Domino Effect

SEC and ‘crypto’—the first domino

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The SEC has been taking center stage this week in the ‘crypto’ industry. Announcing civil lawsuit charges against the industry’s biggest exchanges by volume, Binance and Coinbase (NASDAQ: COIN), it has sparked much debate and discussion, overflowing into Congress itself. While the outcome of this campaign to reign in the pirates of crypto has still yet to be determined, one thing is for sure, this increased scrutiny from previously dormant U.S. regulators has scared away over 76% of the liquidity in the crypto markets. So whether by hook or by crook, Binance, and other exchanges are in hot water, legally and business-wise, as most reasonable investors turn elsewhere with their capital.

But is the SEC justified in its newfound mission to clamp down on what they have, up to this point, remained largely quiet on1? Understandably, many coin investors have been crying foul on this, including some in Congress. Indeed that is the main defense that Ripple claims in their own lawsuit, that they were not told that what they were doing was illegal at the appropriate time. So why didn’t the SEC do something about this earlier? Are they at fault for not doing so, and does this absolve the now embattled exchanges from any wrongdoing?

To answer this question, one must understand what the SEC is, and their charge, their raison d’etre. But we should first go over the different types of regulation.

Regulation is how the government ensures that private enterprises conduct their business in a certain way or move towards a certain societal or political goal. It is literally one of the means by which the governed are governed by the government. They are a set of standards and rules that regulatory bodies enact to enforce laws.

As any quick internet search can reveal, the SEC was created in response to the massive economic chaos following the stock market crash of the early thirties, which led to the Great Depression—the crash, which was brought about by the rampant speculatory markets and stock frauds of the 1920s2, which lead to over leverage and inflation of the global economy, as more and more money was transferred from the middle classes to the small upper class of ‘Gatsby’s,’ the financiers. To enact and enforce rules such that the same calamity could not happen again, then U.S. President Franklin Roosevelt signed into law the Securities Exchange Act, which created the SEC. The mission of the SEC was to regulate all market participants of securities to protect the individual investor. Simply, their stated mission is:

1) Ensure that companies offering securities for sale to the public must tell the truth about their business, the securities that they are selling, and the risks involved.
2) Businesses who sell and trade securities must put the interests of the investor FIRST and treat them fairly and honestly.

With the knowledge that this is the stated mission of the SEC, let’s go over the different types of regulation.

Firstly, there is regulation by Command and Control.

This method is when the regulating body defines and dictates exactly what needs to be done by the regulated parties to run their business. This method is also called “method-based” regulation. An example of this is the Atomic Energy Commission, which specifies exactly the types of equipment that can be used or processes that must be followed in order for a nuclear plant to operate. While this is very effective in ensuring that maximum pubic safety is achieved, this method has been criticized as being expensive and ‘top heavy’ while stifling innovation.

Secondly, we have performance-based or goal-based regulation. In this model, the regulators aim to set a goal, such as the carbon emissions target, and allow the industry players to try to achieve that however, they see fit.

This method allows maximum innovative potential, but is only appropriate when the goal can be easily quantified and measurable. When the desired goals or behaviors are too general to be used as a performance measure, we must resort to the remaining forms of regulation.

Thirdly, we have management-based regulation, which is otherwise known as “self-regulation.” In this method, the industry is left to its own devices, and the regulator is only involved in helping the industry develop processes and standards that they will subject themselves to. An example of this is the Hazards Analysis and Critical Control Points approach that the FDA uses, where food producers are tasked to come up with the potential risks to public health of their processes and the ways in which these risks can be minimized. The challenge of self-regulation, however, is that it may often be difficult for government agencies to judge the effectiveness of the processes and rules that the industry may come up with and whether or not they are sufficient. The benefit is that it is the most cost-effective (tax dollars wise) of all the regulation methods.

Finally, there is a regulation by enforcement, which is the model the SEC is employing. In this model, the regulatory body does not seek to specify exactly how a business should run (Command-and-Control), but allows businesses to do as they wish, so long as the guiding rules set forth3 are followed. This allows for innovation in the industry, but also keeps it from going too far down the path of the “roaring 20s”, as the SEC maintains the threat of punishing actors violating the guiding principles they have set.

In this light, we can see that the arguments of Ripple, Binance, and others claiming that the SEC didn’t clearly tell them what they could do are bollocks. The SEC doesn’t regulate by command and control. They only act when it seems apparent (and they have ample evidence for) that an industry actor has violated either of the principles that the SEC is charged with enforcing: Telling the truth to investors, treating them fairly, and honestly.

The only claim that the crypto industry players have is that somehow because the word “crypto” isn’t spelled “S-E-C-U-R-I-T-Y” it can’t be a security, that it can’t pass the Howey Test, and that is why they should not be subject to the rules that the SEC is tasked to enforce4. Well, for that, as a programmer, we have a saying in duck-typing…

“If it walks like a duck, and quacks like a duck, it is a duck”.

I think many exchanges in crypto that have been skimping on legal advice and only hiring lawyers that tell them what they want to hear will find out how well these arguments hold up in court soon. In light of many individual investors losing their life savings or even committing suicide after the crypto market crashes5, I think the moral obligation of the courts to reign in these exchanges so that they abide by the same rules that traditional securities companies are subject to seems like the most reasonable outcome that we can expect.

Jerry Chan
WallStreetTechnologist

[1] One notable exception being Ripple, and XRP, which are still embroiled in lawsuits.
[2] It is quite sobering when one compares the exuberance of the 20s and the crash of the 30s and how it directly relates to the boom of crypto in the last decade.
[3] See Above
[4] In other words, they are saying they should be allowed to be dishonest to investors and to treat their own interests above the public interest!
[5] Fittingly, the Great Depression saw an equivalent increase in suicides (https://dailycoin.com/blood-on-cryptos-hands-real-suicide-rates-due-to-cryptocurrencies/) So the SEC would be right in stepping in here. It is literally their mission to protect the public from this kind of threat.

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