An Open Letter to the SEC

This essay is part of The Token Handbook.

This piece was originally published in a slightly shorter form in The IB Times. The goal of the SEC is to keep retail investors safe. On January 25th, Jay Clayton of the SEC and J. Christopher Giancarlo of the CFTC published an op-ed piece in the Wall Street Journal (ungated here), in which they wrote:

A key issue before market regulators is whether our historical approach to the regulation of currency transactions is appropriate for the cryptocurrency markets. … We would support policy efforts to revisit these frameworks and ensure they are effective and efficient for the digital era.

They conclude:

If history is any guide, DLT [Digital Ledger Technology] is likely to be followed by many more life-changing innovations. But we will not allow it or any other advancement to disrupt our commitment to fair and sound markets

In this direct response, I argue that we now have a remarkable chance to address market regulation from the ground up, rather than trying to fit new products into existing rules. We should adopt an evidence-based approach and find a solution that scales to meet the needs of the 21st century.

NOTE: This is an opinion piece and in no way suggests anyone doing anything outside the law as currently written and enforced. For those raising money, I recommend caution and expect existing laws to be enforced more vigorously. The radical nature of my proposal is equal, I believe, to the scope of the problem.

Executive Summary

The SEC has approached ICOs with a light touch and has dutifully gone after those committing outright fraud and a few who have flagrantly not passed the Howey test. The commission recognizes that progress requires risk, and that we’re in a period of accelerated innovation. It has taken the right approach in waiting and watching.

Regulating transactions — the purchase and distribution of financial products — has parallels with trying to regulate the source and sale of drugs. While it sounds good from a political perspective, in practice it doesn’t achieve the goals. To properly safeguard consumers, I believe …

  1. Tokenization will make many assets tradable, which will fundamentally change markets.
  2. The SEC’s mandate of protecting consumers has had limited effect.
  3. Risk is not the enemy. Leverage and concentration are.
  4. We can better achieve the goal of safe markets by focusing on consumers, not on producers and distributors.

I will first start with a section on the Howey test that helps show point #1, then I’ll move on to set the stage for my proposal: helping consumers limit exposure and build smart portfolios without intermediaries.

… tokenization will make all assets tradable without the need for intermediaries,

Part 1: The Slippery Slope

Much has been written about the Howey test applied to tokens — in the US as well as other countries. To sum up, the Howey test and its interpretation by various courts focuses on the expectations of the buyer. If the buyer reasonably expects to profit from the efforts of others, then she is acting as an investor, and what she buys is a security. Buyers of stock shares don’t want control of a company, they simply want management to do things that make the shares increase in value, so they can later sell them to others. However, as we usually find in so many other cases, this black/white distinction is not that simple to determine. Two buyers could buy the exact same thing with different intent. For example, in the case of United Housing Foundation vs Forman, the US Supreme Court found that the shares investors bought were more for apartments to live in than to speculate on. Thus, the shares were not deemed to be securities.

When people buy housing, which almost always requires the effort of others to create and improve, they always consider later resale value as well as livability. It’s very possible to buy a home for its livability and later sell it because it has appreciated so much (or so little). In the US, homes and land are not considered securities. Technically, you could tokenize and trade them individually without any licenses, even if you rely on others to do your renovations.

Two buyers could buy the exact same thing with different intent.

Furthermore, manufacturers of luxury jewelry, watches, cars, sneakers, and other collectibles know very well that if they announce a very special limited edition, collectors are usually willing to snap those up even before they go into production. Tesla has played this game numerous times — thousands of buyers pre-commit to their cars before they are built. Some of those “early buyers” speculate on the rarity of the car at the time theirs comes off the line to boost its price on eBay. Same item, different intentions.

Usually, there’s a prototype or the product is already made, but there are examples of selling limited editions just based on an artist’s sketch and a company’s past history of delivering products. This is routine in resort and condo development, again without licenses. Is that so different from today’s ICOs and SAFT documents?

High-end art collectors will often snap up new paintings by their favorite artists, or even commission works, and send them to a warehouse. They then pay consultants and staff to get those pieces into museum shows, all in an effort to game the market and profit later. They have no intention of hanging the pieces and enjoying the art. Some patrons will even support an artist during his/her early years, working with galleries and museums to promote and increase the price of the works, harvesting hedge-fund-like returns. Are those paintings securities?

In fact, there’s a web site where you can find a young person to support and participate in the profits of his/her career. Equity in people — should this be available only to accredited investors?

Even the US government plays this game. Governments make good money selling limited edition stamps to collectors, knowing that a) they won’t be used for their utility, and b) the limited edition drives sales today. Stamp collectors making money in the stamp market? Should we have stamp broker-dealers and regulated markets?

The government also takes part in the sale of lottery tickets. What’s the utility of a lottery ticket? What are people expecting when they buy one? Thankfully, the lottery industry is regulated, protecting the public from losing their money.

Toy companies, publishers, and others know that limited-edition boxed sets command not only higher sales prices but a) people often don’t open them, because pristine condition is more valuable later. What’s the utility of a toy no one plays with?

The Token Test
Now, let’s consider cryptographic tokens. Suppose we already have a great software system for doing something everyone wants — an example would be a universal smart wallet. The wallet is free, but to exchange goods, services, and crypto assets, you need to pay a small fee in tokens. This is obviously a utility token. Here are some scenarios:

  1. The creators of the system offer a very small number of tokens in an initial offering, and these tokens are snapped up immediately. To use the system, you need to buy some piece of a token from one of these early buyers. The price of the token rises as more and more people want to use the system. The majority of people buy to use the token, but a minority of people buy to sell at a higher price later.
  2. The creators of the system sell a larger number at a fairly low price. Most people can easily afford to buy themselves a year or so worth of tokens that they plan to use in the system. The token price then goes up and down in a fairly narrow price range.
  3. The creators sell the same number as before, but a TV guru tells everyone that this token is the future and is a must-have token. People bid up the price of tokens 100 times the original price in a few days.
  4. Same as before, but this time a large established company comes out with a competing system and token, and the first system ends up in distant second place. The token becomes a pure utility token with little upside.
  5. Same as before, but the system turns out to be a disaster and the project needs to be rescued by a completely new team who come in and rebuild an entirely new system from scratch. Does the increased risk make the token a security?
  6. The creators sell a large number of tokens, which are widely distributed. The price of the utility token stays very steady and goes up only very slowly for years. Then, suddenly, something comes along that makes that token exactly the thing 1 billion people now need, and the price goes through the roof. Did it just change from a utility token to a security?

This time, the system is nothing more than a white paper and a small team of accomplished entrepreneurs. They are well known and good at social marketing, so they are able to raise $20 million for their security token.

  1. Because the system isn’t built and therefore the risk is increased, is the token a security? Does it matter if the team has previously built a similar system and delivered on time? Does it matter how buyers see it?
  2. The team requires KYC and only allows individuals to invest a maximum of $5,000 — an amount any member of the public could legally blow in a casino in a week. (We effectively did this with our ICO and still raised $20 million, and a few other ICOs had many small investors.)
  3. The system is well built, fills a need, and becomes popular. The token doubles in value each of the successive five years, leading to strong gains for everyone. Volatility is low and utility of the system is high. What exactly makes this a security?

Now let’s consider from the investor’s point of view:

An investor sells his house and uses the proceeds and all his other cash to buy an early cryptocurrency that is considered by the government to be a commodity. a) he loses it all. b) he makes $100m. Is the cryptocurrency a security? Would it be any different if it were a regulated stock?

Bob and Betty make a combined $90k a year. They have $30k in savings. They decide to take a long shot and put $5k into their favorite tokens and support their favorite projects. They hope for an increase in value, but they refuse to put any more money in, they are just buying and holding and see what happens. If it goes up more than 3x, they will remove $5k and put it back into savings and let the rest ride. Regardless of how it turns out, how is this different from taking a $5k vacation and losing the money?

A smart investor knows she shouldn’t invest more than 20 percent of her investable assets into any one asset class and decides to go for it. She invests .5 percent of this allocation into 40 different ICOs that she scrutinizes carefully for scams and fraud. According to her calculations, this portfolio has about a 95 percent chance to at least return her investment amount and a 75 percent chance of beating the S&P 500.

Cryptocurrencies are highly volatile, yet they are unregulated in the US. A diversified portfolio of 100 cryptocurrencies is a high-performance/low-volatility investment, yet a token that represents such a portfolio would be a security .

The world is complex, and markets reflect that. Black-swan events can come to even the “safest,” most highly regulated markets. I hope I’ve shown that simple rules, or even interpreted ones, don’t adequately address the problem space.

Part II: Does Regulation Work?

The Howey test is designed to help protect investors. But does it? Does selling registered securities through retail broker-dealers really protect the public from making risky investments?

Gambling is regulated. As long as a casino complies with the legal framework, it can fleece the public day in and day out. The more you play, the more you lose — there is absolutely no way to gamble in a casino and consistently win without cheating. In the long run, you are guaranteed to lose. Why does the government allow gambling, then? Do people gamble because they understand the price of the entertainment provided? If so, why do so many people play at the high-stakes tables? Even though some people do lose their life savings and are ruined through gambling addiction, the vast majority of gamblers simply lose money and enjoy doing it, the same as owning a sailboat.

The more you play, the more you lose — there is absolutely no way to gamble in a casino and consistently win money without cheating.

In the same way, a lot of people enjoy “playing the markets,” and most of them do worse than buying the S&P 500. Study after study shows that uneducated consumers buy high and sell low in the equity markets, and their regulated brokers happily help them churn their portfolios to extract the highest fees possible (don’t get me started on banks). Members of the public can buy very risky stocks and derivatives through regulated markets. People can and do lose their life savings in the stock market. Intermediaries and rent seekers feed off the fees generated by complying with regulatory requirements.

So how do we know that a bunch of regulations passed in response to the Great Depression (which probably had more to do with the government adopting a rigid gold standard than it did with speculation) will help investors this century? How do we measure the effectiveness of regulation?

First, let’s look at some of the literature:

Empowering Investors: a proposal to defederalize regulation and make states compete for business, a paper from the Yale Law Review on regulatory competition.

Donald Langevoort’s paper, The SEC, Retail Investors, and the Institutionalization of the Securities Markets, asks whether the SEC’s regulations are out of date and appropriate for today’s markets.

Behavioral Economics and the Regulation of Public Offerings — how the SEC is affected by cognitive biases.

Behavioral Economics and the SEC — more on biased regulation by the same author.

REDESIGNING THE SEC: DOES THE TREASURY HAVE A BETTER IDEA? — a look at the role treasury can play in controlling leverage. Better, I think, at exposing the weaknesses of the SEC than the strengths and culture of the Fed.

Finally, I note empirically that all the well-intentioned regulating hasn’t really prevented Bob and Betty from losing their regulated bets and others from losing their savings during relatively regular financial crises, as all markets on the scale of decades are extremely volatile. I would argue that fully compliant overleverage and the policies of the Fed have more to do with investor safety than following the rules set for capital market operations. It’s possible that we will later refer to the current situation as “the failed war on financial crime.”

(In case I’m guilty of biased cherrypicking in my review of the literature, which studies support the efficacy of which legislation?)

I would argue that fully compliant overleverage and the policies of the Fed have more to do with investor safety than following the rules set for capital market operations.

In Blockchain-Based Token Sales, Initial Coin Offerings, and
the Democratization of Public Capital Markets
, one of the best treatise on the topic, Jonathan Rohr and Aaron Wright conclude:

Given the difficulty in applying the Howey test to utility tokens and even some investment tokens, there appears to be a high risk of inconsistent case law or an overly broad application of these laws when courts and the SEC are faced with questions related to this technology. … Laws enacted at a time when it was impossible to contemplate today’s wave of digital and financial innovation would have the effect of excluding everyday consumers from an entire generation of digital technology.

What to do? I think the token economy is forcing a fast re-think and, hopefully, a smart reset. Here are my thoughts on that.

Part III: Evidence-Based Regulation

I’ve tried to show that the current system is broken and is very likely to lead to continued volatility and less investor safety if it continues. Regulators cannot now and never will be able to protect investors from black-swan events.

It’s not like the commission can do A/B testing to learn which regulations lead to the best outcomes. In light of those constraints, and with the assumption that we really are going to tokenize the world in short order, and that will lead to unpredictable acceleration of innovation, I have some suggestions. This is going to sound Libertarian, but in fact my goal here is to help keep investors safe, rather than what we have today. In the spirit of helping the commission build a more effective platform, I believe it makes sense to …

  1. Measure the effectiveness of regulations, and stop those that aren’t helping investors. This would reduce ineffective regulatory burdens on market participants and companies. It may sound scary to tear down much of what has been built over the past 80 years, but such fears are not based on evidence. Some people blame deregulation for various black-swan events, but there are black-swan events with and without regulation. I believe most of the licensing, operational, and transactional regulations aren’t helping investors. As an example, because email is visible forever and highly regulated, no one uses email. Money launderers are very good at money laundering with or without regulations, and it’s not clear that anti-money-laundering laws are helping anyone but politicians. No amount of fixing AML will likely ever achieve its goals. There is too much emphasis on procedural compliance that does not have the effect of making markets safer.
  2. Stop regulating the products. If a product is a security based on the intent of the buyer, then regulating the product itself will not help keep investors safe. In the same way that the Olympics finally allowed professionals to play in the games (because the distinction between amateur and professional was impossible to maintain), it’s time to get rid of the definition of a security and let people buy and sell what they want. Plenty of individual stocks and derivatives are extremely risky, while many hedge funds are very conservative. It makes no sense to tell the public they can buy the risky option but only wealthy people can buy the hedge fund with a Sharpe ratio of 3.
  3. Stop regulating traders. Do insider-trading laws work? People who trade with insider knowledge generally don’t profit from it, because all the signals are now analyzed and responded to in milliseconds. The days of testing and licenses will wane — we will end this century without them. Instead, we’ll have smart regulation that can plug into systems and ensure that the (hopefully evidence-based) rules are followed automatically, without people in the loop. This is what my 2010 book, Pull, was about.
  4. Stop regulating exchanges. It’s very tempting to try to keep investors safe by regulating exchanges and their activities, but if people aren’t allowed to trade something, they will find a workaround. Does exchange regulation really work? As far as I know, around half of trades take place under 1 second, and some of those trades are desirable and some are not. Could removing regulations really make this situation worse?
  5. Fraud should be job #1. I’m not so much talking about securities issuance and trading fraud, because I think we need to redefine securities. I’m talking about lying, Ponzi schemes, fake companies, fake books, special favors, and other nasty tricks. Should we do this pre-emptively, pro-actively, or after the fact? We may already be using an effective solution — let people do what they do and prosecute those who are found to commit fraud. How well does that work? I don’t know. There may be other, more evidence-based alternatives.
  6. Transparency should be job #2. This is a great area for innovation. For example, blockchain transactions are recorded in public forever and are more transparent than most people think. It’s time to unleash some creativity here and double down on the requirement and enforcement of transparency. I won’t say we need XBRL for start-ups, I won’t say XBRL is a magic bullet, but I wouldn’t throw the baby out with the bath water. I do think blockchain-based tools can help tremendously with transparency.
  7. Market manipulation is rampant. After reading Dark Pools, I came away convinced that there is a definite line between liquidity providers and market participants with a systemic advantage. Even with today’s heavy regulation, there is rampant front running, pumping, dumping, market manipulation, and concentration in the markets that most people are unaware of. Much of it happens at the sub-second time scale. What to do? If the government doesn’t regulate exchanges, then there will be an explosion of exchanges and people will have a choice. We now have the technology to make exchanges safe, so they can’t be hacked (now we need to scale that technology up).
  8. Leverage is the hidden bomb that brings markets down. Leverage is very well known to the SEC, but not transparent. We must find ways to make overall system leverage more apparent to everyone, and this is where regulators really should play a stronger role. I will quote John Coffee and Hillary Sale’s paper: 
    … the incentives for financial institutions to increase leverage in order to enhance profitability are strong. This cycle is likely to repeat itself, at least so long as financial managers remain incentivized to accept high risk and “to keep dancing as long as the music is playing.”
  9. Domestic Liquidity is not where it should be. Public markets regularly have small liquidity problems and irregularly have large liquidity problems. Entire asset classes are locked up for years due to restrictive regulation. We can and should let liquid markets replace many expert market makers like venture capitalists, PE funds, hedge funds, and others. Crowdfunding platforms are small and have no liquidity, and smaller markets like AIM and the pink sheets have very little liquidity — this is all due to the design of the system.
  10. International Liquidity is held back by regulations in most countries. Each jurisdiction has such different requirements that worldwide liquidity, even in the FX markets, is lower than you might think. As we move from people trading to bots trading, international and regulatory arbitrage becomes a serious issue. Normalization and agreements could help stabilize world markets tremendously.
  11. Exposure is more important than risk. Nassim Taleb has shown that risk is necessary to move society forward, and Tyler Cowen observes that we have grown too complacent, for both structural and cultural reasons. Moore’s Law of constant acceleration is bringing several new technologies together at the same time to force rapid change. Everything from our educational system to our financial system must be re-examined for fitness. I believe The next twenty years will be very different. In that context, understanding the relationship between risk and exposure is critical. The best investor of all time, Edward Thorp, and Nassim Taleb both explain that money management and risk management are the keys to growing your money at an optimal rate. Increasing your risk is safer and provides better returns than most strategies— if you can control your exposure and build a smart portfolio.
  12. Educate Consumers on building smart portfolios. Give them the tools to increase the risk and decrease the exposure. Diversification is the missing element, and it can be automated. ETFs and index funds are just the beginning. This is true of companies and their project portfolios as well as large institutions and consumers. If we focus on reducing risk, North America and Europe will find their lunch eaten by the Asians, who have more of an appetite for risk. We should focus on exposure, not risk. Ask Ed Thorp to come advise the SEC on how to help keep the public safe.
  13. Use more carrots and fewer sticks. Regulations have been about keeping market participants in a narrow range, between free markets and tight control. I believe we should learn the lesson from the drug wars — don’t go after the supply chain. To keep up the innovation we need, we should create much freer markets and spend our money educating consumers on the merits of a beta-driven portfolio.
  14. We have been held back for too long. The financial system strains under thousands of pages of legislation and regulation, billions of dollars in compliance rents, and slow response to new ideas. I live in London because regulators here are more interested in new ideas and new approaches. Many of the world’s brightest people now regard the US as a backwater for innovation, where ideas flourish but very little can be created without first consulting a small army of lawyers.
  15. We must get serious about reg tech. As I described in Pull, we must write parameterized, executable regulations that are easily incorporated into all systems, so simply by buying something all regs are complied with and taxes are automatically paid. America absolutely must eliminate millions of federal and state jobs with technology or it will be buried under its own bureaucratic weight. Just as banks must now become technology companies, so must governments. Read and my piece on smart law to get a head start. It’s time to start hacking regulation and discovering new ways of achieving the goals I have articulated.
  16. The SEC should collaborate with entrepreneurs to create the products that help us do all the above. We should be hacking regulation. We should allow the sale of smart-beta products that today would be illegal to sell to the public. They don’t need to be regulated, they need to be promoted. Now is the time to accelerate innovation, not add more institutional brakes on the system.
Regulators cannot now and never will be able to protect investors from black-swan events.


Applying the Howey test to all the new tokens is to miss the forest for the trees. The US must lead the way in innovation, which I believe involves overhauling our platforms for education, intellectual property, health care, insurance, law, financial markets, and more. The way forward is through embracing turbulence and educating people. As with the drug wars, we should focus on consumer outcomes, not the supply chain. Rules-based approaches don’t work in a VUCA world. Governments must become much more agile.

Applying the Howey test to all the new tokens is to miss the forest for the trees.

I believe the SEC should focus more on cognitive biases and behavior than on market mechanics. Reg tech and consumer education are the way forward. An evidence-based approach to market regulation will lead us down a more effective path and to a rejuvenated American enterprise that can keep up with the rest of the world. I propose the SEC work with other agencies to educate investors and increase transparency to build the financial system of the 21st century.

David Siegel is a serial entrepreneur from the United States living in London. He is the CEO of 20|30 and the Pillar project, both of which have newsletters you may wish to subscribe to. He is the author of The Token Handbook and an essay on cryptocurrency bubbles. His full bio is at Connect to him on LinkedIn.

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