Crypto regulation: What’s new and what investors need to know

• Recommendations on stablecoin regulations. On October 11, the Financial Stability Board, an organization that coordinates fiscal policy for the world’s largest economies, published high-level recommendations regarding the supervision and regulation of stablecoins and opened the proposed framework for public comment. The proposals would provide more federal oversight for stablecoins and implement standards to reduce systemic risk and concentration of financial power.

• Discount on celebrity endorsement of crypto without proper disclosures. On October 3, the Securities and Exchange Commission announced charges against reality TV star Kim Kardashian for promoting crypto on social media without disclosing the payment she received. She settled the charges by paying $1.26 million in fines and agreeing not to promote crypto for the next three years. In the announcement, SEC Chairman Gary Gensler said the case serves as a reminder to celebrities and others that the law requires them to disclose when and how much they are paid to promote investment in securities.

• Groundbreaking sanctions. On August 8, the US Treasury Department’s Office of Foreign Assets Control, or OFAC, sanctioned Tornado Cash, a cryptocurrency mixer that mixes funds to make their sources harder to trace. This is the first time the United States has sanctioned digital assets rather than a person or entity.

No single entity has complete oversight of cryptocurrency in the United States. Instead, a multitude of government agencies and departments step in only as far as one cryptocurrency – or a crypto-related company – crosses into its specific area of ​​supervision. The SEC, the Commodity Futures Trading Commission and the Office of the Comptroller of the Currency are just some of the government bodies that oversee cryptocurrency to some degree.

Crypto’s fragmented oversight and relative lack of regulation may accelerate innovation, but it may leave individual investors less protected. And the boundaries are being moved all the time. By 2022, state legislatures have introduced over 160 bills that would affect cryptocurrency at the state level, and Congress has introduced more than 50 pieces of legislation.

Understanding crypto regulation is helpful when preparing to pay taxes on crypto or trying to make informed choices about where to store crypto. Being aware of which bills may become law can potentially help you anticipate industry trends.

Cryptocurrency was largely created to exist outside of institutional intermediaries. Bitcoin’s founding document states: “What is needed is an electronic payment system based on cryptographic proof rather than trust, allowing two willing parties to transact directly with each other without the need for a trusted third party.” So it may come as a surprise that the government is as involved at all.

However, many people interact with cryptocurrency through institutions, not peer to peer. Crypto-specific exchanges that offer custodial services or crypto-payment services are the types of centralized institutions Bitcoin was designed to bypass, but consumers have gravitated toward this practical foray into crypto ownership. Traditional financial companies are increasingly moving into crypto as well. That intersection of cryptocurrency and financial services companies is where much of the regulatory attention is focused.

The appropriate role of government is an ongoing philosophical debate in the cryptocurrency community. However, for an investor, the question is what to do because crypto is regulated to a certain extent.

The IRS makes it clear that crypto is taxed. After you’ve filled in your name and basic information at the top of your tax return, one of the first questions you’ll need to answer is: “At any time during [the tax year]did you receive, sell, exchange or otherwise dispose of financial interests in a virtual currency?”

If you sell crypto for a profit, even if you exchange it for another cryptocurrency instead of cash, you pay capital gains taxes. If you earn crypto for a job or service, that may include strikedo you pay income tax on it.

For some, this will be no more challenging than adding stock trades from a traditional brokerage. But crypto brings unusual scenarios:

• Hard forks—major software updates to blockchains that make old transactions incompatible with post-update transactions—trigger tax events, which can be unexpected.

• If you use crypto to pay for something, you are required to pay capital gains tax on the crypto you send to the seller, which can be counterintuitive. A bill introduced in 2022 proposed to exclude the first $200 of potential capital gains arising from transactions like this, while another bill would exclude capital gains on transactions where the capital gain was less than $50. However, none of the bills have become law.

For years, companies have tried to offer true Bitcoin ETFs — exchange-traded funds that hold Bitcoin (or altcoins). Assets in one exchange-traded fund owned by the fund provider. The provider then sells shares in the fund to investors, who can trade the shares as shares. Bitcoin ETFs, which are available in some countries, can allow individual investors to bypass setting up an account with a crypto exchange to effectively hold the same investment.

If this option were available, demand for the underlying cryptocurrencies could increase as new investors add them to their accounts. To date, however, the SEC has rejected all applications for this type of investment. There are some solutions – such as crypto ETFs that attempt to mimic the price pattern of a cryptocurrency by using futures contracts – but none quite meet the definition of an ETF that holds crypto.

Other areas where crypto could expand are retirement accounts, where $33.7 trillion was withdrawn in September, according to the Investment Company Institute, an association that represents regulated investment funds. Investors can adding crypto to a Roth IRA account opened with a small number of suppliers who offer this service. Additionally, Bitcoin becomes an option for a limited set of 401(k) owners. But overall access is still limited.

The traditional economic system is no stranger to being regulated by a wide variety of agencies. But cryptocurrency presents a new challenge.

“They’re trying to fit a square peg into a round hole,” says Jimmie Lenz, director of the Master of Engineering in Fintech program at Duke University and head of the Digital Asset Research and Engineering Collaborative. “Crypto is a very unique asset class. Not only is it a unique asset class, it trades in a very unique way.”

The Financial Stability Oversight Council named its top three gaps between current regulations and cryptocurrency in a 2022 report:

• No rules for spot markets. In the traditional financial system, spot markets – where payment and ownership of assets change hands instantly – operate under regulations that promote “orderly and transparent trading” and “prevent conflicts of interest and market manipulation.” Crypto exchanges exist outside the regulated playing field.

• Regulatory arbitrage. Because cryptocurrency is not comprehensively regulated, individuals who find multiple rules for the same type of activity can potentially game the system. For example, a crypto company may place subsidiaries in multiple jurisdictions in such a way as to prevent a comprehensive understanding of its overall level of risk. Meanwhile, traditional banks that offer similar services face a higher level of scrutiny.

• Centralized services. When the average retail investor buys a stock or mutual fund, a well-defined process begins. By design, multiple entities are involved in each transaction, which can take a day or two to complete. This process acts like a series of watertight compartments in a ship: if damage occurs in one place, the process itself can limit damage elsewhere. In contrast, a crypto exchange can perform many of these otherwise distributed functions themselves. While this can lead to faster settlements, it can also introduce elevated levels of risk.

Financial regulations can provide stability to the system, and many have become so common that it is hard to imagine a world without them.

There is no equivalence in the cryptocurrency space. Crypto firm Celsius declared bankruptcy in 2022 and froze billions in customer funds. Months later, customers are still trying to access whatever remains. Some companies may have private insurance to protect against extreme situations, but it may only cover a portion of the funds it houses for customers, and it does not have the catch-up nature of FDIC or SIPC insurance.