The last few days have created whiplash in the crypto-community. On Tuesday, December the 22nd, the Securities and Exchange Commission filed charges against Ripple and two of its senior executives for operating a unregistered securities offering. On Wednesday the 23rd, the SEC issued a statement and request for comment on the custody of digital asset securities by broker-dealers. These actions are two sides of the same coin. The moves by the SEC are a guide to what is in store for 2021. Support for innovation in the regulated securities market and clamp down on uncontrolled token issuance. Many more ICOs and ERC-20 tokens masquerading as utility tokens can expect actions from the SEC.
The SEC’s rationale for the action against Ripple is stated in their press release and is detailed in the accompanying complaint before the Southern District of New York. Even though it is about seven years since the creation of XRP and Ripple Labs, the SEC argues that the individuals charged in the suit as well as Ripple labs had ample warning not to proceed on the course they took. XRP’s value, although not downed like a shot dog, dropped rapidly. The drop in the last two days has taken off more than 50% of its value since Monday the 21st. This has brought the crypto-twitter army out in full force. The XRP holdlers were irate at the SEC. The various strands of outrage included the following familiar tropes: the SEC has put a stake through American Innovation, the SEC are getting paid by China, if SEC wanted to support ordinary investors then it should have taken action seven years ago, Jay Clayton is stabbing innovators on his way out etc. Among the adherents of BTC and ETH, there was plenty of schadenfreude.
The current CEO of Ripple argues that it is a currency and not subject to SEC control. This will play out in the southern district courts. Ripple would be hard-pressed to assert that 100 billion XRP issued and controlled by a few individuals is a currency; especially if a huge proportion of it is already used to personally enrich individuals. Freely printed private money is off the table for now, even those tethered with fiat backing is being questioned. This is in contrast to BTC and ETH, which have strict controls on money supply and many other characteristics and are more like currency. Utility tokens, security tokens and the Howey Test are familiar to us from the arguments that raged in 2017-2018 in the crypto-sphere. There was even a speech from a Fed governor that called for a conversion of a security token into a utility token as a project matures and the attendant changes in the regulatory agencies that would be needed to control the same token. SEC has undertaken actions against a variety of ICO exchanges and ICOs in the last couple of years. The XRP case is the first one against such a huge token. The members of Ripplenet, major international banks including Bank of America, Santander and Standard & Chartered may stick with Ripple through this rough patch. Although it could be unwise to bet on that outcome.
The flip side of the story are non-cash digital assets. SEC has every right to regulate digital security assets. There are multiple reasons why existing securities and bonds should be tokenised on a shared ledger, a ledger that is selectively visible to beneficial owners, custodians, regulators and issuers in the settlement and custody segments of post-trade activity.The SEC statement and request for comment focuses on custody of digital asset securities. The statement says that a broker dealer operating under the conditions set forth in the statement will not be subject to SEC’s enforcement action for the next five years. It can be said to be a broad no-action letter on digital asset security custody. More of a beach than a sandbox. However, this beach is very narrow. It is an elucidation of rule 15c3-3 or the Consumer Protection Rule for digital asset securities. The current rule requires brokerages to have complete possession of customers’ securities in a separate account unbreachable by the bankruptcy of the custodian. Multiple segregated accounts are to be maintained, based on whether the asset is fully owned, as a margin, or functioning as collateral.
The consumer protection rule is taken to its extreme by the fears associated with digital asset securities, especially the possibility of breach or theft and non-recoverability of the digital asset security through the theft of private keys. This possibility is inflamed further by the stealth, scale of such an attack in the SEC’s note, which could result in the rapid bankruptcy of the custodian. All securities could be drained from the custodian in a very short period of time. Hence, the broker-dealer must limit its business to digital asset securities. This will advantage businesses who have limited themselves to this sector today. Other traditional broker dealers have to establish a separate legal entity to comply with the requirements. Due diligence has to be performed on the underlying DLT platform by the broker-dealers. Most of the statement seems to rely on ideas around the safe-keeping of the private key and of eventual consistency with reference to a 51% attack, these are very specific to certain blockchains. The SEC statement is open for comments; and it is the job of the crypto-community to respond to some of the misapprehensions in the SEC statement.
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Innovation is a challenge for regulators. The consumer protection rule (15c-3-3) is 48 years old. They are usually in response to technologies of the past. Stretching past rules to fit new ideas is always problematic. These days of congressional dysfunction, it is also seems impossible to create new legislation that addresses today’s conditions. This has resulted in inaction or a collective burying of heads in the sand. The SEC itself was established in 1934, in a period of great ferment and change. Now in this period of great uncertainty and technological change, they need help in protecting consumers without stifling innovation. It is good to see the SEC getting involved, without remaining on the sidelines.