The Intersection of Block chain Technology and Securities Laws:…

The crypto industry has made and destroyed fortunes in equal measure. Regulating the industry is extremely difficult because it is multi jurisdictional, technologically complex, and entails numerous use cases. That notwithstanding, the race to develop a new crypto-centric global economic system is on. But how do you regulate an industry whose primary appeal lies in its ability to operate beyond government control?

“Investor protection is just as relevant, regardless of underlying technologies.” Gary Gensler, SEC Chairman.

∘ The Intersection of Block chain-Based Assets and Securities Law ∘ Understanding Securities Laws ∘ Regulating Block chain-based Securities: Current Landscape ∘ Importance of Striking a Balance between Fostering Innovation and Ensuring Investor Protection ∘ Discussion on the Role of Regulatory Sandboxes and Experimentation Frameworks ∘ Future Outlook: Regulatory Development and Challenges ∘ Final Thoughts

Block chain technology is a shared, immutable ledger that tracks assets and records transactions within business networks. Generally, assets are either tangible or intangible. Tangible assets include cars, houses, cash, and land, while intangible assets include brands, patents, copyrights, and other forms of intellectual property. Technological advancements have led to the creation of virtual assets, such as crypto-based assets. Unlike traditional asset classes, crypto-based assets, lack oversight, and are prone to volatility, manipulation, and fraud.

The lack of crypto specific laws in many jurisdictions is offset by clarification and guidance on existing regulatory frameworks, and compliance requirements, flowing from rulings. Generally, Virtual Asset Providers( VASPs) are subject to the same regulatory requirements that apply to conventional financial institutions.

Securities and derivatives markets are critical for the growth of market economies. They enable the exploration of new ideas and corporate initiatives and allow effective financial risk management. Securities laws have three primary roles within the financial sector:

Undoubtedly, regulation is necessary to realize the goals above. However, inappropriate or unclear regulation can impose unjustified burdens on market players, inhibiting growth and innovation. For instance, crypto companies remain frustrated by the US government’s failure to regulate the industry clearly and the Securities Exchange Commission’s (SEC) treatment of crypto companies. The purpose of regulating the crypto industry is based on the need to:

The hybrid and transformative nature of crypto-based assets makes it hard to legally classify them. For instance, crypto assets each have unique business structures and code, which affects their legal classification. Leading to questions like, should crypto assets be classified as commodities or securities? Should different regulatory agencies oversee different aspects of the crypto industry? Based on the volatile nature of the industry, how should regulators balance investor interests and the need to boost innovation?

This article explores the intersection of crypto-based offerings and securities laws.

Block chain technology has revolutionized the business sector. In the past few years, investments in block chain products have surpassed venture capital investments, attracting major tech companies, financial institutions, and even startups. As the global crypto market capitalization skyrockets, investments in block chain offerings are taking over contemporary finance.

Recent declarations and investigations conducted by various securities commissions infer the regulation of block chain-based assets as securities. In the US, for instance, a block chain offering that is not registered with the Securities Exchange Commission is illegal. Similarly, in Kenya, cryptocurrency and token offerings that satisfy the Howey Test are considered securities per the Capital Markets Act. The Capital Markets Authority regulates securities in Kenya.

Governments are anxious to regulate crypto markets because controlling currencies is an effective way of managing economies. Additionally, regulations offer legitimacy and stability to the nascent industry. However, the crypto industry thrives due to anonymity and volatility. This begs the question, how do you regulate an industry whose primary appeal lies in its ability to operate beyond government control?

Undoubtedly, finding a middle ground between moderating a lawless industry while allowing it to create value will be challenging to investors, governments, and crypto companies.

Securities are business investments, which may be in the form of shares, bonds, or packages of mortgages or loans offered by financial institutions or instruments. They represent an investment in a firm or project.

Securities laws are part litigation ( where investors institute proceedings against an issuer on the grounds of fraud in connection to security), part regulatory ( consider the role of the SEC or the Capital Markets Authority), and part transactional ( consider securitization, where different debt instruments are bunched together and sold to investors as securities). Securities laws protect investors by prescribing full disclosure of information relating to an offer, among other requirements.

Lay investors rarely access the legal terms of a block chain offering, as they are embedded in code. Sometimes, the code is open source, making it available for inspection by investors before the transaction. Unfortunately, understanding the code demands significant effort and expertise, which many people lack. Individuals conversant with programming languages are not entirely safe, as block chain developers utilize various languages. Generally, issuers, in their marketing efforts, provide potential investors with white papers detailing critical aspects of their offerings.

Many jurisdictions worldwide protect unsophisticated investors through the “plain English requirement.” Per the US Securities Act Rule 421(d), offerors of securities must provide, on the front and back, covers of a prospectus, a summary, and a discussion of the offer’s most significant risk factors in plain English.

According tothe International Organization of Securities Commissions (IOSCO), the objectives of securities laws are closely related and often overlap in some aspects. Many of the provisions that help to guarantee market integrity also help to avoid systemic risk and protect investors.

Securities may be offered privately or publicly. An Initial Public Offering is an example of a public offering, which companies use to raise funds. In the crypto industries, companies raise funds through Initial Coin Offerings, Liquidity Generation Events, Launchpads, Initial Dex Offerings, and Security Token Offerings ( STOs). A private offering, on the other hand, involves the limited sale of debt or equity to a select group of investors.

The evolution of digital assets, from speculative investments to novel asset classes, has prompted securities agencies around the globe to explore practical ways of regulating the crypto industry. As the crypto industry grows more significant in the global investment landscape, different governments have taken various initiatives to regulate crypto markets. The EU was the first to require crypto service providers to self-regulate by identifying and curtailing illicit digital currency uses, such as terrorist financing and money laundering.

Many years after the invention of Bitcoin, governments did little to regulate the crypto industry. For over a decade, crypto has spread across the globe as a unique decentralized financial asset. Today, governments worldwide are rapidly changing their laissez-faire attitude towards crypto and decentralized finance.

While investors support regulating the industry, many remain confused as to how regulation will affect the industry. Many fear that regulation will alter the fundamental character of crypto: decentralization.

Investors’ support for regulation should not be mistaken for government support. Instead, it is directed toward exchanges and payment companies. Once bitten, twice shy. Generally, investors are weary of industries that self-regulate. However, self-regulation is a viable solution to the unique risk of crypto regulation. Below is a brief overview of the state of crypto regulation around the world:

Since the collapse of FTX, the US SEC has doubled down on its efforts to regulate the crypto industry, and in March 2023, the SEC issued Coinbase a Wells Notice. A Wells Notice is a formal notification from the SEC informing the recipients of its intention to institute enforcement actions against them. It allows the recipient to explain why an enforcement action should not be initiated against them.

The SEC has moved towards regulating the industry through its widely publicized case against Ripple. The SEC alleges Ripple raised over $1.3 billion by selling XRP, its native token, in an unregistered securities transaction.

The SEC chairperson Gary Gensler describes the crypto industry as the ‘wild west.’ Gary Gensler has further stated that nothing in the crypto industry is incompatible with securities laws. However, some feel that regulation by enforcement is neither sustainable nor sufficient. According to Rep. Patrick McHenry, chair of the Financial Services Committee, the approach taken by the SEC was likely to drive innovation away from the US, limiting the nation’s competitiveness.

The Bidden administration has been vocal about combating illicit cryptocurrency use. The US government has stated that it will consider summoning Congress to amend anti-tip-off statutes, the Bank Secrecy Act, and other laws to curb unlicensed money transmissions applicable to the crypto industry. Additionally, the Federal Reserve Bank has warned against the systemic risks of stable coins. This stems from the 2022 Terra Stable Coin collapse, which lost investors over $60 billion.

Like many other jurisdictions, the UK lacks crypto-specific laws. However, the country considers digital currencies property, not legal tender. Additionally, crypto exchanges must register under the Financial Conduct Authority ( FCA). The trading of crypto derivatives is illegal under UK laws. The UK has crypto-specific reporting requirements for combating the financing of terrorism ( CFT), Know your Client standards (KYC), and anti-money-laundering standards ( AML).

In October 2022, the British House of Commons recognized crypto assets as regulated financial instruments. Consequently, crypto exchanges and custodian wallet providers must satisfy reporting obligations provided by the Office of Financial Sanctions Implementations (OFSI). Per the rules, crypto companies must notify the OFSI if they suspect or know that an individual has engaged in a financial sanctions offense or is subject to financial sanctions.

India, like Kenya, continues to sit on the fence regarding crypto regulation. It has neither legalized crypto markets nor has it penalized their use. However, there exists a bill banning all private digital currencies. Additionally, the Indian government levies a 30 percent tax on all crypto investments.

Currently, there are no outright regulations on crypto assets in India. However, the government of India has been working on a central bank digital currency, which may be launched in the 2022–2023 fiscal year. In a meeting hosted by the Federal Reserve Bank of India ( RBI), Mahesh Kumar, Deputy Governor of RBI, advised directors of Indian banks to adopt Block chain and AI technologies to enhance stability and sustainability alongside practicing effective corporate governance.

Under Australian laws, cryptocurrencies are property subject to capital gains tax. Crypto Exchanges can conduct business as long as they register with the Australian Transaction Reports and Analysis Centre (AUSTRAC).

The Australian Securities and Investment Commission (ASIC) promulgated regulatory obligations targeting Initial Coin Offerings in 2019. Additionally, crypto companies must comply with specific reporting requirements, such as combating the finance of terrorism and anti-money laundering obligations. Further, ASIC banned privacy coin offerings.

Privacy coins are digital currencies that uphold anonymity by obscuring money flow across their networks. In 2021, The Australian government expressed its intention to launch a Central Bank digital currency ( CBDC) and to launch a licensing framework around the crypto industry.

In October, 2022, the EU arrived at a policy consensus on the Markets in Crypto assets (MiCA) Regulation. MiCA is the world’s first crypto asset regulatory framework. The main role of the instrument is to provide investor protection and stability while supporting innovation. The regulation will enter into force between 2024 and 2025. MiCA effectively makes the EU attractive to crypto investors and as a global pace-setter.

Since crypto markets are multi-jurisdictional, regulatory frameworks similar to MiCA will aid in the establishment of robust, safe, and necessary eco systems for the crypto industry globally. MiCA establishes a system that ensures stable coins, for instance, live up to their name. It does so by requiring enhanced transparency, and by preventing stakeholders from creating excessive risks. Apart from addressing the financial implications of the crypto industry, MiCA also addresses its environmental implications in a bid to address rising concerns about the environmental impact of the crypto industry.

Each jurisdiction approaches crypto differently, from viewing crypto as legal tender to banning it out rightly. According to the 2021 Library of Congress report titled Regulation of Crypto Currency Around the World:

Like conventional financial markets, there are a few baseline rules that crypto markets must comply with today in many jurisdictions:

Historically, regulatory and product innovation have existed simultaneously. For instance, in ancient Mesopotamia, people stored their grain and commodities, including precious stones and metals, in temples and royal palaces. The temples would, in turn, lend the excess to consumers, just as today’s banks do. Records of temple withdrawals and deposits etched onto clay tablets exist to prove this.

Innovative receipts allowed commerce to operate smoothly and enabled claims to property, among other rights. This only worked because a proper legal framework existed: Hammurabi’s Code. The code set interest rates, protected depositors’ commodities, and remedied unfair practices that harmed consumers. To date, regulators still struggle to respond to financial innovation in a manner that stimulates commerce and innovation while protecting market participants.

Innovation is a constant within the financial sector. It is a disruptive but fundamentally neutral force within the industry. Innovation can enhance the human experience tremendously, but it can also harm consumers if steps are not taken to regulate it. Unsophisticated investors, for instance, lack the requisite knowledge on how new financial products and services may affect them. And while the crypto industry currently operates without adequate oversight, across the globe, there is an ongoing process to establish regulatory frameworks to ensure sustainable growth while limiting risks.

The collapse of the First Republic Bank shook Silicon Valley to the core and sent shock waves across the finance industry reminiscent of the 2008 Financial Crisis. The failure prompted scrutiny from Congress and regulators in a bid to establish what went wrong. It also highlighted the need to develop effective regulatory reforms and legislation to prevent future recurrence.

When an institution like the First Republic Bank collapses, the US Federal Deposit Insurance Corporation ( FDIC) refunds depositors up to $250,000 while initiating processes to recover lost funds. A crypto-centric version of the First Republic Bank would have been worse, as depositors would have no support system nor a way to recover their funds.

The lack of a proper regulatory framework in the crypto industry curtails its growth, as established financial institutions are weary of supporting crypto startups. Since financial institutions are weary of supporting the crypto industry, it is incumbent upon industry stakeholders, policymakers, and regulators to create an adaptive and comprehensive regulatory framework that balances investor protection, stability, and innovation within the crypto industry.

Undoubtedly, crypto companies are often hard-pressed to secure banking partners within the US. Established financial institutions don’t usually provide financial services to establishments that operate outside traditional boundaries. The lack of financial support impedes industry growth, forcing crypto companies to seek alternative funding solutions. Although financial regulations vary from country to country, studies show that financial regulatory frameworks in other countries are more centralized than in the US.

During a Congressional Hearing on Capitol Hill in July 2021, Jerome Powel, the Federal Reserve Chair, clarified that he was not a fan of cryptocurrencies, especially stable coins. The Fed chair mentioned the nation’s main incentive to launch its central bank digital currency ( CBDC) was to eliminate the use of cryptocurrencies in the US. American lawmakers and the Federal Reserve constantly bemoan the rise of stable coins and other digital coins. Unlike ordinary cryptocurrencies, stable coins are a subset of digital currencies whose value is pegged on financial instruments, commodities, or other currencies.

Central banks worldwide are scared about the increasing use of unregulated nongovernmental digital coins primarily because they do not influence the space they operate. According to Nick Carter, a founding partner at Castle Island Ventures, central banks are concerned that a large portion of commercial banking activity is turning to digital coins, a widely unregulated space. Nick Carter further argues that even if the US launches a digital currency, the currency will be entering an already crowded market with over 11,000 digital coins in circulation.

Many regulators strongly feel that if cryptocurrencies are a part of the payment universe, there is a need to establish an appropriate legal framework, which is nonexistent in many parts of the world. While established financial institutions like the First Republic Bank have refused to accommodate crypto companies, all is not lost. Soon traditional financial institutions will rise to the occasion and provide banking and off-ramp services to crypto companies.

Enterprising banking institutions have discovered a market gap and are slowly stepping up to provide banking facilities to crypto firms. Crypto-friendly banks, like Juno, offer crypto trading and traditional banking services, like cashback debit cards and FDIC insurance. While this transition will be slow, these new entrants will contribute hugely to the growth and resilience of the crypto industry. But while a more significant investment pool may benefit everyday investors, increased institutional involvement threatens virtual currencies’ goal to exist outside traditional finance.

In the latest sign that block chain-based assets are here to stay, Goldman Sachs announced that it has been considering offering its clients a “full spectrum” of investments in various digital assets, including Bitcoin, despite widespread skepticism across the traditional banking sector. Reports indicate that Goldman is working towards securing approvals from the SEC and the New York Department of Financial Services.

To shield themselves from traditional banking barriers, crypto companies look to Decentralized Finance ( DeFi) for survival. DeFi offers users services like lending, borrowing, and trading without relying on traditional financial institutions. De Fi is an attempt to replicate some functions of conventional economic systems in an open, decentralized, permissionless, and autonomous manner based on block chain technology. Like any other Distributed ledger Technology based application, decentralized finance offers efficiencies based on automation and disintermediation powered by smart contracts and block chain technology.

Transparent distributed exchanges and De Fi platforms have, in the past years, experienced increased cash flows, offering crypto companies viable means of acquiring financial services and conducting business. DeFi platforms are popular because they offer users faster, more efficient, and more transparent services compared to traditional banks. However, studies and recent occurrences indicate that DeFi platforms are susceptible to severe security threats. Additionally, DeFi is unregulated and prone to volatility and financial misconduct.

The crypto industry is full of paradoxes. On the one hand, crypto companies and investors agree that regulation will legitimize the fledgling sector. On the other hand, they fear that regulation may undermine crypto’s decentralized nature, which is why they are attracted to the industry. In December 2020, Brian Amstrong, Coinbase CEO, said that the US Treasury Department was contemplating a law requiring exchanges to take their clients’ names and physical addresses for transactions exceeding $ 3000.

“Europe has a strong hand to play in block chain, there needs to be regulation, but it shouldn’t constrain … too much regulation and people will go to Dubai.” Julien Romanetto of the Smurfs Society

The term sandbox is prevalent in software development. It denotes an isolated yet fully functional testing environment where innovative technologies, approaches, products, and services which are not entirely compliant with prevailing regulatory and legal frameworks are tested. Regulatory sandboxes help governments and companies to learn the risks and opportunities an innovation possesses. Additionally, they help regulators develop the proper regulatory framework to accommodate innovation. In a nutshell, regulatory sandboxes enhance innovation while future-proofing regulations.

Despite the innovative idea, it must comply with existing regulatory and legal frameworks to realize its full potential. Generally, sandboxes require flexible legal instruments containing experimentation clauses. These clauses empower participants to engage in experiments. A crypto regulatory sandbox helps companies and governments to effectively establish how virtual currencies can be adopted and how to create a future-proof regulatory framework.

The purpose of sandboxes is not to deregulate or undermine industry protection and safety standards. Generally, they are used to developing regulations in sectors, like the crypto industry, that have no existing regulatory frameworks. Crypto regulatory sandboxes will help establish the best way to regulate the crypto industry and cooperate with industry players. In essence, regulatory sandboxes help create optimal testing environments for innovative ideas, products, and services; they also help to ensure that the regulatory framework remains at par with digitization.

As government interest in block chain technology increases, block chain sandboxes have been deployed to establish effective strategies for introducing and implementing virtual currencies within traditional financial systems. Block chain's distributed ledger system ( DLS) is similar to the databases banks use to verify transactions before adding them to publicly viewed ledgers as immutable records. In 2018, 21 members of the European Union signed a declaration that established the European Block chain Partnership ( EBP) to develop European Block chain Services Infrastructure ( EBSI).

Widespread reports of hacking attempts, theft, and scams greatly hinder the mass adoption of virtual currencies. Fortunately, there is a rising trend where regulators are offering some companies opportunities to test block chain products. The UK’s Financial Conduct Authority ( FCA) recently allowed 22 firms access to its regulatory sandbox. Similarly, in 2020, the Spanish government promulgated the Digital Transformation of the Financial Sector Act, establishing a regulatory sandbox for the fintech and crypto sectors. As more governments and companies explore the potential of block chain technology, more regulatory sandboxes will likely be created. Unfortunately, findings from existing regulatory sandboxes have not been implemented.

Undoubtedly, despite regulations being at a developmental stage, it is important to note that the countries and organizations that will be first to quickly and effectively adapt emerging standards will gain a tremendous competitive edge in the crypto industry.

Widespread allegations of fraud, incompetence, financial misconduct, and crackdowns by regulators have cast a shadow of doubt as to the ability of virtual currencies to revolutionize the financial industry. Stakeholders and investors in the crypto industry are searching for a new purpose. In the past few years, the crypto industry has been plagued by a series of unfortunate occurrences; the decline of the cryptocurrency market and the FTX collapse are prominent examples.

According to Laura Shin, host of the “Unchained” podcast, the crypto industry will be involved in numerous clashes with regulators due to harsh regulatory proposals, especially those threatening decentralization. However, as issues surrounding the industry are discussed and resolved, the long-term future of the industry will start taking shape. Regulation will determine the end of the crypto industry.

The proposed crypto and Bitcoin regulations tabled by the US Financial Crimes Enforcement Network will make it easier for the government to track crypto transactions. The regulations require crypto exchanges to store client information and present it to the government when requested. This is a tremendous move, and many people feel the government has not fully contemplated its effect on the crypto industry.

John Reed Stark, former SEC chair, took to Twitter to warn crypto influencers against possible prosecution by the US Securities Exchange Commission for price manipulation. Indeed, the SEC has issued several cease and desist orders and fines in the past few years. Cryptocurrency influencers commonly endorse numerous questionable crypto projects and help them manipulate prices during bull runs. In 2022, Kim Kardashian was fined $1.2 million for promoting a sketchy crypto project known as EthereumMax ( EMAX). According to the SEC, Kim failed to disclose that she had received $250,000 to endorse EMAX on her Instagram page. Similarly, Francis Sabo was charged in a $100 million securities fraud case for using social media to manipulate exchange-traded stocks.

Crypto companies have difficulty catching up with traditional financial systems regarding regulatory compliance. Indeed, conventional financial institutions have had decades to establish compliance programs, while crypto regulation is relatively recent. Many jurisdictions across the globe require crypto firms to comply with Know Your Customer, anti-money laundering, and other regulations before conducting business. While this is necessary, regulators mustn’t curtail industry growth to protect consumers. Achieving a balance between fostering innovation and consumer protection is an uphill task for many regulators worldwide.

Regulators are unable to classify crypto-based assets clearly. This is primarily because of the hybrid and transformative nature of crypto. For instance, the US Commodity Futures and Trading Commission( CFTC) considers Litecoin, Bitcoin, Ether, and a few other fiat-backed stable coins, like Binance USD and Tether to be commodities. This contradicts the SEC’s claim that tokens are securities.

The financial sector has faced numerous challenges successfully over the years. The most significant challenge financial systems have faced so far is the proliferation of digital currencies and the growth of DeFi. The development of DeFi is astounding, considering that it is technical, volatile, and complex. Defi users must be financially savvy, crypto-literate, and capable of quickly adapting to ever-changing market situations and protocols. The potential the DeFi industry possesses is not lost on institutional investors. According to Tyrone Lobban, head of Onyx Digital Assets at JP Morgan, the bank is considering channeling assets worth trillions of dollars into DeFi.

DeFi may replace Centralized finance ( CeFi) in the future. But for this to happen, the industry must embrace simplicity, security, and regulations. The DeFi industry needs to collaborate with regulators to create a practical regulatory framework to ensure widespread acceptance in the future.

Interoperability of CeFi and DeFi is a viable way of enhancing adoptability and the scalability of DeFi applications. Given the growing willingness of conventional financial institutions to hold digital assets, by introducing compliance, DeFi providers have commenced providing institutional services. These are permissioned versions, which include the whitelisting of participants per regulations.

There are DeFi firms that have invested in interfaces that enable users to access markets in user friendly ways. For instance, Consensys’ MetaMask Institutional wallet allows institutional investors to access markets while creating safeguards, by introducing reporting to guard against fraudulent activities by fund managers with access to digital assets.

The question of whether crypto assets are securities has been the cause of widespread debate across the globe. When crypto assets are classified as securities, they become subject to regulations within the jurisdictions they operate. The primary purpose of security laws is to maintain market integrity, protect investors, and avoid systemic risks. Different jurisdictions apply different rules to establish whether crypto assets are securities. American courts, for instance, use the Howey Test to show whether an offering is an investment contract.

The cryptosphere is full of paradoxes. While market players endorse regulations, they fear that regulations may interfere with the fundamental nature of crypto, which is decentralization. Governments, on the other hand, appreciate the potential of the crypto industry and recognize the effects over-regulation may have on the fledgling industry. In trying to regulate the sector effectively, governments and companies have established regulatory sandboxes to ascertain the best way to regulate the industry while boosting innovation.

Block chain technology is set to revolutionize the conduct of business. It has the potential to fundamentally redefine various processes in different sectors, including finance, law, and healthcare. The technology enables, among other things, enhanced trusted efficiency in exchanging goods and services. Traditional financial institutions have begun changing their attitude toward digital assets. They have realized that the crypto industry is here to stay. Goldman Sachs’ decision to offer a ‘full spectrum” of crypto-based investment opportunities is a leading example of this state of matter.

The crypto industry has made and destroyed fortunes in equal measure. Regulating the industry is extremely difficult because it is global, technologically complex, and entails numerous use cases. The industry’s rapid development makes it difficult for regulators to keep up. Lack of regulatory clarity is a severe concern for market players, investors, and governments. The industry has suffered tremendously due to the lack of regulations. For instance, crypto startups usually result to alternative fundraising methods since traditional financial institutions do not provide their services to them. Crypto startups utilize Initial coin offerings and DeFi to access funds. However, the legality of these options is still unsettled across the world.

For many years, the crypto industry has operated lawlessly. Governments had looked the other way, resulting in widespread financial misconduct. The collapse of several crypto behemoths, like FTX, is testimony to this. In their efforts to regulate the crypto industry, governments must strike a balance between protecting investors and enhancing innovation. It is a delicate balance, as the future of the crypto industry is heavily dependent on effective regulation.