US regulators are coming for crypto. What will the future look like?

The US government’s approach to crypto regulation will determine whether the industry evolves to flourish or flounder into obscurity.

US Crypto Regulatory Landscape

Crypto regulation is coming to the US – and it‘s is likely to have a major impact on the future of the industry.

The first key distinction to consider when analyzing the current state of crypto’s regulatory landscape in the US is the difference between the government’s legislative and enforcement approaches. This is like comparing what the government says with what it does in practice, which is important because the difference between the two approaches provides valuable insight into the government’s true intentions regarding the industry and asset class.

On the legislative front, there has been a significant increase in proposals for crypto-related bills over the past year, including by Senators Cynthia Lummis and Kirsten Gillibrands. Act on responsible financial innovationRepresentative Josh Gottheimer’s Stablecoin Innovation and Protection Act of 2022Senator Pat Toomey’s Stablecoin TRUST Act of 2022and Senators Debbie Stabenow and John Boozman’s Digital Commodities Consumer Protection Act of 2022. If these bills are implemented as proposed, the crypto regulation and industry landscape will see significant changes, which most of the stakeholders in the industry have considered as positive.

Perhaps most notably, the Commodity Futures Trading Commission will take precedence over the Securities and Exchange Commission by becoming the primary regulator of the asset class by gaining authority over spot and derivatives markets for cryptocurrency. Until recently, this was considered a very welcome change among industry stakeholders who have grown weary of the SEC’s aggressive “regulation by enforcement” approach.

Another major change that would follow if these bills were passed would be the introduction of significantly stricter rules for the issuance and administration of stablecoins. This could lead to an implicit ban on unbacked, algorithmic or “endogenously secured” stablecoins and 100% reserve requirements for stablecoin issuers. Stablecoin issuers will likely be required to hold bank charters, which are very difficult to obtain, or register directly with the Federal Reserve. This will significantly reduce the depeg risk in the cryptocurrency market. However, it could also centralize the on-chain economy if the space becomes too dependent on regulated stablecoin providers.

Perhaps the most important development on the legislative front, however, is the White House’s recent comprehensive framework for regulating digital assets. The framework was published on September 16 after President Biden signed an executive order to “Ensure responsible development of digital assets” in March. It encompasses the views and recommendations of the SEC, the Treasury Department and several other government agencies on how to regulate cryptoassets.

The framework provides the clearest overview to date of how the Biden administration plans to deal with crypto, including plans to increase enforcement efforts against illegal practices, push users away from crypto and against government-issued and controlled centralized payment solutions like FedNow and CBDCs, amend the Bank Secrecy Act apply explicitly to digital assets, and leverage the country’s status in international organizations to promote greater cross-border cooperation on crypto regulation and enforcement.

If the administration begins to deliver on its plans, the US crypto industry will begin to look increasingly like fintech than the grassroots movement trying to create the alternative financial system it set out to be. By enforcing excessively strict regulatory requirements on the industry, stakeholders may begin to abandon the US for more crypto-friendly jurisdictions, leading to an exodus of Web3 talent and ultimately US subservience on the global crypto scene.

Regulation through enforcement

On the enforcement front, there are several critical ongoing cases that – depending on the outcome – could reshape the cryptocurrency landscape in the country. The most documented of these cases is SEC v. Ripple, in which the securities firm is suing the blockchain company for allegedly conducting an illegal security offering by selling XRP tokens publicly. Judging by the case’s latest developments, the case is likely to be settled out of court, which would be a big win for both Ripple and the US crypto industry. For the securities agency, losing the case or ruling out of court would make it much more difficult to pursue other crypto companies on the same charges, giving crypto issuers and exchanges much-needed breathing space.

The other critical issue is SEC v. Wahi, where the securities firm is suing a former Coinbase employee and two co-conspirators on insider trading charges. In a blatant example of “regulation by enforcement,” the SEC argues that “at least” nine of the cryptocurrencies listed on the exchange were securities. If accepted by the court, this claim could have broad implications in the industry by making it easier for the agency to operate crypto exchanges to illegally offer unregistered securities.

In another ongoing case highlighting the SEC’s “regulation by enforcement” approach, the agency is trying to establish its hold over the industry by making broad allegations that could have serious implications for the asset class. Namely in SEC v. Ian Balina In the event, the agency has argued that Ethereum transactions should be considered “taking place” in the United States because more Ethereum nodes are located in the United States than in any other country. For that reason, the SEC says, Ethereum should fall under its jurisdiction. If the court accepts this argument, the SEC could seek to establish jurisdiction over all Ethereum transactions involving tokens that it considers to be securities, regardless of the location of the transaction counterparties.

In another disappointing development for the crypto community, the CFTC – following in the SEC’s footsteps – is followingsuing a decentralized independent organization and its token holders accused of operating an illegal derivatives trading platform. The CFTC winning this landmark case would set a terrible precedent for DeFi protocols and token holders by ensuring that they can be held liable for various crimes such as “unincorporated associations”. This would effectively devastate DeFi, making it impossible for protocols and DAOs to function without risking prosecution.

Finally, the Treasury’s move to sanction the decentralized privacy protocol Tornado Cash stands out as one of the best enforcement actions that has already had an outsized effect on the industry. The move represents the first time a government agency has sanctioned a smart contract – immutable code that lives on the blockchain – and several key blockchain infrastructure providers, such as Alchemy and Infura, have already complied with the sanctions.

Many crypto-legal experts, including US-based crypto advocacy organization Coin Center, consider the move unconstitutional and a gross jurisdictional overreach and are likely to challenge it in court. But if the Treasury wins a challenging lawsuit, the entire crypto-economy could suffer, casting doubt on its ability to uphold its core principles of decentralization, credible neutrality, and censorship resistance.

Looking forward

Depending on whether the recently proposed cryptocurrency regulations go into effect, and how the enforcement cases go, the US crypto landscape could look very different in a couple of years. The optimistic view is that both the SEC and CFTC lose all the lawsuits that could set the industry back while lawmakers pass the more favorable proposed laws that provide regulatory clarity. If that happens – and the chances are quite high – the US could become the world’s leading crypto-friendly jurisdiction, supporting the entire global industry with it.

On the other hand, the worst-case scenario is that lawmakers take far too long to enact favorable crypto regulations while the SEC and CFTC slowly regulate the space through enforcement. This would seriously hinder the US crypto industry’s remarkable growth and any technological innovation that comes out of it. Given the United States’ outsized political and economic international influence, such a scenario would also bode negatively for the global crypto industry. A potential result of a tough regulatory environment is DeFi’s fragmentation into “RegFi”, which consists entirely of regulatory protocols, and DarkFi, composed of genuinely decentralized, non-compliant, censorship-resistant protocols.

Disclosure: At the time of writing, the author of this feature owned ETH and several other cryptocurrencies.