Wed 03/01/2023 09:04 AM
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Crypto market participants have been anticipating a regulatory response to the paradigm shift from boom to the “crypto winter” and resulting consumer harm caused by the failure of crypto exchanges and other industry players. Following FTX’s collapse in November, the regulatory crackdown on the crypto industry has shifted into higher gear.

This article surveys notable actions, or lack thereof, taken by Congress, the U.S. Securities and Exchange Commission, other regulators and the Federal Reserve impacting the crypto market.

Congress has been relatively quiet, holding two hearings on crypto issues, and has yet to take major legislative action - while questioning the adequacy of the SEC’s response. For its part, the SEC has instituted actions against high-profile crypto companies. These enforcement actions evidence an expansion of the SEC’s securities law enforcement to stablecoins and crypto staking, as well as instituting registration requirements for crypto custody. The Federal Reserve has also sought to insulate banks from the spread of contagion from the crypto sector.

Congress

On Feb. 14, the U.S. Senate Committee on Banking, Housing and Urban Affairs held a hearing entitled “Crypto Crash: Why Financial System Safeguards are Needed for Digital Assets.” At the hearing, Chairman Rep. Sherrod Brown, D-Ohio, and other members discussed the need for the United States to develop a “comprehensive framework” to regulate cryptocurrency products and protect consumers and the financial system. The hearing featured expert testimony from Lee Reiners, Policy Director, Duke Financial Economics Center, Duke University; Linda Jeng, Chief Global Regulatory Officer of the Crypto Council for Innovation; and Yesha Yadav, Associate Dean, Vanderbilt Law School.

Brown said that it was “time to consider how to protect consumers from unregulated crypto assets” and put in place regulations requiring additional disclosures, protections from conflicts of interest, segregation of customer funds, anti-money laundering protocols and other mechanisms for oversight and supervision.

Ranking Member Tim Scott, R-S.C., voiced criticism of SEC Chair Gary Gensler, questioning why regulators had not “acted sooner” to protect customers from not just FTX’s failure but also the bankruptcy of the Voyager Digital, Celsius Network and BlockFi exchanges and injuries to investors in the Terra Luna crypto ecosystem. Scott said that the SEC had failed to take “any action” to address the fundamental causes of “these crypto meltdowns.” If the SEC “had the tools they needed,” it was “asleep at the wheel,” Scott suggested.

FTX’s collapse was also the impetus for the U.S. House Committee on Financial Services to hold its first bipartisan hearing in two years in December 2022: Investigating the Collapse of FTX, Part I.

Representatives are also probing the timing of criminal and civil charges of FTX co-founder and former CEO Sam Bankman-Fried’s arrest, which occurred just prior to his scheduled testimony at December’s hearing. Former chair Rep. Maxine Waters, D-Calif., has called for new Chairman Patrick McHenry, R-N.C., to arrange for Bankman-Fried to testify and continue the committee’s “bipartisan effort to get to the bottom of FTX’s collapse.” McHenry announced in January that Rep. French Hill, R-Ark., will chair the newly formed House Financial Services Subcommittee on Digital Assets, Financial Technology and Inclusion.

Proposed legislation from the previous 117th Congress, such as the Stablecoin Transparency Act (which would establish reserve and audited reporting requirements for stablecoin issuers), has not yet been reintroduced in the 118th Congress. However, apart from the CBDC Anti-Surveillance State Act, legislation that would amend the Federal Reserve Act to prohibit the central bank from utilizing digital currency, the current session of Congress has not yet seen the introduction of any formal bills in the wake of FTX’s collapse.

The Banking, Housing and Urban Affairs hearing featured discussion of various potential bills that could result in SEC oversight of spot markets for digital assets, as well as the stablecoin proof of reserves bill and the potential reintroduction of the Digital Asset Anti-Money Laundering Act.

The crypto legislation environment is shadowed by the substantial political donations by FTX, Bankman-Fried and other FTX officers and principals totaling “as much as $93 million” to “[o]ne in three members of the current Congress” in an apparent effort to influence the regulatory process.

According to the U.S. Department of Justice’s superseding indictment against Bankman-Fried, unsealed on Thursday, Feb. 23, the FTX founder and his co-conspirators “made over 300 political contributions, totaling tens of millions of dollars, that were unlawful because they were made in the name of a straw donor or paid for with corporate funds.” The FTX Group debtors set a Tuesday, Feb. 28, deadline for recipients to return contributions.

SEC

The predicate for SEC regulation is the classification of particular cryptocurrencies or related investment activities as a “security” subject to the SEC’s jurisdiction. The SEC’s framework for evaluating if an investment contract, digital or otherwise, is a security applies the four-factor test developed in the Supreme Court’s 1946 decision SEC v. W.J. Howey Co. The Howley test evaluates if the activity involves an investment of money, in a common enterprise, with the reasonable expectation of profits derived from others.

Within this framework, the SEC has instituted a number of actions, including filing a complaint against Genesis Global Capital and Gemini Trust Co. charging both companies with Securities Act violations in connection with the operation of the Gemini Earn crypto asset lending program. Under the program, Gemini Earn users turned over their crypto assets to Genesis to be lent out and, in exchange, Genesis promised to pay interest on those assets to investors. The SEC says that the Earn program was an unregistered securities offering.

Many attribute the crypto winter to the collapse of the Terra Luna cryptocurrencies and related ecosystem in the spring of 2022. The SEC recently sued Terra’s developer Terraform Labs and founder Do Kwon, as reported by The Wall Street Journal.

The SEC has also objected to confirmation of Voyager Digital’s chapter 11 plan, questioning if the purchase and sale of cryptocurrencies in connection with the rebalancing contemplated under the plan can be accomplished in compliance with federal securities law. In opposition to confirmation, the SEC also points to the uncertain effect of potential regulatory actions against Binance, citing “numerous public reports and press accounts concerning investigations.” Binance US is purchasing Voyager’s assets and will migrate electing customer accounts to its platform under the plan.

The U.S. Federal Trade Commission has also disclosed that it is conducting an active investigation into Voyager and its former management’s “deceptive and unfair marketing of cryptocurrency.”

One of the highest profile actions against a crypto company that is not in financial distress is the SEC’s 2020 suit against Ripple Labs accusing the company of raising $1.3 billion through an “unregistered, ongoing digital asset securities offering.” The complaint seeks a determination that Ripple sold XRP, a token with an approximately $20 billion market value, without registration or adequate disclosure. The action is pending before the U.S. District Court for the Southern District of New York, and a ruling is expected this quarter, according to Bloomberg.

The docket for the Ripple litigation is available HERE.

The SEC has also taken action relating to the foundational pillars of the crypto industry - staking, stablecoins and custodial relationships.

The SEC’s bellwether enforcement action concerning crypto staking involved Kraken, the third-largest exchange behind Binance and Coinbase according to CoinMarketCap. Staking is a mechanic whereby crypto asset holders can earn rewards or fees on their assets by agreeing to lock up the assets to enable the validation of transactions under various blockchain protocols, such as Ethereum. A number of cryptocurrency exchanges offer staking services that allow customers to, in effect, receive interest on their assets, similar to the crypto lending programs targeted by the SEC.

Early this month, the SEC brought a complaint against Kraken charging the exchange with “failing to register the offer and sale of their crypto asset staking-as-a-service program, whereby investors transfer crypto assets to Kraken for staking in exchange for advertised annual investment returns of as much as 21 percent.” Kraken settled the action by paying $30 million and agreeing to cease offering staking services.

Coinbase has issued a statement insisting that its staking services program is not a security, and takes issue with the SEC’s efforts to “superimpose securities law onto a process like staking.”

Stablecoins, the next segment of recent enforcement actions, serve as a means to transact between different crypto currency assets on blockchains without an intermediate fiat-based exchange. Stablecoins also reduce the volatility inherent in cryptocurrency values by collateralizing or “backing” coins with other cryptocurrencies, gold or another commodity or fiat or fiat-denominated assets, such as U.S. Treasury bills.

Regulators have targeted one of the largest stablecoins, Binance USD (BUSD), which has an approximately $11.8 billion market value, according to CoinMarketCap - behind Tether (USDT) and USD Coin (USD), with market values of $70.6 billion and $32.2 billion, respectively. BUSD had market value above $16 billion at the beginning of February, according to CoinGecko. Although BUSD is a Binance-branded product, the stablecoin is issued by Paxos Trust Co., which announced it would stop issuing BUSD and end its relationship with Binance on Feb. 13 in response to regulatory action.

Paxos holds a provisional bank charter from the U.S. Office of the Comptroller of the Currency, and has denied reports that the OCC has requested it to withdraw its application for a full banking charter, according to CoinDesk.

According to the company, “BUSD will remain fully supported by Paxos and redeemable to onboarded customers through at least February 2024” and customers will be able to redeem their funds in U.S. dollars or “convert their BUSD tokens to Pax Dollar (USDP), a regulated US dollar-backed stablecoin also issued by Paxos.”

The New York State Department of Financial Services, which regulates Paxos under its BitLicense regime, began an investigation into Paxos early this month and “ordered Paxos to cease minting Paxos-issued BUSD as a result of several unresolved issues related to Paxos’ oversight of its relationship with Binance in regard to Paxos-issued BUSD.” Also, on Feb. 13 Paxos disclosed that it had received a Wells notice from the SEC stating that the SEC was considering litigation classifying BUSD as a security and proceeding in an enforcement against Paxos for failing to register the token.

Responding to the SEC notice, Paxos stated its disagreement with the classification of BUSD as a security and said it is “prepared to vigorously litigate if necessary.”

In response to regulatory pressure, Binance is considering withdrawing from its relationships with partners in the United States, though its direct affiliate Binance US has no plans to stop operating in the U.S., according to reporting by Bloomberg.

Separately, Reuters reported that in early 2020 approximately $400 million was transferred from Binance US’s account at Silvergate Bank to Merit Peak Ltd., which is managed by Binance CEO Changpeng Zhao. According to the report, Binance US executives “were concerned by the outflows because the transfers were taking place without their knowledge.”

Binance US responded with a statement detailing that although Merit Peak had engaged in market making activities it “stopped all activity on the platform in 2021.” The statement asserts that only Binance US employees have access to the company’s bank accounts, “period,” and that Binance US “has never - and will never - trade nor lend out customer funds.” The statement concludes that despite “many attempts to draw parallels between Binance US and fraudulent exchanges that have gone bankrupt,” the “real facts speak for themselves” and “there is no comparison.”

According to The Wall Street Journal, Binance has admitted to earlier “compliance gaps” in investigations by the DOJ, the Internal Revenue Service, the SEC and the Commodity Futures Trading Commission, and expects to settle the investigations via payment of monetary penalties.

The final broad segment of enforcement action by the SEC involves the custodial storage of crypto customer assets. Last week, the SEC issued a proposed rule to expand its current custody asset rules. The proposed rule, “like the current rule, would define the term ‘qualified custodian’ to mean a bank or savings association, registered broker-dealer, registered futures commission merchant (‘FCM’), or certain type of foreign financial institution (‘FFI’) that meets the specified conditions and requirements.”

The proposed rule highlights “significant developments with respect to crypto assets.” According to the SEC, the distributed ledger or blockchain technology underpinning such assets presents unique risks that “could leave advisory clients without meaningful recourse to reverse erroneous or fraudulent transactions, recover or replace lost crypto assets, or correct errors that result from their adviser having custody of these assets.”

The rule would require custodians to segregate customer funds “in accounts designed to protect such assets from creditors … in the event of the insolvency or failure” of the custodian. “This condition,” the proposed rule states, would provide for investor protections “comparable” to those proposed for “assets held with U.S.-regulated bank or savings association qualified custodians.”

The proposed rule notes that its application “turns on whether a particular client investment is a fund or a security,” but states that “even if a particular crypto asset is not a security, the current rule also covers funds.”

The largest crypto custodian, Coinbase, whose crypto trust is chartered by New York state, says that it already complies with the SEC’s proposal, but maintains the rule would entrench existing providers. The regulation could potentially favor banks over other entrants and also sets up a potential jurisdictional fight between federal banking regulations and state regulation of banks and trust companies.

Federal Reserve

The Federal Reserve has also been active in the crypto space, issuing a warning to banks in a Jan. 27 policy statement that they should limit risks involving crypto assets. The statement was implemented in a final rule effective Feb. 7.

According to the Reserve Board, the rule clarifies its interpretation of section 9(13) of the Federal Reserve Act by setting a rebuttable presumption that regulated banks are prohibited from acting as a principal “in the context of certain crypto-asset-related activities.” Crypto-related activities, the rule adds, must be limited to activities “that are permissible for national banks … unless those activities are permissible for state banks by federal statute or under part 362 of the FDIC's regulations.”

This presumption may be rebutted “if there is a clear and compelling rationale for the Board to allow deviations in regulatory treatment among federally supervised banks, and the state member bank has robust plans for managing the risks of such activities in accordance with principles of safe and sound banking.”

The board notes that it has “not yet been presented with facts and circumstances that would warrant rebutting its presumption.” Specifically, the rule indicates that there is no authority that would permit “national banks to hold most crypto-assets, including bitcoin and ether, as principal in any amount.”

The board says the rule does not “prohibit a state member bank, or an applicant to become a state member bank, once approved, from providing safekeeping services for crypto-assets in a custodial capacity.” The rule also notes that banks could issue “dollar-denominated tokens” using blockchain technologies to facilitate payments if done in compliance with guidance issued by the OCC. However, the rule adds that the board “generally believes that issuing tokens on open, public, and/or decentralized networks, or similar systems is highly likely to be inconsistent with safe and sound banking practices”

A likely motivator for the Federal Reserve’s rule is the effect of FTX’s collapse on crypto-focused Silvergate Bank, which provided “fiat” onboarding to FTX, and similar services to Coinbase, Paxos, Circle, Kraken, Bitstamp, Gemini and Crypto.com. Following FTX’s bankruptcy, Silvergate stated that its direct exposure to FTX was limited to “less than 10%” of its $11.9 billion of deposits, but the bank faced an ensuing run on its crypto deposits that amounted to an $8.1 billion outflow, according to reporting by Bloomberg. Silvergate incurred a $718 million loss when it was forced to sell assets at a significant discount to cover client withdrawals, and also utilized $4.3 billion of advances from the Federal Home Loan Bank to secure liquidity.

Silvergate is also the target of a DOJ fraud investigation, as reported by Bloomberg, in connection with allegations that the bank flouted anti-money laundering and know-your-customer obligations and allowed FTX to route customer deposits through Alameda Research’s bank accounts. A class-action complaint in California federal court alleging similar conduct was dismissed without prejudice earlier this month.

Following the Federal Reserve’s policy announcement, Binance announced in a statement to CoinDesk that it was temporarily suspending U.S. dollar bank transfers after its partner Signature Bank implemented a $100,000 minimum transaction threshold for crypto customers effective Feb. 1. As reported by Bloomberg, Signature has moved to reduce its crypto deposits by up to $10 billion.

In accordance with the general limits on crypto banking, in January the Federal Reserve Board also denied the application of Custodia Bank, a special purpose depository institution chartered by Wyoming with a crypto asset-focused business plan, to become a member of the Federal Reserve System.
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