A Ripple That May Reach All Shores

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Rapid growth in cryptocurrency market capitalization to more than $1.7 trillion, rapid rise in NFTs (25 billion in 2021, 4 billion in January 2022), and other digital assets as well as dramatic increases in DeFi ($75 million) staking, liquidity pools ($108.4 billion as of Dec. 2021) raises two questions: How should digital assets like cryptocurrencies be regulated? And how can this innovative technology bring value to our economy? A SEC enforcement action is currently being conducted in the Southern District of New York. This is due to the aggressive attitude of the Commission toward cryptocurrency. Policymakers and legal experts should pay attention.

The SEC filed a civil enforcement case against Ripple Labs in December 2020. This was a cross-border payment company and its top executives. It claimed that sales of XRP by the company, which is native to Ripple’s blockchain ledger, were unregistered securities sales. SEC’s position is based on the assertion that XRP’s sole utility is as an investment contract between holders of the token and the company. All sales of the token, even on secondary markets, have been and continue be “one long securities trading” to finance Ripple’s operations. This would require registration with the SEC. The Commission’s case is based on its interpretation of the 1946 Howey Supreme Court decision. This has been the standard for determining whether an instrument is a security.

Although the White House recently issued an executive order on digital assets, it only states that there will be “a central response”, but no details are given as to how that response will look. Since years, the SEC has been monitoring cryptocurrency assets. Despite numerous enforcement actions, public comments, speeches and speeches from officials and questionable invitations to innovators to seek individual guidance for guidance, there has not been a cohesive body of guidance. The company has argued that it did not receive fair notice from the SEC about its illegal actions, and this has been made clearer during the Ripple trial. It submitted evidence of the many confusing public and private instructions that the agency gave about XRP and cryptocurrencies generally to this effect.

Ripple claims that it didn’t create or issue XRP using its decentralized ledger and that its sales were similar to asset liquidations. Before the enforcement action was filed, billions of XRP tokens were traded by holders and users without any connection to Ripple for over seven years. During this time, the SEC brought a number of enforcement actions against digital assets. Senior SEC officials made statements that could reasonably be interpreted as indicating that an asset such as XRP would no longer be considered a security.

The SEC’s case is based on conclusory arguments about the nature of XRP. They seem to believe that all reasonable people would accept these arguments, despite extensive activity by a range of experienced and sophisticated market participants over a long period. The SEC has an extremely broad interpretation of its powers, which means it intends to attack any cryptocurrency market participant. This will go back many years and ignore any guidance from its staff and officials.

Market participants will assume that anytoken, digital asset or token could be considered security and be subject to enforcement action, regardless of the guidance provided by the SEC personnel. To avoid costly litigation, all tokens must be submitted to the SEC, regardless of their intended use. The victory of the Commission in Ripple could indicate that the courts will permit the SEC’s to create the rules for cryptocurrency. They don’t need to be consistent or coherent. Employees of issuers could be held responsible for aiding or abetting violations of securities laws, regardless of due process and established precedents. This could allow the Commission to exercise more power than the Securities Act.

If the Southern District agrees to the SEC’s claim that Ripple and other market participants were given fair notice that XRP was a security, and all transactions of the asset are securities trades, this precedent will allow the Commission target any token seller and market participant for any sale at any time. This broad standard could allow future enforcement actions against Bitcoin miners, starting with July 2010’s first sale. Practically, the SEC would have such broad discretion that it could end cryptocurrency trading in the United States. Instead, the court could send innovative people overseas.

The SEC may have launched a wide-ranging legal attack against Ripple in the hope of getting a quick settlement from the company and its executives. Ripple, like many in the growing cryptocurrency industry, appears to be a profitable going concern. It is also stocked with cash and ready to fight. Ripple’s executives have made it clear that they won’t accept any settlement that does not provide regulatory clarity for XRP. The legal stakes are high for both the regulator and the cryptocurrency industry as a whole.

Ripple could win on Ripple’s fair notice defense if the case goes to trial. This would establish a precedent that the Commission failed provide fair notice to market participants in light of the confusion it has created. It would force the Commission to create the much-needed comprehensive industry guidance. If the settlements it extracted in the cases it filed against Kik Interactive and Telegram were able to be put to rest, Coinbase may have confidence to offer its cryptocurrency-backed lending product, ignoring the SEC’s chilling Wells notice issued earlier this year.

All these reasons and trillions of dollars of value are at stake, not to mention the futures of NFTs and DeFi, Blockchain-based Metaverses and Web3 applications, architectures, and Web3 apps, all eyes should be on Ripple in the coming weeks and months. It will have a significant impact on markets and the future of this revolutionary technology, which cannot be ignored.

Daniel Conway is the co-author of this article. He is a professor at University of Arkansas’s Walton School of Business, and co-director of its Blockchain Center for Excellence.

 

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