What’s Next for Cryptocurrency Regulation?
With lobbying spend up over 30% last quarter, exchanges are working to impact regulation that seems imminent as the SEC’s Gary Gensler commits to creating exchange oversight. The CFTC vies to lead the charge (see also, Legislation Introduced to Regulate Digital Currencies). The SEC is actively investigating a number of projects (insider trading, investigation in exchanges, communication about offerings). The federal reserve is issuing guidance contemplating the use of cryptocurrencies in traditional banking. The future of regulation could end up being pretty messy.
As evidenced by a bipartisan bill assigning oversight authority to the CFTC and industry experts, it’s widely agreed that widely traded crypto such as Bitcoin and Ether are commodities. The SEC recently muddled the already pronounced regulatory confusion by filing a complaint against the founder of Ethereum. In the process, the SEC also indicated that Ethereum falls under SEC jurisdiction. These widely traded coins are more obviously decentralized, therefore, more clearly falling under the purview of the CFTC. For cryptocurrency deemed a commodity, traders speculate whether the underlying commodity will rise or fall. While challenges within commodity trading exist such as accurate price setting and market manipulation, what happens to the commodity is not as much of a concern as it might be for securities. On the other hand, fledgling coins are more likely to be considered securities.
Coins or Tokens the SEC is likely to label securities are “investment contracts” or are being used to raise money for the underlying company. Those projects governed by the SEC are subject to a different level of scrutiny. Both exchanges and issuers have to be cognizant that the way a token is offered and what it means for the market will determine whether the offering falls under the SEC’s vigilance. Requirements for projects and exchanges working with securities fall largely around reporting and disclosure, however, SEC regulation touches the facet of securities trade. In fact, Gensler recently requested that all exchanges register with the SEC. The penalty for failing to register is not yet clear but the SEC relied on traditional securities law in recent enforcement.
Notably, the recent SEC investigation into Ripple (XRP) signals how serious the SEC is taking enforcement of its regulations. In 2020, the SEC targeted Ripple for selling unregistered securities and initiating a probing and intrusive legal discovery process. Whether Ripple is successful in the suit turns entirely on whether the token is a security or a commodity. When making this determination, the Howey test is applied. The Howey test analyzes three factors but the one posing the most difficulty is, “3. Do any profits come from the efforts of a promoter or third party?” When does an ICO go from a project being moved forward by its founders to a decentralized commodity? As applied to cryptocurrencies, the answer remains unclear.
A currency regulated by the CFTC will have entirely different rules regarding reporting transactions, the parties involved in transactions, margin trades, contract trades, etc. This means a future might exist whereby exchanges are required to have two entirely different platforms and have to make an independent decision as to whether the cryptocurrency is a security or a commodity. While some trade exchanges facilitate commodities and securities trading, this wouldn’t be the outcome for exchanges.
An ideal outcome for exchanges is governance by a Self-Regulatory Organization made up of industry experts. SROs exist in both agencies but are more prevalent in commodity markets. Here, SROs could assure that the objectives of governmental agencies are honored in a way that promotes the interest of the reputable player in cryptocurrency markets. The SEC neither endorsed using SROs nor denounced SRO governance in the space. On the other hand, the CFTC is likely to push for SRO-focused governance and both agencies are clear about their interest in interagency cooperation.
The XRP case will be a defining moment in the future of cryptocurrency legislation. As exchanges anticipate the future of their platforms, designing platforms capable of navigating the potential regulations will be critical to providing uninterrupted and broadly available trading.