not an easy statement for me to make, having dropped six figures on an Ivy League law degree.
4We need to ask ourselves how long the regulatory arm of a national government organization can possibly reach into an industry that has no center. If you foolishly wanted to cut the head off this hydra, you would struggle to find one. ICOs, coins, tokens, decentralized autonomous organizations, blockchain tech — these innovations are not only disrupting the way money moves around the world, or the way data is stored, but each head of the growing cryptocurrency hydra challenges the very existence of intermediaries in an older, inefficient system that no longer requires them.
The Inability to Regulate at a Worldwide Level
The SEC isn’t the only regulatory body that’s about to have the rug pulled out from underneath it. Inefficiency plagues the bureaucracies that make up our federal government, and there are daily innovative ideas and projects that have the potential to usurp roles that whole departments of our government play currently. More on this in a future article.
Our world is going virtual fast and regulation remains a decidedly local endeavor. Granted, the SEC covers the entire US and any international companies looking to enter the US, but its jurisdiction ends at our border (borders which I argue will not follow us into the future). Those jurisdictional limits were fine 20 years ago when international investment was the purview of only large public companies. Today, all 7 billion of us are connected, and entrepreneurs are able to raise funds from investors all over the world. If you want to invest in a Chinese or Japanese entrepreneurial ventures, that’s easily done. And the methods of making those investments have become available to mass market participation. Local regulatory frameworks aren’t built for where the world is going.
It makes most of us feel good that a space is regulated. A central authority giving its stamp of approval? That’s a source of trust. However, as organizations, financial services, contractual fulfillments, and more become decentralized, we will find ourselves in a society where trust is based on something other than what a government agency says. There will be no need for a central authority because general consensus will take its place. How that plays out in the regulatory space remains to be seen, but it will play out.
The decentralized movement is too hungry, too powerful, and too aligned with the future of the world. Most importantly, it will have numerous positive outcomes, like leveling the playing fields and making the world more equal by shifting capital and lowering the costs of competition. Trying to reconstruct old barriers will prove to be a futile endeavor, and will only prevent U.S. based institutions and investors from benefiting from this next stage in the global economy.
What’s Next
The SEC will most likely issue more decisions in the coming weeks and months. This could mean that the pipeline of ICOs for the rest of 2017 and beyond just got a whole lot tighter. In fact, the SEC recently suspended trading shares of a firm called the CIAO Group over concerns about the accuracy of information regarding their ICO.
Other nation-states are joining the SEC by stepping into the ring. Canada recently expressed its position that many of the ICOs it has investigated are securities offerings, opening a host of regulatory requirements for these offerings and the exchanges that list the resulting tokens. There are other movements underway to control the cryptoverse and you can count on plenty more. Many of these regulatory attempts will be well intended, and many others initiated to keeping the status quo.
We are in the midst of a radical overhaul of global structures, although it will only look like overnight change 50 years from today. In the near future, this fight may look more like a bar room brawl rather than a heavyweight bout. But, don’t bet against the heart, grit, power, and will of the ICO challenger.
What’s Next for You?
Admittedly, I’m no expert in the field of cryptocurrency. But, my experience as a VC during the dotcom era and 20+ years as a business attorney make this transformative industry fascinating to me. If you’d like to check out more of what I have to say about business and business law, check out my Texas business law firm. I love to hear the innovative and interesting things my readers are up to, so don’t hesitate to reach out here or by phone at 512.888.9860.
