Guest Commentary
By Daniel S. Alter, a Shareholder in the New York office of Murphy & McGonigle P.C. and a former general counsel for the New York State Department of Financial Services.
Earlier this month, Securities and Exchange Commission (SEC) Commissioner Hester M. Peirce addressed a FinTech conference hosted by the Medici Project, which is a serious effort to build a blockchain-based securities exchange. In her remarks, Peirce discussed two constructive approaches that financial regulators have taken worldwide in response to the tidal shift in technology that supports financial products and services. The commissioner’s message to conference attendees should encourage all those in both the legal and entrepreneurial communities who, to date, have felt only the punitive response of SEC enforcement actions involving initial coin offerings, or ICOs. And yet, Peirce’s comments stopped just short of advocating for the sort of regulatory approach that would likely be most effective in grappling with fast-paced FinTech developments.
Peirce’s speech compares the regulatory “sandbox” model, adopted by several jurisdictions at home and abroad, to her preferred model of the regulator as “lifeguard.” As Peirce notes, in the sandbox, the regulator sits alongside the innovator making sure “that nobody gets hurt,” while also “having a front-row seat on the innovative process.” In that creative space together, the regulator “sits at the entrepreneur’s shoulder as he thinks how to address structural and aesthetic weaknesses in his sandcastle.”
But Peirce astutely observes that the very dynamic of the sandbox may invite the regulator to “grab hold of the shovels and buckets,” and thereby “try to control the development of new technologies.” She conscientiously worries that such behavior falls “outside the regulator’s proper function,” and could “result in the regulator forcing new technology to fit existing – and familiar – regulatory frameworks regardless of whether those frameworks are appropriate.”
To avoid that pitfall, Peirce argues that it is better for a regulator to act like a lifeguard on the beach – keeping a vigilant watch over swimmers and swim conditions so that “she can spot dangerous activity and intervene with a blow of the whistle or, if necessary, a direct intervention.” Setting aside the metaphor, the commissioner describes a regulator as one who “monitors the landscape, steps in to stop violations when they occur, and stands ready to answer interpretive questions as people seek to understand how the rules apply to their situation.” And according to Peirce, although “[e]ngagement with the regulator is welcomed,” the regulator should “leave[] ample room for innovators to develop their ideas without the regulators sitting at their shoulders taking part in each creative decision.”
Indeed, the stated purpose for Peirce’s whole speech is to ask the FinTech industry how, as a regulator, she could be “a better lifeguard.” To that end, she readily admits that she could not do her job if she did not know what the market needs, and that she hopes more participants in crypto-asset businesses would come speak with her because: (1) she has numerous questions regarding the application of existing securities regulations to digital securities; and (2) a “spirited back-and-forth” helps “regulators do their jobs better.” Fair enough, but the commissioner’s invitation is not entirely realistic. As she herself acknowledges, “[i]ndustry participants may be afraid to ask necessary questions and may avoid—rather than speak frankly with—the regulator.” The age-old warning not to wake a sleeping bear looms large over many in the FinTech space.
There is another old saying—a good lifeguard never gets wet. Good lifeguards must work hard to reduce the risk of emergencies. They must be proactive, and not simply reactive, or they end up in the water.
So too with regulators. The SEC should not sit passively and wait for FinTech industry representatives to initiate conversations with the agency. That strategy could be akin to waiting for a struggling swimmer’s third time under before first attempting a rescue. And while the SEC’s Division of Corporation Finance is doubtless working extremely hard to analyze the implications of FinTech developments on securities regulation, its efforts could only benefit from a formal administrative fact-finding process.
In short, Commissioner Peirce could be a better lifeguard if the SEC were to hold hearings in which she and her colleagues would ask invited crypto-industry experts probing questions, and otherwise receive information, about the application of existing rules and regulations to new technologies. Comprehensive input from market actors solicited by the SEC is necessary for the agency to make informed and “appropriate regulatory allowances that clear the way for innovation to flourish.”
Consistent with that view, Peirce underscores that the job of a financial regulator “includes evaluating new and existing regulations in light of market changes to ensure those rules are still well-suited to their intended purpose and do not unnecessarily stifle growth.” But no regulator can adequately perform that task if the agency does not sufficiently inform itself of the full scope of the market changes at issue. The SEC not only needs “to approach ICOs and tokens with intense curiosity,” it needs to take concrete steps to satisfy that curiosity.
One final thought. Commissioner Peirce wisely recognizes that “there comes a point where regulatory uncertainty is a greater roadblock [to innovation] than confinement within a particular regulatory regime.” Entrepreneurs generally want to know the legal risks associated with any investment before they put down their money, and if those risks are too ambiguous they will simply take their money elsewhere. The regulatory sandbox model responds to that challenge by providing investors with helpful clarity. If they invest in sandbox ventures, they are insulated from regulatory risk.
How can lifeguards provide similar comfort? Peirce hints at a response: lifeguards must “stand[] ready to answer questions about the rules of the beach.” But what does (or should) it mean for a regulator to “stand[] ready to answer interpretive questions” about the application of pre-existing rules in a rapidly changing technological environment? Again, the idea of standing ready should imply the regulator’s proactive willingness to engage in interstitial problem solving.
That the SEC wants to set policy incrementally in the crypto space is both understandable and preferable, at least until it more thoroughly comprehends the impact of technological changes on the agency’s mission. However, during that period, the agency should use its full set of administrative tools, including commission statements and interpretive releases, no-action letters, and interim rulemakings, to combat regulatory uncertainty and its drag on innovation. At least seemingly for Commissioner Peirce, the SEC’s refusal to do so would be “for us to bury our heads in the sand.”
Hopefully, there are lifeguards at the Commission who prefer to stay dry.