Regulatory Progress

Brian Zwerner
5 min readFeb 22, 2022

I have written in the past about the shaky regulatory standing of much of the Crypto and web3 industry. Most of this scrutiny in the United States comes down to what types of coins or NFTs or other digital assets are deemed to be securities under the U.S. laws. As quick background, the main laws for this were written a really long time ago in response to the stock market crash of the Great Depression. The Securities Act of 1933 is a federal law that requires that securities sold to the public be registered with the SEC and it outlines what info needs to be disclosed to investors in registered securities. The Securities Act of 1934 regulates the operation of stock exchanges and trading of securities. This is the first way that something can be clarified to be a security, through legislation in Congress.

In 1946, a lawsuit between the SEC and W.J. Howey Co. was decided at the Supreme Court to further clarify what is and isn’t a security under these laws. The Court determined that to be a security, an instrument needs to involve an investment of money in a common enterprise, with the expectation of profit from the work of others. This is commonly referred to as the “Howey Test”. It is subtle, and it has led to a ton of case precedents over the last 75 years. This is the second way that something comes to be a security, with the SEC bringing a lawsuit to enforce their interpretation of the law and eventually the Supreme Court either agreeing or knocking the SEC back.

*Quick disclaimer here. I have been trained as an investment banker on securities laws, but I am not an attorney, and this is absolutely 100% not legal advice. If you are working on a project that might involve securities laws, hire an attorney. This is for informational purposes only.*

There is generally good support for the concept of Bitcoin as a currency or commodity and not a security under the U.S. laws. There has not been much discussion of any regulator coming after $BTC and even if they did no one knows who its creator is anyways. Ethereum is a bit more complicated. The founders and their lawyers have contended that the utility provided by $ETH takes it away from being a security. They argue that it is used for something, specifically the programmable aspects of $ETH, and thus it is in the clear. The SEC has not taken any action against $ETH, but they also have never explicitly said it is OK either. This has led the market to make assumptions about what features of Ethereum keep it out of securities classification, and it is certainly possible other coins are playing too close to the fire on this. We’ll have to see what the SEC does over the next few years or if Congress weighs in to clarify the view on programmable or utility tokens.

Speaking of SEC actions, we saw a huge one last week. The SEC settled with DeFi leader BlockFi on a massive $100MM penalty. BlockFi runs a huge securities lending program where customers pledge their Bitcoin and other Cryptocurrencies in exchange for a high yield in the 6–10% range. I did a deep dive on the sector a few weeks ago here, and you’ll see I am not a fan. Disclosures are terrible on these products. There is just not enough info in my opinion to make an informed decision. The SEC basically agreed, and they have determined that the yield programs from BlockFi should have been registered as securities. The industry cheered the result, since BlockFi said they are now going to work with the SEC to make these registered securities going forward. However, the SEC has not agreed to this yet, and frankly they may never agree. We’ll see how this plays out over the course of 2022.

I also criticized the stablecoin market in a prior post. Poor disclosures and undersold risks make this another area ripe for regulatory scrutiny. Last week, New Jersey Rep. Josh Gottheimer shared a draft of a bill to regulate these types of coins. Amongst other requirements, stablecoins would need to be fully redeemable for dollars and backed by collateral approved by the US Comptroller of the Currency. This is a great step in the right direction. It is unclear if Rep. Gottheimer’s bill will get the support it needs to leave committee and make it to a vote or not. Either way, it’s a start.

We have not seen any type of SEC or congressional action yet on tokens issued by DAOs that might be construed to have an expectation of profit under the Howey Test. Similarly, there has been no progress in defining fractional ownership in music royalties, collectibles, or income producing assets. These are areas that seem to skate closer to the Howey Test line. Time will tell.

I have spoken to many people in the industry about which slow moving process will lead to resolution first on these securities questions. If the SEC takes more aggressive action against market participants, it will provide some guidance on their thinking. However, the issue would not be fully resolved until someone challenges the SEC in court and goes all the way to a Supreme Court ruling. This process would easily take 2–3 years. Some people I have spoken to are hopefully a bipartisan Crypto bill could make it through Congress after the midterms, so maybe some time in 2023. I am less inclined to believe this will be a priority until after the 2024 Presidential election, so 2025 for this is probably a safer bet.

It looks like it will be a complex few years in the Crypto space as the markets wait to see where the guiderails are set on these important issues. I’m sure I will have more to say on this in future posts.

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