The Distributed Ledger: Blockchain, Digital Assets and Smart Contracts – April 2021 |


This issue discusses a variety of legal, regulatory and enforcement developments in the digital asset space in the U.S. and Europe.

US Litigation

International Developments

Regulating the Digital Asset Space

The advent of bitcoin more than a decade ago spawned an explosion in decentralized, peer-to-peer financial structures using distributed ledger technology, such as blockchain, that pose a stark challenge to the traditional financial regulatory landscape. U.S. regulators have sought to apply principles and rules from a different era to protect the financial markets for public investment without stifling innovation.

Federal regulatory agencies like the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) have used their enforcement authority to combat fraud in the digital asset space, and the SEC has challenged what it has determined to be unregistered securities offerings. Nevertheless, the absence of clear rules or regulatory authority to impose rules for the trading and transfer of digital assets has left regulators, market participants and the public exposed and frustrated. Some legislation has been proposed to address the mismatch between the current federal regulatory framework and the digital asset revolution, but none has yet come close to becoming law.

Leading regulators have recently voiced their concerns about this mismatch, with Acting CFTC Chairman Rostin Behnam expressly calling for a new regulatory regime for digital assets, and the newly confirmed SEC chairman, Gary Gensler, using his confirmation hearing to highlight the importance of laws keeping pace with profound technological changes. Given the recent volatility in digital asset prices and the burgeoning investor demand for access to digital asset products, the environment is ripe for regulatory reform.

The Patchwork Approach of Regulation in the United States

Digital asset innovation has put pressure on the fragmented nature of U.S. regulation of financial markets. Across the nation, individual states have adopted varying approaches to the new products and technology, while Congress to date has left the task to numerous federal agencies with a range of regulatory mandates designed for a 20th century financial system.

State Regulation

At the state level, two approaches have emerged. One is the approach taken by states such as California and New York, which have pursued robust enforcement. For example, in February 2021, the New York Attorney General’s Office (NYAG) announced an $18.5 million fine against the issuer of the tether stablecoin (Tether) and the owner of the Bitfinex Trading Platform (iFinex), which the NYAG had been investigating for false statements relating to the nature of the stablecoin and the alleged loss of customer funds. (For more, see “New York Attorney General’s Office Settles Fraud Charges Against Cryptocurrency Exchange and Cryptocurrency Issuer.”) The companies did not admit wrongdoing as part of a settlement agreement that prohibits Tether and Bitfinex from trading with New York customers. The settlement came one month after the NYAG sued another actor in the cryptocurrency space, Coinseed Inc., alleging that its initial coin offering (ICO) should have been registered as securities and subject to broker-dealer registration requirements.1 In connection with the suit, Attorney General Letitia James warned that “[u]nregulated and fraudulent virtual currency entities, no matter how big or small, will no longer be tolerated in New York.”2 The NYAG has since issued two public alerts in response to the “extreme risk” posed to New Yorkers investing in virtual or cryptocurrencies.3

Other states, such as Colorado and Wyoming have enacted pro-cryptocurrency legislation to attract investment. Wyoming has been particularly welcoming to cryptocurrency businesses: It has issued charters for special purpose depository trust institutions, permitting companies focused on blockchain to provide banking services in the state. Additionally, the state has enacted the Wyoming Utility Token Act, which defines cryptocurrency as an asset class separate from securities and commodities, and thus not subject to regulation as such.

Federal Regulation

In the United States, the federal regulation of digital assets exists in a type of jurisdictional netherworld. The laws applicable to digital assets often depend on how the asset is categorized — either a commodity, security, currency or property. While the agencies endeavor to coordinate so that digital assets are effectively regulated, the lack of clear definitional boundaries and legal authority has created gaps in the regulatory framework that are difficult to overcome.

The two main regulatory players in this space are the SEC and CFTC, and each agency’s approach to digital assets has largely involved enforcement actions. The SEC has sought to protect investors by requiring offerings of digital assets to be registered as securities where the agency has determined that the offering satisfies the elements of the Howey test for an investment contract.4 Application of the 1946 Howey test to digital assets has generated debate, however. In 2019, SEC staff published guidance that sets forth numerous factors to be used in applying the Howey test to determine whether a given digital asset is a security.5 Staff also published the first digital asset-related no-action letters, in which it determined that digital assets that functioned as stored-value cards would not be deemed securities.6 Despite the staff’s intent to provide industry guidance, these issuances have only highlighted the challenges involved in applying a 75-year-old test that evaluated the status of orange groves to the digital world. One SEC commissioner has criticized the agency’s reliance on enforcement actions and urged that a safe harbor be created to avoid deterring innovation.7

In addition to bringing enforcement actions, the SEC has consistently declined to approve vehicles designed to invest in digital assets; indeed, to date, the SEC has rejected every application — more than a dozen — to offer a bitcoin exchange-traded fund (ETF). The commission has made well known its concern that cryptocurrency markets are prone to fraud and manipulation,8 and it has repeatedly tied that concern to the absence of regulation of the spot market in cryptocurrencies. For example, in February 2020, the SEC disapproved a rule change by NYSE Arca, Inc. to list and trade shares of the United States Bitcoin and Treasury Investment Trust sponsored by Wilshire Phoenix Funds, LLC. In doing so, the SEC said that, among other things, to satisfy applicable statutory requirements as interpreted in its prior orders, NYSE Arca had to demonstrate that the portion of the spot market represented by the Bitcoin Reference Rate was “uniquely and inherently resistant to manipulation,” and that it had a surveillance sharing agreement with a “regulated bitcoin market of significant size.” The SEC determined that NYSE Arca failed to meet these requirements, concluding that the level of regulation of the five spot markets on which the Bitcoin Reference Rate would be based did not render them uniquely invulnerable to fraud and manipulation, and that they did not constitute a sufficiently supervised market. In the SEC’s view, the combination of potential Financial Crimes Enforcement Network (FinCEN) and state oversight of the five spot markets or the CFTC’s limited jurisdiction over spot market commodities such as bitcoin did not match the level of oversight it exercises over national securities exchanges.9 In light of the SEC’s position, regulation of the spot market in cryptocurrencies could expand the array of cryptocurrency products available to investors.

Like the SEC, the CFTC has used its enforcement authority in the digital asset space. Under the Commodity Exchange Act (CEA), the definition of “commodity” is expansive, covering, in addition to several enumerated agricultural products, “all other goods and articles … and all services rights and interests … in which contracts for future delivery are presently or in the future dealt in.”10 The CFTC has used this definitional flexibility to assert that all “virtual currencies” fit within the definition of a commodity, declaring in its first cryptocurrency enforcement action that “bitcoin and other [cryptocurrencies] are encompassed in the definition and properly defined as commodities.”11 The CFTC’s enforcement authority over cryptocurrencies was upheld in CFTC v. McDonnell, with the court finding that cryptocurrencies “are ‘goods’ exchanged in a market for a uniform quality and value” and, as such, “[t]hey fall well within the common definition of ‘commodity’ as well as the CEA’s definition of ‘commodities.’”12

While the CFTC has therefore obtained success in pursuing fraud cases involving cryptocurrency, the CFTC’s oversight of the spot market in cryptocurrencies is nevertheless limited to enforcement of violations of the CEA. It has no statutory authority to set rules or establish principles specifically for trading of physical cryptocurrencies, because the CFTC’s mandate is to regulate the trading of derivatives — products such as futures, options and swaps that derive their value from an underlying asset. (In this capacity, the CFTC has allowed the listing and trading of derivatives using cryptocurrency, such as the Chicago Mercantile Exchange’s bitcoin and ethereum futures contracts.) The anti-fraud and anti-manipulation enforcement authority over the physical commodity markets that Congress provided the CFTC is in service of that mandate.13 The distinction is important, because the ability to prosecute bad actors after misconduct has occurred does not offer the same protections as do rules that can help guard against misconduct occurring in the first…



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