Why the SEC should never touch crypto again [Part 2]

In the first part of this series, I discussed the U.S. Securities and Exhange Commission’s recent charges against Coinbase and Binance, their inability to properly regulate the crypto industry, the history of digital assets in the congressional record, and the significant decline in the mentions of digital assets by the U.S. Government.

For this part, we will delve deeper into the implications of the SEC’s actions and explore alternative approaches to crypto regulation that could benefit the industry and its investors.

Digital Assets Commission

There are glaring flaws in the current regulatory landscape and a need for a dedicated digital asset-specific regulatory body—one that acknowledges the unique nature of digital assets, fosters innovation, and protects investors in the dynamic world of crypto.

It is increasingly apparent that a dedicated commission, perhaps a ‘Digital Assets Commission(DAC),’ is required to oversee this rapidly evolving industry and to formulate nuanced regulatory guidelines that foster innovation while protecting investors.

The Howey Test and its limitations

The Howey Test, established in 1946, has long been the standard for determining whether an asset is considered a security under U.S. law. It is a legal framework established by the U.S. Supreme Court to determine if a transaction qualifies as an “investment contract” and, thus, falls under securities regulations.

The test comprises four criteria: investment of money, common enterprise, expectation of profits, and reliance on the efforts of others. Failing any criterion exempts an asset from being classified as a security.

I argue that the Howey Test is not suitable for digital assets in 2023, given the rapidly evolving nature of the crypto landscape and the diverse functionality of these assets. The test’s origins in a time when traditional investments like stocks and bonds dominated the financial market make it ill-equipped to address the complexities and nuances of digital assets.

In response to the SEC lawsuit, Coinbase released the following video to showcase its attempts to follow regulatory guidance in the U.S. with no success. In it, the company highlights the outdated nature of the Howey Test and claims 1 million jobs are at risk due to the lack of clear regulatory guidance.

One key limitation of the Howey Test lies in its focus on the expectation of profits, which does not always align with the motivations of those who engage with digital assets. Users may purchase and utilize cryptocurrencies or tokens for various reasons beyond profit-making, such as accessing decentralized applications, participating in governance decisions, or supporting specific projects and communities.

Additionally, the role of “the efforts of others” in the context of decentralized networks is often unclear, as these networks rely on the collective efforts of numerous individuals and entities, undermining the centralized control typically associated with securities.

Furthermore, the Howey Test does not account for the technological advances and innovative features that digital assets now possess. Concepts such as smart contracts, decentralized finance (DeFi), and non-fungible tokens (NFTs) defy traditional definitions of securities, and applying the Howey Test to these assets may result in regulatory overreach and stifle innovation.

As the crypto ecosystem continues to grow and evolve, the limitations of the Howey Test become increasingly apparent, highlighting the need for a more tailored and nuanced approach to regulation that reflects the unique characteristics of digital assets.

Implications of classifying digital assets as securities

According to the SEC’s charge against Coinbase, the platform provided access to existing crypto asset securities, bringing it “squarely within the purview of the securities laws.” If digital assets are defined as securities, platforms like Coinbase would be subject to stricter regulations, potentially hindering innovation and limiting consumer access to a wide range of digital assets. This reclassification could have significant consequences for the entire crypto industry, as it would necessitate substantial changes in the way digital assets are issued, traded, and managed.

Companies issuing digital assets would be required to register with the SEC and adhere to reporting and disclosure requirements, which could impose substantial costs and administrative burdens on both new and existing projects.

Additionally, the increased regulatory scrutiny may scare away potential investors, leading to decreased funding for innovative projects and stifling the growth of the ecosystem.

For users, the classification of digital assets as securities could limit the availability of certain assets on exchanges and trading platforms, as these platforms would need to comply with securities regulations to offer these assets legally.

This may result in reduced liquidity, higher trading fees, and restricted access for retail investors, especially those in jurisdictions with strict securities laws.

Moreover, this reclassification could impact the development and adoption of decentralized finance (DeFi) applications and other innovative use cases of digital assets, as these applications often rely on the unique properties of digital assets to function effectively.

Historically, the SEC has limited access to staking and DeFi to ‘accredited investors,’ leaving the public out in the cold. For reference, one criterion that enables an individual to be considered an ‘accredited investor’ is holding at least $1 million in assets. So, not a knowledge or experience requirement, just wealth. If your parents leave you a million dollars, you’re qualified for DeFi, basically.

Other ways to qualify as an individual include over $200,000 in annual income, licensed financial professionals, family offices, executives from companies selling the security, and knowledgeable employees of funds.

Therefore, defining digital assets as securities could have far-reaching implications for the crypto industry, affecting issuers, trading platforms, and users alike. While the intention may be to protect investors and maintain market integrity, this approach risks stifling innovation and hindering the growth of a rapidly evolving and potentially transformative sector due to outdated perspectives on digital financial instruments.

The potential impact of the Coinbase SEC lawsuit.

The SEC’s lawsuit against Coinbase carries significant implications for the crypto industry as a whole.

If the SEC succeeds in establishing that Coinbase’s conduct and the digital assets it listed are subject to securities regulations, it will set a precedent that could impact other crypto platforms and potentially stifle growth in the sector. Coinbase, however, has stated that it intends to fight the SEC in court.

The outcome of this lawsuit will likely shape the regulatory landscape for digital assets in the US and beyond. If the SEC’s allegations are upheld, other cryptocurrency exchanges and platforms may be forced to reevaluate their operations and listings, possibly leading to a wave of delistings, increased compliance costs, and a reduction in the variety of assets available for trading. This could discourage new entrants into the market, ultimately decreasing competition and innovation within the industry.

Furthermore, the lawsuit may serve as a catalyst for regulatory agencies in other jurisdictions to follow suit and impose similar restrictions on digital assets, potentially affecting the global crypto ecosystem. This could lead to a fragmented market, with different regulatory regimes and asset classifications across various jurisdictions, making it difficult for businesses and investors to navigate the industry.

On the other hand, if Coinbase successfully defends its position, it could embolden other crypto platforms to challenge existing regulations, potentially paving the way for a more favorable regulatory environment for digital assets.

Move over XRP, the Coinbase and Binance lawsuits just became the most important legal cases in the industry.

Digital assets regulatory framework

A regulatory framework for digital assets should be flexible enough to accommodate the diversity of the crypto landscape while providing clear guidelines for platforms and users. It needs to be driven by a new commission, such as a DAC, with experts in digital assets at the helm. While Gary Gensler may teach students on the topic of blockchain, he has never used any digital assets or dApp.

Would you trust someone who had never used MetaMask to help you set up a wallet?

What about if that person was leading all crypto regulation in the US?

A real digital asset framework must involve creating a distinct category for digital assets that acknowledges their unique attributes, such as decentralization, programmability, and composability.

Such a framework should also encourage innovation and collaboration between industry stakeholders and regulators, fostering a supportive environment for the growth and maturation of the crypto space.

As regulatory bodies, such as the SEC, continue to address the matter, it is crucial for the industry to engage in an open discussion about the best way forward and push for a more suitable regulatory framework that acknowledges the unique nature of digital assets.

I am not claiming to know exactly what a proper framework should look like, but I know the SEC or CFTC doesn’t have a chance.

Square peg, round hole.

Use the Coinbase and Binance lawsuits as a catalyst to get a proper commission in place.

If digital asset securities are defined and managed by a Digital Asset Commission, then the SEC’s case falls at the first hurdle, and retail users have a chance to participate in the future of DeFi in the U.S.