We do the research, you get the alpha!
Gladius Network is the latest in a string of cryptocurrency firms that have borne the brunt of court cases with the US Securities and Exchange Commission (SEC) over an unregistered security. Gladius raised almost $13 million in an ICO in late 2017, which the SEC then claimed was a security; it later agreed to pay back its investors in a settlement. But it ran out of money, and this week switched off the lights.
In the absence of clear SEC guidelines, a Coinbase-led consortium of brokers and exchanges in late September set up the the Crypto Rating Council to try and provide regulatory clarity in the absence of clear SEC guidelines. Firms share some of the legal administrative costs spent on working out whether popular coins count as securities.
Brian Brooks, Chief Legal Officer at Coinbase, told Decrypt in October that the Council’s aim is to rate most of top coins by market cap, an initiative that will take several months, and that several new members would join its ranks. But since its launch, the Council hasn’t released any more ratings, nor more information about its membership. Apparently it’s still operational, according to a Coinbase spokesperson.
And here’s the thing: the determinations made by the Council are basically meaningless. They don’t count as legal advice, nor do they shed much light on how certain conclusions were reached. The Council has already given passing marks to EOS, a coin that was subsequently the subject of SEC action.
So why create it? “Markets hate uncertainty. We're trying to bring more certainty,” Brooks told Decrypt. With certainty, he said, developers can design projects that, compliant with securities laws, can attract capital. That'd be good for the companies in the Council—comprised of exchanges, brokers, and investment companies—whose profits depend upon high-volume trading of cryptocurrencies.
The Council has spoken
Here’s how it works: The Council chooses a coin to rate—without input or petition from others—then puts the matter before a panel of expert lawyers, who answer a few dozen questions about the pending coin. The Council arrives at its conclusions via the Howey Test, a 1946 U.S. Supreme Court decision relied on heavily by the SEC. Per the Howey Test, an asset is a security if it is an “investment of money in a common enterprise,” and “comes with an expectation of profit derived solely from the effort of others.”
The Council, having made up its mind about a coin, rates it on a scale of 1-5, where 5 is a coin most likely to be considered a security, and publishes these ratings on its website. Bitcoin scores 1.00, meaning the Council's lawyers have concluded that the SEC are unlikely to consider it a security—a no brainer, considering the SEC has repeatedly said so. XRP, though, ranks a 4.00, meaning the Council's lawyers have concluded that XRP displays many of the characteristics of a security.
But hang on: the SEC doesn't use the Council's five point scale; assets are either securities or they're not. So when the Council rated EOS a 3.75—not high enough to obviously count as a security, but close enough to seriously consider the possibility—its rating proved useless when just a few days later, EOS settled with the SEC just days after the Council announced its ratings over charges that it had run an unregistered securities offering, and paid a penalty of $24 million. (Granted, Block.One didn’t admit EOS was a security in its settlement).
And Coinbase, which pulled together the Council, misjudged the listing of a token shortly after, albeit this time separate to the Council. Coinbase had integrated Telegram’s forthcoming token, Gram, with its Coinbase Custody program, days before the SEC slapped the messaging company with an “emergency” lawsuit, which alleged that the Gram token was, indeed, a security.
Ratings and guidance
Of course, the Council’s ratings don’t actually constitute legal advice—they're just suggestions.
Yankun Guo, a lawyer who set up her own law office in Chicago to help early-stage startups, told Decrypt that, “It's positive that there's a group of exchanges trying to push forward a consistent framework," but that the ratings aren't particularly helpful. Guo said that a good lawyer provides their own legal analysis, but the market can be dumb: “When you put something out by industry leader, there's a tendency for people to follow”.
Considering its influence, Guo said that the Council had not done enough to explain how it reached specific ratings. Although the Council explains in general how ratings are calculated, it only provides a few words of insight into the ratings of individual coins, such as, "Decentralized development efforts" for Algorand's 2.00 rating, or "Current functionality of the platform" for Foam's 3.75 rating. This has raised concern from one major player in the industry, the creator of the privacy and payments coin, Dash: “To become a true representative body within the blockchain industry, and maybe even evolve to be a self-regulatory organization, [the Council] should provide full transparency on how the ratings are calculated,” said Dash Core Group’s CMO, Fernando Guiterrez.
Still, while the industry waits for further SEC guidance, the Council is crypto's best bet: “I think it provides good guidance as to what we think we can lawfully list,” said Coinbase’s Brooks. Brooks says the council is an attempt to show the SEC, “How we have decided to operationalize their guidance in a way that is auditable and repeatable. So if it's useful to [the SEC], it's out there in public.”