SEC and Cryptocurrency Regulation: Understanding the Need for Oversight in the Crypto Industry

Historical Context: Lessons from the Roaring Twenties

The exuberant 1920s, known as the "Roaring Twenties," witnessed a booming U.S. economy. This era of continuous market surges fueled rampant speculation and gambling. From everyday citizens to CEOs, individuals poured their life savings into the thriving market, chasing the promise of substantial returns.

As the market swelled, investor confidence soared, perpetuating the speculative frenzy. The saying "every boom is followed by a correction" held true, with more capital flooding into the market. Investors either disregarded corrections or viewed them as buying opportunities.

Blinded by the bubble's allure, investors believed it would last indefinitely. However, in 1929, reality struck with an unforeseen corrective move. Unfolding over four waves, it triggered an 89.2% market decline and a staggering 36% plunge in the U.S. economy over four years. This immense loss put many into unemployment and despair, ushering in the twelve-year "Great Depression" from 1929 to 1941.

The Great Depression's aftermath was a period of economic upheaval marked by crushing debt burdens, widespread unemployment, and a depleted government treasury. To revitalize the market and restore stability, then-US President Franklin D. Roosevelt signed the Securities Exchange Act of 1934, establishing the Securities and Exchange Commission (SEC).

The SEC's core mission was to restore equilibrium amidst the economic downturn. In essence, it aimed to reform the financial system, regulate the stock market, and rebuild public trust. The SEC was entrusted with distinct responsibilities: ensuring financial order and, most importantly, safeguarding consumers — U.S. citizens.

The SEC we know today is vastly different from its 1933 inception. Over the past nine decades, it has continuously evolved, explicitly strengthening the system and frameworks to adapt to changing economic and financial landscapes. Most importantly, it caters to market demands by providing a framework for companies to deliver quality services to users, eliminating bad actors, and fostering a safe and secure environment for user engagement.

To understand the SEC's initial framework and its current state, it's important to consider the core principles that established its foundation:

• Restoring Public Confidence

• Regulating Securities Transactions

• Mandating Financial Disclosure

• Eradicating Fraudulent Activities

• Enforcing Federal Securities Laws

• Overseeing Securities Exchanges

• Regulating Securities Brokers and Dealers

• Overseeing the Securities Industry's Self-Regulatory Organizations (SROs)

While these core principles define the SEC's purpose and essence, there have been numerous implementations and adaptations of new laws and frameworks. These implementations, and in some instances, adaptations, reflect several changes. Here are some highlights of the key initiatives undertaken to create a more robust and functional system, expanding its scope to address specific markets.

One such implementation is the Regulation National Market System (Reg NMS), which strives to protect investors and enhance the efficiency of stock markets. Other additions to the SEC's framework to provide a more robust approach include:

• Regulation Best Interest (REG BI) in 2019.

• Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

• Modernization of the Investment Company Act rule 18f-4 of 2020, providing a comprehensive approach to regulating funds' use of derivatives.

• Updates to the accredited investor definition of 2020, a category of investors allowed to participate in private and other sophisticated investment opportunities.

• Proposed amendments to enhance private fund reporting in 2021, increasing reporting requirements for private funds on Form PF.

• The Digital Engagement Practices (DEP) Initiative of 2021 scrutinizes practices involving newer technologies and other digital features designed to engage with retail investors on digital trading platforms.

Numerous iterations have been implemented to provide clarity where needed. Two notable examples include providing additional context to who qualifies as an accredited investor, adding new categories based on professional knowledge, experience, or certifications, and the modernization of funds.

Like in the Roaring Twenties, the cryptocurrency landscape presents similar opportunities and risks, particularly for those seeking to capitalize on a bullish market without understanding the underlying risks.

However, unlike the era that birthed the SEC, the cryptocurrency and Web3 industry offers underlying technologies with profound applications that genuinely address real-world issues. These technologies have unique characteristics, with a significant component being decentralization, which empowers users with autonomy in many cases. This has translated into a $2.5 trillion market at the time of writing, indicative of the significant value it provides.

The key distinction lies in the market structure. Unlike traditional markets like stocks, which fall under the SEC's purview and for which the frameworks mentioned earlier were created, the crypto industry has several components that rely solely on unique technologies.

These technologies include decentralized finance (DeFi), decentralized applications (dApps), decentralized exchanges, and centralized exchanges, among others. They exist outside the traditional market approaches the SEC is accustomed to supervising, such as security exchanges, brokerage firms, exchange-traded funds, and credit rating agencies. The crucial takeaway here is the inherent uniqueness of both markets!

Despite these underlying differences and the clear need for regulation to provide a clear path for operation and offerings, the SEC has struggled to define how the industry operates clearly. This ambiguity has resulted in numerous uncertainties for both developers in the crypto industry and end consumers of these products. The SEC's approach appears unclear and indecisive.

The most glaring example is the recent case involving the SEC and Ethereum. William Hinman, the former Director of the Division of Corporation Finance at the SEC, suggested in a 2018 speech at the Yahoo Finance All Markets Summit that Ether — the native token of the Ethereum blockchain — was not a security.

Currently, the Commodity Futures Trading Commission (CFTC) also views cryptocurrencies like Bitcoin and Ether as commodities. However, the SEC recently retracted its position, stating that Ether is, in fact, security years after significant innovations have been built on its underlying technology, the Ethereum blockchain.

Similar issues have arisen with platforms like MetaMask, the peer-to-peer platform, and Coinbase Wallet, which the SEC considered a broker—the motion to classify the latter — CoinBase Wallet — as a broker was dismissed.

While the Howey Test — used to determine assets to be classified as securities — has served as a proven framework, the SEC has yet to establish proper guidelines or adaptations to existing frameworks to guide the cryptocurrency industry on better operating their services per established legal frameworks. Most existing frameworks are unsuitable and irrelevant in this context.

The SEC has taken aim at several cryptocurrency companies and assets, including well-known platforms like Binance and Robinhood, as well as Ripple Labs Inc. Additionally, the SEC has flagged concerns that certain digital assets, such as Solana, Cardano, and Polygon, may be unregistered securities.

As mentioned earlier, regulating the crypto industry appropriately is complex due to the unique characteristics of cryptocurrencies and their underlying technology. The need for clear and effective regulations is undeniable, as they can help stabilize the market, protect consumers, and ensure fair and transparent practices. Here are some thoughts on the necessity and potential approaches to regulating the crypto industry:

Decentralized Wallets and Broker Definitions: Decentralized wallets and exchanges complicate traditional regulatory frameworks. They don't fit neatly into existing definitions of brokers or clearinghouses because they often lack a central authority to be held accountable. This will help avoid issues like those raised regarding Coinbase Wallet and MetaMask. Defining whether and how decentralized platforms should be regulated involves understanding their role in facilitating transactions and determining the extent of their responsibility in anti-money laundering, counter-terrorism financing, and consumer protection. This is needed just as it was implemented to redefine who an accredited investor is.

Clarity on Securities Status: Providing clear guidelines on what constitutes security in the crypto world is crucial. This should be an adaptation of the Howey Test or a new framework more inclusive of cryptocurrencies. The Howey Test has been a standard, but as digital assets evolve, so too might the need for new criteria or supplementary guidelines tailored explicitly to digital assets and their unique properties. This clarity can empower innovators and developers to understand their legal obligations before launching digital assets, potentially reducing the likelihood of unintentional securities law violations.

Market Integrity and Stability: Regulations can help prevent market manipulation and ensure fairness, which are significant concerns in the highly volatile crypto markets. Regulations that require transparency, such as clear trading practices and disclosures, can contribute to more stable and trustworthy markets. This will reduce the risk of fund loss and manipulation frequently experienced in the industry. This has been particularly helpful, and the result can be observed with the recently approved Bitcoin exchange-traded funds (ETFs).

Innovation vs. Regulation Balance: It's crucial to strike a balance between regulation and innovation. Overregulation by the SEC or other agencies could stifle the innovative potential of blockchain technology, while under-regulation might lead to an unstable market flooded with scams and frauds. A collaborative approach involving regulators and industry stakeholders can help develop a regulatory framework that supports innovation while protecting the interests of consumers and the broader financial system.

Consumer Protection: Many consumers enter the crypto market without fully understanding the risks, driven by stories of rapid gains. Effective regulation can help ensure that consumers are adequately informed about potential risks and that there are safeguards against fraud and exploitation.

The Securities and Exchange Commission's (SEC) crackdown on cryptocurrency platforms is likely to continue until a clear and comprehensive regulatory framework is established or adapted. This need for regulatory guidance is understandable, given the novel nature of cryptocurrency and its unique characteristics compared to traditional markets.

 A clear framework would benefit both the SEC and American citizens. It would allow the SEC to effectively fulfill its core mission of protecting investors while enabling citizens to participate in the cryptocurrency market with more certainty. Conversely, unclear regulations create uncertainty for crypto platforms, making it difficult for them to operate in compliance with the SEC.