Four years ago this week, Security Exchange Commission’s (SEC) Director of Corporation Finance William Hinman detailed a vision for regulating digital assets. The speech was a bait and switch. It promised the opening of a blockchain revolution, the next chapter in the American innovation success story. In practice, the SEC wants to hammer crypto out of existence. On that fateful day, Hinman said that decentralization of a blockchain ledger, where tokens are being “used to purchase a good or service through the network on which it is created”, could transform a digital asset into a commodity outside the SEC’s purview. He opined that once they became “sufficiently decentralized”, a token and its network could operate without fear of an SEC enforcement action for failing to register like a stock. How wrong he was.
Decentralization was the goal from the beginning
Everyone who participated in launching the first blockchain ledgers like Bitcoin, XRP and Ethereum, understood that decentralization was the point. Blockchain technology was developed to remove friction from the economy and enhance the power of peer-to-peer activity. Bitcoin developed the idea of a currency to trade or store value without bankers involved. XRP became a bridge token for clearing and settling cross-border cash payments without intermediaries. Ethereum became a network for carrying out complex peer-to-peer agreements, nicknamed “smart contracts”. The millions of hours in code writing and billions of dollars in investment to build these groundbreaking networks were not meant as get-rich-quick schemes. Rather it was careful engineering to improve the technology of money (think computers over typewriters or email over letters) and to lessen its cost.
Hinman’s speech singled out Bitcoin and Ethereum’s native token ether, and said they are not securities, sending ether’s price through the roof. But all hope ended there, as the SEC took a 180 degree turn from Hinman’s speech and launched a barrage of enforcements contrary to Hinman’s guidance.
The SEC’s Bait and Switch
On his last day in office in December 2020, then SEC chairman Jay Clayton, Hinman’s boss and hiring manager, filed a lawsuit against Ripple, an enterprise software company that sells cross-border payment solutions to banks and uses XRP to settle transfers. The SEC alleged that XRP’s only utility is as an investment contract in Ripple. Further it characterized every sale of XRP by anyone – be it Ripple, some other company using the XRP ledger, or XRP holders who traded it on the secondary markets without knowing anything about Ripple – is an unregistered securities transaction involving Ripple shares. XRP itself is a security, not the way it is packaged and sold. Worse yet, the SEC made the mindboggling allegation that everyone should have known XRP was a security since 2013 when its network debuted. (That would include Hinman and all the SEC staffers who helped him write his 2018 speech, one would presume.)
The enforcement action against Ripple is the opposite of what Hinman said. XRP was devised to be a decentralized network from inception, and Ripple controlled less than 5% of the nodes on the network’s consensus protocol when it was sued. Furthermore, the suit contradicts the core logic of Hinman’s speech, that tokens themselves are not securities, but the way in which they are packaged and sold can create securities transactions. In the Ripple case, the SEC indicts XRP and all who trade it, even if they are buying groceries or gasoline with it in a transaction having nothing to do with Ripple.
Ripple’s lawyers have used the Hinman speech in their defense, which led the SEC to tell the court that Hinman’s speech was “irrelevant” and his own “personal opinion” even though a long list of SEC officials – and apparently some Ethereum-connected investors – had a hand in writing it.
Transparency could expose SEC fraud
The SEC has fought transparency requests on the genesis of Hinman’s speech’s relentlessly, the revelation of which could expose potential agency fraud. Innocent XRP holders lost $15 billion in value and entered the case as friends of the court against the agency. They crowdsourced documentation showing Hinman had multi-million dollar financial interests in a law firm promoting Ripple’s competitor, Ethereum.
Hinman’s speech could have been a revolutionary turning point for American innovation, but it became an unmitigated disaster. Not only did Hinman deceive the public and materially harm thousands of investors, he and his cohorts brought severe damage to the SEC’s credibility and integrity. The SEC made a mockery of its mission to protect investors.
However regulatory scholars are not surprised. They have demonstrated over decades that captured agencies like the SEC favor their preferred players like regulated banks over innovators and consumers. With increasing regulation, Congress has made the problem worse. Now the only backstop is the courts where aggrieved innovators attempt to get a fair shake. Magistrate Judge Sarah Netburn may order the SEC to end its obstruction and provide the internal documents on Hinman’s speech. This could expose the SEC‘s market deception and force a settlement with Ripple. The first step of a long overdue reckoning for the agency may be at hand.