How Regulation Could Help Cryptocurrencies Grow
This article was originally published in the Harvard Business Review on July 17, 2018. Please go to https://hbr.org.
Ignorance may be bliss for some, but ask anyone in commerce or finance, and they will make it abundantly clear: Ignorance is risk. For that reason, U.S. markets embrace reasonable regulation to ensure transparency and fairness. Stocks are regulated by the Securities and Exchange Commission (SEC), commodities by the Commodity Futures Trading Commission (CFTC), and government currency by the Department of the Treasury and the Federal Reserve. But an emergent fourth asset class, cryptocurrencies, has no single regulator, and that is leading to uncertainty and confusion.
In early June the SEC announced the appointment of one of the agency’s veteran attorneys, Valerie Szczepanik, as associate director of the Division of Corporation Finance and senior adviser for Digital Assets and Innovation. This is a welcome development. As "crypto czar," her job will be to rationalize the application of U.S. securities laws to cryptocurrencies and work with other agencies to coordinate regulatory oversight.
That will be easier said than done. But it is vitally important.
Without clear regulations, cryptocurrency innovation in the United States is being stifled. Entrepreneurs sit on the sidelines for fear of innocently running afoul of the law. Investors, meanwhile, hang back because of uncertainty regarding valuations. And the commonweal suffers, as other countries lure innovators away from the United States by creating rules that make their jurisdictions more hospitable to this growing asset class.
Given the regulatory uncertainty, the United States also risks allowing fraudulent purveyors of cryptocurrencies to drive out the good. To be sure, federal and state enforcement officials have aggressively sought to stamp out fraudulent initial coin offerings (ICOs) and cryptocurrency trading platforms. But without clear and coherent guidelines to attract good actors to the U.S. market, fraudsters might push out the good actors. At least one estimate pegs the frequency of ICO scams to be as high as 80%.
Although still nascent, cryptocurrencies worldwide are nevertheless on the rise, with money raised by issuers in the first half of 2018 already exceeding the amounts raised in all of 2017.
Yet the growth of this 21st-century innovation is being hampered in the United States because our regulators are forced to use enforcement tools created decades ago, well before the internet took off, and in some cases even before World War II. Additionally, overlapping oversight by various agencies creates a structural barrier to change and drives up costs for creators of cryptocurrencies. This improvised approach needs to be improved.
The SEC has said that whether securities laws apply to a particular cryptocurrency depends on the "facts and circumstances" of the offering. And it has emphasized that the manner in which cryptocurrencies are sold is key to that analysis. Indeed, it has been relatively rare that promoters have sold cryptocurrencies just so the buyer can purchase a good or service on a fully developed network. Rather, more often the buyer is hoping to realize a return on the instrument based on the work of the promoter, which likely makes it an "investment contract" and thus a security under the 1946 Supreme Court decision in SEC v. Howey Co.
Looking beyond Howey, however, the SEC and the crypto czar could take a few thoughtful steps to promote clarity and innovation in the cryptocurrency market:
- Encourage the formation of a self-regulatory body to promote and enforce standards among the crypto community.
- Convene an interagency working group, including representatives from the crypto community, to harmonize existing regulatory practices and develop a formal U.S. policy on cryptocurrencies.
- In connection with the above, provide public notice of a proposed rule governing cryptocurrencies and take comments from the public. (This was the process used to redefine so-called swap entities after the financial crisis.)
- Officially recognize that the amount of decentralization is an important factor in determining whether a cryptocurrency is a security.
- Go beyond the appointment of a crypto czar. The SEC should follow the lead of the CFTC — which created LabCFTC, an initiative for promoting innovation in fintech — in developing an opportunity for SEC regulators to directly engage with industry to address questions about the application of the securities laws to blockchain technologies before launch.
These steps will help to promote order, consistency, and accountability within the cryptocurrency market without imposing undue burdens. And they will help the United States emerge as a wise leader in the regulation of cryptocurrency, which will spur entrepreneurship and innovation in this country. After all, wisdom — more than ignorance — is a truer form of bliss.
This article represents the personal views and opinions of the authors and not necessarily those of the law firm with which they are associated.