Who Regulates Crypto? – AAF

Concise summary

• Recent congressional work has sought to provide regulatory guardrails to the nascent cryptocurrency industry; for the most part, these efforts have focused on identifying a primary federal agency responsible for crypto.
• The lack of a primary regulator is only part (and possibly a cause) of the regulatory patchwork of inconsistent agency regulations and guidance on various isolated aspects of crypto.
• Except in limited circumstances, the taxation, or , activity of most cryptocurrencies and the processing of digital assets are currently largely unregulated in the United States.

Introduction

In recent months, there has been an unprecedented congressional effort to address the regulatory challenge posed by cryptocurrencies and other digital assets — a market that did not exist until 2008 and late last year reached a market cap of $3 trillion. In June, Senators Cynthia Lummis and Kirsten Gillibrand released a bill that seeks to establish a complete regulatory framework for currencies and in the process establish the Commodity Futures Trading Commission (CFTC) as the primary regulator of crypto. Just last week, Senators Debbie Stabenow and John Boozman released their own proposal that would require all digital commodity platforms to register with the CFTC – and in doing so would also designate the agency as the primary crypto regulator.

This, then, appears to be the theme of the crypto legislation coming out of Congress. While other bills have focused on crypto specifics, including cryptocurrency taxation and reporting requirements (these and other crypto developments are tracked in the American Action Forum’s Crypto Tracker), Congress’s primary efforts have been focused less on the fundamental policy questions the new market poses and more on which federal agency should primarily supervise the market. Why do we need a single point of authority? This provision may be necessary because in the absence of a federal, holistic approach to crypto regulation, the market is overseen by a patchwork of partial and inconsistent regulations emerging from the federal financial regulators. This lack of regulatory clarity led to the release of a presidential order in March directing federal agencies to coordinate their regulatory efforts.

The bill proposed by Senators Stabenow and Boozman would make the CFTC responsible for all regulatory aspects of bitcoin and other cryptocurrencies. This begs the question – in the absence of a single responsible regulator, who currently regulates crypto, and how?

CFTC

The CFTC is the primary regulator of the US derivatives markets, including futures, swaps and other types of options over historical physical commodities. The agency couples with this more limited authority over fraud and other abuses in derivatives markets. The CFTC defines a commodity as including all “goods and articles, … and all services, rights and interests … in which contracts for future delivery are now or hereafter contemplated” and is not limited to exclusively tangible assets. The CFTC asserts control over certain aspects of the cryptocurrency market depending on both the “structure and use” of the financial instrument, in addition to overseeing certain derivatives market participants, such as dealers, intermediaries, exchanges and clearing houses. Since 2015, the CFTC has argued that bitcoin and other virtual currencies are “properly defined as commodities” (a view supported to some extent by federal case law). The CFTC has also argued that the Commodity Exchange Act (CEA), the CFTC’s primary authorizing legislation, also defines cryptocurrencies as commodities (a view that is considerably more difficult to demonstrate). While this has mattered to policy makers by adding significant weight to the argument that cryptocurrencies are commodities and not securities (more on this below), the practical implications are considerably smaller. Outside of its role in policing financial abuse and fraud in interstate commerce, the CFTC does not oversee any aspect of cryptocurrency transactions that does not include the derivatives market; as a result, the CFTC is said to have “enforcement jurisdiction” but not “registration jurisdiction.” Although the bitcoin futures market is not insignificant (with a total trading volume in January of this year of around $1.5 trillion), the futures market remains just one aspect of bitcoin and other cryptocurrencies.

The CFTC has been active in seeking to expand its jurisdiction over crypto markets, with CFTC Chairman Rostin Behnam asking Congress to expand the CFTC’s authority.

SEC

The Securities and Exchange Commission (SEC) is the primary regulator of securities in the United States. The SEC defines a security as an “investment contract” and relies on the Howey test, established by a Supreme Court decision nearly a century old in what is known as the Howey test. Any financial instrument (including potentially a cryptocurrency) is considered a security if it is: an investment of money; in a joint enterprise; with a reasonable expectation of profit; and derived from the entrepreneurial or managerial efforts of others. Assuming an instrument satisfies the Howey test, the SEC will regulate it as a security regardless of the instrument’s form. Crypto issuers have previously attempted to avoid designation as a security by marketing their cryptocurrencies as having “coupon-like properties” — protests the SEC has ignored by continuing to use only the Howey test.

Bitcoin and Ethereum, the first and second most traded cryptocurrencies on the market, do not satisfy the Howey test (largely to fail at the last prong, i.e. derived from the efforts of others) and as such are not regulated by the SEC. In this, the SEC treats them as the exception rather than the rule, and SEC Chairman Gary Gensler continues to suggest that most cryptocurrencies are securities. If a cryptocurrency is determined by the SEC to be a security, the crypto issuer must register with the SEC and a number of SEC regulations become binding. One such rule (which does not apply to bitcoin and Ethereum) is the “wash-sale” rule, which prevents investors from selling and then immediately buying back an asset to take advantage of investment losses for tax purposes. If an exemption from registration is sought and obtained, the cryptocurrency becomes available only to “accredited investors,” an extremely small subset of high net worth individuals.

What liability both the CFTC and the SEC have been able to claim has been zealously enforced. The SEC has shown it is more than willing to take enforcement action against crypto issuers, including Telegram and Kik for securities violations, Forsage for “a textbook Ponzi scheme” and others. Late last year, the CFTC ordered cryptocurrencies Tether and Bitfinex to pay $42.5 million in fines for misleading statements that the currencies were backed by the US dollar.

Recently, the SEC, like the CFTC, has been pushing to assert its regulatory control over other aspects of digital finance, from decentralized finance, crypto exchanges and stablecoins.

The tax authorities

The Internal Revenue Service (IRS) is the federal agency responsible for collecting taxes. The IRS defines cryptocurrencies in yet a third way, as “property” (and definitively not as currency). For tax authorities, cryptocurrencies can be considered assets subject to capital gains tax if they are held for more than one year and gains are realized. Realized gains on cryptocurrencies held for less than one year are subject to ordinary income tax. The primary implication for crypto issuers and other entities involved in any way with crypto markets is the requirement for extensive record keeping, which could prove very burdensome for those using cryptocurrency to purchase goods or services. In July, Senators Pat Toomey and Kyrsten Sinema introduced a bipartisan bill that sought to make virtual currencies more attractive for everyday purchases by exempting transactions of less than $50 from taxes. Although seemingly more hackneyed than the more haphazard approaches of other agencies, it can be extraordinarily difficult for firms to calculate their crypto tax liabilities.

Other federal agencies

Pursuant to the Bank Secrecy Act (BSA), the Financial Crimes Enforcement Network (FinCEN) regulates money services businesses. Where crypto issuers and other actors are considered “money transmitters” (according to FinCEN guidance, this represents both virtual currency exchanges and digital wallets), FinCEN requires these entities to implement strict anti-money laundering (AML) procedures designed to prevent both money laundering and financing of crime. FinCEN also processes the Specially Designated Nationals and Blocked Entities List (SDN List) as part of the US coordinated sanctions program.

The Office of the Comptroller of the Currency (OCC) oversees the federal banking system and determines both the cryptocurrency offerings of banks and also the process by which fintechs and other startups apply for banking licenses. In November 2021, the OCC reversed previous guidance, emphasizing that banks must seek permission before engaging in crypto-related activities on behalf of their clients; guidance reiterated in early 2022 by the Federal Deposit Insurance Corporation (FDIC).

The Federal Trade Commission (FTC) shares a briefing with the CFTC on the prevention of abuse in the form of fraud or other misrepresentations.

states

Certain states have gone significantly further than others in setting up a regulatory framework that covers digital assets. In early 2022, Wyoming, Arizona and then California introduced proposals that would allow taxpayers to make tax payments in cryptocurrencies. Wyoming lawmakers proposed legislation that would pave the way for the issuance of the first state-backed digital token. In the main, however, government efforts have been characterized by their relative friendliness towards the crypto industry in an effort to appear attractive to crypto investors and startups. State-based crypto regulation has therefore evolved towards strengthening rather than restricting crypto. One of the few counterexamples was the limited moratorium on crypto mining at fossil fuel plants imposed by New York, which ended up being significantly more limited than environmental activists had hoped.

What is not covered by existing legislation?

If bitcoin, a cryptocurrency, digital asset, or the producers, holders or distributors of those assets do not fully meet limited criteria, they are essentially unregulated. If a virtual financial instrument does not have derivative aspects or is considered by the SEC to be a security, it can only be said to be regulated if it is punishable; the same applies to crypto market players. The IRS has been more successful in its approach to defining virtual assets, but in practice this has proven almost useless. As a result, significant aspects of the virtual asset market thus escape skepticism or oversight. This is not entirely the federal government’s fault, as significant logistical difficulties are posed by the challenges of policing opaque distributed networks. The situation is also not helped by the lack of clarity about which cryptocurrencies is for regulatory purposes or who their primary regulator should be. Critics of crypto note the use of crypto to avoid state capital controls, state sanctions and any form of financial crime and financing of crime and terrorism. More specifically, the patchwork of federal oversight has some glaring gaps, with a lack of federal regulation covering topics as diverse as cryptomining, reporting requirements, or estate and will planning.

Conclusions

Who Regulates Bitcoin? Everyone and no one. While having multiple regulators is hardly unusual, for all the sound and fury of the CFTC and SEC, they claim surprisingly little ground, where they claim anything at all, in the regulatory turf that is crypto. Of course, both agencies have made significant progress in annexing new territory, but this has been piecemeal and often contradictory. In September 2021, cryptocurrency exchange Coinbase dropped plans to launch an investment product, claiming that the SEC threatened to sue to prevent the issue. Without a clearly defined regulatory apparatus, the United States cannot continue to promote innovation while protecting consumers and investors.