The view expressed in this post are my own and do not necessarily reflect the opinions of anyone in particular at Blockchain Capital and should not be taken as the position of the firm in any way.
The SEC has certainly been busy this year. Making lists, checking them (at least) twice. Companies have been sleeping on securities laws and subpoenas have been quite the tool to wake them up. Unfortunately for the crypto industry, most of the SEC’s marks are coming up naughty.
All of this unceremonious coal-dumping, has encouraged a moved towards tokenized securities with hopes of finding salvation in the shibboleth of the season, the “STO.” The SEC, perhaps eager to avoid grinchian comparisons, has opened a new office to interact with innovators seeking to sell, among other things, security tokens. But are STOs our crypto messiah? And is the security token mold what’s needed to bring regulators and innovators together?
Many institutional firms have been excited about security tokens, as some legitimate use cases for them exist. Blockchain Capital (my firm) invented and pioneered the concept of the security token by being the first venture capital firm to tokenize a fund, the BCAP, and its eponymous token began trading on a platform for alternative assets for the first time this month. We consider this an important achievement and one we believe will help propel the blockchain industry forward. Whereas BCAP represents an indirect economic interest in the limited partnership interest in the fund (a traditionally illiquid asset), other industry verticals include real estate holdings and the profits portions of financial products such as, among others, cash flows, dividends, and interest payments.
Tokenization does not itself create liquidity. Convenience in trading does not always translate into volume. But it is useful to remember what makes tokenized equities convenient: it streamlines multiple points of friction that prevent markets from forming for what otherwise would be (or could be) more liquid assets – like some private securities. Tokenization does this by automating the clearing and settlement functions of a trade.
In the United States, the offer for sale of a security by an issuer requires registration with the SEC (absent an exemption from registration). In order to qualify for an exemption from registration, when an investor purchases a private security (e.g., a limited partnership interest in the BCAP fund) that investor would likely have had to have been an “accredited investor,” a defined legal term. When it comes to secondary market sales, the secondary “offering” also must fall under one of various exemptions to registration as the investor would be selling securities that have not been previously registered. A lawyer can speak to you for hours about these exemptions. In short, resales of private securities are complicated. Such resales traditionally require that each individual transaction has many intermediaries, like lawyers, transfer agents, clearing houses, and central depositories, to verify that the appropriate exemptions apply and that the proper procedures occur to transfer ownership.
The result here is a big bah humbug for liquidity. It usually takes too long and costs too much to transfer private securities – until tokenization. Security tokens allow coding-in of the above requirements in all of their granular detail glory, and on top of that, allow for automated price negotiation (when listed on a compliant secondary trading platform), validation of ownership by the seller and an automated, real-time cap table that is instantaneous and fully auditable. Their potential compliance features come alongside other features that could bring great value to investors.
It’s easy to see how this is an attractive development in the crypto industry. Imagine digitized elves doing the work of securities regulation compliance.
However, all innovative technology presents regulatory friction. After all, the SEC’s most recent actions against AirFox and Paragon called for what seems like a very administratively cumbersome refund and Exchange Act registration (under Form 10) process for the tokens (not the equity of the companies themselves). A compliant security token offering might have resolved much of the SEC’s concerns in those situations.
The key words there are “might have.” Are security tokens truly our guiding star? Well, no. Outside of the narrow purposes they purport to serve, they are actually a distraction from a glaring regulatory problem – a problem that security tokens don’t share because they are fundamentally different from other tokens in the industry. Security tokens are intended to be a tokenized representation of something we all already agree is subject to SEC jurisdiction. Many other tokens, probably most, in the crypto ecosystem do not share that same intent.
Legal practitioners here will be quick to point out that a token seller’s intent is not one of the four elements of the Howey test, and they would be right. However, when crafting a regulatory strategy for a bleeding edge industry that has the potential to power the next era of tech innovation, perhaps regulators should consider the purpose of innovation and seek to help innovators work through the law.
Legal commentators will again, I’m sure, point out that the SEC’s tripartite mandate does not call for coddling potential issuers. Well, the SEC has done an exceptional job pursuing its raison d’etre of investor protection in the crypto space but it has done a rather poor job thus far of facilitating capital formation (its tertiary charge). In fact, innovation and investment in the crypto space appear to have already begun to dash away to other jurisdictions, particularly Europe, in what should be at least a somewhat concerning trend for regulators and lawmakers alike.
Flight of innovation and investment to other jurisdictions shouldn’t be surprising here. Many other jurisdictions are making great efforts to wrestle with the distinction between what the financial industry would traditionally consider to be a security (and the tokens that represent that) and tokens that are intended to be something else. Switzerland, for example, was one of the first to show this type of engagement  and has recently provided additional guidance. German regulators have made similar efforts as well. Within the past few weeks, the Monetary Authority of Singapore has updated its extensive guidance on initial coin offerings complete with case studies to aid in understanding how regulations apply in given circumstances, while Japan and South Korea appear to be considering issuing guidelines for ICOs and other crypto activity.
I’m not suggesting that the U.S.’s regulatory scheme for things like tokens and ICOs should copy/paste any of these examples, but it is evident that efforts toward clarity in regulation are making other markets more attractive when compared to the regulation-by-enforcement strategy on display here at home. As a venture capitalist, I have a front row seat to seeing this type of attractiveness play out – we regularly find ourselves discussing the potential benefits of incorporating and seeking investment in non-U.S. jurisdictions with current and prospective portfolio companies.
In the midst of all this, the SEC looks intent to force the crypto ethos into an incongruent regulatory framework built for securities alone, recent comments from Valerie Szczepanik (the SEC appointed “Crypto Czar”) notwithstanding. Some took the Airfox and Paragon orders as long-awaited validation that the SEC was finally laying down the law against regular ICOs, not just fraudulent ones. Indeed, the SEC in a self-referential statement also highlighted these two orders and others to tacitly suggest these actions provide all the guidance needed for crypto issuers, investors and secondary trading platforms to avoid violating securities laws. But none of these cases were particularly difficult to discern as far as a Howey analysis is concerned. Both AirFox and Paragon had similar “fatal” facts to the SEC actions taken against Munchee and Plexcoin including three cardinal sins of an asset issuance: (1) using the proceeds of the offering to develop the business on which purchases would expect profit from holding tokens, (2) suggesting that tokens would increase in value and (3) promising efforts to list tokens on secondary trading platforms.
Put another way, these SEC actions don’t really say anything new about token regulation. They don’t contemplate, for instance, networks substantially developed at token offering with at least some threshold of functionality for the token or projects that encouraged the purchase of tokens based on their use cases (as opposed to purchases primarily for possible value increase).
Many projects have purposely avoided references to secondary trading or listing of their tokens; the SEC orders provide no guidance for any of these.
So where does that leave us? Well, the advent of security tokens, while a good thing for the industry and for regulation alike, is really only a solution to a securities problem – not a token regulation problem. But here’s holding out hope that, as Szczepanik suggested is within the realm of possibility (though with no better chance of occurring than a Christmas miracle), the SEC will bring us a brand-new no-action letter this holiday season to finally show us what they won’t go after. And while at this point that might simply feel like waking up to only an orange in your stocking, I guess it’s better than a big ol’ lump of enforcement.