Just hours before Security and Exchange Commission (SEC) Chairman Jay Clayton left the building on December 23 at the end of his tenure, the SEC filed a lawsuit against Ripple Labs Inc., alleging that it raised over $1.3 billion through the sale and distribution of the digital assets of XRP without registering. Ripple, founded in San Francisco in 2012, operates the RippleNet and the XRP payment protocol, considered superior to bitcoin with its improved ledger, faster settlement speed, and digital wallet for international transactions across 55 countries. Ripple is one of the titans of the new crypto industry in the U.S., developing real-economy products from revolutionary technology.
Ripple’s blockchain-like exchange network is claimed to be an efficient, inclusive, and low-cost supplement (some say alternative) to traditional payment networks like the Society for Worldwide Interbank Financial Telecommunication (SWIFT) and others. The SEC suit does not allege fraud but seeks unspecified damages and to ban Ripple’s executives from participation in digital asset market trades. The case appears to impugn one of the few positive aspects of Clayton’s 2017 Statement on Cryptocurrencies and Initial Coin Offerings noting that these “disruptive, transformative and efficiency enhancing” technologies could “facilitate capital formation and provide promising investment opportunities for institutional and Main Street investors alike.” More largely the case reaffirms Clayton’s statement in which he claimed supreme SEC authority to regulate every digital asset imaginable, regardless of its design, intention or use.
Following the suit, the price of XRP plummeted by 25 percent, and some trading has been halted. Ripple launched a vigorous response, calling the suit an attack on the emergent cryptocurrency industry at large. The case has interesting parallels to telecommunications in which regulators use obsolete laws to regulate new technologies, undermining U.S. competitiveness in innovation. Clayton’s parting shot was his most audacious swipe against an innovative industry he spent four years trying to dominate with authority claimed from a 1934 statute. With potentially sweeping implications, the case is shaping up to be the crypto trial of the century. Here are the some of the key issues.
1. Currency or Security?
The central question is whether XRP is a currency or security. Currency is a medium of exchange and store of value, like dollars, gold, or frequent flier miles. A security, on the other hand, is a financial investment contract, typically tradeable, like a stock or bond. This matters because different laws and regulations apply. In 2015 the US Departments of Justice and Treasury concluded, as part of a settlement with the Financial Crimes Enforcement Network (FinCEN), that XRP is a currency. Indeed, Ripple has been complying with rules for digital currencies with these agencies for 5 years, in addition to the currency compliance it performs across countries. Ripple notes that the XRP ledger is decentralized and open-source, operating on consensus among a growing community of users and developers making new products with it, and XRP is not an investment contract in their company nor something they control. If investors want to invest in Ripple, they would buy shares in the company itself, not XRP.
This determination has not stopped the SEC from claiming that Ripple’s practices with XRP amount to investment contracts under the Howey test and hence require disclosures as “securities.” The SEC has brought similar suits against other cryptocurrencies, notably Grams from Telegram and Kik Interactive tokens, causing tension in the cryptocurrency world as America’s eight financial regulators jockey for pre-eminence as the top cop in fintech.
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2. Regulatory Boundaries
The case represents a significant regulatory overreach. Reasonable minds can agree that however compelling financial technology may be, Congress, not regulators, decides what is regulated. Despite cryptocurrency industry pleas for a rational framework, Congress unfortunately has said little about cryptocurrency, leaving regulators to make up their own rules. This development parallels the regulatory experience of broadband internet, which has but a passing reference in the Telecommunications Act of 1996. Having no Congressional framework in place, the Obama Federal Communications Commission (FCC) attempted to regulate the internet with the laws designed for price regulation of the telephone. Arguing that the internet was a mere extension of the telephone network, FCC Democrats promoted a policy designed to protect Silicon Valley giants in the name of helping consumers. The gambit spawned more than a decade of litigation and thwarted billions of dollars in investment in new broadband networks, depriving broadband network operators of the ability to recover costs and creating a digital divide in rural areas. With the Ripple case, the shoe is on the other foot; a Republican agency in an expressly “deregulatory” administration purports to protect consumers by going after currency innovators. Such turf grabbing is a classic symptom of regulatory obsolescence, and perversely keeps legions of lawyers in business in federal courts.
3. Do regulators protect China or US consumers?
While disclosure is recognized as an important element for a functioning market and consumer protection, it’s notable that the SEC has allowed hundreds of Chinese firms with a collective value of $2.2 trillion to list on US exchanges without disclosures or audits for almost two decades, gravely endangering US investors. Earlier this year the bipartisan US-China Commission submitted this in a report to Congress and described how China enjoys the fruits of America’s financial markets while it simultaneously upsets global norms. However it seems that America’s fledgling cryptocurrency industry was the focus of Clayton’s wrath, not China.
In any event, consumers are increasingly drawn to Ripple and cryptocurrencies precisely to avoid the cost and complexity of traditional, highly-regulated financial services, a trend which itself demonstrates that innovation frequently delivers better outcomes than regulation. Moreover, the flagrant deficit spending by the US government drives down the value of the dollar and drives investors and consumers to more transparent, decentralized money like cryptocurrency.
4. What is the US strategy for cryptocurrencies and blockchain?
The conflicting approaches amongst US regulatory agencies reflects the lack of larger regulatory framework. While permissionless innovation has helped spawn the innovation, regulators left unchecked will seek new things to regulate. In the past the bumbling approach may have mattered less, but today the US faces an existential economic and security crisis with China, which is determined to supersede America. Seeing that the US doesn’t have its crypto act together, China has moved to issue its own digital currency, build a blockchain ledger from it, and pilot the technology’s use in its domestic economy. Clayton’s replacement could make a much-needed reset. While the SEC Chair may inherit a flawed lawsuit, this new leader need not repeat the flawed policy. More important, Congress should step up in 2021 and make the proper framework for cryptocurrency to ensure US leadership and clarify regulatory boundaries.