Don’t put the cart before the horse when regulating crypto

[This article has been published in Restoring America to highlight how invasive government regulation hurts individual investors and the economy as a whole.]

On May 4, 2022, California Governor Gavin Newsom signed an executive order calling for comprehensive regulation of crypto assets in California. The order, which aims to harmonize a California regulatory regime with a still underdeveloped federal framework for digital assets, rightly acknowledges that in the crypto sphere, “responsible innovation has been hampered by regulatory uncertainty, particularly with respect to federal law”. The best way to resolve the uncertainty identified in the California order is for regulators to clarify if and when existing laws apply to the crypto ecosystem, and not to use enforcement action as a substitute for elaboration of formal rules, as has too often been the case.

Similar to the Biden administration’s March 2022 executive order on ensuring responsible development of digital assets, which largely instructed federal regulators to identify policy gaps and report with recommendations, the order California is calling on state agencies to gather stakeholder feedback, produce reports, and begin developing a crypto regulatory approach. While state and federal laws prohibiting fraudulent and deceptive business practices have long existed, policymakers have yet to clarify key details about whether more technical requirements apply to crypto projects, such as registration, disclosure and reporting obligations in areas such as securities, taxation and anti-fraud. – money laundering laws.

Not rushing to judge new and complex issues can be prudent, but delaying or avoiding the development of formal rules while simultaneously subjecting market players to unpredictable enforcement makes compliance a difficult guessing game and can push contractors outside the United States. Pursuing enforcement actions without first issuing formal rules is a long-standing flaw in the Securities and Exchange Commission’s (SEC) approach to crypto regulation. The day before Governor Newsom signed its order, the SEC had suggested it was doubling down on enforcement, announcing an increase in staffing for the Crypto Assets and Cyber ​​Unit within the Division of Enforcement. SEC Commissioner Hester Peirce
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to this news, the better: “The SEC is a regulatory agency with an enforcement division, not an enforcement agency. Why are we leading with the application of crypto? »

The SEC has been leading enforcement for quite some time. In 2017, the SEC instituted a cease and desist order against Munchee (the developer of a restaurant review app) for selling crypto tokens that the Commission considered unregistered securities; Munchee’s app sought to pay restaurant reviews with these tokens, which were to be redeemable for in-app and restaurant purchases. The SEC has launched numerous other enforcement actions against so-called “initial coin offerings” (ICOs), including where, as with Munchee, the tokens were developed to provide access to certain goods and services within a network. Yet not all crypto projects have necessarily involved the offering of securities in the eyes of the SEC. In 2019, on the other hand, the Commission provided a no-action letter in the event of a token sale where, among other things, the offeror would not use the proceeds to develop its platform, which would be fully operational by the time where the tokens would be sold. .

In an apparent effort to reveal some of the thinking behind this enforcement approach, on the same day the Commission issued the 2019 no-action letter, the SEC’s Strategy Center for Innovation and FinTech has published a “Framework for the Analysis of Digital Assets ‘Investment Contracts’.” The framework outlined some factors to consider when evaluating whether the sale of a digital asset is a security offering, which which often boils down to the question of whether the buyer of a token is “relying on the efforts of others” or, in other words, whether the project is too “centralized” to avoid a collision with the law of securities.

While these informal guidelines are no small feat, the framework is far from definitive as guidance, let alone as a clear and definitive set of rules. In the framework’s own words, the factors provided “are not intended to be exhaustive in assessing whether a digital asset is an investment contract or any other type of security, and no single factor is determinative on its own.” Further, the document notes:[T]he Commission has neither approved nor disapproved [the Framework’s] content.”

To complicate the ambiguity, a notable 2018 speech by William Hinman, then director of the SEC’s Corporate Finance Division, hinted that the Commission may have overlooked a slide where a major token network cryptographic – Ethereum – which might once have involved securities sales. in the eyes of the SEC has become decentralized enough that the token (Ether) is no longer a security. According to Hinman, “applying the federal securities laws disclosure regime to pending Ether trades would appear to add little value.” Nonetheless, while Ethereum may have benefited from decentralization at the right time, in 2020 the SEC again provided a cautionary tale, alleging that from 2013 to 2020, Ripple engaged in an unregistered securities offering. when selling XRP tokens (the native coins of a blockchain designed to facilitate real-time payments, remittances and settlements).

When it comes to Ripple, it’s fair to ask if XRP was as decentralized in 2020 as Ethereum was in 2018. Nonetheless, it’s also fair to ask the SEC how market participants should assess their positions in compliance in the light of the Commission’s checkerboard pattern. crypto enforcement actions (and apparent inaction) and lack of formal rules interpreting how securities laws apply to crypto projects. Judging by the absence of such regulation in the SEC’s most recently published regulatory agenda and by SEC Chairman Gary Gensler’s view that the Commission has already stated its views on the subject, the regulatory clarity sought by Governor Newsom’s order may remain elusive.

This article originally appeared in the Cato to freedom blog and is reproduced with the kind permission of the Cato Institute.