Everything “crypto” is red hot these days, with news stories on bitcoin volatility and the broader world of cryptocurrency trading every day. It seems like everyone has an opinion on the future direction of these assets, whether they understand them or not. The past couple of days, in particular, saw a surge in these stories, when BitCoin “crashed” by almost 40% overnight. Of course, the fact that it recovered almost as fast (as seen in the chart above) did suppress the coverage a bit. We could choose to be amused by the ignorance of pundits who cheer when BitCoin falls or those that lampoon investors in crypto assets indiscriminately, but it is not that funny, however. The danger of such views, is that the regulators or (even worse) politicians will attempt to quickly force the crypto markets into the 75+ year old securities regulatory framework without considering the impact. Doing so too quickly, would hurt millions of investors and create a tremendous disruption in the market, while risking the U.S. losing ground to the rest of the world in a transformational technology.
Before describing what, I believe, the approach should be, I want to make clear that I am not against sensible regulation, nor do I have any issue with what the SEC has said, so far. What is clear, however, is that, while government thinks that they can legislate or regulate markets to be “safe” for the average investor, the reality is that many of their efforts have been counterproductive. The most glaring example is how early stage investing has been almost exclusively reserved for elite investors that participate in venture capital (VC) and private equity (PE) funds. This did not happen overnight, but rather from the cumulative effect of securities regulation, public company disclosure and accounting rules, litigation risks, and rule exemptions making it much easier for companies to raise capital privately.
The problem with this, of course, is that PE and VC funds have essentially cornered the market for successful early stage investing. Since this is the source of some of the largest available investment returns, it has exacerbated wealth inequality, while contributing to enormous public appetite for risky investments in search of such returns. This is the real story behind crypto investing, which has been fueled by public demand.
The spectacular returns of BitCoin, Ethereum, Ripple, Dash, Monero, and others and the incredible demand for Initial Coin Offerings (ICOs) are due, at least in part, to the pent-up public demand for early stage investing. Ironically, there have also been symptoms of this demand, seen in the regulated market for equity securities, which prove the futility of a heavy-handed regulatory approach. Recent runups in Riot BLOCKCHAIN and Long Blockchain (formerly Long Island Ice Tea) (both of which have no real business plan or future prospects in the industry beyond an intent), demonstrate that forcing ICOs or other crypto-assets to be regulated as equities will not stop incredible volatility or quell potentially ignorant investing.
Considering that these examples took place in the most regulated NMS equity securities, it is almost ludicrous to believe that forcing ICOs to be registered in the same manner as OTC equity securities will reduce risks to investors. The reality, however, is that the most likely impact of suddenly forcing most cryptocurrencies to be treated as equities, would be to harm the innovative companies that currently trade them along with investors in those instruments.
Fear of this eventuality is probably what prompted senior Executives at Bittrex, one of the leading exchange in the US for trading cryptocurrencies against BitCoin or Ethereum, to publish a thoughtful commentary in the WSJ about the importance of digital currencies and the ability to trade them. The conclusion of the piece is that driving innovation in the U.S. will require a smart approach that includes partnerships between the federal government and trusted industry players. I agree with that wholeheartedly, and would like to also point out that a heavy-handed approach to regulation will fall hardest on the investors that the government is supposed to protect. For example, if Ethereum were unilaterally declared a “security” by the SEC, it would effectively stop US investors from trading in the asset and all the tokens that rely on its ERC20 “smart contract” protocol overnight. This would create massive losses for investors in the short term, potentially devastate an emerging industry, and, most important, accomplish little actual investor protection.
Few market professionals deny that, despite not being either equity or debt, many crypto-assets function as securities, from the perspective of investors. That said, regulators should recognize both the limited value of outdated regulation as well as its potential for disruption. This is not to suggest that fraud should be ignored, however, as preventing charlatans from taking advantage of investors should always be a priority.
It would be best, therefore, if regulators worked with the industry to develop appropriate risk disclosures for ICOs that recognize the differences between tokens for autonomous networks and equities. They should also attempt to update rules on the timing of investing and trading in such securities and create a reasonable process to allow OTC trading venues (a.k.a. crypto exchanges) to operate in a manner consistent with ATS’s. Such a process will likely involve new standards for such entities that takes into account the differences between the products. This will require cooperation between financial market professionals, regulators, and the blockchain or crypto experts who have spearheaded the innovation to date.
If, however, regulators decided to suddenly force markets to comply with regulations that are 70 years old, it could trigger widespread losses, panic among investors, and force all activity overseas where the U.S. would lose all influence over its future. I fervently hope that this will not be the approach taken by regulators, and hope that the catcalls and news stories don’t create pressure on them to do so.