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Crypto exchanges are dead Pt 2

This article is part 2 of a 2 part series, you can find part 1 here

In the first article we argued that utility tokens should have a hard upper ceiling on what value they can achieve and should carry no real arbitrage opportunities. Which also means that exchanges that are reliant on trading such tokens should see decreasing trade activity and there is no real prospect of a price recovery or growth on a number of crypto tokens making them a basket case if you viewed them as an investment in the first place.

In this article we will highlight an even more pressing problem as far as crypto exchanges are concerned. The SEC is going after crypto exchanges for operating unregulated securities markets

Simply put this dusts up the security vs utility token debate and puts a second order consequence into spotlight. A number of ICOs passed themselves as utility tokens to get around security regulations. There are several reasons for this, which vary from entrepreneurs not having enough appreciation of security regulation to a desire to avoiding paperwork to outright scams. Whatever the reasons may be on an individual case by case basis, a number of these ICOs clearly exhibited attributes that a security would exhibit.

For instance in the US, you have something that is called the Howey test

  1. It is an investment of money
  2. There is an expectation of profits from the investment
  3. The investment of money is in a common enterprise
  4. Any profit comes from the efforts of a promoter or third party

Very very few ICOs can legitimately claim that they would not fall under the Howey test. Personally I believe apart from Bitcoin and Ethereum, almost all others fall under one or more of the above clauses.

But before we dive into details lets take a quick recap of what these token sales really are. Taking the example from the last article, where you want to build a casino, and you don’t want to or are unable to attract investor partners for your venture. So what you do instead is create a bunch of chips and sell them to the general public as a kind of pre-sale. The premise is that these chips can be then used to play in the casino once it is built.

The so called tokens are analogous to the chips. The premise behind the ICOs is to have potential future users of your system to fund the development of what they deeply care about. But to say that only potential users of all these systems participated in token sales is a bit of stretch. You had people scooping up tokens who essentially perform the same role as ticket scalpers.

Scalpers for all the negative attention they attract perform a vital role, they ensure that the show gets the necessary funds on time and then they resell the tickets at a higher price in due time to interested buyers. Often times those putting up shows do not have the necessary marketing budgets to attract attention from the intended audience in time. A smart scalper would identify good shows in advance and performs a necessary economic service by making funds available faster to the performers.

In the same vein there is nothing morally wrong with those who participated in ICOs and looked to sell the tokens at a higher price at a later date. It is a necessary economic service and makes it possible for good projects to come to life.

However it is an investment of money and there is an expectation of profit. And often times projects like DAO involve common enterprise, where many people come together and co-ordinate their efforts in the pursuit of profit.

The list of projects that fail under the common enterprise test is long. And once you add the expectation from profits from a 3rd party’s efforts is even longer. For instance NEO distributes transaction fees to its token holders. Closer to home Havven has a similar model for its stable coin. To claim that these transaction fee distributions are not akin to dividends is a stretch. I personally think both NEO and Havven are great projects backed by a superb bunch of people.

But they are securities, plain and simple. And any exchange which allows trading in them is running a securities exchange and needs to have suitable authorizations.

Guess how many crypto-exchanges actually have such securities trading authorizations? Hardly any.

This is a time bomb whose fuse is already lit.

Closer to home ASIC takes a slightly different, even more restrictive view. If you conduct token sales for a platform that is yet to be built then it is deemed as falling under the Managed Investment Scheme regime. Using that logic, even Ethereums original sale would be a security sale in ASICs view as Ethereum did conduct its sale without having a real platform in place in order to finance its build.

This article is not meant to be a “Holier than thou” or “I told you so” badgering. Personally I am all for innovative financial solutions, but I also believe in a rules based order. I believe rules exist not to stifle entrepreneurship but to provide a predictable framework under which business can operate and prosper.

For instance if there were no rules around how we should drive on roads. No traffic signals, no right of way, no restrictions on which side of the road we should drive, what would happen. Well we would have crashes galore and no one would get anywhere.

By the same analogy, rules especially in the financial world exist to preserve its integrity and make it work smoothly.

Securities unlike real property cannot be touched and felt. They represent a share or claim on something else. For instance if you were selling shares in your home, you divided it into 100 shares and sold it to potential investors. What prevents you from creating and selling thousand more shares in the same property to others. And what prevents you from selling shares in a property that you already have sold to someone else or did not own in the first place?

All these scams have already happened in some shape or form in the securities world over the last few centuries. Regulation in financial world exists to prevent scamsters from having a field day. Regulation is what protects trust, the key currency that makes the financial world move.

But that brings us to the key arguments, which proponents of crypto make. Crypto and Blockchain eliminates the need for a trusted 3rd party. So there is no need for external regulation in a trustless future.

That is however an incorrect assessment.

While Blockchain does eliminate the need for a trusted 3rd party to enforce transactions, it does not do anything on its own to prevent fraud.

Lets come to the original issue of why a regulator would have a problem with an exchange trading securities without having the necessary authorizations. And no it has nothing to do with them trying to be the man.

In a securities market, assets are traded every minute every second. Investors make a buy and sell decision based upon whether or not they think the market value of the asset reflects its true inherent value or not. In order for them to make that judgement call they need to have all the latest information they need in real time and everyone should have the same information at the same time.

If company directors were allowed to dump shares because they knew that the company has lost a major contract and withheld that information from the market, then that is an injustice to other investors. It is also called insider trading and is appropriately deemed a crime.

One of the oldest scams in the securities markets is called painting the tape. A buyer and seller who are in cahoots with each other will buy and small a small amount of stock with each other repeatedly at an increasing price. The rest of the market would be none the wiser that it is not a real price but an artificially inflated one. At the peak, the scammers would offload the bulk of their holdings and exit the market at the expense of others who would have bought it thinking the price is going up based on some fundamentals.

Securities trading opens up a myriad of opportunities for fraud. And it is the responsibility of the market operator to put in the right procedures to prevent them. A securities market license comes with the requisite obligations to ensure that investors are provided the latest information in real time, insider trading is prevented, paint the tape scams are nipped in the bud and so on.

A well regulated market that has all these checks and balances would actually protect investors. And it is high time that these requirements are applied to all exchanges whether or not they claim to trade securities.

Some day in the future someone will develop systems/frameworks that handle all these protections as an integral part of the platforms functionality. But in the meantime token exchanges are toast. Most of the tokens they trade are clearly securities and most of these exchanges neither have the necessary market making licenses nor do they have the appropriate procedures to protect investors.



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