Builders’ Guide to Regulations and Securities in Web3
An overview of the regulatory frameworks, securities laws, and recent cases relevant to Web3 builders
In 2023, regulatory frameworks are becoming more prevalent in the industry, making it crucial to understand how they apply to your dApps.
Our guide provides an overview of relevant crypto laws and recent cases that may impact your projects. Plus, join us on Twitter for an in-depth discussion with legal specialist Guilherme Maia.
Don't let legal uncertainties hinder your success - read on to stay ahead in Web3 regulations and securities.
The basics of laws and regulations
The law is nearly as old as civilization. When a large number of people live and do business together, the need to dissolve disagreements becomes increasingly apparent. So, laws and regulations were created to prevent certain activities, set standards for dealing with each other, and solve potential wrongdoings through fines, restrictions, and imprisonment.
This also applies to conducting business and financial markets. Hence, there are laws and regulations in place to promote competition and stability, control market power, protect consumers and investors and help achieve the goals of governments.
Various government agencies enforce laws and regulations. The three key pillars for this are; a legislature for making laws, an executive branch for the enforcement, and a judiciary arm for interpreting the law.
The various branches of law for markets
Below, we'll touch upon the several regulatory frameworks that apply to crypto.
Commodities such as grain, gold, coffee, and possibly Bitcoin are regulated under commodities laws. In the US, so are derivatives such as futures, options, and swaps, as they were initially most widely used for commodities. Any crypto organization offering derivatives has to comply with commodity laws and falls under the CFTC in the US.
Anti-money laundering (AML) laws
The purposes of these laws are to prevent money laundering. They enforce compliance with AML regulations, which include Know Your Customer (KYC) requirements and the obligation to surveil specific types of transactions and report them to the government. These also apply to crypto service providers and intermediaries. However, complexities arise when dealing with open-source code, smart contracts, and public ledgers.
Sanctions are economic penalties used by governments as a foreign policy tool against other nations. Any company must comply with sanctions. In the web3 space, this can prove to be difficult due to the (on-chain) markets’ open and borderless nature.
Taxes are unavoidable and regulated by tax codes. Every company and participant in web3 has to pay their fair share of taxes, although this can sometimes still be difficult. Web3 presents many novel mechanisms such as mining, airdrops, hard forks, providing liquidity, and DAOs for which the exact applicable taxation still has to be clearly defined in most jurisdictions.
Securities are financial assets such as stocks or bonds that represent a claim on future financial returns. In the context of the crypto industry, securities regulations have been a hot topic, with the US Securities and Exchange Commission (SEC) playing a key role in their enforcement. The SEC regulates securities and associated actors such as exchanges, brokers, and investment firms. Under US law, an asset is considered a security if it meets the Howey Test, a set of four questions.
Under the Howey Test, a transaction qualifies as a security if it involves the following four elements:
- An investment of money
- In a common enterprise
- A reasonable expectation of profit
- Derived from the efforts of others
The definition of securities is different across the world and how they apply to crypto has still not been fully defined. However, as the largest market and industry for crypto, the US requires securities to be registered with the Securities and Exchange Commission (SEC). If crypto were classified as securities under US law, this could be a massive blow to the industry as registering with the SEC and being tradeable on SEC-regulated platforms is an expensive and onerous process.
Fortunately, a new regulatory exemption has emerged, known as the Hinman test, which measures the decentralization of a network. If the network is considered sufficiently decentralized, meaning that its future growth and direction are not dependent on a small group of individuals, the asset may not be considered a security, but rather a commodity.
Crypto and securities: Case Studies
While the jury’s still out, the SEC and its chairman Gary Gensler have stated multiple times that, in their perspective, “everything other than Bitcoin is a security”. This has created uncertainty amongst US-based entrepreneurs, leaders, and investors, but other jurisdictions and even US-based agencies seem to disagree with the SEC.
NFTs vs Securities
In 2021, a lawsuit against Dapper Labs was filed, claiming that its NBA Top Shots were in fact securities. In February 2023, this was confirmed by a judge using the Howey Test, meaning the lawsuit moved forward. This could set a precedent for classifying NFTs as securities in the US.
On the other hand, German officials have stated that NFTs are not securities as they perceive them as digital collectibles. However, a caveat was added as NFTs providing passive income streams such as interest payments could be classified as securities in the future.
Stablecoins vs Securities
Mid-February 2023, news came out that Paxos, a US-regulated stablecoin issuer, could get sued over its issuance of Binance’s BUSD stablecoin. At the heart of the claim was that Paxos was in fact, issuing and selling an unregistered security. This has left many scrambling, as a stablecoin is pegged to a fiat currency, in this case, the US Dollar, and hence does not come with an expectation of profits. This legal process is still ongoing, but classifying stablecoins as securities could spell bad news for the sector. However, Chair of the US commodities agency Rostin Beham argues that stablecoins could in fact be commodities which would place them under the CFTC’s jurisdiction instead of the SEC.
Ethereum vs Security
On the same day that Ethereum upgraded to Proof of Stake (PoS) in September 2022, Gary Gensler stated that PoS cryptocurrencies could be subject to securities laws. This viewpoint was recently echoed by the New York Attorney General, who classified Ethereum as a security in a lawsuit against KuCoin. Nonetheless, Ethereum is likely to satisfy the Hinman test described earlier, as it is a highly decentralized network.
Stay Ahead of the Regulatory Landscape
The 2022 crypto industry slump has brought regulatory oversight to the forefront, creating uncertainty in the short term but ultimately leading to much-needed clarity on tokens and web3 company legal structures. While the SEC's stance that all cryptocurrencies and NFTs are securities is daunting, it may be challenged. Nonetheless, it is crucial to understand the regulatory frameworks that apply to your project and keep an eye on the evolving landscape.
Knowing the regulations will help identify key issues requiring legal advice. As crypto extends beyond the US, exploring jurisdictions with more favorable laws and regulations is worth considering. 2023 might become a hallmark year for crypto regulations, so stay tuned!
If you’d like to learn more about crypto, applicable regulations, and recent developments, come join our podcast space where we talk to legal specialist Guilherme Maia!
Poolside is an ecosystem for Web3 builders and consists of multiple verticals. Poolside Accelerator is a 12-week program designed to take the project from inception to execution to market with an initial funding of up to $100,000. Poolside Hub is the physical Web3 hub in Lisbon. Poolside Podcast is our dedicated podcast channel for Web3 builders. Poolside DAO is our community of builders, investors and mentors.
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