Is the SEC the new crypto sheriff in town?

The future of cryptocurrency regulation is an open question. While pending congressional legislation would make the Commodity Futures Trading Commission the chief regulator, the Securities and Exchange Commission is flexing its muscles in an influential way.

SEC Chairman Gary Gensler has made it clear that the agency intends to be the lead regulator of the US crypto market.

Gensler said on September 8 that the SEC will aggressively monitor crypto tokens and intermediaries. And on September 19, the agency quietly – but radically – suggested in a lawsuit that it would assume jurisdiction over the entire Ethereum network.

Ether, the second largest crypto by market capitalization, was previously considered a commodity and not within the SEC’s jurisdiction.

These two events may well shape the regulations that crypto companies and users will face for months and years to come. Industry stakeholders and intermediaries will have to adapt to the SEC’s new enforcement tactics and assertion of jurisdiction over the markets.

Crypto tokens as securities

Gensler’s comments on crypto tokens indicate that he believes most crypto tokens are securities, and therefore need to be registered and regulated.

Gensler has explained that he believes most digital tokens meet the definition of a security under the Supreme Court’s 1946 Howey test, claiming that generally “investors buy or sell cryptocurrency tokens because they expect profits from the efforts of others in a joint enterprise.”

While Gensler has made similar comments before, it’s notable that he took the time to address the primary statutes the SEC uses to regulate the traditional financial markets and make it clear that he believes they apply with equal force to crypto markets.

Gensler also stressed that the SEC has been clear about its stance on these issues.

While many in the crypto industry have called for additional regulatory guidance from the SEC, Gensler noted that both he and his predecessor have clearly stated that the SEC considers most crypto tokens to be securities.

Gensler has emphasized that the crypto industry needs to ensure that tokens are registered and regulated as securities, where appropriate, and has asked his staff to register and regulate crypto-security tokens as securities.

Gensler said that “investors deserve disclosure to help them sort between the investments they think will prosper and the ones they think will flounder,” adding that “the law requires these protections.”

Intermediaries must register

Gensler has also said that because many digital tokens constitute securities, crypto-intermediaries that trade in securities must register their various functions with the SEC.

He explained that intermediaries, whether they call themselves centralized or decentralized, match orders in crypto-security tokens from multiple buyers and sellers using established non-discretionary methods, and therefore meet the regulatory criteria to be securities exchanges.

Investors in crypto will benefit from the use of “exchange rulebooks that protect against fraud, manipulation, front-running, wash selling and other misconduct,” he said.

From Gensler’s perspective, cryptointermediaries that transact in the security token are brokers. And those who engage in the business or buy and sell crypto security tokens for their own accounts are dealers. Because of this, crypto investors should “get the protection they receive from regulated broker-dealers,” Gensler said.

Crypto intermediaries may offer exchange functions, broker-dealer functions, custody and clearing functions, and lending functions. Gensler noted that “the intermingling of the various functions within crypto-intermediaries creates inherent conflicts of interest and risks for investors.”

As a result, the agency director has asked the SEC to work with intermediaries to register each of their functions with the commission, which could eventually lead to those functions being split into separate legal entities.

Jurisdiction over the Ethereum Network

The SEC has continued to expand its claim of authority over the digital asset market. For example, it issued a cease-and-desist order on September 19 against Sparkster Ltd. for unregistered offers and sales of securities in crypto assets. The SEC also filed a complaint against crypto investor and promoter Ian Balina.

Significantly, the complaint appears to assert jurisdiction over the entire Ethereum network.

The SEC’s complaint against Balina, filed in federal court in Texas, alleges that he failed to disclose that Sparkster had agreed to give him a 30% bonus on the tokens he bought as consideration for his promotional efforts.

According to the complaint, the contributions to Balina’s pool were validated by a network of validator nodes on the Ethereum blockchain that “are clustered more closely” in the United States, and thus “took place in” the United States.

The language in the Balina complaint appears to give the SEC jurisdiction to police any Ethereum network-based project. This is a huge break from the past. Previously, the SEC and CFTC seemed to agree that Ether is not a security.

Gensler has famously called crypto the “Wild West”. Clearly, the SEC is not waiting for Congress to put a regulatory agency in place of the crypto police.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

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Mark Bini is a partner in Reed Smith’s global regulatory practice in New York. He served as an Assistant United States Attorney in the Eastern District of New York and as an Assistant District Attorney in the Manhattan District Attorney’s Office.

Joanna Howe is a New York-based litigator at Reed Smith, focusing on regulatory enforcement and investigations.