Blockchain Compliance / Proof-of-Stake Regulation
Preface: The current laws in the USA, the bills in the second reading from December 2022 around digital assets, stablecoins, proof of stake/work, and statements of the SEC all clearly point in the direction that these regulations will take effect in 2023. This article covers the legal framework of crypto regulation in the United States of America. We regard this as a global trend because our analysis shows a very comparable picture in Europe and Asia regarding regulation on virtual assets, stablecoins, amendments to the Anti-Money Laundering, Counter-Terrorist Financing, and KYC audits.
I. Current Legal Framework / US-Regulation on Proof-of-Stake
The following legal provisions set the current framework for proof-of-stake based on assessment in the US.
1. Howey-Test: Main Criteria for Classification as a Security
The Security and Exchange Commission (SEC) uses the Howey Test, named after the Supreme Court case SEC v. W.J. Howey Co. of 1946, to determine whether an asset is a security or not. The four criteria of the Howey Test are: (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) earned through the efforts of others. The consequence of being classified as a security are regulated business activities, strict investor protection, and disclosure requirements. [1]
2. Internal Revenue Service: Digital Assets are a property
The Internal Revenue Service (clarification: revenue service for the United States federal government, responsible for collecting U.S. federal taxes) considers cryptocurrencies and digital assets as property. General tax principles applicable to property transactions apply to transactions using digital assets, with the obligation to report digital asset activity in the tax return. [2]
3. Commodity Exchange Act: Cryptocurrencies are Commodities
The Commodity Exchange Act regulates the trading of commodity futures in the United States and provides federal regulation of all commodities and futures trading activities and requires all futures and commodity options to be traded on organized exchanges. [3]
4. Digital commodity Consumer Protection Act (proposed law)
This proposed law requires digital commodity platforms to prohibit abusive trading practices, eliminate or disclose conflicts of interest, maintain sufficient financial resources, have strong cybersecurity programs, protect customer assets, and report suspicious transactions. [4]
5. AML: Due diligence and auditing obligations based on laws for the prevention and sanctioning of money laundering
The Bank Secrecy Act (BSA) obliges financial establishments in the United States to help federal agencies uncover and stop money laundering. Specifically, the BSA obliges financial institutions to maintain records of cash transactions of negotiable instruments, file reports if the daily cumulative amount is over $10,000, and report any activity that could indicate money laundering, tax evasion, or other unlawful activities in a suspicious activity report. [5]
The Money Laundering Control Act is a United States Act of Congress that makes money laundering a federal crime and requests: An individual must have the clear intent to conceal the source, ownership, or control of funds when making a transaction for it to be considered a violation of the law. There is no need for the funds to reach a certain amount and the transaction does not necessarily have to be successful in hiding the money. The definition of a “financial transaction” is broad and does not have to involve a financial institution or business. It can be as simple as passing money between two people, as long as the intent is to conceal the source, ownership, location, or control of the funds. [6]
6. Digital Asset Anti-Money Laundering Act (draft) from 2022/12/15
The draft of the Digital Asset Anti-Money Laundering Act from 2022/12/15 aims to bring the digital asset ecosystem into greater compliance with the anti-money laundering and countering the financing of terrorism (AML / CFT) frameworks governing the greater financial system.
Extended responsibilities including KYC
The act leads to extended responsibilities including KYC (Know-Your-Customer) requirements, to
a) digital asset wallet providers,
b) miners,
c) validators,
d) and other network participants that may act to validate, secure, or facilitate digital asset transactions by directing Financial Crimes Enforcement Network (FinCEN) to designate these actors as money service businesses.
Add KYC to unhosted (non-custodial) wallets as a prerequisite for a transaction
The draft of the Digital Asset Anti-Money Laundering Act would require banks and money service businesses to verify customer and counterparty identities, keep records, and file reports in relation to certain digital asset transactions involving unhosted (non-custodial) wallets or wallets hosted in non-BSA (Bank Secrecy Act) compliant jurisdictions. [7]
7. US Federal Regulation: Requirements for Certain Transactions Involving Convertible Virtual Currency or Digital Assets (draft)
The December 2020 proposed rule requires banks and money service businesses to submit reports, keep records, and verify the identity of customers in relation to transactions involving convertible virtual currency or digital assets with legal tender status digital assets or held in unhosted (non-custodial) wallets, or held in wallets hosted in a jurisdiction identified by Financial Crimes Enforcement Network FinCEN. [8]
8. Infrastructure Investment and Jobs Act Reporting Requirements
The new Act expands the reporting requirements for transactions over $10,000 to include digital assets. This has the potential to change the way businesses collect and report information concerning crypto transactions to the IRS. The Act is a clear indication of additional regulation being implemented for crypto, though it remains vague and does not provide detailed regulation. This implies that while 1099 reporting will be applied to digital assets, the SEC and IRS may issue more comprehensive regulations in the future. [9]
9. Counter Terrorist Financing and the USA PATRIOT Act
Section 312 amends the Bank Secrecy Act by imposing due diligence & enhanced due diligence requirements on U.S. financial institutions that maintain correspondent accounts for foreign financial institutions or private banking accounts for non-U.S. persons.
[10]
10. Stablecoin Transparency of Reserves and Uniform Safe Transactions Act of 2022”, S.3970 — Stablecoin Transparency Act
Based on Stablecoin Transparency Act the following entities are authorized to issue payment stablecoins: depository institutions, entities that receive a newly created federal license specifically for payment stablecoin issuers, state-based money transmitting businesses, non-depository trust companies, and other entities authorized by state banking supervisors, as well as national trust banks. Those entities with the new federal license and other payment stablecoin issuers with similar business models will be entitled to Federal Reserve master accounts and services. The Stablecoin Transparency Act establishes new, standardized public disclosure requirements for payment stablecoin issuers. These requirements include what assets back the payment stablecoin, the issuer’s redemption policies, and attestations from registered public accounting firms. Additionally, it requires all issuers to fully back their payment stablecoin with high-quality liquid assets. The Office of the Comptroller of the Currency (OCC) is establishing a new federal license for payment stablecoin issuers, allowing them to operate nationally. Furthermore, the Stablecoin Transparency Act clarifies that payment stablecoins are not securities and that payment stablecoin issuers are not investment companies or investment advisers, thus exempting them from securities requirements. The use of payment stablecoins requires specific privacy and data security requirements. Therefore, users of payment stablecoins are provided with proper privacy and data security protections.
[11]
11. Statement: Gary Gensler, Chair of the SEC, emphasized that Bitcoin is classified as a commodity, and thus falls under the jurisdiction of the Commodity Futures Trading Commission (CFTC), not a security, and adds that “all other digital assets apart from Bitcoin are securities,” which has major implications for the regulation of cryptocurrencies and digital assets in the United States.
Background: In July 2022, SEC Chairman Gensler declared that Bitcoin was a commodity and not a security, thus falling under the jurisdiction of the Commodity Futures Trading Commission. In February 2023, Jake Chervinsky suggested that Gensler may have already determined that all other digital assets aside from Bitcoin were securities. This conclusion was made based on Gensler’s avoidance of directly answering the question about other digital assets.
Subsumption: The SEC will have a more assertive approach to regulating the cryptocurrency market, which means stepped-up enforcement against digital asset issuers that are thought to be securities, as well as exchanges that trade them. Additionally, this results in fresh regulations to bolster visibility and responsibility in the crypto sphere. Gensler’s statement that all digital assets other than Bitcoin are securities would have far-reaching implications and be subject to SEC regulations and oversight, including registration and disclosure requirements, as well as strict trading, reporting, and investor protection rules. But: The SEC has made it clear that it will evaluate each token on a case-by-case basis to determine if it meets the criteria of a security. Therefore, just because a digital asset is not Bitcoin does not necessarily mean that it is a security. Is SEC Chairman Gensler’s view compliant with the Stablecoin Transparency Act? SEC Chairman Gensler’s unique perspective focuses on the characteristics and advantages that make a stablecoin a security, such as the benefits provided by Binance and BUSD on its platform, including no fees when exchanging BUSD for certain other tokens, providing motivation for Binance users to keep their token.
[12]
II. Application of the Current Legal Framework / US Regulation on Proof-of-Stake for Cardano
1. Is Proof-of-Stake a Security on Cardano under the Howey Rule?
Proof-of-Stake on Cardano is not regarded as an investment contract and not regarded as a security, due to the architecture of Cardano, keeping the ownership of the ADA and just delegating the stake. Holding ADA on the Cardano network means having a stake in the network, with the stake size being proportional to the amount of ADA held. Holders of ADA may delegate the stake associated with their ADA to a stake pool, allowing them to participate in the Cardano network without running their node. This delegation process contributes to the decentralization of the network, as the size of the stake is proportional to the amount of ADA held. (1) an investment of money: Staking in Cardano Proof-of-Stake is not an investment of money, even under the expanded definition that includes any “specific consideration” that is given up “in return for a separable financial interest.” This is because users who stake ADA do not give up their assets — they maintain full ownership of their ADA and just delegate their stake in the network. (2) in a common enterprise (3) with a reasonable expectation of profits (4) earned through the efforts of others: Based on current secondary literature and case law, the other three criteria apply.
2. What are the Current Legal Requirements for Pool Operators on Cardano to be Compliant?
Based on the current legal situation, there is no need for change.
Cardano and the protocol are compliant.
3. What regulatory changes can be expected in the area of proof-of-stake based on the current draft legislation?
The overall assessment of current legislation, legislation in the drafting stage focusing on adding KYC, especially the Digital Asset Anti-Money Laundering Act Draft from 2022/12/15, SEC´s penalty for Kraken from 2023/02/09 for it staking service being classified as a security lead to the high probability that the lawmakers will implement KYC / KYB / AML / CTF in all blockchain transactions, also in Proof-of-Stake. Due to its importance and market capitalization, these anticipated compliance changes will also affect Cardano. Crypto is no longer exempt from a range of regulatory requirements.
Table 1: Application of current legal compliance framework to Cardano proof-of-stake
III. How to ensure compliance with Cardano Proof-of-Stake based on requirements of the current U.S. legislative proposal Digital Asset Anti-Money Laundering Act
Setting a standard as an industry leader
Cardano Stake-Pool-Operators (SPO) validate transactions on the Top 1 Proof-of-Stake cryptocurrency blockchain in terms of global market capitalization. In their role as an industry-leader SPO anticipate the changes in the regulatory landscape and take it further by setting higher standards than what is currently enforced in order to add trust by adding compliance. Our investors and delegators expect and deserve nothing less. The following table 2 explains the process for the creation and recyclability of the KYC / KYB including the information on the legal validity per company.
Table 2: Reusable KYC / KYB: How it works in three steps
IV. About IAMX One-Stop-Compliance
Regulatory-compliant KYC, KYB, AML onboarding processes worldwide
Together with KYC SPIDER, IAMX provides a fully regulatory-compliant KYC, KYB, and AML onboarding process. Our KYC and KYB processes are legally sound and ensure regulatory compliance worldwide. The major USPs of our product are customizability, white label, interoperable API and data process integration, upgrades and updates per regulatory module, physical and digital access delegation of KYC files for reusability in the financial sector, 10 years storage, and access to Compliance front-end.
Global regulatory compliance made easier
This comprehensive solution is capable of providing regulatory compliance worldwide. With its scalable setup, high volumes from multiple regions could be processed centrally or decentrally. Any operating model for Compliance is fully supported.
Experience secure, and flexible KYC and KYB solutions with Our product, all reusable
One of the major USPs of our product is its reusability, as well as the 10-year storage of KYC and KYB records. Furthermore, customers can also opt for physical or digital access delegation of KYC files, as well as upgrades and updates per module.
Comprehensive and secure KYC, KYB, and AML onboarding process offers essential regulatory compliance solution
Overall, IAMX AG’s fully regulatory-compliant KYC, KYB, AML onboarding process is an essential solution for businesses in need of a comprehensive, streamlined, and secure compliance process.
Customize your product experience with a wide range of fields for optimal results
Our product comes with a wide range of custom fields such as client type, client interest use CBAG services, asset flow client and CBAG, client experience crypto assets, investments in the last 12 months, trading volume currency p.a., and more.
Triangular agreement streamlines KYC/KYB processes
The triangular agreement ensures that our KYC and KYB processes are legally sound, and that a subscription model or pay-per-module structure is available for easy finance-related transactions.
Unlimited custom features: Tailor your product to your specific needs
We also offer unlimited custom features, allowing customers to tailor the product according to their specific needs. Our team of experienced professionals is always available to provide assistance regarding any queries.
Table 3: Sample content for a DID that includes a FINMA-compliant KYC result
List of Sources
[1] Howey Test
https://en.wikipedia.org/wiki/SEC_v._W._J._Howey_Co.
[2] Internal Revenue Service
https://www.irs.gov/businesses/small-businesses-self-employed/digital-assets
[3] Commodity Exchange Act
https://en.wikipedia.org/wiki/Commodity_Exchange_Act
[5] Bank Secrecy Act
https://en.wikipedia.org/wiki/Bank_Secrecy_Act
[6] Money Laundering Control Act
https://en.wikipedia.org/wiki/Money_Laundering_Control_Act
[7] S.5267 — Digital Asset Anti-Money Laundering Act of 2022/12/15 (draft)
https://www.congress.gov/bill/117th-congress/senate-bill/5267
[8] Requirements for Certain Transactions Involving Convertible Virtual Currency or Digital Assets
https://www.govinfo.gov/app/details/FR-2020-12-23/2020-28437
[9] Infrastructure Investment and Jobs Act Reporting Requirements
https://en.wikipedia.org/wiki/Infrastructure_Investment_and_Jobs_Act
[10] USA PATRIOT Act
https://www.fincen.gov/resources/statutes-regulations/usa-patriot-act
https://www.fincen.gov/sites/default/files/shared/31_CFR_Part_103_312_EDD_Rule.pdf
[11] S.3970 — Stablecoin Transparency Act
https://www.congress.gov/bill/117th-congress/senate-bill/3970
https://www.banking.senate.gov/imo/media/doc/stablecoin_trust_act_section-by-section.pdf
[12] Statement, Article, NYMAG, Feb 23, 2023: Gary Gensler, Chair of the SEC, emphasized that Bitcoin is classified as a commodity
SEC on Kraken
https://www.sec.gov/news/press-release/2023-25
About IAMX
IAMX is a token-based SSI and authentication protocol that empowers individuals with the means to own their identity. Adhering to the strictest of regulatory standards for identity protection, IAMX builds on the foundational principles of SSI to provide a robust and secure system where individuals can take control and manage their identity. Users of IAMX will realize significant time and cost savings through novel approaches to identity management and e-commerce transactions, like 1-click fulfillment, which are legally binding and maintain local regulatory compliance. With users controlling their identity data, time-consuming processes like KYC and KYB become near-instant, highly secure transactions.
IAMX builds upon the foundations of SSI, blockchain, and decentralized identifiers (DIDs), enabling individuals, organizations, or any entity to prove their identity independent of external parties or centralized authorities. This way, the authenticity of anything tied to an IAMX DID can be independently confirmed by the entity holding the DID.
IAMX is at the forefront of the Web3 revolution, bringing the world’s most secure, decentralized, and user-friendly SSI solution to the Internet. Adding the layer of identity and authentication to the Internet, with IAMX you can treat the Internet like you are always logged in. Pursuant to its mission and vision, IAMX is working to solve the problem of providing an identity to the billions of people who do not currently have a state-recognised, legal identity. Using a Biometric Identity Gateway, users with or without state-level identification can create their own identity for use online, one that relies on their unique physical attributes, including their face, iris, and fingerprints.
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