Beginner’s Guide to Crypto Regulation

It is a common misconception that the digital asset industry is unregulated. In the United States alone, federal agencies and regulators such as the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), and the Treasury have all issued rules and guidance on how crypto falls under their respective responsibilities. This is not even touching on various government regulators and law enforcement agencies that have taken similar initiatives or multiple efforts from financial regulators around the world.

However, crypto regulation has been difficult. This is because digital assets break the mold when it comes to traditional classifications. Ether, the native token of the Ethereum multipurpose blockchain, has or had characteristics of a commodity, currency and security. In addition, there are many examples of regulators arguing over jurisdiction. At the start of 2023, the SEC and CFTC disagree on whether ether is a security or commodity, which will determine which is the primary regulator. This is an unfortunate consequence of crypto’s newness because with nearly $1 trillion in total market capitalization, many people’s financial livelihoods are tied to the digital asset ecosystem.

Why do we need regulation?

The Cypherpunk ethos revolves around the use of cryptography to protect people’s privacy and security against governments and corporations. Because crypto was born out of this community, many early entrants take a laissez-faire approach to investing and building in the sector.

Yet this ethos will have to come to terms with the fact that institutions that exist for consumer protection will have a hard time standing as some take advantage of unwitting investors in what has become a $1 trillion industry. To a large extent, regulators are justified in stepping in to provide restrictions due to initial coin scams, Ponzi-based schemes, misrepresentations, and flawed token designs that can cost investors billions of dollars. The recent string of bankruptcies, highlighted by the collapse of FTX, underscores the need to protect consumers in this volatile industry.

Previous attempts at regulation

Previous stabs at regulation, or even just classification, show the complexity of the challenge. Take bitcoin as an example. The asset was defined as a virtual currency and payment system by the US Treasury back in 2013. It was then considered a commodity under the Commodities Exchange Act by the CFTC in 2014. If that wasn’t confusing enough, it was also classified as property by the Internal Revenue Service for income tax purposes that year. Then, in 2021, an infrastructure bill passed by Congress treated bitcoin as physical cash, requiring reporting of transactions over $10,000 in value.

These multiple classifications put bitcoin holders in a precarious position. Capital gains tax is required when you sell bitcoin for a gain due to the property classification, but does a holder have to disclose to the IRS when they tip someone $1 through the Lightning Network? The technical answer is yes, although this contradicts crypto’s status as money.

Congress has introduced over 50 bills regarding digital asset taxation, classification, regulatory treatment, stablecoins and central bank digital currencies (CBDCs). Prominent examples include the 21st Century Dollar Act (HR 3506), the Keep Innovation in America Act (HR 6006), and the Blockchain Regulatory Certainty Act (HR 5045). In June, two senators, Cynthia Lummis (R-Wyo.) and Sen. Kirsten Gillibrand (DN.Y.), filed landmark legislation aimed at providing specific solutions to most of crypto’s quagmire, such as distinguishing a security token from a digital last and provides clear tax rules, called the Responsible Financial Innovation Act of 2022 (RFIA). In addition, Congress held at least 15 hearings focused on cryptocurrency and blockchain policy in 2022. The most active committees were the Senate Banking Committee and the House Financial Services Committee.

Indeed, in part a reaction to the FTX collapse and reflection of the industry’s potential, the House Financial Services Committee under Chairman Patrick McHenry (RN.C.) created the first body dedicated to digital assets. Called the House Subcommittee on Digital Assets, Financial Technology and Inclusion, it will be chaired by Representative French Hill (R-Ark). In an exclusive interview with Forbes, Hill said one of his first priorities is going to be stablecoins, building on what he calls a very “collaborative effort last summer and early fall between House Democrats, House Republicans and the Biden administration, in thinking through the right approach.”

As for the White House, on March 9, 2022, President Joe Biden signed the Executive Order on Ensuring the Responsible Development of Digital Assets. This became a comprehensive government effort in which the administration tried to define how the US should approach digital assets. The order required several cabinet-level departments to conduct investigations into the risks and opportunities of digital assets within their areas of responsibility.

The hope in the industry is that Congress and the White House will work together on a productive approach to guarding the path of digital assets. But when things get tough and investors get hurt, as in the case of 2022’s countless bankruptcies, blame can be thrown around. “Washington loves to find a scapegoat,” former congressman and acting White House chief of staff Mick Mulvaney said in an interview with Forbes. These comments came on the back of a statement issued by the White House in late January accusing Congress of dropping the ball on crypto regulation.

What to expect in 2023

The White House and Congress are largely saying the right things when it comes to setting crypto’s ground rules. Indeed, Hill and Mulvaney agree that even in this divided political climate, crypto is a cause of bipartisan support and interest. However, in the weeks or months before any laws are passed, the industry is likely to see a continuation of the increase in enforcement actions against key players in the space that regulators believe are not following the rules.

In recent weeks, the SEC has issued Wells Notices notifying companies that they are under investigation and announced settlements against crypto exchange Kraken (allegations that the ether staking program is a security), New York trust company Paxos (accusing it of issuing a Binance-branded stablecoin that is also a security), and Terraform Labs (the founding company behind the stablecoin terraUSD and its associated governance token luna which collapsed in May 2022). The CFTC has filed similar lawsuits against players in the industry, and key banking regulators such as the FDIC, the Federal Reserve and the Office of the Comptroller of the Currency are warning banks under their supervision to avoid excessive exposure to crypto, whose volatile nature can lead to rapid and large in – and outflows of deposits.

The industry would much prefer a piece of legislation that sets the rules of the road to a mix of orders and enforcement actions (which by definition are not precedent-setting as they only apply to the exact circumstances of a case). However, reading the tea leaves can be left for a little while longer.