Regulation is one of the biggest question marks facing cryptocurrency. Complex, opaque, and oftentimes non-existent, regulation is frustrating for consumers, crypto entrepreneurs, and even lawmakers themselves.
Globally, we see regulatory landscapes differ dramatically. In general, the European Union has extremely favorable tax laws for both crypto businesses and crypto trading, making it a paradise for the industry (Switzerland alone has 14 crypto unicorns). Russia and China are dealing with ongoing internal domestic battles regarding crypto, mainly focused on mining operations.
Crypto regulation is frustratingly nebulous in the US. While tech hubs domestically are hotbeds of tech talent and venture capital, regulation is a nightmare. The root of this issue is the fact that digital currencies and tokens are decentralized, with no precedent for regulation (and in some cases, no one to regulate).
|A slightly outdated graphic on crypto legality|
Paradoxically, both crypto entrepreneurs and investors mostly admit regulation in crypto is badly needed. Institutional money will not flow to these risky assets without defined guardrails in place, and without institutional money, we won’t see the global participation investors are hoping for. Regulatory clarity is also required for CeDeFi (centralized DeFi), the integration of traditional financial systems with decentralized ones.
Today, we’ll dive into:
- The current landscape around crypto legislation
- Where we might be headed
- How crypto companies and protocols handle it
- How it affects you as an investor
The S.E.C. is an agency that governs all public securities in the United States. They ensure that specific compliance and filing processes are strictly followed in order to list securities on public markets, which allows investors to access the assets. Failure to comply results in heavy fines, lawsuits, and the loss of the ability to receive public investment.
They’re officially chartered with three responsibilities: protecting investors; maintaining fair, orderly, and efficient markets; and facilitating capital formation (the growth of wealth in the country).
The S.E.C. has had such trouble regulating the industry for two reasons: crypto is unprecedented (it’s a completely novel asset class) and it’s decentralized (it’s hard to go after anyone in particular. The stance of the agency so far has been largely unequivocal: Gary Gensler, the S.E.C. chair, states that crypto is “rife with fraud, scams, and abuse.” But ironically, he himself once taught a course on blockchain at MIT. Why the sudden change?
|Gary Gensler teaches Crypto|
Well, the S.E.C. can’t really tell you to go out and invest in crypto if it’s unregulated, thus it’s forced to be overly risk-averse. Perhaps regulatory clarity can help expand the pie for both the government (tax dollars) and cryptocurrency (institutional and widespread adoption). The S.E.C. doesn’t regulate commodities, though, only securities—so the bigger question is: are cryptocurrencies securities? And if not, does the S.E.C. have any right to regulate the industry in the first place?
The Ripple (XRP) Lawsuit
In December 2020, the S.E.C. filed a lawsuit against Ripple for having conducted an “unregistered securities offering.” The claim was that XRP, the token native to the Ripple blockchain, is a security, and the sale should have been registered with the S.E.C.
Ripple takes the other side in claiming that it is not a security, but a cryptocurrency, a different asset class entirely. If Ripple wins, jurisdiction of crypto will be taken away from the S.E.C. and instead be overseen by different (and likely more lenient) agencies.
The Howey Test is the current legal precedent that tells us if an asset is a security. For something to be a security, it requires you to answer ‘yes’ to the following three questions:
- Is there an investment of money with the expectation of future profits?
- Is there investment of money in a common enterprise?
- Do any profits come from the efforts of a promoter or third party?
According to the S.E.C., XRP should be classified as a security under the Howey test. Ripple used money raised through the sale of $XRP to fund its ongoing operations, meaning that buying $XRP was an investment in Ripple as a business.
Ripple argues against this, saying that other cryptocurrencies like Bitcoin and Ether are treated as commodities. Additionally, the S.E.C. has been self-contradicting in their approach to regulating crypto, with statements varying in how the assets should be classified.
Ethereum first funded its operations with an ICO. The S.E.C. has said that because Ethereum operates in a decentralized manner, it has no basis to regulate it as a security. Bitcoin, with no central backing behind it and no profit motive couldn’t be regulated as a security either.
While it may be years until a decision is reached, the implications of this are massive. Countless other projects exist under the scope of this case, and whichever way it ends up settling, the effects will radiate through the rest of the crypto ecosystem.
The biggest takeaway here? If XRP isn’t a security, then cryptocurrencies can basically operate as on-chain businesses and can launch without much regulatory oversight. They can also conduct buybacks and payouts without fear of legal retaliation.
If XRP loses, then crypto companies in the US will have to go through same legal rigors as securities to launch. While it might help protect investors, it would probably crush the industry domestically.
Don’t Jump Through the Hoop—Jump Over It
While crypto protocols that launch tokens to raise money face regulatory scrutiny, we can look at tokens like Uniswap to see how some protocols bypass regulators.
Uniswap, a decentralized exchange (DEX) launched with VC backing. In 2020, it airdropped (for free) a large portion of its token allocation to people who had previously used the service. It required no investment from users, nor was there an ‘expectation of future profits,’ thus it passed the Howey Test and wasn’t classified as a security. It was a ‘Governance Token,’ strictly used to make voting decisions around the project.
But the token wasn’t worthless, because Uniswap promised to someday decentralize their protocol, and investors saw an opportunity to redirect cashflows earned by the protocol to token holders. To date, that ‘value accrual’ hasn’t been turned on, but someday it might be. By then, though, the protocol may be adequately decentralized, meaning that the profits don’t come from any business entity.
And in that case, who will the S.E.C. sue? There’s no single entity controlling operations. Who can they find to regulate? It’s just code deployed on Ethereum. Airdropping a token, then decentralizing using that token is a roundabout way to get around these laws.
Who You Gonna Sue?
Another interesting case study is the decentralized derivatives exchange dYdX, a protocol we’ve written about in Crypto Pragmatist Pro. They’re attempting to decentralize in a similar way to Uniswap, but didn’t airdrop to US residents at all—only international ones. This became a popular talking point to poke fun at the S.E.C., as many crypto investors have sarcastically ‘thanked’ the S.E.C. for ‘protecting’ them from free money.
In fact, the entire protocol, although decentralized, is inaccessible by US residents (unless you use a VPN). Derivatives are highly regulated in the US and thus dYdX receives even more oversight than Uniswap. It’s still technically legal for US residents to both own the token and use the exchange, however. The fact that you can’t buy the dYdX token on centralized exchanges and can’t use the protocol is more about protecting the businesses from liability than protecting retail investors.
Again, though, perhaps decentralization might change things. While it’s unlikely that the dYdX token will ever be available on platforms like Coinbase, if it decentralizes sufficiently, it could open the derivatives exchange to US customers. There would be no repercussions, as there’s no way to turn that access off.
The US Wants it All
For readers who live outside of the US, none of this may seem concerning. After all the US, can do whatever they want and it won’t impact international protocols, right?
Not exactly. In September last year, Terraform Labs and CEO Do Kwon were served subpoenas by the S.E.C. regarding Mirror protocol’s synthetic assets, otherwise known as mAssets.
The unique part? Terraform Labs is incorporated in Singapore, and Do Kwon is a South Korean native that currently lives in Singapore. On an operations level, Terraform Labs and Kwon have zero involvement with the US.
After being served, Kwon and his lawyers filed a lawsuit against the S.E.C. claiming that they do not have jurisdiction over himself and TFL. The S.E.C. fired back:
- Do Kwon entered the US (to speak at crypto conference Mainnet, where he got served)
- Terraform Labs allows US citizens to trade synthetic assets
Because US citizens were trading these synthetic assets, the S.E.C. felt responsibility to protect investors. While most DeFi users in the US would argue that they don’t need “protecting” from trading crypto assets, the S.E.C charter requires that US investors are not exposed to otherwise avoidable risks.
Its another case to watch, and while the S.E.C. might have legal precedent in the US, they might not be able to shut down or regulate a protocol that operates internationally.
What Does This All Mean for Investors?
Another relevant case of the S.E.C. waging a war against crypto is seen with Coinbase’s “lend” product, which allowed users to earn 4% APY on their USDC dollar-pegged stablecoins.
The product was effectively shut down after the S.E.C. said they would sue the exchange if they went through with the launch, showing that even the leading public crypto exchange (and posterchild for regulator-friendly crypto company) in the US is not safe from the wrath of the S.E.C.
It is likely that crypto investors and entrepreneurs will continue to face regulatory headwinds in 2022 and beyond, at least until attitudes and legal precedents shift.
For better or for worse, this puts the US at risk of losing the crown of financial capital of the world. Companies and developers will continue to take their innovative products outside of the US simply to avoid the uncertainty. This is especially impactful in a time where innovation is in an accelerating state due to tremendous web-3 developer growth. And while the US is still a hotspot for developer activity thanks to strong networks of intellectual talent and venture capital, it won’t be forever if it’s impossible to operate crypto businesses here.
Still, with more institutional players and politicians becoming pro-crypto, it seems likely the tides might shift someday (maybe soon). You and I both know that crypto is here to stay—maybe regulators will get on board as well.
For now, as a crypto investor in the US, you’re in no danger of getting in trouble for investing in crypto, buying assets, and using any crypto product available, as long as you report it on your taxes properly. Non-US readers should do their own research.
Nonetheless, understanding the landscape and how it might change in coming months and years may very well give you an edge in your crypto investing.