Dragonfly Partners: How Do U.S. SEC Regulatory Actions Affect the Cryptocurrency Market?

This article was published on ChainNews, written by: Lindsay X. Lin, partner and legal head of the blockchain investment fund Dragonfly Capital, translated by: Perry Wang.

On January 4, 2018, the Texas Securities Commission issued a cease-and-desist order, requiring the suspension of BitConnect's lending and staking programs, halting its upcoming initial coin offering (ICO), and stopping BitConnect tokens ("BCC"). The regulatory authorities claimed that BitConnect's products were unlicensed and unregistered securities.

When I read the tweets about this news, I opened CoinMarketCap. I thought BCC would face a crash in the market, after all, this meant BitConnect was notorious for being classified as a Ponzi scheme. Although theoretically, the Texas Securities Commission's authority is limited to within the state, this action would clearly open the floodgates for scrutiny and enforcement by other regulatory bodies.

Despite the news being several hours old, the price of BCC had only dropped by less than 4%.

At that time, the price of BCC remained relatively stable for three consecutive days before starting to decline slowly. On January 9, the North Carolina Securities Commission also issued a cease-and-desist order. By midnight that day, BCC had dropped 20% compared to its price on January 3, and the downward trend continued. Ultimately, on January 16, its price plummeted by over 80%, crashing from $200 to $30. BitConnect subsequently announced that it would shut down operations due to these cease-and-desist orders.

If there had been an easy way to short BCC immediately after the Texas cease-and-desist order was issued, traders with their ears to the ground could have made a significant profit. Within a month, BCC fell from about $450 to $7.

What can traders learn from this anecdote? At that time, the crypto market was still too simplistic, and derivatives were immature, leading to the bizarre event of BitConnect. Nowadays, traders typically possess more relevant knowledge and information, and the range of products offered by derivatives exchanges has expanded significantly. Is it still possible to gain positive trading opportunities based on news of enforcement actions by securities regulators?

Although BitConnect ceased operations under the orders of state securities regulators, the U.S. Securities and Exchange Commission (SEC) is undoubtedly the most active and influential securities regulator in the United States, significantly impacting crypto projects entering the U.S. market. This article analyzes whether shorting crypto assets based on SEC enforcement information can be profitable.

The answer: perhaps sometimes it can make money.¹

Fundamentals

First, let's look at why the underlying assets of a project would experience a price drop if the SEC sues it for conducting an unregistered, unexempt securities offering.

First, litigation is an expensive and time-consuming process. Most projects are already overwhelmed by the need to deliver code, products, or partnerships quickly, and the evidence disclosure, written interrogatories, negotiations, court appearances, and everything else involved in litigation is a time sink for the company. Additionally, the initial stages of securities litigation can cost hundreds of thousands to millions of dollars, leaving almost no funds in the project's treasury for actual development.

Second, SEC lawsuits damage the reputation of the relevant projects, which can often be precarious. Potential business partners, investors, and employees are reluctant to work with a company accused of serious misconduct that may soon shut down. Community members may feel they do not want to bear regulatory risks and turn to other communities.

Third, since most cryptocurrency exchanges are not securities broker-dealers, exchanges are likely to delist the relevant tokens to minimize the risk of trading securities. This will harm the liquidity of the token, making it harder for people to acquire and use it.

Fourth, the SEC may require the project to register its token sales as securities offerings. If this happens, trading of the token can only occur on securities exchanges and alternative trading systems (ATS), and it must comply with securities trading restrictions. If the relevant token is a payment token or used for decentralized activities, the friction brought by registration will almost completely stifle its utility.

In short, once news of an SEC lawsuit against a project breaks, the value of its token will drop.

Conversely, it can be said that if a project reaches a favorable settlement with the SEC, the outcome will be quite different: if the settlement requires a fine but allows the token to trade normally as it does today, it may cause temporary brand damage, but at least the project can continue to develop. It can even be argued that the project can push its development with greater regulatory certainty.
Analysis

I personally tracked SEC announcements against certain projects and the subsequent price movements of their tokens over 1 day, 7 days, 30 days, and 90 days. Since market movements tend to drive all tokens (and vice versa), I also examined the prices of tokens in terms of both USD and BTC.

Given that this analysis focuses on vertical market price impacts, I excluded tokens that were required to repay investors, provide refunds to token purchasers, and/or register as securities with the SEC, such as Bitclave CAT, Dropoil DROP, Gladius GLA, Paragon's PRG, and Airfox's AIR. These tokens are not publicly traded yet, so there are no market prices.

I categorized the remaining tokens into two groups: those that received "positive" resolution news (e.g., no need to provide refunds to purchasers, or settlements or final judgments that do not require the tokens to be registered as securities) and those that faced SEC lawsuits. I included Kik's KIN in both categories, as Kik had made progress in the litigation before a final judgment was reached.

Positive resolutions:

• EOS ("SEC reaches settlement with Block.one")
• SALT ("Salt Blockchain Inc. f/k/a Salt Lending Holdings, Inc." somewhat spared from SEC scrutiny)
• KIN ("SEC makes final judgment against Kik Interactive for unregistered issuance")

SEC lawsuits:

• LBC ("SEC sues LBRY, Inc.")
• XRP ("SEC sues Ripple Labs et al.")
• KIN ("SEC sues Kik Interactive Inc.")

Price Movements

I tracked the end-of-day prices for each relevant token on T-1, T, T + 1, T + 7, T + 30, and T + 90, where T is the announcement date. I then calculated the percentage change in price from the end of T-1 to each of the other dates to track the trend over time. For example, a 0.00% change at T + 7 means the token price changed compared to T-1.

Positive Resolutions

SEC Lawsuits²

Findings

Projects that received positive resolutions tend to have their tokens maintain or exceed previous prices in BTC terms by T + 90. They may even see price increases on the day the positive resolution is announced, as positive resolutions can be viewed as a "victory" and eliminate regulatory uncertainty surrounding the token.³

On the other hand, projects facing SEC lawsuits often experience significant price drops on the announcement day, and their tokens will decline in BTC terms by T + 90, although their USD prices may still rise due to overall market forces. The downward trend in relative BTC prices indicates that these projects may be losing market share, and their ecosystem strength is also weakened.

It is important to note that there are not yet enough cases to form strict conclusions. The analysis has not isolated other shocks that may occur, such as new version releases or key executive departures. Moreover, the SEC's eagerness to reach favorable resolutions for projects varies at different stages of market conditions. That said, it seems that no fixed characteristics have concretely emerged.

The purpose of this article is to provide a phenomenological analysis. For those who wish to conduct a more rigorous analysis, I recommend examining the BTC price movements of a basket of 10 or 20 top tokens during SEC regulatory phases and considering the average volatility of each token by testing for significant differences.⁴

Conclusion

Perhaps due to the increasing prevalence of global crypto derivatives exchanges over the past two years, along with the rise of institutional traders and professional market makers in the crypto space, the market has significantly improved its efficiency in integrating regulatory news compared to the BitConnect era.⁵ In 2019 and beyond, it seems that after news of regulatory actions is revealed, the prices of major projects tend to move in a rational direction. However, it is important to note that it is difficult to quantify the actual price impact of any such announcement, making it hard to determine when news has been "effectively" priced in.

Market composition is also important. Most cryptocurrencies are traded globally, and different regulatory bodies have varying definitions of what constitutes a security.⁶ If global traders reside in countries and regions with more lenient securities laws regarding cryptocurrencies, they may not care much about SEC rulings. Therefore, if a token's primary trading population consists of non-U.S. users, its price may not react as strongly to SEC news compared to tokens primarily traded by U.S. users.

As institutional holders, professional market makers, professional traders, and more conservative investors (such as pension funds and endowments) enter the crypto industry and occupy a larger market share compared to retail investors, SEC lawsuits may become more influential. Few parties subject to reporting and/or licensing requirements are willing to take the risk of potentially engaging in unlicensed, unregistered securities activities.

In summary, SEC announcements seem to have significant implications for the market, and the direction appears to be more rational. As the SEC enters a new phase of enforcement with Gary Gensler as its new head, it will be interesting to observe whether these trends continue.

Special thanks to Celia Wan and Haseeb Qureshi for their feedback on this article.

Notes:

[1] Nothing in this article should be construed or interpreted as legal, investment, or financial advice. Dragonfly Capital holds no positions in any of the cryptocurrencies discussed.

[2] Since the SEC has only recently taken action against LBC, and it has not yet been 90 days, there are no T + 90 data points.

[3] Many people are likely congratulating Block.one, as reports indicate that its $4 billion ICO reached a settlement with a $24 million fine from the SEC.

[4] If you are interested in writing an academic article analyzing these impacts, please contact me, and I will assist you.

[5] To be fair, state securities regulators arguably do not have the direct jurisdiction of the SEC.

[6] For example, the UK's Financial Conduct Authority (FCA) has a narrower definition of what constitutes a security compared to the SEC, and transactions that the SEC considers securities offerings may not constitute securities offerings under the FCA's jurisdiction. Another example is Japan's Financial Services Agency, which announced that XRP does not meet the definition of a security under Japanese law, contrary to the SEC's position under U.S. law.