Increased regulation of cryptocurrencies by the Securities and Exchange Commission (SEC) appears imminent. But details, scope and timing are up in the air. Three crypto experts weigh in with their take below.
Cryptocurrencies (as we know them today) were initially conceived as a means by which individuals or business entities could free themselves from hectic or disadvantageous federal monetary policies. But increasingly, the same government that (in part) inspired their creation through its regulatory failures is looking to bring these wild horses to heel.
Any discussion of crypto regulation has to start with the facts that there are already laws against fraud and that “crypto” is not monolithic. There are many layers to “crypto” here are my thoughts and all are subject to change as I learn more
— Mark Cuban (@mcuban) September 16, 2021
2021 has heralded record values for digital coins. Market penetration has never been deeper or wider. And businesses have found significant leverage in this new landscape. Some companies have enjoyed greater gains from crypto trading than they have from sales of products or services. Investors now treat stocks in companies with crypto-heavy balance sheets like MasterStrategy, Tesla and Galaxy Digital as de facto coins. Bipartisan political will in Washington to regulate digital coins as a result appears to have snowballed over the summer. The Senate-passed infrastructure bill includes greater reporting requirements for digital wallet providers and miners. The House has set a September 27 deadline to vote on the legislation. But the Progressive Caucus has also tied the fate of the bill to other measures it hopes to pass via budget reconciliation, and it remains to be seen whether it will land on President Biden’s desk.
SEC Chairman Gary Gensler, who previously researched and lectured on digital currencies at the MIT Sloan School of Management, has led the regulation charge. “If you want to invest in a digital, scarce, speculative store of value, that’s fine,” he said during a speech at the Aspen Security Summit in August. “Good-faith actors have been speculating on the value of gold and silver for thousands of years. Right now, we just don’t have enough investor protection in crypto. Frankly, at this time, it’s more like the Wild West.”
In the same speech, Gensler described digital coins as “rife with fraud, scams and abuse.”
Corporate Compliance Insights reached three cryptocurrency experts for a forecast as to what comes next. Nick Morgan, currently a partner at Paul Hastings, previously worked as a senior trial counsel at the SEC’s Enforcement Division. Hogan Lovells Partner Aaron Cutler has advised former House Majority Leader Eric Cantor (R-Virginia) on issues of policy and outreach. Ted Sausen serves as a director and AML expert for NICE Actimize.
Nick Morgan: The Crypto Sheriff Sees No Limits to SEC Jurisdiction over Digital Assets
The SEC has never gone out of its way to recognize its own limitations. But SEC Chair Gary Gensler takes this expansive view to new levels when it comes to the SEC’s jurisdiction over what he recently called the “Wild West” of crypto.
From the early days of the SEC’s grappling with jurisdiction over digital assets, the SEC has applied a decades-old legal framework in this novel context. In 2017, as initial coin offerings (ICOs) exploded, the SEC under then-Chair Jay Clayton issued the DAO Report, which concluded that coins were, in fact, securities. The report referenced the 1946 Supreme Court case SEC v. Howey to assert jurisdiction over the ICO tokens it described. To briefly oversimplify, the SEC claimed jurisdiction over the DAO token because people had purchased the tokens with an expectation of profits as a result of the managerial efforts of the promoters.
What followed for the remainder of Chair Clayton’s term was a series of enforcement actions and pronouncements in which the SEC and its staff said that one ICO token after another was a security. By early 2018, Chair Clayton gave testimony in which he said, “Every ICO I’ve seen is a security.”
As a result, the offerings and sales of ICO tokens had to be registered with the SEC or fit within an exemption from registration; companies brokering token transactions had to be registered; and people making misrepresentations, manipulating or impermissibly touting the tokens fell within the SEC Enforcement Division’s crosshairs. In short, the SEC firmly asserted that ICO tokens were securities and, therefore, the SEC had jurisdiction over them.
What the SEC did not do during Chair Clayton’s tenure, with a very few insignificant exceptions, was to identify the characteristics of any digital assets that did not fall within the SEC’s jurisdiction. In other words, many people were eager to hear whether a digital asset could be designed such that purchasers were not, in the words of the Howey case, expecting profits as a result of the managerial efforts of others. At one point in 2018, William Hinman, the Director of the SEC’s Division of Corporation Finance, hinted at some theoretical limits of the SEC’s jurisdiction in the crypto realm when he said that two digital coins, Bitcoin and Ether, were not securities in his view.
“If crypto is the Wild West, some fear Chair Gensler appears poised to launch a regulatory land grab.”
Flash forward to today: SEC Chair Gary Gensler’s recent comments on the same subject have some people scratching their heads. In his August speech, Chair Gensler unsurprisingly agreed wholeheartedly with Chair Clayton’s comments about all ICOs being securities. But he went on to talk about Bitcoin and other cryptocurrencies, stablecoins and other digital assets. He made passing reference to the Howey case as “but one of many ways we determine whether tokens must comply with the federal securities laws” and concluded with a hope for “additional Congressional authorities.” Read broadly, Chair Gensler appeared to be claiming aggressively expansive jurisdiction in the digital realm, and he made clear he wanted even more from Congress.
If crypto is the Wild West, some fear Chair Gensler appears poised to launch a regulatory land grab. His comments were alarming enough that a Commissioner from the CFTC, the agency Gensler formerly chaired, tweeted “Just so we’re all clear here, the SEC has no authority over pure commodities or their trading venues whether those commodities are wheat, gold, oil . . . . or #crypto assets.”
Just so we’re all clear here, the SEC has no authority over pure commodities or their trading venues, whether those commodities are wheat, gold, oil….or #crypto assets.
— Brian Quintenz (@CFTCquintenz) August 4, 2021
Given Chair Gensler’s deep knowledge of crypto assets – he was a professor at MIT and a senior advisor to MIT’s Media Lab Digital Currency Initiative – he could have described technical aspects that would cause a digital asset to fall outside the definition of a “security.” Instead, he appears headed in the opposite direction: expanding the boundaries of what constitutes a “security” to claim more regulatory turf in the area.
In his speech, Chair Gensler may have inadvertently suggested where the SEC jurisdictional limits may ultimately be determined. He noted, “Over the years, the SEC has brought dozens of actions in this area, prioritizing token-related cases involving fraud or other significant harm to investors. We haven’t yet lost a case.”
Setting aside the fact that the overwhelming majority of ICO cases settled or defaulted, one of Chair Clayton’s parting gifts to his successor was a lawsuit that remains hotly contested. The case involves a lawsuit brought by the Commission against Ripple, another digital coin. In that case, the SEC has been fighting tooth and nail against the public seeing the deposition transcript of former Director William Hinman, head of the Division of Corporation of Finance, who said in 2018 that Bitcoin and Ethereum were not securities.
Even if Chair Gensler’s SEC won’t recognize limitations on its jurisdiction over digital assets, a court just might.
Aaron Cutler: Crypto Regulation Is Entering New Territory
The entire cryptocurrency industry is waking up to a new reality: Politicians and regulators have decided to wade into cryptocurrencies, which until now had largely flown under their radar. A House Committee Chair is launching a working group, the SEC is seeking new authorities to regulate digital assets as securities and the Senate-passed infrastructure bill includes crypto tax and reporting requirements.
The last handful of weeks has seen arguably more regulatory activity around digital currencies since the name Satoshi Nakamoto first entered the popular lexicon, and anyone whose business deals in this asset class will need to pay close attention.
House Financial Services Committee Chair Maxine Waters announces the members of a Digital Assets Working Group, which she says will study crypto, CBDCs and financial inclusion. pic.twitter.com/8yhTNcvXqV
— Hannah Lang (@hannahdlang) June 16, 2021
In Congress, the Committees of jurisdiction are led by energetic chairs, skeptical of digital currencies and broadly supportive of robust federal regulations. House Financial Services Committee Chair Maxine Waters (D-California) and Senate Banking Committee Chair Sherrod Brown (D-Ohio) have held congressional hearings on cryptocurrencies and are eager to put up regulatory guardrails.
In June, Waters announced she is forming a Cryptocurrency Working Group to tackle growing concerns about cryptocurrency. The announcement came during a committee hearing on digital currencies. Waters said the group will work “to engage with regulators and experts to do a deep dive on this poorly understood and minimally regulated industry.”
On the Senate side, Sen. Elizabeth Warren (D-Massachusetts) has emerged as a leader in calling for increased oversight and regulation. In a July 7 letter to SEC Chairman Gary Gensler, Warren raised concerns about cryptocurrency markets, saying “the harms to consumers as a result of this under-regulated market are real and continue to proliferate in the absence of effective SEC regulations.” She asked Gensler if Congress needs to grant more authority to the SEC so the Commission can “close existing gaps in regulation that leave investors and consumers vulnerable to dangers in this highly opaque and volatile market.”
Gensler largely agreed with Warren. In his response letter, he wrote, “investors using these platforms are not adequately protected.” Gensler said the SEC needs “additional authorities to prevent transactions, products and platforms from falling between regulatory cracks. We also need more resources to protect investors in this growing and volatile sector.”
Gensler echoed his concerns during his speech at the Aspen Security Forum. This is not a departure from his predecessors. In 2018, then-Chair of the SEC Jay Clayton told the Senate Banking Committee that digital assets like initial coin offerings, or ICOs, are securities. “I believe every ICO I have seen is a security — we have jurisdiction, and our federal securities laws apply,” Clayton said.
Gensler also said platforms that facilitate “buying, selling and lending crypto” should be registered and regulated under the Commission, “unless they meet an exemption,” and that stablecoins “may be securities and investment companies,” and the SEC will apply “the full investor protections … and other federal securities laws to these products.”
Gensler also signaled that the Commission is looking into “investment vehicles providing exposure to crypto assets” and anticipates filings “with regard to exchange-traded funds (ETFs) under the Investment Company Act (’40 Act)” and that the SEC is seeking comment on “crypto custody arrangements by broker-dealers and relating to investment advisers” and looking for ways to “maximize regulatory protections in this area.”
That being said, Gensler indicated the SEC lacks the authority to “fill in the gaps.” In a closing request to Capitol Hill, Gensler said, “regulators would benefit from additional plenary authority to write rules for and attach guardrails to crypto trading and lending.”
We expect the SEC to thoughtfully pursue industrywide rules instead of promulgating policy by way of enforcement actions. In the short term, we would expect official guidance on which digital assets the SEC will define as securities and over which platforms the SEC will claim full regulatory jurisdiction. Outside of that, the commission may seek to be equipped with additional authorities from the Congress before venturing too far into the “Wild West.”
Ted Sausen: Regulations Have Been in Place for Years. Enforcements Have Resulted in Billions in Fines.
For several years, U.S. regulators have been alerting the markets of the risks involved with cryptocurrencies and the necessity to take action to protect their institutions and their customers. It’s hard to believe that it has been a decade since virtual assets worked their way into regulations set forth by FinCEN. In 2011, FinCEN changed the definition of Money Services Businesses (MSBs) to include virtual assets. This was further clarified in 2013, when FinCEN said that MSBs that deal with convertible virtual currencies (CVCs) are money transmitters and must abide comply with the rules set forth in the Bank Secrecy Act (BSA).
This was again stated in the AML Act of 2020. Cryptocurrencies are within the scope of the BSA. Interestingly enough, you won’t specifically find the words “virtual,” “digital” or even “crypto” currencies in these regulations. It is much more broadly stated, making reference to any “value that substitutes for currency.”
But let there be no doubt that enforcement actions have begun. As early as 2015, we started to see actions taken against companies like Ripple for not registering as an MSB. In 2017, FinCEN made its first sizeable ($110 million) fine against BTC-e for operating without a license and conducting criminal behavior. In 2019, FinCEN assessed a civil money penalty against an individual, Eric Powers, for willfully violating the Bank Secrecy Act’s (BSA) registration, program and reporting requirements. And just recently (August 2021), FinCEN and the CFTC settled their civil lawsuits against the BitMEX crypto exchange and its holding company to the tune of $100 million. To date, U.S. regulators have levied over billions in penalties since Bitcoin’s debut in 2009 – most of which have come from the Securities and Exchange Commission.
Editor’s note: Many people today believe that cryptocurrencies fuel money laundering and other illegal activity. That is true, but those same concerns also apply to cash, which is even more anonymous. FBI was able to recover roughly half of the ransom paid by Colonial Pipeline to cyber attackers in June. Still, those who mine, hold and exchange crypto must comply with AML regulations.
Are crypto firms laser-focused on AML compliance? The term “laser-focused” may be a bit strong, at least for the U.S. market; however, special attention is being focused on complying with AML regulations. The amount of focus and resources applied, though, varies by the organization. There are larger, more established institutions that have addressed these issues head on. They recruited experienced AML experts and established compliance teams. Processes are in place to do all the necessary checks to onboard clients and monitor their activities throughout the life of the customer relationship. As many of these organizations are new, they have implemented the latest technologies for such things as identify verification using facial recognition. Progress has been made, and advanced technology has been adopted.
Unfortunately, this is not always the case with every institution dealing with cryptocurrencies. As with traditional financial institutions, AML program maturity varies, sometimes significantly. Crypto firms understand AML compliance is a requirement; however, they don’t all have skilled resources, and some look to do the bare minimum needed to get by. As with the U.K., there are virtual asset service providers in the U.S. market that are not registered. This opens the door for money launderers and bad actors of other illicit activities, such as terrorist financing.
Where do we go from here, particularly in the U.S.? Regulations are set, and the “grace period” is over. We’ve seen several enforcement actions, some sizeable, and we can expect to see additional enforcement. Tighter controls will be put in place to enforce adherence to regulations, and new regulations will continue to evolve. There may always be unregistered virtual asset service providers; however, the number will continue to shrink.
But one thing the markets can count on is that in the next several years, we will see stronger enforcements and unprecedented fines. If cryptocurrency firms don’t become invested in strengthening their anti-money laundering compliance programs, it will be to their detriment, and it will certainly result in a major loss of profits. More important, it could be detrimental to their reputations, which are key to successful market adoption.