Regulators are in no rush to write rules for cryptocurrencies. The Securities and Exchange Commission and the Commodity Futures Trading Commission have initiated a total of more than 100 enforcement actions against cryptocurrency market participants. However, none of the agencies have issued a single rule specific to cryptocurrencies and are unlikely to change tactics anytime soon. But what if agencies decide to do this? What rules can they write using existing regulators?
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Federal securities laws are primarily intended to reduce information asymmetry between issuers of securities and investors. When a company decides to raise capital from investors by selling securities, laws require the company to provide information to investors in order to minimize information gaps for outside investors. In addition, the laws require exchanges, brokers, dealers and investment advisers that provide access to or advise on securities to register with the SEC and adopt policies and procedures designed to protect investors.
This opinion piece is part of CoinDesk's Politics Week . Michael Selig is a consultant for Willkie Farr & Gallagher.
The drafters of the federal securities laws did not have crypto-assets in mind when they drafted the laws. But the SEC has the legal authority to issue rules that will allow crypto assets and crypto brokerages to operate under federal securities laws. The agency could start by writing rules to create an effective framework for issuing and trading crypto assets.
Emissions
Crypto assets are network assets. Unlike companies, networks are generative. The value of a network comes from the applications, organizations, and projects created by its users on the network. A network designer may choose a proprietary network cryptographic asset when there is little publicly available information about the network to encourage users to join the network. Once a critical mass of users have joined the network and begin to participate, the developer may no longer have an informational advantage over the users. Until now, investors in crypto assets could not apply for the protection of federal securities laws.
It is illegal to offer or sell securities without registering the offer or sale with the SEC, unless there is an exception. The definition of the term "securities" includes a list of financial instruments such as stocks, bonds, bonds and investment contracts. Crypto assets are generally subject to federal securities laws when sold under an investment contract.
The term "investment contract" comes from the "blue sky" laws created to govern proposals for written contracts where a person invests money with a promoter who promises to use the money to make a profit for the investor. In a 1946 decision (which formed the basis of the Howey Test), the United States Supreme Court defined the term "investment contract" for purposes of federal securities law as an agreement, transaction, or arrangement whereby an investor invests in a joint investment. . . an enterprise with a reasonable expectation of entrepreneurial returns or the management activities of others.
There is little mention of investment contracts in the SEC's rules, because before crypto assets, no one intentionally intended to issue them. The Securities and Exchange Commission has filed lawsuits for decades arguing that a contract, transaction or scheme should be as reliable as an investment contract because it has the economic substance of a security. After the SEC began filing these lawsuits against cryptocurrency issuers, several cryptocurrency projects adopted the definition of investment contracts and attempted to issue these instruments in compliance with federal securities laws.
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Cryptocurrency issuers have experimented with offering investment contracts with various exemptions from SEC filings, and one has even filed an investment contract with the SEC. Others are sold exclusively overseas in jurisdictions where cryptocurrencies are not regulated as securities. These issuers may have expected the SEC to eventually write rules that would allow crypto assets to operate within the SEC's regulatory perimeter. But the rules didn't go into effect, and there was no clear path for these crypto stocks to unsecured status or liquid secondary markets in the US.
However, the SEC has acknowledged that cryptoassets can, over time, destroy the shell of an investment contract. In 2018, the then-director of corporate finance at the SEC suggested that a crypto asset could be offered or sold first as part of an investment contract and then resold as a security. The following year, SEC officials released a "review" of cryptoassets, indicating that in some cases a cryptoasset "previously sold as a security must be revalued during subsequent offerings or sales" to determine whether it remains a security.
This view is also expressed in the SEC's liquidation orders, which require an issuer to register a crypto asset as a security, but provide that the issuer can later terminate the registration on the basis that the crypto asset is no longer owned. At least one issuer has taken this approach by offering a crypto asset as collateral and then filing a withdrawal statement stating that the crypto asset is no longer a security.
Another crypto project recently claimed to have "converted" its crypto asset from a security system to software. But the SEC has not issued rules codifying a registration exemption for decentralized network assets or a procedure for offering a crypto asset as a security and then determining that the crypto asset is no longer a security. Issuers who choose this approach risk being sued by the SEC.
The Securities and Exchange Commission will not need legislative authority to exempt offers and sales of network assets from registration. The agency has broad powers to issue rules exempting transactions, securities and persons from registration. For example, the SEC may condition this exemption on the issuer periodically disclosing material nonpublic information if the issuer does not have a reasonable informational advantage over network users.
SEC Commissioner Hester Pierce has proposed two rules that would create a "safe haven" for some cryptocurrency issuers. Issuers that choose to rely on escrow will be exempt from registering their cryptocurrency offerings for three years. Issuers that have developed a sufficiently decentralized network during this period may declare cryptocurrencies as non-securities. Pierce's Safe Harbor provides a sound framework that protects investors and encourages innovation.
exchanges
Public financial services were the first regulators to start licensing cryptocurrencies. These agencies have stated that crypto assets are a form of monetary value, and thus, cryptocurrency exchanges are transmitters of money. The purpose of money transfer laws is to protect customer deposits from misappropriation and abuse and to prevent money laundering. These laws are much less comprehensive than those applicable to scholarships. As a result, current cryptocurrency exchanges are not designed to support cryptocurrency stock trading. However, SEC Chairman Gary Gensler stated that many of these platforms must register with the SEC as a "national exchange".
Despite Gensler's call to action, there are no cryptocurrency exchanges registered with the SEC today. This is because the standard operating model of a cryptocurrency exchange is a product of the requirements of the Money Transfer Act and is not suitable for a stock exchange. Additionally, each exchange requires a substantial SEC exemption to list cryptocurrencies under current SEC rules.
Many SEC requirements create hurdles for potential registrants. For example, stock exchanges may only offer trading in registered securities. There are very few registered crypto assets available today, and some of the most popular are non-securities. In addition, exchanges only operate during certain hours and are closed on national holidays, while cryptocurrencies are traded on global markets that never close.
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Among the main concerns is that retail investors cannot trade and hold securities directly on exchanges, as is the case with cryptocurrency exchanges. Instead, they must place orders and hold assets with an SEC-registered broker-dealer who acts as a "member" of the exchange. Broker-dealers are permitted to trade and hold crypto-asset securities if they are offered and sold pursuant to a valid registration or issuance statement. However, brokers cannot effectively trade or hold crypto assets that are not hedging instruments.
The SEC has broad authority to issue rules exempting cryptocurrency exchanges, brokers and dealers from the requirements of federal securities laws. Deliberate changes to the SEC's national stock exchange and broker-dealer rules will expand the trading of securities related to cryptoassets in compliance with federal securities laws.
The SEC may conditionally exempt national exchanges and brokers that exclusively offer cryptocurrencies from SEC requirements that are inconsistent with current market structure, as long as they do not harm investors. It may also allow these brokers to offer risky cryptocurrencies and crypto-asset securities that are not registered or tax-exempt, as long as the broker does so in compliance with SEC requirements.
CFTC
The CFTC Licensing Act primarily regulates the trading of derivatives such as futures and swaps. The CFTC has declared that some cryptocurrencies are commodities subject to its general anti-fraud and manipulation powers, but generally does not have the power to issue rules that provide oversight of spot commodity markets.
However, the CFTC has jurisdiction over offers to retail investors of margined, leveraged, or funded spot trading. Outside the US, most cryptocurrency exchanges allow retail investors to trade cryptocurrencies on margin. In the United States, cryptocurrency exchanges must register with the CFTC as a futures exchange in order to offer margin trading of cryptocurrencies to retail investors. Additionally, a CFTC-registered futures commission dealer must provide margin, and these trades must go through a CFTC-registered clearinghouse. The CFTC has issued interpretive guidance explaining the circumstances in which an exchange can claim a strict exemption from these "actual delivery" requirements, but few have been able to find a way to do so.
The CFTC may adopt a lighter set of rules for cryptocurrency exchanges that offer margin trading, but not futures or other types of derivatives. As CFTC Commissioner Caroline Pham noted, the agency has the authority to do so. Many cryptocurrency exchanges want to offer margin trading in the US, but are intimidated by the requirement to register with the CFTC as a futures exchange, offer margin through a futures commission dealer, and integrate with a clearinghouse.
Additionally, these exchanges are likely to require significant dormant assistance from the agency in order to offer margin trading in compliance with current CFTC rules. The new set of cryptocurrency margin trading rules will allow these platforms to responsibly innovate and develop under the CFTC's regulatory oversight.
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Unfortunately, the SEC and CFTC are unlikely to write new rules for cryptocurrency markets anytime soon, as they have a lot to gain with their existing powers. But politicians' calls for regulation through regulation rather than enforcement offer hope for the future.