Securities Regulations & Building in a Regulated Industry

Bruce Fenton

Today Coinbase posted a blog post about its recent communications with the SEC on its Lend product The SEC has told us it wants to sue us over Lend. We don’t know why. Coinbase expressed frustration at the SECs communications process. Coinbase also said that they do not believe the Lend product to be a security.

I’ll leave a discussion about whether Lend is a security to Coinbase, the SEC, and the many experts debating it. I will comment on one theme of the post as well as CEO Brian Armstrong’s tweetstorm on the same topic: lack of clarity and communications is a severe problem in the US regulatory environment. The CEO of the largest crypto company in America and his staff should be able to get the answers they want.

This post is about something different: how to build and innovate in a heavily regulated industry.

Unfortunately, because securities regulations are so complex, opaque, and difficult to comply with, many companies seek to avoid securities regulations entirely. The industry has been focused on avoiding securities regulations for years: classifying tokens as “utilities” rather than investment contracts, setting up ratings services to determine if something is not a security, or creating “governance tokens” instead of simple voting equity. We see this again now with many DeFi projects whose main priority is avoiding the law rather than making a solid investment structure. This is a strategic mistake.

What is a Security?

The definition of a security in the US is defined in the 1933 Act and is very broad. Bonds, debentures, various other debt instruments, and certainly equities are all considered securities under the law. Almost any type of mainstream financial product you can think of touches securities laws or is a security under the law. The only way to make sure an instrument does not meet the definition is to strip out all the terms that would meet the definition such as equity rights or sharing profits in a common enterprise. What you are left with once all this is stripped out is typically a much weaker investment.

Watchdog Capital is building in a very different way. Instead of trying to avoid securities or the definition of securities we already knew the definition is broad and anticipated exactly the types of actions we are seeing now. Instead of taking shortcuts and spending millions in court fighting, we spent time, money, and effort getting licenses and building capabilities to work with securities. Securities are a great structure and despite the regulatory hurdles, people should remember that securities are legal. Equity is a well-proven means of sharing risk and reward. We’ve been building a platform that works for equities, bonds, and almost other structures. We now have a fully SEC-registered Broker-Dealer and FINRA member licensed in all 50 states and 3 territories able to engage in a broad variety of securities transactions.

In 2016 The DAO was released on Ethereum. This was the first project of its kind and instantly raised $30 million then went on to raise $120 million more. These were stunning numbers at the time. I distinctly remember having two simultaneous reactions:

  1. Wow, that’s impressive.
  2. That’s definitely an unregistered and non-compliant securities offering.

I was right on the second point, as the SEC later confirmed SEC Issues Investigative Report Concluding DAO Tokens, a Digital Asset, Were Securities The first point remains true. Digital tokens are an outstanding way to raise money and move things of value around. Many saw this opportunity but most took the path of trying to avoid being classified as securities or brokers. We thought the opportunities could best be pursued as a regulated entity. I think that token fundraises just like the DAO can be done in compliance with existing regulations and I think that products like Lend or other lending products can be done in compliance with the regulations.

We are excited to be able to now legally and compliantly offer services that much larger companies are not licensed to. We believe this gives Watchdog Capital a significant advantage over other firms. We have built the foundation for a rich customer experience where investors can receive advice about crypto, sell private shares in the secondary markets, invest in small startups or buy shares in public companies — all on the same platform.

Cypherpunk ideals are not necessarily at odds with regulations. Customer privacy for example is one area where regulators and cypherpunks have some common ground. Regulated brokerage firms are actually required to have safeguards on customer privacy so we are hoping for more innovation in this area. The stock market’s core nature of open, free markets is very aligned with cypherpunk ideals and the core values of Bitcoin and crypto in my opinion. Hopefully, technology will help the capital markets reach their potential just as they have many times before.

At the end of the day, securities laws are here and here to stay for the foreseeable future. Securities have been Federally regulated for 88 years and the overall industry and regulatory apparatus covers all public companies from Apple to Zoom and directly regulates many of the largest companies in our economy, banks, and brokerages. The laws are not perfect and the clarity issues should be improved. Trying to game or work around the regs is not going to work. Continually trying to invent new structures that avoid the Howey test is a fool’s errand. Better to bite the bullet and do the work needed to comply. More companies will inevitably go the registered route and more digital assets will be offered as registered or exempt offerings. We are one of the first licensed firms in the crypto space but we won’t be the last. We are excited that all our building has paved the way for what’s next.