The world of cryptocurrencies is famously decentralized, but when an asset class grows to $3 trillion (and then shows its volatility by plunging again) centralized institutions like governments are bound to take notice. Problems can start to arise when these two worlds meet, especially when governments try to crack down on emergent technologies they don’t fully comprehend.
Everyone agrees that outright fraud and theft are out of bounds, of course, but what about the thornier issues that come along with any kind of complex financial transaction? So far, the Securities and Exchange Commission has taken the lead when it comes to crypto regulation in the U.S., and the agency has made it clear that the space will be a priority for both regulation and enforcement. The agency highlighted its moves in the crypto space in its recent report on enforcement in 2021, and its chair Gary Gensler has likened crypto assets to the “Wild West” and repeatedly said that he wants to bring them into the regulatory fold to protect investors.
What hasn’t been so clear is what the SEC’s attention will actually mean – and it has the market on edge.
“There's really been a lack of clarity around the regulation of cryptocurrency, crypto assets, DeFi and token offerings,” attorney Brian S. Korn, who heads the Financial Services Transactions, Fintech and Blockchain group at law firm Manatt Phelps & Phillips LLP, told us.
Adding to the confusion is an alphabet soup of other regulators with an interest in crypto regulation, ranging from the Commodity Futures Trading Commission, to the Federal Reserve, to the IRS, to the Treasury’s Financial Crimes Enforcement Network and even the FBI. These agencies are all looking not only to avoid stepping on each other’s toes, but also to make sure that when they do come out with regulations covering such a fast-moving and technologically complex space they can’t be easily sidestepped by savvy developers and investors. Additional coordination may be on the horizon, President Joe Biden is reportedly planning to release an executive order as soon as February that will ask federal agencies to determine the risks and opportunities associated with crypto.
“For the industry to really go mainstream, there has to be a renewed focus on which regulations apply,” Korn said. “And some direction from proper authorities, so that everyone can agree that we're all on the same page.”
Here are the areas where the crypto community has the biggest questions.
1. What crypto assets are securities?
Securities have been around so long that you’d think the entities that regulate them would have a pretty good handle on what they are and what they aren’t. But when it comes to crypto, that longevity leads to confusion since the rules were made for a time when something like blockchain couldn’t even be contemplated. The three part test for what constitutes a security (and what is therefore subject to SEC rules on registration and disclosures) comes from the Supreme Court’s 1946 decision in SEC v. Howey, which centered on leaseback arrangements for Florida orange groves. Under the test, an asset is security if it involves an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.
So, how do orange groves translate to blockchain? A debate is still raging over whether crypto assets truly involve a “common enterprise,” but so far, the SEC has taken a firm stance in some enforcement actions that companies conducting token offerings should treat them as securities. In high-profile court cases against Ripple (the case is still ongoing and Ripple is fighting back hard) and Telegram (which settled with the agency in June and agreed to give investors back $1.2 billion to investors), the agency aggressively asserted that tokens are securities under Howey.
Korn said that due to the stance the government has taken in the courtroom, he is already counseling clients issuing tokens that there are “very few situations” where a token has enough of a use case that the SEC will consider it anything other than a security.
Still, the crypto industry could use more direction than simply watching the SEC go after what it considers to be bad actors after the fact, especially since Gensler isn’t always forthcoming about the agency’s position on just what crypto products are or are not securities.
2. What does that mean for exchanges?
If most tokens are indeed deemed to be securities, then exchanges where people trade crypto can be seen as analogous to other securities exchanges and the rules that govern such platforms should apply – and that certainly appears to be where the SEC is headed.
Gensler said in January that he had asked his staff to examine how to get crypto trading platforms “inside the investor protection remit.” He further hinted that 2022 would be the year this all happens, saying “if the trading platforms don’t come into their regulated space this would be another year of the public being vulnerable.”
The exchanges tend to assert that the tokens people trade through them are not, in fact, securities. The largest exchange, Coinbase, has already clashed with the SEC. Coinbase and the SEC had a public spat over the exchange’s plan to launch a feature allowing users to earn interest on certain coins. The platform ultimately canceled the program’s launch in the face of a potential lawsuit from the agency despite initial defiance. And Gensler has called out the exchange in particular for not considering itself subject to the agency’s registration requirements.
Even if they do fight back, the sheer amount of money flowing through the crypto space makes the exchanges a target for regulators, and the crypto community is waiting to see how this plays out.
“If you go to Coinbase…and you look at all the tokens that are available for trading, it’s as if 1,000 tokens have IPOed overnight with no review, no financials, no management team, no updated information – really no investable information at all other than a white paper, which explains in varying degrees of clarity what the function is of each token,” Korn said, noting this state of affairs has got to be “unsettling” to regulators.
3. What’s next for stablecoins?
While the questions around what constitutes a security and how that impacts exchanges are mostly about how to apply existing laws and regulations to cutting edge technology, one place where new law is actually expected is around stablecoins, which are designed to maintain a stable value relative to the U.S. dollar.
In most cases, with more politically resonant concerns in the foreground, Congress is likely to have bigger fish to fry than crypto — Korn pointed out that two attempts to update the Howey standard have failed to make it out of committee so far – but there might be more pressure to legislate stablecoins because many regulators see them as posing potentially systemic risks to the financial sector.
A report issued by the President's Working Group on Financial Markets and major bank regulators in November called on Congress to limit the issuance of stablecoins to insured depository institutions and to require custodial wallet holders to be subject to federal oversight.
Although Stablecoins are just one type of cryptocurrency, if these laws do come to fruition, the impact on the industry at large could be huge by drawing more big financial players into the game. The requirements could prompt banks to issue their own stablecoins, and analysts at Bank of America have reportedly predicted that the regulation could give a boost to big players like Mastercard, Signature, Visa and Western Union.
Any new legislation specifically addressing cryptocurrencies could also help shed light on how regulators will approach the rest of the market going forward.
4. Will spot bitcoin ETFs be allowed?
One closely watched area of regulation that does fall squarely within the SEC’s purview is whether (and when) the agency will permit spot bitcoin ETFs to start trading. The agency has signed off on exchange traded funds based on bitcoin futures, which don’t hold the underlying cryptocurrency assets, but it has yet to give the go ahead for a spot bitcoin ETF, which would allow retail investors to actually hold the underlying cryptocurrencies without any of the hassle of acquiring and storing the coins.
The crypto community sees great promise for advancement if these ETFs are allowed to trade, but so far the agency has taken a dim view of them. The SEC has consistently rejected applications for spot bitcoin ETFs, citing concerns that they do not protect investors well enough from potential volatility, with some of the most recent denials coming just before Christmas and another denial issued in January.
When it hasn’t outright rejected spot bitcoin ETF proposals, the agency has dragged its feet on making decisions on them, including pushing back decision dates for applications from NYDigs and others.
While the SEC clearly has reservations about these types of ETFs, they are permitted in other jurisdictions, including Canada, and major players in the investment world such as Fidelity have opted to offer them, so many hope the U.S. will ultimately relent.
5. How will U.S. regulation align with the global landscape?
The question of spot bitcoin ETFs, which U.S. regulators have dragged their feet on while other countries have allowed them, brings to the fore an even larger issue: just how will U.S. regulations line up with those abroad?
While it’s unlikely that the U.S. would go so far a to impose a ban, given the amount of money at stake and the increasing interest financial players with lots of clout have shown in cryptocurrencies, whether the regulation it chooses is more or less stringent than what crypto faces elsewhere will shape how the market develops – specifically how much of the market ends up based here.
“To the extent that we become an outlier on a lot of these issues, will people move to other countries or start foundations on Caribbean islands and run whole businesses and ecosystems that are really outside of our control?” Korn asked.
“If I was the U.S. government, I'd rather have sensible regulations that are welcoming to people, but at the same time, strong enough to enforce the law, than have something which encourages a black market to be done somewhere else,” he said. “The blockchain world is global.”