History of Crypto 101
When Bitcoin’s pseudonymous creator, Satoshi Nakamoto, mined the first block of Bitcoin more than 13 years ago, he kick-started what is now a phenomenon in modern finance: decentralized, digital currency. That aim—a monetary system not tied to any country’s central bank or mint—is inherent in a not-so-subtle reference, left in Bitcoin’s initial block of data, to a Times of London article reporting the UK’s Chancellor of the Exchequer “on the brink of a second bailout for banks” as a result of the 2008 financial crisis.
But what began as an academic idea has erupted into a modern financial phenomenon: thousands of cryptocurrencies are trading peer-to-peer and through centralized exchanges, consumers and businesses are eschewing traditional banks for the world of decentralized finance and lending, Bitcoin has become legal tender in El Salvador, and in late 2021, worldwide cryptocurrencies eclipsed a value of more than $3 trillion.
That success has led to a push [login required] by governments and cryptocurrency investment firms for clear and defined regulations of cryptocurrencies, which, as of now, are patchy at best. For anyone seeking to counsel clients in the cryptocurrency and blockchain arena, a solid knowledge of the current state of ever-changing regulations is a must.
Federal Regulations: A Work in Progress
In the past year, at least nine bills aiming to regulate cryptocurrencies, digital assets, and related areas of the crypto sphere have been introduced. Only one has passed the House; however, even if passed into law, the legislation would not actually regulate cryptocurrencies but instead would require the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission to establish a working group to “provide recommendations regarding digital asset market fairness and integrity, cybersecurity standards, and the reduction of fraud and manipulation.”
The SEC has made no secret [login required] about its desire to change the current hole in the federal regulatory scheme surrounding cryptocurrencies, with SEC Chairman Gary Gensler noting in testimony to Congress last year that crypto exchanges should have more oversight but that “only Congress” could address it. That has put Gensler—who has expressed [login required] skepticism of what he calls the “Wild West”—in the position of asking crypto trading firms to “work with us” to “get registered.” Gensler has also turned up the rhetorical heat, warning crypto trading platforms that they should be “asking for permission” rather than “begging for forgiveness” once formal regulations are in place.
Then, in January 2022, the SEC announced a 650-page plan to bring “Alternative Trading Systems that trade Treasuries and other government securities under the regulatory umbrella.” While the proposed rule does not mention cryptocurrencies or decentralized finance protocols, pro-crypto SEC Commissioner Hester Pierce pointed out that the proposal could implicate them. The rule would amend Securities Exchange Act Rule 3b-16 to include Communication Protocol System—defined as “a system that offers protocols and the use of non-firm trading interest to bring together buyers and sellers of securities”—under the definition of an “exchange” that must register under section 5 of the act. As of now, 17 C.F.R. § 240.3b-16(a) defines exchange as an organization that “[b]rings together orders for securities of multiple buyers and sellers” and “uses established non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of a trade.” The amendment would change this definition to include as an exchange function the “[b]ringing together buyers and sellers of securities using trading interest” and “making available established, non-discretionary methods (whether by providing a trading facility or communication protocols, or by setting rules) under which buyers and sellers can interact and agree to the terms of a trade.” [Emphasis added.]
The change is subtle but potentially far-reaching. By seeking to govern markets that bring together “buyers and sellers” and make trading facilities or mere communications protocols “available” for buyer sand sellers, the proposed rule could implicate the raft of decentralized finance protocols—such as Aave, Compound, Uniswap, and Loopring—that connect and allow users to lend, borrow, receive rewards in, and exchange cryptocurrencies and tokens without the need for a central intermediary.
Critically, the proposed rule is meant to apply to “any type of security,” which Gensler has opined includes the crypto tokens that are the backbone of nearly all decentralized finance protocols. That is key because cryptocurrency projects and related digital assets typically have been thought to operate outside the U.S. Supreme Court’s definition of security in SEC v. W.J. Howey Co. 328 U.S. 293, 298–99 (1946). In Howey, the Court held that a “security” encompasses any “contract, transaction or scheme whereby a person [1] invests his money [2] in a common enterprise and is led to [3] expect profits [4] solely from the efforts of the promoter or a third party.” Id. The SEC tugging cryptocurrencies and digital tokens within this definition would represent a tremendous shift in the industry, requiring registrations from hundreds of decentralized finance protocols and crypto assets that have, until now, operated largely outside of regulatory scrutiny.
For its part, in March, the Biden administration took a to-be-determined approach to crypto regulations, issuing an executive order—which the crypto world saw as a positive departure from the SEC’s tougher views on crypto—directing the Treasury, the Department of Commerce, and other federal agencies to develop a national policy for digital assets. Then, in early May, California’s governor, Gavin Newsom, issued a similar executive order “to create a transparent regulatory and business environment for web3 companies which harmonizes federal and California approaches [and] balances the benefits and risks to consumers.” What these policies will look like remains to be seen, but what is clear, given the SEC’s stance on cryptocurrencies and digital assets and its recent proposed rule, is that more regulation is on the horizon in the near future.
State Regulations: A Patchwork of Light Hands and Tight Fists
At the state level, crypto regulation is in some places robust and in others light-handed—altogether a patchwork of different requirements.
New York. New York, perhaps not surprisingly being as it is the financial center of the country, has adopted comprehensive regulations of cryptocurrencies. The most notable of these regulations is known as the BitLicense regulation, which New York first rolled out in 2015. The regulatory scheme requires anyone who “engage[s] in any virtual currency business activity” to obtain a license from New York’s Superintendent of Financial Services. N.Y. Comp. Codes R. & Regs. tit. 23 § 200.3(a).
The definition of virtual currency is specifically far-reaching, encompassing “any type of digital unit that is used as a medium of exchange or a form of digitally stored value,” including “digital units of exchange that[] have a centralized repository or administrator; are decentralized and have no centralized repository or administrator; or may be created or obtained by computing or manufacturing effort.” Id. § 200.2(p). Likewise, virtual currency business activity broadly implicates
“(1) receiving virtual currency for transmission or transmitting virtual currency . . . ; (2) storing, holding, or maintaining custody or control of virtual currency on behalf of others; (3) buying and selling virtual currency as a customer business; (4) performing exchange services as a customer business; or (5) controlling, administering, or issuing a virtual currency.”
Id. § 200.2(q). The only specific exceptions to the BitLicense requirement are crypto mining firms, businesses that accept cryptocurrencies as payment for goods and services, and anyone chartered under the New York Banking Law.
With a BitLicense comes a number of additional regulatory requirements with which licensees must continuously comply, including know-your-customer rules, liquidity and reserve requirements, disclosure requirements, consumer-protection obligations, and anti-money-laundering rules. And if a firm wants to manage and transfer assets on behalf of clients, it must meet additional regulatory requirements and apply for a limited purpose trust charter under the New York Banking Law. That additional layer of licensure allows an entity to exercise fiduciary powers, which the law expressly bars BitLicensees from wielding.
Perhaps due to the nature of these regulations, only about 30 entities—including Coinbase, Gemini, and PayPal—have obtained licensure under New York’s crypto regulatory regime. And only 24 out of the thousands of individual digital assets in existence have been approved, or “green-listed” for use.
Wyoming. If New York’s regulatory framework is robust, Wyoming provides perhaps the best example of a light-handed regulatory scheme. There, a 2019 law allows companies trading in digital assets to apply for status as special purpose depository institutions. This allows companies that do not wish to become a federal chartered bank to keep custody [login required] of digital assets and offer crypto-related banking products; transfer money without obtaining state-specific licenses; and offer other products found at traditional banks, like rewards debit cards. The state also amended its version of the Uniform Commercial Code to specifically categorize [login required] digital assets as “intangible personal property”—a move that removes an ambiguity over whether cryptocurrencies, digital tokens, and NFTs can serve as collateral for secured lending. And, under a 2017 law [login required] cryptocurrency tokens—which, as noted above, the SEC believes largely to be investments subject to its enforcement power—can be classified as utility tokens: digital assets that grant users access to services on a particular blockchain protocol, rather than serve purely as an investment. That provides—at least until further SEC action on the subject—token issuers some form of safe harbor.
Other states. As for the rest of the states, regulations are light—if they exist at all—as evidenced by the following examples:
- Delaware, by a 2017 law, allows companies to use blockchain technology for corporate records such as their general ledgers.
- Colorado allows candidates for political office to accept campaign contributions in cryptocurrency, but any donor wishing to remain anonymous—a typical feature of cryptocurrency transactions, especially those transmitted peer-to-peer—can only donate up to $20.
- Minnesota, on the other hand, has introduced, but not passed, a bill specifically barring crypto campaign contributions.
- Arizona and Tennessee expressly allow for the enforcement of smart contracts—self-executing agreements that are a backbone of decentralized finance.
Conclusion
The takeaway, it appears, is this: While the world of cryptocurrencies, digital assets, and decentralized finance has evolved into an economic juggernaut, the regulatory scheme around it is a nascent patchwork—but one that looks to mature quickly.
Steven Aquino is a senior business litigation and dispute resolution associate at Thompson Coburn Hahn & Hessen LLP in New York, New York.
