What’s the point of investor protections?
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What’s the point of investor protections?

Are cryptocurrencies securities? If so, who can buy them? William Hinman of the Securities and Exchange Commission went some way to answering these questions last week, but why did he leave retail investors in the cold?

Since cryptocurrencies burst onto the scene, we have been told that this new, digital age will reshape the financial world.

But much of the change seems to have actually gone the other way, as the new world of crypto-innovation has been gradually shaped by the moulds of traditional finance

But perhaps some change is about to come the other way. The SEC’s Hinman dropped hints in a speech that could change the fabric of securities law forever, asserting that assets could be securities at one time in their lifespan, without being securities forever.

When cryptocurrencies are launched in an initial coin offering, most sold in the US avoid the onerous securities registration process by selling only to sophisticated investors (defined as anyone who is a millionaire) through one of the SEC’s safe harbours.

While the letter of securities laws states that any sale of a security must either go through the registration process or make use of a safe harbour, the cryptocurrency market has chosen to ignore this and, once the initial coin offering is complete, trades security tokens freely among anyone wishing to buy them.

The SEC appeared simply to be tacitly tolerating this behaviour, perhaps simply because arresting and prosecuting everyone to have traded anything from ether to dogecoin was too daunting a task.

But the regulator seems to have decided it will adopt this status quo as the new legal reality. Taking ether (the second largest cryptocurrency, after bitcoin) as an example, William Hinman of the SEC said that he believed it was not a security now, but that it likely was a security when it was launched.

While that means it was sold illegally, it is unlikely the SEC will pursue a retroactive enforcement action.

For an asset to be a security at one stage, then to undergo a transition such that it is no longer a security is almost unheard of. Indeed, the Howey Test (used by the SEC to determine if an asset is a security) was established in a case hinging on the very issue of assets losing their status as securities.

Hinman drew some comparisons to property, which can be sold as assets or as part of an investment contract, but there seems to be clear water in between such a case and primary versus secondary market cryptocurrency transactions.

The rationale is that, at launch, there is a central party responsible for the token’s management and that, as such, it can be held liable for the provision of all the disclosures and filings required to inform investors.

Thereafter, the central party disappears. Its relationship with the token is dissolved and it can no longer be expected to provide the information required for a securities registration, and neither can anyone else.

Much of this is disputed loudly and vociferously (mostly on Twitter). 

For one thing, the idea that the issuer of a cryptocurrency has no managerial relationship with its subsequent value seems a little fanciful given the realities of bug fixes, not to mention the management of a platform in which the token is supposed to have value.

For another, it is a change in the status of an asset based on a change in the issuer, not any material difference in the investment proposition of the asset, as would be the case with property.

The new stance is also a get-out-of-jail-free card for all issuers of cryptocurrencies. Those, like Ripple, who launched a cryptocurrency then continued to hold huge quantities of it are unlikely to be deemed to have dissolved their relationship with their token, meaning that XRP may still be considered a security.

While the SEC may have found a neat if rather lazy way of legalising the status quo, a deeper question about the purpose of such legislation remains unanswered. 

What is the point?

If investors who fall short of the SEC’s million dollar hurdle are shut out from ICOs because they are not trusted to speculate on dangerous assets without the aid of the filings required by SEC registration, why should they be allowed to speculate on the same assets simply because there is nobody capable of providing that same information?

Or, put another way, why should private investors be excluded from the discounts available in initial coin offerings but permitted to speculate on the assets when bought at market rate?

Note that cryptocurrency issuers do not actually provide the information required in an SEC registration at the time of their ICOs. They simply sell only to those investors deemed mature enough to make their decisions without it. 

To GlobalCapital’s knowledge, Praetorian is the only start-up that has gone through the securities registration process.

The SEC is doing an admirable job in working out the cryptocurrency world and how to control it, but with the stance in Hinman’s speech, it appears to be selecting expedience over fairness and investor protection.

It will prove difficult to balance offering investors’ protection and requiring a reasonable standard of transparency with fostering development in the nascent cryptocurrency market, but the solution surely cannot be to shut investors out of a stage distinguished only by cheaper prices.

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