The State of Play on Cryptocurrency Regulation

For legislators and regulators, writing rules for crypto-related assets requires balancing the tension between innovation and entrepreneurship, and between sound markets and investor protection. In previous articles, Bates Research has described some of the definitional challenges which directly affect which agencies govern crypto assets: the SEC asserts jurisdiction over most initial coin offerings (ICOs) as securities (but not Bitcoin or Ether), while the CFTC asserts jurisdiction over Bitcoin futures and options. To FinCEN the subject is simply a currency (and, thereby, subject to Bank Secrecy Act [BSA] and Know Your Customer [KYC] obligations); to the IRS, it’s just another capital asset. Regulators of all stripes continue to issue warnings, advisories, guidance and in some cases—as in NASAA’s crypto-sweep—take enforcement actions that remind everyone that the States also have an interest in asserting their authority. In this article, we review recent developments in the ongoing debate over regulating crypto, including legislative proposals, and regulatory activity by leadership at the SEC, the CFTC and FINRA.

SEC Commissioner Hester Peirce on First Principles

In a February 8th speech titled “Protecting the Public While Fostering Innovation and Entrepreneurship: First Principles for Optimal Regulation,” SEC Commissioner Hester Peirce described the challenges facing regulators that want to apply old models of regulation to cryptocurrencies. She argued that applying securities laws and legal tests (as to what is or is not a security) to virtual currencies and ICOs will negatively impact cryptocurrency development and investment.

The Commissioner raised many questions as to whether tokens are securities for purposes of raising funds. In a pointed comment, she explained that “enforcement actions are not my preferred method for setting expectations for people trying to figure out how to raise money.” Then she announced that the SEC staff is working on "supplemental guidance" to "help people think through whether their crypto-fundraising efforts fall under the securities laws."

Beyond the token issue, however, Commissioner Peirce questioned how certain crypto trading platforms may differ from exchanges or alternative trading systems designed for traditional securities. She also questioned how traditional regulation may need to change to accommodate these differences. Further, she raised important questions about the regulation of exchange-traded products based on Bitcoin or other cryptocurrencies.

In a final cautionary note she stated: “We owe it to investors to be careful, but we also owe it to them not to define their investment universe with our preferences.”

CFTC Setting Stage for Ethereum Futures

On December 11, the CFTC announced that it was seeking public comments to better understand “the technology, mechanics, and markets for virtual currencies beyond Bitcoin, namely Ether and its use on the Ethereum Network.” Currently, Bitcoin is the only regulated network trading in futures. The outcome of this CFTC effort may be a futures trading framework for Ether that will likely impact the agency’s broader approach to virtual currency futures, options and swaps. Such a result would further strengthen the CFTC’s authority to define and regulate such classes of crypto assets. 

FINRA Seeks Feedback, but Wants Compliance

As Bates Group described previously in July 2018, FINRA issued regulatory guidance stating it was monitoring developments in the digital asset market. As a result, FINRA requested that firms notify it if they or their associated persons or affiliates, “engage[], or intend[] to engage, in any activities related to digital assets…” The Notice stated that firms must disclose “purchases, sales or executions of transactions in digital assets, pooled funds that invest in digital assets; or derivatives tied to digital assets.” FINRA said that firms should provide these updates to their regulatory coordinator until July 31, 2019, along with disclosure of any facilitation activities such as clearing or settlement of digital assets.

In its 2019 Risk Monitoring and Priorities Examination Letter, FINRA alluded to this effort, saying that “some firms have demonstrated significant interest in participating in activities related to digital assets.” FINRA asserted that it will be reviewing “firms’ activities through its membership and examination processes related to digital assets and assess firms’ compliance with applicable securities laws and regulations and related supervisory, compliance and operational controls to mitigate the risks associated with such activities.” Specifically, FINRA noted it will “consider how firms determine whether a particular digital asset is a security and whether firms have implemented adequate controls and supervision over compliance with rules related to the marketing, sale, execution, control, clearance, recordkeeping and valuation of digital assets, as well as AML/Bank Secrecy Act rules and regulations.”

Legislative Proposals

Congressional representatives have also jumped into the debate. While regulators are asking for more input from the market, legislators are offering sweeping solutions. Though the current climate would not suggest that legislation that could significantly alter the crypto landscape can pass, several bills—some bipartisan—were introduced in the waning days of the last Congress. Perhaps the most-discussed bill comes from Representatives Darren Soto (D-FL) and Warren Davidson (R-OH), who introduced the Token Taxonomy Act.

The bill, expected to be reintroduced in the new Congress, would, among other things, (i) amend securities laws to exclude digital tokens from the definition of a security, (ii) adjust taxation of virtual currencies held in individual retirement accounts, (iii) create a tax exemption for exchanges of one virtual currency for another, and (iv) create an exemption from taxation for gains realized from the sale or exchange of virtual currency for other than cash. The bill also serves to define the term “digital token” and to clarify the application of securities laws to certain companies that use blockchain.

The Token Taxonomy Act is a reaction to startups fleeing offshore and to the downturn in the market. That downturn, is generally perceived to be due to SEC securities designations and other uncertainties and costs of U.S. regulation. SEC Commissioner Peirce referred to this legislation in her recent address, noting that Congress has the power to clear up many uncertainties by “simply requiring that at least some digital assets be treated as a separate asset class.”

Other bipartisan bills introduced last year, such as the Virtual Currency Consumer Protection Act and the Virtual Currency Market and Regulatory Competitiveness Act were also intended to reduce regulatory uncertainty, bring business back to the United States, and examine ways to encourage the development of the market.

Conclusion

The debate over current and future government regulation of cryptocurrencies may come down to reworking the definitions and legal tests that force them uncomfortably into traditional regulatory categories. It is also possible that the future may be a prolonged period of uncertainty punctuated by enforcement interpretations, conflicting agency guidance and short-lived rules. There is even a possibility that some legislative action could create an entirely new alternative regulatory framework. What can be discerned from Commissioner Peirce’s insight, the CFTC and FINRA market inquiries, and the recently proposed legislative fixes, is that any or all of these outcomes are possible.

The best that market participants can do is to keep up with these developments, do their best to anticipate regulators’ expectations, and attempt to develop compliance risk frameworks accordingly.