How Will SEC Regs Change Cryptocurrency Markets?
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How Will SEC Regs Change Cryptocurrency Markets?

6 Min.

The Securities and Exchange Commission (SEC) has disclosed a significant employee increase for its unit responsible for enforcing cryptocurrency laws. Several crypto issuers have already faced SEC enforcement. Gary Gensler, the SEC Chair, has urged crypto exchanges to register as securities trading platforms with the agency. Regulators are closely monitoring stablecoins and other tokens. The SEC's increasing number of settlements with the industry indicates that the agency now recognizes crypto businesses that adhere to securities laws.

Basics

The surge in cryptocurrency markets, driven by growing skepticism towards traditional government-issued money, has given rise to a profound shift in perceptions. This change now compels the crypto industry to grapple with a crucial government role: overseeing and regulating financial markets and securities trading.

At the forefront of this movement is the U.S. Securities and Exchange Commission, actively advocating for subjecting cryptocurrency markets to comprehensive financial regulations. In an announcement made by SEC Chair Gary Gensler in April 2022, he highlighted that the leading five exchanges, responsible for nearly all cryptocurrency trading, "are likely engaged in securities trading." Consequently, Gensler emphasized the necessity for these exchanges to register with the SEC and abide by relevant laws. Moreover, he urged stricter enforcement of financial regulations concerning stablecoins and other forms of crypto tokens.

Further bolstering their regulatory efforts, the SEC disclosed in May 2022 their intent to expand the staff of their Cyber Unit from 30 to 50 members. This unit will be rebranded as the Crypto Assets and Cyber Unit, a dedicated division aimed at reinforcing regulations in the realm of cryptocurrencies. This enforcement drive by the SEC promises to bring about substantial transformations in how cryptocurrency markets operate. Anticipate the following three significant changes to materialize sooner rather than later.

Potential Regulatory Scrutiny for New Tokens

The landscape of token regulation has evolved significantly, with the Securities and Exchange Commission making its position clear during the initial coin offering (ICO) frenzy in 2017. This was exemplified by the SEC's determination that DAO tokens constituted investment securities. Subsequently, in 2020, Ripple Labs Inc. and two executives faced a lawsuit from the SEC, alleging violations of securities laws related to the sale of XRP tokens without proper registration and disclosure compliance.

ICO issuers have faced penalties and settlements due to the SEC's enforcement actions. However, as new types of blockchain tokens emerged in recent years, such as decentralized finance (DeFi) and nonfungible tokens (NFTs), they presented unique challenges regarding securities laws.

These new projects often navigate securities laws by either lacking central administrators or positioning tokens as collectibles, such as in-game items or digital artworks. Nevertheless, if these tokens are marketed and sold as investments, they remain subject to securities laws.

In August 2021, the SEC initiated its first enforcement action within the decentralized finance space, reaching a settlement with the DeFi Money Market over the alleged handling of over $30 million in digital tokens that should have been registered as securities. The project's founders agreed to disgorge $12.8 million and pay individual fines of $125,000.

Subsequently, in February 2022, BlockFi Lending LLC settled with the SEC and 32 states, agreeing to pay $100 million for failing to register its BlockFi Interest Accounts as securities. Additionally, BlockFi committed to registering a new lending product with the SEC.

Nonfungible tokens, although sometimes marketed as collectibles or artworks, may also fall within the purview of securities laws if acquired as investments. Regulators are showing increasing interest in applying securities laws to NFTs, with Commissioner Hester Peirce cautioning investors about potential legal issues.

During his speech in April 2022, SEC Chair Gary Gensler stated that most crypto tokens are likely to be considered investment contracts under the Howey Test, as defined by a U.S. Supreme Court ruling. This test refers to "an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others."

While the SEC has not yet announced specific enforcement actions targeting NFTs, there have been reports of the agency issuing subpoenas to NFT creators as part of its investigative efforts.

Potential Requirement for Exchanges to Register as Broker-Dealers

During a Senate Banking Committee hearing in September 2021, SEC Chair Gensler emphasized that crypto exchanges should register as securities exchanges. Gensler reiterated this call in April 2022, as he highlighted the parallels between crypto platforms and regulated exchanges, asserting that investors should receive comparable protection.

Historically, crypto exchanges have operated opaquely, enabling operators to generate profits without sufficient regulatory oversight or accountability. Many exchanges have faced allegations of engaging in wash trading, front running, or even freezing customer balances.

If compelled to register with the SEC, crypto exchanges would be compelled to implement technology systems ensuring audit compliance for their order books. They would also be subject to stringent regulations governing order execution to prevent market manipulation.

In his April 2022 speech, Gensler further identified the custody challenges faced by exchanges, citing thefts exceeding $14 billion in crypto assets throughout 2021 as a concerning issue.

In the past, numerous exchanges opted to evade U.S. regulation by locating themselves overseas and refraining from accepting U.S. customers. However, some exchanges have recognized compliance as a prerequisite for accessing the lucrative U.S. market. Notably, platforms like Coinbase have pursued SEC rule compliance by acquiring broker-dealers registered in the United States.

Increased Regulatory Focus on Stablecoins

Regulators are focusing on stablecoins, blockchain tokens that maintain a fixed value in relation to a fiat currency like the dollar. To support their peg, most stablecoins hold significant reserves of cash, treasuries, or other low-risk assets.

The collapse of the Terra (UST) algorithmic stablecoin in May 2022 has raised concerns regarding the regulation of other stablecoins. Backers of Tether (USDT), the largest stablecoin, reached a settlement of $18.5 million with the New York Attorney General in 2021. Additionally, they faced a $41 million fine from the Commodity Futures Trading Commission the same year, accused of misrepresenting their reserves.

To address these concerns, Tether now provides limited daily information regarding its reserve holdings.

In April 2022, Gensler questioned the backing of stablecoins, emphasizing the need to ensure that these holdings can be reliably converted to dollars on a one-to-one basis. Gensler highlighted the potential systemic risks posed by stablecoins to the crypto ecosystem and beyond, citing concerns about money laundering and sanctions evasion.

Considering crypto exchanges as de facto securities brokers, the SEC is likely to classify most stablecoin trades as securities transactions. Although the SEC has not initiated litigation, it has indicated its involvement in the ongoing investigation of Tether alongside other government agencies.

Conclusion

The SEC's recent crypto settlements highlight their commitment to collaborating with industry participants. SEC Chair Gensler aims to extend the same investor protections that have fostered the success of U.S. securities markets to the crypto realm. The increasing number of regulatory settlements within the cryptocurrency sector signifies the impact of this message.

Securities and Exchange Commission (SEC)
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