Regulators are increasing their power over crypto, but with little to show for it
Federal regulators are notorious for eating away at industries and stifling economic growth with countless regulations, which is why most industries don’t want to ask Congress to pass more regulations. Yet that is precisely what cryptocurrency companies and investors are asking for.
The fact that Congress has yet to consider any crypto-specific legislation has left regulators to their own devices, to which they have responded by adopting a strategy of regulation through enforcement: Instead of prescribing what is and is not possible in this space , they only react to the actions of market participants and then determine whether what they did is actually permissible.
While such based on what is now known regulations are easier for regulators, it leaves us with a market where those who innovate in this market risk being subject to retroactivity and devastating lawsuits.
Disruptive technology companies live in fear that the SEC will target them next, and the uncertainty in the market affects everyday investors. Innovators have the opportunity to move abroad and follow the regulations elsewhere. But as many as one in five American adults have invested in or used cryptocurrency. The lack of regulatory clarity is one reason for the market volatility.
The Securities and Exchange Commission (SEC), led by Chairman Gary Gensler, has held crypto companies to a regulatory standard that assumes the market will simply not exist in the near future.
Two years ago, the SEC decided to go after Ripple Labs, a software company that uses crypto-technology, including a digital asset called XRP
The SEC’s case rests on a 75-year-old legal doctrine called the “Howey test.” In the decades before the Great Depression, there was a pervasive problem of financial fraud, with companies preying on investors by offering worthless stocks, fake real estate, and other fraudulent investment contracts. In an effort to protect investors, states began passing new financial security laws. When a Supreme Court judge famously quoted that these scams “have no more basis than so many meters of blue sky”, these financial laws became known as “blue sky laws”.
While states began to adopt these ‘blue sky’ laws, there was still uncertainty about what could be considered an investment contract and thus be subject to these laws. The resulting series of ‘blue sky’ cases interpreting these laws formed the basis of the Securities Act of 1933, and led to the landmark 1946 Supreme Court case SEC v. Howey called the “Howey test” – a four-part test for identifying an investment contract security .
The Howey test states that an investment contract exists if there is (1) an investment of money (2) in a joint venture with (3) an expectation of profit (4) to be derived solely from the efforts of others.
For the Howey test to be applied to XRP transactions, it must be greatly stretched and distorted to claim that an investment contract exists between two parties who do not even know each other – as is the case with many second-hand XRP transactions. Many holders of XRP have never even heard of Ripple, and the SEC’s own expert testimony says that XRP’s value has not been tied to Ripple’s actions. In short, the SEC is stretching the boundaries of the Howey test in the Ripple case to maximize its regulatory power, not to protect investors.
While predicting what the cryptocurrency market will look like in a decade is a fool’s errand, absent punitive government restrictions, it is clear that most investors are betting that they will play a role in global financial markets. Absent US leadership in the development of the market may hinder its growth, but if it survives in some form, it will leave domestic investors vulnerable to the vicissitudes of foreign regulators.
It’s time for Congress to take action to support American innovation and truly protect American investors.
