a16z: The Crypto New Age, What Should the SEC Do?

Original Article Title: A new (digital) age at the SEC

Original Article Authors: Scott Walker, Bill Hinman

Original Article Translation: Luffy, Foresight News

As technology continues to evolve, the U.S. Securities and Exchange Commission (SEC) must also keep pace with the times. This is particularly evident in the cryptocurrency field. The new leadership and the newly formed cryptocurrency working group have provided the agency with an opportunity to take concrete action and make adaptive adjustments.

Now is the time for action: the cryptocurrency market has grown in size and complexity, to the extent that the SEC's previous reliance solely on enforcement while neglecting regulation is in need of an update. With professional investment services entering this emerging industry, driving market development, encouraging innovation, and protecting investors can only be achieved in this way. The principles that underpin relevant securities laws—disclosure, prevention of fraud, and maintaining market integrity—should always be sacrosanct. However, applying these principles in a manner that reflects the uniqueness of crypto assets requires targeted regulatory reform.

This article proposes immediate and actionable adjustments that the SEC should take to establish applicable regulatory rules without sacrificing support for innovation and investor protection measures. While legislation is crucial for clarifying the classification of crypto assets and regulating secondary markets, these measures will bring immediate benefits to the market.

1. Provide Explanatory Guidance on "Airdrops" and Other Incentive-Based Rewards

The SEC should provide explanatory guidance on how blockchain projects can distribute crypto assets to participants without being deemed a securities offering. These distributions are commonly known as "airdrops" or "incentives" and are typically conducted by blockchain projects for free or for a nominal fee, often as a reward for early use of a specific network or ecosystem. Such distributions are a key means for blockchain projects to build a community and achieve decentralization gradually, distributing ownership and control of the project to users.

This decentralization process has many benefits. Decentralization can protect investors from risks usually associated with securities and central control and foster network development, thereby enhancing its value. If the SEC can provide guidance on distribution matters, it can curb the trend of airdrops being conducted only for non-U.S. individuals. This trend essentially transfers ownership of blockchain technology developed in the U.S. overseas, effectively sacrificing the interests of U.S. investors and developers to create windfalls for non-U.S. individuals.

Implementation Details:

·  Establish Eligibility Criteria: Set basic standards for crypto assets that would be exempt from being deemed investment contracts (and thus securities) in airdrops and incentive-based reward distributions. For example, crypto assets whose market value is primarily derived from the programmatic running of a distributed ledger or similar technology, or from executable software deployed to a distributed ledger or similar technology, should be eligible for such distributions if they do not fall under another securities category.

2. Amend Crowdfunding Rules to Regulate Exempt Offerings

The SEC should amend crowdfunding rules to more effectively regulate exempt offerings of crypto assets.

The current limitations on fundraising scale and investor participation in crowdfunding activities are not suitable for crypto startups, as these companies often need to distribute crypto assets more widely to establish a sufficient user base and network effects for their platform, application, or protocol.

Implementation Details:

·  Raise Fundraising Limits: Increase the maximum amount that can be raised through crowdfunding to a level that matches the needs of the enterprise (e.g., based on disclosure depth, up to a maximum of $75 million or a certain percentage of the total network).

·  Exempt Offerings: Allow crypto projects to reach a broader set of investors (beyond just accredited investors) through crowdfunding platforms while relying on exemptions similar to those in Regulation D.

·  Investor Protection: Implement appropriate safeguards such as setting individual investment limits (similar to current Reg A+ practices) and establishing detailed disclosure requirements covering key information relevant to the crypto enterprise. (For example, while issuance disclosures may typically involve matters like directors, compensation, and shareholding details, disclosures around underlying blockchain, governance, and consensus mechanisms may be more critical for crypto asset investors.) Tailoring these requirements to crypto asset investors can ensure they are well-informed and protected from fraud.

These changes would enable early-stage crypto projects to access a wider investor base, promote transparency, and democratize investment opportunities.

3. Allow Broker-Dealers to Engage in Crypto Asset and Securities Business

The current regulatory environment restricts traditional broker-dealers from substantial involvement in the crypto space, primarily because it requires broker-dealers to obtain separate approvals for conducting crypto asset transactions and imposes stricter regulations on broker-dealers wishing to custody crypto assets.

These restrictions create unnecessary barriers to market participation and liquidity. Allowing broker-dealers to facilitate transactions of both security and non-security crypto assets will enhance market functionality, investor access, and investor protection. On today's crypto trading platforms, non-security crypto assets (such as Bitcoin, Ethereum) can seamlessly trade alongside crypto assets that the SEC may deem to be securities.

Specific Approach:

·  Enable Registration Mechanism: Establish a clear registration path for broker-dealers to register to engage in (and custody) crypto asset (both security and non-security) activities, with specific requirements based on the nature of these assets.

·  Enhance Regulatory Framework: Set up supervisory mechanisms to ensure compliance with Anti-Money Laundering (AML) and Know Your Customer (KYC) regulations to uphold market integrity.

·  Collaborate with the Industry: Partner with the Financial Industry Regulatory Authority (FINRA) to issue joint guidance to address the unique operational risks of crypto assets.

This approach will help build a safer, more efficient market, allowing broker-dealers to bring their expertise in best execution, compliance, and custody to the crypto market.

4. Provide Custody and Settlement Guidance

Custody and settlement remain key barriers for institutional adoption of crypto assets. The lack of clarity in regulatory treatment and accounting rules has deterred traditional financial institutions from entering the custody market. This means many investors are unable to benefit from professional asset custody services and must instead self-custody and arrange their own custody solutions.

Specific Approach:

·  Issue Custody Guidance: Provide guidance on custody rules under the Investment Advisers Act, outlining how investment advisers can custody crypto assets, ensuring adequate safeguards like multi-signature wallets and secure offline storage. This should also include guidance on idle asset pledging and governance decision voting for crypto assets held in custody by investment advisers.

·  Establish Settlement Standards: Develop specific guidance for crypto transaction settlement, including timing, verification processes, and error resolution mechanisms.

·  Build a Technology-Agnostic Framework: Allow for the flexible adoption of innovative custody solutions that meet regulatory standards without mandating specific technological requirements.

·  Correction of Accounting Treatment: Revoke SEC Staff Accounting Bulletin 121 (SAB 121) to allow the accounting treatment of custodial digital assets to reflect the actual nature of the custodial arrangement rather than presuming a liability exists. Background information is that SAB 121 states, "as long as a company is responsible for safeguarding the cryptographic assets held in its custody platform... a company should recognize a liability on its balance sheet to reflect its obligation to safeguard cryptographic assets held on the platform for platform users," offset by an asset. The overall effect of SAB 121 is to include custodial cryptographic assets on the custodian's balance sheet, a practice that runs counter to the traditional accounting treatment of custodial assets. Therefore, unlike typical custodial arrangements, this accounting treatment may result in custodial cryptographic assets being included in the custodian's bankruptcy estate in the event of the custodian's insolvency. Most notably, SAB 121 lacks legality. The Government Accountability Office found that it was, in fact, a rule subject to congressional review under the Congressional Review Act, and in May 2024, a joint resolution was issued by the House and Senate disapproving of SAB 121, which was subsequently vetoed by President Biden.

This clarity will establish a foundation for institutional confidence, enabling large participants to enter the market, while enhancing market stability and competition among service providers. Additionally, both retail and institutional investors will benefit from the protections associated with professional, regulated asset management services.

5. Reform Exchange-Traded Products (ETP) Standards

The SEC should take reformative measures regarding Exchange-Traded Products (ETPs) to promote financial innovation. These proposals aim to provide broader market access opportunities for investors and custodians accustomed to managing ETP portfolios.

Specific Actions:

·  Restore Market Scale Test: SEC's reliance on the "Winklevoss Test" for market surveillance protocol has delayed the approval of Bitcoin and other cryptocurrency ETPs. This test requires that for commodity-based ETPs to trade on a nationally recognized exchange such as the New York Stock Exchange (NYSE) or Nasdaq, the listing exchange must have a surveillance agreement with the "significant markets" for that commodity or its derivatives. Given that the SEC does not consider crypto exchanges as "regulated markets," this effectively means that ETPs are only viable for cryptocurrencies that have futures markets (regulated by the Commodity Futures Trading Commission) and provide highly predictive price discovery for the underlying asset. This overlooks the significant scale and transparency of the current crypto market. More importantly, it creates an arbitrary distinction between the standards for listing applications of cryptocurrency ETPs and all other commodity-based listing applications. Therefore, we propose restoring the historical testing standard for significant market size: requiring only that the commodity futures market have sufficient liquidity and price integrity to support the ETP product. This adjustment will align the approval standards for crypto ETPs with those of other asset ETPs.

·  Enable Physical Settlement: Allow the encrypted ETP to settle directly in the underlying asset. This will bring about better fund tracking, cost reduction, price transparency improvement, and reduced reliance on derivatives.

·  Adopt Custody Standards: Strict custody standards are mandatory for physical settlement transactions to reduce theft or loss risks. Additionally, provide a pledging option for idle ETP assets.

6. Implement 15c2-11 Certification for Alternative Trading Systems (ATS) Listing

In a decentralized environment, the issuer of a cryptocurrency asset may no longer play a significant ongoing role, raising the issue of who is responsible for providing accurate disclosure information about the asset. Fortunately, there is a similar beneficial rule in the traditional securities market, the Securities Exchange Act Rule 15c2-11, which allows broker-dealers to trade a security provided that, among other conditions, investors can access the most up-to-date information about that security.

Extending this principle to the cryptocurrency market, the SEC can permit regulated cryptocurrency trading platforms (including exchanges and broker-dealers) to trade any asset that can provide investors with accurate, up-to-date information. The outcome will be increased liquidity for such assets in SEC-regulated markets, while ensuring that investors have the ability to make informed decisions. Two clear benefits of this approach are enabling the trading of digital asset pairs in SEC-regulated markets (where one asset is a security and the other is not), and discouraging the incentive for exchanges to operate overseas.

Specific Approach:

·  Simplify Certification Process: Establish a simplified 15c2-11 certification process for cryptocurrency assets listed on Alternative Trading Systems (ATS) platforms, providing mandatory disclosure about asset design, purpose, functionality, and risks.

·  Implement Due Diligence Standards: Require exchanges or ATS operators to conduct due diligence on cryptocurrency assets, including verifying issuer identity and key feature and functionality information.

·  Clarify Disclosure Requirements: Mandate regular information updates to ensure investors receive timely and accurate information. Additionally, specify when issuer reports are no longer relevant to potential buyers due to decentralization, eliminating the need for further reporting.

This framework will promote transparency and market integrity while allowing vibrant innovation in a regulated environment.

Conclusion

The SEC is at a critical moment in deciding the future regulation of crypto assets. The newly formed cryptocurrency special workgroup indicates the Commission's intention to depart from the enforcement-heavy approach of the past. By promptly taking the key steps outlined above, the SEC can begin to shift away from its previously contentious enforcement-centric posture, providing much-needed regulatory guidance and practical solutions for investors, custodians, and financial intermediaries. This will better balance investor protection with fostering capital formation and innovation.

The proposed reforms outlined above would reduce uncertainty and support financial innovation in the crypto space. Through these adjustments, the SEC can reclaim its mission, repositioning itself as a forward-looking regulatory agency ensuring the competitiveness of U.S. markets while safeguarding the public interest. The long-term future of the U.S. crypto industry may ultimately require Congress to provide a comprehensive, fit-for-purpose regulatory framework. However, until such a framework is in place, the steps outlined in this article represent a path toward appropriate regulation.

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