The Blockchain Battlefront: Technology, Business and Regulation
Comedian John Oliver joked that cryptocurrency is “everything you don’t understand about money combined with everything you don’t understand about technology.” He missed another area of notorious confusion: the law. The major regulatory bureaucracy has woken up to the importance of blockchain-enabled technology, led by the SEC.
The government is sure that cryptocurrency needs to be regulated, but it faces a knotty question: What kind of asset is cryptocurrency? Safety? Merchandise? Currency? Something else? Meanwhile, technologists and entrepreneurs create new applications that influence the answer.
The new engine of innovation that is the crypto markets is a lot like the stock stocks we are familiar with, except with fewer intermediaries and less (you guessed it) regulation. Enterprises can mint tokens that are representative of the underlying technology, thereby financing business activities with a mechanism directly linked to these activities. This drives innovation because innovators are free to pursue funding without third-party involvement, and the market is able to reward success and punish failure with minimal interference.
The similarity to stocks has not gone unnoticed by the SEC. In fact, cryptocurrency’s capacity to function as an investment vehicle is the hinge upon which the future of the crypto industry will hinge. Such vehicles are regulated as securities in federal law. So we return to the nuanced question of what kind of asset are cryptocurrencies?
Currency, security or commodity
The obvious answer is cryptocurrencies are currencies! It’s there in the name. BitCoin started the whole industry by proposing to create a digital currency to stand alongside fiat currencies as a medium of exchange. But cryptocurrencies have expanded far beyond this notion, and even in the case of a straight cryptocurrency like BitCoin, the asset does not behave like currency.
The next bucket that cryptoassets can fall into is commodities. Commodities are regulated by the Commodity Futures Trading Commission (CFTC). These include assets such as gold, oil and wheat – generally, a commodity is any asset that is an item of value, and the financial activity around it is based on the changing supply and demand for that commodity. Curiously, for a non-physical entity, BitCoin and its relatives share some characteristics with this asset class: Because blockchain transactions are permanent entries in the global ledger, they can be traded and valued somewhat like a commodity.
The last traditional asset class to consider is securities. The Howey test (based on a 1940s case that established the SEC’s jurisdiction) is a standard test for determining whether something is a security. The three characteristics of securities are:
A. The investment of money
B. Joint ventures
C. Reasonable expectation of profit from the efforts of others
The first two properties are fairly easy to establish for most digital assets. However, ‘C’ is more difficult to determine, and this is where we come back to the observation that cryptoassets act a lot like stocks, which is precisely what ‘C’ is after.
The universe of digital assets has a wide range of nuanced differences, bearing characteristics of all three asset classes – currency, commodity and security – in varying means.
We can begin to get an understanding of how the SEC thinks about these issues by looking at what SEC Chairman Gary Gensler said about BitCoin being a different animal from the rest. He has said on a couple of occasions that BitCoin, and only BitCoin, is a commodity.
This has been backed up with action. In May, the SEC doubled its crypto enforcement arm and renamed it the “Crypto Assets and Cyber Unit”. It opened a probe with Coinbase and has launched an insider trading case that includes a securities tax, which will bring at least some crypto projects under the SEC’s jurisdiction.
These moves were criticized by CFTC Commissioner Caroline Pham who said they were a “striking example of ‘regulation by enforcement,'” a criticism that suggests both that the CFTC is interested in finding a foothold in the regulatory space and that clarity in the field is missing.
Why classification is important
The general consensus is that by being classified as securities, the crypto industry will be more tightly regulated, but it will also grow more expansively as it matures. As a commodity, crypto would be less regulated but also more limited in terms of growth.
Going back, it seems pretty clear that crypto-enabled digital assets are a new kind of thing, bearing the hallmarks of every asset category depending on the project. For example, some projects explicitly use the equity fundraising model of “initial coin offerings” (ICO), the crypto-equivalent of the traditional IPO. This is why the SEC has its spotlight on ICOs.
It is likely that we will begin to see litmus tests that determine what clay crypto projects fall into, with securities requiring the most rigorous scrutiny. All of this will of course increase the costs of running these projects, and slow down innovation in the short term. In the long term, approval at the federal level will lead to greater adoption and more investment in the space.
In the medium term, we will see a convergence of traditional stock markets and crypto exchanges – something that is already happening. The FTX crypto exchange recently included stocks, while Webull, a more traditional exchange, includes crypto.
The ongoing battle
Perhaps the most central battle in the larger war is the one between the SEC and Ripple. Ripple created the XRP coin, designed for blockchain-based payments. The SEC and Ripple have been locked in an epic legal battle since December 0221, when the SEC sued Ripple for raising over $1 billion via the sale of their token, alleging that it is an unregistered security.
It is such a precedent-setting battle in unfamiliar terrain that unconsidered problems arise. For example, on July 30, 2022, a third party joined the fray, arguing that cryptographic keys should be removed from proceedings, similar to how bank accounts are handled.
The SEC action put a big dent in XRP’s value and led to its removal from US exchanges such as Coinbase. It also sent a shiver through the entire industry. The truth is that both sides have a point: The streamlined fundraising, which is closely related to the actual technological medium, holds an astonishing promise for innovation, but it has a great potential for abuse.
An equal approach that avoids forcing cryptoassets into existing categories and frameworks is needed. Not only do we want to avoid throwing a wet blanket on the entrepreneurial promise, but blockchains are decentralized global networks and we don’t want to force them into the shadows, but welcome them into the fold in a way that preserves their uniqueness and provides adequate protection to investors and users.
One size does not fit all in software projects. A small open source project that wants to finance itself should not be treated with the same instrument as a large corporate effort. Hopefully, in addition to an appropriate mix of categories, a sensible scaling of laws can be worked out, to allow for innovation with the agility so important to software projects of all kinds.
