In the last few weeks, the SEC has been on a regulatory rampage, reportedly going after crypto staking, Kraken, Paxos, Terraform labs, and even former coinbase employees, some within a matter of weeks.
This recent crackdown has raised many questions such as: why now and not a year ago? What’s the future of crypto regulation in the US? What even is a security? How will this affect the development of crypto? And so much more…
What is a security?
First and foremost what falls under the classification of a security and how do we distinguish which crypto assets are and aren’t securities?
When the conversation around securities comes about, generally the first thing people bring up is the “Howey test” which basically states that an investment contract is:
The Investment of money
In a common enterprise
With reasonable expectations of profits
derived from the efforts of others
However, the Howey test only refers to the criteria for an investment contract and is just one of the criteria for security.
According to an article from cornell law The term “security” refers to:
“Any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”
What Digital Assets May and May Not Be Classified as Securities
Stablecoins
The SEC has recently issued a wells notice to Paxos for not filing their offering of the BUSD stablecoin. This news originally startled investors into moving capital out of USDC – which is under U.S. jurisdiction – and into USDT (which is an offshore firm).
Fortunately, USDC volumes have recovered.
Unfortunately, we still don’t have a lot of information on the SEC and BUSD situation, but if we were to assume that BUSD isn’t different from any other prominent stablecoin – USDC, USDT, USDP – that would lead us to speculate that the SEC going after Paxos isn’t so much about stablecoins and much more about Binance.
Stablecoins, provided they are properly backed 1:1, would not be considered securities in our view unless they:
are redeemable for a security – making them a derivative.
They pay a yield for holding – which could make them a certificate of deposit or a certificate of interest.
However, they are much more comparable to an interest bearing account (savings account) and not a security, because they are backed by liquid USD and USD equivalents.
Staking as a service accounts
This is where things get much more tricky. the SEC got crypto exchange Kraken to shut down its staking as a service program and pay a $30 million fine for not registering it.
According to an article published by the SEC Kraken has said that its “staking investment program offers an easy-to-use platform and benefits that derive from Kraken’s efforts on behalf of investors, including Kraken’s strategies to obtain regular investment returns and payouts.”
Assuming this is an accurate assessment by the SEC we can point out “Kraken’s efforts on behalf of investors” and “Kraken’s strategies to obtain regular investment returns and payouts” both as statements that would pass the Howey test.
Staking
There have also been rumors that the SEC is attempting to also crackdown on crypto Staking in the US, claiming that staking falls under securities law.
So if staking as a service – at least in Kraken’s situation – is a security what does this mean for staking directly on a blockchain, such as Ethereum, or through a liquid staking protocol such as LIDO or Rocketpool?
Staking on a blockchain should not be a security because Stakers aren’t just relying on the efforts of others, they’re actually providing a service to the protocol by running a node to secure the network. In other words, they’re getting rewarded for their efforts as opposed to making an investment that relies on the efforts of others to be profitable.
Liquid staking protocols
In liquid staking protocols on the other hand, people are pooling their money into a DAO that does the work and runs the nodes. Making It “An investment in common enterprise with the expectation of profits relying on the efforts of others.”
The probability that the SEC could make a case against Liquid staking after successfully winning against Kraken is maybe higher than most expect. However, staking directly on a blockchain is a much tougher case for the SEC to make.
Crypto Tokens
Last but not least is crypto tokens, if we’re being honest many crypto tokens are securities. Here are a few of the things to look for when determining if a token could be a security or not:
The asset gives you ownership in a decentralized autonomous organization (DAO).
Tokens are burned based on protocol revenues.
The token pays a yield by default.
Tokens were initially sold as opposed to airdropped.
A single entity issuing the tokens owns a significant portion of the supply.
The team or organization issuing the token controls the supply.
The token is connected to a protocol that is predominantly controlled and changed by a single entity.
While the SEC has not directly gone after any crypto projects for issuing unregistered securities, they have gone after a former coinbase employee for insider trading, charges to which the former employee has pleaded guilty.
Some are speculating that this is the SEC’s way of passive-aggressively classifying crypto as securities. If the court were to rule in favor of the SEC, the 9 assets involved in the lawsuit and effectively all similar assets would therefore be securities.
This would also mean that all exchanges allowing the trading of those assets would come under heavy crackdown from regulators, which could potentially destabilize the entire industry in the United States.
The Big Questions
Are individuals and companies in the crypto industry being intellectually dishonest and playing dumb or should the SEC actually have more explicit regulatory guidance for crypto assets?
It seems that there has been a large disconnect between most of the crypto industry and regulators. On one hand, the industry is expecting some sort of special treatment or regulatory guidelines. Meanwhile, on the other hand, the stance from the SEC is that securities law and guidelines are already in place and the individuals and companies in the crypto industry need to perform their due diligence to comply with the pre-existing laws.
Since this is the case from the SEC why is it just now starting to crack down hard on the industry?
Whether we like to admit it or not, crypto has lost the luxury of having a corrupt poster child who is shoveling money at regulators to make them turn a blind eye, which seemed to be the case before the FTX collapse. It’s also possible that the SEC is just now cracking down because they’re embarrassed of their failures during the 2022 crypto exposay, leading them to overcorrect.
One of these two is likely the case but whatever it may be, the days of little attention from regulators are likely behind us, meaning that moving forward the hope for the industry is that the SEC will play nice after they get their point across that they are no longer messing around.
The Implications Of A Regulatory Crackdown On Crypto
The Final question to address in this situation is what are the implications moving forward. At some point, there needs to be some sort of agreement or collaboration between regulators and the industry, instead of the constant fight that has taken place recently.
If things were to continue the way they’re currently going the outlook for the growth of crypto and financial innovation in the US is grim.
The more hostile the relationship is between crypto and regulators the worse it will be for the country, as well as the consumer, because all that will happen is crypto and financial innovation moves offshore, meaning fewer consumer protections, as well as less jobs, economic growth, and global leadership from the US.
Per Bloomberg: many firms in the crypto industry are increasingly moving outside the U.S. due to the hostility and lack of clarity from regulators. If the U.S. continues on the same path it’s currently on, what will that mean for the development of the industry under its jurisdiction? The regulator won’t hurt cryptos’ growth, but it will hurt the U.S. benefits of it.
The hope moving forward is that either:
The recent crackdown pushes the industry into being more proactive in complying with Securities and investor protection laws.
The SEC and the US government want to accommodate crypto and give firms an official framework and timeframe to comply with whatever precedent they set before proceeding to go after the entire industry. This would be bad for investors and development in the US.
Regardless of what happens we still believe the outlook is bright in the long run, especially with the investments and partnerships from large regulated institutions such as BlackRock, Fidelity, and Visa who now have a dog in the fight when it comes to lobbying in Washington. The development of financial innovation and digital assets isn’t going to slow down anytime soon.