Cryptocurrency Law and Regulation #

Guest lecture by Jake Chervinsky, The Blockchain Association

Basics of regulations #

Regulations: rules that either prohibit conduct or condition it on compliance with specific obligations; call for punishment of violators
Purpose: control market power, facilitate competition, attract investment, protect consumers, achieve other government interests

Creators and enforcers of regulation:
- Regulation on both state, federal level
- Legislature makes laws, executive enforces law, judiciary interprets laws
- Elected vs. appointed officials, policymakers vs. enforcers
Codification:
- United States Code (USC) - actual laws/statutes passed by Congress
- Code of Federal Regulations (CFR) - regulations by executive agencies
- Plus guidance, settlements, no-action letters, etc.
- Unique system in all 50 states

The Securities and Exchange Commission (SEC)
- Mission: protect investors, facilitate capital formation, maintain fair, orderly, efficient markets
- Federal securities laws originated in 1930s after Great Depression, seen as being caused by financial abuse and info. asymmetry
- SEC regulates “securities” and a broad range of securities market actors
Crypto x Securities
- Securities: subject to regulatory requirements that may not work with crypto
  - Registration with SEC, traded on SEC-regulated venues, held by SEC-approved custodians, etc.
- Crypto industry spends a lot of time and money avoiding SEC regulation as they perceive it as a “death blow”
Investment contracts and the Howey test:
- SCOTUS defines investment contract as (SEC v. W.J. Howey Co, 1948)
  1. Investment of money
  2. Common enterprise
  3. Reasonable expectation of profit
  4. Based on efforts of others
Regulation by enforcement:
- Jun. 2018: Bitcoin and Ether are “sufficiently decentralized”
- Apr. 2019: dozens of factors relevant to “based on efforts of others”
- Since then: efforts by chair Gary Gensler to classify digital assets as securities

Commodity Futures Trading Commission (“CFTC”)
- Mission: promote integrity, resilience, vibrancy of US derivatives markets: futures, options, swaps, etc.
- Created 1974 when most futures were traded in agriculture market
- Responsibilities greatly expanded after Great Recession + Dodd-Frank Act of 2010
CFTC-SEC turf war: are cryptocurrencies securities or commodities?
- General industry preference for CFTC due to friendlier positions, until Ooki DAO

Financial Crimes Enforcement Network (FinCEN): enforces Bank Secrecy Act (BSA) - US AML/countering terrorism financing (CFT) laws
- Requires regulated financial institutions to comply with certain AML program compliance requirements - incl. Know Your Customer (KYC)
- Includes centralized crypto institutions like exchanges and custodions
Crypto x AML
- In general, BSA deputizes financial intermediaries to perform task of surveiling our transactions and reporting on them to government

Office of Foreign Assets Control (OFAC)
- Sanctions: foreign policy tool used to influence behavior and diminish capabilities of foreign actors through economic penalties
- OFAC administers US sanctions by designated specific targets on Specially Designated Nationals (SDN) list, who are then cut off from US markets
  - Illegal for any US-based person to transact w/ anyone on SDN list
Crypto x Sanctions
- Sanctions compliance enforced on US-based crypto traders + exchanges
  - Despite sometime difficulty of knowing who is on SDN list given “borderless” crypto; customers only identified by wallet addresses
- Bittrex: $24m settlement in 2022 for violations from 2014-2016
- Virgil Griffith: 63 mos. imprisonment for aiding North Korea
- Policymakers think crypto is particularly useful for sanctions evasion
  - Guest lecturer claims not particularly, with exceptions of NK Lazarus Group generating revenue from ransomware payouts and DeFi hacks, argument as follows:
    1. Came up after Russia invaded Ukraine, concerns about Russia using crypto to evade sanctions
    2. Crypto does not really allow Russia to get physical assets
    3. Use-case of crypto too limited for broad-scale sanctions evasion in Russia: Bitcoin/Ruble, Ether/Ruble market too weak
    4. Affects average citizens in sanctioned countries trying to get access to financial services, less so nation states

Guest lecturer response:

Ransomware existed before crypto, but crypto makes ransomware profitable
- Easier for ransomware actors to profit
Need to get security house in order to prevent against attacks
- Before ransomware - bad security state; ransomware makes security state more apparent
- Argument: cannot use ransomware as an excuse for preventing average people from using crypto; “just clean up security”
Ransomware has exposed how effective of Russia and other countries’ (esp. NK) hacking operations, esp. state-sanctions
- NK: ransomware serious source of revenue

Internal Revenue Service (IRS)
- IRS is responsible for collecting US federal taxes and administering US tax code, including how it applies to digital assets
- Unanswered questions about crypto taxes:
  - Mining and staking?
  - Hard forks and airdrops?
  - DeFi transactions and interest income
Infrastructure bill
- 2021: Infrastructure Investment and Jobs Act (IIJA) amendment with 5 new crypto provisions, incl. KYC
  - Guest lecturer claims all are problematic

Privacy after TornadoCash mixer shutdown
- Mixer: can pool crypto access in a wallet, then withdraw funds to a new, fresh wallet address
  - Allows users to obscure transaction flow
  - Abused by bad actors e.g. Lazarus Group for money-laundering purposes
- Question: does OFAC have authority to make software illegal in the US?
Stablecoins after Terra collapse
- Will centralized stablecoins get preferential treatments due to UST?
DAOs after Ooki
- CFTC case: if governance token gets used to vote on protocol change, voter personally liable to CFTC case if commodities law violated
- Question: are DAO voters personally liable for operating DeFi protocols?
DeFi after Lazarus
- Can DeFi stay permissionless despite concerns about illicit finance
DCCPA, RFIA, DCA, etc.
- Will Congress grant CFTC juisdiction over crypto spot markets?
Politics
- How will Congress composition change outlook for US crypto policy?