Good afternoon, I am going to talk to you about blockchain technology and its real potential. And I believe it does have a real potential in the world of finance.
It’s an innovative way, of course, to verifiably move value or apply code or “dapps” as some people call them on a distributed network, but what’s moving value or code on a distributed network, but really finance because it ties to the essential plumbing of the financial sector which at its core moves and allocates money and risk. So, value and code, money and risk.
It seems, in essence, this is the core to the plumbing of the financial sector. To reach its potential though, and for public confidence, blockchain technology has to be compliant with laws.
It doesn’t mean the laws have to stay exactly the same, but laws that have been established over many, many decades that customers and investors and to make sure that markets work efficiently, that’s called market integrity. So, customer protection, investor protection, market integrity. And to really work I believe blockchain technology needs to come within that public policy framework.
Now this can be done by balancing those protections while at the same time promoting innovation. But as we currently see things, we’re not in a pretty good shape right now.
There really is significant non-compliance with respect to the laws, certainly in this country and in many many other countries as well. Many initial coin offerings probably well over a thousand, many crypto exchanges, probably 100 to 200, are basically operating outside of US law.
And when I say outside, that means non-compliance with the laws right now. So, that’s a lot of this marketplace right now, now I’m an optimist, I want to see this technology succeed, it is in essence about the plumbing of the financial system and it’s a new technology that can really enhance the financial system.
So, I think we need to kind of bring it inside. And there’s gonna be a lot of technical and commercial challenges, and you’ve heard about that during the conference – about scalability, about interoperability, and governance and privacy and the like.
I’m going to just sort of focus on the public policy side, I think ultimately when it does succeed, this innovation has a chance to lower costs, lower risk and yes, in some ways, bore into some of the economic rents of centralized institutions, where they can collect excess and extra rents. The question is then, really, for this new technology, ‘How do we go forward?’ And it is often said that the devil is in the details.
So initial coin offerings. What do we know? $6.5 billion in the first quarter of 2018. Hasn’t slowed down. $6 billion dollars in 2017 which in itself was a 40-fold increase. So maybe this year could we see $25 to $50 billion dollars all year if it keeps ramping up? Is it $20 to $30 billion?
It’s no longer a small market, it surpasses a lot of the VC space and other ways of raising money. But there’s significant frauds and scams in this market as well.
One of my colleagues Christian [Catalini] thinks upwards to 25 percent. Some outside sources have numbers even well in excess of that as well. But this innovative way of crowd funding offers prefunctional, transferrable tokens for use on a future blockchain application.
And it has mixtures of economic attributes, which is both investment and consumption. So you’ve heard this debate – is it a utility token, is it a consumable token or is it investment?
Well kind of the answer is it’s both. I know that’s not an answer that a lot of people like, but that’s kind of where we are right now. The fungible nature of the tokens and the expectation of profits distinguish it from a theater ticket or a personal seat license at a sporting event. It’s fungible and you’re expecting future profits when the network comes together.
The presence of a transferrable usable token and an expectation of profit further distinguishes it from crowd funding on Kickstarter or Gofundme or elsewhere. So, lacking traditional features of equity or bonds, doesn’t pay a dividend, you don’t necessarily get a coupon, you say ‘huh I’m home free.’ Not really, not really. Because the investing public is clearly hoping for possible appreciation based on the efforts of promoters and development teams. And so, this brings me to a very important test in the law – it’s called the duck test.
Riley is not familiar to the rest of you maybe, but when you quack like the duck, when you swim like the duck, when you walk like the duck, Riley 100 years ago said, ‘I think the bird’s a duck.’ So, why is that, why am I talking about that at a blockchain conference? Well, in essence, when investing in any form of finance, whether an ICO or traditional forms like stocks and bonds, the public benefits from full and fair disclosure.
The investing public benefits from prohibitions against fraud and manipulation. And so many years ago, in the 1930s, Congress invented in the securities laws a definition of security. But that definition of security includes something other than just stocks and bonds, it also includes something called an investment contract. This is not arcane law, it’s been tested over and over again at our supreme court as recently in the last 15 years. But in the 1940s, the key test was something called the Howey Test.
So, what is this all about? Well, there was a man named William Howey and William Howey had orange groves in Florida. You might say why am I talking about orange groves? Well this company sold land and gave the buyers an option to lease the land with an affiliated company – it was not stocks, it was not bonds, but guess what – the Supreme Court said it was an investment contract. And what the Supreme Court said is an investment contract is that what you see up on the screen.
Is it an investment of money, is it a money going to a common enterprise, is it a reasonable expectation of profit relying on the efforts of others. Think of those four-part test, it’s all nuanced, it’s all facts and circumstances, but always always recall the duck test as well. And so the Supreme Courts also ruled subsequent to that in 2004 that when they’re talking about profits, the profits don’t have to be dividends. The profits don’t have to be some other right of return. The profits include something that you think is about appreciation and that was in the Edwards case.
The SEC ruled on this last summer in The DAO letter and the Munchee Order and this Centra complaint, but more important than that, SEC Chairman Jay Clayton has spoken about this. And I quote, this was Chairman Clayton, it’s not me, ‘I believe ICO I’ve seen is a security. You can call it a coin, but if the function is a security, it’s a security.’
That sure sounds like you can call it a coin, but if it’s a duck, it’s a duck. But anyway, I tend to agree with the Chairman. I haven’t reviewed all the ICOs. Who could review 1,000 to 2,000? But other than maybe CryptoKitties – which I think CryptoKitties is not a security, I’m not sure it’s an ICO though – I tend to agree with him.
So, the question now is where do we go? What’s next. And I don’t think it’s any longer question of if, I don’t think it’s a question of when, ICOs really must comply with securities, commodities and derivatives laws here in the U.S. and frankly around the globe.
And I should even throw in also anti-money laundering and know your customer because the U.S. Treasury Department is written on that as well. And this is not just because one reason – the economics, with $6.5 billion raised, when one firm – Telegram – raises $1.7 billion, what do we call that? That’s capital formation. Investors protection, consumer protection is worthy in this space. Yes, it’s a utility token, but yes it’s an investment contract.
So, the duck test, the economics, the law, the Chairman, the statement all say this is where we’re headed. So, let’s just talk about what that means. I’m going to go to four general considerations and four specific considerations.
So, four general considerations. Remediation. So, how might regulators bring 1000 past ICOs into compliance? Might be retroactive registration with rescission rights. Some requirements are going to be difficult to sort of put in there. It’s not easy to tuck them all in, particularly beneficial ownership. There’s been a requirement since the 1930s that you know your shareholders – initially to avoid double spending – just like the blockchain. But more recently to comply with anti money laundering laws. Secondly, how do you recover the losses? Can regulators and the courts help?
Well guess what, private citizens have a right under our securities law to bring their own private rights of action.
Whether it’s against ICOs, or exchanges or the like, but the money might not be there. Thirdly, it’s compliance with possible tailoring. Again, laws were written at an earlier stage. I stand here on the stage saying investor protection is important… But I’m also saying that I think we might need to tailor some of these rules and regulations so that they fit into this new technology while still protecting investors.
And lastly a regulator talking to you all, the question is what tools in the regulatory tool kit does a regulator use? Is it some enforcement actions, give a few speeches and expect the market to come into compliance? Is it hoping that private citizens will bring private rights of actions? Or is it also in addition using the rule writing authority? And I think you’ve seen that at the CFTC at the agency I was honored to run, but I think you’ll see that at the SEC at some point too.
So now let’s talk about some specifics about the ICO market.
So, first what you read a little bit about in The New York Times is, OK, the SEC and regulators around the globe need to look at all these tokens. I think that’ll bring clarity to the market. And I think that’s not just the ones we call initial coin offerings, but it’s really critical to go through the top tokens. And so, we did a little analysis, I’ve done this analysis, but with the help of some others on just the big five.
Bitcoin, litecoin, bitcoin cash all strikes that they’re probably not. As a non-lawyer, I get it. People were starting to tweet, you know, is he a lawyer? But bitcoin and so forth, probably not and why do I say that? Because bitcoin came into existence as mining began as an incentive in validating a distributed platform. No initial token offerings, no pre -mined coins, no kind of common enterprise under that Howey Test. And litecoin and bitcoin were both forks off of that.
But what about ether and ripple? And you can go down. I’m not trying to pull these out, it’s just these are the big five. These all seem to have attributes of that Howey Test. Was money given over in 2014 for ether, bitcoin for ether? Was money given to ripple every month they sell another bit of it out of the escrow?
Is there a common enterprise. Ripple labs sure seems like a common enterprise, or the Ethereum Foundation in 2014, I’m talking about. Is it on the expectation of profits, well the Ethereum Foundation offering had an 50 percent appreciation right in the first 42 days written into the offering.
And Ripple even today links to 16 market makers in XRP and they’re doing a lot to enhance the value of XRP for the benefit of holders of XRP for the benefit of their own company because they own 60 or 61 percent of XRP. And is it on the efforts of others? Well, in the Ripple case, that feels to be the case, ethereum sort of evolved into something maybe else. But, the Ethereum Foundation is still quite central, maybe not as central as Ripple Labs.
So, I think there’s a strong case, but it’s not whether I think so. I think there’s a worthy public debate about these issues.
The second issue is token design. Is there possibly a design that’s really about consumption and not about investment? And sort of solely about consumption not investment? It’s gonna be a challenging time because the SEC’s already said in the Munchee order that it will take more than semantics, or more than a token being functional. So, this functional, bit is an important bit but not enough.
Third, how should multi-stage contracts happen. Like, when filecoin raised a quarter of a billion dollars in something called a SAFT. And there’s a lot of debate.
Can you put a packaging around a token, and so the package is a security and so the token later on is not. Is that alright? The SEC has not yet spoken on that, and there’s controversy around it. Let’s call that, that’s yet to be determined.
And then fourth, is a new concept, can a security token transform to be something else. And a group of venture capitalists went into the SEC ten days ago, they’ve circulated paperwork to a lot of people and they’re sort of saying, ‘believe us we get you, we’re with the SEC, but we have a bunch of clients that are going to evolve to be a consumable token.’ I’m kind of don’t think this is going to work. I don’t think there’s any precedent in the law for a security to transform to be something else. But this is an issue on the table and it’s a worthy debate.
So, in conclusion, blockchain technology has a real potential to change the world of finance. It could lower costs, and risks and economic rents but for broad adoption the technology needs to move forward in the public policy sphere. I think basic norms are what’s critical. The basic norms of investor protection, and consumer protection and of course making sure illicit activities can’t occur. But we also need to adapt some of the rules of the road so that this new technology fits in. But I don’t think it means that we just exempt the whole field and say ‘good luck investors’.
Not when the money and the dollars are so big. With over 1,000 of these already launched, good chance it’s going to be a pretty interesting year in 2018. Market participants have a role, have a very real role with regulators and technologists figuring this all out.
But I do think the public will benefit and ultimately reap the benefits and if anybody’s interested I’ll be teaching on Tuesdays and Thursdays next fall this course.
Question and Answer:
I want to start with probably the most controversial statement you made, which is, how can you say CryptoKitties are not a security?
I just… there’s something about CryptoKitties that is wonderful, but I don’t think it’s an initial coin offering. It did have a little airdrop, by the way I think airdrops don’t get you off the hook. But it started that way, but then you have this unique – I think it’s more like a seat license.
That you have a unique asset and you own your kitty rather than like these others. But there’s actually a SEC case long ago, actually a court case called the Weaver Beaver Association, so look that one up, that’s kind of a neat one.
In fact, the controversial statement that you made obviously was that ethereum and ripple might end up being classed as securities. First of all, there’s no reason why you wouldn’t have, but do you have a sense of how long it might take the SEC to come to a ruling on stuff like this?
I don’t know, I think that this is a multi-year process.
The reason I say that is to write a rule, get public comments, to get feedback, finalize that rule, give a period of time for implementation and maybe court challenge is two years at a minimum and possibly three to five years when you really see how things go. I think 2018 and I’ll be speaking more about exchanges later this week, but 2018’s a period of time to try to bring compliance into this sort of 1000 plus tokens.
What ripple and ether, while I think there’s a strong case particularly for ripple or XRP given the centrality and the common enterprise around Ripple Labs, and that they’re selling it every month and so forth. That’s really a discussion between them and the SEC and ultimately the way I would think is if the SEC declares that there’re securities that might end up in court, and so it won’t be the SEC it maybe not even a federal district court but an appellate court, that will decide or the Supremes.
But let me say this, if they decide that they’re not securities, I think that too probably ends up in court and the reason is is because somebody else will say, ‘well why are they getting out of regulation and I’m not.’ So, law is best when applied consistently and we went through the duck test and the Howey Test – a little humorous – but it’s also because for whichever way authorities go they have to have an eye on consistency as well.
So, I think nine months at the least, maybe two to five years at the longest.
So let’s say at some point the SEC rules that a large number of these things are in fact securities, does that have a chilling effect on the whole blockchain space?
I believe that it’s a net positive. So much in our economic life and in our personal lives oscillates so it might have a chilling effect on this frothy ICO market, but I think it’s a positive for blockchain.
We have right now major institutions that want to significantly adapt and adopt, asset managers who want to invest in this space, major exchange companies who want to move into this space.
The unregulated exchanges in aggregate – I’m making an estimate here that the unregulated exchanges in aggregate – make more money, more bottom line than the aggregate regulated spaces in the securities field around the globe right now. So they want to get into the space. Right now the incumbents are making less than the startups.
Well, you might say that that’s bully good, but the incumbents are doing it in part because they’re front running and they’re not treating their customers and investors in a way that probably you’d want.
Does it restrict the kinds of things that can be done with tokens? To simplify grossly, we’re talking about tokens that are issued on blockchains that are trying to be anonymous, decentralized, distributed. Can something that is anonymous and decentralized also be SEC compliant?
I think it’s very challenging.
There’s a number of public policy considerations and this is in 180 countries. But tax authorities don’t want to lose much of their tax base, and none of use want to really promote illicit activities around money laundering or terrorism financing and the like. E
very nation has signed into if you do an offer you know the beneficial owners. That’s not just a US thing that’s around the globe. And yet the technologists in this room would probably tell me it’s a little tricky on a blockchain to know something more than the public key and Monero and others even find a way to put, shall we say, fog on top of the public keys. So, knowing your customer and beneficial ownership is at the heart of nearly every developed country’s securities laws and investor protection laws.
I think that’s going to be, that’s something that if technologists figure it out, that’s going to be a real plus.
Scenario: SEC clamps down on lots of these things, it says a lot of you guys who issued tokens and a lot of you people holding tokens what you were doing was illegal. Well the holder’s not necessarily. The public might have been scammed but they weren’t necessarily breaking the law.
So two classes of people with two classes of problems. The people who issued the tokens, are they criminals? What happens to them? And then the people holding the tokens, were they scammed and how do they get redress?
I think regulators around the globe will sort it through but as you saw in the first of these last summer, the DAO, the SEC chose to write an order but they didn’t actually then have a civil money penalty, they just wrote an order and tried to change behavior.
I think there’s a reasonable case to be made that if you can come into compliance, if the securities and exchange commission gives some number of months and I don’t know that that’s the right period of time, but some number of months or a year or whatever to come into compliance, then they’ll look forward. The challenge is compliance is about disclosure, that’s hard to do but it’s do-able.
Compliance is about the manner of sale. You can’t change the manner of sale from two years ago, but maybe you can change the manner of sale going forward. Compliance is about beneficial ownership, that’s a tricky one. Compliance is about anti-fraud and insider trading rules.
So, I think it’s more like let’s look forward and there’s a thousand plus horses running out on the field that got out of the barn and we’ve gotta kind of bring them into compliance. And even for Ripple and ether, or maybe it’s EOS or NEO or.. but for the big market cap ones, there needs to be clarity in the market and if the clarity in the market is that they’re not securities they might still be commodities, they might still need to comply with all of those laws, but I think it’s a period of time, but if you do an issuance now in April of 2018 do it under the US securities laws.
I think everybody’s on notice now. And Chairman Clayton did that in February pretty clearly, and any law firm advising them I’m sure is telling them we can’t write you an opinion unless you comply with one of the exemptions. There are various exemptions if you only sell to accredited investors or other various ways to package these things. They’d still have some burden, they still have costs and this kind of tricky question of how you figure out who all your beneficial owners are.
Exemptions and selling to accredited investors – the SAFT – which you mentioned do you think that that resolves the problem?
Well I think you’re asking two questions. The first is do I think selling to accredited investors under what’s called Regulation D works. Yes, if you comply with all the exemptions and all the requirements of Reg D. Do I think that a SAFT or a multi-staged where you can one day be a security and a year or two later no be, or in essence, filecoin’s token, not to pick on them but it’s a real case, will filecoin’s token not have to be registered?
I think that’s unlikely but they might be successful. That’s between them and the securities lawyers at the SEC. I think that at the core is the economics. The core is you can be both a consumable token and an investment token and then you need to comply with securities laws. And if somebody’s raising a quarter of a billion dollars as filecoin did or $1.7 billion as Telegram did, and the market is the size that the market is, there’s a lot of investors who are investing and then I think the laws should adapt.
There’s going to be a lot of changes over that over the next two to five years are appropriate. But it’s better to bring it inside of the public policy framework even if there’s a bit of a chill. But to bring it in, to be stronger and reap the benefits later. And I think the internet went through this a bit and other technologies, railroads went through it in the 19th century.
New technologies usually come about outside of a public policy framework and at some point whether it’s a taxing authorities or other authorities, but we still want to achieve something. In this world we want to protect investors and consumers, we don’t want like consumers money to be lost like a half a billion dollars got lost at Coincheck in Japan in January.
I mean we all remember Mt. Gox about four or five years ago. This keeps happening.
So there’s still core public policy goals, and they’re still worthy and sort of adapting the technology and adapting the laws to fit them together.