TL;DR: In the United States, perhaps no regulatory body has as much influence as the Security and Exchange Commission upon traditional financial markets. Recently, Commissioner Hester M. Peirce spoke to the University of Missouri School of Law about the delicate balance, near tightrope walk, high wire act, of at once “protecting the public while fostering innovation and entrepreneurship,” in pursuit of what the law school termed “optimal regulation.” With some in the community hoping Bitcoin ETFs someday come into effect, others are beginning the tedious work of reading what amounts to tea leaves in an attempt to divine where the agency’s thinking is at when it comes to cryptocurrencies as a whole and the issue of securities.
SEC Commissioner Hester M. Peirce on Regulation Inside the Machine
At about the four hour mark, MizzouLaw began of live stream of Peirce’s talk on February 8th, 2019 to a symposium audience. She’s a coveted speaker due, of course, to her politically appointed position in the Trump administration, but also because of her interest in cryptocurrencies and presumed favorable opinion of them generally. Parts of the ecosystem have even dubbed her, Crypto Mom.
In her speech, Regulation: A View from Inside the Machine, Peirce gives an overview of the agency’s importance to markets, and how the challenges always seem to come down to themes such as decentralization. “Blockchain-based networks offer a new way of coordinating human action that does not fit as neatly within our securities framework,” she explained.
“Satoshi Nakamoto, in the white paper that introduced bitcoin to the world, envisioned a ‘network [that] is robust in its unstructured simplicity,'” and continued to give a rough outline of nodes and networks. “The objective of many of these blockchain projects is to build networks that run on diffuse contributions, rather than to create centralized entities that run networks. In the end, there may not be anyone steering the ship,” she said.
Tokens as Investment Contracts
Peirce also stressed, “Tokens sold for use in a functioning network, rather than as investment contracts, fall outside the definition of securities,” a line widely cheered by enthusiasts, especially those tied to initial coin offerings (ICOs). Attorney Patrick Berarducci argued, however, “But there’s still a lot of confusion about whether and when a token itself is an ‘investment contract’ and therefore a ‘security’ under US law.” He’s a lawyer for ConsenSys and The Brooklyn Project, which are owned by Joseph Lubin, a co-founder of Ethereum, a blockchain deep into tokenization.
The issue of clarity on such matters is not small, as now literally billions of dollars of tokens are sloshing around the world, with many more such projects waiting in the wings. The most popular iteration of tokens are derived from ERC-20s, and some proponents of them believe SEC foot-dragging and rumor has put downward pressure on prices. Fewer might want to hold or buy a token which could be regulated out of existence or worse (lawsuits and jail time).
“Specifically,” Berarducci continued, “if there is an ‘investment contract,’ is the token itself the IC or is there some type of formal or informal agreement surrounding the token (e.g., sales agreement, informal ‘services’ agreement based on sales promises) that constitutes the IC? Or both?” He reminds readers tokens are really just “usable software” rather than securities as anyone has previously understood the term.
“Yet many of these projects begin in a centralized manner that looks about the same as any other start-up,” Commissioner Peirce insisted in her remarks to law students. “A group of people get together to build something and they need to find investors to fund their efforts so they sell securities, sometimes called tokens. The SEC applies existing securities laws to these securities offerings, which means that they must be conducted in accordance with the securities laws or under an exemption. When the tokens are not being sold as investment contracts, however, they are not securities at all. Tokens sold for use in a functioning network, rather than as investment contracts, fall outside the definition of securities.”
Berarducci argues Peirce’s comments are “in the context of a project becoming ‘truly decentralized,’ and, as I explain, that’s not a sufficient trigger for the SEC allowing usable software to shed status as a ‘security.’ The core problem with this approach is not disclosure obligations. Most projects are happy to provide transparency, and if there were clear disclosure requirements, I’m confident projects would comply,” he assumed. Indeed, The Brooklyn Project is developing what it calls The Transparency Scorecard.
It purports to rate “the quality of statements and documentation describing how a project is approaching the important topics identified in the Transparency Goals of the Framework. The ratings don’t assess the quality of approaches chosen by projects; instead, they grade the completeness, clarity and consistency of how a project describes its approaches,” its blog post explained. He cited this and many other similarly inclined sites as proof enough the industry is ready to abide by standards.
Old Laws and Regulations Did Not Anticipate Crypto Innovation
“So the problem is not disclosure. It’s other requirements that, in the U.S., apply to ‘securities’ that just don’t make sense or even work when applied to usable software instead of the passive financial instruments for which they were designed,” Berarducci argued. There’s a fundamental gap, he believes, in that legislation simply doesn’t exist to deal with what tokens are. The frustration for him and other attorneys in the field is how regulators such as Peirce are really applying the wrong tools, or might.
“Treating usable software (whose intrinsic characteristics are not a financial instrument) as a security is a mistake. We won’t fix that mistake by saying it will not be a security if/when the creation/maintenance/operation of the software becomes ‘sufficiently decentralized,'” Berarducci stressed.
Regulatory relevance derived from an industry already employing standards seems to be a better way to go down that road. Token markets are facing a triple whammy, some insist, due to the SEC not catching up: prices have tanked, investors are left with a surplus causing a glut, which compounds price drops, and newer projects won’t launch out of fear of legal reprisal out of nowhere. “Other projects with usable software need clarity for themselves and their customers,” Berarducci wrote. “It shouldn’t cost $500,000+ in legal bills for someone to sell a piece of software.”
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