Since their debut more than a decade ago, bitcoin and other digital assets have enjoyed heightened interest among retail and institutional investors across geographies and achieved several adoption milestones over this period. This progress has occurred despite the very different approaches taken by regulators in different regions who are, in some cases, still refining their own rulemaking processes.
Indeed, agencies like the Securities and Exchange Commission, the Commodity Futures Trading Commission, Wyoming’s Blockchain Task Force and others are attempting to keep up with the global investment community’s desire to increasingly embrace this new asset class, particularly as big technology companies start to enter the market with new use cases and potentially disruptive payment systems. As a result, staff at regulatory bodies all over the world are facing increasing pressure to gain a better understanding of digital assets. These regulators are learning how to police both the institutions and market participants that transact in these products as well as those that offer critical infrastructure to them. The role of regulators, and part of their challenge, is to protect investors and, at the same time, encourage innovation.
Regulators’ approach to carrying out these objectives range from implementing outright bans in some countries, to establishing various legal hurdles in others, to enacting policies that are far more supportive of emergent digital assets. To date, the regulatory focus has been on the possible impact that digital assets can have on monetary policy; and how the processes, procedures and customs of traditional financial markets can be applied to crypto currency. Issues like custody and tax treatment, for example, present different challenges for crypto than they do traditional asset classes, and regulators bear the brunt of untangling them. They have also been looking at how they can protect investors from potential nefarious and malicious activities including fraud, money laundering, and market manipulation.
Currently, there is no unified global regulatory approach in place. That uncertainty has, to a certain degree, affected some investors, who may be delaying their decision to enter the asset class. Yet in the absence of such clarity, regulators and market participants can together take steps to remedy this perception. Such efforts start with developing an enhanced dialogue in which all parties not only operate within the existing framework, but also collaborate together on the evolution of a more proactive rulemaking process.
Amid an increasing global awareness of both the upside and potential risks related to digital assets, regulatory approaches can thus far be divided into two categories: reactive and proactive.
The reactive approach is characterized by real-time policymaking in response to high profile events. For an example, look no further than Congress’s response to Facebook’s announcement of its Libra initiative. Such newsworthy moments often force legislators to clarify, narrow and define concepts that have a significant impact on regulations. In this instance, public hearings on Capitol Hill hinted at a new level of understanding of digital assets as members of Congress attempted to draw distinctions between the Libra project and the broader cryptocurrency ecosystem. Several bills currently making the rounds in Washington D.C., including the Keep Big Tech Out Of Finance Act and the Managed Stablecoins are Securities Act of 2019, were largely crafted in response to the news of the development of this potential payment system. Unfortunately, this reactive approach has tended to produce proposals that are aimed at a specific target, e.g. Libra, but which have broader implications and potential unintended consequences.
Conversely, a proactive approach can provide a comparatively structured, intentional framework within which companies and investors can safely operate. No such approach is perfect — particularly as the world adjusts to a nascent industry. However, some jurisdictions have sought to work constructively with the industry to provide clarity that will thwart the intentions of bad actors, without hindering innovation. It is in this arena that digital asset firms and the many global regulatory bodies will need to make further advancements.
INTERNATIONAL STATE OF PLAY
To date, many jurisdictions around the world are tackling the regulation of digital assets through a combination of both proactive and reactive approaches. Notable examples include the following:
- Malta: Cryptocurrency exchanges are legal in Malta and in 2018, the government introduced legislation to define a new regulatory framework to address Anti-Money Laundering / Countering Financing of Terrorism Act (AML/CFT) concerns. This framework includes three bills and establishes a global precedent with a regulatory regime applicable to crypto exchanges, initial coin offerings (ICO), brokers, wallet providers, advisers, and asset managers (Comply Advantage). Other regional jurisdictions have crafted rules that provide regulatory security and offer perks like tax breaks (Reuters).
- Bahamas: In 2019, the Securities Commission of the Bahamas released Digital Assets and Registered Exchanges Bill, 2019 (“DARE Bill, 2019”) to regulate the sale or issuance of digital tokens in the Bahamas. The Bill proposes a legislative structure with standards for the digital token space. It also outlines how sellers and intermediary service providers are required to conduct themselves (International Investment).
- Seychelles: MERJ Exchange Ltd — operator of the stock exchange in Seychelles — listed the first regulated security token on a national market (Bloomberg). Lightly regulated jurisdictions like the Seychelles and Belize allow far easier market access, but states with such rules can offer less protection for investors and have looser checks on money laundering, lawyers say (Reuters).
- Switzerland: Switzerland classifies digital currencies as assets (property). It has relaxed burdens on/entry barriers for innovation in fintech, and kept risks associated with ICOs to protect investors, prevent financial crime, and guard against cyber threats (Library of Congress). Legislation in Switzerland consists of AML legislation, financial market laws (treatment of ICOs), and tax treatment (Non-U.S. jurisdictions).
- Japan: Cryptocurrency exchange businesses in Japan are regulated by the Payment Services Act. These businesses must be registered, keep records, take security measures, protect customers, etc. They are also subject to money laundering regulations. (Library of Congress)
- Singapore: Singapore is referred to as one of the world’s “crypto havens” because of its regulatory regime, headed by the Monetary Authority of Singapore. Although the regulator has not outright defined what a cryptocurrency is, it has set forth a set of rules to declare it is not a store of value and recognizes cryptocurrency as assets and personal property. The body has also encouraged it as a means of exchange/payment (Global Legal Insights).
- Germany: As of 2020, new AML regulations are in effect in Germany. These regulations require cryptocurrency businesses to hold a Federal Financial Supervisory Authority (BaFin)-issued license. Crypto assets are considered a financial instrument under this legislation. BaFin also recently approved an Ethereum-based real estate bond for the first time. Some welcome this regulation because they feel the tech has not been adopted by institutional investors due to a lack of a reliable legal Framework. (CoinTelegraph)
- Bermuda: Bermuda does not have legislation/regulations that specifically govern cryptocurrencies. However, the government is crafting regulations that aim to establish the country as a destination for companies operating in the space — similar to its status in the insurance and reinsurance sectors (Library of Congress). Bermuda also has established a task force to “advance the regulatory environment” and will be introducing a framework to regulate DLT (distributed ledger technologies).
The bottom line: while these approaches are admirable, without international passporting, each framework is only as good as its local jurisdiction. Where the jurisdiction is small or only available to institutional investors, these types of laws have limited efficacy — even if well intentioned and well designed.
The most crypto-friendly jurisdictions approach regulation by addressing three main concerns: 1) money laundering, 2) protecting investors from fraud, and 3) proper risk disclosures and transparency. They do this all the while implementing programs that foster innovation and offer regulatory clarity and tax incentives.
These three concerns should be taken together as the comprehensive goal of any regulatory framework that seeks to advance the digital asset space. As U.S. regulators become more advanced in their understanding of the space, they should make a conscious effort to balance these concerns to ensure the U.S. does not fall behind.
THE PATCHWORK APPROACH
In addition to the challenge of disjointed approaches to regulation all over the world, the U.S. has multiple regulators, including the SEC, CFTC, the New York State Department of Financial Services and others, all engaged in the regulation of digital assets.
As a result, the experience to date for firms working on innovative new products within this asset class has been burdensome. Firms that seek to become major players within the digital asset ecosystem often shell out hundreds of thousands to millions of dollars — likely tens of millions in the aggregate — to lawyers to help them analyze their proposed products. These payments are common among firms seeking to establish a trustworthy reputation among institutional investors, and compliant products and business operations. It should serve as no surprise then that firms seeking such counsel often tend to be the more professional, responsible, and compliant institutions.
Even firms that prioritize compliance and regulatory cooperation have been frustrated by the challenges they have faced in the process. In some instances, an identical set of facts, presented to multiple top securities law firms often produces a completely different conclusion from firm-to-firm. In virtually all cases, the conclusion is inconclusive, i.e. “it depends”, “here are things to consider”, “the SEC could take a view that…” — adding a layer of unpredictability to an already uncertain landscape. Some firms have been guided by counsel to engage the SEC, but this is an open-ended non-deterministic process that typically requires more time from outside and internal counsel, and an additional unbounded expense.
In response to these circumstances, there have been several independent efforts by the industry to form “token framework” consortia. Prominent examples include Crypto Rating Council, Chamber of Digital Commerce Token Alliance, the SAFT Project, and the Enterprise Ethereum Alliance Token Taxonomy Initiative.
Due to ambiguity, well intended efforts by professional organizations have sprung up to fill the gap and although they lack the legal authority of the regulators, there is much to learn from their efforts. Their goals are generally to inform and educate, provide proposals on frameworks and highlight where some groups have found consensus on key topics. One can run an asset through any of the framework(s) to better assess the potential that it may be deemed a security, but ultimately, the decision to launch/list/trade is a gamble. In the meantime, offshore markets and issuers are launching, listing, trading tokens with impunity.
WHERE WE STAND
Yet, despite the uncertainty surrounding these diverse regulatory approaches, it may seem the U.S. has taken a reactive approach. Several of the bills proposed in the country are well intentioned but may have broad, unintended negative consequences.
The reason? This is partly because lawmakers are predisposed to crafting new rules, which, in some instances, are too general and created on an ad-hoc basis to address a single company or product. Yet there is room to improve this approach by creating a deterministic, time-bound process for new products in which they are submitted to regulators and evaluated and then approved or rejected, offering a conclusive outcome.
It is important to not lose sight of the fact that the impetus is on companies to work within the framework of regulations that already exist. It behooves financial institutions and tech providers to not sit idly as lawmakers pave the way forward, and to study existing laws and regulations before assuming they don’t apply or that new ones are necessary. The future of the digital asset landscape depends in large part on the ability of all these parties alike to learn together, develop new frameworks and make the necessary modifications along the way. Such efforts will be important to ensure the future of innovation from a U.S. standpoint as countries such as China embark on ambitious plans to develop their own central bank digital currencies.
MORE WORK NEEDS TO BE DONE
The SEC has already gained a sufficient enough understanding of the industry to start taking tangible action. Initially, the agency only acted against the overtly fraudulent companies that had no intention of building anything real — these companies, which include PlusToken and Argyle Coin, essentially amounted to Ponzi schemes. The SEC addressed a few of these examples, such as Block.One, Telegram Group, and Kik, relatively early on and has since moved on to review instances in which companies intended to build a network, but the efforts ultimately violated securities regulations.
Concurrently, the CFTC has taken the role of issuing licenses to businesses focused on cryptocurrencies within their jurisdiction. These licenses are not granted lightly — they require a great deal of investment and understanding from regulators and the market. This progress should be considered a big win for the CFTC’s evolving understanding of the digital asset space.
Yet despite these victories, more work needs to be done. Uncertainty can serve as a barrier to adoption and the potential for firms to capitalize on loopholes in the system, given the disparate regulatory climate, is a very real and potential threat. Against this backdrop, a more proactive approach would be beneficial for the industry. Market participants have already undertaken several activities with more regularity including a more consistent dialogue between companies and regulators, earlier engagement ahead of product launches and recurring meetings about how to enhance market structure and collaboration on how to effectively prevent market manipulation. The industry now needs to move on to the next phase. The goal for companies and regulators should be one and the same — to enhance the confidence, stability and protection of the digital asset ecosystem.