Understand how the crypto industry will respond to regulation in the future in one article?

Since the birth of encryption technology and the day it entered the human vision, the issue of encryption industry regulation has become an unavoidable topic. It seems to be particularly tolerant of Bitcoin and Ethereum, but other encryption projects seem to have been included in the scope of regulation. This contradictory status quo proves that the supervision of the encryption industry has not formed a specific system. What will the future of encryption regulation look like still needs to be witnessed by all of us present here.

The following is Jack Niewold's opinion on the regulation of the crypto industry, compiled by CryptoGeek. It has been edited.

Regulation is one of the biggest issues facing the crypto industry. Complex, opaque, or often non-existent regulation drives consumers, crypto entrepreneurs, and even lawmakers themselves to despair.

Globally, the regulatory environment varies greatly. In general, the European Union has extremely favorable tax laws for crypto businesses and crypto transactions, making it a haven for the industry, with Switzerland alone having 14 crypto unicorns. Russia and China are dealing with ongoing domestic struggles over crypto, mostly focused on mining operations.

Crypto regulation in the United States is murky. Despite being a hotbed of tech talent and venture capital, regulation is a nightmare. The root of the problem is that digital currencies and tokens are decentralized, there is no precedent for regulation, and to put it bluntly, in some cases, there is no regulation.

Paradoxically, crypto entrepreneurs and investors mostly admit that they are in dire need of crypto regulation. Without clear guardrails, institutional money will not flow into these risky assets, and without institutional money, global participation will not be possible. Centralized decentralized finance (CeDeFi), which is the integration of the traditional financial system with the decentralized financial system, also needs clear regulation.

Today, we’ll take a deep dive into:

The Current State of Crypto Legislation

Where we might be heading

How crypto companies and protocols are handling crypto regulation

How Crypto Regulation Affects Investors

Securities and Exchange Commission

The Securities and Exchange Commission is the agency that regulates all public securities in the United States. They ensure that specific compliance and filing procedures are followed strictly in order to be listed on the public market, thereby allowing investors to access the assets. Failure to comply can result in large fines, lawsuits, and the loss of the ability to receive public investment.

The SEC is charged with three responsibilities: protecting investors; maintaining fair, orderly, and efficient markets; and facilitating capital formation.

But it has had trouble regulating the crypto industry for two reasons: crypto is a brand new asset class, and it's hard to target anyone in particular. So far, the agency's position has been largely clear: crypto is "rife with fraud, scams, and abuse." But ironically, he himself once taught a course on blockchain at MIT. Why did he suddenly change his mind?

Perhaps regulation can help expand government tax revenue. However, the SEC does not regulate commodities, only securities - so the bigger question is: Is the crypto industry a security? If not, does the SEC have the authority to regulate this industry?

XRP Lawsuit

In December 2020, the Securities and Exchange Commission filed a lawsuit against Ripple, accusing it of conducting an "unregistered securities offering," claiming that Ripple's blockchain token XRP is a security and the transaction should be registered with the SEC.

If Ripple wins its case, which it claims is not a security but an entirely different asset class, jurisdiction over the crypto industry would be taken away from the SEC and regulated by a potentially more lenient agency.

The Howey test is a judgment call to determine whether an asset is a security. To qualify as a security, it requires you to answer “yes” to the following three questions:

1. Is there any monetary investment with the expectation of future profit?

2. Do ordinary companies have funds to invest?

3. Do any profits come from the efforts of the promoter or a third party?

According to the SEC, XRP should be classified as a security under the Howey test. Ripple uses the funds raised from the sale of XRP dollars to fund its ongoing operations, which means that buying XRP is an investment in Ripple as a business.

Ripple has objected, saying that Bitcoin and other cryptocurrencies such as Ethereum are considered commodities. In addition, the SEC has been contradictory in its approach to regulating the crypto industry, with varying statements on how assets should be classified.

Ethereum initially used ICOs to fund its operations. The SEC said that because Ethereum operates in a decentralized manner, it has no reason to regulate it as a security. Bitcoin has no central backing and no profit motive, and cannot be regulated as a security.

Although it may take several years to reach a final verdict, the impact of this verdict is undoubtedly huge. It will radiate to other parts of the crypto ecosystem.

Uniswap: Skipping the Regulators

While crypto protocols that launch tokens to raise funds face regulatory scrutiny, we can look to tokens like Uniswap to see how they are circumventing regulators.

Uniswap, a venture-backed decentralized exchange (DEX). In 2020, it airdropped most of its tokens for free to people who had used it before. It requires no investment from users and has no "expectation of future profits," so it passes the Howey test and is not classified as a security. It is a "governance token" that is strictly used to make voting decisions around the project.

But the token is not worthless, because Uniswap promises to one day decentralize their protocol, and investors see an opportunity to redirect cash flows earned by the protocol to token holders. To date, this "value accrual" has not yet started, but it will one day start. By then, the protocol may be sufficiently decentralized that profits will not come from any commercial entity.

Who can the SEC sue in this situation? With no single entity controlling the operations, who can they find to regulate?

dYdX: Who are you going to sue?

Another interesting case is the decentralized derivatives exchange dYdX, which attempted to be decentralized in a similar way to Uniswap, but did not airdrop to US residents at all — only international residents. This became a popular topic to make fun of the SEC, as many crypto investors sarcastically “thanked” the SEC for “protecting” them from free money.

In fact, the entire protocol, while decentralized, is inaccessible to US residents because derivatives are highly regulated in the US. However, it is still technically legal for US residents to both own the tokens and use the exchange. The fact that you can’t buy dYdX tokens on a centralized exchange and use the protocol is more about protecting businesses from liability than protecting retail investors.

But perhaps decentralization could change things. While it’s unlikely that the dYdX token will be used on platforms like Coinbase, if it were decentralized enough, it could potentially open up the derivatives exchange to U.S. customers.

Terraform Labs: Strong U.S. Regulation

To people living outside the U.S., none of this may seem to matter. After all, the U.S. can do whatever it wants and it doesn’t seem to affect international agreements, right?

That’s not entirely true. Last September, the SEC issued subpoenas to Terraform Labs and CEO Do Kwon regarding Mirror Protocol’s synthetic assets, also known as mAssets.

What's unique about this? Terraform Labs was founded in Singapore, and Do Kwon is Korean and currently lives in Singapore. At the operational level, Terraform Labs and Kwon have no ties to the United States.

After being served, Kwon and his lawyers filed a lawsuit against the SEC, claiming that they had no jurisdiction over him and TFL. The SEC fired back:

• Do Kwon enters the United States and speaks on the mainnet of the crypto conference where he was served

• Terraform Labs Allows US Citizens to Trade Synthetic Assets

Since American citizens are trading these synthetic assets, the SEC feels a responsibility to protect investors. Although most decentralized finance users in the United States would say they do not need “protection,” SEC regulations require that American investors not be exposed to avoidable risks.

What does this mean for investors?

Another relevant case in which the SEC is waging war on the crypto world is Coinbase’s “lending” product, which allows users to earn 4% APY on their dollar-pegged stablecoin.

The SEC said they would sue the exchange if they successfully launched the product. Subsequently, the product was effectively shut down, showing that even the top US public crypto exchanges are not immune to the SEC’s wrath.

Crypto industry investors and entrepreneurs will likely continue to face regulatory headwinds in 2022 and beyond, at least until attitudes and laws shift.

For better or worse, this puts the US at risk of losing its crown as the world's financial capital. Companies and developers will continue to take their innovative products outside of the US simply to avoid uncertainty. In an era where innovation is accelerating, the huge growth of Web3 developers has a big impact. While the US remains a hotspot for developer activity due to its strong intellectual talent and venture capital network, this will change if crypto businesses cannot operate here.

Still, with more and more institutional players and politicians supporting crypto, it seems like the tide may turn someday. The crypto world is here to stay, and maybe someday regulators will get on board too.

Currently, as a crypto investor in the U.S., you have no risk of getting into trouble for investing in crypto, purchasing assets, and using any available crypto products, as long as you report it correctly on your taxes.

Regardless, understanding the landscape now and how it might change in the coming months and years will likely give you an edge in your crypto investments.