Crypto Regulation: Where We've Been And Where We're Going

Many investors see increasing regulation as a key driver of the crypto bear market of 2018, and blame the ICO (initial coin offering) market’s cool-down on the potential threat. In October 2018, ICO issuers collected $770 million, but that sum was only about half of what they raised in December 2017, according to CoinDesk. The slowdown was likely influenced by SEC Chairman Jay Clayton’s continued pronouncements that most ICOs are securities, implying that any that hadn’t registered with the SEC could face legal trouble.

In the spring, crypto regulation had brief moments of bullish sentiment emanating from Washington. William Hinman, director of the SEC’s division of corporation finance, declared that ether and bitcoin aren’t currently securities, citing their decentralized nature as a key reason. Since ether held an ICO in 2014, but it became more decentralized over time as many people began mining the currency and validating transactions, analysts concluded that digital assets can morph from being a security to not being one. Another moment of hope for crypto bulls came after the SEC rejected the Winklevoss twins’ proposal for a bitcoin ETF. After the decision, SEC Commissioner Hester Peirce issued a dissenting statement, saying she believes the proposal should have been approved.

Starting this fall, U.S. regulators started making waves again, stirring up fear among investors. At a tech conference in Dubai, CFTC Commissioner Brian Quintenz said cryptocurrency application developers could be held accountable if their apps are used for illegal purposes, even if they’re not running a business and if their code is open-source, or publically available. So if an engineer builds a gambling platform that later facilitates betting in states where that’s illegal, he or she could be held personally accountable. This statement caused concern among developers because it went against a widely held view that, if you build open-source software and you’re not running a business, you’re not liable.

In November, the SEC announced it had charged EtherDelta, a decentralized crypto exchange that has no single corporate owner, with operating an unregistered trading platform. Robert Cohen, the head of the SEC’s cyber unit, told Forbes, “The focus is not on the label you put on something or the technology you’re using. The focus is on the function, and what the platform is doing. Whether it’s decentralized or not, whether it’s on a smart contract or not, what matters is it’s an exchange.” The action prompted other decentralized exchanges like 0x to release statements saying they aim to abide by the law in their operations.

A week later, the SEC announced it had charged two crypto projects, AirFox and Paragon, with selling unregistered securities. Before these cases, the SEC had only closed one other non-fraud ICO case—it involved a restaurant-review app whose company had told investors they could expect their tokens to increase in value.

“Companies that issue securities through ICOs are required to comply with existing statutes and rules governing the registration of securities,” said Stephanie Avakian, Co-Director of the SEC’s Enforcement Division, in a statement. Just days later, a news report indicated that the Department of Justice was investigating market manipulation involving bitcoin, stable coin tether and one of the largest crypto exchanges in the world, Bitfinex.

Basis, a high-profile cryptocurrency designed to serve countries with unstable central banks, shut down in December, saying its tokens were likely going to be deemed unregistered securities. The startup pledged to return investors’ money—it had collected $133 million from big names like Andreessen Horowitz, Google Ventures and Bain Capital.

Yet five days before Christmas, a bullish signal appeared. Ohio congressman Warren Davidson and Florida representative Darren Soto announced a bipartisan bill, the Token Taxonomy Act, which could prevent ICOs from being deemed securities. The bill “clarifies that securities laws do not apply to companies that use blockchain once they reach their goal of becoming a functional network,” according to a press release. It “makes it clear that the finished product (or oranges as it relates to the Howey Test) is no longer a security.”

What To Expect In 2019 

With its actions against AirFox and Paragon, the SEC didn’t provide details on why it targeted those projects, outside of calling them unregistered securities. “They’re taking care of the minnows first,” says Ari Nazir, managing partner at crypto fund Neural Capital. He thinks AirFox was a “clear and easy case” because the team behind it was cutting legal corners when selling its tokens to investors. As a result of its settlement with the SEC, AirFox will create audited financial statements and file quarterly reports publicly.

In 2019, expect to see many more such crackdowns. “There’s been a huge wave of ICOs and unregistered securities that the SEC needs to regulate,” says Alex Sunnarborg, cofounder of cryptocurrency investment fund Tetras Capital. Nazir agrees and thinks most ICOs will be deemed unregistered securities. “There are about 100 more that the SEC is investigating actively,” he adds. And with more precedents, investors can hopefully gain more clarity on how the SEC is applying securities laws to cryptocurrencies.

On the institutional side, crypto ETF approvals are worth watching. VanEck, a 63-year-old investment management firm, has an application out for a bitcoin ETF, and the final deadline for the SEC to decide on approval is in late February. Bakkt, the new cryptocurrency trading and custody platform that’s being launched by NYSE parent company Intercontinental Exchange, is awaiting CFTC approval for its new physically-settled bitcoin futures. Bakkt expects to launch that product and a custody service on January 24, 2019.

Given the SEC’s actions against EtherDelta, regulation of exchanges is another area to monitor. Some investors have questioned whether large trading platforms like Binance could face scrutiny, since they’re not registered with the SEC but are used by U.S. residents to trade coins that could be considered unregistered securities. The larger question is whether the SEC would choose to take up such a big and complex case, especially given that Binance is based outside of the U.S.

If the Token Taxonomy Act advances, its next step would be to go the appropriate house or senate committee with jurisdiction. Committee members could then make changes and either redirect it to a subcommittee for further research or send it to the House floor for further debate. It's hard to say if and when the bill might even go to committee. Most bills die before they reach that step, and for those that move forward, the time it takes to reach a committee ranges widely, from days to months.

A version of this article appeared, CryptoAsset & Blockchain Advisor.

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