The meteoric rise of blockchain technology and its associated digital assets has significantly reshaped the financial landscape across the globe. But, this new and exciting area of untapped economic potential also brings new challenges for regulating crypto currency and crypto exchanges. Regulatory and compliance bodies are struggling to understand the unique features of cryptocurrencies and the risks they bring.
In 2021 alone, illicit transactions involving digital currencies reached an alarming high of approximately $14 billion. In 2022 the number increased to over $20 billion. This surge intensified regulatory scrutiny and underscored the urgent need for robust compliance frameworks in this vibrant sector.
Unpacking the Regulatory Quandaries of Digital Assets
Digital assets, particularly cryptocurrencies, pose several unique regulatory challenges primarily due to their inherent design, which enables peer-to-peer transfer of value with decreased dependency on trusted intermediaries. Here are some key factors that contribute to these challenges:
- Disruption of Regulated Markets: Blockchain technology disrupts highly regulated financial markets by introducing new asset management and transaction modes.
- Reliance on Intermediaries: Existing regulatory frameworks primarily focus on regulating financial intermediaries, a concept that digital assets inherently challenge.
- Diversity of Assets: The multitude of digital assets available do not fit neatly into traditional categories of financial instruments, yet they operate in a manner akin to conventional financial markets.
- Global Reach: The global nature of blockchain technology necessitates international regulatory coordination, which is often challenging due to jurisdictional differences.
The Regulatory Landscape for Digital Assets in the U.S.
In the U.S., several federal and state regulators oversee digital assets, creating a multi-layered regulatory environment. Federal law focuses on securities, commodities, and banking laws, with state laws introducing additional requirements. Key areas of regulatory oversight include:
- Federal and state securities and commodities laws.
- Federal and state banking laws governing money services businesses.
- Specific state regulations like New York’s BitLicense requirement for virtual currency business activities.
The SEC and Securities Laws
Cryptocurrencies are unique assets that don’t fit neatly into traditional asset categories. To regulate them, the SEC draws on existing legal frameworks. Central to this approach is the Howey Test, a standard derived from a 1946 Supreme Court case, used to differentiate securities sales from other transactions.
If the asset is an “investment of money in a common enterprise, with a reasonable expectation of profits to be derived from the efforts of others” it is considered a security and it falls under the SEC’s jurisdiction and must comply with securities laws.
To this end, the SEC’s regulatory stance varies depending on the nature of the cryptocurrency. For example, Bitcoin, Ether, and Litecoin are considered commodities rather than securities, while others, such as tokens sold in Initial Coin Offerings (ICOs), may be deemed securities if they meet the criteria under the Howey Test.
The SEC has been assertive in ensuring compliance with securities laws in the crypto industry. It has brought numerous lawsuits (twenty-three in 2023 so far) against crypto creators and platforms that failed to register their offerings as securities. These lawsuits serve as a warning to other players in the crypto industry and set precedents for future enforcement actions.
Commodity Futures Trading Commission Oversight of Crypto Currency
The Commodity Futures Trading Commission (CFTC) is the primary regulator responsible for overseeing commodity derivatives markets in the United States. The CFTC has broad jurisdiction over interstate transactions involving “commodities” and exclusive regulatory authority over commodity derivatives markets, including futures, swaps, and certain types of options.
Under the CEA, the CFTC has the power to regulate who can trade derivatives, where and how these trades can occur, and the conditions under which they are conducted. The CFTC also works in tandem with the National Futures Association (NFA), a self-regulatory organization that registers and regulates market intermediaries.
The Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010 amended the CEA, which expanded the CFTC’s authority to regulate over-the-counter (OTC) markets in swaps and options. These regulations apply equally to OTC derivative transactions involving digital assets. However, only eligible contract participants (ECPs) can trade swaps on cryptocurrencies unless these swaps are traded on a registered exchange.
The CFTC’s jurisdiction extends beyond exchange markets to include retail commodity markets. Retail commodity transactions, which involve non-ECPs engaging in leveraged, margined, or financed commodity transactions, are subject to specific provisions of the CEA. However, certain contracts that result in the actual delivery of a commodity within 28 days or create an enforceable obligation to deliver the commodity are exempt from most CFTC regulations.
While digital assets and cryptocurrencies are not explicitly defined as “commodities” under the CEA, the CFTC expressed in a 2015 settlement order that Bitcoin and other virtual currencies are commodities and fall under its enforcement authority. This position was upheld by a U.S. District Court decision in 2018. The CFTC continues to assert its regulatory authority over the spot market for digital assets and advocates for legislative authority to develop a regulatory framework for the cash digital asset commodity market.
Prudential Regulators Assessment of Cryptocurrency
Prudential regulators, including the Federal Reserve, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency, have also recognized the need to address the risks posed by crypto assets. In a joint statement issued on January 3, these regulators emphasized the importance of preventing the contagion of risks from the crypto industry to the banking sector.
The guidance provided by these regulators requires banking organizations to demonstrate adequate risk management and provide prior notice before engaging in any crypto-asset-related activities. The regulators will evaluate the ability of banks to participate in these activities on a safe and sound basis. This joint statement builds upon previous regulatory guidance and reflects concerns about the risks associated with the crypto sector, its participants, and crypto companies in general.
The guidance provided by the prudential regulators indicates a preference for keeping crypto-related activities outside the regulatory perimeter. This approach aims to prevent the perceived risks to safety and soundness from entering the banking system. However, this stance could further develop a shadow crypto banking system.
The joint statement may strain relationships between regulated financial institutions and the crypto sector. The perceived risk associated with the crypto industry could lead to de-risking accounts of banks’ crypto partners and customers, potentially impacting traditional banking institutions that have embraced fintech banking models.
Additionally, by pushing crypto-related activities further outside the federal regulatory perimeter, the joint statement opens doors for state regulators to take the lead in crypto regulation. States like Wyoming and New York have already developed comprehensive regulatory frameworks for crypto companies operating within their jurisdictions.
Key Takeaways from the January 2023 Joint Statement
The joint statement by the prudential regulators highlights several key risks associated with crypto assets and their impact on banking organizations:
- Limiting Balance-Sheet Risk: The regulators assert that holding or issuing crypto assets on open, public, and decentralized networks is inconsistent with safe and sound banking practices. This position extends to crypto assets transferred on such networks, potentially encompassing tokenized representations of traditional assets.
- Systemic and Contagion Risk: The regulators emphasize the importance of mitigating contagion risk within the regulated financial system. They caution that risks from the crypto sector should not migrate to the banking system.
- Concentration Risk: Banking organizations heavily focused on servicing firms involved in crypto assets face significant safety and soundness concerns. The regulators express concerns about business models with concentrated exposures to the crypto asset sector.
- Market Risk: The joint statement highlights risks to retail and institutional investors, customers, and counterparties associated with the crypto sector. These risks, traditionally within the purview of market regulators, are now recognized as relevant to prudential banking regulators.
- Decentralized Finance: The regulators express concerns about decentralized finance, often seen as a less risky alternative to centralized crypto-asset exchanges. The lack of reliance on a single third party in decentralized finance does not eliminate the risks associated with these activities.
State Regulations
Without comprehensive federal-level regulation for digital assets, many states have taken their own legislative and enforcement actions. Some states require businesses transmitting virtual currencies to obtain money transmission licenses. Others have enacted separate laws requiring licensing for virtual currency business activities.
For example, New York introduced the “BitLicense,” which requires businesses engaged in virtual currency activities to obtain a license from the New York Department of Financial Services. The application process for a BitLicense is often lengthy, time-consuming, and expensive. However, Wyoming has taken a different approach by exempting certain virtual currency activities from money transmission licensing requirements.
Wyoming has also introduced legislation to provide a legal framework for forming and operating decentralized autonomous organizations (DAOs). DAOs handle digital assets and execute actions through blockchain technology and smart contracts. Wyoming’s legislation defines the roles and liabilities of DAO members and allows for both member-managed and algorithmically managed DAOs.
California Governor Gavin Newsom has signed an executive order to bolster responsible development of digital asset technology and protect consumers in the state. The order aims to engage with stakeholders and encourage regulatory clarity for digital assets.
Congressional Initiatives
Recognizing the importance of digital assets and their risks, several legislative initiatives have been introduced in Congress to address various aspects of their issuance and use. These initiatives aim to provide a more comprehensive regulatory framework for blockchain-based digital asset activities.
Senator Pat Toomey released a draft of the “Stablecoin Transparency of Reserves and Uniform Safe Transactions Act” in April 2022. The proposed bill seeks to define payment stablecoins and establish licensing regimes for stablecoin issuers, including state-licensed stablecoin issuers, national limited payment stablecoin issuers, and insured depository institutions.
In May 2022, the “Defending Americans from Authoritarian Digital Currencies Act” was put forward by Senators Tom Cotton, Mike Braun, and Marco Rubio. This legislation seeks to prevent app stores in the United States from facilitating or endorsing transactions involving China’s digital yuan, due to fears of possible penetration into the U.S. financial system and illegal monetary transfers.
In June 2022, the “Responsible Financial Innovation Act” was put forward by Senator Cynthia Lummis of Wyoming and Senator Kirsten Gillibrand of New York. This bill proposes a comprehensive regulatory framework for digital assets, including definitions for different types of digital assets, regulatory authority for spot markets, requirements for stablecoins, disclosure obligations for digital asset service providers, taxation structures, and the need for additional studies on digital asset use and regulation.
This past August (2023) showed the most progress towards advancing crypto legislation as the House Financial Services Committee advanced two bills (H.R. 4763 and H.R. 1747) aimed at codifying the Commodity Futures Trading Commission as the regulator for cryptocurrency.
H.R. 4763 would classify a digital asset as a commodity, regulated by the CFTC if the blockchain (digital ledger) on which it runs is certified as decentralized. The bill would define a decentralized network as, among other things, one in which no one person or entity has “unilateral authority” to control the operation of or access to the blockchain. The proposal would provide parallel permissions for individuals and firms to certify with the SEC or the CFTC that digital assets they plan to list meet the decentralized criteria. The proposal would provide the SEC and CFTC authority to reject such certifications with cause within a specific time frame. Digital assets that run on blockchains that are not decentralized would, depending on specific characteristics, be classified as securities.
Conclusion
As the use of digital assets becomes more pervasive, regulatory oversight becomes increasingly necessary to protect investors and ensure market integrity. The Commodity Exchange Act (CEA) plays a crucial role in regulating cryptocurrency markets, with the Commodity Futures Trading Commission (CF sTC) and the Securities and Exchange Commission (SEC) exercising jurisdiction over different aspects of these markets.
As the landscape of digital asset regulation continues to evolve, market participants must stay informed about the changing regulatory environment and ensure compliance with applicable laws and regulations.
