What can regulators do about crypto?

The recent collapse of FTX has cryptocurrency investors scrambling to save their assets and regulators trying to repair the damage caused in an unclear regulatory environment.

If cryptos were government currency issued by banks, or if they were securities where FTX was a registered stock exchange, the kind of risky lending that FTX made to its affiliate, Alameda Research, would be patently illegal and customer deposits would be protected by a number of Laws and regulations.

Instead, the Securities and Exchange Commission and the US Department of Justice are trying to right a wrong using the limited regulatory tools at their disposal. The Justice Department is pursuing allegations of criminal fraud, and the SEC is investigating potential securities law violations.

But Wall Street’s regulators and investigators should also be focused on preventing and protecting investors from future wrongdoing and risk.

Here’s what I think politicians and regulators can do:

1) The SEC should say which cryptocurrencies are securities.

The SEC should state, either via regulation or guidance, which cryptocurrency securities laws apply. Right now, it assumes that most cryptocurrencies satisfy the Howey test, making them securities. The Howey test is a four-step test to determine whether a transaction qualifies as a security. The four elements are: (1) an investment of money, (2) in a joint enterprise, (3) with the expectation of profit, and (4) being derived from the efforts of others. When these elements are met, the transaction is considered a security.

Investors need transparent, consistent guidance explaining why certain cryptos are or are not securities under this test. Such a clarification will help to promote predictable application of the law. In addition, it would be preferable to the current landscape to demonstrate what the rules are via the latest enforcement action.

2) The SEC should definitively say that it will regulate crypto as it does other securities today, instead of showing its views via enforcement actions.

Regulation of crypto through enforcement has now become a long-standing pattern and has effectively made securities laws apply to crypto, a reality the industry must accept. Additionally, in light of recent fraud, regulation of crypto through securities laws is necessary for investor protection.

It appears that the current tailwind is likely to culminate in regulations for crypto on par with those for securities today. Furthermore, such regulations are better for the development of the asset class and industry players in it, as they will bring clarity to the current regulatory affairs of crypto.

The SEC has cracked down on crypto, conducting around 100 crypto enforcement actions since the first in 2013. The bulk of these actions occurred in recent years. For example, there was only one case in 2016 compared to the 19 cases filed in 2022.

The 2016 action focused on bitcoin market participants SecondMarket Inc. and Bitcoin Investment Trust, accusing them of manipulative activities related to a securities offering and resulting in a $54,000 fine. In contrast, a September 2022 action ordered Sparkster, Ltd. and its CEO, Sajjad Daya, to pay a $35 million fine. The fine was paid to a damaged investor fund for unregistered offers and sales of crypto assets.

In fact, the majority of crypto enforcement actions brought by the SEC have been for unregistered offers and sales of crypto assets, demonstrating SEC Chairman Gary Gensler’s belief that many cryptocurrencies are actually securities and should therefore be registered with the SEC.

Just last week, the SEC charged Terraform and its CEO, Do Kwon, with violating anti-fraud statutes by misleading investors and engaging in unregistered transactions.

Another type of securities violation that the SEC has investigated in relation to crypto is insider trading. In July 2022, the SEC filed a case against Ishan Wahi, an employee of Coinbase COIN. Wahi repeatedly tipped the timing and content of upcoming listings and earned $1.1 million. Although Coinbase is not registered as a stock exchange, the SEC sent a signal that insider trading in crypto is not allowed.

Likely emboldened by these victories, the SEC has pursued claims that further cloud the security status of crypto. When reality TV star Kim Kardashian was charged earlier this year with promoting crypto tokens on social media without disclosing that she had been paid for it, the SEC essentially used the finding that the coin is a security to fine Kardashian since securities regulations require disclosure of payments for endorsements. Kardashian agreed to settle the charges and pay $1.26 million in penalties, disgorgement and interest.

With this type of enforcement action, the SEC is demonstrating that it is willing and able to sue crypto players for traditional securities violations and that it has power over the crypto enforcement market. A clear statement detailing why certain coins, such as bitcoin, are not considered securities by the SEC while others are, has not been provided to investors.

3) The SEC should prioritize investor protection when considering future regulation.

On February 15, the SEC voted 4-1 to propose changes to the obligations of registered investment advisers related to the custody of alternative assets, including crypto, managed by an investment adviser. The proposal amends the current rule to include “funds, securities and other positions in a client’s account” to the definition of an asset that it would require investment advisers to maintain with a qualified custodian. Because most cryptoassets are traded on platforms that are not qualified custodians, if an advisor manages such assets, the advisor would be in violation of the proposed rule.

The proposal shows the SEC moving toward rulemaking when it comes to crypto, instead of what Commissioner Mark Uyeda called a historic use of “enforcement actions to introduce new legal and regulatory theories.” While the specific investor protection benefits of this rule remain to be elucidated through commentary, it is certainly preferable to tell investment advisers what is expected of them proactively rather than penalize them later for not being diligent about crypto assets when they were not expected to be responsible for them in the same way as established securities.

Businesses should prepare for cryptocurrencies to be regulated by securities laws

True investor protection involves proactively creating a predictable regulatory regime – not reacting to punish when investors have already been harmed and the harm cannot be fully remedied. It is probably best for firms to prepare for a world where most cryptocurrencies will be regulated by the securities laws, and the SEC should state as much directly and formally. The SEC should also consider whether and how new regulations are necessary for investor protection, given how much it has been able to do under existing securities regulations.

Editor’s note: Jasmin Sethi is assistant director of policy research at Morningstar. The views here are her own.