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BEFORE We Regulate Crypto

Rafi Reguer

Rafi Reguer

BEFORE We Regulate Crypto
Experts Urge Caution Before Trying to Fit Crypto into Our Existing Regulatory Framework

The battle over which U.S. regulator should oversee cryptocurrencies – and digital assets in general – has heated up, and it’s about to get hotter.

A big part of the debate is due to the highly fragmented nature of the U.S. financial regulatory landscape. As recently noted in an article by SEC Commissioner Caroline Crenshaw in The International Journal of Blockchain Law, multiple federal authorities, both agencies and regulators, have jurisdiction over the general world of decentralized finance (DeFi), including the Department of Justice, the Financial Criminal Enforcement Network, the Internal Revenue Service (IRS), the Commodity Futures Trading Commission (CFTC), and the Securities and Exchange Commission (SEC). States have also claimed some authority, such as New York State’s BitLicense or Wyoming’s Special Purpose Depository Institution charter.

For this reason, Coinbase last month issued a whitepaper outlining its plan for a regulatory framework for all digital assets. Among its principal recommendations was its proposal that a new federal regulator, solely focused on digital assets, be created. The issue was brought into the spotlight again two weeks later when reports surfaced that the SEC and CFTC have each been lobbying lawmakers to put them in charge of digital asset oversight. And as recently as November 16, the House Agriculture Committee proposed the “Digital Commodity Exchange Act of 2021,” which aims to fill the gaps between the CFTC and SEC’s regulation of digital asset markets. For its part, the U.S. Treasury – through its Office of Foreign Assets Control – has already used its authority to sanction two cryptocurrency exchanges.

There’s also the question of whether this is needed in the first place, with a large number of individuals firmly believing that the whole point of crypto is to have no government regulation at all. Traditional markets are one thing and digital asset markets are another. Why turn MMA into boxing if the former evolved specifically to avoid the rules of the latter, the argument goes.

Regardless, these are not merely academic arguments. While the discussions about regulation go back several years, some decisions will likely need to be made sooner rather than later. The recently passed infrastructure bill includes tax provisions for broadly defined “cryptocurrency brokers” and reporting requirements for transfers of all digital assets. It’s hard to believe regulation to sort that out isn’t far behind.

So if decisions on regulation are coming, what must stakeholders consider before those decisions are made?

There’s No Such Thing as a Fish

Famed biologist Stephen Jay Gould once pronounced that there is no such thing as a fish, meaning that classifying a diverse group of sea creatures under this single category made little sense from a scientific viewpoint. A salmon is actually more closely related to a camel than a hagfish, he argued, and lumping them together is as lazy and misleading as classifying dogs together with cats, goldfish, spiders and humans simply because those are all species that live in your house.

For similar reasons, experts warn that we should make sure our categories make sense before regulating a category that may not adequately reflect the diverse nature of the financial instruments it contains. Are digital assets securities, whereby the SEC would have oversight? Or commodities, in which case the CFTC would regulate? So far, the answer to that question is murky.

One approach, according to veteran securities industry lawyer Eric Hess of Hess Legal Counsel, is to apply the Howey Test, which is used to determine whether or not something meets the definition of a security. The problem, however, is that the answer may depend on where a cryptocurrency is in its lifecycle. For example, in 2018, former SEC Chair Jay Clayton said Bitcoin is not a security. That same year, he also said he had never seen an Initial Coin Offering (ICO) that wasn’t a security.

“One of the four prongs of the Howey Test is whether or not there is a reliance on ‘the efforts of others,’ and those efforts need to be managerial in nature,” he said. “In the case of a cryptocurrency, that reliance almost always exists when it’s initially introduced, but often it evolves toward being decentralized and then that reliance disappears. You could argue that many digital assets start as securities and morph into commodities.”

Another notable difference between cryptocurrencies is that some are stablecoins (e.g. Tether), which are tied to the price of the U.S. dollar or another fiat currency, and some are not (e.g. Bitcoin). On the surface, Tether seems like it should perhaps be regulated like a money market fund given that it’s trying to maintain a constant $1 price and (hopefully) carrying assets on its books to back its value. That certainly sounds like a money market fund, in which case a regulator should be auditing its holdings. However, that doesn’t apply at all to Bitcoin.

Given these considerations, it seems that the blanket term “cryptocurrency” should be questioned before attempting to regulate the broader category. Are cryptocurrencies similar enough to be regulated as a group? Or are they collectively what Gould would call “fish,” sloppily lumped together into a general category that ignores huge underlying differences?

If it’s the latter, it would seem that regulation should occur on more of a case-by-case basis. Which, of course, creates problems of its own.

Should We Make the Peg Rounder or the Hole Squarer?

Some feel that since we have an existing regulatory framework in place, we should do the difficult work of determining just how cryptocurrencies should operate within it. Others – most notably SEC Commissioner Hester Peirce (aka “Crypto Mom”) – have expressed concern that applying existing securities regulations to crypto start-ups would stifle creativity and force these projects outside U.S. jurisdiction.

Instead, she has proposed implementing a three-year safe harbor for token projects. That would afford these start-ups some breathing room after their ICO, she argues, allowing them to potentially achieve a level of decentralization that would pass the Howey Test and therefore avoid classification as a security.

The crypto markets have seen extraordinary innovation in a very short time, explains Hess, and rushing toward regulation might crush innovation without providing much benefit.

“We need regulation that protects investors without being overly burdensome. We need regulation that focuses on bad actors, not forcing a securities disclosure regime on fledgling technologies that are moving toward becoming commodities. Most of all, we need to avoid a rigid regulatory structure out of the gate, because it’s hard to believe that we are going to get everything right on the first try,” said Hess.

Who Foots the Bill?

Establishing the regulatory who, what and how of this is only part of the equation. Figuring out who pays for it is another.

The SEC’s approximately $2B 2022 budget is funded by Section 31(a) transaction fees on equity trades, points out Jim Toes, President and CEO of Security Traders Association (STA). Adding crypto oversight to its responsibilities might require a substantial budget increase over the next few years, and that may be a problem, as STA noted in 2014.

“…the methodology by which today’s SEC collects fees was established in 2002 and then modified by the Dodd-Frank Act in 2010. The SEC’s budget in 2001 was $423mln, but the Dodd-Frank Act significantly increased its responsibilities, including additional asset classes. At the same time, the Dodd-Frank Act shifted 100% of the responsibility for funding the SEC to entities and investors that pay section 31(a) fees when buying or selling equities, while other fees that previously contributed to funding the SEC are directed to the general Treasury. In short, the mechanism for funding the SEC was narrowed rather than broadened to offset the costs of regulating other asset classes and activities.

As STA argued seven years ago, when one entity fully pays or largely subsidizes the costs of regulating another entity, inefficiencies are bound to result. STA made that point when the SEC was tasked with oversight of the credit ratings agencies, but regulating crypto is a far, far more significant task. A much larger budget would be needed, and equity market participants are understandably not going to want to be saddled with the regulatory bill for another asset class, says Toes.

“‘Assign it to a regulator and we’ll figure out how to pay for regulation later’ is a poor approach to regulation,” said Toes.

Whoever the regulator winds up being, it would be best to determine ahead of time where the funding is coming from. And if it’s going to ultimately be through the crypto equivalent of a 31(a), that should be planned for in advance since it will be far harder to introduce in the future, he argues.

Slow Isn’t Always a Bad Thing

It may seem to some, especially those who have been involved in cryptocurrencies for several years, that the decision of who, what and how to regulate the digital asset markets is taking too long. Indeed, it has taken years, but that may not be such a bad thing, according to Hess. “The digital asset landscape moves very fast, but policymakers need to resist the urge to try to match its speed with poorly considered regulation. Policymakers and regulators are still struggling to understand what it is they are even regulating…or who should be doing it. Figuring this out will take time but in the interim, we need to develop a workable construct that doesn’t regulate innovation away by enforcement.”

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