Advocating for Self-Regulation in the Global Digital Asset Space

A. Brief Overview of the Cryptocurrency and Blockchain Space:

The digital asset space needs novel regulation to account for novel applications, software, technologies, utility, and burgeoning economic frameworks. For this reason, among others, to be explored in later papers, cryptocurrency and blockchain are inextricably linked and should be (self-)regulated as such.

Among the key value propositions of the cryptocurrency and blockchain sector is the ability to serve as an engine for continuous innovation and disruption. It also serves as a meaningful opportunity to empower citizens of the world with self-sovereignty over their assets and facilitate a higher quality of life by reducing economic friction caused by a massive network of intermediaries.

This has rippled across all sectors of business from logistics to finance (including but not limited to investment, banking, cross-border payments, peer-to-peer transactions, self-sovereignty and self-custody of digital assets, real estate, and more), legal, artificial intelligence, network communications, media and entertainment, and more.

Arguably, the expansive reach of innovation and disruption which has spawned from the blockchain and cryptocurrency industry should speak volumes to the need for self-regulation.

B. Introduction to the Topic of Self-Regulation:

Self-regulation by FINRA and other SROs within the US securities market has been essential to developing one of the world’s largest and healthiest capital markets. This same approach has been used in the US trade finance and commodities markets.

The digital asset space is primed for self-regulation and the ability to generate similar outcomes at scale, in a fully-interconnected, global economic environment.

Statement of Position:

I posit that this same approach of self-regulation is vital to developing a fully-globalized economy in which interconnected, digital assets of all types can be created, innovated upon, disrupted, and transacted.

II. Argument 1: The Unique Nature of Cryptocurrencies and Tokenized Assets

While various tokens, tokenized assets, and cryptocurrencies can mirror securities, commodities, or some blend thereof, they can also exhibit fully unique characteristics. One such example is bitcoin. Since the Taproot Upgrade, it can deploy a broad range of code-driven utilities, such as “ordinals”, or on-chain artworks and tokenized representations.

Taking the underpinning technology a step further, “Ordinals Theory” represents only one of many technological innovations that have emerged from this industry which provides a novel utility that cannot be contained within the securities and commodities classifications, or even within a split definition or overlapping definition of these terms.

Broadening these terms (securities, commodities) stands to cripple innovation within the US and force a vibrant ecosystem of innovation overseas, thereby placing the US further behind in economic and technological innovations.

Underlying code innovations are being pioneered which leverage the use of blockchain and distributed ledger technology, for use in creating novel artwork types, such as “living” artwork and evolving artwork.

Other innovations that are being tackled, like automated royalty distributions, stand poised to revolutionize both the creator and global economies in ways never seen before at scale.

For these reasons and many others, I posit that cryptocurrencies and other digital assets deserve to be classified within a separate category that does NOT include securities and/or commodities.

I do expect that some cryptocurrencies and digital assets will be disqualifiable from this separate category, however, and would likely then fall into the definition as either a security or a commodity.

This separate classification should remain sovereign and include rules that govern taxation, identity, transparency, interoperability standards, and other vital definitions.

III. Argument 2: The Inappropriateness of Backward-Looking Analysis in Cryptocurrency Regulation

Some digital assets, such as cryptocurrencies have been used as fundraising vehicles, leading to the SEC’s notion that users who purchased such digital assets beyond a certain date have had an expectation of profitability.

I posit that we cannot reasonably define an expectation of profitability “after a certain date” when that date falls well beyond the point that the underlying digital asset was available on secondary markets.

This scope stands poised to enable a gross overreach and abuse of power on the SEC’s part, particularly as a NON-ELECTED body.

Ecosystems, such as $MATIC (collectively the Polygon Ecosystem), are built by a wide range of third parties and promoters. The technology has grown to scale due to a burgeoning need in a novel digital ecosystem.

It doesn’t make sense to stifle the ability of innovators to create decentralized and/or decentralization-oriented solutions as a result of archaic decision-making systems that, when applied at the highest government level (US Supreme Court), feature defining tools that compare all elements with the term “employee” (see Supreme Court definition of common enterprise as applied in legal precedent.)

It can readily be argued that the Polygon ($MATIC) ecosystem (and likely other “Digital Asset Securities”) could have been built, albeit more slowly, without any required investment of funds. Ecosystems have emerged which have built their codebases and communities without an external investment of funds, such as the Pi Blockchain ecosystem and the initial launch of Bitcoin.

Currently, the US is evaluating new legislative avenues to properly regulate and oversee cryptocurrency markets. The European Union recently passed its MiCA framework as well.

Startlingly, CoinBase was approved for bitcoin and ether futures products before any spot markets or ETFs were approved. In an environment built to “protect” investors, it just doesn’t make sense to approve leveraged financial products before approving regulated spot market product availability.

IV. Counterargument: Cryptocurrencies as Securities and Commodities

Some cryptocurrencies and digital assets are readily definable as securities or commodities. Many of these have been named, marketed, and sold as “Security Tokens” via “Security Token Offerings (STOs).”

Meanwhile, other “Asset-Backed Tokens” (ABTs) have been marketed and sold as being backed by commodities, such as silver, gold, oil, etc.

I do NOT think that all cryptocurrencies and digital assets should fall outside of securities and/or commodities registration and regulation.

I DO, however, think they should be evaluated for their provisional qualification as novel (or non-novel) asset(s) that are exempt from registration and/or regulation as a security or a commodity BEFORE being classified as either commodities or securities.

V. Rebuttal: The Need for Novel Classifications for Cryptocurrencies

Commodity:

“A commodity is a basic good used in commerce that is interchangeable with other goods of the same type. Commodities are most often used as inputs in the production of other goods or services. A commodity, thus, usually refers to a raw material used to manufacture finished goods.”

Commodities are, traditionally, things like oil, natural gas, gold, silicon, diamonds, salt, produce, etc.

One common facet among all of these goods: The ability to interchange them. They are fungible—purity

Under “Ordinals Theory”, not every bitcoin is the same and is therefore not able to be classified as a commodity. Each bitcoin contains 100,000,000 satoshis (the smallest unit of bitcoin, one one-hundred-millionth of one bitcoin), which are now being used to “inscribe” data onto the bitcoin blockchain. This removes the fungibility of the underlying currency.

Bitcoin is just ONE example from among many which exist that evade classification along these means.

VI. Recommendations

A. Proposal for a quantifiable test for qualification as a security that can apply to cryptocurrencies at scale and adapt as new characteristics of cryptocurrencies emerge.

To this end, I propose a test, the NDADT, which should be applied to digital assets before any securities or commodities-based tests, which would seek to prove that a digital asset IS NOT justified in classification under a separate asset class.

This test would be a five-pronged analysis, based on the pre-existing best practices of blockchain and cryptocurrency as an industry that is beginning to show meaningful signs of maturity at a global scale.

1. Utility Test:

   
   

   Does the asset lack a clear utility or function within its native platform or ecosystem?

Novel digital assets should provide some unique functionality or use within their respective systems.

2. Innovation Test:

   Does the asset fail to present a significant innovation or advancement compared to existing digital or traditional assets?

   
   

Novel digital assets should offer something new or different that is not present in existing asset classes.

3. Interoperability Test:

   Is the asset unable to interact with or be utilized by other systems, platforms, or technologies?

   
   

A defining feature of many novel digital assets is their ability to operate across multiple platforms or systems. This may include interoperability via cross-chain atomic swaps, Inter Blockchain Communication (IBC) Protocol, Arbitrary Virtual Machine (XVM), or other means of interoperability.

This should not be taken as an exclusion to novel Layer 1 blockchain protocols.

4. Decentralization Test:

   Is the asset controlled by a centralized entity, without any mechanism for distributed consensus or decentralized governance?

   
   

A key characteristic of many novel digital assets is their decentralized nature.

5. Transparency Test:

   Is there a lack of transparency regarding the asset's creation, distribution, or operational mechanics?

If this “NDADT” test is failed, then I propose that the digital asset be evaluated for CLASSIFICATION as:

• A Security (regulated by the SEC)

• A Commodity or Future (Regulated by the CFTC)

• A Separate, “Non-Novel” Digital Asset to be regulated under the purview of a self-regulatory organization that has been built and developed from within the global industry and that can therefore account for and properly administer rules and regulations for the industry at large.

  
  

  That second test should be a five-pronged test, which either:

• Fulfills the “Howey Test” for an investment contract (and therefore a security);

  Fulfills classification as a commodity or futures;

  Fulfills the three prongs of a non-novel digital asset; AND

• Fulfills neither: The Howey Test; OR Classification as a commodity or future simultaneously.

• Fulfills both: The Howey Test; AND Classification as a commodity and/or future.

That test is as follows:

• Purpose Test (Non-novel, yet differentiated asset prong #1):

  
  

  Evaluate the primary purpose of the token:

  Does it serve a functional purpose within a platform (utility token)?

  
  

  Is it primarily used as a store of value or a medium of exchange (currency)? Is it used to represent an underlying asset (asset-backed token)?

  
  

  The purpose test can help establish the basic nature of the token.

  
  

• Howey Test: Apply the Howey Test to determine if the token qualifies as an investment contract.

1. This includes looking at whether there is:
2. An investment of money,
3. With an expectation of profit,
4. Derived from the efforts of others.

If the token fails to meet all conditions of the Howey Test, it is likely not a security (under the classification of investment contracts, which have been the primary vehicle for pursuing crypto regulation by enforcement.)

• Governance Test (General Securities Disqualification prong):

  Evaluate the governance model of the token.

  
  

  Does the token allow holders voting rights or a say in the project's direction (similar to shareholders in a company)?

  
  

  If not, this may suggest it is not a security.

  
  

• Economic Realities Test (Commodity vs Non-novel, yet differentiated asset prong):

  
  

  Consider the economic realities surrounding the token.

  
  

  Does it behave more like a commodity in the marketplace?

  
  

  Does it exhibit significant price volatility?

  
  

  Is it bought and sold primarily for speculative investment purposes or for its use value?

  
  

• Novelty and Differentiation Test (Non-novel, yet differentiated asset prong #3):

  Finally, evaluate whether the token demonstrates unique properties not covered by existing asset classes.

  
  

  Does it combine aspects of securities and commodities in a novel, innovative, decentralized, or disruptive capacity?

  
  

  Does it leverage blockchain technology to provide for expected forms of value or interaction?

  
  

  If so, it might constitute a non-novel, yet differentiated asset class.

VII. Conclusion

I believe that the proposed tests and theories create sufficient space and differentiation to justify the classification of “digital assets and cryptocurrencies” in a separate and sovereign category that does not overlap with either securities or commodities.

I further believe that “Digital Asset Securities” is an inappropriate term that has begun circulating due to a lack of efficient regulatory oversight and communication, despite repeated (sometimes multi-year long requests) for such clarity by the SEC which remain unanswered.

I fear that the use of such terminology is yet another overstep of the regulatory directive of the SEC, which will lead to further gross and unjust misclassifications of assets in the name of expanding regulatory regimes.

I call upon regulators, policymakers, and key industry stakeholders (executives & directors within key companies in-industry, subject matter experts, consultants, and other “knowledgeable” parties) to review this position paper and provide feedback based on their insights and expertise.