Regulators Are Slowly Starting to Get It

11 July, 2018

Michael J. Casey is the chairman of CoinDesk's advisory board and a senior advisor for blockchain research at MIT's Digital Currency Initiative. The following article originally appeared in CoinDesk Weekly, a custom-curated newsletter delivered every Sunday exclusively to our subscribers.

"I want to quash this false narrative that's been going around for the past two years that you can separate blockchain from crypto. You can't."

No, that's not a bitcoin maximalist, a HODLer or a crypto-anarchist talking. It's a regulator.

And Sopnendu Mohanty, the chief fintech officer of the Monetary Authority of Singapore, wasn't preaching to the crypto-converted, either, when he issued this reminder that native tokens are integral to a decentralized blockchain.

Rather, he was addressing a room full of curious but wary central bankers and international development officials, all of whom were attending a G20 forum in Riyadh, Saudi Arabia on technology and financial inclusion.

It was refreshing to hear someone in the official sector take issue with the simplistic "blockchain without bitcoin" refrain that gets sold to corporate and government leaders who don't always realize that their problems might be better solved with a less cumbersome distributed database.

That wasn't only because it's important for people to understand how native digital tokens are an integral part of the incentive and security models upon which open, permissionless and censorship-resistant transaction-recording systems are built. It was also because Mohanty's intent was to help shape sensible crypto regulation.

He was urging regulators to adopt nuanced policies that recognize certain crypto-tokens belong to a new type of technology for improving economic coordination, one that can't be jammed into a decades-old securities law framework. And it's also encouraging to see evidence that he's not alone in thinking this way.

Various regulatory authorities around the world are opening up to the idea that, when tokens have a clearly functional role within a blockchain network, it's better to manage them with existing consumer protection and anti-money-laundering laws than with burdensome securities regulation.

To be sure, they're doing so somewhat nervously; many are understandably concerned about investors being duped by scammy ICOs in Wild West token markets.

Nonetheless, their gradual yet earnest attempts to define these concepts open the door to blockchain technology's more meaningful integration into the global economy.

Forward-thinking states

Here, Singapore's central bank is leading the way. In a March speech, MAS Managing Director Ravi Menon laid out a clear rationale for distinguishing "good" tokens from "the bad and the ugly."

The Swiss Financial Market Supervisory Authority, or FINMA, has also been proactive. It came up with a useful taxonomy that divides tokens into three categories: payment tokens (bitcoin, litecoin and co.), utility tokens (ether and, in theory at least, various kinds of ERC-20 tokens) and asset tokens, with only the latter being subject to securities laws.  

Other developed-country jurisdictions are also wading in. Both Malta and the U.K. dependency Gibraltar have shown an open regulatory posture toward ICOs and token exchanges. Meanwhile, Caribbean countries such as Bermuda  are developing regulatory frameworks for tokens that would promote blockchain innovation while preserving their status as trusted domiciles for foreign financial institutions.

Governments are also taking action at the provincial level. Wyoming's state legislature passed legislation defining utility tokens as a new asset class and exempting them from securities regulations.

Until last month, it appeared that the U.S. Securities and Exchange Commission was taking the exact opposite approach. In February, Chairman Jay Clayton, speaking before the Senate, said, "I believe every ICO I've seen is a security." The implication was clear: most, if not all, of the hundreds of tokens already sold in this manner should have registered with the SEC and complied with related disclosure and compliance requirements.

In stoking fears of a dragnet approach from the SEC against all tokens, this statement prompted ICO issuers to ring-fence themselves from the U.S. markets. It also gave a boost to purveyors of "security tokens," who don't pretend to be inventing anything more than a more efficient means of selling securities to investors.

But since then, the SEC has also softened its stance. Clayton later told CNBC that bitcoin would not be classified as a security. And, then, in a landmark speech last month, William Hinman, the SEC's director of the Division of Corporate Finance, answered a question that had been nagging the ethereum community. Hinman said that although ether was a security at the time of the ethereum proto-ICO in 2014, it no longer met that definition because of how it now functions within the ethereum network.

This was not as proactive as other jurisdictions' moves to explicitly carve out the concept of a utility token. Hinman was merely defining what ether was not. But by coming to that conclusion, he had recognized the unique qualities of this particular token: how ether is a kind of "crypto fuel," used to pay for the decentralized computation by which smart contracts are executed on the ethereum platform.

What's important is that regulators are doing their homework and starting to recognize there's at least potentially something different going on here from what they're used to seeing. There's a lot of learning still to come, but light bulbs are quietly going off in different corners of the regulatory world.

Whether you're in the camp that welcomes regulatory clarity to foster public confidence in this technology or among those in the crypto community who see government engagement as anathema to a system of money originally designed to bypass the state, this emerging regulatory awareness represents a seminal moment.

The race is on

Clearly, many countries taking these steps have their eyes on the potential economic gains generated by the freewheeling ICO market, one that has raised $20 billion so far and which, with $275 billion in (admittedly poorly measured) market capitalization, has come to constitute a significant parallel capital market. There are tax windfalls to be had and there's the real prize of attracting innovation to their shores.

They need to be careful, though, as this is an exceptionally fleet-footed form of capital. They risk encouraging global "regulatory arbitrage." When a technology is as geography-agnostic as this, its users will often choose their home base depending on where regulation is lightest, stoking competition among jurisdictions. Given the inordinate number of scammers in the ICO business, the danger is that the worst players gain too much freedom and, by extension, too much influence over how this industry is broadly perceived.

In times past, U.S. regulators could rise above such problems. The sheer amount of money raised in the U.S. left global actors with no option but to comply with their rules just to ensure access to it. But with foreign capital markets deeper in the age of globalization, globally distributed blockchain development teams are deciding that the U.S. just might not be worth it. We are already seeing ICO issuers deciding that they can comfortably raise all they need from Asian investors.

Where this is all pointing, I hope, is to a coordinated international effort to better harmonize the regulatory approach.

Mohanty told me he sees six or so of the world's more important regulators coming to a broad agreement on utility tokens and on what distinguishes them from payment and security vehicles. There's a need, for example, to define pressing questions about what level of platform functionality, and when, a token must have to earn exempt utility status. And, beyond the securities laws exemptions, regulators should agree on strategies to apply existing consumer protection laws to ensure that ICO issuers are still held to account for the promises they make to people who put money into their token pre-sales.

Some have forcefully argued that carving out explicit legislative definitions of a utility token – a laWyoming – overly constrains innovators to those definitions and creates contradictions across jurisdictions. Better to rely on existing laws than to add to the body of legislation, they say. But such concerns should not prevent regulators from creating clearly signaled guidelines to participants in the blockchain development community about how they will apply existing law to different scenarios.

There's a still a lot of work needed to improve and scale blockchain technology and to foster broad confidence among future buyers of crypto tokens. Best practices among issuers, exchanges and investors/buyers need to be developed. But encouraging the expansion of utility token models is a worthy goal, one that's much harder to achieve if the burdens of securities laws were to be imposed on all those who create them.

To understand this, one need look no further than the financial inclusion objectives of the Riyadh-based conference that Mohanty spoke at. Organized by the Global Partnership for Financial Inclusion under the leadership of Argentina, which holds the G20's current presidency, the event explored, among other goals, how to encourage entrepreneurship in low-income, developing countries.

If we want the whole world, include enterprising people in such countries, to have access to the powerful economic advantages of decentralized, peer-to-peer applications and business models, regulatory barriers to entry must be softened.

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