The Queen City of Crypto and the Regulatory Landscape
Cincinnati, the Queen City of the (Mid)west, is fast becoming the Midwest’s queen of crypto. Unfortunately, the city is coming of age during a time of regulatory uncertainty. As more local companies launch products related to cryptocurrencies, local entrepreneurs will need to engage with Washington regulators to ensure a happy ending.
In June 2021, Cincy Inno reported that crypto ATMs were popping up around Cincinnati; in fact, the number more than doubled to 113 in less than a year! The trend is driven by the number of people purchasing, mining, and investing in crypto and the availability of debit cards linked to digital wallets. At the time, Cassandra Gulia, Bitcoin Depot’s strategic marketing manager, noted that “[i]n the last year, a lot of people have been looking away from banking and the stock market and towards cryptocurrencies as a means of diversifying portfolios.” And that trend has only continued.
In July 2021, a group of Cincy investors launched their second crypto fund—Cincinnati Exchange Fund L.P. (The first fund, Cincinnati Crypto Fund, was launched in 2018; the fund reportedly raised $5 million.) According to the Cincinnati Business Courier, “[t]he fund takes investors' cryptocurrency and stores it while exchanging it for a share of the partnership, much like an investment in a mutual fund.” The fund provides tax and diversification benefits to crypto holders. As noted in the article, crypto is fast becoming an asset class held by institutional and retail investors. The benefits are a lack of correlation with U.S. equities and other markets. The risks are high volatility and lack of regulation.
But investors are not the only business adopting cryptocurrency. Cincy Inno has reported on Hyde Park retailers accepting crypto as payments and real estate startups trying to use the blockchain to resolve affordable housing issues. More recently, I helped IDX Advisors launch the first risk-managed Bitcoin futures fund, one of only a few Bitcoin-related mutual funds in the country. After getting the fund registered, I also published a blog post on key regulatory issues related to registered crypto funds.
The latest news announced the possible IPO of Griid Infrastructure, a Cincinnati-based Bitcoin mining upstart. Griid and Adit EdTech Acquisition Corp. announced the possible launch of a “SPAC, or special purpose acquisition company” that could acquire Griid and take it public. The deal could value the company at more than $3 billion. Griid claims to engage in carbon-neutral Bitcoin mining, which is a resource-intensive process.
The Path to Crypto
In the past decade, we’ve seen crypto go from a decentralized form of payment known only to the nerdiest of computer geeks to one of the hottest investment products in mainstream America. It's the modern tulip craze. But as these forms of decentralized financial instruments improved their technology and produced spinoffs, new coin offerings, and more, their staying power increased.
As a result, regulators are starting to get involved in cryptocurrencies and other digital assets. On December 8, 2021, CEOs of various cryptocurrency-related companies appeared before Congress to educate representatives on this budding industry. Their goal: “tout what supporters believe to be the potential upsides of crypto and blockchain technology while playing down the risks highlighted by many policy makers and consumer-protection advocates.” Supporters argue that existing regulations don’t fit digital assets, and trying to shove these square pegs into a round hole will cause innovators to move overseas. Opponents are concerned about fraud and threats to financial stability.
The Path Forward
The path forward will require cooperation between innovators and regulators. At the annual SEC Speaks conference on October 12–13, 2021, Commissioner Caroline A. Crenshaw focused her remarks on the SEC’s regulation of digital assets, including cryptocurrencies. She directed her comments to developers, saying that the path forward requires a meaningful exchange of ideas between innovators and regulators. Ms. Crenshaw suggested that a well-regulated digital market would increase investor trust and confidence and lead to heightened growth. She concluded her remarks by emphasizing the SEC’s authority to regulate these markets but noting that traditional rules and laws don't provide a sufficient framework. Rather, she noted the need to reconcile the existing regulatory regime with these rapidly evolving products.
Today, the debate around cryptocurrencies is not whether they are here to stay (they are), but how the government should regulate them. Hence, we’ve seen the evolution of the crypto asset class go from direct purchase only (through a coin exchange), to private funds available only to the wealthiest investors (who can afford to lose their shirts on a volatile, risk asset), to mutual funds and ETFs that are available to mom-and-pop investors. As cryptocurrencies and crypto-related investments continue to penetrate the market, regulators are struggling with how to handle such novel investment assets.
The Regulatory Landscape
Currently, the SEC and the Commodity Futures Trading Commission (CFTC) are racing to be the preeminent regulator of cryptocurrencies and crypto-related assets. The recent $3 million fraud related to a digital currency based on Netflix’s Squid Game shows the need for some government regulation in an area that often lacks transparency and, therefore, is ripe for misconduct. Here's a basic primer on how each of these government regulators is staking their claim to crypto.
The CFTC claims that crypto is a currency and, therefore, a commodity regulated by the Commodity Exchange Act of 1934 (CEA), a law that was created long before crypto. Setting aside whether a law that was invented in the time of slide rules can effectively manage a digital asset, the CFTC is trying to regulate derivatives of cryptocurrencies, but not the currencies directly. The reason is a lack of legal authority over currencies. Futures, options, and derivatives fall under the CFTC’s authority, but not currencies, which are regulated by the Federal Reserve and Treasury Department. The CFTC can regulate futures and options markets but not “spot” markets, where commodities (like soybeans and copper) are traded directly. Most digital coin exchanges are considered spot markets.
The Need for Crypto Clarity—and Investor Protection
The SEC is staking its claim on the definition of a security, which includes investment contracts as established in the 1946 Supreme Court case of SEC v. Howey (again, harking back to the days of slide rules, although some computers existed around this time). Under the Howey Test, a security includes an “investment contract” under the Securities Exchange Act of 1934. The test turns any contract, scheme, or transaction into a security if there's an investment of money in a common enterprise with a reasonable expectation of profit from the work of others. Clearly, that definition is extremely broad and can be applied to a myriad of situations.
Oddly, the SEC has already said that Bitcoin and Ethereum, the two largest cryptocurrencies by market size, are not securities. But as noted in a recent Jurist article, “the SEC has cleverly identified other aspects of the crypto ecosystem which are more similar to securities and has declared those areas to be fair game for SEC regulation.” Specifically, the SEC is trying to regulate initial coin offerings (ICOs), which would apply to any new cryptocurrencies hitting the market, not ones already in circulation. The SEC is also going after Decentralized Finance (DeFi) products related to lending and borrowing crypto on decentralized platforms. Since these instruments are more akin to debt, they are more clearly in the SEC’s purview. The SEC is also going after crypto-related companies that have issued stock or other securities to investors. Those securities offerings, whether registered or unregistered, are also clearly in the SEC’s authority.
On August 3, 2021, SEC Chair Gary Gensler provided remarks at the Aspen Security Forum on the current state of U.S. crypto asset regulation. While acknowledging the contributions crypto assets and blockchain technology have made to financial and monetary innovation, Mr. Gensler noted the immediate need for investor protection considering the hype, frauds, scams, and abuses in the crypto asset space that have harmed investors. Mr. Gensler remarked on the protections that existing U.S. securities laws provide, particularly with respect to ICOs, many of which have been subject to SEC enforcement action as offerings of unregistered securities. Nevertheless, he warned that significant investor protection gaps exist with respect to foreign and decentralized crypto trading platforms that fail to prohibit U.S. investors from participating. Mr. Gensler noted that products providing exposure to crypto assets have been around for several years and there are a few mutual funds that invest in Bitcoin futures that trade on the Chicago Mercantile Exchange (CME). He noted that these products include the significant investor protections provided by the Investment Company Act of 1940 but stressed that further congressional action is needed to close regulatory gaps regarding crypto assets.
The SEC Flexes Its Regulatory Muscle
Within days of announcing a need to protect investors, the SEC brought numerous enforcement actions against players in the crypto and DeFi space. For example, a few days after Chair Gensler’s comments, the SEC announced a settled enforcement action against a DeFi platform and its executives for unregistered securities sales of more than $30 million and misleading investors. Blockchain Credit Partners used smart contract and DeFi technology to sell two types of digital tokens: mTokens and DMM governance tokens (DMG). The mTokens paid fixed interest and the DMG tokens purportedly gave holders certain voting and profit-sharing rights. The DMG tokens were meant for resale in a secondary market. The SEC found that the tokens were investment contracts under the Howey Test, and therefore the offerings should have been registered under the Securities Exchange Act of 1934.
A week after Chair Gensler’s comments, the SEC announced a settled enforcement action against Poloniex LLC for operating an unregistered online digital asset exchange in connection with its operation of a trading platform that facilitated buying and selling of digital asset securities. The SEC again determined that the digital assets were investment contracts. The exchange traded Bitcoin, Ether, Monero, Tether, and USD Coin. Poloniex didn't offer any fiat currency functionality or trading, but it did charge trading fees from each transaction and aggregated the fees in a Poloniex-owned address of the digital asset underlying the trade.
More recently, the SEC brought a civil lawsuit against Ryan Ginster for engaging in two unregistered and fraudulent securities offerings. In SEC v. Ryan Ginster, the staff alleged that Mr. Ginster sold about $3.6 million in Bitcoin through multiple coin exchanges, promising unrealistic rates of return. Mr. Ginster then converted about $1 million of the Bitcoin into cash and used it to pay personal expenses. In a press release, Michele Wein Layne, Regional Director of the SEC's Los Angeles Regional Office, stated that “[i]ndividuals who hide behind the anonymity of cryptocurrency transactions to defraud investors should expect that the SEC will trace their illegal activity and hold them accountable for their actions.”
On December 2, 2021, the SEC brought another crypto-related enforcement action, this time for a foreign scheme that allegedly defrauded retail investors of more than $7 million in two unregistered digital asset securities offerings. This time, the case was brought by the SEC’s Cyber Unit, a specialized unit within the SEC’s Division of Enforcement. In the press release, Kristina Littman, Cyber Unit Chief, reiterated that the SEC “will continue to detect and pursue those that seek to victimize investors in the digital asset space.”
The Battle over Crypto Continues
In early December 2021, SEC Chair Gensler said at an SEC Investor Advisory Committee meeting that many digital tokens are securities and fall under the SEC’s authority. As reported by InvestmentNews, Gensler stated that “[t]he American public is buying, selling and lending crypto on trading, lending and decentralized finance platforms, where there are significant gaps in investor protection. This leaves markets open to manipulation.” In its year-end report on SEC enforcement in fiscal year 2021, the SEC noted that it had brought first-of-their-kind actions involving securities using DeFi technology.
Despite Chair Gensler’s position, the fact remains that digital assets like cryptocurrencies don't fit neatly into the SEC’s regulatory framework. A bit of legal gymnastics is needed to vault and land on the conclusion that crypto is a security. Regardless of the accuracy of the SEC’s position, the crypto market will see increased government regulation in the years to come, and many welcome it. One group that would welcome crypto clarity is registered investment advisers, whose clients are increasingly interested in crypto as part of their investment portfolio.
As always, our experts at Joot are here to help you navigate the complex regulatory landscape of cryptocurrencies and other digital assets. Get in touch with any questions you have.