Producer｜Euco Cloud Chain Research Institute
Author｜Matthew Lee
On September 27th, SEC Chairman Gary Gensler attended a hearing of the US House Committee on Financial Services. The hearing examined regulatory developments, rulemaking, and activities of the SEC during a period since October 5, 2021, including SEC’s proposed amendments to the definition of “exchange” and expanding SEC’s authority over digital asset trading platforms. Although Gary Gensler still maintains a strict attitude towards virtual assets, the SEC is no longer a united front, and internal personnel are already exhausted. Bloomberg’s senior ETF analyst also stated, employees hope to be liberated from this type of work before the government shuts down.
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Although US regulations have been suppressing the industry’s development, the advantage lies in its establishment of a legitimate procedural legal system. When things may go out of control, it ensures the proper corrective measures (refer to the losses of US and Asian investors caused by FTX’s bankruptcy).
In the past three months, the court has ruled on three industry-related cases, namely Risley vs Uniswap, SEC vs Ripple, SEC vs Grayscale, and the rulings are relatively favorable for the industry. Combined with a series of judgments by the Department of Justice against the SEC, one cannot help but speculate whether the SEC’s “long arm” behavior towards virtual assets will be restricted.
There are very discussable details in the judgments that highlight the positive factors of the US regulatory environment. Below, we will observe the attitude of the judicial system towards virtual assets and SEC regulation, as well as explore the regulatory trends of virtual assets based on recent judgments by the Department of Justice.
TL;DR
Key Points of the Risley vs Uniswap Judgment
The court’s judgment on Uniswap and Risley received the least public attention, but it has the most detailed judgment details, including some very clear and directional viewpoints that can illustrate the court’s attitude towards the industry.
Accusations
Risley’s accusations against Uniswap Labs and its venture capital companies LianGuairadigm, Andreessen Horowitz, USV, etc. are mainly as follows:
i). Uniswap platform sold unregistered securities;
ii). Uniswap is an unregistered broker-dealer;
iii). Uniswap Labs profited through false advertising.
Court’s Response
Uniswap’s decentralized architecture makes it unable to identify fraudulent token issuers, resulting in the absence of “identifiable defendants” in this case. And securities laws directly apply to DeFi’s lack of clarity and there is no federal law that allows the court to hold Uniswap Labs and its venture capital companies accountable. Therefore, merely based on Uniswap Labs collecting transaction fees and other aspects of authority is not sufficient to conclude that Uniswap Labs or the venture capital companies should be held responsible.
Highlights of the Judgment
This paragraph is a very important statement. The judge believes that the law should not be separated from the situation, and combining the actual situation with the law, it is considered normal for tokens to lack registration with the SEC. Therefore, many of the SEC’s accusations, such as “failure to register or issue a prospectus or annual report with the SEC in violation of securities laws,” do not hold up.
Due to the characteristics of decentralized governance, the judge understands the lack of management of “Scam Tokens,” but with the gradual improvement of the law, decentralized organizations should also adopt on-chain tools to remind users of the risks associated with certain tokens in order to avoid legal disputes. When institutions engage in large-scale transactions on decentralized autonomous platforms, they should also consider using on-chain tools to avoid risky interactions.
The judge revealed two pieces of information: i) recognition of the legality of smart contracts in operation; ii) recognition of the attributes of Ethereum commodities (SEC claimed that ETH is a security, not a commodity, when suing Coinbase).
Due to the lack of laws, decentralized trading platforms have not been punished, but there will be stricter regulation targeting decentralized organizations, especially trading platforms. Take Hong Kong and Singapore as examples, both have established strict legal requirements for trading platforms to conduct rigorous reviews of transaction tokens on the platform. Many platforms have also purchased data labeling services from on-chain data service providers to comply with anti-money laundering requirements. In the future, decentralized trading platforms will not have too many privileges.
However, the judge’s current conclusion clearly differs from the previous view of the SEC chairman that “most DeFi trading platforms are actually no different from traditional exchanges.”
The court also dismissed the plaintiff’s reference to the SEC’s viewpoint, believing that having incentive structures does not prove a relationship of interest between the defendant and the project party. This view can bring relief to many projects with incentive measures.
Summary
The judgment contains two very important pieces of information: i) the judge has a deep understanding of the operational logic and characteristics of decentralized projects; ii) the judge is relatively tolerant of the running of decentralized project code and recognizes the legality of smart contract operation.
However, the main reason is the decentralized operating model and the lack of a legal framework that makes it difficult for the court to make objective judgments. Now, several senators have proposed a new legal framework for virtual assets, KYC, and even decentralized protocols, aiming to clarify the regulatory framework and responsible parties.
Key Points of Grayscale vs SEC Judgment
Accusations
Grayscale accused SEC of arbitrarily and repeatedly refusing to list Grayscale’s Bitcoin ETP, but approving essentially similar Bitcoin futures ETPs.
Court’s Response
SEC did not object to Grayscale’s claim that there is a 99.9% correlation between the Bitcoin spot market and the futures market, nor did it suggest that market inefficiency or other factors would undermine the correlation. The judge believed that SEC had inconsistency in dealing with similar products.
Therefore, the judge approved Grayscale’s request and overturned SEC’s order.
Highlights of the Judgment
The court rarely states in the judgment that an institution has violated the law (Administrative Procedure Act), and the court used very harsh words to imply that the “defendant’s” decision was hasty, capricious, and even “an abuse of discretion.”
In the judgment, negative words like “arbitrary” and “capricious” appeared nine times.
The judge also took public opinion into consideration, and it can be said that SEC was almost universally disliked in this judgment.
Summary
In this overwhelming 3-0 judgment, the judge questioned how Grayscale’s ETPs are fundamentally different from other approved ETPs, allowing for SEC to be “discriminatory.” SEC failed to answer this question successfully.
Regarding the judgment against Grayscale, LianGuairadigm’s policy director also provided some additional information: two judges appointed by Presidents Obama and Carter were very critical of SEC’s arguments, so as Democrats (who are generally opposed to crypto assets), they also joined conservative Rao’s opinion. Therefore, the probability of SEC requesting a joint trial is very low, as it is likely to anger the court. If they were to present reasons for non-approval again, it should be about the company’s internal operations rather than hidden risks of the ETP itself.
Key Points of SEC vs Ripple Judgment
Accusations
i). Ripple’s institutional token sales are alleged to constitute the sale of securities;
ii). Ripple’s public token sales on digital trading platforms are alleged to constitute the sale of securities;
iii). Giving tokens to outsourcing companies is suspected of constituting the sale of securities;
iv). No similar prospectus or updated annual report has been filed with the SEC.
Due to the extensive use of the Howey Test in the article to verify whether a security exists, let’s first provide a brief introduction to the Howey Test: 1. Whether there is an investment of money; 2. Whether the investment is in a common enterprise; 3. Whether there is an expectation of profits; 4. Whether the profits come solely from the efforts of others.
*The SEC believes that most tokens meet the second and third criteria.
Court’s Response
i). Ripple’s sale of tokens to institutions through contracts constitutes the sale of securities. The court found that institutional funds were purposefully concentrated and used to develop and enhance the value of XRP. The institutions’ participation was not blind and meets the criteria of the Howey Test;
ii). Ripple’s sale of XRP to the public through “programmatic interfaces” (exchanges) does not constitute the sale of securities. The public does not know the source of the tokens and does not have an expectation of profit from the efforts of the issuer (but rather from other factors such as market trends), and does not possess the characteristics of an expectation of “profits”. It does not meet the third and fourth criteria;
iii). Distribution through other channels does not constitute the sale of bonds. Since no “tangible or definable thing” is paid to Ripple, the payment of XRP cannot be considered the sale of securities. It does not meet the first criterion.
Highlights of the Judgment
Ripple proposed the “essential elements” test – a narrow version of the Howey Test, which was unquestionably rejected by the court. The judge also demonstrated the logic of determining securities, which is definitely not a rigid application of the “test”, but rather a basis for protecting investors based on an analysis of the current situation. In comparison, Ripple’s proposed test focuses more on formality.
The court found that institutional users clearly understood the terms of the investment contract, and they did not regard their purchase of XRP as currency or commodity, but as an investment product. Therefore, the sale of XRP to institutions constitutes the sale of securities.
On the other hand, ordinary users do not understand various SEC documents and Ripple’s market promotions, nor do they associate them with investment returns, so they do not meet the “expectation of profit” in the Howey Test.
Ripple argues that XRP is not a security and is more like ordinary assets such as gold and silver, so it does not have a “commercial nature” as a security. The court does not recognize the logical relationship of XRP because it believes that even commodities can be sold in the form of investment contracts.
Many projects claim that their tokens are not securities, but utility tokens. However, from the perspective of the court, although they have utility, it does not prevent them from being recognized as securities.
Summary
Unlike the overwhelming “support” for Grayscale and Uniswap, although the judge has a more positive attitude towards the virtual market, the court still makes some rulings that are favorable to the SEC. For example, the Howey test should not be confined to form, and this determination to some extent conforms to the SEC’s definition of securities. Projects that claim their own tokens are “utility tokens” will have a hard time in court.
What confuses me about this ruling is that the recognition of tokens sold to institutional investors as securities is because institutional investors are aware of the investment regulations and sources of sales, while retail investors are “unaware”. However, the “intention” of determining securities is to protect investors, and retail investors have not been protected. And according to this logic: if tokens are sold through exchanges, then securities laws do not apply, and retail investors who purchase tokens on trading platforms can be unprotected?
Regulatory Signals Revealed by the Ruling
Several rulings have shown some “unreasonable” aspects, demonstrating the judiciary’s bias towards the industry and indirectly highlighting the checks and balances within the United States. In the past few years, the SEC has taken aggressive measures to try to expand its “jurisdiction” on whether virtual currencies are securities. However, before the legislative branch takes formal action, the judiciary has begun to strongly strike the administrative branch.
Ripple, as an example specially used by the SEC to issue warnings to the industry, has not established authority, but instead has given the industry a big gift. As a country represented by case law, the punishment of “Ripple vs SEC” will provide a clearer direction for the industry that lacks definition and legislation, especially pointing out that tokens sold “programmatically” do not belong to the SEC’s definition of “securities”.
Although the Uniswap ruling is unrelated to the SEC, it reveals the attitude of the court: decentralized projects are different from ordinary companies, and tokens cannot be confused with the securities of companies. Judge Katherine Failla, who presided over the SEC and Coinbase cases, is also highly regarded by the market that Coinbase will reject the SEC’s lawsuit.
If the Ripple and Uniswap cases are goodwill gestures from the judiciary to the industry, then Grayscale’s punishment is a blow to the SEC. The overwhelming 3-0 ruling reveals disappointment with the SEC from both the progressive and conservative parties.
The hearing held yesterday also indirectly sent signals to the industry. The SEC’s strong regulation will be constrained, and the legislative branch will also closely follow and clarify the regulatory framework. Although regulation will not be completely relaxed, future enforcement will be more “rule-based”. I believe that members of Congress will not give up this opportunity to promote their own positions in the cryptocurrency industry and gain political capital. There will be a large number of ETF applications in October, and these applications have already exerted strong political pressure on the SEC. Combined with the recent “rise in the east and fall in the west” that brought a chill to the Permissionless conference, it is all a blow to the SEC. If they continue to take unreasonable measures, they will be abandoned by public opinion and political resources.
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