Signals: Who gets to regulate crypto?

Hey Fintech Friends,

Here's a quick state of the union on crypto:

US lawmakers think it’s about time for the crypto market to become officially regulated. This feels right given how many of us have gotten scammed, robbed in a hack, or just bought Bitcoin in the hopes of making a quick return and instead ended up strapped into the emotional roller coaster that is Owning Crypto.

The SEC, Treasury Department, and Commodity Futures Trading Commission are all pushing for regulatory authority over the cryptoassets they argue are most similar to the financial instruments that they regulate today. It isn't clear which regulatory body will get oversight of what, which begs the question... legally speaking, what is crypto?

... to paraphrase a report that the Treasury published on stablecoins at the end of 2021. Stablecoins have emerged as a powerful tool for facilitating transactions by standing in for an underlying asset, usually the US dollar. Stablecoin issuers peg the value of these coins to USD by either holding an equivalent amount of fiat USD in reserves (fiat-collateralized), or creating an algorithm that ties the stablecoin's value to other coin(s), incentivizing traders to keep its value in line with USD by minting or burning stablecoin as the value of USD fluctuates (algorithmic).

The market for stablecoins is blowing up:

Governments have concerns. For starters, they'd like for someone to be making sure that the fiat USD collateralizing stablecoins is, you know, there (👀Tether). And since stablecoins are designed to stand in for fiat USD, it stands to reason that stablecoins be subject to the same guardrails against money laundering, terrorist financing, and other financial no-nos as fiat is.

There's also a prospect that stablecoin holders suddenly lose confidence in a given stablecoin and sell off their holdings en masse, triggering a run on US dollars and destabilizing the entire financial system. This week TerraUSD ($UST), the largest algorithmic stablecoin, lost its dollar peg when sudden unwindings launched the values of $UST and its affiliate coin $LUNA into a death spiral. $UST plunged from trading at $1 to a current low of 30 cents and its issuers have stepped in to defend the peg using Bitcoin reserves. Terra’s founder since announced that they will start collateralizing $UST, but the episode is causing Bitcoin's price to tumble in the meantime.

The Treasury's proposed solution: Start regulating centralized stablecoin issuers like we do traditional banks.

Circle– the issuer of USDC, which is the second-largest stablecoin by market cap– is on board. They've already announced plans to obtain a bank license (as we've covered, a huge pain in the ass to do). But there are still a lot of open questions lawmakers need to answer: Will stablecoin bank accounts be eligible for FDIC insurance? Can stablecoin issuers participate in fractional reserve banking? Will there be a minimum reserve ratio requirement? Will the Fed backstop privately-issued stablecoins? Who's going to regulate decentralized stablecoin issuers?

Meanwhile the SEC wants to be the main regulator for the entire crypto market, arguing that most cryptoassets are technically securities.

Many cryptoassets do squarely fit the US’s legal definition of a "security" as outlined by the Howey Test, meaning they comprise (1) an investment of money, (2) in a common enterprise, (3) with the expectation of profit (4) to be derived from the efforts of others. Let's say that This Week in Fintech wants to raise funds to throw a happy hour on the moon, so the team mints TWIFToken and releases them in an Initial Coin Offering, promising TWIFToken holders a share of the profits from Moon Happy Hour. TWIFToken would pretty explicitly be playing the role of a "security token" by this standard.

But it turns out that a lot of tokens are not considered securities by this definition! Many tokens can be earned through ecosystem participation, so aren't (1) investments of money as much as they are rewards for engagement. Also, tokens aren't necessarily acquired (3) with the expectation of profit– a developer may buy a dividend-free token purely to redeem it for services from the underlying project i.e. a “utility token”. Finally, one can argue that a given token's value isn’t actually (4) derived from the efforts of others (in this context, "others" usually being the team that issued the token) if the token has enough standalone utility.

To further complicate things for the SEC, it's almost impossible to regulate crypto issuers directly as a number of projects don't have centralized governance (and the SEC can't exactly come after a smart contract). What the SEC can do is regulate centralized exchanges, which is where 99% of crypto trades take place anyways.

So far, Gary Gensler's had little success convincing crypto exchanges to register with his agency, probably because no crypto company wants to be regulated by the SEC. Securities laws are onerous to comply with. Maybe more importantly, crypto leaders critique the SEC’s style of punishing companies without proactively putting out guidance on what’s acceptable. Coinbase’s Brian Armstrong’s criticized this behavior as "regulation by litigation".

The Commodity Futures Trading Commission is responsible for regulating derivative markets, i.e. where institutional traders place bets on the future prices of commodities like copper and corn. They also want to regulate crypto, with allies in Congress arguing that any “fungible intangible personal property” that can be transferred "without necessary reliance on an intermediary"  is effectively a digital commodity.

Regulators already agree that Bitcoin and Ethereum qualify as non-security commodities as they don’t pass the Howey test. Crypto companies really want their cryptoassets to also become official members of the Commodities Club as they would much rather be regulated by the CFTC, whom they view as a friendlier regulator than the SEC.

When all is said and done, crypto exchanges, custodians, and issuers will probably be overseen by some combination of all 3 regulatory bodies. Cryptoassets are so commingled at the exchange level that to users, any distinction between a security, commodity, or currency feels arbitrary– but may have profound impacts on how we engage with crypto.

Beyond creating burdens for crypto companies and projects, applying securities laws to crypto may limit non-accredited investors’ ability to participate in fractional NFTs, DAOs, and crypto communities like Bored Apes as the associated tokens could be classified as private placements. This is a huge threat to crypto’s ethos of enabling open ecosystems as only 10% of American households meet the capital requirements for investing in these assets.

There’s still room for regulators to design new legal categories for crypto that would benefit the ecosystem without creating barriers to innovation or access. The Biden administration’s executive order on crypto hinted that the government is open to creative solutions that embrace crypto’s potential upsides. This has given the crypto world hope that whenever regulators do issue formal guidance, the new rules won’t necessarily be aimed at spoiling the party. We’ll be HODL-ing our breaths in the meantime.