As technology evolves, the US Securities and Exchange Commission (SEC) must evolve with it. Nowhere is this more true than in crypto, and now: the market for cryptoassets has grown in size and sophistication such that the SEC’s recent pernicious approach to enforcement and abdication of regulation needs a quick update.
While the long-term future of the crypto industry in the US will likely require Congress to sign off on a comprehensive legislative framework, here are 6 steps the SEC could take immediately to create “fit-for-purpose” regulations – without sacrificing innovation or critical investor protections.
#1 Provide guidance on ‘airdrops’
The SEC should provide interpretive guidance on how blockchain projects can distribute incentive-based crypto rewards to participants — without these being characterized as securities offerings.
Blockchain projects typically offer such rewards—often called “airdrops”—to encourage use of a particular network. These distributions are a critical tool in enabling blockchain projects to gradually decentralize, as they convey ownership and control of a project to its users.
If the SEC were to provide guidance on distributions, it would curb these rewards being issued only to non-US persons – a trend that effectively offshores ownership of blockchain technologies developed in the US, but at the expense of US investors and developers.
What to do:
Establish eligibility criteria for cryptoassets that may be excluded from being treated as investment contracts under securities laws when distributed as airdrops or incentive-based rewards. (E.g. crypto-assets that are not otherwise securities and whose market value is substantially or is expected to be derived from the programmatic operation of any distributed ledger or onchain executable software).
#2 Change crowdfunding rules
The SEC should revise Regulation Crowdfunding rules to make them suitable for crypto startups. These startups often need a wider distribution of cryptoassets to develop critical mass and network effects for their platforms, applications or protocols.
What to do:
Expand the offering limits so that the maximum amount that can be raised is at the level of the crypto-venture’s needs (eg up to $75 million or a percentage of the total network, depending on the depth of disclosures).
Exempt crypto offerings in a manner similar to Regulation D, allowing access to crowdfunding platforms beyond accredited investors.
Protect investors through caps on the amounts that a single person can invest (as Reg A+ currently does); robust disclosure requirements that include the essential information relevant to the crypto-venture (eg, regarding the underlying blockchain, its governance and consensus mechanisms); and other security measures.
These changes will allow early-stage crypto projects to access a wide pool of investors, democratizing access to opportunities while maintaining transparency.
#3 Enables broker-dealers to operate in crypto
The current regulatory environment restricts traditional broker-dealers from engaging meaningfully in the crypto industry — primarily because it requires brokers to obtain separate approvals to trade crypto-assets, and imposes even more burdensome rules around broker-dealers who wish to hold crypto-assets.
These restrictions create unnecessary barriers to market participation and liquidity. Removing them would improve market functionality, investor access and investor protection.
What to do:
Enable registration so that broker-dealers can trade – and hold – crypto-assets, both securities and non-securities.
Establish oversight mechanisms to ensure compliance with anti-money laundering (AML) and know-your-customer (KYC) regulations.
Work with industry regulators such as FINRA to issue joint guidance addressing operational risks tailored to cryptoassets.
This approach will foster a safer and more efficient marketplace, enabling broker-dealers to bring their expertise in best execution, compliance and custody to the broader crypto market.
#4 Provide guidance on custody and settlement
Ambiguity over regulatory treatment and accounting rules has deterred traditional financial institutions from entering the crypto custody market. This means that many investors do not get the benefit of fiduciary asset management for their investments, and instead are left to invest on their own and arrange their own custody alternatives.
What to do:
Clarify guidance on how investment advisers can hold crypto assets under the Investment Advisers Act, ensuring adequate safeguards such as multi-signature wallets and secure off-chain storage. Also provide guidance on efforts and voting on governance decisions for crypto assets in the custody of investment advisors.
Develop specific guidance on settlement for crypto transactions – including timelines, validation processes and error resolution mechanisms.
Establish a flexible, technology-neutral framework that can adapt to innovations in custody solutions and meet regulatory standards without imposing prescriptive technology mandates.
Correct the accounting treatment by repealing SEC Staff Accounting Bulletin 121 and its treatment of balance sheet liabilities for held cryptoassets. (SAB 121 moves custodial cryptoassets to the custodian’s balance sheet – a practice contrary to the traditional accounting treatment of custodial assets.)
This clarity would provide greater institutional confidence, increase market stability and competition among service providers, while improving protection for both retail and institutional crypto investors.
#5 Reform ETP standards
The SEC should adopt reform measures for exchange-traded products (ETPs) that can promote financial innovation. The proposals promote wider market access for investors and managers accustomed to managing portfolios of ETPs.
What to do:
Return to the historical market size test, which only requires that there be sufficient liquidity and price integrity to the regulated commodity futures market to support a spot ETP product. Currently, the SEC’s reliance on the “Winklevoss test” for surveillance agreements with regulated markets that meet arbitrary predictable price discovery has delayed the approval of bitcoin and other crypto-based ETPs. This approach overlooks the significant size and transparency of the current crypto markets, their regulated futures markets, and creates an arbitrary distinction in the standards that apply to crypto-based ETP listing applications and all other commodity-based listing applications.
Allow crypto ETPs to settle directly in the underlying asset. This will result in better fund tracking, reduce costs, provide greater price transparency and reduce reliance on riskier derivatives.
Mandates robust custody standards for physically settled transactions to reduce the risk of theft or loss. In addition, ensure the option to bet idle underlying assets in the ETP.
#6 Implement certification for ATS lists
In a decentralized environment where the issuer of a crypto-asset may play no significant ongoing role, who is responsible for providing accurate information surrounding the asset? There is a useful analog from the traditional securities markets here in the form of Exchange Act Rule 15c2-11, which allows broker-dealers to trade a security when current information about the security is available to investors.
By extending this principle to markets for cryptoassets, the SEC could allow regulated cryptotrading platforms (both exchanges and brokerages) to trade any asset that the platform can provide investors with accurate, up-to-date information. The result would be greater liquidity for such assets across SEC-regulated markets while ensuring that investors are equipped to make informed decisions.
What to do:
Establish a streamlined 15c2-11 certification process for cryptoassets listed on alternative trading system (ATS) platforms that provides mandatory disclosures about the assets’ design, purpose, functionality and risks.
Require exchanges or ATS operators to perform due diligence on cryptoassets, including verification of issuer identity as well as key features and functionality information.
Mandates periodic disclosures to ensure investors receive timely and accurate information. Also clarify when reporting by an issuer is no longer necessary due to decentralization.
This framework will promote transparency and market integrity while allowing innovation to flourish.
***
By taking the above steps now, the SEC can begin to pivot away from its historic and highly contested focus on enforcement efforts and instead add much-needed regulatory guidance. Providing practical solutions for investors, fiduciaries and financial intermediaries will better balance protecting investors with promoting capital formation and innovation – to achieve the SEC’s mission.
A longer version of this post originally appeared on a16zcrypto.com.
