Learn: What Are the Stakes in the SEC vs. Ripple Case?

The ongoing legal battle shows the need for comprehensive crypto regulation

There are rumors circulating that Ripple Labs Inc., the U.S.-based technology company that builds XRP infrastructure, may soon settle with the U.S. Securities and Exchange Commission (SEC). There is hardly an example of how many unsettled legal questions surround crypto as this case, currently in the dockets of the Court of Southern District of New York.

The SEC asserts that Ripple distributed 14.6 billion units of a crypto token known as XRP, and sued the company and its executives CEO Brad Garlinghouse and co-founder Christian Larsen for failure to register XRP as security, that being a requirement for the public offering and sale of securities.

The question for the court, therefore, is whether XRP can be considered a security, which would determine if Ripple should have registered XRP.

The SEC argues that XRP is security for reasons that make sense in some contexts, but not if thinking holistically about cryptocurrencies. For its part, the agency has said there is generally information asymmetry between token issuers and buyers (that is: issuers of crypto tokens almost always possess superior information that would traditionally be grounds for disclosure through registration with the SEC). Secondly, purchasers of crypto tokens can reasonably be said to expect to profit from the managerial or entrepreneurial efforts of token issuers.

However, XRP purchasers do not necessarily expect profit from the efforts of Ripple's managers. In terms of information asymmetry, an infinite list of factors can potentially contribute to profitability or decline of XRP. This includes its open-source design, which enables anyone to build new business models or applications on the XRP protocol, which Ripple does not control.

Therefore, developers cannot speak with certainty how changes on the protocol will impact the value of XRP in a decentralized ecosystem. In other words, what exactly would they disclose in an SEC “registration statement?” Issuers instead are just as ignorant as token purchasers.

On the flipside, the SEC’s argument may not be totally misplaced. In reality, some cryptocurrencies may not be totally decentralized in operation and information asymmetry sometimes exists. For instance, in 2018, engineers discovered a vulnerability on the Bitcoin blockchain that could inflate the total amount of bitcoin beyond its 21 million cap. The developers who fixed the bug withheld information of the bug and its risks that could have possibly devalued bitcoin (BTC) until the exposure was fixed.

It therefore stands to reason the ideal way to apply securities law to crypto is not set in stone. Regulators may have made their determinations, but that does not mean the current regulatory regime will be acceptable to the courts.

This type of regulation by enforcement can have unintended consequences for financial stability and integrity both in the crypto sector and wider economy. If the court for instance rules in favor of the SEC that XRP is a security, this can translate to heavier regulatory burden on other crypto firms including exchanges and market-makers to comply with onerous requirements.

Moreover, this opens up the crypto industry to enforcement actions for failure to fulfill regulatory requirements which, to be fair, are largely tailored towards the traditional securities market as opposed to decentralized cryptocurrencies. Not only does this potentially stifle innovative financial technology, it effectively operates as an indirect ban on cryptocurrencies.

Not only are bans of crypto hard to enforce (given that decentralized protocols broadly defy regulation by essence of their design), they come with a knock-on effect of pushing legitimate operations into gray or black markets, further compromising financial integrity. In fact, crypto use reportedly jumped in China after a ban was imposed by the Chinese government.

On the flip side, a ruling in favor of Ripple may have its own bad effects. Even a small signal of judicial approval could be read as validating the industry, giving destructive impetus to an ecosystem that is already volatile and prone to abuse. Crypto's extremists, feeling legitimized, pose their own risks to financial stability.

Again, the real risk here resides 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 crypto and vice versa. It is not uncommon for the media to promote this narrative – such as the common headline cliche suggesting there’s a regulatory “war on crypto." Rather all stakeholders should consider and treat legal controversies as necessary parts of the rule-making process for the regulation of an emerging, albeit disruptive, financial technology.

Worthwhile rules will require both regulatory and judicial creativity as well as industry support. Both sides need to want to come to the table to carefully craft out distinct disclosure requires and standards that reflect the genuine nuances of cryptocurrencies.

Cryptocurrencies are clearly not securities, so trying to fit them into traditional regulations is like forcing a square peg into a round hole. However, it will be foolhardy to ignore the need for disclosure standards in the crypto industry – there are clear examples of information asymmetry and significant concentration of power in the crypto ecosystem.

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

This article first appeared Coindesk, by Femi Olude