This month, with his brother and a friend, Ishan Wahi, a Coinbase product manager, was charged with the first-ever insider trading scam.
They have amassed more than $1.1 million. Ishan, who possessed insider information, allegedly provided them with information on the date and content of impending listing announcements. They were accused of insider #trading this week and could face up to 20 years in prison.
According to the #SEC, nine of the 25 #crypto #assets purchased by the shady trio were #securities.
The problem is that #Coinbase claims that this is not the case.
According to their CLO (Chief Legal Officer):
“Coinbase has a comprehensive process in place to assess and review each digital asset before making it available on our exchange – a process that the SEC has reviewed.”
“This process includes a study of whether the asset is a security, as well as regulatory compliance and information security components of the asset.”
Coinbase petitioned the SEC to explain the ambiguity of what security is.
They argued expressly that:
“Due to the lack of a clean and workable regulatory environment, the United States does not currently have a functioning market in digital asset securities. Today’s digital assets share many of the characteristics of commodities.”
Although it is not apparent to the untrained eye, the underlying consequences of this debate might devastate the entire sector since the regularization of #cryptocurrencies as securities would, to put it mildly:
This would completely alter the #crypto #market landscape and significantly impact how you approach crypto #investing.
What are securities, and what are the consequences of a cryptocurrency becoming one?
According to #Investopedia, security’s definition is:
A fungible and negotiable #financial instrument with #monetary #value. It reflects #stock ownership in a publicly listed #firm, a creditor connection with a governmental body or #corporation represented by owning that entity’s bond, or #ownership rights represented by an option.
More specifically, the SEC (U.S. Securities and Exchange Commission, which is in charge of protecting markets from #manipulation by establishing rules and regulations governing the issue, marketing, and #trading of securities) employs the #Howey Test to evaluate if something is a security.
The Howey Test is a 1946 decision that states that for something to be classified as a security, it must meet the following criteria:
- Is there a financial investment with the hope of future #profits?
- Is money invested in a joint #enterprise?
- Are there any benefits from the efforts of a promotion or a third party?
The primary distinction between a security and a #commodity is that securities give you a #stake in a corporation’s ownership and management.
In the case of a commodity, it grants you rights to products or property sold in exchanges rather than control over the underlying company.
As a result, interpreting how the Howey Test relates to cryptocurrencies is crucial in determining if everything remains the same or changes in crypto.
And what are the #ramifications?
If cryptocurrencies were classified as securities, the SEC would have a stranglehold on the crypto industry:
For starters, crypto projects would face considerably stricter regulation, such as producing quarterly and annual reports and other periodic reports, like public businesses and other regulated companies. They would also have to publish public narratives outlining how the year’s operations went. In other words, complete transparency would be mandated rather than urged.
These #coins would also have to be registered with the SEC.
Cryptocurrency #exchanges may be required to register as #Brokers-Dealers.
Thanks to that, it would indicate a considerably stronger commitment from them to authorities, even though crypto exchanges have historically been notoriously opaque.
For example, many of the exchanges giving insane #APYs (the interest you get on your deposits on these platforms) did so by gambling that money on the #DeFi market to give back such a significant return to #investors.
Many in the space say that this is precisely what crypto exchanges require to avoid circumstances in which #CeFi exchanges like Celsius fail due to the overwhelming strain of simple gambling to pay the ridiculous APYs they promised.
both algorithmic and asset-backed, would face intense examination.
In the former scenario, to ensure that occurrences such as the LUNA/UST collapse do not occur again, and in the latter situation, to ensure that stablecoins such as #Tether demonstrate that they have the reserves to back the #stablecoin issue.
DeFi, DAOs, and the #Hinman Paradox #DAOs have become the governance medium for DeFi protocols, including many of the ‘big’ ones, such as #Uniswap, #Aave, and #MakerDAO, which are now all governed by them.
Along with currencies issued through #ICOs (Initial Coin Offerings, which are analogous to a company’s #IPO to go public), the SEC’s opinion on DAOs appears clear: DAO tokens should be considered securities.
DAO tokens are subject to what UCLA law professor James J. Park calls “the Hinman Paradox.“
“A token may only be extensively distributed to the general public if the project with which it is related is operational,” Park wrote in 2018. “However, a blockchain project cannot work until its tokens are widely disseminated.”
Regulatory guidance has subsequently begun to suggest that functionality is insufficient – historically, the utility of the #tokens has been used to argue that many cryptocurrencies are not securities because they provide actual use. As a utility token, they would be subject to the regulation of digital assets (#VASPs) rather than financial legislation, which is significantly stricter.
As a result, a token can only be extensively disseminated to the public if the project with which it is linked is equally widely used and regulated by those users rather than a #centralized team. A token released before user-based governance is thus not a token but a security comparable to ICOs.
In that sense, governance tokens can only be issued if they are already widely used to make decisions. This, of course, means that the tokens themselves do not need to be issued. As a result, we are in a riddle-like situation for DAO tokens.
Even though the situation appears hopeless, there is a silver lining. Regulators base their decisions and thought processes on security regulations that are over seventy years old and implicitly believe that a centralized, legal organization supervises all security.
However, this is not the situation with cryptocurrencies. Thus their classification should not be based on regulations that do not reflect how the world operates today.
What should you anticipate?
Although the debate between the SEC and the crypto industry is not new, recent SEC actions indicate that the commission is poised to address this matter shortly.
The SEC is leading the drive for greater control over cryptocurrency. Gary Gensler, the SEC head, stated in an April 2022 address that various factors must be considered:
- That most #crypto tokens are likely to qualify as #investment contracts under the Howey Test standard established in a United States Supreme Court decision.
- The top five exchanges account for 99 percent of cryptocurrency trading and should be required to register with the SEC and comply with applicable regulations.
- He also advocated for stricter financial regulation of stablecoins and other crypto tokens.
Although many of these views aren’t new, the SEC has taken concrete steps to resolve the conflict with the crypto industry.
In this regard, the SEC stated in May 2022 that it would boost the workforce of its Cyber Unit from 30 to 50 and rename it the Crypto Assets and Cyber Unit to strengthen regulatory enforcement in cryptocurrencies.
Regulation is required, but new laws are also necessary.
As Coinbase has said to the #SEC, there is currently no clear definition of what constitutes security in the context of digital, #decentralized assets.
Suppose the SEC is to fulfill its mission of protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation.
In that case, it must demonstrate a willingness to cooperate and an understanding that financial #markets are changing and that #technological progress should not be stifled by the law but rather encouraged by it.
Regarding the DAO issue, if they were classified securities, DAOs would be in new territory, as they would be required to do identity checks, among other things, potentially destroying one of the most fundamental elements of DeFi, which is to respect #wallet anonymity.
Fortunately, this does not imply that DeFi will vanish; instead, DeFi would need to develop ways to comply with legislation while maintaining maximum anonymity.
DeFi, however, must first address the question of accountability.
Although DeFi protocols have managed to avoid regulation since they are administered in a decentralized fashion, the SEC is keeping a careful eye on them.
Unless and until DeFi protocols demonstrate their real decentralized nature, the SEC and other regulators have ample reason to believe they are centrally owned by particular parties or persons, converting their coins into securities.
Obtaining a semi-anonymous #KYC may be the solution.
Fortunately for all of us, considerable progress has been achieved on the subject of identity verification, which is the most challenging hurdle DeFi must overcome to succeed in this situation:
DeFi Passports validate user repute.
These passports would be the DeFi counterpart of KYC (Know Your Customer) processes enforced by centralized exchanges.
This is already in #Solana’s pipeline, although only ARCx is actively working on it now.
#Soul-bound tokens (#SBTs).
These tokens, which were first proposed in a research paper by Vitalik Buterin, the founder of Ethereum, are simply tokens connected to the user’s soul (wallet), making them untransferable. These tokens could provide information about the wallet’s reputation and identity while only providing the knowledge that the wallet’s owner wishes to make public, allowing KYC without revealing who owns the wallet.
Once again, decentralization is a fundamental element of crypto since it represents the most critical technical asset for blockchains and may also be the industry’s regulatory safeguard.
For that reason, in protocols and initiatives where decentralization has not been established, their actual use case is dubious, and they are also considerably more vulnerable to negative regulation that may become their timely executor.
As a staunch believer in the sector, I am confident that crypto founders and developers will come up clutch to avert heavy regulation by doing what the crypto business has done best: developing outstanding technology.
Furthermore, regulators have defined Bitcoin and Ethereum as commodities, so there is precedent in the area for exploring ways to achieve favorable regulation for new cryptocurrencies in the future.