What are the stakes in the SEC vs. Ripple?

There are circulating rumors that Ripple Labs Inc. , the US-based technology company that is building the infrastructure for XRP, may soon settle with the US Securities and Exchange Commission (SEC). There is hardly an example of the number of unsettled legal questions surrounding cryptocurrency as this case, currently on the records of the Southern District of New York court.

Femi Olodye is studying an LLM in Corporate Law and International Commercial Law at Lincoln University.

The Securities and Exchange Commission confirms that Ripple distributed 14.6 billion units of the cryptocurrency token known as XRP, and is suing the company and its executives Brad Garlinghouse and co-founder Christian Larsen for failing to register XRP as a security, which is a requirement for public offering and sale of securities.

Thus, the question before the court is whether XRP can be considered a security, which will determine whether Ripple should register XRP.

The SEC argues that XRP is a security for logical reasons in some contexts, but not if you think holistically of cryptocurrencies. For its part, the agency said there is generally an information asymmetry between token issuers and purchasers (ie: cryptocurrency issuers almost always have superior information that would traditionally be grounds for disclosure by filing with the SEC). Second, it can reasonably be argued that buyers of crypto-tokens expect to profit from the managerial or entrepreneurial efforts of the token issuers.

However, XRP buyers do not necessarily expect a profit from the efforts of Ripple managers. In terms of information asymmetry, an endless list of factors can contribute to profitability or a drop in XRP. This includes its open source design, which enables anyone to build new business models or applications on the XRP protocol, which Ripple has no control over.

Therefore, developers cannot say with certainty how changes to the protocol will affect the value of XRP in a decentralized ecosystem. In other words, what exactly are they going to disclose in the SEC’s “Statement of Enrollment”? Instead, the issuers are just as clueless as the token buyers.

On the flip side, the SEC’s argument may not be entirely misplaced. In fact, some cryptocurrencies may not be completely decentralized in operation and there are sometimes information asymmetries. For example, in 2018, engineers discovered a vulnerability in the Bitcoin blockchain that could inflate the total amount of bitcoin beyond its cap of 21 million. The developers who fixed the bug have withheld information about the bug and its potential risk of devaluing Bitcoin (BTC) until the exposure is fixed.

So it makes sense that the ideal way to apply securities law to cryptocurrencies is not fixed. Regulators may have made up their minds, but that does not mean that the current regulatory regime will be acceptable to the courts.

This kind of regulation through enforcement could have unintended consequences for the financial stability and integrity of both the crypto sector and the broader economy. If for example a court rules in favor of the SEC that XRP is a security, this could translate into a heavier regulatory burden for other crypto companies including exchanges and market makers to comply with onerous requirements.

Furthermore, this opens up the crypto industry to enforcement actions for failing to meet regulatory requirements that, to be fair, are largely geared towards the traditional stock market rather than decentralized cryptocurrencies. Not only does this innovative financial technology prevent potential strangulation, it also effectively acts as an indirect ban on cryptocurrency.

Not only is cryptocurrency prohibitively difficult to enforce (given that decentralized protocols challenge large-scale regulation by the very core of their design), it comes with the spillover effect of pushing legitimate operations into gray or black markets, further endangering financial integrity. In fact, the use of cryptocurrencies is said to have jumped in China after the Chinese government imposed a ban.

On the flip side, ruling in favor of Ripple could have its ill effects. Even a small sign of judicial approval can be read as vindication for the industry, giving a devastating impetus to an already volatile and abuse-prone ecosystem. Crypto extremists, feeling legitimized, pose their own risks to financial stability.

Again, the real risk here lies in the signals sent to the market and the market reaction in response to those signals. Governments and regulators should not appear to be at war with cryptocurrencies and vice versa. It is not uncommon for the media to promote this narrative – such as the common key cliché that there is a “regulatory war on cryptocurrency”. Instead, all stakeholders should consider and treat legal disputes as necessary parts of the rule-making process to regulate an emerging, albeit disruptive, financial technology.

Feasible rules will require both regulatory and judicial creativity as well as industry support. Both sides need to come to the negotiating table to carefully craft distinct requirements and disclosure standards that reflect the real nuances of cryptocurrencies.

Obviously, cryptocurrencies are not securities, so trying to integrate them into traditional regulations is like forcing a square peg into a round hole. However, it would be reckless to ignore the need for disclosure standards in the crypto industry – there are clear examples of information asymmetry and high concentration of power in the crypto ecosystem.

Whether Ripple is an example of such a concentration of power is up for the courts to decide.

#stakes #SEC #Ripple

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