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It is almost impossible to scan the news without seeing multiple
headlines relating to cryptocurrency and other digital assets.
Perhaps the definitive sign that crypto for the masses has arrived
and is here to stay is the fact that Bitcoin and Dogecoin
whisperer, Elon Musk, recently hosted Saturday Night Live, which
also parodied NFTs. Earlier this year, Tesla announced it was
investing $1.5 billion in Bitcoin, adding momentum to a wave of
corporate and institutional investments in cryptocurrencies.
According to Gemini’s recently released 2021 State of U.S.
Crypto Report, more than 21 million adults own cryptocurrency such
as Bitcoin or Ethereum, and the number of crypto investors is
projected to double this year. The rapid and widespread adoption of
crypto and digital assets at the corporate, institutional and
individual level is outpacing the existing legal frameworks that
apply to digital assets, causing confusion and frustration for
market participants.
There are many legal and regulatory issues related to trading
and investing in digital assets, including securities and
commodities law concerns, custody issues, trading terms,
know-your-customer and anti-money laundering requirements,
reporting requirements, and intellectual property as well as tax
and accounting issues. Regulations differ based on jurisdiction
and, in some cases, the characteristics and use of a particular
digital asset.
In the United States, a threshold regulatory question for
digital assets is whether the asset is a security or commodity. The
rules for each category are different, as are the primary
regulators, with securities being regulated by the Securities and
Exchange Commission (SEC) and derivatives related to commodities
being regulated by the Commodity Futures Trading Commission
(CFTC).
SEC regulation of digital assets as securities
The classification of digital assets as securities has
wide-ranging implications for the regulatory obligations that flow
from the offer, sale, trading and clearing of such assets.
Platforms that bring together purchasers and sellers to trade
digital assets that are securities in the United States are
generally subject to registration as exchanges or alternative
trading systems. Individuals or entities facilitating clearing and
settlement of securities may be subject to registration with the
SEC as a clearing agency, and individuals or entities that effect
transactions in digital assets that are securities in the United
States may be subject to registration with the SEC and in certain
states as a “broker” or “dealer.” After
registering, the individuals or entities would be subject to
continued regulation by the SEC and applicable states.
It is likely that many initial coin offerings (ICOs) will
constitute offerings of securities under the prevailing “Howey
Test” used by the SEC to determine whether digital assets
constitute securities. In short, if the digital asset can be
characterized as an investment of money in a common enterprise with
an expectation of profits derived from the efforts of others, it
likely qualifies as a security under SEC precedents. Digital assets
that constitute securities are subject to the applicable regulatory
requirements for all publicly traded securities, including
disclosure requirements and rules for public and private offering
and selling, as well as investing and trading in, such digital
assets.
An important regulator to watch is former CFTC Chairman Gary
Gensler who recently took the reins as SEC Chairman. Gensler has
extensive expertise in this space and previously served as
Co-Director of MIT’s FinTech Initiative and Senior Advisor to
the MIT Media Lab Digital Currency Initiative.
Market watchers are eagerly awaiting the SEC’s decision on
whether to allow exchange-traded funds (ETFs) that are linked to
Bitcoin and other digital assets. If approved, such a move will
exponentially increase both retail and institutional participation
in the space. However, approval is far from certain, especially
after Gensler testified before Congress in early May about how the
crypto market “could benefit from greater investor
protection.”
CFTC regulation of digital assets as commodities
The CFTC is the federal agency responsible for regulating U.S.
commodity futures, option and swap markets. CFTC regulations will
apply to digital assets that are not securities, depending on the
type of product and the type of transaction conducted.
Some digital assets, such as Bitcoin, were designed for the sole
function of value exchange, while other digital assets facilitate
transactions such as smart contracts or particular activities on
purpose-built networks. For example, Ether via Ethereum allows for
the payment of certain computation costs associated with executing
smart contracts.
Popular digital assets like Bitcoin and Ether are considered to
be commodities from a regulatory perspective, and therefore
futures, option, swap or other derivative transactions relating to
those assets fall under the CFTC’s jurisdiction. The CFTC
generally does not regulate spot transactions in commodities,
although such transactions are subject to CFTC prohibitions on
fraud and manipulation.
The alphabet soup of regulators
While some countries have a centralized agency that regulates
(or potentially could regulate) all digital assets — for
example, the UK Financial Conduct Authority — in the U.S. we
have an “alphabet soup” of rules and regulators, each
with a distinct mission. For example, the Bank Secrecy Act (BSA) is
a comprehensive federal anti-money laundering and counter-terrorism
financing statute requiring that certain financial institutions
(e.g., banks, brokerdealers, futures commission merchants, money
services businesses and casinos) implement “know your
customer” (KYC) and antimoney laundering (AML) programs.
Enforcement of the BSA is led by the Financial Crimes
Enforcement Network (FinCEN), which is the bureau of the U.S.
Department of the Treasury responsible for combating money
laundering. Under the BSA, financial institutions and money service
businesses (MSBs) must register with FinCEN, prepare a written AML
compliance program, and file BSA reports for suspicious activity
and currency transactions. Other BSA requirements relate to
record-keeping for certain transactions and obtaining customer ID
information.
The Office of the Comptroller of the Currency (OCC), SEC and
FINRA as well as state agencies, depending on the type of
transaction and institution involved, regulate the custody of
digital assets. Custody is a particularly tricky issue as it
relates to digital assets with the tension focused on ease of
access (e.g., hot wallets and omnibus accounts) versus strength of
security (e.g., cold wallets and multi-factor authentication
protocols). Examples of custody legal issues include establishing
an operation under appropriate legal framework, like a
state-licensed trust company, achieving Qualified Custodian status
under federal law, access issues and limitations on liability.
At the state level, there are 50 attorneys general and various
state agencies that enforce digital asset-related laws (or other
general laws that may apply to digital assets) passed by state
legislatures and applied by the courts. Individual states are
taking different approaches, and the laboratory of ideas is
actively at work. For example, the New York State Department of
Financial Services has enacted the Virtual Currency Business
Activity regulatory framework (e.g., the “BitLicense”
framework), which covers substantially all virtual currency
activity by New York firms and residents.
On the opposite end of the spectrum, Wyoming has passed
legislation exempting virtual currency transactions from its money
transmitter regulations, utility tokens from certain state
securities registration and money transmitter laws and virtual
currencies from property taxation laws. And Colorado recently
issued guidance exempting certain types of digital asset exchanges
from the state’s money transmitter licensing requirements. It
remains unsettled whether federal regulation will supersede state
regulation in respect of digital assets and FinTech more generally,
as the courts have not yet ruled on many aspects of crypto
regulation.
What’s next for crypto regulation?
Increasingly, cryptocurrency and digital assets are looking less
and less like a trend that will fall out of fashion and more like
an important part of the future of finance. China is aggressively
pushing its new Central Bank Digital Currency (CBDC), the digital
Yuan, and the UK and US are actively exploring their own CBDC
initiatives. In the private sector, PayPal will soon allow
customers to pay using cryptocurrency at more than 29 million
online stores, and many major banks are rolling out crypto wallets
and offering digital asset options to their customers.
Whether as a store of value, medium of exchange, or digital
representation of a physical asset, the possibilities presented by
digital assets for reimagining the financial system, who has access
and how they participate, is wide open.
In the next column, we will look at some use cases for digital
assets, what FinTech start-ups have been focused on, and what this
means for financial institutions and other incumbents in the
space.
Originally Published by Reuters Legal News and Westlaw
Today, 14 June 2021
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
