How the Crypto Asset Council Affects DeFi

As many of us in the digital asset ecosystem are aware, regulatory clarity surrounding the legality of many of the top cryptocurrencies has been far and few. In rare cases where legal precedent has been set, it’s often been with very obscure projects in which regulators such as the SEC have deemed different Initial Coin Offerings illegal for one reason or another.

Today, the blockchain industry aims to take a step forward through the introduction of the Crypto Rating Council, a consortium of top exchanges tasked with determining whether or not many digital assets are in fact securities.

The Council aims to rate different tokens on a scale of 0-5, with tokens rated on the higher end of the spectrum (i.e. 5) more likely to be ruled a security. On the other end of the spectrum, assets that rank lower are expected to have a much higher chance of not being deemed a security at some point in the future. A full list of all tokens that have currently been rated can be found here.

Image by TheBlock

For those unaware of what makes an asset a security, the Howey Test is most commonly used. The Council also uses this framework, which tests 4 primary components, (i) an investment of money, (ii) in a common enterprise, (iii) with an expectation of profit, (iv) solely from the effort of others. All of these factors must be met for something to be a “security”.  In the context of digital securities, the SEC has expressed the view that the first two prongs are generally met, and the third and fourth prongs are the most important.

Consisting of many well-known blockchain companies including but not limited to Coinbase, Kraken, Bittrex and Grayscale, many have been quick to point out that there could be a conflict of interest for many ratings as digital asset exchanges inherently benefit from the trading of tokens that are deemed non-securities. In particular, Larry Cemak of the Block stated:

“In my opinion, this rating system creates a massive conflict of interest. All of the companies that joined this consortium are massively incentivized to rate the vast majority of tokens as non-securities. Coinbase listed some very questionable tokens including XRP, Tezos, EOS”

Why Does This Matter?

For those unfamiliar with the digital asset landscape, virtually all of the top assets listed on popular sites such as CoinMarketCap or Messari consider themselves “utility tokens”, therefore exempting them from having to follow traditional compliance standards surrounding fundraising and reporting.

As a result, assets that are deemed “securities” have been known to suffer fatal blows in the form of full refunds from any previous fundraising (most commonly ICOs) and a mandatory KYC/AML process for any and all holders of the token.

Furthermore, securities will likely come with a number of future implications including the inability to raise funds from unaccredited US investors, mandatory vesting periods and an inability to list on many top exchanges include Binance.

The introduction of the Crypto Rating Council comes at a crucial time as many exchanges have recently begun exploring how the United States investor landscape plays into the grand scheme of things. With the recent launch of Binance US, Coinbase also put out a statement with a group of potential assets they were considering listing in the near future. In short, the Council aims to provide investors with confidence that certain assets are or are non-securities.*

*Please note that rulings from the Crypto Rating Council may influence SEC decisions but are by no means a fundamental legal opinion.

How DeFi is Affected

In order for DeFi to truly accomplish its mission of becoming a trustless and permissionless ecosystem for all, well-known DeFi assets being listed as securities could pose serious regulatory pressures that would likely push these services towards a more centralized experience.

In particular, MakerDAO’s native token, MKR, was rated as one of the assets most likely to be deemed a security. If this were to play out and the SEC were to agree, this would likely bar a portion of the Maker community from being unable to participate in governance polls, one of the most important aspects of the project as a whole. Stated another way, MKR as a security would require a number of hoops (including KYC and possible accreditation checks) in order for the average US-based user to acquire and utilize MKR for it’s designed use-cases.

As such, the trend of DeFi projects continuing to proceed without developing a native token seems to be a much more straightforward path as there is no need to worry about the “utility vs security argument”.

As the digital asset ecosystem continues to evolve, regulatory clarity on the inner workings of different token structures will be vital to long-term growth. Seeing as the industry is finally approaching a place of pure utility and tangible products rather than overarching speculation, many new companies would strongly benefit from a clearly defined set of rules over what does or does not constitute a token being a security.

In the meantime, be sure to stay up to date on the Crypto Rating Council as their ratings are likely to have a strong influence over which digital assets are likely to be traded on many of the well-known US digital asset exchanges.

If one thing is for certain, clear legal opinions on the nature of various tokens will directly correlate to which assets have the biggest roles in DeFi over the coming years.

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