Rethinking Crypto Regulation Means Throwing Out Old Questions

The first question facing policymakers addressing the need for sensible crypto regulation is how to distinguish securities from cryptoassets. The growing consensus in Congress and the Securities and Exchange Commission is that the dividing line between securities and crypto should be the degree of “decentralization” in the network or blockchain protocol on which the cryptoasset is issued and recorded.

This thinking holds that once a network is sufficiently decentralized—meaning some substantial portion of its consensus mechanism isn’t controlled by any one person or group—the cryptoasset migrates from securities to crypto regulation.

But it isn’t clear this is the best framework to use.

There are good reasons to focus on decentralization. If no one controls a network, then there’s no one to carry the burden of SEC registration. And since investors can’t reasonably rely on “efforts of others” when investing in a decentralized project, the cryptoasset wouldn’t meet the “investment contract” test under the US Supreme Court’s 1946 decision in SEC v. W.J. Howey Co.

Former SEC chair Gary Gensler relied on Howey to assert that nearly all cryptoassets are securities. So the decentralization question was often a focus when assessing a cryptoasset’s status. The Bitcoin network was held up as a protocol that had achieved sufficient decentralization, but nearly every other protocol that came under SEC scrutiny failed to reach that standard.

Many in the industry disagreed with the SEC’s analysis of decentralization as applied to specific cryptoassets. But federal courts have made no progress refereeing the disputes. That’s because decentralization, and its close cousin control, are facts-and-circumstances questions. Reasonable arguments can often be made both ways.

Securities lawyers address a similar question when determining whether a seller of securities is an affiliate of the issuer.

Affiliation has significant consequences: It means the seller faces underwriter liability or economically onerous restrictions when selling securities into the market.

The answer turns on whether the seller controls, is controlled by, or is under common control with the issuer. Sellers are sometimes surprised that control, and thus affiliation, arise at very low ownership and influence levels.

While it’s usually safe to conclude a holder of less than 10% of an issuer’s stock isn’t an affiliate, the answer is murky above that threshold. Once the holder owns more than 20%, the holder usually is, to the SEC, an affiliate.

Similarly, if the holder is an officer or director—even without authority to direct the issuer’s activities—that person is generally considered an affiliate.

In the Gensler era, the industry often had no choice but to engage on this terrain when arguing that a protocol was sufficiently decentralized for its cryptoassets not to be securities.

But we are no longer in that era. We can now demarcate the line between securities and non-securities by statute or rule without reference to Howey. The question then is whether to remain tethered to decentralization. Four reasons suggest not to do so:

• Howey aside, centralization isn’t the mark of a security. The iPhone operates at the center of a tightly controlled, highly centralized ecosystem, but no one would say this is a reason to regulate it like a security.
• The difficulty in saying whether decentralization has occurred counsels against using it as a dividing line, even if useful for other regulatory purposes. If the SEC can argue that a network has not achieved decentralization, the agency will do so, and the industry will return to the morass of the Gensler era.
• Decentralization changes. A protocol that achieves it can lose it if the consensus mechanism comes under someone’s influence. Avoidable confusion would result if a cryptoasset flips back and forth into securities status.
• A test focusing on decentralization necessarily excludes networks that are designed to be centralized. Decentralization is one element of a business model, where developers may believe it’s the best way to achieve network security and resilience. But there are business models where developers propose other means to achieve these goals. It doesn’t make sense to consign their cryptoassets to securities regulation because they pursue a different path.

A better dividing line would focus on the asset—and the essential nature of what we consider a security—rather than the network where the asset lives.

Equities trading on the New York Stock Exchange and debt trading over the counter have something in common that isn’t shared by cryptoassets: These securities represent legal and contractual claims on the assets, revenuesand profits of a business or government.

Bitcoin, Ethereum, and the vast majority of cryptoassets trading on popular crypto trading platforms don’t.

This is why the SEC’s disclosure rulebook is mostly irrelevant to crypto. There isn’t a business that needs examining to understand the value of the investment. There may be commercial activity, but even when network control is centralized, in a vibrant networkthat activity is the product of uncoordinated decisions by users.

Similarly, many trading rules for securities are based on the fact they involve businesses. We wouldn’t worry about sudden crashes or short selling if all that mattered was speculative trading.

But because a business’s access to capital is affected by these events, we regulate. Policymakers want to penalize manipulative activity in crypto markets, but the SEC does not have a monopoly on deterring this conduct.

Predictability is the best reason to base the divide on the nature of the asset and not its protocol. It’s simple to determine whether an instrument is a claim on a business’s assets, revenues or profits. Either it is or it isn’t.

An approach that focuses on what the instrument represents, rather than the decentralization exhibited by its protocol, would thus yield a better outcome for the development of the crypto industry.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Joseph Hall is partner and head of the corporate governance practice at Davis Polk.

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