SEC vs Crypto
How the SEC is trying to lay claim to the burgeoning Digital Asset space
The Securities and Exchange Commission (“SEC”) has been in the criticized in the crypto community for its lack of clarity regarding crypto. The SEC is trying to carve out a niche for itself in the digital asset space, something it is expressly prohibited from doing as regulators draw their power and remit from Congress.
The role of the SEC
The SEC is an independent agency of the Federal Government, created during the peak of the Great Depression in 1934. It is responsible for enforcing Securities laws in the United States. Their stated mission is to protect investors, facilitate capital formation, and maintain fair, orderly, and efficient markets [1].
The traditional definition of a security
Securities are fungible and tradable financial instruments used to raise capital in public and private markets. There are primarily three types of securities [2]:
· equity — which provides ownership rights to holders
· debt — essentially loans repaid with periodic payments
· hybrids — which combine aspects of debt and equity
The US Supreme Court gave a broader definition of securities through Howey vs SEC (1946). The case produced the Howey Test, which relies on four prongs to determine if a transaction qualifies as an investment contract and can therefore be considered a security [3]. An investment contract exists if:
· there is an investment of money
· in a common enterprise
· with the expectation of profit
· to be derived from the efforts of others.
What does this have to do with crypto?
Cryptocurrencies or digital assets are a nascent asset class that defy traditional regulatory definitions. Some digital assets are native tokens of an underlying Distributed Ledger Technology (“DLT”). For example, ETH is the native token that secures the Ethereum blockchain and HBAR does the same for the Hedera Hashgraph.
However, some crypto tokens are simply used as funding instruments for new projects that may have little merit. In this instance, the project founders could issue an ERC-20 token on the Ethereum blockchain to be traded on the open market. This token would serve no use other than as a funding instrument for the project and a promise to exchange the ERC-20 tokens for native tokens of the new DLT when it goes live. The EOS ICO in 2017–2018 is one famous example where $4.4 billion was raised by the issuer, Block.one [4].
Other tokens may only serve a narrow utility within a particular platform. For example, the now bankrupt FTX crypto exchange issued their own ERC-20 tokens that were used to trade various digital assets on their platform [5].
Given these nuances in how digital assets are used, this leaves a lot of regulatory uncertainty.
Ripple is building the future of Cross-Border Payments
Ripple is a FinTech based in San Francisco that wants to create “the internet of value.” In simple terms, they want value to move as quickly as information does today using the internet [6]. They were valued at $15 billion in 2022 [7]. They were also listed as one of CB Insights FinTech 250 companies in 2022 [8]. Their flagship product is called “On Demand Liquidity” (“ODL”). The solution utilizes XRP, the native token of the XRP Ledger, as a bridge asset to facilitate cross-border payments. The solution provides several advantages over traditional payment rails:
· Settlement in 3–5 seconds instead of 3–5 working days [9]
· No need to prefund accounts around the world in different currencies
· Payments not bouncing or being lost in limbo — this is compared to SWIFT’s 6% error rate [10]
XRP and the XRP Ledger serve as the infrastructure for “The Internet of Value”
Many people mistakenly refer to XRP as Ripple. This may be because of the symbiotic relationship between the XRP Ledger and Ripple in the early years. The mistake of not creating a clear difference in naming was another mistake.
The XRP Ledger, built under the name “Ripple,” was created in 2012 by David Schwarz, Jed McCaleb, and Arthur Britto. David Schwarz is also the Chief Technology Officer of Ripple and has been with Ripple since 2012 [11]. The three founders built a more efficient version of Bitcoin that was purpose-built for payments. Instead of using Proof of Work (“PoW”) to secure the network, their new ledger has no validator incentive for securing the network. Validators can “gossip” about bad actors and thus ensure there is a trusted list of validators at any given time to secure the network [12]. The founders minted 100 billion XRP at genesis. This is the maximum supply which actually decreases over time as each transaction burns a tiny portion of XRP. The original name for XRP was “ripples.” This changed to “opencoin” in 2013. Not long after, the current name, XRP, was adopted [13].
The network is decentralized, with no one party controlling a majority of validators. There are 150 validators of which 35 are on the trusted node list (“UNL”). Ripple only runs 2 of these trusted nodes [14]. Other UNL node operators include University College London, Haas School of Business, University of Waterloo, Coil, Digifin, and Brex.
SEC vs Ripple: An Ongoing Battle for Clarity
The SEC filed the lawsuit against Ripple in December 2020, claiming that Ripple and two of its executives violated US securities laws by selling XRP, beginning as early as 2013 [15]. The SEC has a high bar to clear to emerge victorious in this case. They need to first prove there exists an investment contract between Ripple and the buyer of the XRP. After satisfying this requirement, all four prongs of the Howie Test need to be satisfied for the sales to constitute securities transactions.
Since retail investors bought their XRP on secondary market exchanges, they could have been buying the token without knowing about Ripple. In terms of satisfying the Howie Test, the SEC is also on shaky ground. John Deaton, a lawyer representing over 70,000 XRP holders through amici status [16], tweeted that the SEC claims that even if one person acquired a token expecting a profit that token must be a security [17]. This was in relation to the SEC vs LBRY case. This is clearly not a correct application of the law. If we extend the SEC’s logic, any acquisition of gold or oil would also constitute securities transactions since some market participants will speculate on the future price of those commodities.
The judiciary has handed down some unfavorable commentary on the SEC’s approach to the Ripple case. Magistrate Sarah Netburn handed down a ruling in July where she criticized the SEC’s motivations for pursuing the case against Ripple, writing the SEC is pursuing its own legal agenda and not following a “faithful allegiance to the law [18].”
Some of Ripple’s customers have actually joined the fight on Ripple’s behalf. TapJets, a private jet chartering company, and I-Remit, a remittances company, have filed amicus curiae briefs in support of Ripple. Amicus curiae means “friend of the court,” the same status John Deaton uses to represent XRP holders.
TapJet’s legal team stated,
TapJets has adopted XRP, invested in technology to accept, process, and account for this digital currency, and now has an interest in the outcome of this litigation. TapJets rightfully fears that by losing the ability to accept XRP, TapJets business will suffer losses, both financial as well as a loss of goodwill with thousands of clients who use XRP as a form of digital currency/payment.”
I-Remit echoed concerns about losing the business value derived from using XRP, stating,
“I-Remit has been an active user of ODL since 2019. ODL is useful for I-Remit because XRP and the XRP Ledger lower the cost of real-time payments and allow greater customer access to currency markets with a high level of speed and security. On an annual basis, I-Remit accommodates the utilization of XRP to process and payout remittance transactions equivalent to hundreds of millions of US dollars.”
“Contrary to the SEC’s insinuation in its lawsuit and summary judgment motion, Ripple does not pay I-Remit to use ODL or XRP; I-Remit uses ODL and XRP voluntarily because they benefit I-Remit’s remittance partners. Simply put, the SEC’s allegations misunderstand the extent and function of ODL’s usage, thereby also misunderstanding the purpose of XRP [19].”
Despite these promising developments, John Deaton has gone on record that the case may only be concluded several months into 2023. Brad Garlinghouse, Ripple’s CEO, has stated that he expects the case to be wrapped up by the end of H1 2023 [20].
Implications for the Crypto Industry
Given the SEC’s reluctance to provide any clarity on any digital asset besides Bitcoin, it leaves every other crypto project vulnerable to attack. The SEC Chair, Gary Gensler, has said that Bitcoin isn’t a security due to its decentralized nature, calling BTC a commodity [21]. However, he has never provided a framework to explain why Bitcoin is sufficiently decentralized. It is possible he is referring to Bitcoin’s extremely high Nakamoto coefficient, the minimum number of nodes required to disrupt the blockchain’s network. Bitcoin boasts a Nakamoto coefficient of over 7000, while most blockchains are well under 100 [22]. To be fair to the altcoins, Bitcoin is much older than the later generation blockchains and the community has had more time to decentralize Bitcoin’s supply and mining hash power.
Gary Gensler’s unwillingness to comment on Ethereum’s status as a security is in contrast to the infamous Bill Hinman speech of 2018 which labeled Bitcoin and Ethereum specifically as non-securities [23]. The Ethereum blockchain’s move to “Proof of Stake” (“PoS”) from PoW has been flagged by Gensler as potentially centralizing influence on the network’s governance model. This raises serious concerns for the almost 1,000 ERC-20 tokens on the Ethereum network [24]. Many smaller projects will not have the resources to take on the SEC in a legal battle. It is likely that many projects would need to close shop or leave the US entirely to continue to operate. Ripple has been able to survive the SEC onslaught because of its unicorn status: the company will have spent well over $100 million on the SEC lawsuit when it’s all said and done [25].
All of this has been taking place while Congress, the branch of government responsible for providing legal guidance, has failed to move speedily on issues relating to digital assets. However, the FTX blowup appears to have forced The House Financial Services Committee and Senate Banking Committee to look at crypto regulations more seriously [26]. Ron Hammond, Director of Government Relations at the Blockchain Association expects “[legislation] to come a lot sooner than folks expect” and that “nothing spurs legislation like a crisis.”
The lack of regulatory clarity in the US market has pushed innovation abroad at a time when the US, like the rest of the world, it trying to recover from a spate of global crises relating to energy security, the COVID pandemic, war in Ukraine, and rising inflation. Ripple has stated that despite being based in the US, 95% of their customers are outside of the country [27]. Brad Garlinghouse has stated that the company will leave the US if the SEC emerges victorious from the lawsuit [28].
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