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Regulation isn't Enough

Preserving Innovation while Fostering Safety

Nash E. Foster – September 21, 2023

Recent actions by US regulatory agencies, especially the Securities and Exchange Commission (SEC), underscore an unmistakable tension between innovators in the digital assets space and those tasked with their oversight. This article delves into the implications of this heightened regulatory scrutiny, assessing the risks of overreach, the stifling of innovation, and why pure regulation might not be the silver bullet solution to the challenges posed by cryptocurrencies.

The Impact on the Industry

From the outset, the crypto industry positioned itself as the embodiment of a free (as in speech) and decentralized financial future, one less reliant on traditional banking and more accessible to the everyday individual. But as regulatory actions intensify, the vision of widespread decentralization is under serious threat.

Binance, Coinbase, Ripple, and other crypto giants have recently found themselves in the crosshairs of the SEC. Some large industry players, like FTX and its erstwhile CEO Sam Bankman-Fried, deserve the scrutiny. And, in cases like FTX, both law enforcement and regulators have an important role to play. But, broad-based and thoughtless actions by enforcement agencies create immediate legal challenges and potential financial penalties but also cultivate a climate of uncertainty. For startups and potential investors, such litigation has an unecessary chilling effect on the industry.

Additionally, there's a global dimension. While countries like Switzerland and Singapore forge ahead with clear regulatory frameworks for crypto, the US's apparent ambivalence might prompt businesses to consider setting up shop elsewhere, potentially leading to a 'brain drain' of the best and brightest in blockchain tech. Rather than coordinate with crypto firms and lawmakers, US regulators seem hell-bent on applying well-meaning, but desperately outdated, regulations to crypto projects. Without clearer focus and communication with the public about where regulators will draw the lines, the crypto industry faces unecessarily strong headwinds in the US.

The Risks of Overreach

One of the primary concerns among industry players is the perception that regulators are overstepping. Many argue that the SEC's aggressive stance, such as the case against Stoner Cats, leans more towards "regulation by enforcement" rather than offering clear guidelines.

The recent SEC charge against Stoner Cats for the unregistered offering of NFTs, stating that the collectible NFTs are crypto asset securities. The charge has raised eyebrows and prompts comparisons with other popular collectibles that have graced the market.

Consider Beanie Baby frenzy of the 90s. Stuffed animals became a speculative investment for many, with secondary markets emerging where they sold for multiples of their retail price. Ty Inc., the company behind Beanie Babies, leveraged marketing strategies that increased the toys' perceived value, employing tactics such as retiring certain characters to increase demand. Yet, even at their peak market influence, Beanie Babies were never targeted by regulators as securities, despite their massive reselling profits and secondary market dynamics.

Similarly, Magic: The Gathering cards, which now constitute around 20% of Hasbro's revenue and some say nearly all of its profit, have been treated as collectibles and not securities. These cards, just like Stoner Cats NFTs, can be resold in secondary markets, often at prices far exceeding their original value. The strategic withdrawal or rarity of particular cards drives up their market value, just as SC2's marketing highlighted the potential value of their NFTs. But once again, despite the undeniable secondary market dynamics and speculative nature of these cards, regulators haven't deemed them as securities.

In the SEC's own press release, the focus seems to be on specific details of Stoner Cats' marketing campaigns. If this is the case, why has the SEC failed to draw bright lines regarding the marketing of NFTs? Many NFT projects have not experienced enforcement actions by the regulator, but none of these have been identified as "models" that innovators and investors could use to evaluate a project's regulatory viability.

This lack of communication makes SC2's case all the more perplexing. Is Stoner Cats NFTs promotion materially different from that of Ty and Hasbro? SC2 emphasized the Hollywood production value, the expertise of the creators, and the potential for secondary market sales - none of which deviates greatly from the marketing tactics employed by companies selling Beanie Babies or Magic: The Gathering cards. Yet, there's a stark difference in the SEC's treatment of these entities. While Beanie Babies and Magic cards have been accepted as collectibles and part of pop culture, NFTs are seemingly being held to a different standard.

The rapid rise of digital assets, and NFTs in particular, has evidently taken the SEC into uncharted territory. While the principles Gurbir S. Grewal, Director of the SEC’s Division of Enforcement, mentioned regarding the economic reality of offerings determining whether it's an investment contract, are valid, the application seems inconsistent.

Why is the Stoner Cats NFT seen differently from a rare Magic: The Gathering card or a retired Beanie Baby? If the criteria are the expectation of profit, marketing techniques that increase perceived value, and the existence of a robust secondary market, then all these items check the same boxes. However, only one finds itself in the regulatory spotlight.

Stifling Innovation

Historically, every innovative industry, from the automobile to the internet, faced regulatory challenges. While oversight can help to protect consumers and maintain market integrity, there's a thin line between protection and hindrance.

For the crypto industry, the current climate can be chilling. Startups might forgo groundbreaking ideas for fear of regulatory reprisals. The lack of clear guidelines can make navigating the regulatory waters daunting, if not impossible, for new entrants. This lack of clarity, coupled with aggressive enforcement actions, risks curtailing the very innovation that could lead to more transparent, inclusive, and efficient financial systems.

Recent disclosure that SEC Chair Gary Gensler's met with FTX's Sam Bankman-Fried raises questions about the agency's ethics protocols and their relationship to recent enforcement actions. Given the backdrop of SBF's subsequent fraud charges and the apparent lack of formal authorization for their interaction, many are beginning to question the SEC's integrity.

Gensler's meeting with FTX stands contrasts the agency's dealings with major US crypto firms, such as Coinbase. Brian Armstrong, Coinbase's CEO. has voiced frustrations over the SEC's unresponsiveness. The privileged access granted to SBF, coupled with the intertwined histories of Gensler with FTX's lobbyist and other associates, further magnifies suspicions of favoritism. Why was FTX, a firm not even headquartered in the US, given privileged access to the most senior securities regulator, when the US's largest crypto exchange is ignored?

Amidst the SEC's aggressive stance on crypto, there's growing concern that such actions might be smoke screens to divert attention from its own ethical missteps. As the crypto landscape challenges traditional financial systems, it's crucial for regulatory bodies like the SEC to not only adapt but maintain unwavering transparency and ethical standards.

Commissioner Hester Peirce, an outspoken crypto advocate at the SEC, encapsulates this sentiment. She didn't expect the US to be "this far behind" on a crypto regulatory framework when she joined in 2018. Her observations underline a palpable lag, one that may cost the US its position at the forefront of fintech innovation.

Regulation: A Small Part of the Solution

Pure regulation, even if perfectly executed, might not address all the challenges posed by cryptocurrencies. The decentralized nature of these digital assets means they inherently resist centralized oversight. And, as the Ripple case demonstrates, even if a token isn't deemed a security in one ruling, it doesn't prevent future legal challenges. This fluidity is inherent in the crypto DNA.

To truly address the challenges and harness the opportunities, a collaborative approach might be more fruitful. Engaging in open dialogues with industry players, understanding the technology, and crafting clear, forward-looking guidelines could pave the way. The end game should be fostering an environment where innovation flourishes while ensuring consumer protection and market integrity.

In conclusion, while the surge in regulatory actions in the US can't be ignored, it's crucial to approach this inflection point with a balanced perspective. Overzealous regulation risks not only stymieing innovation but also relinquishing global leadership in a sector poised to redefine financial systems. The path forward demands collaboration, understanding, and a shared vision for the future of finance.