Stephen McKeon, the Chief Strategy Advisor to Security Token Academy, a finance professor at the University of Oregon, and a partner at Collaborative Fund, was a guest on a recent episode of the newly-launched Coinlaw Podcast.
McKeon’s work, focusing on security issuance, M&A and cryptoassets, has been published in top academic journals and cited in media outlets such as the Wall Street Journal, Financial Times, and CNBC. In our interview, we focused on crypto regulations in the US.
- If regulation is thoughtfully composed, it actually can have a beneficial effect on the crypto space.
- There still is a tremendous amount of regulatory uncertainty. Establishing some safe harbors, perhaps through no-action letters would be the right move.
- SEC takes time to change its direction. We are looking probably at 12 to 18 months out before we get a higher degree of regulatory certainty.
- With smart contracts, the logic of regulatory compliance can be put in the security itself whereupon it can reference a white list or some other form of identification and check off all the boxes. There is a long way to go in bringing all of this on the chain, but that’s the vision.
- Existing regulation is sufficient to launch an STO, but there is room for a lot of improvement in the regulatory environment, particularly around the way disclosure is executed, the way records are kept and the way retail investors are allowed into the space.
- Technology can be used to democratize access and bring retail investors back into value creation.
How did you get involved in this industry?
I’ve been involved with emerging technologies since the beginning of my career, which started in Silicon Valley, right at the height of the Dot-com boom, back in 1999-2000. I also have a Ph.D. in finance, so I fell into blockchain because it was the perfect intersection of those two skill sets. I guess it really started when I was introduced to Chris Burniske, back when he was at ARK, I credit him with my early education in this space, getting me to jump down the rabbit hole, as they say.
As the space exploded in 2017, I found myself gravitating towards the impact on financial securities, since that’s been my research focus as a professor. It was around that time that I linked up with Harbor as an advisor and also joined Security Token Academy (STA) as the Chief Strategy Advisor. STA is an online resource, we do interviews with corporate member, groups like Harbor, and Securitize and many others; we have something called “The Digital Wrapper”, which is a series of interviews with teams; and we publish the Security Token Edge, which is a newsletter that gets delivered straight to your inbox – access to all of that can be found on securitytokenacademy.com. And the most recent initiative has been CREST, which is Commercial Real Estate powered by Security Tokens, to really dive into commercial real estate and how that’s going to be redefined by security tokens and tokenization.
It’s a lot of hats to wear and an exciting sphere to be in; exciting also for the regulators, who are trying to put some order in it. Can you tell me what is the current regulatory landscape when it comes to blockchain and cryptos in the United States?
We really have a patchwork of regulators who regulate different aspects, depending on different projects and what they are trying to accomplish. We’ve got the SEC and they primarily use the Howey Test as a framework; we’ve got the CFTC and they are the entity that regulates Bitcoin for example, and then we have a variety of other regulators – the IRS for tax law, FinCEN, and several others. Plus, every state also potentially regulates securities, has its own tax laws, and so on and so forth.
So, are cryptocurrencies, is the technology currently regulated in the US?
Absolutely. You could think of the technology as having many different applications, so cryptocurrencies that are fully decentralized might be regulated in one way, while tokenized securities that represent equity, debt, or real estate, might be regulated in a different way. I wouldn’t say that there is a one-size-fits-all regulatory approach to this space.
On the topic of regulators, you’ve been positively surprised by comments from Hester Pierce, an SEC commissioner, who recently said that Howey Test might not be the optimal test for establishing whether cryptoassets are in fact securities. Can you elaborate?
The Howey Test is pretty dated at this moment, it dates back to 1946. It’s a useful framework to start from, but a lot has changed in 73 years. The information I really welcomed from commissioner Pierce, is the idea of welcoming innovation and democratizing access. With regards to Howey Test specifically, what was really interesting were commissioner’s Clayton’s recent comments, specifically around this idea of digital assets, whether they are securities, and that it’s not necessarily a static determination.
In the 1940s decentralized networks were not a paradigm that was envisioned yet, and so Clayton said that digital assets transaction may no longer represent an investment contract if, for example, purchasers would no longer reasonably expect a person or a group to carry out the essential managerial or entrepreneurial efforts. I thought this was a really interesting quote, especially the idea that even if you are using the Howey framework, a digital asset may have departed from that framework in terms of being a security. I thought that was a really useful comment for the industry, just to get a little clarity on what we saw commissioner Hinman comment on a while ago.
You mentioned that a lot has changed in those 73 years. Isn’t this one of the biggest issues with the industry, that it’s evolving so fast that it’s difficult to put it down in law?
That’s exactly right. I think it’s always the case that emerging technologies outpace regulation. This is something I’ve seen throughout my career. I’ve been involved with a lot of different emerging technologies, for example, back in 2012, I co-founded a company in the commercial drone space and it was pretty much the same thing: the technology had outpaced the regulation and the FAA (Federal Aviation Administration) really had to scramble to catch up. And now we’re seeing effectively the same thing in financial securities.
Is there a point of compromise between the industry and the legislators?
You’d like to hope so. I know that the way the FAA approached it, which I thought was really useful, was that they really engaged the industry as they were contemplating what the regulations should look like. If you look at it from the standpoint of a regulator, there are two trade-offs: one is that they want to do protection of the public, whether it’s the airspace for the FAA or the investors for the SEC, but on the other side, if the regulation is too heavy-handed, it can have the effect of quashing innovation or sending it offshore, neither of which is an optimal outcome. So, you’d like to think that financial regulators will engage the industry, so they can figure out how they can thread the needle.
I get the impression that, on one hand, the industry asks for regulations to make the space more organized, hence more trustworthy. But on the other, when the regulation does come, there is a lot of pushback. There seems to be a bit of a schizophrenic approach, isn’t there?
I think you’re always going to have participants with different incentives, and so with almost any regulation that comes out, there’s going be a minority, perhaps a vocal minority, that’s going to push back. Based on what I saw in the commercial drone industry, where it was Part 107 that came out from the FAA that really set down the rules on how you can operate a commercial drone legally, regulation actually spurred a huge wave of innovation, it brought larger companies with enormous resources into the space and effectively allowed everybody to operate under a higher degree of certainty. I think if the regulation is thoughtfully composed than it actually can have a beneficial effect on the space. But not everybody feels that way.
What do you think is the biggest roadblock that the industry is facing when it comes to regulations?
There still is a tremendous amount of regulatory uncertainty, we don’t think the SEC can continue only with consent orders. It would be nice to establish some safe harbors, perhaps through no-action letters – as long as you do X, Y and Z, you’re going to remain compliant. I think what the industry is looking for at this point, is some clarity so that everyone knows how to comply. Because one of the problems in these environments of uncertainty is that even if you want to comply, it’s sometimes difficult to know how to do so.
What do you think should be the direction of the regulatory evolution, or maybe what do you think it will actually be?
As I said before, I think the industry is really looking for the establishment of some safe harbors through no-action letters, I think that’s one of the best things the SEC can do. I’m hopeful that that sort of clarity comes out, but the SEC is kind of like a large ship, it takes a while to turn it in any particular direction, and so, I don’t think this is going to happen in the next few months, I think we are looking probably at 12 to 18 months out before we get a high degree of certainty.
And if and when that happens, you expect similar growth as you’d observed before, in the drone industry?
Yes, we already see a lot of institutional interest in the space, they are starting to dip their toes in, but again, many of them are hesitant, given the regulatory environment. I would anticipate that with additional regulatory clarity, you’ll get more participants in these markets as well.
Let’s talk about tech. How does blockchain technology fit into legislation, or rather the other way around? I’m talking specifically about automation – can legislation be digitized and put on blockchain?
Contracts can certainly be digitized and reference specific elements of regulatory compliance – these are the types of projects that Harbor and many others are building. In the past, the way we imposed compliance with regulations was through so-called “walled gardens” – for example, if you and I wanted to trade shares of stock, we’d have to get accounts at regulated entities and once we were in these “walled gardens”, each of those entities was responsible for keeping track of us and now we could trade.
But what we can do now, with the advent of smart contracts, is to actually put the logic of the regulatory compliance in the security itself. And so, when it passes from your wallet to my wallet, regardless of whether it’s through a regulated exchange, or a decentralized exchange, or simply peer to peer, the security itself can reference a whitelist or some other form of identification, and check off all the boxes: Whether it’s that you need to be accredited investors, be within a certain jurisdiction or some sort of an income test. There is a long way to go in bringing all of this on the chain, but that’s the vision.
Aren’t security token a regulator’s dream, with everything up there, in the ledger, instantly available to see?
I think they could be, and that is actually the way we are pitching it to regulators – once the reporting features are built out, it should be much easier to audit whether a particular security or a particular entity is in compliance or not. So, in some way, I believe it is going to make the regulator’s job much easier, once these things are deployed because you’re not going to have to go through a costly audit process, where there is a lot of information collection. It should be that the information is far more readily available.
Some regulators think that existing regulation is sufficient. What do you think?
I think you can issue security tokens entirely under existing regulations, and that’s the way you’re seeing them done today. They are using Reg D, Reg S, Reg CF, Reg A+ in some cases; we have a suite of security laws that can be utilized today. But I think the place where there is room for improvement is really around the question of credit investors and access for retail investors.
Going back to Commissioner Pierce, her comments around welcoming innovation and democratizing access were the most exciting. She asked: “Can we look for ways for unaccredited investors to pull their resources to invest in private companies?”, and: “Can we change rules that mandate the use of outdated technology, for example, recordkeeping rules, so that financial institutions can incorporate new technology and lower the cost of the services they provide?”, or: “Can we re-examine our assumptions about the types and methods of disclosure we require in light of the enormous change in the means of communication and technology? And can we permit more issuer communication with investors that can open the door to a back and forth type of disclosure by online chats and message boards?”.
So yes, while I think that it’s true that existing regulation can get the job done, there is room for a lot of improvement in the regulatory environment, particularly around the way disclosure is executed, the way records are kept and the way retail investors are allowed into the space.
But it is good to have a friend on the other side, isn’t it?
It’s always good to have a friend on the other side, absolutely! I think the crypto community has really welcomed these comments. If you step back and look at value creation, if you’d look back a few decades at companies like Microsoft, or Intel or other earlier tech companies, a lot of the value was created after IPO. But what you’re seeing now, is many companies that are delaying IPO, whether it be Uber or Airbnb, and they are reaching evaluations of billions and billions and billions of dollars, and all of that is accruing in the private markets. And so, retail investors are, to some degree, shut out of these markets. If we can use technology to democratize access and bring the retail investors back into some of that value creation, I view that as a good thing.
The dream is to tokenize everything, from art to property, when do you think this dream will become a reality?
We are already seeing it start. Real estate and funds are really the first two items, there have been some efforts around tokenizing art as well. It’s still early days. Again, many of these are being executed under Reg D, which has a 12-month lockup before they are tradeable, so even the items that we are seeing tokenized in 2019, won’t be tradeable until sometime in 2020. So, while I think it’s already begun, we are going to see it pick up a lot of speed over the coming years. More and more projects are coming to the market, in terms of platforms, in terms of trading venues, in terms of base layers that can optimize some of these items around security and throughput. I’m excited to watch it unfold.
If you were giving advice to regulators on how to approach security tokens adoption, what would it be?
I don’t know if they need my advice, I think they need to listen to commissioner Pierce, because what she said lines up very similarly with the way we view things – current regulations are sufficient and we can get some things done with them, but for the space to really flourish, it would be great to open up access, welcome innovation with open arms and look what it, not just blockchain but technology generally, can offer in terms of disclosure and interaction between the projects and investors.
This interview has been edited for clarity. Listen to the full podcast episode featuring Stephen McKeon here.