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July 28, 2022

A Spotlight on Digital Asset Regulation in the US

In the US, digital asset regulation is surrounded by a power struggle between the SEC and CFTC – the result of multiple institutions capable of claiming jurisdiction over digital assets.

Understanding digital asset regulation is especially important for Polymesh users–after all, Polymesh is a blockchain specifically built for regulated assets!

To help our users become better acquainted with the global regulatory situation, we’re creating a series of posts spotlighting specific locals. 

This post focuses on digital asset regulation in the US, where a large number of potential Polymesh collaborators and users are based.

In the US, digital asset regulation is surrounded by a power struggle between institutions– the result of multiple state and federal regulators capable of claiming jurisdiction over digital assets. But with no crypto-specific federal framework yet, these institutions are battling out for authority over digital assets based on regulations enacted way before blockchain’s time.

The result is a regulatory situation with fragmentation almost too complex for compliance. Still, there’s hope for the future as federal legislators have made recent first attempts to structure the digital asset market with long-awaited legal definitions.

The main players: The SEC, the CFTC, and other regulatory bodies

The fight for supremacy over digital assets in the US is largely between the Securities and Exchange Commission (SEC), which has full regulatory authority over securities (including investment contracts), and the Commodity Futures Trading Commission (CFTC), which has full regulatory authority over derivatives transactions (including swaps, futures, and options) and more limited authority to regulate in commodities markets. 

SEC chair Gary Gensler argues that digital assets with the potential for appreciation are essentially securities, and as such should be subject to securities law and regulated within the SEC’s regime– even if these assets were first intended as cryptocurrencies. Gensler has been adamant about the SEC’s role in regulating digital assets, encouraging crypto trading platforms to register with the SEC and requesting Congress to give the SEC authority over digital assets to the greatest extent permitted by law. 

Meanwhile, then-CFTC Commissioner Brian Quintenz has refuted the SEC’s authority over pure commodities or their trading venues. The CFTC argues that Bitcoin, Ether, and other crypto currencies are commodities, and as such subject to CFTC regulations. Importantly, the CFTC notes that its jurisdictional scope only covers crypto products that function as commodities; it will not preclude other institutions from exercising regulatory power over crypto products that function differently. 

There are other entities with a role to play too. For starters: the Federal Reserve, which regulates the big banks and restricts their digital asset activities; the Internal Revenue Service, which has a stance on taxation of digital assets; the Financial Crimes Enforcement Network; the Federal Trade Commission; and the Department of Justice. Let’s also not forget the states, which may grant the licensing of money transmission businesses, a category to which many cryptocurrency companies may belong.

For the sake of space in this article, we’ll focus primarily on the two giants: the SEC and the CTFC.

SEC jurisdiction over digital assets

It’s fairly obvious that tokenized stocks, bonds, and transferable shares should fall under SEC regulation; they’re securities after all. What’s less obvious is whether other digital assets such as cryptocurrencies fit the category of “securities”. 

In the SEC’s view, any digital asset that is determined to be a security–which is defined to include “investment contracts”– should be subject to SEC oversight and applicable securities laws.

What constitutes an investment contract is outlined by the U.S. Supreme Court in SEC v. W.J. Howey. Under the “Howey Test”, an investment contract exists where:

  1. There is an investment of money
  2. in a common enterprise
  3. with a reasonable expectation of profits to be derived
  4. from the efforts of others

In the Court’s view, an investment contract is determined by the circumstances around the asset and how it’s offered, sold, or resold. The SEC takes a similar approach to digital assets, examining the nature of a transaction and how it passes the Howey Test as opposed to the asset itself. 

When it comes to cryptocurrency, the SEC has stated that digital assets sold as part of an investment to non-users by promoters to develop the enterprise evidence investment contracts under the Howey Test and in that context are securities. Only coins on networks decentralized enough for purchasers to no longer expect others to carry out managerial efforts would not count as investment contracts.

CFTC jurisdiction over digital assets

Regarding digital assets, the CFTC admits that digital assets may be securities and so would be regulated by the SEC. It also notes that it does not have regulatory authority over cash commodities but only regulates futures contracts on commodities, and other derivatives products such as swaps. 

Contrasting the SEC, the CFTC has taken a rather firm position that cryptocurrencies belong to the category of commodities, which it broadly defines to include all goods, articles, rights, and interests in which contracts for future delivery are presently or in the future dealt in.

When it comes to digital assets, the CFTC is known to use the nature and use of the digital asset to assess whether it’s encompassed within the definition of a “commodity” and, if so, whether its activities are subject to the CFTC’s regulatory scope. 

The CFTC’s position is that unlike other currencies, cryptocurrencies are goods exchanged in a market for uniform quality and value and thus fall within both the common definition of a commodity and the definition outlined in the Commodity Exchange Act. In other words, cryptocurrencies can be properly defined as commodities because there can be a contract for future delivery of the specific cryptocurrency.

However, this doesn’t necessarily mean that cryptocurrency is regulated by the CFTC; what the CFTC regulates is derivatives on digital assets, including the trading and clearing of futures contracts on cryptocurrency listed on CFTC-regulated exchanges. 

In the CFTC’s view, the issue of determining the CFTC’s regulatory authority (and by virtue its enforcement authority) on digital assets should focus not on whether the digital asset is a commodity versus a security, but whether a futures contract or derivatives product is involved.

Regulatory scope + the ramifications

Whether a digital asset is found to fall within the regulatory scope of the SEC or CFTC is important as it has ramifications on what regulations the asset and its related activities will be subject to.

Take securities: all securities in the US must be registered with the SEC or qualify for an exemption according to its requirements. This places restrictions on companies as they then need to meet obligations for compliance, reporting, and so on.

Seen by some as functionally equivalent to SEC-regulated securities exchanges, platforms which promote the buying and selling of digital assets have to be careful as hosting even just one digital asset security will give the SEC regulatory power over the entire platform–meaning the SEC may regulate the exchange for all digital assets, including non-securities. Alternatively, the SEC may choose to require the exchange to stop selling the unregistered digital asset.

Similar rules apply to broker-dealers–like digital asset exchanges, brokers who facilitate transactions in digital asset securities must register with the SEC, and even if a broker trades just one digital asset security, the SEC may regulate that broker’s trading of all digital assets.

Clearly, there are significant consequences for cryptocurrency exchanges if the cryptocurrencies they host are found to be securities subject to SEC jurisdiction.

By contrast, the CFTC’s jurisdiction is much more limited; for currency markets, the CFTC is only mandated to police fraudulent and manipulative activities in interstate commerce. Beyond this, the CFTC only oversees crypto transactions or exchanges that involve margin, leverage, or financing. 

When it comes to buying and selling cryptocurrencies, intermediaries only need to register with the CFTC if hosting future trading, matching counterparties in swaps, or in a position that falls within its mandate to regulate derivatives. There are 5 positions of note: commodity pool operators, commodity trading advisors, futures commission merchants, introducing brokers, and swap dealers. 

Importantly, the CFTC can’t require a spot crypto exchange to register with the CFTC. A spot is where crypto products are traded for immediate actual delivery–a popular example in the US is Coinbase. Nevertheless, if a crypto product in a spot market provides for margin and leverage and is offered to retail customers, it could be considered a futures contract subject to CFTC jurisdiction. 

Can old regulations apply? The SEC v. Ripple

While US institutions grapple with the issue of regulatory oversight, they also have to contend with another complex issue: all of the current regulatory regimes in the US predate digital assets. Existing securities regulations, for instance, were developed in the 1930s. 

With no clear definitions for what kind of product a digital asset is, it’s unclear where exactly it fits within the existing US regulatory framework. Matching digital assets to definitions of existing financial assets might sound clear in theory, but in practice it’s heavily confused by questions about the intent, purpose, and function of a token.

We’re seeing this confusion play out as the SEC remains in a legal battle with Ripple regarding Ripple’s issuance of its payment token XRP, which is used to represent the transfer of value across Ripple’s blockchain networks between financial institutions.

In 2020, the SEC initiated enforcement action against Ripple, alleging that Ripple’s digital token XRP (worth a notional amount of US$1.3 billion) was an unregistered securities offering as it represented an investment contract. It also claimed that in failing to provide a registration statement, Ripple disobeyed requirements of securities issuers. As of yet, there’s no final ruling; it’s declared that the court will be over in late 2022, with settlements ending in March 2023.

The outcome of the case will provide additional guidance on the application of the “Howey Test”– the SEC’s historic criteria for defining a security– to digital assets. Whether the court agrees with Ripple that XRP is not a security will have major implications for the SEC’s jurisdiction over digital assets. In either case, crypto market participants can expect more clarity on the issue along with further regulatory change. 

Heavy regulatory scrutiny amid uncertainty

Despite this uncertainty, US institutions display heightened regulatory scrutiny towards digital assets and aren’t shy to assert their authority. 

In recent years the SEC has taken numerous enforcement actions against blockchain companies as well as doubled the size of its crypto asset enforcement division. Companies with known SEC investigations and pending enforcements include major companies Coinbase, Celsius Network LLC, Gemini Trust, and Voyager Digital.

Another mentionable case is the SEC’s lawsuit against BlockFi in February 2022, where the SEC charged BlockFi for failing to register what it determined to be securities under the Howey Test. BlockFi ultimately agreed to pay US$50 million to settle the charges, cease its unregistered offers and sales of those investment products, and bring its business within provisions of SEC regulation within 60 days.

Similarly, the CFTC has initiated numerous enforcement actions related to digital assets with a heavy focus on exchanges offering crypto derivatives to US persons not registered with the CTFC. Companies of note which the CFTC has brought charges against for illegal cryptocurrency trading operations and anti-money laundering violations include BitMEX, PaxForex, Kraken, Bitfinex, Tether, and Coinbase

What about NFTs?

It’s not yet determined whether non-fungible tokens (NFTs) are securities or commodities, but it’s very likely we’ll see future rulings discussing the issue.

Given the debate around cryptocurrency, a reasonable expectation is that until a comprehensive legislation is introduced, non-fungible tokens will be treated on a case-by-case basis. If found to pass the Howey Test, they’ll be treated as securities; if futures, options, or swap contracts are developed based on NFTs, they’ll be within view of the CFTC.

What's happening at state level?

State attitudes in the US differ, but it’s clear that some states are trying to attract development from digital asset companies by enacting crypto-friendly legislation, even if such laws are slower to enter the federal level. 

Wyoming, for example, has passed a number of blockchain-friendly laws to clarify the regulatory environment around crypto assets, including a banking charter tailor-made for crypto companies. To help bridge the gap between regulatory compliance and decentralization, Wyoming even passed a law granting legal entity status to decentralized autonomous organizations (DAOs), provided they’re organized as a Wyoming limited liability company. 

The case for federal regulation

Recently, there have been several positive developments at the federal level that suggest a more cohesive approach to regulating digital assets might soon come into play.

A notable beginning was in 2021, when the US Congress passed the Infrastructure and Investment Jobs Act (IIJA), the first piece of legislation introduced to directly impact the crypto industry. The IIJA contains two provisions affecting the reporting of transactions involving digital assets for US taxpayers. Specifically, it requires cryptocurrency brokers to report to the Internal Revenue Service (the US’ federal tax body) to help the IRS track cryptocurrency transactions to increase proper tax reporting.

In March 2022, President Biden released an Executive Order (EO) on Ensuring Responsible Development of Digital Assets with the goal of protecting consumers, investors, and businesses while ensuring the stability and integrity of the US financial system. The EO mentions the need to reinforce US leadership in the global financial system through responsible development of digital assets– making clear the US opinion that developments in the space have not been responsible so far and that additional regulation is required.

While news of increasing regulation might not be welcomed by the wider industry for fears it will halt innovation, the improved clarity is likely to be beneficial. In an uncertain landscape, companies are left with the choice of trying to comply with regulatory requirements for multiple institutions or ignore them and face potential legal consequences later on: not an easy place to start when developing a long-term plan.

A clearer line on the matter will ultimately enable companies to comply with US regulation more easily, as well as predict how they can reduce risk when pursuing business needs. It’s also likely to fuel innovation. After all, why would businesses dedicate time, effort, and money into a pursuit likely to be declared illegal?

Moreover, clearer legal perspective makes it easier for companies to preemptively register with regulatory institutions and facilitate better potential prospective offerings. Digital asset exchanges who get in earlier on registering with the SEC, for example, will likely be able to seize a greater market share as well as be better poised to work with token issuers to offer legally compliant tokens. 

Lummis-Gillibrand: CFTC dominance after all?

A milestone moment for crypto policy occurred last month as US federal legislators introduced the first major bipartisan legislation for crypto.

On June 7, 2022, the Senate proposed to introduce legislation to create a regulatory framework for crypto markets under federal oversight that would classify the vast majority of digital assets as commodities and empower the CFTC to regulate most of the industry.

Called the “Responsible Financial Innovation Act”, the landmark bill is the first serious effort to apply comprehensive regulation to the crypto industry and integrate them into existing law. Its sponsors are Sens. Cynthia M. Lummis (R-Wyo.) and Kirsten Gillibrand (D-N.Y.).

Below we’ll discuss three main takeaways from the Lummis-Gillibrand bill. For an easy break-down of the bill and its components (plus concerns around Web3, policy, and NFTs), check out this Twitter thread:

Terminological clarity and the CFTC vs SEC

The Lummis-Gillibrand proposal pushes back on the SEC’s aggressive approach to label most digital assets as securities in favor of defining a vast number of digital assets as “ancillary assets”– or intangible, fungible assets offered or sold in tandem with the purchase or sale of a security– to be treated like commodities under U.S. law. This would enable digital assets to fall under the CFTC, which would also be granted extra power to oversee the crypto spot market and create a process for crypto trading platforms to register with the federal body.

Exempt from this would be digital assets which behave like a security that a business would issue to investors to build capital. This includes cryptocurrency, which would still classify as a traditional security under the SEC’s oversight if its holder is entitled to enjoy dividends, liquidation rights, or a financial interest in the issuer.

Stablecoins

Notably, the Lummis-Gillibrand bill also makes a significant effort to establish a regulatory structure for stablecoins, requiring that sponsors maintain liquid assets equal to 100% of the face value amount of the issued stablecoin in the form of U.S. currency, Treasury bonds, Federal Reserve balances, or other government-accepted cash-like instruments. Within this framework, both banks and non-banks can become stablecoin issuers, although non-banks would still have to work with federal regulators and meet liquidity requirements. 

The bill’s approach to stablecoins is being praised for supporting an environment around stablecoins other than non-central bank digital currencies, which could further expand the US dollar. At the same time, it’s also being criticized for failing to reduce the risk that the Federal Reserve creates a dangerous CBDC akin to China’s digital yuan.

DAO Infrastructure

Lummis-Gillibrand also tackles decentralized autonomous organizations (DAOs), classifying DAOs as business entities for tax purposes by default. In addition, it requires most DAOs to be properly incorporated or organized under the existing laws of an identifiable jurisdiction (e.g. a state or a foregin nation). 

You can see how this posits greater significance to state statutes on DAO incorporation such as Wyoming’s law that permits DAOs to become distinct legal entities if they register as a limited liability company (LLC)–granting them the same protections as traditional LLCs, despite the fundamental differences between them. 

If passed, the new bill will incentivize DAOs to register in states like Wyoming that have more permissive laws. In response, we can expect more state legislation specific to DAOs to come into effect. But, it’s a tricky matter: while legislation such as Wyoming’s legitimizes DAOs and recognizes they bring benefits beyond what’s capable from traditional LLCs, there are multiple ways to classify and treat DAOs. 

For example, regulators might see a DAO which allows voting rights for governance with economic distribution rights similar to dividends as more similar to a security than a corporation. Further, the Lummis-Gillibrand bill itself claims that a DAO can be exempt from classification as a business entity and thereby from business disclosure if it can prove sufficient decentralization.

Ultimately, the complication with classifying DAOs just echoes the complication of defining digital assets. 

A Crypto Sandbox

Another highly constructive provision is the bill’s proposal to create a “sandbox” in which crypto projects can work for two years without regulators shutting them down as long as they honor basic consumer protections. First pioneered by SEC commissioner Hester Pierce in 2020, the sandbox idea is a clear recognition of how securities laws hinder networks from distributing tokens among participants to the extent needed to mature into functional or decentralized networks. 

Impact on Innovation

If passed, the Lummis-Gillibrand bill will have a huge impact on the US crypto industry by finally ending the war between the SEC and other federal bodies and by establishing terminological and legal clarity. 

With this increased clarity, crypto projects will in fact be able to tap into the US market in a more meaningful way because they won’t be threatened by legal unpredictability. Knowing which regulations to follow will open up financial innovation, while US consumers will feel better about participating in this innovation thanks to transparency requirements that act as a quality control to weed out less genuine projects. 

Final thoughts while we ponder the law

The Lummis-Gillibrand bill is one of more than 50 bills introduced that would impact digital assets to be discussed at the 118th Congress. While it’s still too early to tell what the final product may look like if passed (let alone when), it’s safe to say it has major potential to elevate the US into a world leader in digital asset regulation–hopefully enticing the many innovative crypto businesses who domicile overseas out of protection from the US’ current haphazard regulatory landscape.  

In the meantime, we can expect to see discussions around the bill continue, with a clearer picture on the dynamic coming after the November 2022 election. But we shouldn’t be afraid of a fiery debate if one arises–such debate simply fuels the fact that the crypto market can’t be ignored. 

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