As technology evolves, the U.S. Securities and Exchange Commission (SEC) must evolve with it. Nowhere is this truer than in crypto, and now: The market for crypto assets has grown in size and sophistication such that the SEC’s recent harmful approach of enforcement and abdication of regulation needs urgent updating.
While the long-term future of the crypto industry in the U.S. will likely require Congress to sign a comprehensive regulatory framework into law, here are 6 steps the SEC could immediately take to create “fit-for-purpose” regulations – without sacrificing innovation or critical investor protections.
The SEC should provide interpretive guidance for how blockchain projects can distribute incentive-based crypto rewards to participants — without those being characterized as securities offerings.
Blockchain projects typically offer such rewards — often called “airdrops” — to incentivize usage of a particular network. These distributions are a critical tool for enabling blockchain projects to progressively decentralize, as they disseminate ownership and control of a project to its users.
If the SEC were to provide guidance on distributions, it would stem the tide of these rewards only being issued to non-U.S. persons — a trend that is effectively offshoring ownership of blockchain technologies developed in the U.S., yet at the expense of U.S. investors and developers.
- Establish eligibility criteriafor crypto assets that can be excluded from being treated as investment contracts under securities laws when distributed as airdrops or incentive-based rewards. (For example, crypto assets that are not otherwise securities and whose market value is, or is expected to be, substantially derived from the programmatic functioning of any distributed ledger or onchain executable software.)
The SEC should revise Regulation Crowdfunding rules so they are suitable for crypto startups. These startups often need a broader distribution of crypto assets to develop critical mass and network effects for their platforms, applications, or protocols.
- Expand offering limits so the maximum amount that can be raised is on par with crypto ventures’ needs (e.g., up to $75 million or a percentage of the overall 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 any one individual may invest (as Reg A+ currently does); robust disclosure requirements that encompass the material information relevant to the crypto venture (e.g. relating to the underlying blockchain, its governance, and consensus mechanisms); and other safeguards.
These changes would empower early-stage crypto projects to access a wide pool of investors, democratizing access to opportunities while preserving transparency.
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 transact in crypto assets, and imposes even more onerous regulations around broker-dealers who wish to custody crypto assets.
These restrictions create unnecessary barriers to market participation and liquidity. Removing them would enhance market functionality, investor access, and investor protection.
What to do:
- Enable registration so broker-dealers can deal in – and custody – crypto assets, both securities and nonsecurities.
- Establish oversight mechanisms to ensure compliance with anti-money laundering (AML) and know-your-customer (KYC) regulations.
- Collaborate with industry authorities like FINRA to issue joint guidance that addresses operational risks tailored to crypto assets.
This approach would promote a safer and more efficient marketplace, enabling broker-dealers to bring their expertise in best execution, compliance, and custody to the broader crypto market.
Ambiguity over regulatory treatment and accounting rules has deterred traditional financial institutions from entering the crypto custody market. This means that many investors are not getting the benefit of fiduciary asset management for their investments, and instead are left investing on their own and arranging their own custody alternatives.
- Clarify guidance on how investment advisers can custody crypto assets under the Investment Advisers Act, ensuring adequate safeguards such as multi-signature wallets and secure offchain storage. Also provide guidance on staking and voting on governance decisions for crypto assets in the custody of investment advisers.
- 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 custody solution innovations, meeting regulatory standards without imposing prescriptive technological mandates.
- Rectify accounting treatment by repealing SEC Staff Accounting Bulletin 121 and its handling of balance sheet liabilities for custodied crypto assets. (SAB 121 moves custodied crypto assets onto the custodian’s balance sheet — a practice that is at odds with the traditional accounting treatment of custodied assets.)
This clarity would provide greater institutional confidence, increasing market stability and competition among service providers while improving protections for both retail and institutional crypto investors.
The SEC should adopt reform measures for exchange-traded products (ETPs) that can foster financial innovation. The proposals promote broader market access to investors and fiduciaries used to managing portfolios of ETPs.
- Revert to the historical market-size test, requiring only that sufficient liquidity and price integrity for the regulated commodity futures market exists to support a spot ETP product. Currently, the SEC’s reliance on the “Winklevoss Test” for surveillance agreements with regulated markets that satisfy arbitrary predictive price discovery has delayed approval of bitcoin and other crypto-based ETPs. This approach overlooks the significant size and transparency of current crypto markets, their regulated futures markets, and creates an arbitrary distinction in the standards applicable to crypto-based ETP listing applications and all other commodity-based listing applications.
- Permit 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.
- Mandate robust custody standards for physically settled transactions to mitigate risks of theft or loss. Additionally, provide for the option of staking idle underlying assets of the ETP.
In a decentralized environment where the issuer of a crypto asset may play no significant continuing role, who bears responsibility for providing accurate disclosures around the asset? There’s a helpful analog from the traditional securities markets here, in the form of Exchange Act Rule 15c2-11, which permits broker-dealers to trade a security when current information for the security is available to investors.
Extending that principle into crypto asset markets, the SEC could permit regulated crypto trading platforms (both exchanges and brokerages) to trade any asset for which the platform can provide investors with accurate, current information. The result would be greater liquidity for such assets across SEC-regulated markets, while simultaneously ensuring that investors are equipped to make informed decisions.
What to do:
- Establish a streamlined 15c2-11 certification process for crypto assets listed on alternative trading system (ATS) platforms, providing mandatory disclosures about the assets’ design, purpose, functionality, and risks.
- Require exchanges or ATS operators to perform due diligence on crypto assets, including verifying issuer identity as well as important feature and functionality information.
- Mandate 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 would promote transparency and market integrity while allowing innovation to flourish.
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By taking the above steps now, the SEC can begin to rotate away from its historic and heavily 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 fostering capital formation and innovation — achieving the SEC’s mission.
A longer version of this post originally appeared on a16zcrypto.com.
