The Regulatory Landscape of Cryptocurrency in the United States: Challenges and Perspectives

Introduction

So far, the crypto-sector has remained largely unregulated, resulting in an environment where scams occur frequently, investors are prone to significant losses, and developers are stuck between a rock and a hard place when it comes to compliance with existing laws. Over the years, the importance of clear guidelines and regulations has become ever clearer. This has led to an increased interest of governments and regulatory agencies around the world to provide this clarity, which has only been accelerated by the recent fall of the FTX exchange. The most prominent example is the MiCAR bill in Europe, but the UK, Hong Kong and the UAE are also taking steps toward establishing clearer crypto-specific rules. The United States on the other hand, is still struggling to provide clarity, despite housing a significant part of the industry. Instead, in the last two years, the U.S. saw a record entry of enforcement actions against industry participants. This, together with the beforementioned lack of regulatory clarity, has led to companies now considering exchanging the continent for a region that does allow for operating without uncertainty. 

This article aims to provide an overview of the regulatory situation in the U.S. We will look at what rules are yet to be established, at exactly why there is a lack of clarity and subsequently consider the differing views of the numerous entities involved in the ongoing debates. In particular the recent allegations of Binance and Coinbase by the SEC will be explored. Furthermore the court case of the SEC vs Ripple will be considered as well, since this case has been going on for over two years and its outcome could be significant for the entire regulatory situation in the country.  

Asset designation: commodity or security?

But who is responsible to provide those regulations? Partly, this task falls under the Security and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). As their name implies, the SEC regulates the security markets and the CFTC regulates the commodity markets. At first glance, it might seem obvious that a distinction needs to be made for each crypto-currency: is it a security or a commodity? However, this is easier said than done. There exists an enormous amount of different crypto assets, all of which have their own characteristics; there are a lot of nuances between their consensus mechanisms, initial token distributions, involvement of the developer teams and tokenomics. All of these contribute to the total amount of decentralization, which thus differs enormously under the existing crypto assets, and this might play a role in determining whether the asset is considered a security or not. One thing that the two regulatory bodies seem to agree on is Bitcoin’s status as a commodity. But for the remaining assets, it is clearly a complex question, and there is not yet a framework in existence that can help make this distinction. 

Contradictions among regulators

Instead, the SEC relies on the Howey test, a 77 year old test that is based on four criteria to determine the presence of an investment contract. This is the case when one can speak of an “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.” (Investopedia). With investing in crypto-assets, there is an expectation of profit present and money is invested in a common enterprise. The only point of question, then, is if this expectation of profit can be derived from a third party. According to head of the SEC Gary Gensler, this is the case. Namely, in an interview with the NYT last February, he suggested that every crypto-asset other than Bitcoin is a security. The reasoning behind this statement comes primarily from the believe that every asset other than Bitcoin can be linked to a group of people from which investors can derive said expectations of profits. Earlier on, after the Ethereum merge to Proof-of-Stake (POS) was complete, he had stated that POS assets could be viewed as securities. If these claims are to be correct, it could mean that the SEC would have jurisdiction over most of the crypto-asset regulation. But the CFTC and the SEC do not completely agree with each other on these issues and it remains unclear which entity should regulate the market. The most prominent example of this occurred last March, when the SEC had sent a Wells Notice to Coinbase, one of the biggest crypto-exchanges. The contents revealed that the SEC plans to sue them on the grounds that the company had sold unregistered securities. However, within a week time the CFTC accused crypto-exchange Binance of committing commodity fraud, because they illicitly offered trading services of commodities. Hereby they explicitly indicated Bitcoin, Ethereum and Litecoin to be commodities, contradicting earlier statements from the SEC.

Bills introduced by congress

Early June, Thompson and McHenry of the House of Representatives, introduced a procedure for developers to classify their tokens as commodities if their project is sufficiently decentralized. The CFTC would then have oversight over these assets. However, if the SEC can prove that an asset is a security, it gets the authority to classify that asset and have oversight over it. If this bill comes through, it could grant more clarity on the whole security-commodity debate, as it would entail the beginning of a more robust asset classification framework. Furthermore, the roles that the two regulatory bodies need to play could become clearer. 

So far, a lot of bills have been introduced, but little regulatory guidance can be found through congress yet, as lawmakers of these bills are still to make significant progress on them. It also doesn’t help that the opinions regarding the crypto markets differ enormously among the members of congress. On the one hand there are politicians that openly adore Bitcoin and/or crypto-technology, among which presidential candidates that even spoke at this year’s Bitcoin Miami conference. On the flip side there are members that narrate crypto technology as extremely harmful, with senator Elizabeth Warren taking it the furthest by raising a self-proclaimed “anti-crypto army” as part of her re-election campaign. 

Additionally, with predominant issues like the debt ceiling debate and the banking crisis going on, congress has had a lot on its plate to deal with, leaving crypto regulation uncertainty as a matter yet to be solved. 

Allegations against Binance and Coinbase

In April, Gary Gensler had to testify in front of congress and was questioned directly over Ethereum’s status as a security. He could, however, not provide a clear answer, but ensured that the rules were clear: companies should come in and register with the SEC to comply. On the 5^th of June, the SEC filed numerous charges against Binance, and one day later, they sued Coinbase for security fraud. The latter was not all that surprising, considering the beforementioned Wells Notice Coinbase received from the SEC earlier. There exists some overlap between the allegations; both exchanges took on the triple role of exchange, broker-dealer and clearing agency without registering as any of them. Furthermore, they both participated in the selling of unregistered securities. Tokens labeled as securities on both exchanges include popular crypto assets ADA, SOL, MATIC, ALGO, FIL, SAND, MANA and AXS. In Binance’s case, BNB, BUSD, ATOM and COTI were also listed as securities, and for Coinbase NEAR, DASH and FLOW were deemed securities, among others. The exact reasons why specifically these assets are considered securities and others are not is not completely known yet. However, one reason the SEC gives is the deflationary model some of the tokens have. According to them, the burning of tokens can be seen as an expectation of profit, because this reduces the supply of the token which should result in an increase in price.

For Coinbase, the types of allegations the SEC accused them of don’t get more consequential than this. For Binance on the other hand, the remaining accusations are much more serious, and also extend to BAM Trading (the operators of the US version of the exchange) and CEO Changpeng Zhao (Better known as “C.Z.”). According to the SEC, they commingled user funds (included to entities owned by Zhao) and created BAM Management and BAM Trading as a fraudulent scheme to avoid security laws, which would result in the continued hidden access of high-value U.S. customers outside of their U.S. exchange. 

If these accusations turn out to be true, then it could damage the global reputation of the industry, which is already not that strong to begin with. Furthermore, it could set the industry back in terms of accessible fiat-to-crypto on ramps if Binance were to halt some of its current operations. However, Binance has denied the accusations and stated that customer assets are safe. They claim they have actively tried to work with the SEC for years and that they are disappointed in the situation.

Regulation by enforcement, justified or not?

There exists a lot of disagreement among the industry about the actions that the SEC, and Gary Gensler in particular, has taken. Arguments against them include criticism against applying the Howey test to crypto assets, which is deemed too outdated. Furthermore, other reasons the SEC uses to label crypto’s as securities is also scrutinized. According to reporter Bessie Liu (1), their reasoning for deeming projects that utilize a deflationary tokenomics model as securities is wrong; the SEC doesn’t take into account the full picture of the mechanism. Namely, the tokens are burned so that the fee prices become more predictable and to prevent heavy network congestions. Another big argument is that the SEC doesn’t make it easy to come into compliance with them. This hinges on the fact that companies claim that they have repeatedly tried to register, and have asked for more comprehensive guidelines but are now instead faced with enforcement actions. Consider Robinhood and Coinbase, they have come out and stated that there is no path to compliance with the SEC, despite their efforts. 

But according to Gensler, the story is different. The current federal laws are clear and can be applied to the crypto-sector. The problem, he says, lies with the companies that are unwilling to make the necessary adjustments so that they can comply with said laws. In light of this, last May, the brokerage firm Prometheum Ember Capital LLC became the first SEC registered brokerage dealer to provide digital asset security services to customers. Thus, proving that registering is not impossible as a crypto firm. However, Prometheum capital was built in such a way that it would comply with the existing security laws. According to Aaron Kaplan, who is the co-CEO of the parent company of the brokerage firm, there is no lack of clarity when it comes to compliance. Nonetheless, existing crypto companies might need to rebuild themselves in order to meet regulatory compliance. 

That said, a questionable attitude towards the SEC’s regulatory approach is not confined to industry participants or enthusiasts. Hester Pierce, who is a commissioner of the agency, is of the opinion that they failed to provide clear guidelines, and instead have brought “enforcement actions after the fact”(2). However, the intentions of the SEC are of good will; namely to protect investors.

The Ripple vs SEC court case

Regardless of intentions, regulatory clarity is crucial for the crypto-space to operate professionally. More information on whether the current regulatory approach will continue can be found from arguably the most important court case on the matter; the SEC vs Ripple. The case has been going on for over two years now and might increase certainty about which assets will be considered securities when it is resolved. Namely, the SEC accuses Ripple Labs, a blockchain developer that created the crypto asset XRP, of selling an unregistered security (XRP). It is therefore up to the judge of the case to decide whether XRP can be considered a security or not. This is significant, because the SEC’s reasoning for XRP being a security coincides with their reasoning towards other assets. Many believe that a victory of the SEC in this case could result in them officially becoming the primary crypto regulator. Whereas a victory by Ripple might force the SEC to abandon their current reasoning. One of Ripples’ arguments stems from a speech given by William Hinman, a former director of the SEC. In it, he argues that Ethereum should not be considered a security because it is sufficiently decentralized. The same reasoning could be applied to XRP, therefore Ripple had requested materials related to this speech, the so-called “Hinman Documents”. The SEC wanted the documents to remain sealed, arguing that their contents were irrelevant towards the judge’s decision, but on the 16^th of May, the judge decided that the documents will be unsealed. This has led to speculation that the case might relatively soon finally reach a conclusion, but this is not guaranteed and remains to be seen. 

Conclusion

Comprehensive rules about how to regulate the crypto-markets in the U.S. have yet to be established. The current regulatory agenda mainly consists of agencies taking the regulation by enforcement approach and of introduced bills by congress taking a long time to be processed. Multiple industry participants and enthusiasts are not content with the current situation and are in disagreement with the SEC. Regardless of opinion, it is clear that a lot of work remains to be done before U.S. crypto-companies can operate under a clear regulatory framework. And this is of high importance. 

Numerous institutions have shown interest in investing in digital assets and integrating crypto-technology. However, without knowing exactly what kind of assets they will be dealing with and what kind of rules apply, they will remain hesitant to do so at best. This is especially true for the assets that have been labeled as securities by the SEC in the lawsuits against Binance and Coinbase. How the future of these assets is going to look like is very uncertain with the current lack of clarity. Furthermore, it is of importance for industry participants to know that they are not operating illicitly if they want to provide innovation to the space. It is thus not only important that clear regulations are established, but also that the regulations are set up in such a way that investors are protected and illicit activities will be suppressed as much as possible, while projects are not significantly compromised with regards to their decentralization and innovation is not stifled. If no such clarity can be established in the US, the continent shouldn’t be surprised if companies were to leave and crypto innovation moves elsewhere. Hopefully, a comprehensive regulatory framework will be established sooner rather than later in the U.S., but judging from the current situation, this might still take a long time. 

Sources

1. Liu, B., & Wagner, C. (2023, June 7). The SEC Says These Crypto Assets Are Securities: Their Reasoning Is Wrong. Retrieved 28-06-2023 from https://blockworks.co/news/the-sec-says-these-crypto-assets-are-securities-their-reasoning-is-wrong
2. Khalili, J. (2023, April 6). Binance and Coinbase Have Been Sucked Into a Regulatory Turf War. Retrieved 28-6-2023 from https://www.wired.com/story/binance-coinbase-regulatory-turf-war/