This morning, we were treated to an unprecedented event in the history of market regulation: a joint OpEd written by the heads of the two most powerful market regulators in the U.S. The reason for this piece is clear, in their opinion the practices of the crypto community during the current crypto boom have gone too far, in their opinion, and they are (rightfully) concerned about it. The OpEd is well written, articulates many valid concerns, and is clearly meant to be a wake-up call to an industry that is making too much money, too fast, for its own good.
There is a kind of bewildering arrogance exhibited by today’s “crypto millionaires” which rarely ends well. When people or corporations make so much money, they start to believe that they can do no wrong, don’t adapt to changing situations and often suffer massive growing pains or fail outright. From a corporate perspective, the worst symptom is groupthink, where the company only hires like-minded people, eschews external or any contradictory advice, and ultimately fails to embrace industry best practices, particularly with respect to compliance. This behavior can lead to ignoring (or skirting) regulations, either because they see that their “peers” in their narrowly defined community are skirting the same rules, or because they believe that they are “too important” to be penalized. Sadly, this has been on display in the crypto community, with ICOs continuing to be offered outside of securities laws, exchanges operating without even investigating the registration process, and advice being given by many with no fiduciary concerns or legal standing to do so.
Remarkably, I have seen this sort of behavior before in my career on Wall Street. The most recent was the late 1990s, when the tech community, shady boiler room operators, internet commentators, along with Wall Street’s elite analysts, traders, salespeople and bankers all made a lot of money by propelling the internet bubble higher. In that case, and today, despite being remarkably wrong in many cases, some of the people and companies involved displayed incredible arrogance and self-importance based on the belief that getting rich quick validated their actions.
Getting back to the OpEd, Jay Clayton and J. Christopher Giancarlo identify significant issues throughout the crypto industry, but also recognize the potential for the industry to generate wealth. Unfortunately, despite the flaws that are pointed out in the piece, many involved in the industry remain in denial. It seems like the leading crypto-exchanges and many of the “successful” recent ICOs are hiding behind the idea that the underlying technology is revolutionary, and the current rules are not designed well to govern the assets they represent. While that idea is likely correct, so are the sentiments expressed in today’s OpEd: there IS a lot of fraud going on, disclosures DO need to be improved, issuance IS unregulated, secondary trading of these assets is handled poorly by the incumbent markets, and “advice” is being handed out without any regard to principles of KYC or fiduciary care.
Let’s examine each of these issues in turn, with an eye toward suggesting a way forward:
Fraud — Thankfully, this is the easiest to deal with, since no new rules are required. There is nothing stopping the SEC (or the tort bar) from penalizing ICO promoters, advisors, and founders for making fraudulent or materially misleading statements to investors. Those who pumped and dumped pink sheet stocks on “message boards” during the late 90s can attest to this. Many of the punished individuals weren’t brokers, and many brokers, bankers, & analysts who were punished followed the letter of the law at that time, but violated basic principles of “just and equitable markets.”
Disclosures — There are many in the crypto-industry already calling for better disclosures of ICOs including of project governance, token “rights” including the methodology for “voting” for protocol changes. Many ICOs have already adopted language in their “whitepapers” that are similar to the language in IPO prospectuses in terms of risk disclosures as well. There is, however, a lot more to be done to improve this process. It is worth stating that equity disclosures are far from a panacea, as investors still pile into “story” investments, but it is reasonable and prudent for the regulators to insist upon a minimum level of diligence and accountability for ICOs regardless. To that end, I suggest that the SEC work with the crypto industry to document which disclosures in the current rules make sense, which do not, and what additional disclosures are necessary for ICOs that do not depend on a traditional corporate structure.
Issuance – The only valid reason for ICO issuance to exist outside of the current securities issuance framework is that the current frameworks need fixing. Reg A+ is a good start, but there are aspects of the rule that are problematic for ICOs. For example, Reg A+ has a “non-discriminatory” pricing rule that says that the sale price of the shares during the crowdfunding period must be the same. Since ICOs are priced in crypto-currencies such as BitCoin that fluctuate every second, however, it is hard to comply. (Amusingly, CoinRoutes recently announced RealPrice is a solution for ICO providers as it can be accessed as new investors are processed and includes an audit-able time series.)
There are other examples, however, particularly around restrictions on reselling shares. These can be quite problematic for crypto-assets whose smart contracts are written to be freely exchangeable, and the regulators should work with the industry to address these issues. In addition, ICOs are often used for extremely early stage investing, as opposed to funding operating entities, and the disclosures and structure of the rule is based on the notion of an operating company. There is no inherent reason why the public should be blocked from investing in pure “ideas”, or in assets being created by networked groups without corporate affiliation, other than the obvious; such investing is extremely speculative and risky. To help mitigate that risk, a logical additional step would be to register ICO advisers and brokers with an SEC approved Self-Regulatory Organization (SRO) in order to introduce an increased level of professionalism into the process.
Trading – This is the area where I have the most direct knowledge, as the data from CoinRoutes shows how poorly coordinated the markets are. It is also the trickiest of all the categories, as there is a lot of money currently invested in assets that trade on platforms which, based on the arguments in this OpEd, should be registered as Alternative Trading Systems (ATSs) with the SEC. It has been stated to me many times (by the crypto “exchanges” themselves) that markets trading BitCoin do not need to be ATSs, since that has been labelled a commodity by the CFTC. I would suggest, however, that if ICOs are deemed securities, platforms trading Ethereum or other Crypto-assets will eventually be required to do so. It is important to note, however, that to register as an ATS, the platforms would first need to become broker-dealers, subjecting them to rules including KYC, best execution, and other investor protection regulations. This is where it gets tricky, since the broker dealer application process, as well as the establishment of ATSs, take a fair amount of time to accomplish. It would, therefore, be a very bad idea to require this immediately. If the current exchanges were told to “cease and desist” trading until obtaining such licences, millions of American investors would lose access to their assets, likely triggering enormous financial losses and panic. Thus, I would suggest that the SEC issue guidance, including a “grace period” for all the current “exchanges” operating in the US to be able to transition to becoming broker dealers and ATSs.
Advice – This is the area where existing regulations are probably going to be the least helpful. It is hard to distinguish between promoted “advice” for crypto and the hundreds of websites, newsletters, and research reports offered on existing securities. It is unclear if any research services would opt to become advisers, and it is equally unclear how stock services that tout “making millions from legal marijuana investing” are different from ones that explain how to become a “crypto millionaire.” That said, one benefit to regulation might be to force currently registered investment advisors to learn about the crypto markets as opposed to reflexively condemning them, due to the fact that they compete with products that they can currently recommend.
In conclusion, we should applaud the efforts of the Chairs of the SEC and CFTC for working together and for correctly identifying that a unified regulatory approach is warranted towards crypto investing. We should also, however, encourage the crypto and financial communities to work together with the regulators to guide this process. We collectively have an opportunity to encourage this new technology while reigning in the excesses that have developed.