SEC sues Ripple, is it stifling innovation or controlling risks?

A sword of Damocles is hanging over the heads of XRP holders.

On December 22, 2020, the U.S. Securities and Exchange Commission (SEC) officially released an indictment against Ripple and its founders Bradley Garlinghouse and Christian A. Larsen. The document stated that from 2013 to the present, Ripple and its founders have sold more than 14.6 billion units of digital asset securities "XRP" in exchange for more than US$1.38 billion in funds. The defendants did not register their offers and sales of XRP, nor did they obtain any registration exemptions, violating the registration provisions of the federal securities law.

In response to the lawsuit, Ripple CEO Brad Garlinghouse said: "We are not wrong, we will actively fight this battle in court and win to clarify the rules in the United States."

Over the years, the "love-hate relationship" between Ripple and the SEC has attracted widespread attention and discussion in the industry. What did Ripple do to make regulators so worried? How should XRP be defined? As a landmark event in US regulation, what impact will the "confrontation" between Ripple and the SEC have on the industry?

Ripple's past and present

"In the last bull market cycle, Ripple surpassed Ethereum to become the world's second largest cryptocurrency. Looking back on its development history, the initial version of Ripple was actually far earlier than the birth of the Bitcoin mainnet. It aims to solve the global low-cost and fast transfer of cross-sovereign currencies through a decentralized system." Chen Lei, Secretary-General of Peking University Blockchain Club and founder of BitBlue Whale, told "Chain News".

Ripple is a project that predates Bitcoin. In 2004, the Ripple payment protocol RipplePay was born. The initial setting mechanism was limited to use among acquaintances. In 2013, the company was officially renamed Ripple and began to focus on cross-border remittances. It also introduced two important tools, gateways and XRP (Ripple currency), which enabled it to develop rapidly.

Traditional cross-border payment has always been dominated by the SWIFT (Society for World Interbank Telecommunications) system. SWIFT was established in the 1970s and is currently the main service provider for cross-border settlements between international banks. Due to the lack of standardized payment operation methods between different banks, most transfers can only be carried out through the SWIFT protocol. However, under the oligopoly, this cross-border payment system is often accused of low efficiency, high cost and poor reliability. Due to the involvement of many stakeholders and responsibility issues, it is also difficult to gather the momentum for innovation and reform.

Targeting these pain points, Ripple has built a digital payment network without a central node, using distributed identity authentication technology, and providing three products: xCurrent, ODL cross-border payment platform, and xVia. These functions have been integrated into RippleNet at the end of 2019.

Among them, xCurrent has the highest acceptance and can provide basic solutions for financial institutions. In short, one financial institution only needs to convert the local legal currency into XRP, and then the other financial institution converts the received XRP into the legal currency of the country and pays it to the recipient. In this way, XRP can be used to reduce the liquidity cost of funds.

Since XRP is a native asset based on blockchain, when using XRP for xCurrent payment, the counterparty can directly verify the XRP reserves of the initiator and respond quickly. After several years of development, Ripple's customers have covered at least 350 financial institutions in more than 40 countries. These mature business cooperations are regarded as one of the important value supports of XRP. Since its birth, XRP has increased by more than 100 times.

"XRP reached its all-time high in 2017, but it continued to fall last year due to regulatory litigation, going against the current bull market. The recent increase in XRP is just making up for the impact of this unexpected incident. Compared with the current mainstream cryptocurrencies, especially the increase in benchmarks such as Bitcoin and Ethereum, XRP's market performance is far below expectations. Whether the SEC and Ripple can reach an out-of-court settlement will largely determine the future short-term trend. As a decentralized payment system, Ripple has a wide global audience and should continue to develop." Chen Lei explained his judgment.

Dangers and opportunities under litigation

On December 22, 2020, the SEC filed a lawsuit against Ripple. The SEC believes that Ripple is an unregistered security, but it has been illegally sold since 2013. Therefore, it sued Ripple and its CEO Brad Garlinghouse and co-founder Chris Larsen.

The SEC also specifically emphasized that Brad Garlinghouse and Christian Larsen are important XRP "securities" holders. The two conducted "personal sales" of up to $600 million in XRP, but did not apply to the SEC to register the sales and offers of XRP. At the same time, the two did not obtain exemptions from registration, thus violating the registration provisions of the federal securities law. According to the regulations of the SEC, individuals and crypto companies must register the "securities" products they issue with regulators or apply for exemptions.

“The SEC claims that Ripple was sold as a security product without review, which is untenable from a product technology perspective. However, Ripple and its authorized agents have attracted customers with the high investment returns of XRP and have conducted organized institutional sales. The sales path is suspected of violating regulations on the sale of securitized products,” Chen Lei told Chain News.

This incident had a huge impact on the price of XRP. After the news was released, the price of XRP dropped by nearly 20%. In addition, some cryptocurrency exchanges directly removed XRP from the shelves in order to avoid regulatory risks.

It is curious why the SEC has such a different attitude on the Ripple issue, given that it has previously made clear that the “decentralized” nature of Bitcoin and Ethereum qualify them as cryptocurrencies rather than securities.

Chen Lei believes that the SEC chose Ripple as an important target in the field of cryptocurrency not only because Ripple has a record of selling to American citizens many times, but also because of two characteristics that deserve the attention of regulators:

First, Ripple has always been operated as a company, with a clear operating entity and management team, and has carried out long-term organized sales and customer maintenance work, and the law enforcement and litigation subjects are clear;

Second, in the course of Ripple's development, it has proactively established business relationships with European and American banking systems, third-party payment companies, and Asia-Pacific investment banks on many occasions, and has also carried out some investment and mergers and acquisitions. This makes Ripple's penetration and influence on the traditional financial field no less than any other mainstream cryptocurrency, and may even pose a greater threat.

In fact, in the eyes of some users in the cryptocurrency community, XRP's cooperation with financial institutions has deviated from Satoshi Nakamoto's vision of peer-to-peer currency that would enable people to take back control from banks. They call XRP a pseudo-blockchain project, a "Q coin," and a cash-out tool for the team.

How does regulation balance innovation and risk?

“In this lawsuit, Ripple’s attorney has filed a counter-injunction, asking the SEC to explain why Bitcoin and Ethereum are not subject to securities regulation. In this way, the SEC will have to give a principled opinion on the entire cryptocurrency industry, whether it is an institutionally operated or fully distributed project.”

Chen Lei believes that after years of adjustment, the US regulation of cryptocurrencies has matured in terms of transaction compliance, tax policies, anti-money laundering, institutional investment channels, etc. Overall, the US regulatory direction is still prudent, inclusive, and allowing development.

He expressed optimism, “After this lawsuit, the definition and regulation of cryptocurrency and traditional financial industries will become more mature, and the path of cryptocurrency institutional operation may become clearer, which is good for cryptocurrency to get closer to and penetrate deeper into social and economic activities.”

Earlier, former U.S. Commodity Futures Trading Commission (CFTC) Chairman and encryption expert Gary Gensler confirmed his election as SEC Chairman. Ripple CEO Brad Garlinghouse tweeted: "Congratulations Gary Gensler! We are ready to work with SEC leadership and the broader Biden administration to chart the path for blockchain and encryption technology innovation in the United States."

It seems that the legal battle between Ripple and the SEC is far from being concluded, and there are still many variable factors.

In the three major financial fields of commodity derivatives, banking, and securities in the United States, the progress of the development of cryptocurrencies is different due to the different attitudes of the corresponding regulatory agencies towards crypto-finance. Among them, the SEC's regulatory approach in the field of crypto-finance is to deal with individual cases. It has not put forward a clear guidance that can both meet existing securities regulations and incorporate innovations in this area of ​​the market into the regulatory framework. Therefore, various attempts by market players are carried out at the risk of violating regulations.

In order to regulate this market, the SEC has been constantly emphasizing the definition of securities, which is commonly known as the Howey Test: If a cryptocurrency or token meets the Howey Test, then it should be identified as a security product. Its operation also needs to be in accordance with securities regulations. On the one hand, the SEC constantly emphasizes its basic position, and on the other hand, it constantly takes regulatory measures to prosecute projects in the market that it believes are in violation of regulations. Ripple is one example.

Zhou Xinjian, senior researcher at MeiChain Technology, told ChainNews that digital currency is a product of the public chain incentive mechanism. Since it is impossible to avoid the various benefits brought by the public chain, including distributed technology, we should consider how to balance technological progress and the risks that go along with it.

“If digital assets are kites, then supervision is the string that holds the kite. A kite without a string cannot fly high, and the length of the string must be adjusted according to market conditions and the kite’s flying performance. When new things emerge, governments are still in the process of exploration, and they need to constantly try and error within a certain framework to find the model that suits them best.” Zhou Xinjian finally said.