Toxic Taxonomy: what does not work with the regulation approach on cryptoassets

With the widespread of the cryptoassets, ICO, STO, NFT, DeFi, DEX have become popular terms in the crypto jargon. Moved by the understandable fear that this crypto hype could harm public interests, regulators all over the world have started to set a regulatory regime for cryptoassets in the last few years.

The first regulatory approaches have been focused on identifying categories and subcategories of tokens, thus creating the token taxonomy. Security token, utility token, and payment token are the terms coined to represent the main three macro-categories of the taxonomy. Regulators exploit this taxonomy to identify, based on which category the token is part of, what discipline should apply to that token. This method, called functional, has been widely used in comparative law, where scholars analyze differences and similarities between the legal systems of different countries. The functional method offers a methodological tool based on the principle that different rules can have similar functions in different legal systems. The functional method considers the elements of a legal system with the function they have in responding to a social problem. This method recognizes that other systems may use different instruments to meet the same need; the comparison between different legal systems takes place paying attention to factual circumstances, such as consequences of certain legal acts or facts, as legal elements must be read and understood in the light of their functional relationship with society. As part of the governance of a DLT system, the regulator assesses which elements of the DLT system have the corresponding function to elements within the legal system; based on this connection, the regulator applies the rules set for those elements to the DLT system.

Taking as an example the security tokens, the regulator assesses on a case-by-case basis whether a certain token has the functional characteristics of a financial instrument and, if so, the securities regulatory framework shall apply. Therefore, the issuance of the token must be accompanied, for example, by a prospectus and the issuer shall be supervised by the market surveillance authority, which has the power to issue sanctions if the token issuer does not comply with the regulation applicable to other market operators. This brings to treat a token as security depending on the definition of security in the various legal systems. The US legislation identifies the securities including ‘any interest or instrument commonly known as a security’. The founding elements of security were set by the Supreme Court which provided the definition of investment contract and which established that each security falls within the macro-category of investment contracts. The ‘Howey test’, a principle deriving from the well-known case SEC v. W. J. Howey Co. (1946), identifies four criteria for an investment contract: investment of money; raising funds from a pool of investors called to share profits or losses; expectation of tangible benefits which shall derive solely from the activity carried out by the person proposing the investment or by third parties. Therefore, identifying a security is a complex interpretation exercise, which may bring diverging outcomes. Moreover, not every jurisdiction follows these criteria to define a security. Consequently, the functional approach is far from achieving the same results when applied in jurisdictions that have a different regulatory framework on securities. It should also be remembered that the functional approach disregards the formal qualification given to the cryptoasset by the issuer, in fact overcoming any conventional agreement. In addition, according to the functional approach, if the token has, beyond the features of a security, also other ones, as for the example of governance , the token may fall into the category of securities due to the power of attraction, also called ‘vis attractiva’.

The functional approach shows its weaknesses mainly related to the fact that an existing framework, designed for a certain context, is adapted to a completely new environment. The functional approach requires a case-by-case assessment, subject to margins of discretion on the side of the token issuer and the regulator. If we are asked to trust the token issuer in carrying out this assessment, we have the risk that certain projects will not properly qualify their token. If the regulator carries out the assessment, it has to be decided whether it is appropriate to obtain the authorization ex-ante, before the launch of the initiative, or whether the regulator should intervene only ex-post, in case of law infringements. In the first case, in addition to the increase of public funding for performing all the compliance checks, there is a risk that a project which receives the endorsement of the regulator before being proposed to the public, will be subject to changes or adjustments when it is presented to the market, thus impacting the regulatory protection function. In addition, multiple initiatives could be inhibited, as the need to receive prior approvals could be seen as an obstacle. In the case of ex-post control, the regulator would stop scam projects that, in most cases, have already committed frauds against investors. Moreover, it seems difficult even to identify, as in the case of a DAO, the responsible entities behind a certain initiative, as decentralized protocols exist in an extremely liquid context, disconnected from clearly identifiable entities. This jeopardizes the possibility for the supervisory authorities to offer effective protection to investors.

Although the token taxonomy may be useful to see the state of art in the cryptoasset scene, we need to be careful in thinking that this taxonomy can provide clarity and legal certainty. Most of the regulatory interventions in the cryptoasset field carry out a balance of the different interests at stake, from attracting investments, on the one hand, to the need to protect public or national interests, on the other. Therefore, regulators embrace token taxonomy to create a fertile ground for these new industries, and, at the same time, to limit initiatives in the crypto space following the procedures and criteria used for other situations. The real contradiction of the functional approach stays in trying to exploit the hype generated by investment opportunities in the cryptoassets by re-proposing the same regulatory schemes used in the past, without really questioning what role the regulator should have in a world moving with new dynamics.