‘Back to the basics’: What the SEC’s ruling on DAO tokens mean for the industry

In a ruling issued Tuesday, the U.S. Securities and Exchange Commission finally came out and said what the blockchain community has known all along: DAO tokens are securities and are “subject to the requirements of the federal securities law.”

The DAO, which stands for Decentralized Autonomous Organization, was the automated, leaderless ethereum-based funding vehicle that suffered a massive hack last year after raising millions of dollars from investors in the token sale. This ruling could be “the end of the beginning phase for blockchain,” said Emin Gun Sirer, associate professor at Cornell University and co-director of the Initiative for Cryptocurrencies and Smart Contracts.

“What we were beginning to see with the ICO craze was every Jack and Jill coming up with an old idea, wrapping it up in a token and issuing securities in a virtual company of some kind,” Sirer said. “I hope we will see a return back to the basics. There’s a lot of infrastructure work to be done. People will start to take a close look at their own ICOs and quite a few will fail these rules the SEC applied.”

The rules follow a three-pronged test known as the Howey Test. A token is a security if they’re selling something for money; are they promising future profits; and the future profits predicated on the efforts of other people and third parties.

Here are three key takeaways from the ruling.

This doesn’t change much
If anything, the ruling was “a reminder” of something people already knew was coming and maybe were surprised was taking so long, according to Angela Walch, an associate professor at St. Mary’s University School of Law and research fellow at the Centre for Blockchain Technologies at University College London.

“It’s not like they came out with a new conclusion of law or policy, they reminded us that the existing policy applies to these new forms of fundraising,” she said. “The only difference is that we’re doing it in a technological way and calling it something different.”

The SEC tends not to give guidance on whether something is a security or not so as not to discourage innovation. In the guidance it didn’t even define what a security is or isn’t. The fact that the DAO tokens are treated in the eyes of the SEC as legal securities doesn’t mean the market is going to suddenly shut down. People that want to continue with their ICO plans can probably do so — in a way that’s compliant with U.S. securities laws.

There is some uncertainty as to what will happen to token sales that will happen in the interim, Walch said. Those that occur after this point are clearly on notice and need to figure out how to comply with securities law. But there’s some ambiguity among people that launched their token sales between the the time of the DAO and now. They’re not necessarily off the hook.

“I think the future is bright for non-securities tokens,” said Marco Santori, a partner at law firm Cooley LLP, tweeted Wednesday. “This is the first step in a critical maturation process.”

This isn’t the end of ICOs
If anything, the guidance could slow down the pace a little bit, according to David Lucking, a partner at law firm Allen & Overy. There has been a lot of focus on ICOs in the last year, and many people have set them up without really considering the legal ramifications.

“The SEC is sort of putting the market back on notice: the tokens themselves can be treated as securities, and the platforms on which these tokens trade may be treated as securities exchanges. Both things are regulated in the U.S.,” he said.

Of course, not all tokens are securities. The SEC was pretty clear it would take a case by case approach to this kind of activity, “depending on the particular facts and circumstances,” making it a nice time to be a lawyer versed in crypto.

“It will bring back to the forefront the need to involve lawyers, which for so many people is not that desirable because obviously, the beauty of blockchain and distributed ledger technology is somewhat to disintermediate established ways of doing things and established market participants,” Lucking said. “This reins that in a little bit.”

Sirer highlighted the quick emotional reaction by many in the blockchain community — some gloated about having seen this coming, some worried all tokens were securities and that this might affect their ICOs — to guidance on a narrow class of activity pretty specific to the DAO. The SEC could issue other findings — that will inevitably come later, but for now, not just any ICO is binding by the SECs recent findings.

“We’re living through a time of ICO mania,” he said. “There are worthless ICOs, there are scam ICOs and all sort of other rogue ICOs that shouldn’t exist. But this ruling doesn’t say anything about them — this is a ruling on the DAO and things like the DAO.”

Implications for bitcoin and ethereum
Many people that read that guidance couldn’t help but notice the SEC’s choice identifier of ethereum as a “virtual currency” as opposed to a virtual “token” or “coin.”

“My reading of this is it has no implications for the underlying infrastructure,” Sirer said. “Currencies themselves are not regulated by the SEC, securities are regulated by the SEC.”

Plus virtual currencies in the U.S. got their ruling in March 2013. It’s legal to own and transfer them without a license (although the exchange doing the actual transferring may need one).

Jo Ann Barefoot: ‘If regulators can tilt fintech, they’ll be able to tilt all of finance’

For Jo Ann Barefoot, regulation can be sexy. The CEO of Barefoot Innovation Group, which advises firms on tech and regulatory issues, says she has “set the task for myself of trying to help adjust the regulatory world to fintech.”

Barefoot, who is also Harvard University’s John F. Kennedy School of Government’s Center for Business & Government and was the first female Deputy Comptroller of the Currency, also hosts Barefoot Innovation podcast.

“I feel our regulatory systems aren’t built to optimize the opportunities and manage the evolving risks. To do that, you have to connect people and pull them out of their silos. A podcast is a great way to go across a great big wide ecosystem and get people listening to people they might not ever be in the same room with,” she said on this week’s Tearsheet podcast.

Subscribe: iTunes I SoundCloud

Below are highlights, edited for clarity, from the episode.

 

The role of startups in the financial ecosystem
“I have no doubt that fintech startups are changing the banking industry. What shape that will take long term, no one really knows. Most of these startups won’t replace banks — there will be much more of a merging and mixing of the startup technology with incumbents. Banks that don’t change, though, will be facing tremendous competitive risk. Startups bring a much better user experience and many are geared to millennials, which is now the largest generation in the U.S. They’re using data differently. AI and big data are transforming finance. Banks have a lot of data that’s locked up because of their old IT systems.”

The career trajectory of a former regulator
“I went to Washington D.C. straight out of college. I was 20 years old. I had a couple of boring government jobs. I got started in finance after working briefly in HUDD when I went to the Federal Home Loan Bank Board, which doesn’t exist now but was the savings and loan regulator. That got me started on technology issues. I was recruited from there to the National Association of Realtors and then to the Senate Banking Committee where I thought a lot about public policy.

I then started the first of my companies and sold it to KPMG, becoming a partner and managing director. I’ve worked for many years in these regulatory issues and had my own hand in crafting public policy on consumer protection and inclusion. I don’t mean to criticize the past but we’ve built a huge edifice of organizations but they’re not working very well. Look at the financial crisis — people were not well protected even after they received all the required disclosures. They didn’t understand what they were getting. There are 80 to 100 million people in the U.S. who don’t have access to mainstream financial services. It doesn’t matter whether we did the best we could in 1969. We know we can do better today with new technology.”

Financial reform: Friend or foe to fintech startups?

Financial services companies have been buzzing with equal parts fear and excitement about Donald Trump’s plans to unravel the financial reforms put in place after the 2008 financial meltdown.

As expected, Trump signed an executive order two weeks into his presidency to begin undoing the Dodd-Frank Act, a 2,000-page policy so overbearing to many legacy banks that it’s been blamed for the decline of community banks and business lending.

While banks eagerly await a rollback, its implications for fintech startups have been less certain.  Loosening the rules should make banks better able to partner with fintech startups, but consumer protection and access to data could still be at risk. And there’s been buzz about the possibility scrapping the Consumer Financial Protection Bureau, which was created under Dodd-Frank, but Trump hasn’t made that order yet.

We asked attendees at the LendIt USA conference in New York to share their views and concerns with the current administration’s proposed regulatory reform — and whether it’ll be a friend or foe to the fintech industry.

Rob Frohwein, CEO, Kabbage
A change in Dodd-Frank will be a boon to the fintech industry. There are two major blockers for banks getting into this industry. One is regulatory. The other is technology. If you remove the regulatory challenges — or at least the perceptional regulatory challenges — you put them in a position to start thinking about product in the space. We are a provider of technologies. We would love to work with banks and provide them a better service and product for small businesses.

Leslie Smith, managing director, Silver Hill Funding
I don’t think it’ll impact the tech per se. It’ll impact how people use technology. Most of these companies do things automatically. There are no people in many processes. The biggest impact to this space would be that they do need people in order to check off the box that says they’re in compliance. People continue to innovate and create really awesome tools through technology. The regulations will drive whether they can do that without people.

Rohit Arora, CEO, Biz2Credit
There’s a lot of optimism among banks, especially the small- and mid-sized ones who have been most impacted by deregulation in the last eight years. 1. As banks get more aggressive, there will more opportunity for more bank-fintech partnerships. 2. With the proposed [Office of the Comptroller of the Currency] fintech charter, fintech companies can become limited-purpose banks without having to get a charter. It’s pretty positive, but the administration has to follow through. They say a lot of things, but we haven’t seen any action. They’ve raised expectations now.

Melissa Goldberg, senior innovation strategist, Commonwealth
We’re particularly concerned about consumer protection and making sure all the work that’s been done to protect consumers doesn’t get undone. When you think about our organization, that’s half of it. The other half is around promoting innovation because fintech for financially vulnerable consumers is a great opportunity to reach people outside the traditional banking sector. Right now, we’re trying to figure out the balance between the two that allows people to innovate and think in a new way that doesn’t go against rules there to protect the interest of consumers.

Lenore Kantor, president, Launch Warrior
It means uncertainty and unpredictability, which equals volatility. That will be good for trading but not so good for fintech startups or anyone looking to launch a new initiative. All businesses should be preparing multiple scenarios for how to adapt in a rapidly changing environment.

Colin Darke, general counsel and chief compliance officer, RocketLoans
Smart regulation is important for the industry. If that involves deregulation in the sense that there are overlapping regulations or regulations no longer applicable to the modern age, then that’s good. But you still need to balance it so you have responsible innovation — you always need to protect consumers. There’s definitely room where deregulation amounts to smart regulation that would help this industry. There are a lot of misconceptions and confusion in fintech.