Regulators are in no hurry to write rules for crypto. The Securities and Exchange Commission and Commodity Futures Trading Commission have brought a combined total of more than 100 enforcement actions against crypto-asset market participants. Yet, neither agency has issued a single crypto-specific rule, and it is unlikely that they will change course any time soon. But what if the agencies decided to do so? What sorts of rules could they write using their existing regulatory authorities?
Federal securities laws are principally designed to reduce information asymmetries between the issuers of securities and the investing public. When a firm elects to raise capital from investors by selling a security, the laws require the firm to make investor disclosures to minimize the informational disadvantage of outside investors. Additionally, the laws require exchanges, brokers, dealers and investment advisers who provide access to securities or securities-related advice to register with the SEC and adopt policies and procedures designed to protect investors.
This opinion piece is part of CoinDesk's Policy Week. Michael Selig is counsel at Willkie Farr & Gallagher.
The framers of the federal securities laws didn't have programmable crypto assets in mind when they drafted the laws. But the SEC has the statutory authority to issue rules that would make it possible for crypto assets and crypto intermediaries to operate within the contours of federal securities laws. The agency could start by writing rules to establish a workable framework for crypto-asset security issuances and exchanges.
Crypto assets are network assets. Unlike firms, networks are generative. The value of a network derives from the applications, organizations and projects built on the network by its users. The developer of a network may opt to issue the network’s native crypto asset when publicly available information about the network is scarce to encourage users to join the network. Once a critical mass of users has joined and is participating in a network, the developer may no longer have an informational advantage relative to the users. At this point, investors in the crypto asset may not require the protections of federal securities laws.
It is unlawful to offer or sell a security without registering the offering or sale with the SEC, absent an exemption. The definition of the term “security” includes a list of financial instruments, such as stocks, bonds, notes and investment contracts. Crypto assets most typically come within scope of federal securities laws when sold as part of an investment contract.
The term investment contract originates from “blue sky” laws designed to govern offerings of written contracts under which a person invests money with a promoter who promises to use the money to generate profits for the investor. In a 1946 opinion (giving rise to the so-called Howey Test), the U.S. Supreme Court defined the term “investment contract” for purposes of federal securities laws as a contract, transaction or scheme whereby an investor invests money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.
There is little mention of investment contracts in the SEC rules because before crypto assets came along, nobody knowingly intended to issue them. For decades, the SEC has brought lawsuits asserting that a contract, transaction or scheme should remedially be classified as an investment contract because it has the economic substance of a security. After the SEC started to bring these lawsuits against crypto-asset issuers, some crypto projects embraced the investment contract designation and attempted to issue these instruments in compliance with federal securities laws.
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Lack of clarity
Crypto-asset issuers experimented with investment contract offerings under various exemptions from SEC registration, and one even registered an investment contract with the SEC. Others exclusively sold offshore in jurisdictions where crypto assets aren't regulated as securities. These issuers may have anticipated that the SEC would eventually write rules to make it possible for crypto assets to operate within the SEC’s regulatory perimeter. But the rules haven’t come, and these crypto-asset securities were left without a clear path to non-security status or liquid secondary markets in the United States.
Nonetheless, the SEC has recognized that crypto assets may evolve to shed their investment contract skin over time. In 2018, the then-current director of the SEC’s Division of Corporation Finance expressed the view that a crypto asset may initially be offered or sold as part of an investment contract but may later be resold as a non-security. The following year, the SEC staff released a “framework” on crypto assets, indicating that, in some instances, a crypto asset “previously sold as a security should be reevaluated at the time of later offers or sales” to determine whether it remains a security.
This view is also expressed in SEC enforcement action settlement orders, which require the issuer to register a crypto asset as a security but provide that the issuer may later terminate the registration on the basis that the crypto asset is no longer a security. At least one issuer followed this approach by offering a crypto asset as a security and then later filing an exit report declaring the crypto asset to no longer be a security.
Another crypto project recently declared its crypto asset to have “morphed” from a security into software. But the SEC hasn't issued rules codifying an exemption from registration for decentralized network assets or a procedure for offering a crypto asset as a security and later determining that the crypto asset is no longer a security. Issuers that choose to take this approach remain at risk of an SEC lawsuit.
The SEC wouldn't need legislative authorization to exempt from the registration requirement offers and sales of network assets. The agency has broad authority to promulgate rules exempting transactions, securities and persons from registration. The SEC could, for example, condition such an exemption upon the issuer making periodic disclosures of material nonpublic information until the issuer reasonably has no informational advantage relative to users of the network.
SEC Commissioner Hester Peirce has twice proposed rules that would create a “safe harbor” for certain crypto-asset issuers. Issuers that choose to rely on the safe harbor would be exempt from registering their crypto-asset offerings for a three-year period. Issuers that develop a sufficiently decentralized network within this time could declare the crypto assets to be non-securities. Peirce’s safe harbor offers a sensible framework that would protect investors while encouraging innovation.
State financial-services agencies were the first regulators to begin licensing crypto exchanges. These agencies reasoned that crypto assets are a type of monetary value and crypto exchanges are therefore money transmitters. The purpose of money-transmitter laws is to protect customer deposits from misappropriation and misuse and prevent money laundering. These laws are far less comprehensive than those applicable to securities exchanges. As a result, incumbent crypto exchanges are not designed to support crypto asset securities trading. Yet, SEC Chairman Gary Gensler said that many such platforms are required to register with the SEC as a “national securities exchange.”
Despite Gensler’s call to action, there are no SEC-registered crypto exchanges today. This is because the standard crypto exchange operating model is the product of money-transmitter law requirements and isn't workable for a securities exchange. Moreover, significant SEC exemptive relief would be needed for any securities exchange to list crypto assets under current SEC rules.
Many SEC requirements present roadblocks for potential registrants. For example, securities exchanges may offer trading only in registered securities. Very few crypto assets available today are registered, and some of the most popular are non-securities. Additionally, securities exchanges are open only during defined hours and close on national holidays, whereas crypto assets trade in global markets that never close.
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Among the most critical issues is that retail investors cannot trade and hold securities directly on securities exchanges as is typical with crypto exchanges. Instead, they are required to place orders and hold assets with an SEC-registered broker-dealer, which acts as an exchange “member.” Broker-dealers are permitted to trade and hold crypto-asset securities if they were offered and sold pursuant to an effective registration statement or exemption. Broker-dealers, however, effectively cannot trade or custody non-security crypto assets.
The SEC has broad authority to issue rules exempting crypto exchanges, brokers and dealers from the requirements of federal securities laws. Targeted amendments to the SEC’s national securities exchange and broker-dealer rules would make it possible for crypto-asset securities to trade more broadly and in a manner that comports with federal securities laws.
The SEC could conditionally exempt national securities exchanges and broker-dealers that solely offer crypto assets from SEC requirements that are incompatible with current market structure if there would be no investor harm. It could also permit these intermediaries to offer non-security crypto assets and crypto-asset securities that weren't registered or offered under an exemption, provided that the intermediary does so in accordance with SEC requirements.
The CFTC’s authorizing statute chiefly governs the trading of derivative instruments, such as futures and swaps. The CFTC has declared certain crypto assets to be commodities subject to its general anti-fraud and anti-manipulation authority, but it generally lacks the authority to issue rules providing oversight for commodity spot markets.
Nonetheless, the CFTC has jurisdiction over offerings of margined, leveraged or financed commodity spot trading to retail investors. Outside the U.S., most crypto exchanges allow retail investors to trade crypto assets on margin. Within the U.S., crypto exchanges must register with the CFTC as a futures exchange to offer crypto-asset margin trading to retail investors. Additionally, a CFTC-registered futures commission merchant must provide the margin, and these transactions must be cleared by a CFTC-registered clearinghouse. The CFTC issued interpretive guidance clarifying the circumstances under which an exchange can qualify for the narrow “actual delivery” exemption from these requirements, but few, if any, have managed to find a way to do so.
The CFTC could take the pen on a lighter touch set of rules for crypto exchanges that offer margin trading but don't offer futures or other types of derivatives. As CFTC Commissioner Caroline Pham has pointed out, the agency has the authority to do so. Many crypto exchanges wish to offer margin trading in the U.S. but are intimidated by the requirements that they register with the CFTC as a futures exchange, offer margin through a futures commission merchant and integrate with a clearinghouse.
Moreover, these exchanges would likely require significant no-action relief from the agency to offer margin trading under current CFTC rules. A new set of rules for crypto-asset margin exchanges would allow these platforms to innovate and grow responsibly under the CFTC’s regulatory umbrella.
It is a shame that the SEC and CFTC are unlikely to write new rules for crypto-asset markets any time soon because there is a lot they could accomplish using their existing authority. But calls from policymakers to regulate through rulemaking rather than through enforcement offer a glimmer of hope for the future.
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