The SEC sets crypto free

US regulators have always said that a token representing a decentralized protocol would be free from securities law.

The problem was how to get to decentralization.

It’s not easy. Crypto protocols are ultimately products, and building a product that people want to use generally involves a lot of centralized activity: raising money, developing software, iterating on ideas, marketing.

Getting to community ownership — and therefore freedom from securities law — requires the kind of essential managerial efforts that make an asset a security in the first place.

As SEC Commissioner Hester Peirce put it in 2020, “Proving that tokens have utility prior to being distributed to a widespread user base is difficult.”

She recognized this as a Catch-22:

Six years later, the crypto task force Peirce leads for the SEC has proposed a solution — a way for growing crypto assets to shed securities law like a butterfly shed its chrysalis.

Regulation Crypto Asset’s Safe Harbor Rule proposes that tokens will be set free when their issuer has “completed or otherwise permanently ceased all essential managerial efforts” related to the protocol they represent.

Until then, tokens sold to investors are considered investment contracts (and therefore securities). But Regulation Crypto Asset (RCA) offers a temporary exemption from securities law while protocols remain centrally managed.

This would grant developers as much as four years to do what crypto protocols were originally supposed to do: operate without centralized control. 

I’ve phrased that awkwardly because the proposal doesn’t necessarily require that a protocol be decentralized for its token to cease being an investment contract.

It can also just be “functioning.”

Specifically, the proposal explains that protocols will exit the regulatory regime when they’ve “matured into a decentralized or functioning network that is not dependent on a single person or group to carry out the essential managerial or entrepreneurial efforts."

Exactly what qualifies as functioning is not fully spelled out.

But the distinction allows for a remarkable concession: crypto developers will be able to continue working on their projects after their token has been granted immunity from securities law.

"It is our view that services to secure, maintain, improve, or enhance such a network or application or its functionality, or to facilitate network effects, whether through sponsoring or funding development projects or other similar activities, would not constitute essential managerial efforts," the proposal says.

In short, exemption from securities law does not require that developers abandon their projects.

Rather than demand that every protocol be as perfectly decentralized as Bitcoin, the rule only requires reliance on a broader community: "The activities of and contributions made by many parties (including, for example, the issuer, other developers, validators and/or miners, liquidity providers, users, and holders of the crypto asset) would affect the failure or success of the associated crypto network or associated crypto application after such network or application is functional."

In that sense, “functional” reads like a highly practical version of “decentralized.”

That is a generous concession to the crypto industry — and one that might improve it.

The SEC’s functional criteria seem to exclude crypto projects that are decentralized in name only — the all-too-common practice of protocols being governed by a handful of developers in control of a multisig that implements DAO votes they can simply ignore.

In this, the SEC seems to have taken crypto’s professed principles of community governance seriously — perhaps more seriously than crypto itself typically has.

How many protocols are genuinely governed by their token holder communities? Various studies suggest it’s not many.

Despite the industry’s poor track record in that regard, the SEC has also proposed to allow crypto projects to decide for themselves when they’ve achieved functional decentralization.

Their safe-harbor test to exit from securities law is based on promise fulfillment: protocols are expected to self-certify that their managerial efforts have successfully resulted in a decentralized or functional network.

This allows the SEC to avoid being the arbiter of exactly what is and isn’t decentralized or functional, which is welcome.

It also creates an odd incentive for developers to under-promise: the less they promise to do, the easier it will be to say they’ve done it.

Kind of weird. It could lead to developers being even more opaque about what exactly they’re doing.

But also kind of useful? For an industry that has chronically over-promised and under-delivered, toning things down a bit might not be such a bad thing.

Could the SEC even end up making crypto fulfill its original promise?

The funniest thing about Regulation Crypto Assets may be that it finally gives crypto a reason to become what it always said it would be: genuinely — or at least functionally — decentralized.

The crypto industry spent years trying to convince regulators that decentralization was the point.

It may now take regulators to convince crypto.

— Byron Gilliam

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