The Breakdown - Are Crypto Safe Harbors an Idea Whose Time Has Come?

Episode Date: August 21, 2022

This episode is sponsored by Nexo.io, Chainalysis and FTX US. On this edition of “Long Reads Sunday,” NLW reads: “Let Ugly Ducklings Grow: Why Crypto Needs a Safe Harbor” by Michael Casey “Safe Harbor 2.0” by SEC Commissioner Hester Peirce    - Nexo is a security-first platform where you can buy, exchange and borrow against your crypto. The company safeguards your crypto by relying on five key fundamentals including real-time auditing and insurance on custodial assets. Learn more at nexo.io. - Chainalysis is the blockchain data platform. We provide data, software, services and research to government agencies, exchanges, financial institutions and insurance and cybersecurity companies. Our data powers investigation, compliance and market intelligence software that has been used to solve some of the world’s most high-profile criminal cases. For more information, visit www.chainalysis.com. - FTX US is the safe, regulated way to buy Bitcoin, ETH, SOL and other digital assets. Trade crypto with up to 85% lower fees than top competitors and trade ETH and SOL NFTs with no gas fees and subsidized gas on withdrawals. Sign up at FTX.US today. - I.D.E.A.S. 2022 by CoinDesk facilitates capital flow and market growth by connecting the digital economy with traditional finance through the presenter’s mainstage, capital allocation meeting rooms and sponsor expo floor. Use code BREAKDOWN20 for 20% off the General Pass. Learn more and register at coindesk.com/ideas. - “The Breakdown” is written, produced by and features Nathaniel Whittemore, aka NLW, with today’s editing by Eleanor Pahl and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. Music behind our sponsors today is “The Now” by Aaron Sprinkle and “The Life We Had” by Moments. Image credit: Doug van Kampen, van Kampen Photography/Getty Images, modified by CoinDesk. Join the discussion at discord.gg/VrKRrfKCz8.

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.com, and ftX, and produced and distributed by CoinDesk. What's going on, guys? It is Sunday, August 21st, and that means it's time for Long Read Sunday. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to to dig deeper into the conversation. Come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod. Also, I want to tell you about CoinDesk's new event, the investing in digital assets and enterprises summit or ideas. The event facilitates capital flow and market growth by

connecting the digital economy with traditional finance. Join CoinDesk October 18th and 19th in New York City for a 360-degree investment experience where you can source, invest, and secure the next big deal in digital assets. Use code breakdown 20 for 20% off a general pass. You can register today at coin desk.com slash ideas. All right, so for this long read Sunday, we are discussing the line, the space really between innovation and regulation. This is one of the constant tensions that shapes what we do here. For a country like the United States, there is on the one hand a goal to continue to be an economic leader and a sense that to do so requires a lot of allowing new types of enterprise and especially new types of technology, the chance to grow into

their final form without being strangled in the crib. At the same time, there is a desire among regulators in particular to see those new innovations fit within protective regulatory frameworks. It's also worth noting that there are at least a couple different categories of thinking as to why an industry might need regulation, specifically in the case of novel financial products like those being produced by the crypto industry. One side of this is consumer protections. This is the idea that consumers and investors, specifically less sophisticated retail investors, might be less able to understand the risks of new financial products. As such, they might be more susceptible to fantastical claims and generally more likely to lose their livelihoods on something

that is too good to be true. Another very different logic for regulation has to do with systemic risk. This is the fear that new types of financial instruments could actually cause harm outside of the little domain where they originate. How might that happen? Well, one example that has been brought up in the crypto space is what happens if hedge funds take big exposure to crypto assets, and then volatility in the crypto space forces them to sell their other holdings that are more traditional equities or commodities. That sort of forced selling could have ripple effects, and that's one potential way that contagion could spread from the crypto space into traditional markets. It's worth pointing out the difference between these two notions in that

they have very different roots and potentially different systems of belief around them. The underlying notion of investor protection, for example, rubs a lot of people as overly paternalistic and making assumptions about people's ability or inability, as the case may be, to manage their own risk. But some of those same folks might think that ensuring that cross-market contagion doesn't happen is a generally good thing. Anyway, in the context of crypto assets, one big point of contention has been trying to figure out just what the hell they are. Are they securities to be regulated by the SECC, or are they commodities better suited to the CFTC? Are they, in fact, both at different times in their life cycle. We're going to start today with a piece by Coindesk's Michael Casey, but before we

do a quick definition, the Howie test is the Supreme Court standard for what constitutes a security. It's from a Florida Orange case in the 1940s, but the key aspects come down to four parts. A financial product is a security if there is an investment of money in a common enterprise, with the expectation of profit, to be derived from the efforts of others. This last part, derived from the efforts of others, has historically been the biggest fight with crypto. Anyway, with that setup, let's read Michael Casey's piece, Let Ugly Ducklings Grow, why crypto needs a safe harbor. Too much regulation may hinder the development of viable decentralized models. Asked for his view on cryptocurrencies, Securities and Exchange Commission

Chairman Gary Gensler likes to quote the poet James Wickcombe Riley, who wrote, When I see a bird that walks like a duck and swims like a duck and quacks like a duck, I call that bird a duck. The point of Gensler's duck test is that he believes the vast majority of crypto projects are in fact unregistered securities with little ambiguity. In Genzer's mind, almost all meet the more conventional Howie test measure for that. It's a nice line, but perhaps not the best analogy. After all, a more famous literary reference also draws on the duck image to remind children that first impressions are not always reliable. In Hans Christian Anderson's classic fairy tale, the ugly duckling, a newborn signet is mistakenly thought to be a member of a barnyard

mother's duck brood and is teased for being so plain-looking compared to the other ducklings. Eventually, it flees the farm and grows into a beautiful, graceful swan. Let's face it, lots of cryptocurrency projects are pretty ugly in their infancy. In 2013, when Bitcoin was four, its blockchain suffered an accidental hard fork, as a failure to reconcile two versions of its code led miners to unknowingly start building two separate chains. One year later, an attacker exploited the so-called malleability bug to launch a crippling denial of service attack against the Bitcoin network, while others used the same exploit to steal Bitcoin from the doomed exchange Mount Gox. Then, in 2016, two-year-old Ethereum faced a massive crisis when an attacker found a bug

in the smart contract code for the decentralized investment project, the Dow, and drained it of $60 million worth of ether. In all three cases, the issues were resolved with the decisive leadership of core groups of Bitcoin and Ethereum developers. In the first and third instances, the interventions involved coordinating a rollback in the blockchain, with the consensus of users to cancel transactions occurring after the attack. This speaks to the presence of some degree of centralization in these early phases of protocol development, when bugs and performance problems that clearly hurt the network need to be resolved efficiently. Notably, as Bitcoin and Ethereum's networks have grown, both have become increasingly decentralized, making coordination of core code upgrades more challenging.

A key indication of this is the years of development work and consensus building it is taken for Ethereum developers to migrate the blockchain from proof of work to proof of stake, which is now poised to happen next month. It is this evolved state of decentralization that, according to SEC pronouncements, appears to have made the current iterations of Bitcoin and Ethereum exempt from securities registration. Both now fail the part of the Howie test that says an investment scheme is a security if returns for investors hinge on the work of a small group of people. Bitcoin's founder and earliest adopters are out of the picture,

and Ethereum's founders don't have the influence they once had to unilaterally push through changes. Here's the problem. The SEC's approach to these issues implies that Bitcoin's and Ethereum's transitional experience are the exception, not the rule. Gensler has said he concurs with his predecessor Jay Clayton's statement that every ICO I've seen as a security, referring to initial coin offerings, the means by which many crypto projects attracted their initial funding. He has also urged decentralized exchanges, Dex's, to register with the SEC. This poses a challenge for these protocol-based systems. Who, among their decentralized communities of users and developers,

would make the call to file the documents, and under what authority? Such semantics won't stop the SEC from taking action. likely against the founding developers of Dex's, if it so wishes. Meanwhile, actions such as the recent insider trading case against a former Coinbase employee, which simultaneously described nine Coinbase listed tokens as securities, are a reminder that, under the blanket Duck Test view, all token projects other than Bitcoin and Ethereum are vulnerable to SEC enforcement. It's a Damocles soared threat, and it forces many potentially valuable projects to exercise excessive caution, such as blocking customers that use USIP addresses, which means innovation,

in this space is inherently constrained. But if Bitcoin and Ethereum could grow into swans, what's to say others can't in the future? And shouldn't policy incorporate the prospect of that transition from unavoidable centralized structure at initiation to a later decentralized structure that no one can effectively control? Enforcement actions can cripple otherwise high potential projects. They can condemn them to permanent ugly ducklinghood. This prospect for transition is precisely what SEC Commissioner Hester Purse's proposal for a safe harbor provision for crypto projects is attended to achieve. It would give crypto projects a three-year grace period within which to develop a robust decentralized functionality that would render them exempt from securities registration requirements.

Sadly, Pierce's approaches gained little to no traction among her fellow commissioners. It's important that we ask why. After all, the past that Ethereum has received appears to be based on a notion developed by former SEC director of the Division of Corporate Finance, William Hinman, who in a June 2018 speech suggested that the Ethereum network had over time become, quote, sufficiently decentralized, and so had lost the security status it held at launch. In its case against Ripple Labs over its XRP token, the SEC has tried to distance itself from what it described as a personal errand by Hinman, suggesting that his thesis on transition does not necessarily represent agency doctrine. But Judge Saranetburn delivered Ripple a big victory last month,

ruling that a draft of the speech, which may well show SEC staff helping to shape Hinman's thinking, can be admitted as evidence in the case. The popcorn is ready on this one. Let's assume the hymn and doctrine is a thing then. Why would there be a resistance to giving token projects a grace period to become sufficiently decentralized? Perhaps because U.S. regulators don't see the benefit of decentralization. They like having someone they can hold accountable. Without that, they reason how can they protect U.S. citizens from bad actors? What they're missing is that decentralization is central to the core value proposition for cryptocurrencies. Without it, they're worthless. Decentralization enables censorship resistance

for Bitcoin so funds can be sent peer-to-peer. For example, a donor in the U.S. can send BTC to an activist in Russia without Putin's government or another central authority interceding. It's also a necessary condition to attain the programmability with which decentralized finance or defy protocols can automatically execute settlement and collateral contracts. If a third party has control over the system, it has the power to intervene, which means there's no guarantee of automaticity. Programmability is lost.

If we want a more open, fluid, and equitably accessible financial system, one that's not subject to the political and economic manipulation by Wall Street's too big to fail intermediating institutions, decentralization is a worthy goal. After all, the recent big failures in crypto-lending projects were concentrated in centralized finance providers such as Celsius and Voyager, while broadly decentralized defy protocols such as Ave and compound survived the industry's de facto stress tests remarkably well. It's quite simple, really. If there is a centralized entity with custody of its customers' funds, it can lose or otherwise impair those funds against its customers' interests. If there is no custody, only the customer can lose funds.

In that case, there's literally no one to regulate. If regulators keep imposing rules that favor centralization, as with the demands placed on crypto providers to block accounts using the Ethereum-based mixing service tornado cash, they will simply build the same risks into the system and hinder the development of viable decentralized models. Let's let the ugly ducklings grow up. In times like these, security of your assets should be your number one priority.

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Gain unparalleled visibility and maximize your potential with the leading blockchain data platform by visiting us now at Chainalysis.com Coindesk. The breakdown is sponsored by FTXUS. FtXUS is the safe, regulated way to buy and sell Bitcoin and other digital assets with up to 85% lower fees than competitors. There are no fixed minimum fees, no ACH transaction fees, and no withdrawal fees. One of the largest exchanges in the U.S. FTXUS is also the only leading exchange that supports both Ethereum and Solana NFTs. When you trade NFTs on FTCS, you pay no gas fees. FTX app today and use referral code breakdown to support the show. Now, since Michael is here referencing the Safe Harbor proposal from SEC Commissioner Hester Perce, I thought it would be good to read the first part of that. This is available on GitHub. Proposed Securities Act Rule 195, time-limited exemption for tokens.

The analysis of whether a digital asset is offered or sold as a security is not static and does not strictly adhere to the digital asset. A token may be offered and sold initially as a security because it is wrapped in a transaction involving an investment contract, but the token may later be offered and sold outside of an investment contract. For example, sales of a particular token likely would not constitute sales of an investment contract if purchasers could no longer reasonably expect a person or group to carry out the essential managerial or entrepreneurial efforts. However, for a network to mature into a functional or decentralized network that is not dependent upon a single person or group

to carry out the essential managerial or entrepreneurial efforts, the tokens must be distributed to and freely tradable by potential users, programmers, and participants in the network. The application of the Federal Securities Laws to the primary distribution of tokens and secondary transactions frustrates the network's ability to achieve maturity and prevents tokens sold as a security from functioning as non-securities on the network. Accordingly, this safe harbor is intended to provide initial development teams with a three-year time period, within which they can facilitate participation in and the continued. new development of a functional or decentralized network.

Exempt from the registration provisions of the federal securities laws so long as certain conditions are met, the safe harbor is designed to protect token purchasers by requiring disclosures tailored to the needs of the purchasers and preserving the application of the anti-fraud provision of the federal securities laws to token distributions by an initial development team relying on the safe harbor. By the conclusion of the three-year period, the initial development team must determine whether token transactions involve the offer or sale of a security. token transactions may not constitute securities transactions if the network has matured to a functioning or decentralized network. Now, this goes on then to talk about all the initial disclosures,

the information token offers would need to provide to initial buyers. It also involves the sort of exit report that would be required to prove quote-unquote network maturity. The interesting thing is that while Michael contends that this has not gotten traction with her fellow commissioners, which is certainly true, some of the thinking here of this idea that that's something that is security-like at offering, but no longer security-like at maturity, has found its way into the regulatory discourse around crypto in the U.S. In the Lammis-Jillibrand Responsible Financial Innovation Act, one of the most notable features is that they define something that they call an ancillary asset.

It is effectively exactly this, an asset that is security-like at the beginning of its life, but evolves into something that looks much more like a commodity. Here's the way they sum it up in the overview. For the first time, this bill makes a clear distinction between digital assets that are commodities or securities by examining the rights or powers conveyed to the consumer, giving digital asset companies the ability to determine what their regulatory obligations will be, and giving regulators the clarity they need to enforce existing commodities and securities laws, bringing digital assets into the regulatory perimeter from the current vacuum.

Lemis Gillibrand accomplishes this by codifying existing precedence under the Howey test that an ancillary asset provided to a purchaser under an investment contract is not inherently a security. Digital assets which are not fully decentralized and which benefit from entrepreneurial and managerial efforts that determine the value of the assets, but do not represent securities because they are not debt or equity or do not create rights to profits, liquidation preferences or other financial interest in a business entity, aka ancillary assets, will be required to furnish disclosures with the SEC twice a year. Ancillary assets in compliance with these disclosure requirements are presumed to be a commodity. So this is a little different than the safe harbor, but is certainly in the same spirit.

Now, we really don't know yet what sort of traction or interest there is going to be in this bill, except insofar that we know that it's not going to be debated right now, certainly not before the November midterms. Is it possible that this idea, this definition of an ancillary asset, could find its way into more narrower or tail? tailored legislation that can help determine how crypto assets fit within the existing framework? I don't think it's impossible, and I thought one of the most encouraging things about Llamas Gillibrand was the fact that they actually took this particular question, one of the absolute thornyest, head on. So perhaps the time for ugly ducklings has arrived, and 2023 or 2024 will be the year of the swans. For now, I want to say thanks again to my sponsors,

nexus.com, chain aliasis and FTX. And thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace.