The crypto community is willing to take extreme actions to avoid the dreaded “Security” designation, due to a very real concern that securities laws would dramatically increase costs for both entrepreneurs and crypto trading firms.
As a result, there is a strong incentive to classify as many digital assets as possible as something other than securities. This has led to the recently introduced Token Taxonomy Act, which is seen by many as a great step forward.
Unfortunately, while it will help clarify what can be traded by markets that aren’t regulated by the Securities and Exchange Commission (SEC), this approach ignores fledgling digital assets that are securities, which could result in the U.S. being left behind in that evolving market.
This could be extremely troubling, as I believe that over the next couple of decades, all assets will ultimately be traded digitally, to take advantage of its true global, multi-currency capabilities. Even if one does not agree with my bull case for digital assets, It is sad that being classified as “securities”, due to a regulator devoted to investor protection, is the designation that an entire industry is seeking to avoid.
Before delving into thoughts on a way forward, it is important to understand how the current situation evolved. The laws that created the Securities and Exchange Commission (SEC), as well as many of the rules the SEC have written, were created in direct response to the excesses that triggered the Great Depression.
That era featured incredible leverage, rampant market manipulation, significant information asymmetries and a wide variety of “get rich quick” scams. The resulting rules accomplished many noteworthy things , such as the structure for stock exchanges and self regulatory organizations (SROs), rules that specify the amount and conditions for individuals to access margin loans, and establishing a framework for regulating asset managers.
They also, however, set many arbitrary restrictions, including rules that limit public trading to established companies, and those that limit private investments to the rich exclusively. (I have often thought that it strange that only rich people are allowed to buy stakes in startup businesses, but everyone can buy lottery tickets or gamble on sporting events.)
Other rules established requirements for custodial and transfer agent functions that are irrelevant to digital assets, and created significant reporting requirements that, most often, go unread.
That said, it is important to understand that the Securities and Exchange Commission (SEC) views its primary role as protecting investors, while facilitating capital formation. As a result, when faced with the fraud that characterized the 2017 ICO boom, no one should be surprised by their extreme negative reaction.
Moreover, when the trading venues for these products refer to themselves as “exchanges”, despite ignoring best execution obligations and being late to embrace the concept of “fair and orderly markets”, it has been a pleasant surprise that the SEC has been as measured in their approach as they have been.
Lastly, one can’t ignore the uniquely U.S. situation regarding regulatory jurisdiction. We have separate regulators for Financial Futures and Commodities (CFTC) and Securities (SEC), which complicates matters and encourages lobbyists to attempt regulatory arbitrage between the two.
With those facts in mind, the conundrum facing the SEC and CFTC is how to provide a more efficient path forward for digital asset issuers, including startups and newly created assets, as well as for companies involved in the secondary trading of those assets. It is particularly important to recognize that a feature of digital asset platforms is that they are global, meaning that platforms are often based overseas and serve investors from all over the world.
This type of innovation could dramatically reduce costs and improve liquidity for investors and issuers alike, so should, therefore, be encouraged, not rendered impossible by U.S. centric rules.
To accomplish that goal, there is a path forward, but it will require an adoption of principles-based regulation rather than enforcing the current gordian knot of rules.
The key principles should be for digital asset investment opportunities to be available to all (not only the rich), for issuers to be held to consistent and applicable disclosure standards, and for exchanges, other market centers, OTC desks, and agency trading desks to have best execution obligations in addition to upholding principles of fair and orderly markets.
Specifically, if I were to put together a “wish list” for the digital asset industry, it would include the following reforms:
- Streamline the Reg ATS (Alternative Trading System) process and allow for an expedited “digital broker” designation to operate such systems, including foreign owned and operated entities. This would allow existing crypto exchanges a path to compliance and would allow cryptocurrencies (those assets deemed to not be “securities”) to be traded on the same platform as those which are securities.
- Allow all investors that complete an appropriate questionnaire and acknowledge receipt of risk disclosures to invest in digital assets. Such an approach is used for trading options, which are equally risky and it works well. It makes much more sense than restricting digital securities to “accredited” investors that are defined as those with sufficient net worth.
- Allow broker dealers that deal in other asset classes to provide services for digital assets without forcing a 4–6 month FINRA review. This would facilitate firms trading crypto and security tokens, with the same policies and procedures for both, that respect best execution and other key principles.
- Help the digital asset industry to form their own SRO (Self Regulatory Organization) to govern digital asset exchanges, trading desks and brokers. It is important for the industry to understand that this would not be an advocacy organization, but rather a regulator that would focus upon investor protection.
- Rewrite/propose new disclosure rules to apply to startup or very new companies as well as new asset backed securities. Requirements that assume the need for significant operating history block the public from investing in early stage companies or assets, or force new companies to acquire “shell” companies that serve no useful purpose.
- Reform transfer agent, custodial and other rules to consider digital assets. Current rules were designed long before blockchain technology existed. (One example is the nonsensical idea that “miners” who mathematically validate “on chain” transactions should be regulated as broker dealers. This might be true based on the letter of today’s archaic law, but makes no sense as these firms have absolutely no discretion in the transactions they are validating. I believe that people are lobbying for such a designation to exclude public blockchains from consideration for capital market uses, which would be bad public policy.)
If such an approach were taken, it could go a long way to eliminating the current idiocy where firms avoid trading assets that might be securities, or avoid the U.S. altogether.
As an aside, such an approach could also help alleviate the current crisis in publicly invest-able assets, where, due to paternalistic regulation, private companies are limited to the rich, depriving the average investor, regardless of their qualifications, the ability to participate. I strongly suspect that the ability to raise money from the general public via digital assets with fully disclosed voting rights and revenue participation would be broadly appealing to both issuers and investors.