By: Thomas Lee, Senior Writer at SharesPost
Earlier this year, the global cryptocurrency markets shuddered amid revelations that the U.S. Securities and Exchange Commission subpoenaed dozens of companies related to Initial Coin Offerings (ICOs), Blockchain, and Bitcoin trading.
The ensuing price volatility would likely continue, experts predict, until the SEC offered clear guidance to industry players, specifically on whether the agency would classify tokens as securities and thus subject to regulation.
In that case, expect the volatility to continue because the SEC will probably not give the industry the clarity it so desperately wants. At least not for foreseeable future.
“There’s only so much certainty that a regulator is able to provide at the outset because you can’t foresee all the facts and circumstances as they may unfold over time,” said Troy Paredes, a law professor and founder of Paredes Strategies consulting firm in New York.
“Regulators are often reluctant to give any sort of sweeping declaration too early from their vantage point,” he said, “because they realize that with further understanding or consideration, they may prefer to have decided things differently. They may be reluctant, for example, to say something is not a security, only to realize, as things play out, that wasn’t the right judgment as they see it.”
Paredes holds more insight on SEC thinking than most people. In 2008, just before the financial crisis and the onset of the Great Recession, President George W. Bush appointed Paredes to serve as one of the agency’s five commissioners. During his five-year tenure, Paredes helped oversee the roll out of the Dodd-Frank Act, a massive set of new regulations passed by Congress in response to the financial crisis, and the 2010 JOBS Act, a law designed to encourage more startups to go public.
It’s probably safe to say that Paredes’ approach to regulation leans more pro-market. Yet much of Paredes’ tenure at the SEC was marked by crisis, which prompted quick and extensive government efforts to stabilize the economy.
So Paredes certainly appreciates the delicate balancing act of responding to rapid change, while holding true to the SEC’s historic approach of careful, deliberate regulation, which has worked pretty well for the most part. There’s a reason why the U.S. capital markets remain the best in the world.
“Even as technology changes, we should consult first principles that underpin the marketplace and our legal and regulatory environment,” Paredes said. “First principles are just that because they are the foundation upon which we build, because they make good sense, because they have proven to be robust even as technology and other things have changed around us.”
The heart of U.S. financial regulation goes back to the Securities Act of 1933 and the Securities and Exchange Act of 1934, which created the agency to oversees the sales of securities, or “investment contracts,” across state lines. In 1946, the Supreme Court developed the “Howey Test,” that defined an investment contract as “a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”
With cryptocurrencies, the big question is whether the SEC, using the Howey Test, determines whether to classify a token as a utility, which grants the holder access to a service, or a security, in which the holder expects to earn a profit from the labors of others.
“If I acquire a token, what does it entitle me to?” Paredes said. “What do I get? What do I want to get? Going back to Howey, the SEC has essentially said that if you want a return on the money you put in, you want an interest in the company and its success and you hope to earn a profit, that’s the makings of an investment. That’s going to be a major consideration in the judgment as to whether or not something is a security.”
For example, a token might start as utility, in that it grants the user access to certain services on the Blockchain, but then becomes a security once it gets traded on the secondary market. In other words, a holder might initially buy a token to exchange for a service but then decided to sell it to another investor.
“To the extent I can resell a token I purchase for a profit, and to the extent that’s part of the reason I acquired the token in the first place, even it allows me some functionality,” Paredes said, “the Commission has indicated that that’s the kind of thing they would take into account in evaluating whether or not the token is a security.”
But even Paredes admits the Howey Test will not always give a clear answer.
“There are some instances where it may not always be clear cut,” he said, “such as where there is both functionality and at least some indicia of investment.”
However, despite pressure from the industry, Paredes does not think the SEC will develop a new test just for cryptocurrencies. The agency will continue to use the Howey Test on tokens on a case by case basis, he said.
“I don’t expect the regulator to come up with a brand new test for what’s a security that is specific to tokens and coins,” Paredes said. “Maybe there will be a particular set of questions that continue to come up where the Commission says, in effect: ‘All right, the following questions constantly come up, and so we can lean into it a bit more by developing a set of targeted answers to frequently asked questions.’ That could provide valuable guidance.”
Even so, technology might be outpacing regulators’ ability to police the markets. For example, there are growing calls for Congress to revise anti-trust laws so they apply to Internet giants like Amazon. Currently, the Federal Trade Commission, in determining whether or not to block a merger, still uses a formula based on geographic market share even though Amazon knows no geographical boundary.
For years, Amazon had successfully argued that states cannot force them to pay sales taxes because the company did not operate physical stores in that state. (The Supreme Court recently ruled state and local official can collect more online sales taxes). We’re still wrestling with questions on whether the Federal Communications Commission should regulate Internet Services Providers like telephone companies.
“The pace of technological change in the crypto space can be so rapid, that regulators may need to move more quickly to provide necessary guidance and, where appropriate, balanced accommodations to ensure that beneficial innovation isn’t impeded,” Paredes said. “If it takes several months or a year to get clarity, that can create real difficulties for a business that’s trying to do the right thing, especially for a startup that might run out of funding.”
The SEC seems to knows this. The agency recently appointed a “crypto czar” and created several working groups to study the issue.
The agency is also perfectly aware that countries like Japan and South Korea have adopted a more permissive stance on cryptocurrencies.
“That’s not going to escape their attention,” Paredes said. “They’re going to recognize what’s going on elsewhere.
“U.S. lawmakers and regulators should keep an eye on the following: one, making sure that the regulatory approach doesn’t unduly stifle technological progress that promises a lot of benefit for our economy and society as a whole,” he said. “And two, paying attention to what other jurisdictions are doing so that the U.S. doesn’t fall behind. This doesn’t mean that the U.S. should follow suit necessarily. But it’s important to be mindful that markets are global, capital is global, technology is global. Blockchain doesn’t respect geographic boundaries.
“Policymakers are working diligently and earnestly in an effort to protect investors and consumers from wrongdoing and so that innovation can flourish – both critical goals for our markets to thrive,” Paredes said.