The promise of digital assets is to decentralize finance. Yet in 2022, investors in decentralized technologies lost billions of dollars as the global market cap of all cryptocurrencies fell by 64.1% to $829 billion.
Increased interest rates and the collapse of the unregulated algorithmic-stablecoin, “TerraUSD” precipitated this downtrend. TerraUSD’s failure eliminated $60 billion of investor value in a week. The financial contagion from TerraUSD bankrupted many other high profile digital asset platforms. The year ended with the collapse of Bahamas-based crypto behemoth, FTX. FTX allegedly lost tens of billions by improperly trading with customer funds.
The digital asset industry’s catastrophic failures have left commenters asking one question: will Congress comprehensively regulate digital assets at last?
The Federal Government’s Current Regulatory Approach to Digital Assets
The Securities Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) share overlapping jurisdiction over digital assets. Except for Bitcoin (which the SEC views as a commodity), the SEC considers most cryptocurrencies to be a security. Industry observers have criticized the SEC for failing to provide clear regulatory guidance as to which digital assets constitute a security, subject to the SEC’s registration requirements. Criticisms have also been levelled at the SEC for taking a regulation-by-enforcement approach to digital assets.
In contrast, the CFTC’s regulatory efforts have focused on regulating “virtual currencies” and their derivatives as commodities under the Commodities Exchange Act. The Act establishes rules and supervises exchanges, clearing organizations, large traders, and entities handling customer funds or offer trading advice. The CFTC’s “pro-innovation” approach to digital assets has made the CFTC the preferred cryptocurrency regulator among industry members. Nonetheless, the agency has successfully prosecuted numerous enforcement actions against entities allegedly engaged in fraudulent activity, or that failed to register as a Commodity Pool Operator under the Commodities Exchange Act.
The Federal Government Is Attempting to Catch Up
Unsurprisingly, digital asset regulation has entered the federal government’s regulatory agenda in 2023. Urging Congress to facilitate digital asset regulation, the White House highlighted conflicts of interest, law-breaking, and lack of risk controls as digital assets’ principal risks. In Congress, the House Financial Services Committee established the Financial Services Subcommittee on Digital Assets, Financial Technology and Inclusion, chaired by Rep. French Hill (R-Ark.). The subcommittee’s purpose is to hold hearings and play a frontline role in developing bills. And in the Senate, Senator Cruz (R-Texas) proposed a concurrent resolution requiring food service vendors on Capitol Hill to accept cryptocurrencies.
The federal government’s clear interest in cryptocurrencies demonstrates that digital asset regulation may be imminent. In addition to conducting hearings, Rep. Hill remarked that his subcommittee’s efforts will review prior legislation in its report. As a result, analysis of prior-introduced digital asset regulations may provide insight to the future.
Previous Regulatory Frameworks May Provide Insight to Future Regulations
Over the summer of 2022, Senator Cynthia Lummis (R-WY) introduced the Lummis-Gillibrand Responsible Financial Innovation Act (RFIA), and Senator Debbie Stabenow (D-MI) introduced the Digital Commodities Consumer Protection Act of 2022 (DCCPA).
- Granted the CFTC exclusive jurisdiction over digital assets, except for assets that give the holder: (i) a debt or equity interest; (ii) liquidation rights; (iii) an entitlement to an interest or dividend payment; (iv) a profit or revenue share derived solely from the entrepreneurial or managerial efforts of others; or (v) any other financial interest. Digital assets lacking these characteristics were deemed commodities under the RFIA.
- Created a category of digital assets referred to as “ancillary assets.” The term solved a regulatory challenge that cryptocurrencies pose: in their infancy, many cryptocurrencies rely on others’ managerial efforts—and therefore resemble securities. But upon later achieving full decentralization (at which point, it is no longer reliant on the efforts of others), the digital asset more closely resembles a commodity. Enter ancillary assets, defined as “an intangible, fungible asset that is offered, sold or otherwise provided … in connection with the purchase and sale of a security … that constitutes an investment contract.” Critically, ancillary assets do not provide any dividend, interest payment or security-like feature.
- Placed disclosure requirements on issuers of ancillary assets, subject to the SEC’s requirements. But compliance with the SEC’s requirements created a presumption that the ancillary asset is a commodity, subject to CFTC regulation, rather than a security.
- Provided digital asset service providers the option to register with the CFTC, subject to certain limitations on trading, permitted investments, disclosures, conflicts of interest, financial condition, and segregation of customer assets.
Whereas the DCCPA:
- Granted the CFTC sole jurisdiction over digital commodity trades, plus the authority to decide which cryptocurrencies constitute a digital commodity.
- Required the CFTC to establish customer protection rules and guidelines.
- Expansively defined “digital commodity” as a “fungible digital form of personal property that can be possessed and transferred … without necessary reliance on an intermediary,” and specifically included Bitcoin and Ether within the term’s definition.
- Created unique regulatory requirements for three categories of market participants, including: (i) digital commodity trading facilities, (ii) digital commodity dealers and brokers; and (iii) digital commodity platforms (a catchall term for entities who engaged in one or more activities described in (i)-(ii)). Amongst other regulations, digital commodity trading facilities were prohibited from trading in commodities that are subject to manipulation. Dealers and brokers were required to establish fair and objective prices, establish internal risk management systems, and meet minimum reporting requirements. And digital commodity platforms were required to implement conflict of interest procedures; maintain financial resources; ensure cybersecurity and comply with CFTC requirements for the treatment of customer assets.
- Required digital commodity platforms to register with the CFTC.
Future regulation likely will take the best features from each bill. By distinguishing between a cryptocurrency in its infancy and a mature cryptocurrency, the RFIA’s invention of the “ancillary asset” term solves a key ambiguity in the unsettled debate over whether non-Bitcoin digital assets constitute securities. Given the term’s effectiveness, subsequent bills will likely contain a similarly defined term. In terms of the DCCPA, that bill created a practical framework to categorize industry participants and prescribed regulations that, at minimum, identified comprehensively the key risks digital assets pose.
But both bills may grant the SEC too little jurisdiction. Under the RIA, the SEC only had jurisdiction over digital assets that clearly constitute securities—effectively eliminating the SEC’s jurisdiction over borderline cases. Moreover, by allowing issuers’ ancillary assets to presumptively be categorized as a commodity, the RFIA permitted ancillary asset issuers to skirt SEC regulation, despite being an “investment contract” by definition. Like the RFIA, the DCCPA also bypassed the SEC by granting the CFPB exclusive jurisdiction over digital commodities, plus the ability to decide which cryptocurrencies are digital commodities.
The prior bills addressed some of cryptocurrency’s complexities, identified which parties should be regulated, and which elements of their activities are of concern. But given the losses crypto investors experienced during 2022 and the SEC’s mandate to protect investors, it is unlikely the agency will take a backseat in future digital asset regulation.