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Myth – Regulation Will Kill Crypto
The crypto winter only intensified the buzz about the popular myth that the U.S. government will regulate crypto out of existence (therefore, there's no point in investing in it). We strongly disagree. We've already seen signals from the Commodities Futures Trading Commission (CFTC), the Internal Revenue Service (IRS), the Securities and Exchange Commission (SEC), Congress, and the White House that, while regulation is coming, it's not intended to strangle crypto in any way. In fact, it's the opposite. Policymakers want crypto to thrive. To do that, they want to curb excesses and ensure more transparency.
Chair Gary Gensler at the SEC can sound like a regulatory hawk, but as legislation has moved forward, he and the SEC emphasized early cooperation far more than excessive enforcement. The crypto industry broadly supports the two major bills likely in some form to become law.
So far, the SEC has cracked down on fraud, as it should, but the SEC fundamentally wants crypto entities and assets that act like securities to have some rules. For Gensler, if a token barks like a security, walks like a security, and talks like a security, it's a security. As of this writing, we're confident of a strong bipartisan law and new funding for the CFTC to handle its new legislative assignments. The parties on Capitol Hill, the White House, and the agencies want a steady, progressive, regulatory structure. It's essential to know the fundamental conflicts inherent in this transition.
But we'd like to wave a little bit of caution here. Regulation too fast, too hard can kill innovation. Just look back at the Red Flag Act of 1865. During the oil and automobile revolution, the UK government came out with legislation that required every car to have at least one person walking in front of the automobile to have red flags out to let people know that a car was coming. The intent was safety. However, the knock‐on effects were disastrous. That legislation killed the automobile revolution in the UK. Let's not let history repeat itself here in the United States, where it appears we're doing everything we can to kill innovation.
You'll want to note that by the end of 2022, only three of the top 15 blockchain protocols are headquartered in the United States, whereas during the Internet Age 10 of the top 15 Internet companies were headquartered here.1
Investing is about making good bets. Good bets require knowing the odds, and knowing the odds requires having reliable information. If you bet on an NFL game, we suspect you know who is starting at quarterback, who is injured, what the team's record is, and a plethora of transparent stats. The legendary futures trader Larry Hite observed, “There are just four kinds of bets. There are good bets, bad bets, bets that you win, and bets that you lose. Winning a bad bet can be the most dangerous outcome of all because a success of that kind can encourage you to take more bad bets in the future when the odds will be running against you. You can also lose a good bet no matter how sound the underlying proposition, but if you keep placing good bets, over time, the law of averages will be working for you.”2
The Sticking Point
Part of the difficulty with regulating crypto assets is that they can evolve. There are times in the lifecycle of a crypto asset when it acts more like security and others when it acts more like a commodity or even something else altogether. Because of this, there is confusion about what body has the jurisdiction to regulate it. Our greatest concern is that some regulatory bodies here in the United States may become short‐sighted and damage the chance innovation has to benefit our society and our economy. And frankly, if we get regulation wrong here, the innovation will simply go to wherever in the world it's treated best.
Regulating too expansively would be like regulating the Internet before we understood how online commerce would function in the world. That would have been bad, indeed. Ideally, regulation will be strong enough to protect investors from fraud but not so strict that it will stifle entrepreneurship, innovation, and investment. Moreover, good crypto regulation should reflect U.S. values, including privacy, security, freedom, and sovereignty. If we leave it up to other countries, such as China, we could be tied to a system built on entirely different values – tracking, surveillance, central authority, and lack of public transparency.
Like the Internet in the early 1990s, the crypto sector is still in its infancy. We don't know what a flash‐in‐the‐pan will be (Google Reader, anyone?) or what will become fundamental to our lives, like social media or the iPhone. In the early days of the Internet, Congress could not have predicted the role that personal data mining and political disinformation would play, much less how to protect consumers against them. At the time, the industry was pushing for an open Internet, where anyone could create a web page.
As it turns out, it may be that both the SEC and the CFTC are correct: there are times in the lifecycle of a crypto asset when it is more like a security and others when it is more like a commodity. There are also times when it may act like something else altogether. Because of this, there is confusion as to what body has the jurisdiction to regulate it. This is a critical issue being wrangled over by Congress, the White House, and the industry. Another complicating factor: many people are under the impression that crypto assets are all the same, but this is incorrect. Several distinct classes and models range from cryptocurrencies to utility tokens to governance tokens. We have a detailed exploration of each asset class in our book Crypto Asset Investing in the Age of Autonomy; suffice it to say for this book that each comes with unique risks, governance, purpose of use, ways of accruing value, and roles in the larger ecosystem. Cryptocurrencies were designed to be a store of value and a medium of exchange. An investor can buy them, sell them, purchase things with them, and lend them out to generate yield through an interest rate like sovereign currencies. In contrast, governance tokens (discussed more fully in Chapter 17) give the holder the right to vote on managing, upgrading, and governing a crypto network. Regulators need to recognize this complexity and tailor new rules to the distinct types of crypto assets.
Indeed, we support the idea of “temporality” that the SEC has considered: that an asset can begin as a security and change into a commodity over time. Tokens from an initial coin offering (ICO) where the builder is looking for an up‐front investment are securities. Once the crypto network is built and is sufficiently decentralized, the assets become commodities.
Crypto Classification: Security versus Commodity
So then, let's unseal this whole “Is crypto more like a stock or a pork belly?” debate and figure out where we are as regulation is coming into view.
In 2017, many in the market started to declare the idea of a utility token and to distinguish it from a security token. A security token represents a tokenized version of a financial security. You can think of real estate or equities that are tokenized assets as security tokens. In contrast, a utility token is a token used to power a blockchain network – to provide “use.” Many protocol coins and tokens use a utility token to transact on their network. Ethereum and Solana are examples of blockchains that use utility tokens. In this case, in order to complete a transaction on each of these respective networks, you need to use a little bit of their respective tokens, ETH and SOL.
Howey Test
The basic framework used to determine whether something is a security or not is called the Howey Test, which refers to a court case between the SEC and the W. J. Howey Company. It consists of three questions:
- Is there an investment of money with the expectation of future profits?
- Is the investment of money in a common enterprise?
- Do any profits come from the efforts of a promoter or third party?
Securities produce a return to a common enterprise, which we say is a central organization. It's ownership in the enterprise's capital structure, whether equity or debt. The spirit of the law is to capture an agreement: “I'll give you some money for a percentage of the potential profit the enterprise generates.”
That is not what's happening with most crypto utility tokens. They are not generating a return that is then divided by the owners via dividends or share repurchase. Although some tokens do split returns generated from fees, most expectations of future returns are generated by scarcity of supply and demand. There may be an expectation of profit, but that's where it gets tricky, because that's not inherent in their design.
Consider Similar Analog Assets
We can point to plenty of assets people buy with this expectation of a return. Most of them revolve around scarcity of the asset playing into a tight market of supply and demand. While not necessarily understood by all investors, this is a key factor to generating profit with crypto assets. It's much clearer to see in the analog world, where rare and scarce items often demand a pretty penny. Examples include:
- Numismatic (rare, collectable) coins
- Precious metals
- Collectibles
- Concert tickets
- Rare art
None of these assets, are considered to be securities, yet they accrue in value. It's really important that you understand this distinction. Scarcity drives value, and not everything that grows in value is a security. All three factors of the Howey Test need to be considered collectively.
Commodities – Looking at “the What”
Commodities are goods, property, or assets that can be bought or sold on an exchange, typically raw materials or agricultural products. They don't produce a return from a common enterprise, they are goods or property that are mined or grown, and their intrinsic value is based on market supply and demand. This is what distinguishes commodities from securities. Commodities aren't characterized by their fundamental nature but by prices and availability. Milk is a commodity. So is oil, lumber, corn, and raw coffee. Commodities of the same grade are fungible, meaning they can be swapped with each other, no matter who produced, mined, or farmed them. So a coffee broker buying “specialty grade” green coffee beans from two different growers in Hawaii isn't concerned for the most part with the grower but with the quality and purity of the beans.
As with other commodities, bitcoin can be traded on the futures market overseen by the CFTC through exchanges, including the Chicago Board of Trade and the New York Mercantile Exchange. Through these exchanges, traders close a deal on when a trade will happen, agreeing on a fixed price and future delivery date for the goods being traded. On that date, the commodity is sold, and money exchanges hands. The price at that time is the one in the contract, no matter what the current price of the commodity on the open market is.
The Punchline
At the end of the day, this all boils down to one thing. Regulators are getting their hands around this in a way to promote crypto, not kill it. The EU has taken bit steps with their 2022 Markets in Crypto Assets (MiCA) law, which is groundbreaking. As of this writing, all language has been agreed upon and overwhelmingly accepted by a vote of 28–1. The law is expected to go into effect in 2024 and provides regulatory clarity and guidance regarding consumer protection, money laundering, and stablecoins. One highlight regarding stablecoins is that the EU wants to promote euro‐backed stablecoins and limit the use of U.S. dollar–backed stablecoins. They are now looking ahead and getting ahead of the digital asset wave that is on the horizon. The United States should take note for a couple of reasons, notably that this points to a world that may be less and less dollar‐based in the future.
Regulation like this provides clarity, and clarity will promote adoption. We're already seeing big players like BlackRock partner with Coinbase in anticipation of regulatory clarity. From our view, this clarity will facilitate growth and does not hamper it.