Rule or Be Ruled: Crypto Regulation and Innovation
Self-regulation will always be a challenge, but if somebody’s going to be in charge, it might as well be me — Daniel Akst
We don’t need no stinkin’ rules
Whether you agree with the idea or not, more and more regulations are coming to the crypto space. Financial regulators in the United States are already cracking down, with the Securities and Exchange Commission (SEC) and the New York State Department of Financial Services (NYSDFS) leading the way. They are doing this because a large percentage of crypto projects are already heavily regulated because of their function.
While a crypto promoter might characterize an investment as a token, or an ecosystem, or a platform, what the SEC hears is ‘investment contract.’ Whether or not something offered for sale is an investment contract is determined (in the US) by the Howey test. The Howey test came from the 1946 case SEC v. Howey Co., where a citrus grower sold strips of land to out-of-town buyers visiting a resort hotel owned by the grower.
…a large percentage of crypto projects are already heavily regulated…
If a visitor bought land and a 10-year service contract (to plant, tend, and harvest the fruit) they would receive a percentage of the profits from the harvest within the parcel. The SEC sued and the Howey test was born. The three-pongs of the test are:
- The investment of money
- In a common enterprise
- With a reasonable expectation of profits from the efforts of others
This is what the court said in Howey (emphasis mine):
Thus, all the elements of a profit-seeking business venture are present here. The investors provide the capital and share in the earnings and profits; the promoters manage, control, and operate the enterprise. It follows that the arrangements whereby the investors’ interests are made manifest involve investment contracts, regardless of the legal terminology in which such contracts are clothed. The investment contracts in this instance take the form of land sales contracts, warranty deeds, and service contracts which respondents offer to prospective investors. And respondents’ failure to abide by the statutory and administrative rules in making such offerings, even though the failure result from a bona fide mistake as to the law, cannot be sanctioned under the Act.
This case made it to the Supreme Court. The lower courts tended to agree with the idea that the form of the investment was land sales and service contracts, so they should be governed by real property and contract law. Whether you agree with the Supreme Court or not, this case set the stage for the SEC and the functional regulation of crypto assets today. They haven’t been resting, just look at all the crypto related enforcement actions the SEC has brought recently. That list is only going to get longer — but it doesn’t have to.
Thanks a lot, you moved too fast and you broke things
Mark Zuckerberg’s infamous quote, ‘move fast and break things’ typified the internet age. Everything from taxis to record labels to television studios suddenly found themselves upended by tech disruption. Consumers gained noticeable improvements, but at a cost we are only just starting to understand, let alone pay. Meanwhile, the tech innovators became corporate behemoths that are now fully aligned with legacy corporate interests. In other words, tech companies became part of the problem they claim they set out to solve, and in many ways, made the world much worse.
With that in mind, right now the crypto space is at a crossroads. The early pioneers of crypto seemingly embraced the ‘move fast break things’ mantra and they have. Right now I can log onto Coinbase and purchase early seed round and venture capital investment contracts (crypto assets) with no income qualification, while receiving minimal disclosures, and with almost no regulatory oversight. The last time I would have been able to do a similar thing in the United States was the 1920s.
Tech companies became part of the problem they claim they set out to solve
Back then, they didn’t call them ‘tokens’, but stock exchanges were widespread, and just as full of fraud and false promises as the crypto space today. Much like today though, regulators saw value in raising capital through a market mechanism. This is why stock trading was not banned outright. This is also where the regulatory framework stock traders live in now was created.
To be certain, regulations did not prevent fraud, they just made it much harder. At the very least, the regulators wanted to ensure potential investors were: 1) able to afford losing money; 2) being given honest, credible information before they invested; and 3) able to seek legal remedies from a national authority. Before the SEC, various state ‘Blue Sky’ laws (named after fraudsters selling the ‘blue sky’) governed equity sales.
But what would happen is a stock promoter would sell bogus equities in one state and when the authorities chased after them, they would just move on to another state. Once in the new state, the previous state’s regulators couldn’t touch them, so they were free to set up the scam all over again. This cat-and-mouse game was stopped by the national authority of the SEC.
Like then with stock markets, I think it is pretty clear regulators see value in crypto assets. The head of the SEC has a dedicated email address for DeFi developers to contact her about, well, anything really. This is what she said:
In a recent speech I requested input from digital assets market participants (citation omitted). Unfortunately, that has not yet yielded much of a response from a community that often says it lacks necessary guidance from the SEC, among others. My door remains open, and I welcome your ideas. I’ve created a dedicated mailbox for this purpose: crenshaw-defi@sec.gov.
I believe it is critical for crypto pioneers to engage with prudential regulators. I mean, think about it…the HEAD of the SEC gave them an open invitation! Why wouldn’t they? Any other course is bordering on madness.
Look, the internet changed the world forever and broke a lot of things along the way. Cryptographic digital ledgers, cryptocurrencies, Non-Fungible Tokens (NFTs), Decentralized Autonomous Organizations (DAO), artificial intelligence (AI), and all of the other innovations coming down the pike are going to make the internet look like a steam locomotive. The internet changed the world, and not always for the better. If crypto pioneers are not careful, they could shatter it.
Or, they could fix it...
Move fast and fix things
Remember, the SEC is not the only regulator involved in crypto. There are the Treasury Department and the Financial Crimes Enforcement Network (FinCEN), the Comptroller of the Currency, the Commodities Futures Trading Commission (CFTC), and the Internal Revenue Service (IRS) all poking their noses into the world of crypto. At their core, what these regulators want to ensure is the crypto space is free from crime, fraud, and dirty dealing. All except the IRS of course…they just want a cut of the pie.
Just think for a minute what unregulated crypto markets have given us so far. As just one example, there are probably several thousand ‘whales’ that can move markets, or quite literally make or break new projects. How a bunch of pseudo-anonymous, completely unregulated individuals scattered around the globe controlling the fate of millions of crypto holders and projects in their hands is somehow better (or safer) than the Federal Reserve, or a bunch of bankers is not clear to me. This is not even considering the huge issues with Tether and USDC that are absolutely going to cause major disruptions and losses for crypto investors very soon.
Make no mistake, those two examples are major, potentially catastrophic problems. I also believe there exists in the mind of someone, somewhere, a technical solution to those problems. Likewise, I think fraud is a problem. I also believe there exists someone, somewhere that has a technical solution to that as well. Same for financial crime, tax evasion, corporate malfeasance, government corruption, and any number of other things. The big questions are: will crypto pioneers incentivize those solutions? Or, will they incentivize ever-expanding problems?
Maybe just one or two rules…
Remember, banking and finance regulations were solutions to fraud, crime, and unfair dealing in the past. They are terribly imperfect — so much so, they have become a major source of risk today. But, the people that created those solutions did not have the technology that we do. Right now, crypto has the potential to destroy the old system and simply hope the one that emerges is better. Or, crypto can reorient itself to prioritize and incentivize better solutions than the ones our grandfathers came up with.
It won’t be easy. But so what? I believe crypto represents one of the first, best, legitimate opportunities human beings have ever had to make the world fair and equitable for everyone. We have the potential at our fingertips right now. I just hope we don’t burn it all up in the quest for treasure.
Nevertheless, this process has to start with self-regulation. Whether it is a decentralized, autonomous regulatory function, or a human made regulation through association, or something else, it is imperative that crypto pioneers start thinking about these issues. If they can create legitimate, fair, workable, and scalable solutions to these problems that are superior to what regulators can offer, the regulators will stand aside and the space will blossom. If they keep following the ‘move fast and break things’ motto, the regulators will impose order. The space will still grow, but it will almost certainly benefit corporate interests at the expense of everyone else.
Rule or be ruled. Innovate and break, or innovate and fix. The choice is yours and mine and everyone else involved in crypto. Question is, what are we going to do about it?
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