On Infant Industries and Regulation

For a regulatory framework to be effective, it needs to be tailored with precision to serve the dual goals of (x) mitigating risk and tamping down acts of fraud and malfeasance while (y) still enabling innovation and growth.

Especially in the context of an infant industry, it is incumbent upon regulators to nurture and support the space. While some governments have historically protected these economic ecosystems through trade protectionism, at a minimum, regulators should be flexible and an encourage innovation in their oversight and guidance of the space. As a function of oversight, they are able to set appropriate guidelines for behaviors in furtherance of public policy goals such as consumer protection. However, these guidelines must be in a form that is carefully crafted as not to erect unnecessary barriers to entry or unduly burden operations in order to support (rather than stifle) the growth, stability and long-term prospects of the market and the participants in the nascent economic ecosystem. The need for permissive regulation has been especially true for the crypto space — where the technology is still being developed and incubated; where many projects are not yet live and the use cases not yet implemented; and where it is hard to predict where the space will move next.

While some have criticized the SEC for making sweeping pronouncements that apply to the space (myself included at many times) —namely, that all ICOs they have seen to date are securities offerings, in retrospect they have shown great restraint in the space. This is apparent in conversations with the staff but also overtly apparent when compared against, say, New York, China and a number of other jurisdictions that have regulated the space at various times both proactively and reactively, with less than ideal outcomes.

The SEC, overseeing a market in which the overwhelming majority of token issuers have been out and about pre-selling tickets with a surprising degree of success to roller coasters that are not only not yet built but may ultimately be a tilt-a-whirl or, less ideally, a private yacht for the ticket salesman, has reacted in a measured manner. Watching over the space from a high level, they have carefully stepped in to set guidelines when warranted (or, from their perspective, reinforce existing law and actively tamped down fraud. By framing their pronouncements around what they have historically seen, they leave the door open for future projects to begin a dialogue with them to help guide token projects for which a securities law framework is inappropriate.

This measured approach is not without its drawbacks. There has been a yawning gap in the last several months in terms of public guidance or other regulatory movement that would help dictate to the market how to satisfactorily comply with securities laws in the token offering space, to the extent a project is attempting that path forward. Many securities token projects are attempting to navigate a potential catch-22 of structuring tokens and offerings to avoid 12(g) and TEFRA issues while running into uncertainties caused by the lack of accounting guidance in the space — this may serve to hinder attempts at successful registered token offerings in the space for those compelled to register (noting there is no platform to list on, as the ATS platforms are still in development and not yet live). Many are coming up with workarounds, but absent explicit regulatory buy in, the appetite of some for embracing these workarounds has chilled in the wake of the SAFT.

At the same time, token projects that attempt consumer facing tokens and currency-like instruments (ie. privacy coins, and stablecoins) have a similarly murky path forward. The SEC, by using this facts and circumstances test, while flexible and capable of shifting to cover the technology as it evolves, is taking on an incredible administrative burden for an agency with finite resources and a broad mandate. To the extent you tell this market that a“facts and circumstances” test applies / that there are no bright line rules/ that prescriptive guidance would be a “waste of time” while inviting projects to begin a dialogue to help get clarity — all parties involved in that resultant dialogue should expect that it will not be an efficient process as it is a significant time commitment (on a project-by-project basis and a more macro level) and amounts to a side gig for an agency that has its plate more than full overseeing Wall Street.

Though the SEC’s approach is time consuming for all parties involved, it is appropriate for this market. It has had the (likely intended) effect of chilling new market entrants as well as some of the less than ideal practices in the space. It has made the market aware that existing laws and regulations apply; of the need for best practices (see the Brooklyn Project’s framework for consumer tokens) and self-regulatory organizations in the space; as well as the need to provide disclosures to protect the token purchasers (whether characterized as investors or actual consumers; see the FTC’s past involvement in the space and upcoming workshop) and end-users of their product offerings, once live. In this SEC imposed cooling off period, market participants can reflect on the goings on of the crypto capital markets to date and evaluate the tensions of fitting into existing securities law frameworks through the lens of co-authoring a path forward. It is through increased dialogue that pain points will continue to be identified, as well as corresponding solutions. As SEC Commissioner Hester Peirce recently offered up in a balanced and thoughtful speech touching on the role of regulators before the Medici Conference on May 2nd:

I hope more people come to talk to me. I still have questions. For example, I understand that some issuers are conducting ICOs as private placements under Reg D. Does that approach work? Is there anything about our regulation of private placements that just doesn’t work with tokens? Should Reg D be revised in any way? Are other exemptions being used? How are those working? Where are the pain points? What can we do differently? How can we think through when a token that starts out as a security turns into something else? How should our thoughts on that question affect trading platforms? How should governance structures affect how we look at ICOs? What are some potential applications of distributed ledger technology in the securities space?

Again, while imperfect, the SEC’s approach is a reasonable and light touch way to approach the space. As we have seen from the New York’s proactive attempt to regulate the space through the BitLicense regulations (though some would argue reactive as it was passed in the wake of Mt. Gox),broad and rigid regulatory frameworks age particularly badly in this space. Equally unproductive are the reactive knee jerk legislative and regulatory responses to reported ills in the space, such as the crypto mining bans, moratoriums and tariffs as well as China’s ICO ban and giving in to the temptation to label things you are unable or unwilling to attempt to understand as fraud and only used to further terrorism and crime. Regulators have the responsibility to protect main street consumers and of the various approaches taken in so doing, the current lack of certainty around a securities law compliant path forward is decidedly more palatable than having no path forward.

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