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In today's issue: Regulation is coming to crypto, and that's a good thing.
In light of all the well-publicized meltdowns this year, calls are growing for lawmakers to better regulate crypto.
In today's column, you'll learn why good laws will be good for crypto investors. You'll also know of a groundbreaking new paper that charts a path forward. Read on. |
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| | | Must Read Today's most important story for crypto investors. |
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It's the groundbreaking paper everyone's talking about. It's The Ineluctable Modality of Securities Law, which admittedly sounds like the name of a three-hour independent film.
Despite the name, the paper is a huge step forward in separating tokens from the underlying securities law, which could have a huge impact on the industry.
If you want the TLDR version, check out the Harvard Law summary, where they rave about Ineluctable Modality and summarize the main points in a format you can read over lunch.
Investor takeaway: While an ICO should be classified as an investment contract (and subject to the same laws as an IPO), the authors argue that tokens themselves are not securities. If adopted, this idea could clarify the laws around crypto, which would unlock the floodgates of innovation. Keep reading. |
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Ready for Regulation by John Hargrave |
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| While it’s been a dark year for crypto, there’s an incredible silver lining. Regulation is coming. Many in the crypto community will disagree that this is a good thing. They think regulation will stifle the industry; that crypto wants to be free. Well, we see where that’s gotten us: the collapse of Terra, 3AC, FTX, and many others. There’s another narrative going around that it’s centralized exchanges that are the bad guys, and that only decentralized projects can be trusted. However, they’re only as trustworthy as their code. We’ve seen how trustworthy that is; the list of hacks and bugs is too long to mention. I'm still a big blockchain believer, but I also see the writing on the wall. The litany of crypto failures this year means that regulation is coming. It’s inevitable. And if you can’t beat ‘em, join ‘em. Of course, there are good laws and bad laws, and we can only hope the laws regulating crypto will be good ones. This industry has had five years to build a powerful lobbying force in Washington and make significant political donations, so we hope the laws will be wiser. Time, I hope, has worked in our favor. But overall, regulation is a good thing because we will finally understand the rules of the game. This is what will allow crypto to flourish. To explain why, let me go back to the first big crypto winter of ’18. Actually, let’s go back to… |
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The ICO Summer of 2017 Back in 2017, we weren’t naming the crypto seasons yet. If we were, we would have called it “ICO summer.”
Everyone was launching initial coin offerings, which looked a lot like initial public offerings, but they were tied to tokens instead of securities. I’m pretty sure this made them unregistered securities. It was an exciting time (if you weren’t there, my book captures the spirit of this important chapter in crypto history).
It’s fashionable now to call ICOs “scams,” but I heard countless pitches from entrepreneurs who were genuinely interested in building useful products. There was a spirit of radical change. Decentralization was going to completely transform the Internet, and the world. This was a revolution! What happened between 2017 and 2018, where bitcoin lost more than half its value and the market imploded, is harder to explain. Sure, the technology bubble popped, but why? It wasn’t a big collapse like the ones seen recently... It was the lawyers. As more people started filing ICOs, they started hiring lawyers who looked at the "wild west-ness" of it all and cautioned these ICOs might be unregistered securities (the SEC, too).
It was the uncertainty of regulation around ICOs that started the first crypto winter. |
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The simple investor takeaway is that laws bring clarity. When there is clarity (assuming the laws are good), this industry will accelerate beyond our wildest dreams. So, how do we make good laws? I’ll simply explain the hard problem and a newly-proposed solution. The Hard Problem: Are Cryptos Securities? I've described how most ICOs were likely unregistered securities. Entrepreneurs raised money from investors by selling them tokens and used the money to build their projects. Investors hoped the token prices would go up as the projects got more valuable.
There's nothing wrong with this. People raise money to start businesses all the time, except these were investment contracts which are governed by securities laws (and enforced in the U.S. by the SEC). I think the industry has been caught in this big lie ever since: trying to prove tokens are not securities. First, we changed the name of the ICO (multiple times). There was the IDO, then the IEO, etc., until we ran out of rhymes.
Then, we created “governance tokens” claiming to decentralize ownership, even though a core team of managers still did all the work. This was what I've called "decentralization theater" -- trying to act like you're not a security. It's a lie. At Bitcoin Market Journal, we’ve held to our philosophy that tokens are like securities. We should treat them like common stock and their underlying projects like companies. Let’s call a spade a spade. Everyone thinks of tokens like stocks. Can we please just admit this? The entire structure of CoinMarketCap looks exactly like a stock exchange: |
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| We all buy tokens hoping “prices go up” on the efforts of others. That’s the very definition of a security. BUT… there’s a big “but.” In some ways, blockchain tokens don't look like securities. Even though we always talk about ETH being like “stock” in the Ethereum “company,” Ethereum is not a company. If things went south, whom would you sue? The stakers? The developers? Vitalik's parents for conceiving him? The SEC admits this. Its position has been that crypto projects start out as securities but at some point, some of them become sufficiently decentralized so they are no longer securities. Ethereum is the classic example. But when, exactly, did Ethereum become decentralized enough to pass from “security” to “not a security?” When was the date? What was the metric? If we can’t answer this question, we cannot get this industry to really fly because we still don’t understand the law. No one does. Fortunately, we now have a solution. |
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Unlike Power Rangers, tokens can't morph from "security" to "non-security."
The Solution: Separate the Fundraising from the Token A new paper, The Ineluctable Modality of Securities Law, does a masterful job of explaining why the tokens themselves are not securities. It’s the fundraising contracts that are securities.
I wish all lawyers could write like this. The paper starts with “The Parable of the Stowrange Seeds,” a fictional story about a horticulturist who develops a new fruit called the Stowrange (rhymes with orange). She sells a lot of Stowrange seeds to get her new fruit company off the ground (seed capital... Get it?). After a while, people are trading the seeds themselves not to grow fruit, but in the hope that "prices go up." It’s a memorable story that's masterfully told because it drives home this central point. The seeds themselves are not investment contracts any more than the orange groves in the famous Howey case. In crypto, the authors argue that an initial token launch (ICO or whatever) is a securities offering if investors buy the token hoping the price goes up on the efforts of others... Plain and simple. But after the launch, the token itself is no longer a security. Please read that sentence again.
The authors laugh at the idea that Ethereum could magically morph from “security” to “not a security.” They argue that if the SEC can't pinpoint when that morphing happens, it's not a workable model.
Under their proposed framework, the initial Ethereum ICO was an investment contract with the first investors who bought ETH. After that, once it was sold on secondary markets, ETH was not a security. This distinction gives us a path forward. If you want to issue a new token to fund your crypto project, you do it like any other security, but after that initial offering, most tokens would no longer be legally classified as securities. If this becomes law, most projects will probably airdrop their tokens for free to users (like Uniswap did) to get around the investment “contract,” but even that might not be a bad thing. At least they’d have actual products with actual users. The authors argue the tokens would instead be regulated as commodities under the CFTC. Here, they admit new legislation is still needed, so we’re still kicking the can down the road, but the proposal has two big benefits:
1) clarity around the initial offering process, and 2) a way to stop the turf wars between the SEC and the CFTC. There’s enough crypto to share with all the regulators. With legal clarity, there will be even more. |
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Why Crypto Regulation Is Good To those in crypto who are still resisting legislation: your faith is weak.
If the technology is really as great as you say, won’t it still be great if we have laws around it? To me, it’s obvious that just as regulatory uncertainty caused the crypto winter of 2018, regulatory certainty will usher in a new crypto spring. Think about it. If everyone understands the path to launching a legal crypto project, the investment dollars will come flooding in. Every company, bank, and financial institution will start hiring and investing in the space. It will have to be part of their strategies like the internet was in the 2000s. Even the wild west needed sheriffs. Once people felt they could walk into a saloon without getting robbed, that’s when the growth of the American west really took off. The paper is a good start. Let’s build good laws from there... We’re ready. |
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Health, wealth, and happiness,
John Hargrave Publisher Bitcoin Market Journal |
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Bitcoin Market Journal is a daily newsletter that makes you a better crypto investor. It's created by John Hargrave, Nick Marinoff, Steve Walters, Anatol Antonovici, Ben Burn, Preetam Kaushik, and Daniel Joel.
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