This article will give Web3 product designers an understanding of why there are tensions between Web3 tokens and US regulators like the SEC, in particular. SEC regulations are sure to come in the next several years, so we talk about potential outcomes of this regulation. Stay tuned for future Web3 Design Courses where we deep-dive into products in the Web3 ecosystem.

The SEC determines whether or not something is a security with the Howey Test, a precedent set by the Supreme Court lawsuit between Howey Company and the SEC back in 1946. Howey Company operated a hotel with an adjacent orange grove. The company started selling plots of the orange grove to its hotel guests. The owners of these plots would have rights to a portion of the revenues generated from the orange grove. Howey argued this was the sale of real-estate; however, the SEC argued this was the sale of a security and won the Supreme court case, thus establishing the definition of a security. Something is considered a security if it is:

  • An investment of money
  • In a common enterprise
  • With the expectation of profit
  • To be derived from the efforts of others

Clearly, according to the Howey Test, the crowdsale of Web3 tokens constitute a securities offering that requires SEC regulations in order for US investors to participate. But what is the purpose of SEC regulations, and what does it mean for Web3 tokens moving forward? The SEC cares about protecting US investors from fraudulent activity, and wants securities markets to operate fairly and efficiently. Security token issuers must make disclosures to reduce information asymmetries between the issuer and the investor. Also, the SEC would be able to hold fraudulent token issuers accountable, like the scam tokens discussed in the section above

The downside is that there will be much more friction when it comes to launching security tokens. Launches will take longer while waiting for SEC review, and will cost more due to the increase in legal overhead. Also, this token regulation will likely make it more difficult for retail investors to get the same exposure to early-stage Web3 investments as they currently enjoy in the wild-west of ICOs. Some security token frameworks have been established to simplify the process of regulated token issuance – see SAFT to learn more.

However, the Howey Test was established back in the 1940’s, and many Web3 evangelists believe that securities laws are too outdated to handle Web3 tokens. They argue that the regulatory framework needs modification to effectively handle emerging digital assets. An example of this is Hester Peirce’s Safe Harbor proposal, which allows for unregulated token issuance as long as the Web3 project decentralizes ownership and governance of the protocol within three years from launch.

The proposal takes advantage of the fact that an asset can change from a security to non-security over time. In other words, an asset that starts off as a security offering, may eventually change so that the Howey Test no longer classifies the asset as a security. On several occasions, the SEC has alluded that this is their view on Ethereum. Ether started as a security offering with its public crowdsale; however, the token has been distributed across so many independent actors that Ethereum can no longer be considered a “common enterprise”.

Last thing to say, there are regulatory bodies, other than the SEC, that have a stake in Web3 technologies. These include the Fed, Treasury, CFTC, OCC, CFPB, and FDIC. As Ryan Selkis points out in his annual crypto report, currently these entities range from neutral to openly opposed to Web3. There is still much to be determined in terms of regulation. Regulatory outcomes are sure to affect the growth and evolution of Web3 around the world. It’s unclear at this point how it will all play out; however, some jurisdictions are trying to attract Web3 entrepreneurs and businesses with more welcoming dialogue and regulation. Foreign countries like Switzerland, Germany, and Portugal, as well as US states like Wyoming, Texas, and Florida are among some of these Web3-friendly havens.

All the Web3 tokens mentioned thus far are “fungible” tokens. Fungibility exists in the real-world, with fiat currency being a good example. One paper dollar bill is equivalent in value to another paper dollar bill. Fungible tokens are the same way: one bitcoin is equivalent in value to another bitcoin; however, non-fungible tokens serve vastly different purposes. In the next section, we’ll give a background on non-fungible tokens and discuss their varied use-cases.

If you enjoy videos over reading when it comes to online learning then checkout the course on YouTube. This is part 6 of 7 in the Crypto Design Trends 2022 series. Also, make sure to stay tuned for future Web3 Design Courses where we will get into more interesting topics about emerging dApps.


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