Cryptocurrency is already "non-compliant," especially its "business model," at least in the opinion of U.S. Securities and Exchange Commission (SEC) Chairman Gary Gensler.
Since this view is prevalent among U.S. agencies responsible for regulating securities, it’s no surprise that enforcement actions involving crypto are at an all-time high.
In just a few short years, we have watched the so-called “Wild West” of unregulation become the “bull’s-eye” of the SEC, often visited by the Commodity and Futures Trading Commission (CFTC) and the Department of Justice (DOJ), in addition to the SEC. Last hit."
Make no mistake, these regulators are not hiding secrets, at least when it comes to their interest in law enforcement.
They have taken steps, including going after top players they believe may have misled investors or illegally promoted cryptocurrencies. These enforcement actions attracted mainstream media attention, and some were resolved with multimillion-dollar settlements.
The most surprising aspect of these enforcement operations, however, is how they are carried out. One might be anticipating a new wave of legislation aimed at regulating cryptocurrencies and other digital assets, but you would be wrong. Enforcement actions, based on laws that are, in some cases, 90 years old, have shown that they are still stuck in their ways.
As regulators step up enforcement efforts relying on far-fetched interpretations of existing laws, two questions arise: 1. What is the SEC’s next goal? 2. Outdated securities laws and cryptocurrency industry, which one will be eliminated first?
What's the next step? crypto wallet
After closely observing the actions of regulators, we expect that crypto wallets and certain digital asset exchanges will be the next targets.
Based on previous federal enforcement actions and signals from these agencies in notices, we expect digital asset enforcement to proceed in two ways: The Securities Exchange Act of 1934 (the “Exchange Act”) may be interpreted to cover enforcement of crypto wallets Regulation, as brokers and traditional financial institutions subject to anti-money laundering and know-your-customer laws (AML/KYC), tools such as mixers will face compliance challenges in the digital asset space.
We predict that the next area of regulation from the SEC involves the regulation of crypto wallets acting as brokers.
The concept was first raised by the SEC in its Wells notice to Coinbase, which preceded its prosecution of the cryptocurrency exchange. Among other allegations and language raised in the notice and repeated in the lawsuit, the SEC alleged that Coinbase Wallet, a product that provides users with self-custody services for digital assets, violated the Exchange Act by operating as an unregistered broker.
In response to the Wells notice, Coinbase argued that its wallet product is nothing more than software and does not perform any of the traditional functions customary to brokerage activities. In particular, the Exchange Act defines a “broker” as “any platform engaged in the business of transacting securities for others.”
Coinbase's reasoning is that the wallet can only be used to interface with secondary market transactions, which from Coinbase's perspective do not involve investment contracts, so they are not securities. Coinbase further argued that the 1% fee that had previously been charged each time the "wallet swap" function was used (now eliminated) did not change the SEC's analysis.
The SEC isn’t convinced. The agency sued Coinbase and Binance, accusing the two companies of operating their wallet services as unregistered broker-dealers.
TradFi trading
The second area where we predict the SEC’s enforcement scope will expand is to strengthen the supervision of traditional financial institutions engaged in digital asset transactions. With the growing focus on new crypto tools and services, we expect that designing, implementing and maintaining compliance systems to adhere to AML/KYC laws will pose significant challenges for these institutions, and as such, it will soon become a target of regulators.
In particular, enforcing AML/KYC laws in the digital asset space will require these institutions to rely heavily on information beyond their control. Take, for example, the proposed internal policy of flagging transactions where more than 10% of the value can be traced back to the proceeds of stolen assets.
In practice, a compliance program capable of such marking would require the cooperation of third parties, which is well beyond the capabilities of most companies within and outside cryptocurrency.
First, whether it is a government entity or a private investigative agency, the theft must be made known and the wallets/tokens involved must be tracked and identified. A repository must then be created to maintain that information. To the extent that multiple such repositories are required to track the currency movements associated with the many thefts and hacks, this proliferation only makes the problem more costly to resolve. Finally, once a company wants to screen for illegal and questionable transactions, it must sift through the data on a per-transaction basis, flagging questionable transactions.
At every step except the last, financial institutions must rely on the work of others to generate input that helps drive compliance programs. This decentralization makes compliance costly, both in terms of time and money.
The scope of law enforcement is rapidly expanding
The scope of crypto enforcement is rapidly expanding, already leaving some players thinking about their next steps.
Coinbase CEO Brian Armstrong said during London Fintech Week that due to the lack of "regulatory clarity," "any direction can be considered, including leaving the United States or whatever is necessary." It is not difficult to imagine that most crypto market participants are Agreeing with Armstrong, "We just want a clear rulebook."
However, rather than developing a clear set of rules to regulate the cryptocurrency space, the various federal agencies responsible for regulation are relying on provisions of decades-old laws that they could not have considered when they were first established. The technology on which digital assets rely.
In some ways, it begs the question: Are crypto market participants actually setting their business models to be “non-compliant,” or is the emergence of non-compliance simply a byproduct of regulatory chaos?
While we await the regulatory compliance playbook, investors and exchanges should work with legal compliance teams to ensure that their transactions comply with ever-varying interpretations of federal securities laws and banking regulations and their application to the cryptocurrency industry. Each deal presents unique regulatory hurdles created by federal agencies insisting on applying decades-old regulations to a rapidly evolving industry.
