During early March 2017, on the brink of the South African Blockchain conference, wearing the Bitcoin badge of innovative positivity was the article entitled “Financial Product Wrappers: A Regulatory Home for the Wayward Bitcoin” written. An article inspired by the then pending Winklevoss Bitcoin exchange traded fund (“ETF“) application, the approval of which was at the mercy of the United Stated Securities Commission (“SEC“).
On 11 March 2017, the SEC rejected the Winklevoss BitCoin ETF, reaffirming the concerns of the conservative Bitcoin contenders whilst frustrating Bitcoin aficionados worldwide. Amidst criticisms of the decision from the accuracy of the information that was considered to lack of understanding of the BitCoin ETF concept, there is a crucial and global lesson to be learned from this decision: The SEC, a regulator within the United State financial services industry, rejected the BitCoin ETF on the premise that the product is a threat to consumer protection. A premise that informs the Bitcoin concerns expressed by various regulators around the world including our own. A premise that may be fundamentally flawed.
The SEC Decision
In a 38-page decision setting out commentary from both sides of the BitCoin debate, the SEC rejected the Winklevoss BitCoin ETF on the premise that approving the ETF would be contrary to the US securities laws which obligate national securities exchanges to ensure the prevention of fraudulent and manipulative acts in order to protect investors and the public interest.
This protection of investors, as elaborated by the SEC, is the product of a chain of events. Investors are protected where sufficient surveillance-sharing agreements are concluded between the ETF and the underlying BitCoin markets. Such agreements may only be concluded with regulated underlying markets. BitCoin markets are currently unregulated and as such, no surveillance sharing agreements can be concluded, and investors cannot be protected.
Despite rejecting the BitCoin ETF, the SEC’s decision does, however, conclude with a message of hope: Whilst noting the BitCoin market is still developing and unregulated, in time and pursuant to regulation of the BitCoin market, the SEC may reconsider its decision in this regard.
The Deciding Provision
Amidst the assertions made by various BitCoin commentators, the submissions of by the Winklevoss BitCoin ETF trust, as well as the crash courses on the BitCoin economy and the structuring of exchange-traded-funds, the SEC’s decision was primarily based on its application of section 6(b)(5) of the United States Exchange Act (“the Deciding Provision“).
As succinctly set out by the SEC the Deciding Provision comprises of two elements:
- An overarching objective: “the rules of a national securities exchange must be designed to prevent fraudulent and manipulative acts and practices and to protect investors and the public interest.”
- The requirements needed to achieve the overarching objective: “The Commission believes that, in order to meet this standard, an exchange that lists and trades shares of commodity-trust exchange-traded products (“ETPs”) must, in addition to other applicable requirements, satisfy two requirements that are dispositive in this matter. First, the exchange must have surveillance-sharing agreements with significant markets for trading the underlying commodity or derivatives on that commodity. And second, those markets must be regulated.”
The Deciding Provision essentially creates the circular inquiry where the answer to question of whether the overarching objective can be achieved is determined by first answering whether the requirements have been satisfied – Albeit such requirements not stemming from the context specific question of what is needed to achieve the overarching objective.
While the Deciding Provision may be rooted in US law, its conflated inquiry is echoed in the investor protection legislation of various other jurisdictions, including South Africa as a tried and tested approach to determining whether new financial product entrants pose a risk to consumer protection. A cart-before-the-horse approach which equates the satisfaction of pre-determined requirements for consumer protection to the contextual overarching question of whether consumers will actually be protected, and how.
But it works…
It works because the requirements for consumer protection stem from a long established understanding of the traditional asset markets that underpin financial products such as ETFs. An established understanding of the manner in which such markets operate and how such operations can ensure consumer protection.
However, the emergence of digital asset markets do not form part of this established understanding, and accordingly, the fundamental flaw in the decision of the SEC is the presumption that established consumer protections applicable to traditional asset markets is the bar by which digital asset markets should be measured.
Consumer Protection and Digital Assets
Within a digital asset inquiry, consumer protection can no longer be a conflated question. To apply the conflated inquiry would be to presume that digital assets and traditional assets operate in the same manner, share a common structure and / or are of the same nature. This is, however, not the case.
Digital assets are uncorrelated to the economic events which impact traditional assets. Information on digital assets and its manner of dissemination differ significantly from the established methods utilised by traditional assets. The method in which digital assets are distributed (e.g. the Blockchain) is markedly different from the manner in which traditional assets are distributed or the market participants that may be involved.
The consumer protection inquiry in digital assets thus, requires two distinct questions to be asked:
- What are the consumer protection objectives that need to be achieved?
- Given the nature of digital assets and the manner in which is differs from traditional assets, what requirements need to be met to ensure consumer protection within the digital assets space?
Lessons for the Regulators
- In the emergence of fintech, cryptocurrency and digital assets, regulators must refrain from applying traditional principles and ideologies to the manner in which such sectors are regulated or even to way in which such products are perceived.
- The purpose of housing BitCoin and other cryptocurrency in financial products is not encourage retail consumers to access unregulated assets, the purpose is to bring such assets into a regulated space where its development and distribution and can be monitored and regularised.
- Consumer protection should be objectives based, with clearly formulated objectives, as opposed to rigid requirements. The question should be whether digital asset financial products are or can be structured in such a way to achieve consumer protection objectives – not whether digital asset financial products satisfy consumer protection requirements developed on the back of traditional assets.
- As much regulatory approval or the regulating of BitCoin and BitCoin financial products may require further development of the BitCoin market, the development, demand and stability of the BitCoin market requires regulatory endorsement in the first instance. Regulators are not an eventual stop in the BitCoin journey; regulators are intricate to the development of BitCoin as a tool in building financial inclusivity.
Lessons for the BitCoin Financial Product Suppliers and Market Participants
- It is crucial for BitCoin financial product suppliers and BitCoin market participants to gauge a clear understanding of the regulatory concerns that underpin BitCoin. Technological developments in the mining, distribution, storing and monitoring of BitCoin must encompass consumer protection mechanisms that respond to regulatory concerns.
- Regulatory inquiries and engagements pertaining to BitCoin financial products will naturally stem from existing financial services legislation and the extent to which existing controls and mechanisms may be applicable to BitCoin financial products. Suppliers and market participants must have regard for such legislation as well as the extent to which its application does not envisage digital assets but rather traditional assets.
- The sharing of information regarding BitCoin as a digital asset with both consumers and regulatory bodies must be a priority of suppliers and market participants.
South Africa’s Saving Grace
Notwithstanding the position in the US or our current turbulent political and economic climate, the South African financial services industry finds itself in an interesting phase within is regulatory development. As South Africa moves toward the adoption the Twin Peaks model of financial regulation, a host of proposed legislation and proposed amendments to existing legislation is on the precipice of coming into effect and essentially reforming the entire financial services sector.
As we near the impending regulatory regime and the process of de-crystallising the legacy business practices within the financial services sectors, digital asset financial product suppliers and market participants are currently presented with a unique opportunity to proactively affect that manner in which the fintech industry at large may be regulated.
Outcomes Based Consumer Protection
Consumer protection is moving away from a rigid rules based approach to outcomes based focus. Suppliers and market participants need to be able to demonstrate that BitCoin financial products, in accordance with its own processes and technology which may differ from that of traditional assets, sufficiently satisfy these outcomes.
Industry Engagement
In the process of promulgating new legislation as well as amendments to existing legislation, proposed legislation is open for public comment and thus, presents a key opportunity for regulator engagement and ensuring that the fintech stakeholders’ concerns are reflected in the incoming legislation. Suppliers and market participants must utilise the opportunity by commenting on incoming legislation.
The Financial Inclusion and Transformation focus
The Regulator has expressed the need to increased accessibility to appropriate financial products and the development of means to better financial inclusivity of those current marginalized by the financial services sector.
The financial inclusion and transformation focus echoes the very objectives BitCoin, digital assets and fintech seek to achieve within South Africa. This shared aim is the crucial departure point from which archetypal financial service concepts such as consumer protection can begin to develop mechanisms which align with the unique needs, risks and nature of digital assets.
Seshree Govender of Webber Wentzel
About Webber Wentzel
Founded in 1868, Webber Wentzel is today one of Africa’s leading law firms with a total staff of approximately 800 with offices in Johannesburg and Cape Town. Our core strategy is to support our clients wherever they do business. We are a full service partnership with deep expertise and experience across a comprehensive range of sectors. A deep understanding of our clients’ needs and our tailored approach has led to numerous independent awards, both in South Africa and on the continent. These include being named Africa Law Firm of the Year at the African Legal Awards Sub-Saharan Africa Legal Advisers of the Year at the European M&A Awards hosted by the Financial Times and Mergermarket, and Who’s Who Legal South African Law Firm of the Year for five consecutive years. Core to the ethos of our firm is the belief that diversity is the key to delivering effective legal services in South Africa. In harnessing the varied experiences, perspectives and backgrounds of our partners, employees and stakeholders we ensure that we are able to serve our clients appropriately. The firm’s collaborative alliance with Linklaters provides clients with market leading support across Sub-Saharan Africa and beyond through Linklaters’ Anglophone, Lusophone, Francophone and US law capability. It also provides us with access to ad hoc international law advice on matters. Webber Wentzel’s offering is further enhanced by its network of best friend law firms across Sub-Saharan Africa, and its associate membership of ALN, an integrated network of African law firms.
