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While it is clear the major regulators have their eyes on the crypto markets, there currently is no single set of regulations that applies to all cryptocurrencies. The new asset class has increasingly grown in popularity over the past decade, and as it does not appear to be going anywhere, will need more formal oversight.
We have seen many headlines that make it clear regulators are increasingly cracking down on fraudulent or illegal activity in the crypto space. We saw the SEC go after BitClave in 2020 for conducting an unregistered initial coin offering (ICO) of digital asset securities where they were fined $25 million. Beginning in January of 2021, we saw the FCA ban the sale of crypto-derivatives to retail consumers. In 2022 there was the highly publicized crash of one of the major crypto exchanges, FTX, of which the SEC followed up with charges around defrauding investors. And, as recently as March of 2023, we saw the CFTC sue Binance, another major crypto exchange, with willful evasion of federal law and operating an illegal digital asset derivatives exchange.
The main issue at the root of all these enforcements comes from the potential trading of unregulated securities on unregulated exchanges.
To take a step back, what is the definition of a “security,” and what is an “exchange”? In the US, the regulators rely on the definition set forth in the US Supreme Court opinion SEC v. W.J. Howey Co., decided in 1946. In the holding, the Court established four criteria required to determine whether an investment meets the definition of a “security”, better known as the “Howey Test”. Per the Howey Test, a security exists when there is an “investment contract,” and an investment contract exists when there is an investment of money in a common enterprise with the expectation of profits primarily from the efforts of others.
In the US regulatory environment, spot markets and derivatives markets are subject to different regulatory programs. Currently the CFTC is the primary regulator of commodity derivatives marketplaces, while the SEC is the primary regulator of cash securities marketplaces, and the two agencies share oversight responsibility for certain aspects of security derivatives marketplaces. No regulatory body in the US has clear enough legislation to enforce much regulation around crypto assets. In addition, there is a further regulatory split for spot markets (sometimes called “cash markets”), where the applicable regulatory program depends on whether the product being traded is categorized as a security (where the SEC regulates) or a commodity that is not a security (where the CFTC along with state regulators, via money transmitter or money services business licensing, have precedent for enforcement). All want oversight jurisdiction, but it will be up to congress to decide and empower the regulatory bodies.
When we apply a “gut check” to the crypto universe, it feels to us as if the asset class (and the markets it trades in) fall into these definitions in some fashion. Even as we draft this article, SEC Chair Gensler issued a statement that the SEC is re-evaluating the definition of an exchange to fit more modern markets. At the end of the day, the goal of regulators is to protect investors. In more mature markets, we have regulatory actions to protect investors from trading in unregistered securities, such as Form D. We expect to see similar regulations come into place in the Crypto markets, hopefully sooner than later.
The pain point in the industry right now is that there has been no clear and consolidated explanation from the regulators on how crypto should be handled as an investment product. The enforcements that have been issued begin to build some precedence, but the market waits with bated breath for more clear guidance from the regulators around how crypto assets should function from the start, as opposed to issuing punishments after the fact (although often warranted) that let people know what they already have done was wrong.
The crypto industry should be expecting and preparing for upcoming waves of rule proposals, enforcement actions and releases will impact the compliance and investment management programs of all broker dealers and crypto advisers across the globe.
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