‘Regulation by enforcement’: New report unpacks US approach to digital asset regulation

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A new report covering global trends in digital assets regulation presents an extensive analysis on the complex and contentious U.S. situation, where regulators continue to jostle for jurisdiction over the digital asset space, court cases abound, and lawmakers hurry to play legislative catchup with international peers.

The report, titled “Trends in Regulation of Digital Assets,” was commissioned by FTI Consulting and produced by Block Research, which focuses on research content covering the digital assets, fintech, and financial services industries. The 30-page research document is broad in scope, looking at where digital asset regulation globally currently stands and where it might be going.

The US situation

About half of the report was spent unpacking the current approach to digital asset regulation in the U.S., described as a combination of a case-by-case process—or “regulation by enforcement”—and the expansion of existing traditional financial market frameworks.

“Initial expectations of a compromise between U.S. crypto businesses and regulators have shifted, with crypto firms now being encouraged to operate like traditional financial institutions and comply with existing frameworks,” the report said.

This might be true at a national level, where the U.S. is yet to implement any digital asset-specific regulatory regime. So existing financial services regulation is being applied to the industry, but at a state level, there have been developments.

“There has been a regulatory regime for crypto entities for nearly as long as they have existed, contrary to the perception of being unregulated until SEC (Securities and Exchange Commission) enforcement in 2017-2018,” the paper read.

Specifically, it noted how Financial Crimes Enforcement Network (FinCEN) issued guidance in 2013, introducing the Money Services Business regime for administrators and exchangers of digital currency, which prompted state banking departments and regulatory agencies to create their frameworks.

A prominent example was New York’s BitLicense regime, “the first detailed state licensing regime for the digital asset sector.”

A business must obtain a BitLicense if it engages in Virtual Currency Business Activity (VCBA) involving New York State or any person that resides, has a place of business, or is conducting business in New York State. VCBA is a broad spectrum, including receiving and transmitting digital assets for financial purposes; storing, holding, and maintaining custody; or controlling digital assets on behalf of others; buying and selling digital assets as a customer business; and performing exchange services.

When obtained by any entity deemed participating in VCBA, BitLicenses impose minimum capital requirements, marketing rules, and anti-money laundering obligations, and license holders must submit to regular examinations and inspections, as well as submit financial reports and audited financial disclosures.

“The BitLicense has continued to evolve and the New York State Department of Financial Services has been building its industry knowledge and establishing a state-based regulatory framework that is the most complex and nuanced among all states. It wouldn’t be surprising to see other states follow suit and implement their own state based regulations,” said Robert Musiala, a Partner at BakerHostetler and co-leader of the firm’s Blockchain Technologies and Digital Assets practice, quoted in the report.

In the absence of comprehensive Securities and Exchange Commission (SEC) guidance, suggested the research, digital asset financial services have developed within the Money Services Business regime, with firms obtaining state licenses, pursuing trust charters, and registering as Money Services Businesses.

Despite this, “recent SEC enforcement actions have shown that state licenses do not provide complete immunity from regulatory scrutiny, underscoring the importance of additional legal considerations.”

Regulation by enforcement

An entire section of the research paper examined the SEC and its somewhat controversial approach to digital asset oversight.

“The SEC is concerned about crypto platforms offering multiple services without proper separation, leading to conflicts of interest and inadequate supervision. To register with the SEC, companies must meet various requirements, such as regulatory filings, business conduct standards, customer protection rules, minimum net capital, AML program implementation, record maintenance, written policies and client disclosures,” the report noted.

Many in the industry are simply unwilling, or unable, to meet these requirements and so choose to either flee the U.S. to more ‘favorable’ jurisdictions or operate in the U.S. without registering with the SEC. Those who go the latter route presumably hope that the lack of concrete digital asset-specific law/regulation will provide them enough leeway to avoid, or weather, any SEC enforcement action.

This hope has been increasingly tested since the heightened SEC crackdown on crypto-cowboys that followed in the wake of the FTX scandal and the ‘crypto winter’ of 2022.

The Block report pointed out that despite industry complaints about its—supposedly—heavy-handed ‘regulation by enforcement’ policy, “the SEC asserts that existing regulations provide sufficient clarity and attributes non-compliance to deliberate decisions made by crypto companies.”

The report also noted that the SEC appears to be doubling down on its approach rather than backing down under criticism.

In May 2022, the SEC doubled the size of the Crypto-Assets and Cyber Unit in the Division of Enforcement, and in March 2023, SEC chairman Gary Gensler announced that the team would continue to hire as the enforcement efforts increase.

Despite this show of faith in its own method, the SEC has faced some recent legal challenges to add to its popularity issues.

In the SEC’s case against Ripple Labs, a summary judgment by a federal judge in July threw a cat amongst the pigeons by ruling that ‘programmatic sales’ of the digital asset XRP through exchanges and algorithms did not amount to a security sale because they lacked “a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”

This ruling has been questioned, and the SEC has already been granted leave to appeal. Still, it nonetheless served to introduce another element of doubt into the already cloudy U.S. regulatory situation.

In its report, the Block’s research team saw four ways out of this regulatory quagmire towards increased clarity:

1. Congress proposing new laws
2. Creating a single self-regulatory organization (SRO) with combined jurisdiction of the SEC and Commodities Futures Trading Commission(CFTC) for supervising the crypto markets
3. Maintaining enforcement under current laws
4. Enhancing oversight of the federal rulemaking process—such as President Biden’s Executive Order, which aims to improve and modernize the regulatory review process

Regarding the first and most likely of these suggestions, U.S. Congress has not been totally idle. On July 26, the U.S. House Financial Services Committee passed three pieces of legislation aimed at “providing robust consumer protections and legislative clarity for the digital asset ecosystem”: the Financial Innovation and Technology (FIT) for the 21st Century Act, the Blockchain Regulatory Certainty Act, and the Financial Technology Protection Act of 2023.

The first of these is possibly the most substantial for the digital asset industry, as it would create a comprehensive regulatory framework for the issuance and trading of digital assets at the SEC and the CFTC, as well as provide more clarity on which digital assets are regulated by each agency.

This was added to on July 27, as the Clarity for Payment Stablecoin Act was also passed by the same committee. This bill aims to establish regulations for stablecoins and makes the Federal Reserve Board the overseeing authority.

Outside of its analysis of the U.S. regulatory landscape, the report went on a whistle-stop tour of digital asset regulation globally, stopping at various locations a little further along the regulatory road than the United States.

International jurisdictions

The overview covers a range of jurisdictions, such as Hong Kong and Singapore in APAC and Argentina and Colombia in Latin America, all of whom have made some regulatory progress in the digital asset space in the past year.

An example noted was the Securities and Futures Commission (SFC) of Hong Kong’s release of a consultation on regulatory requirements for virtual asset trading platforms (VATPs) in February 2023, followed by the publication of AML/CTF guidelines in May 2023. Based on the SFC’s consultation conclusions, the territory opened the way for retail investors to buy and sell digital assets—something explicitly banned in China.

In terms of the Middle East, Dubai took the headlines. In February 2023, its Virtual Assets Regulatory Authority (VARA) issued the Virtual Assets and Related Activities Regulations 2023 to promote economic sustainability and cross-border financial security.

“The regulations encompass aspects such as custody and segregation of client money, prudential requirements (insurance and liquidity reserves), Financial Action Task Force (FATF) considerations (AML-CFT, KYC, Client Due Diligence, Travel Rule), and market manipulation/abuse prevention (data privacy and information security),” explained the report.

Of course, any conversation about global digital asset regulation would not be complete without a look at the EU’s landmark Markets in Crypto Assets (MiCA) bill, which the European Council passed in April and, when it comes into force early next year, will create a uniform legal framework across the EU. Amongst its features are new rules for stablecoin issuers and custody services providers, who will be obliged to fulfill security and risk management criteria, such as capital reserves and liquidity requirements.

The report also journeyed across the channel to cover the U.K.’s recent regulatory efforts.

This includes the Financial Services and Markets Bill (FSMB), which was approved on June 29 and will “ensure crypto is treated as a regulated activity and give the FCA and Payments Systems Regulator power to regulate the sector and protect consumers,” said the report.

The passage of the FSMB was followed shortly, in August, by the U.K. Treasury releasing a consultation response on systemic stablecoins, which updated proposals for a regulatory regime for systemic stablecoins. The government proposed that systemic stablecoins would be supervised by the Bank of England and the Financial Conduct Authority (FCA), the former taking charge of “prudential matters,” while the FCA would cover conduct.

After rounding off its world tour of digital asset regulation, the Block’s report offered some general conclusions about how the current state of regulation globally might impact and shape the digital asset industry.

“Given our report findings and discussion with practitioners, we see four possible industry developments: focus on safer assets, U.S. exposure reduction, segregation of activities, and emphasis on compliance effectiveness,” it stated.

Whether U.S. exposure reduction becomes a popular route to regulatory security and compliance will depend largely on the passage or not of some of the bills currently working their way through Congress. If some of the more ‘innovation friendly’ legislation eventually gets made into law, then digital asset firms may not feel the need to reduce exposure to the U.S. market.

This remains to be seen, so in the meantime, a combination of these four approaches will likely be the go-to approach for digital asset firms in the U.S. and globally as regulation continues to evolve.

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