By: JB Ferguson
December 7, 2021 — Last Friday’s large selloff in cryptocurrencies kicked off a predictable wave of schadenfreude from crypto critics and defensiveness from its supporters on Twitter and in offices worldwide. If nothing else, the growing public relevance of “magical internet money” has prompted entertaining discussions of what crypto is, whether it truly matters, and whether it has any value outside markets in illicit substances and services. Unlike many issues covered by Capstone, both the pro- and anti-crypto camps cut across party lines and, unlike privacy regulation, there are not unbridgeable gaps (e.g., private right of action) that prevent forward progress by either side. The case for and against regulating cryptocurrencies is especially interesting in that both sides are mostly right about their areas of concern.
The case for additional regulation is clear: crypto assets are exploding in size, it is an opaque market rife with investor protection issues, and the combination of those two factors militate for regulators to get ahead of a scenario where one token is suddenly a systemically important payments mechanism. It is also clear that a significant number of illicit transactions (ransomware, narcotics, etc.) are made with cryptocurrency, and industry participants should be on a level regulatory playing field with traditional money transmitters (including exchanges and depository institutions) for anti-money laundering or know-your-customer compliance. Further, it also seems obvious that many tokens are likely unregistered securities and their issuers and the exchanges on which they are traded are vulnerable to enforcement action.
The crypto industry’s case for moving past the current regulation-by-enforcement approach is equally clear: the SEC has effectively said that Bitcoin and Ether are not securities. Every subsequent argument over a token’s status as a security becomes a question of how close its development and deployment are to those of Bitcoin and Ether. In the SEC’s current litigation against the Ripple Labs, the creator of a cryptocurrency (XRP) intended to be used for international remittances, the similarity to Ether underlies the contentious issue of whether Ripple received fair notice of potential securities law violations. Industry participants also point to differences of opinion within the SEC itself as a problem. We have heard that at least one commissioner is advising crypto companies not to have “informational” meetings with the agency, given the potential risk of subsequent enforcement action.
In my view, both positions are reasonable. There are important institutional reasons for the SEC to avoid bright-line securities definitions specific to crypto if it can, as enforcing new rules can engender less deference from the judiciary compared to very old standards like the Howey test, that the SEC uses to determine whether an investment is a security, which the commission would therefore have legal jurisdiction over. At the same time, the agency runs the risk of putting itself in the position of picking winners and losers among the thousands of tokens out there. Let us not even consider the complexities of non-fungible tokens (NFTs), now a $2 billion/month business up from $400 million/month in January, which often involve elements (e.g., claims on future production) that would fail parts of the Howey test.
For the crypto industry’s part, it cannot forever exist in a regulatory hole where the legality of a product is indeterminate unless and until its creators get sued. Participants’ approaches to regulators have occasionally been ham-handed, and Twitter tantrums in response to regulator action are ill-advised. It seems shortsighted that the exchanges have not agreed on a standard for which tokens are indisputably over the lines established by the Howey test.
The core questions here are ultimately questions of law to be eventually decided by the judiciary branch, either directly (Ripple) or as a second-order effect of new rulemakings. Decisions by judges (especially below the appellate or Supreme Court level) are difficult to predict, especially on novel contentious questions. We think the next high-level catalysts for understanding the ultimate framework of crypto regulation in the US include the following:
- Attachment of any “crypto fix” bill targeting the language in Biden’s infrastructure package to must-pass legislation.
- Initial rulemaking steps by Treasury on the same language (potentially first quarter of 2022 for public information requests)
- Decision or settlement in SEC v. Ripple Labs (mid-2022)
These are not the only potential catalysts. We think a blowup in any stablecoins (e.g., Tether), an overwhelming ransomware attack on the electric grid or other strategic assets, or simple jockeying for turf by agencies like the Commodity Futures Trading Commission (CFTC) with responsibilities in the space could change the regulatory trajectory in unanticipated ways. What’s clear is the regulatory ambiguity can’t last.