Blockchain Confidential - 29 July 2022
A moment of clarity
“I believe we have a crypto market now where many tokens may be unregistered securities, without required disclosures or market oversight. This leaves prices open to manipulation. This leaves investors vulnerable.”
— SEC Chair Gary Gensler, Aspen Institute, August 2021
“Thank God for granting me this moment of clarity, this moment of honesty
The world'll feel my truths through my ‘Hard Knock Life’ time my gift and a curse
I gave you volume after volume of my work so you can feel my truths“
— Jay-Z, “Moment of Clarity,” 2003
SEC Chair Gensler has at different times indicated he believes “dozens” of tokens on Coinbase may be unregistered securities, upwards of 80%. The nine tokens the SEC recently cited as securities as part of an insider trading case represent just a fraction of Coinbase’s listings, and so for me the notable thing about last week’s news was not the finding, but the likelihood that it is just a starting point. The SEC may have wished to reinforce their case — to establish that this insider trading activity was clearly within their remit — so they started here, but this is not where it will end.
Coinbase’s stock reacted to this news immediately, but the impact on the broader crypto market was more muted. This might represent some mis-pricing of regulatory risk. Although our models do not aim to capture these kinds of risk, institutional investors in digital assets especially have to watch out for these risks. One major trigger for the last crypto winter was the ICO crackdown. Some issuance moved to STO’s within a clearer regulatory framework, but many just moved offshore, geofencing or requiring whitelisting of wallets to screen out U.S. investors. It remains to be seen if a broad-based finding on the securities status of digital assets will have a similar chilling effect, and will it lead to a broader exodus.
Howey — of the famous Howey Test for securities — is not a law or a regulation; it refers to a case from 1946, SEC v. W.J. Howey Co., involving a lease-back arrangement for citrus groves. This is important: when companies in the crypto industry call for regulatory clarity, they are asking for the wrong thing. At least in the U.S., the issue is decades of legal precedent layered on top of laws and regulations. In many ways there is an excess of clarity, because a principles-based test like Howey can flex to cover a staking protocol just as easily as an orange grove. Gensler’s hands are tied unless there are laws that specifically make room for digital assets. In their absence, he has to apply laws written in the 1930’s overlaid with precedents from decades ago. There is a reasonable debate — it’s not so clear-cut as this — but absent new legislation or what could be years of court cases that establish new precedents, I believe the default position of the SEC is going to be things that are securities-like are securities.
This most recent event amounts to an “I told you so” in response to everyone who has been assuming that just because the tech is novel and they have done clever things with DAO decentralization that some kind of reckoning is avoidable. Airdrops, provisions to share “income” from protocols, governance tokens that grant voting rights, yield protocols that are not bank accounts and thus don’t get the protection from securities laws that come with that classification — goodbye, Coinbase Lend — if you squint at them do look like dividends, equity voting rights and more, and all these things tend to go with a securities classification. It’s fair and in fact important to ask questions about this presumption because there are other attributes that look distinctly non-securities-like, but … the presumption is likely going to be that these tokens are securities unless there is a broad precedent establishing otherwise which marks out its own tests to make exceptions. Or you need law changes like Rep. Patrick McHenry’s proposed Safe Harbor bill that write those exceptions into law.
This is not legal advice or a market forecast. This is instead a call to ask for the right things. What the industry needs is not clarity, but rather brand new rules. These rules should take into account the unique attributes of tokenized assets and adapt them to existing laws and regulations. What will fall out of that is that some tokens are indeed securities in the U.S., and this has consequences. Exchanges like Coinbase will either need to de-list tokens and their trading will move fully off-shore, or they will need to be subject to the regulations as other securities exchanges — rules that include protections and surveillance to guard against employee insider trading and a whole host of other abuses that right now don’t apply to crypto exchanges. Personally I think a repeat of the ICO denouement, where token issuance just moved offshore due to a blunt, sweeping classification of many of them as securities, leaving just a few indisputably commodities-like tokens regulated by the CFTC on-shore, would be a terrible thing. The reality is these protocols are running on technical infrastructure that is global, censorship-resistant and rapidly evolving, so it would be far better to accommodate them. The way to get stronger investor protection on-shore is, ironically, to be a bit more flexible and allow for differential treatment.