Policymakers are rethinking crypto regulation, moving away from using decentralization as the main criterion to distinguish between securities and cryptoassets. The current focus on decentralization has led to confusion and inconsistent regulation. A proposed solution is to focus on the intrinsic nature of the asset, which offers clearer guidelines for differentiation compared to traditional securities. This shift aims to promote a more conducive regulatory environment for the crypto industry.
When considering crypto regulation, policymakers face the challenge of distinguishing between securities and cryptoassets. The prevailing view suggests that this distinction hinges on the decentralization of the corresponding network or blockchain protocol. A network is deemed decentralized when no single entity controls a significant portion of its consensus mechanism, potentially indicating that the cryptoasset does not qualify as a security.
The rationale for prioritising decentralization in regulatory discussions is compelling. If a network operates without control by any one party, the burden of SEC registration shifts away from that party. Additionally, investors cannot rely on the “efforts of others” within decentralised projects, which aligns with the criteria established in the 1946 SEC v. W.J. Howey Co. decision regarding investment contracts.
Former SEC Chair Gary Gensler used the Howey test to argue that most cryptoassets are indeed securities, placing decentralization at the forefront of asset classification. While Bitcoin exemplifies sufficient decentralization, many other protocols did not meet this strict standard, often leading to contention within the industry. However, the absence of judicial clarification continues to perpetuate confusion around the decentralization threshold.
Legal considerations of control are similarly relevant when evaluating the affiliations of individuals involved in securities transactions. Affiliation can lead to significant legal liabilities under SEC rules, especially regarding those who control, are controlled by, or share common control with the issuer. Often, questions of control can arise even at low ownership levels, which complicate matters further in the context of crypto regulation.
Recent shifts indicate a departure from the Gensler doctrine, suggesting that regulatory lines between securities and non-securities could be clearly defined through statutes or regulations without needing to refer to the Howey test. Four reasons argue against a central focus on decentralization:
1. Centralisation itself is not inherently characteristic of a security, exemplified by products like the iPhone, which is tightly controlled but not regulated as a security.
2. The ambiguity surrounding the evaluation of decentralization can lead to inconsistent regulatory interpretations, diverting back to the complications of the Gensler period.
3. Since protocols may lose their decentralisation over time, fluctuating between status as a security and a non-security could generate unnecessary confusion for market participants.
4. Networks intentionally designed to be centralised could unfairly be categorised as securities notwithstanding their legitimate business models that achieve security and resilience through alternative methodologies.
A more effective regulatory approach would emphasise the intrinsic nature of the asset rather than its network, especially considering that traditional securities represent identifiable claims on the assets or revenues of businesses or governments. In contrast, many popular cryptoassets, including Bitcoin and Ethereum, lack these fundamental characteristics, making current SEC disclosure regulations largely irrelevant in this sector.
The uniqueness of cryptoassets necessitates a consideration of trading rules that differ from those of traditional securities, which are closely bound to the behaviours of the businesses they represent. The potential for speculative trading in crypto does not correlate with the same regulatory concerns that arise in securities contexts, where corporate capitalisation is a significant factor.
Determining the nature of the asset as a foundational criterion helps create clarity within the regulatory landscape. By providing a clear framework that centres on what the financial instrument represents, rather than on the decentralisation status of the underlying protocol, regulators can foster a healthier environment for innovation within the crypto industry.
