Policymakers face the challenge of establishing sensible crypto regulation, with the primary question being how to differentiate securities from cryptoassets. That difference has huge impact—even more so when it comes to affiliation and regulatory issues. We need an enforceable bright line, either through new enabling statutes or administrative regulations. This legislative approach will replace the vague convoluted regulatory Gensler experience, just based on more than just the Howey test. This article further explores the challenges of defining securities in the crypto space. It looks at the role of decentralization and focuses on the need for a regulatory framework that recognizes the inherent differences of cryptoassets.
Defining Securities in the Crypto Space
The discussion on whether a given cryptoasset should be classified as a security, almost inevitably, returns to first principles. These principles come from the US Supreme Court’s 1946 ruling in SEC v. W.J. Howey Co. This case provided the foundation for the “investment contract” test. Yet, it has emerged as a key touchstone in determining what counts as a security. The old Howey test cannot be easily squared with the decentralized, diffuse nature of many cryptoassets.
Equities trading on the New York Stock Exchange and debt trading over the counter share a fundamental characteristic with securities. They are the only common legal and contractual claim on the business’ or government’s assets, revenues, and profits. This is a very important difference that makes them distinct from most cryptoassets that do not give such direct claims.
Statutes and rules can easily draw the line where securities end, and non-securities begin. This approach doesn’t have to be so dependent on the Howey test. This approach could provide more certainty and clarity for the crypto industry, reducing the ambiguity that has often led to regulatory challenges. Affiliation carries high stakes. It can result in underwriter liability and place economically prohibitive conditions on underwriting and selling the securities into the market, making government’s definition very important.
The Role of Decentralization
Under Gary Gensler’s tenure as SEC chair, the crypto industry was constantly in battle trying to establish how decentralized a protocol was enough. So they claimed, because of this decentralization, their cryptoassets weren’t securities. The SEC’s interpretation of decentralization in certain cryptoassets was met with considerable resistance from the industry. The iPhone, for instance, exists within a very centralized ecosystem, but it isn’t regulated as a security.
"If no one controls a network, then there’s no one to carry the burden of SEC registration." - Joseph Hall
We consider decentralization to be an important business model element that developers should adopt in order to increase network security and resilience. A network achieves true decentralization only when no individual or coalition party can dominate the whole of its consensus mechanism. This decentralization of power improves the security and equity of the network. Once this level of decentralization is achieved, we should move oversight of the specific cryptoasset from securities regulation to regulation of the crypto ecosystem.
The SEC would only need to assert that a network does not have sufficient decentralization. If so, the industry will no doubt find itself again haunted by the regulatory bogeymen of the Gensler era. Centralization, even if applied properly through the Howey test, is not the only centralizing factor that makes a security. Central to the discussion should be whether the asset accrues to or embodies a contractual right to a business’s assets, revenues, and profits.
Moving Beyond Traditional Frameworks
Identifying affiliation is often nebulous, even over the 10% cap on equity interests in an issuer. This legal ambiguity underscores the importance for regulatory guidance that specifically grapples with the new and emerging technologies and innovations characteristic of crypto networks. By creating clear and reasonable standards, regulators can prevent crushing decentralized innovation with arbitrary liability while still safeguarding investors.
Yet the SEC’s disclosure rulebook, created for traditional securities, is completely misaligned with crypto. Cryptoassets are fundamentally different from traditional financial instruments such that they function differently. A regulatory framework adapted to the unique characteristics of cryptoassets is necessary to promote innovation while reducing risks.
We need to devote all of our attention to proposing regulations that address the distinct dangers that cryptoassets present. Such as combating market manipulation, fraud, and cybersecurity threats. Now more than ever, we need regulators, industry participants, and experts to engage in this collaborative process. By working together, they can build creative solutions that enable a safe and sustainable crypto landscape. To truly benefit from the promise of cryptoassets, policymakers should go beyond existing, established paradigms. By embracing these new approaches, the SEC will better protect investors and promote healthy capital markets.
