How SEC Regs Will Change Cryptocurrency Markets

Following the bankruptcies of FTX, BlockFi, Voyager Digital, and other cryptocurrency platforms, the U.S. Securities and Exchange Commission (SEC) accelerated its push to subject these markets to the full spectrum of its financial regulations. In the first half of 2023 alone, the SEC took 24 cryptocurrency enforcement actions.

The SEC says it made these and other recent crypto-related moves to prevent further fraud, reduce market manipulation, and force more disclosure of relevant information to investors and cryptocurrency holders. Critics in the industry charge that these moves are overreach. In either case, the SEC’s aggressive enforcement efforts could fundamentally change how cryptocurrency markets work.

SEC Chair Gary Gensler has defended the regulator’s actions, saying in 2022 that the top five crypto exchanges “likely are trading securities” and thus need to register with the SEC. These exchanges account for 99% of cryptocurrency trading. “When a new technology comes along,” Gensler said, “our existing laws don’t just go away.”

Gensler has also urged greater financial regulation enforcement of stablecoins and other crypto tokens. In May 2022, the SEC said it would increase the size of its Cyber Unit by 40%, from 30 to 50, and rename it the Crypto Assets and Cyber Unit as it expands its crypto enforcement efforts.

To fall under SEC regulations, cryptocurrency markets must meet the Howey Test. This standard is derived from a 1946 Supreme Court case concerning orange groves and has since been used to differentiate the sale of securities from other purchases​. The court ruled that a contract falls under the SEC’s jurisdiction if someone invests “money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”

The Cryptocurrency Market: Reasons for Its Popularity

Until the downturn from 2021 to 2023, the cryptocurrency market had strong momentum. One reason for its popularity was its promise to decentralize money and trade. Unlike traditional monetary systems where central banks and governments hold sway, cryptocurrencies are on networks using blockchain technology. In theory, their use should lead to less control and regulation by entities like the SEC, central banks, and other political institutions. Advocates argue that this, in turn, will lead to a more equitable financial ecosystem. Furthermore, given its underlying technology can’t be changed and is transparent to those with the expertise, blockchain encourages trust among those in the market without needing external enforcement, as with fiat currencies.

Another driver of cryptocurrency’s popularity is the possibility of financial inclusion. There are billions of unbanked or underbanked individuals globally estranged from the conventional banking system because of geographical remoteness or lack of documentation. Cryptocurrencies allow these individuals to make transactions, save, and access credit. In addition, crypto tends to have lower transaction fees than traditional banking systems, a benefit for individuals and businesses.

That cryptocurrencies offer a new asset class also entices many investors. The meteoric rise in the value of some cryptocurrencies has been an opportunity for strong returns, albeit with a lot of volatility. In times of economic uncertainty or lower interest rates, the cryptocurrency market has been considered the place to invest when diversifying a portfolio and hedging against traditional financial market risks.

Crypto also offers seasoned and novice investors relative ease of market entry and exit, adding to its appeal. The market is also viewed as innovative. The emergence of diverse applications such as smart contracts, decentralized finance, and non-fungible tokens could eventually be a mainstream alternative to traditional financial and contractual systems. These innovations offer a glimpse of a future where transactions, contracts, and digital ownership could be managed more transparently and efficiently and be more automated. The appeal of being at the frontier of financial innovation continues to draw entrepreneurs, developers, and investors into the cryptocurrency domain.

Why Is There a Need for SEC Enforcement of Cryptocurrencies?

The SEC’s regulation of cryptocurrencies involves complex issues crucial for the many stakeholders involved, including investors, entrepreneurs, and the broader public. Regulators are seeking to increase investor protection, stability, and transactional clarity in a rapidly evolving digital financial landscape. Here’s a breakdown of the rationale behind SEC enforcement of cryptocurrencies:

Investor Protection

• Fraud prevention: Cryptocurrency markets are relatively new and have been associated with many frauds and scams. SEC enforcement could deter fraudulent activities and protect investors from bad actors.
• Disclosure standards: By pulling crypto markets within securities laws, the SEC can ensure these enterprises provide more accurate and thorough information to investors, enabling them to make informed decisions.

Market Integrity

• Price manipulation: The anonymity and lack of regulation in cryptocurrency markets make them susceptible to manipulative practices. SEC oversight could help curb such practices to secure fair prices.
• Market surveillance: Monitoring the crypto markets for unusual activities could help maintain market integrity and investor trust.

Legitimacy and Adoption

• Legal framework: The SEC’s regulations could legitimize cryptocurrency enterprises and attract more traditional investors and institutions, potentially leading to broader adoption.
• Innovation and competition: By creating a level playing field, SEC enforcement could encourage innovation and competition, which are essential for the long-term sustainability and growth of the crypto sector.
• Money laundering and terrorism financing: By enforcing anti-money laundering (AML) and counterterrorism financing (CTF) regulations, the SEC and other agencies could address two major public concerns about cryptocurrencies.

Regulatory Clarity

• Defining boundaries: The SEC’s involvement could help determine the boundaries between traditional securities and crypto assets, providing much-needed clarity for entrepreneurs and investors.
• Compliance standards: Establishing compliance standards can help crypto enterprises comply with widely known regulations, reducing legal uncertainties.
• Cross-border collaboration: Cryptocurrencies are without borders, so international cooperation and enforcement could help address the global challenges.

The Howey Test Meets Crypto

The Howey Test is a legal principle used in the U.S. to determine whether a financial arrangement qualifies as an investment contract and is subject to regulatory requirements. The Howey Test has become a cornerstone in the SEC’s assessment of various financial instruments and arrangements, including cryptocurrencies and initial coin offerings (ICOs).

The test stems from SEC v. W.J. Howey Co., a 1946 U.S. Supreme Court decision establishing the criteria. The Howey Test is crucial for entities in the financial sector, including the burgeoning cryptocurrency space, as its application can significantly affect which, if any, regulatory framework governs these entities. Here are the four criteria under the Howey Test:

1. Investment of money: There must be an investment of money or something of value.
2. Common enterprise: The investment must be in a common enterprise, although courts have had varied interpretations of what that means.
3. Expectation of profits: At least one of the parties must anticipate potential profits from the investment. This is typically where the efforts of a third party—the promoter or a third party affiliated with the promoter—significantly affect the value of the investment.
4. Profits derived from the efforts of others: The profits must come predominantly or solely from the efforts of others, not from the investor. Essentially, investors are reliant on the actions of others to generate a return on their investments.

Let’s clarify this with an example: Suppose you invest in a real estate investment trust (REIT), which pools money to buy, manage, and sell real estate assets. The REIT is managed by a team of real estate professionals, the third party in this case. It decides which properties to buy, how to manage, and when to sell them. Your expectation of a profit largely depends on the real estate expertise and work of this management team. This meets the criteria under the Howey Test because 1) you invested money, 2) your investment is in a common enterprise (the REIT), 3) you set out to earn profits from your investment, and 4) the third party does the work.

If the SEC determines a cryptocurrency or token is a security and falls under its regulatory purview, this will have far-reaching implications for those involved. They may face stricter regulatory requirements and compliance burdens. The Howey Test thus serves as a critical legal tool in navigating the complex regulatory landscape of the financial and crypto markets.

Possible Regulatory Frameworks

The SEC has a broad set of regulatory tools that can be tailored to address the unique characteristics and challenges posed by cryptocurrencies. Here are the types of regulations the SEC could adopt for the crypto market:

• Registration requirements: Mandating the registration of cryptocurrency exchanges and ICOs could be a pivotal step. The registration process could confirm that these platforms and their offerings adhere to the disclosure, reporting, and operational standards of traditional financial entities.
• Disclosure standards: Establishing robust disclosure standards could help confirm that crypto enterprises give investors comprehensive and accurate information. This includes financial statements, business operations, and the risks associated with the crypto assets they deal in.
• Anti-fraud and price manipulation measures: The SEC could adopt stringent anti-fraud and anti-manipulation measures to deter deceptive practices and safeguard the integrity of crypto markets. This could include rules to curb practices like wash trading and pump-and-dump schemes.
• Investor education and protection initiatives: The SEC could broaden its efforts to educate investors about the unique risks associated with cryptocurrencies. Creating mechanisms to address investor grievances and disputes could also boost investor confidence in these markets.
• Cybersecurity regulations: Given the digital nature of cryptocurrencies, imposing rigorous cybersecurity regulations on crypto platforms could be instrumental in protecting these markets against hacks and data breaches.
• AML and CTF regulations: Collaborating with other regulatory bodies to enforce AML and CTF regulations would address some of the public security concerns about cryptocurrencies.
• Market surveillance: Deploying market surveillance tools to monitor trading activities could help detect irregular activities early, maintaining a fair and transparent market ecosystem.
• Global regulatory cooperation: Given the borderless nature of cryptocurrencies, forging alliances with international regulatory bodies to create a coordinated regulatory framework could be beneficial. This global cooperation could help tackle cross-border crypto crimes and provide a coherent regulatory approach across jurisdictions.
• Innovation-friendly regulations: Adopting a balanced regulatory approach that encourages innovation while protecting investors and market integrity will be crucial. This could include creating regulatory sandboxes that allow experimentation and real-time regulatory feedback.
• Clear tax guidelines: Providing more straightforward guidelines on the taxing of crypto transactions with guidance from the Internal Revenue Service and state tax authorities would remove a significant area of uncertainty for investors and market participants.

These regulatory frameworks, if judiciously implemented, could strike a delicate balance among the needs for innovation, protecting investors, and maintaining market stability, which would contribute to the healthy growth of the cryptocurrency market.

Recent Crypto Scandals Behind SEC Action

Cryptocurrency scandals underscore their vulnerability to fraud, which the SEC has said calls for more robust regulation in the area. Here are some recent high-profile cases:

• FTX crypto scandal (2022-2023): FTX, once the leading global cryptocurrency exchange, became the face of crypto fraud when its founder and former CEO Sam Bankman-Fried was arrested on behalf of U.S. authorities in the Bahamas on charges of fraud, money laundering, and violating campaign finance laws. FTX quickly went into bankruptcy.
• Voyager bankruptcy (2023): Voyager, a New Jersey-based crypto lender, declared bankruptcy in 2023 as part of the fallout from the liquidation of crypto hedge fund Three Arrows Capital, which defaulted on loans to Voyager totaling $654 million. This put a spotlight on the high-risk nature of crypto lending practices​.
• BlockFi (2022): The SEC charged BlockFi Lending in early 2022 with failing to register its retail crypto lending product, which is a breach of securities laws, including violations of the registration provisions of the Investment Company Act of 1940. The SEC’s action was the first of its kind for retail crypto lending products. BlockFi settled with the SEC to resolve the charges and was fined $100 million.
• Mining Capital Coin (MCC) (2022): The CEO of MCC, Luiz Capuci Jr., was indicted in March 2022 for orchestrating a $62 million fraud scheme through a purported cryptocurrency mining and investment platform while diverting investors’ money into crypto wallets under his control.
• Kraken Exchange (2022): The SEC charged Kraken’s parent companies with violating securities laws for not registering its crypto asset staking-as-a-service program. Kraken settled the charges by paying a $30 million fine and discontinuing its staking service for U.S. customers.
• Celebrity and influencer crackdown (2022-2023): The SEC began cracking down on celebrities and influencers using social media to advertise cryptocurrencies without proper disclosures​. In one example, Kim Kardashian came under the scrutiny of the SEC after she touted a crypto asset, offered and sold by EthereumMax, on social media without disclosing she was paid to do so. Kardashian ultimately paid a $1.26 million fine to settle the charges.

Historical Crypto Cases

The cryptocurrency sector has had high-profile scandals since the beginning. Here’s an overview of some major historical scandals:

• Quadrigacx scandal (2019): The crisis for Quadrigacx, a Canadian cryptocurrency exchange, was set off when its CEO, Gerald Cotten, who said he had sole access to the exchange’s funds, died in December 2018, leaving over $190 million in cryptocurrency inaccessible to investors. At this point, the exchange could not fulfill customer withdrawal requests, and in January 2019, the exchange filed for bankruptcy. A later investigation by Ernst & Young found that Cotten had operated the exchange through pseudonymous accounts and had transferred customer funds into his personal accounts.
• Coincheck hack (2018): In a security breach, hackers stole over $530 million worth of NEM tokens from the Japanese cryptocurrency exchange Coincheck. The heist underscored how crypto exchanges were still vulnerable to such attacks.
• BitConnect scam (2017): BitConnect, operating as a lending platform, turned out to be a Ponzi scheme, causing financial losses estimated at $2.4 billion and the platform’s closure.
  
• OneCoin scam (2017-ongoing): Founded in 2014 by Ruja Ignatova in Bulgaria, OnceCoin is estimated to have defrauded around $25 billion from investors. Ignatova disappeared in 2017, and OnceCoin’s other co-founder was found guilty of fraud and sentenced to 20 years in federal prison.
• Bitfinex hack (2016): Bitfinex, a popular cryptocurrency exchange, had a security breach resulting in the theft of almost 120,000 bitcoins. The platform responded by dividing the losses among its users, illustrating the risks borne by users of crypto platforms.
• DAO hack (2016): Maker DAO, a decentralized autonomous organization (DAO) or investor-directed venture capital fund based on Ethereum, was attacked by those exploiting a vulnerability in its code, leading to a loss of over 3.6 million Ethereum. This hack led to a hard fork in the Ethereum crypto network to recover the funds, creating two blockchains, one following the “classic” currency and another for Ethereum going forward.
• Mt. Gox (2014): Mt. Gox, once the world’s largest Bitcoin exchange, filed for bankruptcy in 2014 after losing 850,000 Bitcoins (worth approximately $460 million at the time) in a hacking attack. The event highlighted the security vulnerabilities faced by crypto exchanges.

Aspects of the Crypto Market Open to Regulation

Regulatory bodies globally grapple with framing rules that balance innovation with consumer protection and market integrity for the exchange of cryptocurrencies. Here’s a glimpse into various crypto market segments and how they might be regulated:

• Cryptocurrencies like Bitcoin: The pioneer and most recognized cryptocurrency, Bitcoin could have regulations that focus on its use as a currency or a commodity.
• Utility tokens: Utility tokens provide access to a product or service within a blockchain-based platform. Regulations could confirm that these tokens are not veiled securities and follow consumer protection laws.
• ICOs: Akin to initial public offerings in the crypto space, ICOs have been scrutinized for bypassing traditional securities regulations. Regulations might confirm proper disclosures and better investor protection and anti-fraud provisions.
• Non-fungible tokens (NFTs): NFTs demonstrate ownership or proof of authenticity for a unique item using blockchain. Regulations could have to do with requiring provenance verification, intellectual property rights, and potential securities classification.
• DAOs: DAOs work through smart contracts on a blockchain, enabling collective and automated decision-making. Regulations might address governance, legal liability, and registering them as securities.
• Stablecoins: Stablecoins, often pegged to traditional fiat currencies or other assets, have gained wider attention because they could lower the volatility often associated with cryptocurrencies. Regulations could cover reserve management, disclosure practices, and treating some exchanges as banks. The May 2022 collapse of the Terra (UST) algorithmic stablecoin has increased concerns about other stablecoins and their regulation. Backers of Tether (USDT), the largest stablecoin, paid $18.5 million in a settlement with the New York attorney general in 2021 and incurred a $41 million fine from the Commodity Futures Trading Commission the same year over allegations they misrepresented its reserves. Tether now publishes limited details about its reserves holdings daily.
• Crypto exchanges and wallets: These platforms support the buying, selling, and storage of cryptocurrencies. Regulations might focus on ensuring better AML and CTF measures, cybersecurity protocols, and consumer protection. Exchanges, for example, might have to register as broker-dealers and be subject to SEC oversight. If registered with the SEC, crypto exchanges must adopt technology to make their order books audit-compliant. They would also face strict rules on order execution to prevent market manipulation.
• Crypto lending and decentralized finance (DeFi) platforms: Regulations could address licensing, consumer protection, and ensuring DeFi platforms and crypto lending ventures follow AML and CTF laws.
• Crypto asset management: Managing crypto assets on behalf of investors involves navigating a complex regulatory environment, potentially requiring compliance with securities laws and other financial regulations.
• Cross-border transactions: Given the global nature of the crypto market, finding a way to smooth out regulatory differences across different states through international cooperation could help subvert illicit activities.

Each of these presents distinct challenges for regulatory authorities. As the crypto market continues to evolve, adaptable and well-thought-out regulations could encourage consumer protection while not doing away with the innovation for which the sector is known.

The Bottom Line

While announcing its settlements with crypto exchanges, the SEC has gone out of its way to emphasize its willingness to work with cooperative industry participants. The goal, Gensler has said, is to extend to crypto the investor protections that have ensured the success of U.S. securities markets. The growing number of regulatory settlements by cryptocurrency companies suggests that the message is starting to resonate.

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