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Crypto and DeFi’s greatest enemy is back and aiming for the kill

Date: 2022-08-02

The first ever insider-trading crypto scheme has unearthed far scarier implications and an old enemy


Photo by Tingey Injury Law Firm on Unsplash

The SEC is looking to settle this old dispute now

This month, Ishan Wahi, a Coinbase product manager, was charged alongside his brother and a friend with committing the first-in-history insider trading scheme.

They were pretty successful until they were caught, as they managed to gain more than $1.1 million. Ishan, who possessed insider knowledge, allegedly tipped them with the timing and content of upcoming listing announcements. This week, they were charged with insider trading, and the trio could be facing up to 20 years of prison.

Cool story bro, but I don’t use Coinbase so why should I care

In theory, this should be the end of the story. However, sadly for Coinbase and you, it’s not. According to the SEC, of the 25 crypto assets the sneaky trio bought, 9 of them were securities.

The issue at hand is that Coinbase argues that this is not true.

In the words of their CLO (Chief Legal Officer):

“Coinbase has a rigorous process to analyze and review each digital asset before making it available on our exchange — a process that the SEC itself has reviewed,”

also explaining that:

“This process includes an analysis of whether the asset could be considered to be a security, and also considers regulatory compliance and information security aspects of the asset.”

Moreover, Coinbase sent a petition to the SEC for it to clarify the unclear certainty of what a security is. More explicitly, they argued that:

“The U.S. does not currently have a functioning market in digital asset securities due to the lack of a clear and workable regulatory regime. Digital assets that trade today overwhelmingly have the characteristics of commodities.”

Although it is certainly not evident to the eye of an ordinary investor, the underlying implications of this dispute could come as a wrecking ball to the whole industry, as the regularization of cryptocurrencies as securities would, to put it very mildly:

Completely change the crypto market landscape and would severely affect how you should approach crypto investing.

What are securities and the implications of a cryptocurrency becoming one

To truly understand the importance of this dispute, we first need to understand what is a security and the implications of becoming one.

So, what on earth is a security?

According to Investopedia, the definition of security is:

A fungible, negotiable financial instrument that holds some type of monetary value. It represents an ownership position in a publicly-traded corporation via stock; a creditor relationship with a governmental body or a corporation represented by owning that entity’s bond; or rights to ownership as represented by an option.

More explicitly, the SEC (U.S. Securities and Exchange Commission, in charge of making sure the markets are protected against manipulation by setting rules and regulations regarding the issuance, marketing, and trading of securities) uses the Howey Test to determine if something is a security.

The Howey Test is a 1946 ruling that explains that, for something to classify as a security, it needs to meet the following criteria:

  • Is there an investment of money with the expectation of future profits?
  • Is the investment of money in a common enterprise?
  • Do any profits come from the efforts of a promoter or third party?

The key difference between a security and a commodity (the financial categorization that Coinbase and all the crypto industry are seeking for the vast majority of cryptocurrencies in the space), is that securities give you a share in a corporation’s ownership and control.

In the case of a commodity, it doesn’t give you control over the underlying entity, it gives you rights to goods or property sold in exchanges.

Consequently, the interpretation of how the Howey Test applies to cryptocurrencies is critical to determine if everything stays the same or if absolutely everything changes in crypto.

And what would be the implications?

If cryptocurrencies end up being defined as securities, the grip of the SEC over the crypto industry would be huge:

  • For starters, crypto projects would endure a much tighter regulation, having to submit, like public companies and other regulated companies, quarterly and annual reports as well as other periodic reports. Also, they would need to make public narratives explaining how the operations for the year went. In order words, sheer transparency would not be requested but demanded. Also, these cryptocurrencies would have to be registered in the SEC (this is exactly what the SEC is accusing Coinbase, of selling unregistered securities).

  • Crypto exchanges may have to register as Brokers-Dealers. This would imply a much strong commitment from them to authorities when, historically, crypto exchanges have been infamously opaque. For instance, many of the exchanges offering crazy APYs (Annual Percentage Yield, the interest you earn in your deposits on these platforms) did so by using that money to gamble it on the DeFi market to be able to give back such a huge return to investors (failing miserably by the way)

Many in the space argue that this is what crypto exchanges actually need, to avoid situations where CeFi exchanges like Celsius collapse by the sheer pressure of straightforward gambling to pay the obscene APYs they promised.

  • Stablecoins would suffer great scrutiny, both algorithmic and asset-backed. In the former case, to guarantee events like the LUNA/UST collapse don’t happen again, and for the latter to ensure stablecoins like Tether truly prove that they have the reserves to back the stablecoin issuance.

DeFi, DAOs, and the Hinman Paradox

DAOs (Decentralized Autonomous Organization, an organization whose leadership and decisions are decentralized) have become the ‘de facto’ governance medium for DeFi protocols, including many of the ‘big’ ones like Uniswap, Aave, or MakerDAO, which are all now governed by them.

As well as coins that were launched through ICOs (Initial Coin Offerings, very similar to an IPO that a company does to go public), the SEC’s stance toward DAOs seems clear, DAO tokens — also known as governance tokens —should be considered as securities.

However, it is not that simple. DAO tokens suffer what James J. Park, a UCLA law professor, described as “the Hinman Paradox”.

“A token can only be widely distributed to the public if the project it is associated with is functional,” Park wrote in 2018. “But a blockchain project can only be functional if its tokens are widely distributed.”

Regulatory guidance has since begun to suggest that functionality is not enough — the utility of the tokens has historically been the argument for many cryptocurrencies to not be considered securities, as they offer actual utility. Being considered a utility token would therefore make them subject to the regulation of digital assets (VASPs) and not by financial law, which is far more strict.

Hence, a token can only be widely distributed to the public if the project it is associated with is also widely used and governed by those users rather than by a centralized team. A token issued prior to user-based governance, therefore, is not a token but a security, similarly to the case of ICOs.

In that sense, governance tokens can only be issued if they are already widely used to make decisions. This, of course, would mean that the actual issuance of the tokens wouldn’t be necessary. Consequently, we find ourselves in a riddle-like situation for DAO tokens.

Although the situation seems impossible to solve, there is actually a silver lining. Regulators base their thought-process and decisions on security laws that are more than seventy years old, and that implicitly assume that every security is overseen by a centralized, legal entity.

However, that is not the case for cryptocurrencies, so their categorization shouldn’t be based on laws that aren’t representative of how the world works right now.

What should you expect?

Although this dispute between the SEC and the crypto industry isn’t new, from the recent moves from the commission it seems that the SEC is ready to tackle this issue soon.

The SEC’s stance is… well, ladies and gents, not good

The SEC is leading the charge to gain tighter control over crypto. Gary Gensler, the SEC chair, commented in an April 2022 speech on many things that are to be taken into consideration:

  • That most crypto tokens likely qualify as investment contracts under the aforementioned Howey Test definition set out in a U.S. Supreme Court ruling.

  • That the top five exchanges accounting for 99% of cryptocurrency trading “likely are trading securities” and should have to register with the SEC and comply with applicable laws, stating that “these crypto platforms play roles similar to those of traditional regulated exchanges. Thus, investors should be protected in the same way”

  • He also called for increased enforcement of financial regulations for stablecoins and other crypto tokens.

Although many of these comments aren’t new, the SEC has begun specific actions to really commit to solving this dispute with the crypto industry once and for all.

In that sense, in May 2022, the SEC announced it would increase the staff of its Cyber Unit from 30 to 50 and rename it the Crypto Assets and Cyber Unit to bolster the enforcement of regulations in cryptocurrencies.

If naming an entire SEC department “Crypto Assets and Cyber Unit” isn’t a bold declaration of intentions, then I don’t know what is.

Regulation is necessary but new laws are also needed

As Coinbase explicitly told the SEC, clearly there isn’t, as of right now, a clear definition of what is a security when it comes to digital, decentralized assets.

If the SEC wants to be true to its mission — to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation — it has to prove that, not only they are willing to cooperate, but that they also understand that financial markets are changing and that technological progress shouldn’t be restrained by the law, but actually fostered by it.

With regards to the DAO issue, if they were to be considered securities, DAOs would be in unprecedented territory, as they would need to, along with many other things, carry out identity checks, thus potentially eliminating one of the most important features of DeFi, which is to respect wallet anonymity.

Could be this the end of DeFi? Well, in my honest opinion it would just mean the end of DeFi as we know it.

What I mean is that actual DeFi protocols wouldn’t be even close to meeting the requirements of the SEC if DAOs were to be enforced to comply with securities laws.

Luckily, that doesn’t mean DeFi would disappear, it means that DeFi would need to find ways to comply with regulations and maintain anonymity to the highest degree possible, all at the same time.

However, DeFi must first tackle the issue of accountability

Although DeFi protocols have managed to remain elusive from regulation because they are supposedly governed in a decentralized manner, the SEC is setting its eyes on them ever more closely.

News like the Solend story of last month, when they tried to intervene someone’s money by rewriting a smart contract after approving the intervention with an extremely sketchy DAO vote, or the 2020 SushiSwap drama, when the founder of the protocol converted all his tokens to Ethereum, plummeting the value of the coin, make it clear that many of these protocols aren’t really decentralized.

Unless DeFi protocols prove their true decentralized nature, the SEC and other regulators have plenty of grounds to consider they are centrally owned by certain parties or individuals, thereby turning their coins into securities.

Achieving semi-anonymous KYC could be the solution

Happily, for all of us, some advancements have been made in the field of identity checking, the biggest hurdle DeFi needs to go over to succeed in this situation:

  • DeFi Passports that verify user reputation. These passports would be the equivalent of KYC (Know Your Customer) procedures that centralized exchanges have implemented, but for DeFi protocols. This is already in Solana’s pipeline, but as of right now only ARCx is actively working on it.

  • Soul-bound tokens (SBTs). First presented in a research paper by Vitalik Buterin, founder of Ethereum, these tokens are essentially tokens that are bounded to the soul (wallet) of the user, thus being untransferable. These tokens could give an idea of the reputation, and the identity of the wallet, only describing the information that the wallet’s owner wants to make public, making KYC possible without revealing who’s the owner of the wallet.

Decentralization will save the day, again

Once again, decentralization is the key feature of crypto, as it not only represents the most valuable technical asset for blockchains, it also could be the safeguard of the industry when it comes to regulation.

For that in protocols and projects where decentralization isn’t proven, not only their actual use case is debatable, they are potentially much more subject to unfavorable regulation that could become their timely executioner.

As a firm believer in the industry, I trust that crypto founders and developers will come in clutch to prevent tight regulation with the only way the crypto industry has become the most innovative of all financial markets, building damn good technology.

Also, Bitcoin and Ethereum have both been defined as commodities by regulators, so at least there is precedent in the space for finding ways to obtain favorable regulation for other cryptocurrencies in the future.

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