Understanding the Regulatory Landscape of Crypto: Part 2
Welcome back to our 2022 regtech series, where we trace the evolution of regtech adoption in financial services and the legal industry, the regtech funding market, and specific strengths and weaknesses of regtech. In our last post, we started to survey the complex regulatory landscape of crypto and decentralized finance (DeFi). Here, we continue to navigate this tough terrain.
The SEC Strengthens Its Claim to Digital Asset Oversight
In April 2021—a week before Chair Gensler’s confirmation—Hester Pierce (aka Crypto Mom) published an updated version of her “Token Safe Harbor” proposal for crypto and digital assets. Commissioner Pierce added “exit guidance” to her proposal. According to CoinDesk, “[u]nder the Token Safe Harbor 2.0, companies would have to tap outside counsel to evaluate their projects and create a report assessing whether the project meets certain criteria to be considered ‘decentralized’ or ‘functional.’” Again, the Commission declined to formally consider Commissioner Pierce’s proposal, although the new chair, Mr. Gensler, spoke openly about the SEC’s authority to regulate digital assets.
Chair Gensler has repeatedly argued that digital assets may fall under the SEC’s remit if investors buy them to fund a company or project with the intention of profiting from those efforts. That determination is based on the Howey analysis, a 1946 U.S. Supreme Court decision defining investment contracts. Despite minor CFTC forays into digital asset enforcement and U.S. Treasury tax regulations on digital assets, the SEC continued to stake its claim as the primary regulator of digital assets. The SEC strengthened its ties to the DeFi community when it authorized the first registered investment companies that principally invest in Bitcoin futures on CFTC-approved exchanges. On December 7, 2019, a day which may live in infamy, the SEC approved the NYDIG Bitcoin Strategy Fund, a closed-end management investment company that primarily invests in Bitcoin futures. At the time, Commissioner Pierce tweeted the approval was a “bit of progress.”
Two years later, the SEC approved the first ETF to invest in Bitcoin futures contracts, the ProShares Bitcoin Strategy ETF. A month later, the staff approved the IDX Risk-Managed Bitcoin Strategy Fund, a mutual fund that primarily invests in Bitcoin futures contracts. (IDX Funds tried to launch a similar fund for Ether futures contracts, but the SEC requested that IDX Funds withdraw the registration statement until the Ethereum merge is completed.)
The SEC continues to focus on digital assets, as noted in its 2022 examination priorities, and has almost doubled the size of its crypto enforcement unit. The increase in the Division of Enforcement’s Crypto Assets and Cyber Unit was announced on May 3, 2022. The Commission has also added private funds to its list of high-priority areas. Chair Gensler noted at the International Limited Partners Association Summit in November 2021 that the $17 trillion of private fund assets are increasing in size, complexity, and number. While many of these funds’ investors (or limited partners or members) are wealthy individuals, increasingly retirement plans, government pension plans, and other non-accredited investors are investing in these funds. The recent rise in crypto funds has occurred within the private fund framework. The Commission’s focus on private funds will no doubt bring it into closer contact with crypto and other DeFi assets.
Years after the First ICOs, U.S. Regulation Is a Mess
On June 6, 2022, U.S. Senators Cynthia Lummis (R-WY) and Kirsten Gillibrand (D-NY) proposed a bipartisan crypto bill (the DeFi Bill) that would begin to apply a legal framework to the digital asset space. The 69-page bill covers a lot of ground, including taxation, securities and commodity regulation, consumer protection, and more. It also seeks to establish definitions throughout the space. The bill would also require a study of the environmental impact of crypto mining and other activities related to the industry.
I’ve written about how the SEC is beating the CFTC in a regulatory land grab to be the de facto cryptocurrency regulator. Well, the DeFi Bill would define cryptocurrencies under the commodity category. Specifically, the CFTC would get exclusive authority to regulate the spot markets for cryptocurrencies, which would be defined as commodities and not securities. The SEC would get some oversight responsibilities when digital assets are issued as equity, debt, or other forms similar to securities. Additionally, firms offering stablecoins would need to establish 100 percent reserves for the digital asset and provide detailed disclosures.
The overall reaction of the crypto community was mildly optimistic because the bill was reasonable and supported innovation. Plus, the CFTC is only about one-sixth the size of the SEC and tends to engage in less rule-making and enforcement activity. All positives for a market that still resembles a digital Wild West.
According to CFTC Commissioner Goldsmith Romero, most digital assets that depend on the managerial efforts of the issuer, but are not equity in the issuer, are ancillary assets that are commodities regulated by the CFTC. She agrees that the DeFi Bill would make the CFTC the dominant regulator, but she notes that U.S. federal courts would interpret the application of the law on a case-by-case basis, which could alter the application of the law. Oddly, the SEC would still oversee the reporting requirements for ancillary assets, even though they are regulated by the CFTC, perhaps because the SEC has a larger disclosure review staff.
So after All This, What’s Next?
Given the recent carnage in cryptocurrency markets, bankruptcies by cryptocurrency service providers, and the clear threat of contagion throughout the industry, the government is finally starting to “talk” about acting. On July 7, 2022, the U.S. Treasury Department issued a fact sheet on a proposed regulatory framework that would help create interagency regulation of digital assets. On July 11, 2022, the Financial Stability Board (FSB) said that, in October 2022, it would issue recommendations for coordinating global rules for digital assets. Nearly all the focus is on stablecoins and central bank digital currencies (more to come on these cookies). As we note later, the collapse of TerraUSD, an algorithmically backed stablecoin, has created the first wave of bankruptcies and crises in the crypto space. Hence, the government views these products as the most dangerous.
But the DeFi Bill has tampered with the SEC’s momentum, and on Tuesday, June 28, 2022, Chair Gensler suggested on CNBC’s morning show Squawk Box that many digital assets, including crypto assets, have key attributes of securities, but he also suggested that Bitcoin (and possibly other cryptocurrencies) are going to be deemed a commodity. Ethereum appears to have the strongest case for not being a security since that blockchain network operates more like a utility for smart contracts and other applications.
On July 14, 2022, Chair Gensler suggested that the SEC might exempt cryptocurrencies from certain securities laws, as reported by Bloomberg. At the same time, he suggested there are many cryptocurrencies that are “non-compliant” with rules around unregistered securities offerings. About a week later, Gurbir S. Grewal, director of the SEC’s crypto enforcement division, was at a congressional hearing regarding the crypto industry. He said very little, probably because a few days later the Department of Justice and the SEC brought insider trading charges against crypto insiders from Coinbase.
One area where the CFTC and SEC seem to agree is the need for segregated accounts. Both agencies want to know if deposits from customers belong to the issuer (and are held in a commingled account) or the customer (in which case each customer’s assets should be held in separate accounts). CFTC Commissioner Goldsmith Romero raised this issue in a 2020 memo and mentioned it recently in an Axios news media event. SEC Chairman Gensler has also raised the issue before. The issue took on greater significance when Coinbase suggested that customer assets were in a commingled account that could be subject to the bankruptcy of the company. Ouch!
On March 31, 2022, the SEC issued Staff Accounting Bulletin No. 121, which expressed the staff’s views regarding “the accounting for obligations to safeguard crypto-assets an entity holds for platform users.” CoinDesk reported that “[t]his move spurred Coinbase (COIN) to declare in a public filing that customers’ assets may be caught up with the company’s in a hypothetical bankruptcy.” Some customers freaked out; most didn’t notice.
The staff also requires that public crypto firms value digital assets at the lowest price struck during the reporting period (e.g., quarter). And it has made it clear to crypto firms—such as MicroStrategy—that they cannot take out the price changes in unofficial accounting numbers. Why does this matter? Because forcing public crypto companies to value their assets at the lowest price during the period affects how those companies report earnings. So if the lowest price of Bitcoin during the quarter that ended June 30, 2022, is about $17,000, then that’s the number public crypto companies must use when valuing their assets and reporting their earnings.
U.S. Federal Reserve Chairman Jerome Powell took issue with the staff’s position on June 22, 2022, during testimony on monetary policy before the Senate Banking Committee. As reported by CoinDesk, Powell stated that “[c]ustody assets are off balance sheet, have always been,” and “[t]he SEC made a different decision as it relates to digital assets for reasons it explained, and now [the Federal Reserve has] to consider those [decisions].” Unfortunately, while the CFTC, SEC, and Federal Reserve try to align with government policy, the crypto market collapsed and some of the worst fears started to become reality.
A recent report by the Bank of International Settlement (BIS) found that most of Coinbase’s assets are off balance sheets (i.e., customer assets that are held in custody). According to the report, Coinbase reported $256 billion of assets on its platform as of March 31, 2022, but its balance sheet showed only $21 billion. Why the difference? Because for customer assets, Coinbase is recording both an asset and a liability on its balance sheet. The associated liability is meant to reflect Coinbase’s obligation to safeguard customer assets.
The custody issues are bringing attention to another concern: transparency. Many of the better-known DeFi firms are using centralized blockchains that are not transparent, which technically means they are not DeFi. Celsius, a crypto lender, is a good example, and in June 2022, it used its control over the blockchain to stop withdrawals. There was no warning to consumers and the backlash was intense. The Celsius meltdown highlighted the need to protect customers’ digital assets.
Privacy and Protection within Crypto
As the Celsius meltdown highlighted the ever-increasing importance of customer digital asset protection within the crypto game, other lenders, as well as the SEC and the U.S. government, took notice. No matter how diversified their money is—be it in stocks, commodities, cryptocurrencies, or beyond—people want it protected. They want to know their investments are safe and not at risk of instances like liquidation or, worse, theft. The crypto markets evolve and these questions and concerns seem to arise throughout the United States and even the world.
In our next blog post, I’ll discuss the global development and impact of cryptocurrency, the litigation and concerns involved, and the big question of “what now?” Stay tuned and reach out to our team if we can help you navigate the crypto space.
This post is part of a series originally published by FinTech Law.