The State of U.S. Crypto Asset Regulation
The question of whether there should be dedicated regulations governing crypto has provided a long-running debate in Washington. Last year, just as it seemed there could be some progress, the sudden collapse of FTX appears to have caused U.S. lawmakers to hit the brakes on further progress while the fallout settled. What is the current state of play, and how could things progress from here?
This article examines the current state of cryptocurrency regulations in the U.S. and considers what could come next.
A slow-burning problem
Unlike jurisdictions such as Switzerland and, soon, the E.U., the US has never had any comprehensive legislative framework governing the issuance or use of digital assets.
In 2014, the Internal Revenue Service (IRS) confirmed that virtual currencies were taxable, effectively making them legitimate to own and trade. However, at that point, launching a cryptocurrency was inaccessible to almost everyone except blockchain developers.
Once Ethereum launched in 2015, it lowered the technological barrier to the extent that virtually anyone could launch their own token. The explosion of activity in the next two years forced regulators into action, as hundreds of startups began selling tokens in what became known as the ICO (Initial Coin Offering) boom.
The Securities and Exchange Commission (SEC) took the leading role in enforcement action against token sales – more specifically, those that deemed to pass the “Howey test.” The Howey test is a decades-old legal ruling that allows officials to determine whether an asset constitutes an investment contract or not. By late 2018, the sector had entered the depths of the “crypto winter,” and the US ICO market was all but dead.
Since then, however, the digital asset markets have grown substantially in both size and complexity, with the emergence of segments such as stablecoins, DeFi, and GameFi that are more difficult to categorize using established rules.
Moreover, alongside the SEC, other regulators, including the Commodity Futures Trading Commission (CFTC) and the Financial Crimes Enforcement Network (FinCEN), have determined that parts of the markets belong under their purview. Consequently, they have used their powers in other types of enforcement actions, such as against BitMEX for allowing US customers to trade cryptocurrency derivatives on its platform without prior approval.
Cryptocurrency advocates and critics alike have long debated the merits of this patchwork approach. In its “wild west” ICO days, the crypto sector was generally resistant to regulation. But now, many within the sector – particularly more trusted operators like Coinbase – are vocal critics of the current “regulation by enforcement” situation, which they complain leaves both companies and customers operating in a haze of uncertainty.
Creating the momentum for new regulations
As investment and interest in the digital asset markets grew during 2021, so did the volume of calls for more comprehensive regulations that would protect investors, give certainty to innovators, and prevent people from falling foul of the law unwittingly. Furthermore, with jurisdictions like the E.U. moving ahead with their own frameworks, there is a risk that the U.S. could end up becoming a less attractive investment jurisdiction. As such, the momentum for digital asset laws has picked up substantially over the last year or so.
In March 2022, President Joe Biden signed an executive order for “ensuring the responsible development of digital assets,” instructing the various government agencies to collaborate on a unified approach to regulation.
In August 2022, Democratic Senator Debbie Stabenow of Michigan proposed the Digital Commodities Consumer Protection Act (DCCPA), a bill with bipartisan support designed to give the CFTC more oversight of digital assets and introduce more safeguards for consumers. Many in the digital asset sector, including the now-disgraced FTX CEO Sam Bankman-Fried, welcomed the development. However, critics have pointed out that it could be damaging to innovation in areas like DeFi.
Before the DCCPA progressed any further, in October 2022, the Financial Stability Oversight Council published a report as a result of the March order from President Biden, recommending that Congress legislate for improving oversight of the digital asset markets. But within a few weeks, FTX crashed. Since Sam Bankman-Fried had become one of the best-known faces of cryptocurrency in Washington D.C., the shock of the collapse seemed to resonate as much on Capitol Hill as it did in Silicon Valley.
In January 2023, Senator Stabenow announced that she would not seek re-election in 2025, leaving the future of the DCCPA in question. And just a few weeks later, on January 27, the White House issued a blog post stating that Congress needed to “step up” when it comes to regulating digital assets, calling specifically for attention to be paid to increasing consumer protections and ensuring separation between the crypto and traditional finance sectors.
For its part, Congress has recently established the first-ever subcommittee dedicated to digital assets, which has a remit that includes “providing clear rules of the road among federal regulators for the digital asset ecosystem, developing policies that promote financial technology to reach underserved communities, [and] identifying best practices and policies that continue to strengthen diversity and inclusion in the digital asset ecosystem.”
Biden’s position on the separation of crypto and traditional finance appears to be mirrored by the Federal Reserve Board. On January 27, the Fed issued a statement announcing that it would apply limitations on crypto-related asset activities to state member banks (SMBs) under its supervision, including the prohibition of holding crypto as a principal, and certain controls on the issuance of stablecoins. The statement confirmed that these limitations, which previously only applied to national banks, are designed to “promote a level playing field and limit regulatory arbitrage.”
The Fed’s announcement comes after a previous joint statement issued in collaboration with the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) urged banks to identify and mitigate any crypto-related exposure.
Moreover, it has demonstrated its desire to clamp down on unwillingness to comply with applying adequate safeguards to the handling of crypto assets. On January 27, it also announced it had declined an application from Wyoming-based Custodia Bank Inc, to become a member of the Federal Reserve system, stating that “the firm's novel business model and proposed focus on crypto-assets presented significant safety and soundness risks.”
At the time of publication of this article, events are ramping up at pace. In early February, the SEC made clear its intention to continue the “regulation by enforcement” approach, taking action against two major players in the crypto space – trading platform Kraken and Paxos, the issuer of the BUSD stablecoin.
On February 10, reports emerged that Kraken had settled a $30 million lawsuit with the Commission, and would be unwinding its staking products for US customers. The SEC alleges that the products, which offered returns as high as 21%, constituted a sale of unregistered securities.
Only a few days later, the WSJ reported that the SEC is planning to sue Paxos, the firm behind the stablecoin BUSD, which it mints on behalf of Binance. Within less than a day, Paxos announced that it had severed its relationship with Binance and, working in cooperation with the New York Department for Financial Services, would cease minting new BUSD with immediate effect.
BUSD, which currently has a market capitalization of $16 billion, will be redeemable for US dollar or Paxos’ own stablecoin, USDP, until February 2024. This story continues to unfold at the time of publication.
Outlook for 2023
With the current piecemeal status of responsibilities and progress, it is unclear exactly how a coherent framework for digital asset regulation will emerge in 2023. Furthermore, given the current political arithmetic, bipartisan support will undoubtedly be a necessary prerequisite for successfully passing any new laws. Ultimately, if both sides of Congress cannot come to an agreement on digital asset regulation before campaigning for the 2024 elections begins, there is a risk that politics could prove to be the biggest blocker.
Despite these barriers, all factors considered – the establishment of the new subcommittee, the progress on the DCCPA, the FTX collapse, and the repeated cajoling of Biden and the Fed – it is reasonable to assume that the U.S. is more likely than not to introduce digital asset regulation. Investors can look forward to an environment of greater clarity; the only question is how soon?
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References and further reading
Nuant Insights, (2022), “EU MiCA Regulation is Coming — But what will it mean for crypto funds?” Available at: https://www.nuant.com/research/EU-MiCA-Regulation-is-coming
Internal Revenue Service (January 13, 2023), “Frequently Asked Questions on Virtual Currency Transactions.” Available at: https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions#:~:text=In%202014%2C%20the%20IRS%20issued,property%20apply%20to%20virtual%20currency.
US Securities and Exchange Commission, (April 3, 2019), “Framework for “Investment Contract” Analysis of Digital Assets.” Available at: https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets
Commodity Futures Trading Commission, (May 5, 2022), “Federal Court Orders BitMEX’s Three Co-Founders to Pay a Total of $30 Million for Illegally Operating a Cryptocurrency Derivatives Trading Platform and Anti-Money Laundering Violations,” Press release. Available at: https://www.cftc.gov/PressRoom/PressReleases/8522-22#:~:text=Co%2DFounders%20Ordered%20to%20Pay%20%2410%20Million%20Each&text=The%20three%20co%2Dfounders%20are,monetary%20penalty%20for%20their%20actions.
Knight, Robert D, (September 20, 2022), “Coinbase CEO Draws Criticism For Suggesting Crypto Industry is ‘Moving Offshore’,” BeInCrypto. Available at: https://beincrypto.com/coinbase-ceo-criticized-suggesting-crypto-industry-is-moving-offshore/
The White House, (March 9, 2022), “Executive Order on Ensuring Responsible Development of Digital Assets.” Available at: https://www.whitehouse.gov/briefing-room/presidential-actions/2022/03/09/executive-order-on-ensuring-responsible-development-of-digital-assets/
S.4760 - 117th Congress (2021-2022), (September 15, 2022), “Digital Commodities Consumer Protection Act of 2022." Library of Congress at Congress.gov. Available at: https://www.congress.gov/bill/117th-congress/senate-bill/4760.
Schulp, Jennifer and Solowey, Jack, (October 26, 2022), “DeFi Must Be Defended,” Coindesk. Available at: https://www.coindesk.com/layer2/2022/10/26/defi-must-be-defended/
Financial Stability Oversight Council, (2022), “Report on Digital Asset Financial Stability Risks and Regulation,” US Treasury. Available at: https://home.treasury.gov/system/files/261/FSOC-Digital-Assets-Report-2022.pdf
Palmer, Stefania and Chipolina, Scott, (November 11, 2022), “FTX turmoil destroys clout of crypto’s Washington spokesman,” Financial Times. Available at: https://www.ft.com/content/bab63556-c539-4285-badd-5a302a842a83
Wright, Turner, (January 5, 2023), “US senator behind efforts to pass major crypto bill won’t seek re-election,” Cointelegraph. Available at: https://cointelegraph.com/news/us-senator-behind-efforts-to-pass-major-crypto-bill-won-t-seek-re-election
The White House, (January 27, 2023), “The Administration’s Roadmap to Mitigate Cryptocurrencies’ Risks.” Available at: https://www.whitehouse.gov/nec/briefing-room/2023/01/27/the-administrations-roadmap-to-mitigate-cryptocurrencies-risks/
Brett, Jason, (January 30, 2023), “Chair Of New House Crypto Panel To Focus On Legal Clarity For Digital Assets,” Forbes. Available at: https://www.forbes.com/sites/jasonbrett/2023/01/30/chair-of-new-house-crypto-panel-to-focus-on-legal-clarity-for-digital-assets/
Federal Reserve Board, (January 27, 2023), “Federal Reserve Board issues policy statement to promote a level playing field for all banks with a federal supervisor, regardless of deposit insurance status,” Press release. Available at: https://www.federalreserve.gov/newsevents/pressreleases/bcreg20230127a.htm
Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, (January 3, 2023), “Joint Statement on Crypto-Asset Risks to Banking Organizations,” Press release. Available at: https://www.occ.treas.gov/news-issuances/news-releases/2023/nr-ia-2023-1a.pdf
Fung, Brian, (February 10, 2023), “SEC reaches $30 million settlement with Kraken,” CNN. Available at: https://edition.cnn.com/2023/02/10/tech/sec-crypto-staking-kraken/index.html
Paxos, (February 13, 2023), “Paxos Will Halt Minting New BUSD Tokens,” Press release. Available at: https://www.prnewswire.com/news-releases/paxos-will-halt-minting-new-busd-tokens-301744964.html
