Cryptocurrency is a financial technology that relies on autonomy and decentralization. The Securities and Exchange Commission is a regulatory agency that relies on strict enforcement of existing rules. The inevitable clash between them is now at a critical juncture.
The timing isn’t coincidental. We are in a crypto winter, with unhappy investors wondering why regulators didn’t protect them from illegitimate banks such as Celsius and uncollateralized stablecoins such as TerraUSD, along with pump-and-dump token ploys involving social-media influencers.
SEC Chairman
Gary Gensler
and other regulators have taken action, saying they are merely enforcing existing rules on assets that are, fundamentally, securities. Crypto’s largest players argue that existing securities rules are outmoded, unclear or irrelevant. This regulatory standoff poses a risk to the growth of blockchain and cryptocurrency technology, as well as to the decentralized financial products of what’s called the “Web3 sector,” where users have governance rights and ownership.
No matter what regulators do, they shouldn’t stifle the innovation that is at the heart of this market. Blockchain is the first technology that enables two parties to transact without a centralized intermediary such as an exchange, broker or bank. The implications are profound. Blockchain technologies have significant potential to increase transparency, reduce risk in capital markets and democratize finance. The settlement and counterparty risk concerns that emerged in the 2008 financial crisis might not have been an issue if blockchain had been widely used.
But to realize the technology’s full potential, both sides must acknowledge two simultaneous truths: Cryptocurrency markets need oversight, and regulators need to do more than regulate by enforcement.
The market needs further interpretive guidance, greater public-private discourse and a balanced tone. The strength of any regulatory regime depends on the ability of builders and policy makers to identify, give priority to and address these issues in a collaborative manner.
Market participants who want to work within the securities laws or engage the SEC don’t have a clear path to compliance.
Coinbase,
a major cryptocurrency market and dealer, went public with the SEC’s approval—and then couldn’t get approval from the Financial Industry Regulatory Authority to offer crypto assets through its own broker dealer since many crypto assets are considered unregistered securities.
The SEC has said it can use existing rules to do its work, but that isn’t really true. Web3 decentralization raises thorny questions for the Howey test—the legal determination of whether a transaction contract is an investment contract and, therefore, a security.
Can a token such as Ethereum start as a security and stop being a security after sufficient decentralization? Under what circumstances is a nonfungible digital version of a collectible a security? The principles of the Howey test are sound and have served markets well, but they don’t answer these questions fully.
An updated regulatory framework is possible. It can be based on a combination of fresh SEC action and, with congressional approval, a self-regulatory agency for this market. At the same time, the SEC could provide constructive guidance building on its 2019 Digital Asset Framework. It’s been more than three years since the SEC has provided constructive direction that might help the market know it is in compliance. Additional guidance would help make the SEC’s enforcement efforts more precise, predictable and fair.
Meanwhile, federal regulators should develop stablecoin audit standards. There is an important role of banks in issuing digital dollars and serving as a custodian for digital assets.
In a fundamental sense, cryptocurrency markets introduce a fresh test of the SEC’s mandate to promote capital formation, promote the integrity of capital markets and protect those who invest. But this is also a test for those who are at the heart of these markets. A promising technology, even one that can reduce costs of existing payment and settlement systems, has to satisfy the legitimate expectations of the investing public and regulators.
If both sides pass this test, the U.S. can strengthen its standing as the world’s leading capital market and global reserve currency.
Mr. Levitt served as SEC chairman, 1993-2001. Mr. Ahluwalia is CEO of Lumida, a digital-asset advisory startup.
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