SEC Enforcement is the wrong way to regulate crypto

Call me naive, but I have always resisted the conspiracy theory that the anti-crypto stance adopted by certain US regulators is meant to stifle this industry and protect the financial establishment it is trying to disrupt. I have preferred to see it as a misguided but well-intentioned attempt to protect consumers.

Recent events have me wondering if there isn’t something more sinister going on. (And that I may be naive.)

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First, all indications are that the Securities and Exchange Commission will outright ban companies from offering staking services to retail customers in the United States, products that give investors an opportunity to share the token rewards that proof-of-stake blockchains deliver to validators. After a hint from Coinbase CEO Brian Armstrong On Wednesday that such a ban came, news broke on Thursday that, in response to an SEC lawsuit, Coinbase competitor Kraken is abandoning the staking service it offered its US customers indefinitely and paying a $30 million fine.

These latest moves will make it even more difficult for average American citizens to participate in this industry, limiting it to large institutional investors, while various innovative startups looking to disrupt those same rent-seeking middlemen will struggle to access liquidity. It is difficult to understand how these actions serve to protect consumers or promote other policy goals such as expanding financial inclusion. It feels like government agents are deliberately trying to force this industry into the hands of Wall Street fat cats.

But here’s the thing: Making it hard for Americans to invest in and build crypto projects won’t stop people outside the US from doing so. Hardline actions here will only push activity abroad. And while the US may continue to generate business in “institutional crypto,” it will miss out on the true innovations happening at the grassroots level.

To be fair, SEC Chairman Gary Gensler has warned for some time that betting services could constitute unregistered securities, which would mean exchanges like Coinbase could be barred from listing them.

The argument hinges on the revenue-like income that validators of proof-of-stake blockchains earn in the form of new tokens and transaction fees when they unlock pre-existing tokens, putting them at stake in a mechanism to keep them honest. It can be argued that the promise of new token income meets part of the important Howey test, which suggests that for an investment instrument to be a security, the investor must have an expectation of return. And from the complaint against Kraken, it appears that the exchange’s role as an intermediary managing the pool of staked token investments meant that, in the eyes of the SEC, it tripped up another Howey assumption: that the expected return is “derived from the efforts of others.” .”

Fine. In a legal sense, the SEC’s strikeback action may have some standing. But why do this now, and in such a brutal way, to shut down a well-functioning program in the United States without offering a company to bring the program into an SEC-compliant structure?

In a statement explaining her lone dissent on this action, SEC Commissioner Hester Peirce argued that the core problem is the general inaction around creating a workable regulatory framework for cryptoassets:

“If you agree with [the Commission’s Kraken] analysis or not, the more fundamental question is whether SEC registration would be possible. In today’s climate, crypto-related offerings are not making it through the SEC’s registration pipeline. An offering like the staking service at issue here raises a number of complicated questions, including whether the staking program as a whole will be registered or whether each token’s staking program will be registered separately, what the important disclosures will be and what the accounting implications will be for Kraken.”

The timing here may be related to Ethereum’s evolution. It’s been less than six months since the second largest blockchain successfully migrated from proof-of-work to proof-of-stake in what was known as the “Merge” and comes just before the blockchain launches its Shanghai upgrade, which will allow holders of locked ether tokens to unlock them.

The action also comes just a month since the Commodity Futures and Exchange Commission declared ether to be a commodity – so not a certainty – which suggests that there may be a small turf war here. Determining the political treatment of Ethereum is a key marker in the race to establish a regulatory standard for blockchains.

More importantly, what is the greater purpose here? Securities laws exist to protect small investors – especially unaccredited investors with lower incomes and wealth who are considered less sophisticated and more vulnerable to abuse by the founder of an investment project than wealthier individuals and institutions. How is it that these retail investors in Ethereum are at risk now that they have a chance to earn a return on their tokens, but were allegedly not at risk when Ethereum was a proof-of-work chain with zero returns?

A solution, writes my colleague Daniel Kuhn, may lie in decentralized alternatives to Kraken’s offer, such as Lido and Rocketpool. However, given that US regulators have signaled a belief that decentralized protocols are not outside their purview, there is no risk that the SEC will also deem these projects illegal and go after their founders and developers, as Tornado Cash (Ethereum) “mixes ” which was sanctioned last year by the US Treasury Department)?

For now, there seems to be nothing stopping individual investors from staking the 32 ether needed to be a validator, but not everyone has that kind of money to put down (nearly $50,000 at today’s prices). And let’s be honest, doing this on your own is too complicated for Joe Public. Finally, small US investors may be able to gain easier investment exposure through strictly regulated exchange-traded funds, but the SEC has yet to approve a bitcoin exchange-traded fund, let alone an ether ETF.

In all of this, it seems we can expect to remain confused because the SEC rarely offers comprehensive guidance on its crypto thinking.

Gensler and his defenders may counter that he has consistently warned that most, if not all, tokens are securities. But the industry’s grip goes beyond that. That is, aside from occasional public invitations to “come in and talk to us,” there has been no real effort to collaboratively develop a regulatory framework that accommodates the unique, decentralized nature of this technology. Even worse, industry leaders say, the SEC practices “regulation through enforcement,” with the Kraken suit as an example, keeping everyone on their toes.

The practice can be a good way for the SEC to showcase its bureaucratic influence, but without a clear legal framework for how to move things forward and reduce the risk of such enforcement actions, it promotes uncertainty and fear. And that is in contrast to innovation and entrepreneurship.

Meanwhile, an even more insidious regulation-by-enforcement approach is playing out in banking supervision.

As Nic Carter explained in his blog post, the widespread reports of US banks being instructed not to serve crypto providers come without official communication from any regulator. He compared it to “Operation Choke Point,” a stealth campaign under the Obama administration to restrict the flow of money to external but perfectly legal services such as gun shops, marijuana dispensaries and porn providers.

The new, unannounced policy was likely a factor in Signature Bank’s move to close the international arm of Binance’s account, prompting the world’s largest crypto exchange by volume to announce it was temporarily suspending US dollar transfers.

I learned of the crackdown last month when the London-based head of an Eastern European bank told me that SWIFT, the US-headquartered international bank messaging service, told the banks that they would not allow large transfers to “crypto” service providers.

The banker’s comment got me thinking: What defines “crypto?” Therein lies another problem: the banks have a certain discretion in how they want to carry out these instructions. Do we honestly think they will stop doing business with BNY Mellon, the world’s largest custodian bank, because it now custodians of bitcoin? Would Microsoft have closed their bank accounts because they work on blockchain and metaverse projects?

These events underscore the dire need for US regulatory clarity around cryptocurrencies, particularly in the form of new legislation from Congress. The SEC’s actions against token staking may technically be in line with Howey test precedent and with the Commission’s guiding statutes, but these Depression-era laws now seem woefully outdated. And as the Blockchain Association’s Chervinsky noted, when there’s a vacuum in legal clarity, regulators tend to default to the kind of stealth operations described above.

Meanwhile, other jurisdictions – big ones like the EU and Japan, and smaller ones like Bermuda – are moving forward with clear driving rules for digital assets, cryptocurrencies and blockchains. This will mean that innovation and trade activity that would otherwise have occurred in the US will shift offshore.

Obviously, regulators in Washington, DC are under pressure to take action against “crypto” right now, given the high-profile explosions last year. But doing it in this ad hoc, seemingly capricious, counterproductive way will eventually backfire.