SEC Crypto Oversight Risks Regulating Public Digital Systems

During the Cold War, the US government supported development of an information sharing network, or ARPANET, that was intended to withstand a nuclear attack.

More computer networks formed, and in 1983, the TCP/IP common communications protocol was adopted, giving birth to the internet. Today’s internet is an open, public digital infrastructure that we all expect to have the right to access and use.

Earlier in my career, when I was a financial regulator at the SEC reviewing policy changes by the New York Stock Exchange or at the Federal Reserve supervising banks such as JP Morgan Chase, I didn’t consider the internet as part of my scope of responsibilities as a financial regulator. I certainly didn’t examine the TCP/IP standard as part of a regulatory examination of online banking.

Yet, I’m seeing signs from the Securities and Exchange Commission, which was mandated by Congress to regulate securities, that it views any public digital infrastructure in the blockchain ecosystem to fall within their financial regulatory authority.

It is rumored that the SEC is investigating whether Ethereum’s native token ETH is a security, and thus subject to requirements of the 1930 US Securities Act and exchange listing requirements of the 1934 US Securities Exchange Act.

And earlier this month, the SEC sent a Well’s Notice announcing its intent to investigate Uniswap, which is one of the most open and decentralized automated protocols in the crypto ecosystem.

These actions along with the SEC’s complaint against Coinbase alleging decentralized blockchain projects such as Solana, Cardano, Filecoin, and NEAR are securities and, therefore, not decentralized, indicate lack of clarity that genuinely decentralized protocols and decentralized base layer blockchains where they’re built, such as Ethereum, are a public digital infrastructure forming the next iteration of the internet—which many call Web3.

More worrying is that the SEC’s misunderstanding of public digital infrastructure is quickly spreading to US courts. US District Court Judge Failla’s most recent ruling in SEC v. Coinbase showed indications of agreement with the SEC’s “ecosystem” argument, which asserts that an underlying blockchain, blockchain participants, and other activity in the ecosystem make the tokens on that blockchain more valuable, thus making them securities.

This is a slippery slope argument because it gives the SEC a route to regulate the entire ecosystem, well beyond just the claims that the tokens are securities. The SEC’s claim also suggests a fundamental misunderstanding of the blockchain ecosystem.

For instance, if the ecosystem argument were applied to traditional financial activities, such as securities trading at the New York Stock Exchange, then arguably, the SEC would regulate the activities of traders who gather on the trading floor, the New York Stock Exchange building itself, and even the streets traders take to get to the stock exchange.

There is no limiting principle to declaring what’s in the ecosystem—a cautionary principle that Failla stressed in the oral arguments but largely ignored in her ruling.

If the behaviors of participants in that ecosystem are key to understanding whether the linchpin of the ecosystem is an unregulated security, then the SEC’s ecosystem theory extends its reach into whatever portions of the ecosystem it desires.

Courts and government agencies must understand that genuinely decentralized protocols, including base layer blockchains, are public digital infrastructure that should serve the public good like the internet does today.

Research is beginning to support this important concept of decentralized protocols as public digital infrastructure forming part of the foundation of our digital economy. The crypto ecosystem supports more than just financial activities, including digital identity, social media, gaming, data storage, cellular phone coverage, and public utilities.

Barring a settlement or leadership change at the SEC, the SEC v. Coinbase case seems bound for a long road of litigation, destined for appellate courts (and maybe even the Supreme Court).

But this case raises more than the question of what is a “security.” It goes to the very heart of the SEC’s regulatory power over the entire digital economy and the public infrastructure that supports it.

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

Linda Jeng is founder and CEO of Digital Self Labs and visiting scholar on financial technology at Georgetown Law. She was a financial regulator before working at blockchain startups.

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