Crypto and Its Regulatory Future in Light of Current Events

On September 16, 2022, the White House released the framework for the responsible development of digital assets. The application of regulation on digital assets may be essential if the purported benefits of digital assets are to become reality. Regulators have already been addressing concerns surrounding digital assets and are applying their existing regulatory frameworks to the industry. After all, investors and the public expect regulators to ensure financial markets are safe from fraud and manipulation. This article will explore, in part, the responses from regulators to some of the priorities from the executive order, what impact regulators have had on the industry, and what we may expect in 2023.

Crypto and Public Policy Frameworks

On March 9, 2022, when the first Executive Order (EO) on the subject of responsible development of digital assets was signed, a regulatory framework around crypto was launched at the same time. The EO outlined an approach to address the risks and the potential of digital assets. Since March, agencies have worked to develop policies to advance the six key priorities discussed in the executive order (outlined below). While the crypto industry waits for regulations, the industry has changed dramatically.

The Summer of 2022 has proven to be difficult for the crypto market, leading to what economists call the “crypto winter”. The prices have plummeted amid a wider economic slump and, as of November 2022, many crypto-handling companies face serious financial difficulties, including insolvency.

Securities regulation generally applies to all securities, whether they are digital or traditional. The U.S. Securities and Exchange Commission (SEC) is the primary regulator of security offerings, sales, and investment activities.  As reported in May 2022, the SEC’s Crypto Assets and Cyber Unit, created in 2017, has brought 80 enforcement actions related to crypto asset offerings and platforms, resulting in over $2 billion in monetary relief.

On October 3, 2022, Gary Gensler, Chair of the SEC, provided a statement on digital assets to the Financial Stability Oversight Council. Chair Gensler stated in part

“...crypto cannot exist outside of our public policy frameworks (emphasis added), regardless of what the crypto industry initially expected or what certain market participants might say today. The policy frameworks include protecting investors and consumers, guarding against illicit activity, and supporting financial stability.”

On November 30, 2022, at an event hosted by the New York Times DealBook, U.S. Treasury Secretary Janet Yellen stated referring to cryptocurrencies:

“I think everything we’ve lived through over the last couple of weeks but earlier as well, says this is an industry that really needs to have adequate regulations. And it doesn’t (emphasis added).”

On December 1, 2022, U.S. Senate Committee on Agriculture, Nutrition and Forestry had a Congressional hearing on cryptocurrencies. The Commodity Futures Trading Commission Chair Rostin Behnam testified on regulating cryptocurrencies. Chair Behnam told lawmakers, in summary, that more regulation is needed and his agency needed the power to write rules and oversee crypto trading. He added that exchanges need registration, the market needs surveillance, and a direct relationship is needed with custodians who hold customers' money to prohibit and deter transferring money that belongs to customers.  

Events are unfolding daily, deciphering the future of digital assets and industry leaders asking “what if” regulation had already been in place. At this point in time, all we can do is speculate. After all, the current value of crypto is based on speculation about its future value. Given it’s not backed by anything, it can only have long-term value if it’s widely accepted as a medium of exchange and, consequently, a store of value.

Priorities of the New Executive Order

A total of 9 reports were submitted to the President. The reports reflected expertise from across the government, industry, academia, and civil society. The end result of the EO was to decipher digital assets. The reports addressed six priorities of the EO and provided further domestic and international action. Let’s discuss 3 key priorities out of the list that may have the most impact on cryptocurrencies moving forward.

1. Consumer and investor protection

The goal is mainly to protect consumers from misleading information about digital assets’ return on investment. Until recently, cryptocurrency was not available as an investment option in defined contributions in pension plans. Guidance issued by the US Department of Labor (DOL) for plan investments, in particular, 401(k). DOL reminded fiduciaries of the standard of care in the investment options for participants.  The concerns by DOL include:

• The speculative nature of cryptocurrency investments,
• Difficulties in evaluating how much to include in investment portfolios,
• Recordkeeping,
• Change in valuation, and
• The unknown regulatory environment.

Some may argue that cryptocurrency in retirement accounts could benefit the participants, while others express concern about it as an investment option. The SEC added positions to their  Crypto Assets and Cyber Unit to protect investors in the crypto markets. “The U.S. has the greatest capital market because investors have faith in them, and as more investors access the crypto markets, it is increasingly important to dedicate more resources…,” said SEC Chair Gary Gensler.  The Commodity Futures Trading Commission (CFTC) will also play a major role in enforcing laws and regulations related to digital assets.

The Federal Deposit Insurance Corporation (FDIC) does not insure crypto products. The FDIC deposit insurance protects bank depositors up to $250,000 in the event an FDIC-insured bank fails. The FDIC deposit insurance does not apply to non-banks like crypto companies. In the same manner, FDIC deposit insurance does not protect consumers with non-deposit products such as stocks, bonds, mutual funds, securities, commodities, or crypto assets. This FDIC Fact Sheet provides additional information about FDIC deposit insurance coverage. The FDIC went further and addressed possible misrepresentations about FDIC deposit insurance by crypto companies by issuing an Advisory Letter.  

2. Financial stability

Financial stability refers to financial institutions being able to provide financial products to individuals, communities, and businesses to invest and grow. In other words, financial stability is a financial system that meets the needs of families and businesses to borrow money to buy a house or a car, or fulfill education needs.

In 2023, the Federal Reserve Banks will launch a new method to make payments more secure, reliable, affordable, and accessible to the general public called FedNow. FedNow is an initiative under the EO to ensure the digital economy is accessible to all Americans and to promote safe and affordable financial services, especially for the unbanked, and to alleviate the cost of non-bank services (i.e., check cashing, money orders, etc.).    

In October 2022, the Financial Stability Oversight Council (FSOC) published a report on digital assets’ risks and regulatory gaps and provided additional recommendations for financial stability. The FSOC was established by the Dodd-Frank Act (Public Law 111-203, Sec. 111) to identify risks to the U.S. financial system. According to the report, digital assets’ risks fall into two categories:

• Interconnections between the crypto-asset ecosystem and the traditional financial system, and
• Vulnerabilities primarily confined to the crypto-asset ecosystem.

The premise is that risks arise from vulnerabilities that amplify the impact of shocks on the financial system or economy. If the “shock” is large enough, it could have a significant impact on the financial system – as compared to a stable financial system that can absorb a “shock” and continue to function.

3. Illicit finance

The EO amplified the importance of mitigating illicit finance and national security risk associated with digital assets. The  U.S. Department of Treasury Action Plan to Address Illicit Financing Risks of Digital Assets emphasized monitoring risks, cooperation with international partners implementing AML/CFT (anti-money laundering and countering-the-financing-of-terrorism) and strengthening regulations, among other items. The risks of laundering illicit proceeds by cybercriminals, drug traffickers, and fraudsters are ever-present.

According to the  2022 National Terrorist Financing Risk Assessment, some virtual assets allow transactions without the involvement of a financial institution with AML/CFT obligations. Virtual Asset Service Providers (VASPs) doing business in the U.S. are recognized as money transmitters and are required to comply with AML requirements, register with FinCEN, develop, implement, and maintain a risk-based AML program (file SARs, CTRs, maintain records). VASPs who neglect AML requirements create vulnerabilities in addition to violating AML regulations. The US laws and regulations do not merely expect compliance with anti-money laundering and deter financing of terrorists, but require businesses that are in the financial markets to prevent such violations from occurring in the first place. Businesses are required to know their customers’ identities and report suspicious activities when necessary.

Will the regulation of digital assets come in 2023?

It seems everyone is yelling advice to REGULATE cryptocurrencies and STOP the fraud associated with the crypto industry. Yet, it can be difficult to provide consumer and investor protection within an industry that is not regulated. Financial stability and deterrence of illicit financing also depend on regulation. We have all read numerous articles and statements from regulators on investigations and recoveries of monies associated with digital assets. But the only constant is that there is too much obscurity and vagueness around what the final digital assets regulations will look like and how they will be enforced.

By regulating digital assets, the SEC, CFTC, or whomever the “official regulator’ is designated to, would be able to require U.S. brokers trading in digital assets, or those assisting consumers or investors, to comply with AML and other reporting laws. Regulators need resources, written rules, be able to examine and inspect markets for compliance, and bring enforcement actions, if necessary, to the developing industry of digital assets. In brief, Congress should assure that regulators have the necessary guidelines of laws and regulations to effectively monitor digital assets. We are beyond the “what if” digital assets regulations would have been implemented years ago and should move on to the “what now” that we have the necessary information to pass laws and regulations for the industry. Key laws and regulations to date:

The Infrastructure Investment and Jobs Act signed into law by President Biden on November 15, 2021, includes 3 changes applicable to users of crypto, blockchain, and digital asset space:

• Internal Revenue Code was amended to update the definition of a broker to include any person providing service effectuating transfers of digital assets;
• Brokers (of digital assets) are required to provide information on tax returns regarding gross proceeds, including any gain or loss with respect to digital assets; and
• Digital assets are treated as cash in certain circumstances.

The Digital Asset Market Structure and Investor Protection Act introduced on July 28, 2021, is intended to:

• Protect consumers and promote innovation by incorporating digital assets into existing financial regulatory structures;
• Provide legal and regulatory certainty for digital assets;
• Provide fundamental investor protections to U.S. retail investors and other consumers;
• Improve trade reporting and transparency;
• Strengthen the Bank Secrecy Act requirements related to the treatment of digital assets; and
• Protect U.S. investors in the digital asset sector.

The Lummis-Gillibrand Responsible Financial Innovation Act (RFIA) introduced on June 7, 2022, establishes a comprehensive regulatory framework for digital assets in similar ways as commodities futures and swaps. RFIA would classify:

• Many cryptocurrencies (including Bitcoin and Ether) as commodities under the purview of the CFTC,
• Tokens that include equity rights under the purview of the SEC, and
• Stablecoins under the purview of banking regulators.

To read about state cryptocurrency legislation in your state, visit the National Conference of State Legislature site.

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