An Open Letter to the SEC

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This essay is part of The Token Handbook. It was originally published in a slightly shorter form in The IB Times.

THE GOAL OF THE SEC is to keep retail investors safe. On January 25th, Jay Clayton of the SEC and J. Christopher Giancarlo of the CFTC published an op-ed piece in the Wall Street Journal (ungated here), in which they wrote:

A key issue before market regulators is whether our historical approach to the regulation of currency transactions is appropriate for the cryptocurrency markets. … We would support policy efforts to revisit these frameworks and ensure they are effective and efficient for the digital era.

They conclude:

If history is any guide, DLT [Digital Ledger Technology] is likely to be followed by many more life-changing innovations. But we will not allow it or any other advancement to disrupt our commitment to fair and sound markets

In this direct response, I argue that we now have a remarkable chance to address market regulation from the ground up, rather than trying to fit new products into existing rules. We should adopt an evidence-based approach and find a solution that scales to meet the needs of the 21st century.

NOTE: This is an opinion piece and in no way suggests anyone doing anything outside the law as currently written and enforced. For those raising money, I recommend caution and expect existing laws to be enforced more vigorously. The radical nature of my proposal is equal, I believe, to the scope of the problem.

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Executive Summary

The SEC has approached ICOs with a light touch and has dutifully gone after those committing outright fraud and a few who have flagrantly not passed the Howey test. The commission recognizes that progress requires risk, and that we’re in a period of accelerated innovation. It has taken the right approach in waiting and watching.

Regulating transactions — the purchase and distribution of financial products — has parallels with trying to regulate the source and sale of drugs. While it sounds good from a political perspective, in practice it doesn’t achieve the goals. To properly safeguard consumers, I believe …

I will first start with a section on the Howey test that helps show point #1, then I’ll move on to set the stage for my proposal: helping consumers limit exposure and build smart portfolios without intermediaries.

… tokenization will make all assets tradable without the need for intermediaries,

Part 1: The Slippery Slope

Much has been written about the Howey test applied to tokens — in the US as well as other countries. To sum up, the Howey test and its interpretation by various courts focuses on the expectations of the buyer. If the buyer reasonably expects to profit from the efforts of others, then she is acting as an investor, and what she buys is a security. Buyers of stock shares don’t want control of a company, they simply want management to do things that make the shares increase in value, so they can later sell them to others. However, as we usually find in so many other cases, this black/white distinction is not that simple to determine. Two buyers could buy the exact same thing with different intent. For example, in the case of United Housing Foundation vs Forman, the US Supreme Court found that the shares investors bought were more for apartments to live in than to speculate on. Thus, the shares were not deemed to be securities.

When people buy housing, which almost always requires the effort of others to create and improve, they always consider later resale value as well as livability. It’s very possible to buy a home for its livability and later sell it because it has appreciated so much (or so little). In the US, homes and land are not considered securities. Technically, you could tokenize and trade them individually without any licenses, even if you rely on others to do your renovations.

Two buyers could buy the exact same thing with different intent.

Furthermore, manufacturers of luxury jewelry, watches, cars, sneakers, and other collectibles know very well that if they announce a very special limited edition, collectors are usually willing to snap those up even before they go into production. Tesla has played this game numerous times — thousands of buyers pre-commit to their cars before they are built. Some of those “early buyers” speculate on the rarity of the car at the time theirs comes off the line to boost its price on eBay. Same item, different intentions.

Usually, there’s a prototype or the product is already made, but there are examples of selling limited editions just based on an artist’s sketch and a company’s past history of delivering products. This is routine in resort and condo development, again without licenses. Is that so different from today’s ICOs and SAFT documents?

High-end art collectors will often snap up new paintings by their favorite artists, or even commission works, and send them to a warehouse. They then pay consultants and staff to get those pieces into museum shows, all in an effort to game the market and profit later. They have no intention of hanging the pieces and enjoying the art. Some patrons will even support an artist during his/her early years, working with galleries and museums to promote and increase the price of the works, harvesting hedge-fund-like returns. Are those paintings securities?

In fact, there’s a web site where you can find a young person to support and participate in the profits of his/her career. Equity in people — should this be available only to accredited investors?

Even the US government plays this game. Governments make good money selling limited edition stamps to collectors, knowing that a) they won’t be used for their utility, and b) the limited edition drives sales today. Stamp collectors making money in the stamp market? Should we have stamp broker-dealers and regulated markets?

The government also takes part in the sale of lottery tickets. What’s the utility of a lottery ticket? What are people expecting when they buy one? Thankfully, the lottery industry is regulated, protecting the public from losing their money.

Toy companies, publishers, and others know that limited-edition boxed sets command not only higher sales prices but a) people often don’t open them, because pristine condition is more valuable later. What’s the utility of a toy no one plays with?

The Token Test
Now, let’s consider cryptographic tokens. Suppose we already have a great software system for doing something everyone wants — an example would be a universal smart wallet. The wallet is free, but to exchange goods, services, and crypto assets, you need to pay a small fee in tokens. This is obviously a utility token. Here are some scenarios:

This time, the system is nothing more than a white paper and a small team of accomplished entrepreneurs. They are well known and good at social marketing, so they are able to raise $20 million for their security token.

Now let’s consider from the investor’s point of view:

An investor sells his house and uses the proceeds and all his other cash to buy an early cryptocurrency that is considered by the government to be a commodity. a) he loses it all. b) he makes $100m. Is the cryptocurrency a security? Would it be any different if it were a regulated stock?

Bob and Betty make a combined $90k a year. They have $30k in savings. They decide to take a long shot and put $5k into their favorite tokens and support their favorite projects. They hope for an increase in value, but they refuse to put any more money in, they are just buying and holding and see what happens. If it goes up more than 3x, they will remove $5k and put it back into savings and let the rest ride. Regardless of how it turns out, how is this different from taking a $5k vacation and losing the money?

A smart investor knows she shouldn’t invest more than 20 percent of her investable assets into any one asset class and decides to go for it. She invests .5 percent of this allocation into 40 different ICOs that she scrutinizes carefully for scams and fraud. According to her calculations, this portfolio has about a 95 percent chance to at least return her investment amount and a 75 percent chance of beating the S&P 500.

Cryptocurrencies are highly volatile, yet they are unregulated in the US. A diversified portfolio of 100 cryptocurrencies is a high-performance/low-volatility investment, yet a token that represents such a portfolio would be a security .

The world is complex, and markets reflect that. Black-swan events can come to even the “safest,” most highly regulated markets. I hope I’ve shown that simple rules, or even interpreted ones, don’t adequately address the problem space.

Part II: Does Regulation Work?

The Howey test is designed to help protect investors. But does it? Does selling registered securities through retail broker-dealers really protect the public from making risky investments?

Gambling is regulated. As long as a casino complies with the legal framework, it can fleece the public day in and day out. The more you play, the more you lose — there is absolutely no way to gamble in a casino and consistently win without cheating. In the long run, you are guaranteed to lose. Why does the government allow gambling, then? Do people gamble because they understand the price of the entertainment provided? If so, why do so many people play at the high-stakes tables? Even though some people do lose their life savings and are ruined through gambling addiction, the vast majority of gamblers simply lose money and enjoy doing it, the same as owning a sailboat.

The more you play, the more you lose — there is absolutely no way to gamble in a casino and consistently win money without cheating.

In the same way, a lot of people enjoy “playing the markets,” and most of them do worse than buying the S&P 500. Study after study shows that uneducated consumers buy high and sell low in the equity markets, and their regulated brokers happily help them churn their portfolios to extract the highest fees possible (don’t get me started on banks). Members of the public can buy very risky stocks and derivatives through regulated markets. People can and do lose their life savings in the stock market. Intermediaries and rent seekers feed off the fees generated by complying with regulatory requirements.

So how do we know that a bunch of regulations passed in response to the Great Depression (which probably had more to do with the government adopting a rigid gold standard than it did with speculation) will help investors this century? How do we measure the effectiveness of regulation?

First, let’s look at some of the literature:

Empowering Investors: a proposal to defederalize regulation and make states compete for business, a paper from the Yale Law Review on regulatory competition.

Donald Langevoort’s paper, The SEC, Retail Investors, and the Institutionalization of the Securities Markets, asks whether the SEC’s regulations are out of date and appropriate for today’s markets.

Behavioral Economics and the Regulation of Public Offerings — how the SEC is affected by cognitive biases.

Behavioral Economics and the SEC — more on biased regulation by the same author.

REDESIGNING THE SEC: DOES THE TREASURY HAVE A BETTER IDEA? a look at the role treasury can play in controlling leverage. Better, I think, at exposing the weaknesses of the SEC than the strengths and culture of the Fed.

Finally, I note empirically that all the well-intentioned regulating hasn’t really prevented Bob and Betty from losing their regulated bets and others from losing their savings during relatively regular financial crises, as all markets on the scale of decades are extremely volatile. I would argue that fully compliant overleverage and the policies of the Fed have more to do with investor safety than following the rules set for capital market operations. It’s possible that we will later refer to the current situation as “the failed war on financial crime.”

(In case I’m guilty of biased cherrypicking in my review of the literature, which studies support the efficacy of which legislation?)

I would argue that fully compliant overleverage and the policies of the Fed have more to do with investor safety than following the rules set for capital market operations.

In Blockchain-Based Token Sales, Initial Coin Offerings, and
the Democratization of Public Capital Markets
, one of the best treatise on the topic, Jonathan Rohr and Aaron Wright conclude:

Given the difficulty in applying the Howey test to utility tokens and even some investment tokens, there appears to be a high risk of inconsistent case law or an overly broad application of these laws when courts and the SEC are faced with questions related to this technology. … Laws enacted at a time when it was impossible to contemplate today’s wave of digital and financial innovation would have the effect of excluding everyday consumers from an entire generation of digital technology.

What to do? I think the token economy is forcing a fast re-think and, hopefully, a smart reset. Here are my thoughts on that.

Part III: Evidence-Based Regulation

I’ve tried to show that the current system is broken and is very likely to lead to continued volatility and less investor safety if it continues. Regulators cannot now and never will be able to protect investors from black-swan events.

It’s not like the commission can do A/B testing to learn which regulations lead to the best outcomes. In light of those constraints, and with the assumption that we really are going to tokenize the world in short order, and that will lead to unpredictable acceleration of innovation, I have some suggestions. This is going to sound Libertarian, but in fact my goal here is to help keep investors safe, rather than what we have today. In the spirit of helping the commission build a more effective platform, I believe it makes sense to …

Regulators cannot now and never will be able to protect investors from black-swan events.

Conclusion

Applying the Howey test to all the new tokens is to miss the forest for the trees. The US must lead the way in innovation, which I believe involves overhauling our platforms for education, intellectual property, health care, insurance, law, financial markets, and more. The way forward is through embracing turbulence and educating people. As with the drug wars, we should focus on consumer outcomes, not the supply chain. Rules-based approaches don’t work in a VUCA world. Governments must become much more agile.

Applying the Howey test to all the new tokens is to miss the forest for the trees.

I believe the SEC should focus more on cognitive biases and behavior than on market mechanics. Reg tech and consumer education are the way forward. An evidence-based approach to market regulation will lead us down a more effective path and to a rejuvenated American enterprise that can keep up with the rest of the world. I propose the SEC work with other agencies to educate investors and increase transparency to build the financial system of the 21st century.

Now you can go back to The Token Handbook.

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David Siegel is a serial entrepreneur from the United States living in London. He is the CEO of 20|30 and the Pillar project, both of which have newsletters you may wish to subscribe to. He is the author of The Token Handbook and an essay on cryptocurrency bubbles. His full bio is at dsiegel.com. Connect to him on LinkedIn.

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Provocateur, professional heretic, slayer of myths, speaker of truthiness to powerfulness, and defender of the Oxford comma.

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