The Blockchain battlefront: Technology, business, and regulation
Comedian John Oliver quipped 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 great regulatory bureaucracy has awakened to the significance of blockchain-enabled technology, led by the SEC.
The government is certain that cryptocurrency must be regulated, but it is faced with a knotty question: What kind of asset is cryptocurrency? Security? Commodity? Currency? Something else? Meanwhile, technologists and entrepreneurs are creating new applications that affect the answer.
The new engine of innovation that the crypto markets looks a lot like the corporate stock shares we are familiar with, except with fewer intermediaries and less (you guessed it) regulation. Ventures can mint tokens that are representative of the underlying technology, thereby funding business activities with a mechanism directly tied to those activities. This drives innovation because innovators are free to embark on funding efforts without third party involvement, and the market is able to reward success and punish failure with minimal interference.
The resemblance to stocks has not gone unnoticed by the SEC. In fact, the capacity of cryptocurrency to act as an investment vehicle is the hinge upon which the future of the crypto industry will turn. Such vehicles are regulated as securities in federal law. So, we return to the nuanced question of what kind of asset are crypto currencies?
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 crypto coin like BitCoin, the asset doesn’t behave like currency.
The next bucket into which crypto assets might fall is commodities. Commodities are regulated by the Commodity Futures Trading Commission (CFTC). These include assets like gold, oil, and wheat—in general, 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 item. Strangely, 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 something like a commodity.
The final traditional asset class to consider is securities. The Howey test (based on a case from the 1940s that established the SEC’s area of authority) is a standard test for determining whether something is a security. The three distinguishing characteristics of securities are:
A. The investment of money
B. Common enterprise
C. Reasonable expectation of profits derived from efforts of others
The first two characteristics are fairly easy to establish in the case of most digital assets. ‘C’ however is more difficult to determine, and this is where we return to the observation that crypto assets act a lot like shares, which is precisely what ‘C’ is driving at.
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 helpings.
We can start to get an understanding of how the SEC is thinking about these questions by looking at what SEC chair Gary Gensler said about BitCoin being a different animal from the rest. He has said on a couple 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 to “Crypto Assets and Cyber Unit”. It opened a probe with Coinbase and has initiated an insider trading case that incorporates a securities charge, which would 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 critique that suggests both that the CFTC is interested in finding its footing in regulating the space and that clarity in the field is lacking.
Why classification matters
The general consensus is that by being classed as securities, the crypto industry will be more heavily regulated, but it also stand to grow more expansively as it matures. As a commodity, crypto would be less regulated, but also more limited in terms of growth.
Stepping back, it seems pretty clear that crypto-enabled digital assets are a new kind of thing, bearing characteristics of each asset category depending on the project. For example, some projects are explicitly invoking the stock fundraising model with “initial coin offerings” (ICO), the crypto equivalent of the traditional IPO. This is why the SEC has a spotlight on ICOs.
It is likely that we’ll start to see litmus tests that determine what camp crypto projects fall into, with securities demanding the most rigorous vetting. All of this will of course increase the overhead in running these projects, slowing innovation in the short term. In the long term, approval at the federal levels will bring greater adoption and more investment into the space.
In the middle term, we’ll 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 that 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 struggle since December of 0221, when the SEC sued Ripple for raising over a $1 billion via sales of their token, alleging it is an unregistered security.
It’s such a precedent-setting battle on unknown terrain, that hitherto unconsidered issues are arising. For example, on July 30, 2022 a third party entered the fray claiming cryptographic keys should be redacted from the proceedings, similar to how bank accounts are handled.
The SEC action put a big dent in XRP value and caused it to be delisted from US exchanges like Coinbase. It also sent a shiver through the entire industry. The truth is both sides have a point: The streamlined fundraising, married closely to the actual technological medium hold astonishing promise for innovation, but it has great potential for abuse.
A even-handed approach that avoids forcing crypto assets into existing categories and frameworks is required. 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 unique characteristics and gives adequate protection to investors and users.
One size does not fit all in software projects. A small open-source project looking to fund itself should not be treated with the same instrument as a big enterprise effort. Hopefully, in addition to a suitable blending of categories, a sensible scaling of laws can be devised, to allow for the space to innovate with agility that is so essential to software projects of all kinds.
