Author: Scott Walker, Chief Compliance Officer at a16zcrypto; Bill Hinman, Advisory Partner at a16zcrypto, former Director of the Division of Corporation Finance at the U.S. SEC

Translated by: 0xjs@Golden Finance

As technology evolves, the U.S. SEC must also evolve. This is especially true in the cryptocurrency space. The new leadership and the establishment of a new cryptocurrency working group provide the agency with opportunities to take meaningful action and adapt.

Now is the time to act: the scale and complexity of the crypto asset market are growing, and the U.S. SEC's recent harmful enforcement actions and abandonment of regulation urgently need updating. As professional investment services begin to operate in this new industry, there is no other way to promote market efficiency, encourage innovation, and ensure investor protection. The fundamental principles of relevant securities laws—disclosure, anti-fraud, and market integrity—should remain inviolable. However, applying these principles in a way that reflects the unique characteristics of crypto assets requires targeted regulatory changes.

This article proposes immediate, easily implementable adjustments that the U.S. SEC should take to create purpose-fit regulations without sacrificing innovation or critical investor protection. While legislation is necessary to provide sufficient regulatory clarity regarding crypto asset classification and secondary market oversight, these measures will bring direct benefits to the market.

1. Provide Interpretive Guidance on "Airdrops" and Other Incentive Rewards

The U.S. SEC should provide interpretive guidance on how blockchain projects can distribute crypto assets to participants without being considered a securities offering. These distributions, often referred to as "airdrops" or "incentive-based rewards," are typically conducted for free or at minimal value as rewards for prior use of a specific network or ecosystem. Such distributions are key tools for enabling blockchain projects to build communities and gradually decentralize, as they spread ownership and control of the project to its users.

This decentralization process has multiple benefits. It can protect investors from risks typically associated with securities and centralized control, and it promotes the expansion of the network, thereby increasing its value. If the U.S. SEC provides guidance on distributions, it will prevent the trend of only airdropping and incentivizing rewards to non-U.S. persons—this trend effectively transfers ownership of blockchain technology developed in the U.S. overseas, creating windfall profits for non-U.S. persons at the expense of U.S. investors and developers.

What to do:

Establish Qualification Standards: Set benchmark standards for crypto assets that qualify for exemption from securities law investment contract treatment in airdrop and incentive reward distributions. For example, if the market value of a crypto asset primarily derives from (or is reasonably expected to primarily derive from) the programmatic functionality of any distributed ledger or similar technology, or any executable software deployed to a distributed ledger or similar technology, and these crypto assets are not originally securities, they should qualify for such distributions.

2. Modify Crowdfunding Exemption Issuance Rules

The U.S. SEC should modify crowdfunding regulatory rules to more effectively oversee the exempt issuance of crypto assets.

Current restrictions on financing and investor participation in crowdfunding activities are not suitable for cryptocurrency startups, as they often need to distribute crypto assets more broadly to achieve critical mass and network effects for their platforms, applications, or protocols.

What to do:

Increase Issuance Limits: Raise the maximum amount that can be raised through crowdfunding to a level consistent with business needs (e.g., up to $75 million or a certain percentage of the entire network, depending on the depth of disclosure).

Exempt Issuance: Allow crypto projects to rely on exemptions similar to Rule D while utilizing the accessibility of crowdfunding platforms to reach investors beyond qualified investors.

Protect Investors: Implement appropriate protective measures, such as limiting individual investment amounts (as currently done by Reg A+) and strict disclosure requirements covering important information related to cryptocurrency investments—this is not addressed by current regulations. (For example, while issuance disclosures typically involve details about directors, their compensation, and shareholdings, disclosures regarding the underlying blockchain, its governance, and consensus mechanisms may be more important for crypto asset investors.) Tailoring these requirements to digital asset investors can ensure they are well-informed and protected from fraud.

These changes will enable early-stage crypto projects to reach a broad base of investors while democratizing promising investment opportunities while maintaining transparency.

3. Enable Broker-Dealers to Operate with Crypto Assets and Securities

The current regulatory environment limits meaningful participation of traditional broker-dealers in the crypto space—primarily because it requires brokers to obtain separate approvals to trade crypto assets and imposes heavier regulations on broker-dealers wishing to custody crypto assets.

These restrictions create unnecessary barriers to market participation and liquidity. Allowing broker-dealers to facilitate the trading of both securities and non-securities crypto assets will enhance market functionality, investor access, and investor protection. It will also recognize that crypto assets that are clearly not securities (e.g., Bitcoin, Ether, or fiat-backed stablecoins) can seamlessly trade alongside crypto assets that the SEC may consider subject to securities laws.

What to do:

Allow Registration: Create a clear pathway for broker-dealers to register for trading (and custody) of crypto assets (both securities and non-securities) and establish customized requirements that reflect the nature of these assets.

Strengthen Regulatory Framework: Establish oversight mechanisms to ensure compliance with anti-money laundering (AML) and know your customer (KYC) regulations, maintaining market integrity.

Collaborate with Industry: Work with the Financial Industry Regulatory Authority (FINRA) to issue joint guidance addressing the unique operational risks of crypto assets.

This approach will promote a safer, more efficient market, enabling broker-dealers to bring their expertise in best execution, compliance, and custody to the cryptocurrency market.

4. Provide Custody and Settlement Guidance

Custody and settlement remain key barriers to institutional adoption of crypto assets. The ambiguity of regulatory treatment and accounting rules hinders traditional financial institutions from entering the custody market. This means many investors cannot benefit from trust asset management and must instead invest and arrange their own custody alternatives.

What to do:

Tailored Custody Guidance: Provide guidance on custody rules under the Investment Advisers Act to clarify how investment advisers can custody crypto assets, ensuring adequate safeguards are in place, such as multi-signature wallets and secure off-chain storage. This should also include guidance on voting governance decisions for staked idle assets and crypto assets held in custody by investment advisers.

Set Settlement Standards: Develop specific guidance for the settlement of crypto transactions, including timelines, verification processes, and error resolution mechanisms.

Establish a Technologically Neutral Framework: Allow innovative custody solutions that meet regulatory standards to operate flexibly without imposing prescribed technological requirements.

Correct Accounting Treatment: Repeal SEC Staff Accounting Bulletin 121, allowing the accounting for custodial digital assets to reflect the nature of the custody arrangement rather than presuming liability. The background is that SAB 121, among other things, states that "as long as [a company] is responsible for safeguarding the crypto assets held on its platform… the company should recognize a liability on its balance sheet to reflect its obligation to safeguard the crypto assets held for its platform users," and specify the corresponding assets. The overall effect of SAB 121 is to transfer custodial crypto assets to the custodian's balance sheet—this practice contradicts the traditional accounting treatment of custodial assets. Thus, unlike typical custodial arrangements, if the custodian goes bankrupt, this accounting treatment could lead to custodial crypto assets being dragged into the custodian's bankruptcy estate. The worst-case scenario is that SAB 121 lacks legitimacy. The Government Accountability Office found that this is actually a rule that should be submitted to Congress for review under the Congressional Review Act, and in May 2024, the House and Senate issued a joint resolution disapproving SAB 121, but the resolution was vetoed by President Biden.

This clarity will lay the foundation for institutional confidence, enabling large participants to enter the market while enhancing market stability and competition among service providers. Additionally, crypto investors (both retail and institutional) will gain protections associated with professional, regulated asset management services.

5. Reform ETP Standards

The U.S. SEC should take measures to reform exchange-traded products (ETP) that promote financial innovation. These proposals will provide broader market access for investors and trustees accustomed to managing ETP portfolios.

What to do:

Restore Market Size Test: The U.S. SEC relies on the "Winklevoss test" to establish market oversight agreements, which has delayed the approval of Bitcoin and other crypto-based ETPs. This test requires that for commodity-based ETPs to trade on national securities exchanges like the NYSE or NASDAQ, the listing exchange must enter into oversight agreements with a "regulated market of significant size" for the commodity or its derivatives. Given that the U.S. SEC does not consider crypto trading platforms to be "regulated markets," this effectively means that ETPs can only exist for those crypto assets that have futures markets (regulated by the Commodity Futures Trading Commission) that have a clearly high predictive ability for the price discovery of the underlying commodity. This approach ignores the current scale and transparency of the crypto market. More importantly, it creates an arbitrary distinction in the standards applicable to applications for listing crypto-based ETPs and all other commodity-based listing applications. Therefore, we recommend restoring the historical test for significant size markets: only requiring that commodity futures markets have sufficient liquidity and price integrity to support ETP products. This adjustment will align the approval of crypto ETPs with the standards applicable to other asset ETPs.

Implement Physical Settlement: Allow crypto ETPs to settle directly in the underlying assets. This will lead to better fund tracking, lower costs, improved price transparency, and reduced reliance on derivatives.

Implement Custody Standards: Apply strict custody standards to physically settled transactions to reduce the risk of theft or loss. Additionally, provide options for staking idle assets in ETPs.

6. Implement 15c2-11 Certification for Listing on Alternative Trading Systems

In a decentralized environment, issuers of crypto assets may not play any significant ongoing role, raising the question: who should be responsible for providing accurate disclosures about the asset? Fortunately, there is a useful analogous rule in traditional securities markets, namely Section 15c2-11 of the Exchange Act, which allows broker-dealers to trade securities as long as there is current information about the securities available to investors.

By extending this principle to the crypto asset market, the U.S. SEC could allow regulated crypto trading platforms (including exchanges and broker-dealers) to trade any asset as long as the platform can provide investors with accurate, up-to-date information. The result would be greater liquidity for these assets in markets regulated by the U.S. SEC, while ensuring that investors can make informed decisions. Two obvious benefits of this approach are the ability to trade digital asset pairs in U.S. SEC-regulated markets (where one asset is a security and the other is a non-security asset) and curbing the operation of trading platforms overseas.

What to do:

Simplify Certification Process: Establish a streamlined 15c2-11 certification process for crypto assets listed on alternative trading systems (ATS) platforms, mandating the disclosure of the asset's design, purpose, functionality, and risks.

Adopt Due Diligence Standards: Require exchanges or ATS operators to conduct due diligence on crypto assets, including verifying the identity of the issuer and important characteristics and functionality information.

Clarify Disclosure Requirements: Require regular updates to ensure investors receive accurate information in a timely manner. Additionally, clarify when issuers are no longer required to report, as reporting may no longer be relevant to potential purchasers due to decentralization.

This framework will promote transparency and market integrity while allowing innovation to thrive in a regulated environment.

Conclusion

The U.S. SEC is at a critical juncture in determining the future of crypto asset regulation. The establishment of a new cryptocurrency working group indicates the U.S. SEC's intention to change the policies of the previous administration. By taking the key measures outlined above, the U.S. SEC can begin to move away from its historically controversial enforcement focus and provide urgently needed regulatory guidance and practical solutions for investors, trustees, and financial intermediaries. This will better balance the protection of investors with the promotion of capital formation and innovation.

The proposed changes—from modernizing crowdfunding rules to establishing clear standards for custody and ETPs—will reduce ambiguity and support financial innovation in the space. Through these adjustments, the U.S. SEC can reestablish its purpose and reposition itself as a forward-looking regulatory body, ensuring that the U.S. market remains competitive while protecting the public. The long-term future of the U.S. crypto industry may require Congress to provide a comprehensive, purpose-fit regulatory framework. However, before that framework is in place, the steps outlined here are one way to achieve appropriate regulation.

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