Author: Lawyer Chen Shanghai
The United States Securities and Exchange Commission (SEC) is the first federal securities market regulator in the United States. It was established by the United States Congress in 1934 in accordance with the passage of the Securities Act of 1933 and the Securities Exchange Act of 1934. It was mainly created in response to the stock market crash that led to the Great Depression in 1929. As an independent federal government regulator, the SEC's main responsibilities are to protect investors, maintain the fair and orderly operation of the securities market, and promote capital formation.
Gary Gensler, the current chairman of the SEC, has repeatedly stated in public that, except for absolutely decentralized virtual currencies such as Bitcoin and Ethereum, virtual currencies issued by most other projects should be regarded as "securities" and therefore need to apply for registration or exemption from the SEC.
Because the SEC has a very large jurisdiction, once digital assets are identified as "securities", they need to comply with the relevant regulations of the SEC and fulfill compliance obligations. Moreover, the digital assets mentioned above are not limited to virtual currencies, but also include other forms of digital assets such as NFTs and stablecoins.
Since the second half of 2023, the SEC's series of operations involving cryptocurrencies and decentralized finance (DeFi) have intensified discussions in the United States about the future of cryptocurrencies, DeFi and Web3 technologies. At present, the SEC's regulation of crypto assets as securities is still mainly aimed at reviewing and cracking down on unregistered tokens. In particular, the SEC's charges against other exchanges such as Genesis and Gemini at the end of 2023 have highlighted the SEC's determination and attitude to focus on enforcing supervision in the field of cryptocurrency.
Although such discussions are still ongoing, cryptocurrency companies, investors and other relevant parties are closely watching how these developments will shape the future of Web3, cryptocurrency and decentralized finance in the United States. With the SEC's increasing regulatory efforts, the cryptocurrency and Web3 industries in the United States are clearly at a crossroads.
As an independent federal agency of the United States, the Commodity Futures Trading Commission (CFTC) was established by the U.S. Congress in 1974 under the Commodity Futures Trading Commission Act. Its goals include promoting competitive and efficient markets and protecting investors from manipulation, abusive trade practices and fraud.
The CFTC is primarily responsible for regulating the U.S. derivatives market. This includes commodity futures, options and swaps markets and over-the-counter (OTC) markets. In order to adequately regulate these markets, the CFTC is primarily responsible for regulating the following organizations: trading organizations, such as designated contract markets (exchanges that host futures transactions) and swap execution facilities (platforms that allow participants to buy and sell swaps).
In July 2023, the U.S. Senate introduced a bipartisan bill that aims to "bring crypto assets under regulatory jurisdiction" by granting the Commodity Futures Trading Commission (CFTC) oversight responsibility for most forms of cryptocurrencies.
The new bill, sponsored by Senators Cynthia Lummis and Kirsten Gillibrand, builds on draft legislation the two introduced during the last session of Congress, and is the result of the Securities and Exchange Commission (SEC) taking the position that nearly all digital assets are securities and therefore fall under its jurisdiction, following the collapse of cryptocurrency exchange FTX and in the absence of clear direction from Congress.
The core of the bill is to grant the CFTC exclusive jurisdiction to regulate transactions involving "crypto-assets," which are defined as electronic assets that confer economic rights or access rights recorded on distributed ledger technology or similar technology. "Crypto-assets" also include "ancillary assets," which are assets such as crypto tokens sold in investment contracts, which are often used to finance crypto projects in their early stages. Under the Act, even if the issuer of an ancillary asset “engages in the entrepreneurial or managerial work that primarily determines the value of the token”—a factor that favors the asset being considered a security, as established by the Supreme Court in SEC v. W. J. Howey Co., 328 U.S. 293 (1946) et seq.—the token is considered a commodity and falls under the jurisdiction of the CFTC as long as the issuer complies with certain SEC disclosure requirements.
The U.S. Treasury established FinCEN in 1990 to provide a government-wide, multi-source financial intelligence and analysis network. In 1994, the organization’s scope of operations was expanded to include regulatory responsibilities under the Bank Secrecy Act, one of the United States’ most powerful weapons against corruption in the U.S. financial system. Its mission is to enhance U.S. national security, deter and detect criminal activity, and protect the financial system from abuse by increasing transparency in the U.S. and international financial systems.
On October 19, 2023, FinCEN announced a proposed rulemaking notice (NPRM) that lists international convertible virtual currency mixing (CVC mixing) as a type of transaction that is currently a major money laundering method. The notice also highlights the risks posed by the widespread use of CVC mixing services by various illegal actors around the world and proposes a rule to increase transparency in CVC mixing to combat the use of CVC mixing services by malicious actors including Hamas, Palestinian Islamic Jihad, and the Democratic Party. The NPRM is a key part of the Treasury Department's efforts to increase transparency in CVC mixing activities.
U.S. Treasury Under Secretary Wally Adeyemo also said: "Today's action highlights the Treasury Department's commitment to combating the use of convertible virtual currency mixing by a variety of illegal actors, including state-affiliated cyber actors, cybercriminals, and terrorist organizations." 1
The lack of transparency in international CVC mixing activities is a serious money laundering and national security risk, and increasing transparency related to this activity is a key component to preventing illegal actors from entering the U.S. and global financial systems. This increased transparency is also consistent with the Treasury Department's long-standing fight against terrorist organizations such as Hamas and Palestinian Islamic Jihad that commit violence against innocent civilians, including attacks by ransomware criminals against critical infrastructure; and efforts by state actors and their supporters to evade U.S. and global sanctions. To support these important goals, the NPRM will require covered financial institutions to report information about transactions when they know, suspect, or have reason to suspect that a transaction involves the commingling of CVCs in jurisdictions within or outside the United States.
The Office of Foreign Assets Control (OFAC) is the U.S. Treasury Department's financial intelligence and law enforcement agency, which originated from the International Emergency Economic Powers Act (IEEPA) passed in 1977 and primarily manages and enforces economic and trade sanctions in support of the United States' national security and foreign policy objectives. Pursuant to the President's national emergency powers, OFAC conducts activities against foreign countries deemed to pose a threat to U.S. national security, as well as a variety of other organizations and individuals (such as terrorist organizations).
Just in August 2022, the U.S. Treasury Department's Office of Foreign Assets Control (OFAC) sanctioned a cryptocurrency "mixer". In addition to this, OFAC also blacklisted some Ethereum addresses associated with the protocol.
Because one of OFAC's main tools is the Specially Designated Nationals and Blocked Persons List (SDN), a list of individuals and legal entities subject to its sanctions. The assets of sanctioned persons under U.S. jurisdiction are frozen, and Americans are generally prohibited from dealing with sanctioned persons. 2 By isolating sanctioned persons from the U.S. financial system, it is difficult for these people to conduct international business, especially when trading in U.S. dollars. This is not the first time OFAC has been involved in the crypto space, as it has previously sanctioned crypto companies or protocols controlled by centralized entities.
After being sanctioned by OFAC, anyone/any wallet (i.e., U.S. individuals and businesses, as well as citizens and institutions of other countries that are indirectly related to U.S. individuals or businesses) who interact with the sanctioned entity or protocol and the above-mentioned Ethereum address must bear strict liability under U.S. law.
Such sanctions, while intended to target bad actors in the space, may have collateral effects on those seeking to innovate and build better or more decentralized ecosystems. Because sanctions and the lack of a clear enforcement mechanism may increase the difficulty for Web3 companies and other cryptocurrency-related entities to access entry or exit services through the fiat banking system. Because sanctions rely on proactive enforcement by banks and other financial institutions, these entities may be overly cautious and overly strict in their compliance measures.
The Internal Revenue Service (IRS) is part of the U.S. Treasury Department and is primarily responsible for the administration and enforcement of U.S. federal tax laws. As early as March 2014, the IRS issued Notice No. 2014-21, Guidance on Virtual Currency, for tax purposes, defining digital assets as "property." On August 25, 2023, the IRS released proposed regulations requiring domestic and foreign exchanges and other types of digital asset institutions to (1) collect identity information of their customers and (2) report the trading activities of U.S. customers to the IRS and these U.S. customers. The regulations will officially take effect in 2025, at which time U.S. taxpayers and the IRS will receive the same type of digital asset information returns as they receive when trading traditional financial assets (such as stocks and bonds) with existing brokers.
Currently, this 282-page regulatory plan only implements part of the Infrastructure Investment and Jobs Act and will only take legal effect after the IRS considers the opinions of stakeholders and implements these regulations in an interim or final form.
On July 12, 2023, U.S. Senator Cynthia Lummis (R-Wyo.), a member of the Senate Banking Committee, and Kirsten Gillibrand (D-NY), a member of the Senate Agriculture Committee, reintroduced the Lummis-Gillibrand Responsible Financial Innovation Act (RFIA). Although it is unclear whether RFIA will be passed in the Senate in its current form, certain consumer protection provisions have been modified from the previous 2022 version to win more votes. Regardless of the future feasibility of RFIA, RFIA has sparked widespread discussion within Congress. For example, shortly after its reintroduction, provisions in RFIA involving anti-money laundering review standards for crypto assets and anonymous crypto asset transactions were added to the 2024 National Defense Authorization Act (NDAA).
Compared to the original 2022 version of RFIA, the 2023 version reflects revisions to adapt to the changing cryptocurrency market, especially considering the impact of a series of cryptocurrency exchange bankruptcies since 2022.
Therefore, the RFIA provisions that have been significantly updated since 2022 mainly include:
According to the current draft, RFIA is committed to creating a new federal framework to regulate crypto assets and crypto asset intermediaries. The framework is committed to clarifying and distinguishing the governance roles of the CFTC and the SEC by providing the necessary statutory powers, guiding these agencies to participate in rulemaking, and introducing the concept of customer protection and market integrity bureaus. 3 These provisions will have a significant impact on these agencies because determining whether an asset is a security will determine the regulators, restrictions, and obligations of crypto assets and related entities. The framework specifically includes:
(1) Enhanced authority of the U.S. Commodity Futures Trading Commission
The CFTC’s existing statutory authority over spot market commodities, including cryptocurrencies, is limited to enforcement authority over fraudulent and manipulative practices in these markets; however, the CFTC’s regulatory authority is limited to derivatives markets (such as futures and swaps). Therefore, in the draft, the RFIA will provide the CFTC with statutory authority to regulate spot crypto asset markets, including cryptocurrency issuers, crypto assets, and other aspects of crypto asset markets.
(2) Spot market jurisdiction
The RFIA grants the CFTC jurisdiction over all crypto assets that are not defined as securities. This will mark the first time that the Commodity Futures Trading Commission has broad jurisdiction over a class of spot market commodities. In particular, the RFIA also gives the CFTC exclusive jurisdiction over any agreement, contract, or transaction involving the sale of crypto assets (including ancillary assets). In addition to limiting the CFTC’s jurisdiction to crypto assets that are not securities and are commercially fungible, the RFIA also excludes digital collectibles and other unique crypto assets from the CFTC’s jurisdiction. 4. Nevertheless, this broad jurisdiction marks the CFTC as a major crypto asset regulator.
(3) Crypto asset exchanges
RFIA defines a “crypto asset exchange” as a trading facility that lists at least one crypto asset for trading. Any trading institution seeking to provide a market for crypto assets or payment stablecoins must register with the CFTC, with the exception of decentralized protocols. RFIA requires each crypto asset exchange to establish and enforce its own rules to ensure that only assets that are not easily manipulated are offered and that customer assets are protected. Under the RFIA, the CFTC imposes new regulations on registered crypto asset exchanges. Although crypto asset exchanges are prohibited from engaging in proprietary trading, the U.S. Commodity Futures Trading Commission may participate in rulemaking to establish standards for allowing market making. In addition, any change in control of a crypto asset exchange that results in a person or entity acquiring more than 25% ownership must first be approved by the CFTC.
While the RFIA establishes the CFTC as the primary federal regulator for most crypto assets, the SEC has jurisdiction over digital assets that are securities. If the underlying digital asset provides the asset holder with debt or equity, liquidation rights, dividend payment rights, or other financial benefits of a business entity, the asset would not be considered a “crypto-asset” or “ancillary asset” and would instead be subject to the CFTC’s jurisdiction.
RFIA authorizes the U.S. Court of Appeals for the D.C. Circuit to make a determination if a conflict arises over whether a digital asset should be considered a crypto-asset.
These provisions represent a significant change from the status quo and attempt to provide a clearer regulatory regime than previous versions of the RFIA. As currently drafted, the SEC would not play the role of primary digital asset regulator, but would still have the authority to deem certain assets securities and challenge the Commodity Futures Trading Commission’s jurisdiction over others. An aggressive SEC, such as the current one, could use this authority to maintain a significant role in cryptocurrency regulation.
As currently drafted, the RFIA creates an Authority for Customer Protection and Market Integrity (the “Authority”), a board of trustees comprised of the SEC and the CFTC. A jointly chartered self-regulatory organization for crypto-asset intermediaries (“SRO”). Membership in the Authority is limited to crypto-asset intermediaries. The Authority’s mission is to regulate, supervise, and constrain crypto-asset intermediaries, and is essentially a self-regulatory organization, although the RFIA does not define it as such.
Under the RFIA, the Authority must allocate 13 board members in the following proportions: three government directors (the Director of the CFTC’s Office of Financial Innovation, the Director of the SEC’s Office of Financial Innovation, and a Director of FinCEN), four independent directors appointed by the Chairman, and six directors appointed by members of the Authority. 5
In its current draft, the RFIA explicitly states that its purpose is to “provide consumer protection and responsible financial innovation, bringing crypto-assets under the regulatory umbrella.” This new focus on consumer protection will run through all of the RFIA’s provisions and may affect the specific liquidation procedures following the bankruptcy of cryptocurrency exchanges in 2022.
(1) Proof of Reserve Requirements
RFIA All crypto-asset intermediaries must maintain a system to demonstrate cryptographically verifiable ownership or control of all crypto-assets held in custody or otherwise held by a customer with the intermediary. The system must be protected from the disclosure of customer data, proprietary information, and other data that could create operational or cybersecurity risks. Crypto-asset intermediaries must retain an independent public accountant to verify ownership or control of all crypto-assets held in custody.
(2) Permitted Transactions
RFIA requires that each crypto-asset intermediary ensure that the scope of permitted transactions involving crypto-assets belonging to customers is clearly disclosed in the customer agreement. In addition, each crypto-asset intermediary must provide clear notice to each customer and require confirmation of the following: (i) whether customer crypto-assets are segregated from other customer assets and the manner in which they are segregated; (ii) how customer crypto-assets will be handled in the event of bankruptcy or insolvency and the risk of loss; (iii) the period and manner in which the intermediary is obligated to return customer crypto-assets upon request; (iv) applicable fees imposed on customers; and (v) the intermediary’s dispute resolution procedures. 6
(3) Lending
RFIA requires that crypto-asset intermediaries disclose to customers any lending arrangements, including potential insolvency treatment of customer assets in the event of bankruptcy, before providing any lending services. Crypto-asset intermediaries must also disclose in any lending arrangements whether the intermediary permits failure to deliver customer crypto-assets or other collateral, and, if so, within what time frame the failure must be resolved. Notably, RFIA explicitly prohibits crypto-asset intermediaries from rehypothecating crypto-assets.
Such a prohibition would put crypto-asset intermediaries at a disadvantage relative to traditional lenders. In traditional finance, lenders use rehypothecation to obtain credit for their own use and thereby achieve their own objectives. A prohibition on crypto-asset intermediaries would limit their ability to take on similar risks for their own purposes.
Under the RFIA as currently drafted, no entity other than a depository institution and its subsidiaries may issue payment stablecoins. This has the potential to affect current stablecoin issuers, many of which are not depository institutions.
The term “payment stablecoin” means a claim represented on a distributed ledger that: is redeemable on demand, on a one-to-one basis, for a U.S. dollar-denominated instrument; is issued by a commercial entity; is accompanied by a statement from the issuer indicating that the asset is redeemable from the issuer or another person; is backed by one or more financial assets, excluding other crypto assets; and is intended to be used as a medium of exchange7.
Depository institutions are required to apply to the appropriate federal banking agency or state banking regulator to issue a stablecoin. If a federal banking agency or state banking regulator determines that a payment stablecoin is unlikely to be conducted in a safe and sound manner; or that the custodian lacks the resources and expertise to manage the stablecoin; or that the depository institution does not have the necessary policies and procedures related to the stablecoin, then the issuance will not be approved.
Once approved, the issuing depository institution must clearly disclose to customers that payment stablecoins are neither guaranteed by the U.S. government nor insured by the Federal Deposit Insurance Corporation. Although payment stablecoins are not guaranteed or insured, persons with valid claims on payment stablecoins have priority over any other claims against the issuing depository institution in the event of a receivership of the issuing depository institution. Stablecoin assets required for payment, including claims related to deposits that have occurred.
(1) Cryptocurrency ATMs
RFIA provides a new system for fighting illegal finance. In the current draft, RFIA instructs the Financial Crimes Enforcement Network (“FinCEN”) to require crypto asset kiosk owners to submit and update the physical address of the kiosks owned or operated. In addition, FinCEN must require crypto asset kiosk owners and administrators to verify the identity of each kiosk customer using a government-issued ID.
(2) Fintech Working Group
RFIA also established an independent financial technology working group to combat terrorism and illegal financing, composed of senior representatives from the Secretary of the Treasury, FinCEN, the Internal Revenue Service, the Office of Foreign Assets Control, and the Federal Bureau of Investigation.
The Task Force has a broad mandate, charged with conducting independent research on terrorist and illicit uses of new financial technologies; analyzing how crypto assets and emerging technologies can enhance U.S. national security and economic competitiveness in financial innovation; and developing legislative and regulatory proposals to improve the U.S.’s efforts to combat money laundering, terrorism, and other illicit financing.
As currently drafted, the RFIA proposes alternative tax treatments for crypto assets. Gross income excludes gains from the sale or exchange of any crypto asset unless the sale or exchange is for cash or cash equivalents; property used by the taxpayer in the active conduct of a trade or business; or any property held by the taxpayer to produce income. Notably, this exclusion does not apply if the value of such sale or exchange exceeds $200 or the gross proceeds exceed $300. Ultimately, this exclusion will ensure that consumers who trade in small amounts of cryptocurrency do not face the same type of tax liability as consumers who trade in large amounts.
The RFIA also does not allow for a deduction of losses from wash sales. A deduction is not allowed for any loss claimed to be incurred from any sale or other disposition of a specified asset if, during the period beginning 30 days before the date of such sale or other disposition and ending 30 days after such date, the taxpayer has acquired substantially identical specified assets, or entered into a contract or option to purchase substantially identical specified assets, or a long-term notional principal contract. Under current law, these restrictions apply to securities transactions. Therefore, even if a crypto asset is a commodity under the rest of the RFIA, it would still be considered a security in this case. 8
At present, the United States has further ensured that the development of the cryptocurrency and WEB3 markets will not be out of order and out of control by combining a "permissive" market background with a "strict" regulatory policy. By clearly incorporating cryptocurrencies into its regulatory scope through policy statements and gradually guiding the expected development of the market, cryptocurrencies will be further introduced into the standardized development channel, and ultimately the goal of making them an important part of the U.S. capital market will be achieved.
Four years ago, if someone told you that in this round of US presidential election, candidates from both parties would actively promote their recognition and support for the crypto industry, even to the point of "keeping up with the Joneses", would you believe it?
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