Digital assets have been high on the regulatory agenda across the world in 2023. The European Union (EU) began to implement its sweeping Markets in Crypto Assets (MiCA) regulation, which came into force in June, the very same month that the U.K.’s updated Financial Services and Markets Act (FSMA) received Royal assent from King Charles, committing the country to integrating digital assets into its exiting financial sector framework.
Meanwhile, across the pond, debates rumble on in both houses of Congress over the best approach to governing the innovative sector, with several bills only just beginning their journey through the slow-moving legislative process—often held up by ongoing conflict between pro-innovation and pro-consumer protection (or digital currency-skeptic) lawmakers. At the same time, court cases abound as U.S. regulators grapple with digital asset players who, either willfully or through ignorance and regulatory confusion, continue to come into conflict with the laws of the land—as they stand.
As 2023 comes to an end, appropriately rounded off by a conviction for FTX’s Sam Bankman-Fried—who perpetrated one of the largest financial frauds in U.S. and global history and faces a sentence of up to 115 years—now seems a good time to sit back and take a look at the state of play in U.S. digital asset regulation as well as what 2024 might bring.
“Our legislative process is at an impasse; nothing is getting passed. The House and Senate oppose each other, there’s an inability to move on anything in actual crypto regulation, and I don’t think that will change, certainly not before the election, which leaves us with the regulatory environment that we have,” says Stephanie Breslow, partner Schulte Roth & Zabel and co-head of the U.S. law firm’s Investment Management Group.
Speaking to CoinGeek, she goes on to explain from where this quagmire might derive:
“There’s a bit of a turf struggle there because the obvious question, ‘which cryptos are securities?’ lurks, and if they are securities, then they need to be privately placed or resold under Rule 144 after a year, and they need to be sold on exchanges that either are not open to U.S. people and are being operated offshore or are open to U.S. people but are only selling cryptos that aren’t securities.”
Rule 144 is a Securities Act clause that regulates the resale of restricted or controlled securities in the United States. It sets conditions for selling such securities in the public market, including holding periods and volume limitations, to prevent market manipulation and ensure transparency.
The implication here is that those provisions of the Securities Act, enforced by the Securities and Exchange Commission (SEC), are part of the reason why the digital asset industry is somewhat in flux in the country. This is primarily down to the ever-raging debate about which digital assets are securities.
The central debate: to be or not to be… a security
When it comes to the question of whether a digital asset is a security in the U.S., the answer always revolves around the Howey Test.
According to the Howey Test, the asset is a security if:
- It is an investment of money;
- In a common enterprise;
- With an expectation of profits;
- Solely from the efforts of others.
If an asset meets these four criteria, it can be seen as an “investment contract,” a form of asset written into securities law.
This seems like it should be a fairly straightforward and clear test, leaving little room for debate. However, Howey derived this from a 1946 U.S. Supreme Court case—SEC v. W.J. Howey Co.—relating to whether a Florida citrus grove investment scheme constituted a security. A lot has changed since then, not least the nature of assets.
“In Howey, you have an orange grove, and you have people ostensibly owning orange trees, but really participating in the profits of that orange grove business,” says Breslow. “The thing about Howey, though, is nobody was ever taking their orange trees away, so you didn’t have to ask yourself whether things ceased to be a security at some point.”
This introduces the idea that something originally considered a security could, at some point, change in nature or in market perception to the point where it might no longer be considered a security. She goes on to clarify:
“The Howey situation was static, you were always going to be participating in the profits of that grove, and it was always going to be run by someone other than you. They didn’t have to delve into the question of what you would do if somebody, for instance, said, ‘I’m coming down to Florida, digging up my tree, planting it in my own yard, and hiring my own gardener to deal with the oranges.’ In crypto, on the other hand, that’s kind of what happens.”
What this means for applying the Howey test in 2023 is debated. However, it should be said up front that the court in Howey made a point of saying that its definition of a security “embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”
Indeed, on that basis, the SEC has had little trouble applying Howey to digital assets.
“Nothing about the crypto markets is incompatible with the securities laws,” Gensler said in 2022, and his view appears unchanged; in September this year, he noted that “there is nothing about the crypto asset securities markets that suggests that investors and issuers are less deserving of the protections of our securities laws.”
“Congress could have said in 1933 or in 1934 that the securities laws applied only to stocks and bonds. Yet Congress included a long list of 30-plus items in the definition of a security, including the term investment contract,” said Gensler. “As I’ve previously said, without prejudging any one token, the vast majority of crypto tokens likely meet the investment contract test.”
Rep. Maxine Waters (D-CA), who also serves as Ranking Member of the House Financial Services Committee, clearly agrees. She stated at a House Committee meeting in July that “our securities laws have protected investors and retirees for 90 years while supporting capital formation and facilitating innovation. Crypto firms should follow the law.”
She went further in September when Gensler visited the same committee for his now bi-yearly haranguing. Again, embracing her role as one of the embattled SEC chairman’s rare cheerleaders, Waters pronounced that “the SEC is very much implementing the priorities that I and my Democratic colleagues championed when we were in charge, and is shaping up to be the most pro-worker, pro-investor, pro-small business SEC since FDR created the agency.”
Breslow, however, suggests that the SEC’s previous chairman, Jay Clayton, had a slightly different idea of how all-encompassing securities laws can be in the digital asset space, one which may, in her reading of it, leave room for something considered a security to eventually lose that title.
“It seemed his view was that once the protocol has proved out, once the market liked the coin for its own merits and not just because they were hoping the issuer would shore it up, at that point, it would no longer be a security,” states Breslow.
Specifically, she’s referring to something Clayton put into writing in a March 7, 2019, letter:
“The analysis of whether a digital asset is offered or sold as a security is not static and does not strictly inhere to the instrument. A digital asset may be offered and sold initially as a security because it meets the definition of an investment contract, but that designation may change over time if the digital asset later is offered and sold in such a way that it will no longer meet that definition… if, for example, purchasers would no longer reasonably expect a person or group to carry out the essential managerial or entrepreneurial efforts.”
For this reason, Breslow believes that under the Clayton-style analysis, an early transaction with an issuer “might have been a security, but a later stage transaction, or use of that token later, would not involve a security. Now, that seems to have been a little bit blurred in some of these recent cases.”
Yet, when it comes to some of these cases, in which the line between security and non-security, or commodity, has—for some observers at least—become blurred, there is equally a case to be made that Clayton’s definition of when a security transitions to no longer being a security is still the policy of the SEC. It’s simply that they haven’t seen a case that meets the description of a complete lack of expectation from the buyer in “essential managerial or entrepreneurial efforts.”
An example of this confusion in action is the seemingly contradictory rulings in the Terraform Labs and Ripple Labs cases, where not dissimilar facts were input into the same definition of security, with two different conclusions coming out the other end.
Terra v Ripple
In December 2020, the SEC sued Ripple Labs, along with CEO Bradley Garlinghouse and Executive Chairman Christian Larsen, accusing them of engaging in illegal securities offerings from 2013 up to the present based on the sale of the firm’s digital asset and native token XRP.
In July this year, Judge Analisa Torres of the U.S. District Court for the Southern District of New York ruled on summary judgment motions from both parties. In a partial victory for each party, Torres ruled that institutional sales of XRP amounted to illegal securities based on Howey, but that “programmatic sales“—such as through exchanges in blind transactions—did not. This, according to the court, was due to the lack of “a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others because those purchasers could not know if the money from their investment was going to Ripple.
Cue a chorus of cheering from crypto-advocates and any other digital asset sector entity in the SEC’s crosshairs. However, the ruling was almost immediately thrown into doubt, not least because the SEC announced shortly after its intention to appeal, but also due to the Judge of another digital asset case suggesting Torres had got it wrong.
Judge Jed Rakoff, who is presiding over the SEC’s case against Do Kwon and Terraform labs, stated in a ruling two months after the Ripple decision that he rejected the court’s approach in that case as being inconsistent with the Howey test and suggested that secondary sales can amount to illegal securities transactions.
In its lawsuit against Kwon and Terraform, filed in February this year, the SEC accused the company and its founder of violating securities laws in connection with its offering of the TerraUSD (UST) token.
In light of the Ripple ruling, Terraform Labs attempted to have the SEC’s case dismissed on the same basis. However, Rakoff rejected the court’s reasoning in Ripple, saying, “Howey makes no such distinction between purchasers,” and as a result, the lawsuit against Do Kwon and Terraform Labs continues.
“That a purchaser bought the coins directly from the defendants or, instead, in a secondary re-sale transaction has no impact on whether a reasonable individual would objectively view the defendants’ actions and statements as evincing a promise of profits based on their efforts,” Rakoff states at the time.
Effectively, this means the Terra Judge decided that secondary market sales of digital assets can amount to securities offerings, if they’re promoted on the basis that the money contributed would be used to further develop the issuer’s network and increase profits for holders. It doesn’t matter whether the ultimate user purchases the tokens directly or via a secondary exchange.
“Simply put, secondary-market purchasers had every bit as good reason to believe that the defendants would take their capital contributions and use it to generate profits on their behalf,” notes Rakoff.
Extrapolating this last caveat to the Ripple case, it suggests that—in the Terra court’s reasoning at least—it’s not unreasonable to assume that secondary market XRP buyers, even if they’d never heard the name Ripple, might still have some expectation that whoever was behind or originated the asset they were purchasing might profit from the trading of said asset. If this leap is not too fantastical, then it follows that it’s also not unreasonable for that buyer to assume some of the profits the original issuer makes might be ploughed back into the enterprise, making the asset stronger in the long run.
Not everyone sees it this way, though. Breslow suggests the Terra and Ripple rulings are actually not as inconsistent as they might seem on the surface, and that the buyer being aware of some form of connection between asset and issuer does not necessarily mean that the asset will always be a security.
“When the [XRP] decision came down, even though the Ripple enterprise itself lost part of that case about the institutional offering and may even face very substantial financial liability as a result, nonetheless XRP itself shored up in value,” says Breslow. “So, it’s clearly not the case that the market is looking to how well Ripple is doing for the value of their XRP token… Whatever one might feel about the original issuance by Ripple, at this point, the XRP token and the fate of Ripple seem to have been largely disconnected.”
This is why it’s a tricky issue because you’re asking Judges to guess how a hypothetical buyer, or group of buyers, felt about an asset when they bought it, as well as what their thoughts were—if any—on the issuer of that asset at the time of purchase.
For Breslow, some level of connection between asset and issuer on the secondary market is natural and does not entail something being considered a security.
“I don’t think that they should need to be fully disconnected in order to conclude that something is not a security because pretty much any investment asset is shored up by the value of some subset of people who are helping it along,” she suggests. “For instance, if I buy art or an antique car, there will always be a subset of people, the creators, the gallery owners, the car dealers, who are helping determine the value of my asset, but nobody thinks just because somebody is helping me to determine the value of my asset. Therefore my asset is a security.”
This debate will likely end up on the plate of a higher court at some point, via appeal or otherwise, at which time they will have to choose with which interpretation to side.
In the meantime, Breslow suggests there are two other ongoing cases that may end up proving more important for the future of the digital asset space in the U.S., those of two behemoths of the exchange world, Binance and Coinbase.
Binance
The SEC sued Binance.US, the U.S.-based subsidiary of Binance, and its founder, Changpeng “CZ” Zhao, in June, accusing them of violating securities laws. In September, the exchange, its holding companies, and CZ filed motions to dismiss, accusing the SEC of regulatory overreach and misinterpreting securities law, amongst other things.
The SEC responded on November 7 with an 88-page rebuttal, filed with the U.S. District Court for the District of Columbia, which argued that a dismissal would “dismantle decades of foundational precedent upon which the nation’s securities laws operate” and in its place, install a “rigid framework that turns entirely on contract law and the form transactions take, in clear contravention of Congress’ broad, flexible regime.”
Breslow explains that the crucial issue in this case is not actually the illicit carryings of the U.S. entity (Binance.US) but rather how the company has enforced the SEC’s restrictions on access to its international platform.
“The fight there is about letting U.S. people in, it’s not a fight about whether they are securities… What they were doing with their offshore exchange is saying, ‘I keep U.S. people off this exchange and therefore I’m not subject to U.S. regulation as a securities exchange,'” says Breslow, who sums up the key issue in the Binance case as being about “the ways that US people have been able to access that exchange.”
This tracks with the SEC’s accusations, as one of the regulator’s principal complaints was that “while Zhao and Binance publicly claimed that U.S. customers were restricted from transacting on Binance.com, Zhao and Binance, in reality, subverted their own controls to secretly allow high-value U.S. customers to continue trading on the Binance.com platform.
However, the SEC also accused Binance.US of unregistered securities sales in the form of the platform’s own “so-called exchange token, BNB” and “so-called stablecoin, Binance USD.”
Coinbase
The other case that’s potentially crucial in the ongoing battle between the SEC and the digital asset industry is the regulator’s lawsuit against Coinbase (NASDAQ: COIN).
On June 6, the SEC charged Coinbase, Inc. with operating its digital asset trading platform as an unregistered national securities exchange, broker, and clearing agency. The SEC also charged Coinbase for failing to register the offer and sale of its digital asset staking-as-a-service program.
Coinbase is the largest digital asset exchange in the U.S., and Breslow suggests that when the company chose to open and base itself in the country in 2012, it did so under certain assumptions about digital assets and securities that have since been dispelled by Gensler’s SEC.
“In Coinbase, the fight is about whether certain assets are securities. Coinbase is not trying to keep U.S. people off its exchange, which is being operated here, but they are trying to limit tokens that have been listed to the ones that are widely traded enough, mature enough that they no longer pass the Howey Test,” says Breslow.
“I think Coinbase’s position is bolstered by a number of things, including the fact that, after all, the SEC did let Coinbase go public, and they did that knowing that the very protocol that Coinbase is now being challenged on is what they followed.”
This may be true, but the SEC has explicitly rejected the notion that its approval of a public listing—via what is known as an ‘S-1 IPO form’—amounts to tacit approval of the firm’s modus operandi. In court documents from a pretrial conference of the SEC case against Coinbase, the regulator’s attorney clarified that giving the firm’s IPO the go-ahead was not the same as signing off on its business structure.
“Your Honor, I’ll say that simply because the SEC allows a company to go public does not mean that the SEC is blessing the underlying business or the underlying business structure or saying that the underlying business structure is not in violation of the law,” SEC trial counsel Peter Mancuso told Judge Katherine Polk Failla at the hearing.
“There is no way that an approval of an S-1 is a blessing of a company’s entire business. In fact, there is no evidence being put forth that the SEC looked at specific assets and made specific determinations and then gave Coinbase comfort that this would not later be found to be a security.”
In other words, according to the SEC, the approval of Coinbase’s public listing does not imply an endorsement of the company’s current or future compliance with regulations.
Whichever side of the fence one leans, with the SEC or with the subjects of its digital asset court cases, Howey has demonstrated the importance of legal precedence in rule-making, meaning much is potentially on the line in the Binance and Coinbase cases.
“If the SEC were to be successful in both of the cases, and if you functionally could not operate any sort of crypto token exchange—except for trading Bitcoin—in the US or in the non-U.S. for U.S. citizens, since crypto trading obviously largely happens on exchanges that would significantly impede the development of the crypto investing for U.S. investors,” says Breslow. “However, if Coinbase prevails, and most cryptos once they cease to be in that early ICO stage, can get to be traded by U.S. people on a U.S. exchange, then I think the result will be favorable for the industry here.”
It might be somewhat of a leap to assume that wins for the SEC would effectively mean the end of digital asset exchanges in the U.S., outside of trading in Bitcoin. It’s worth remembering that the SEC does actually allow the trading of securities. What it doesn’t allow is the trading of unregistered securities. So, what wins for the SEC would actually mean is digital asset firms, exchanges, and token issuers having to register with the agency and abide by its compliance requirements—such as financial disclosures, Know-Your-Customer obligations, and AML/CTF checks.
This is something many digital asset companies may not like, and some see it as too onerous due to the anonymity or pseudo-anonymity that many developers, investors, and customers crave, but it wouldn’t have to be the death knell for the industry.
Nevertheless, if these industry players felt it was impossible for them to comply with SEC registration requirements, for whatever reason, and as a consequence, moved elsewhere, then it’s not unreasonable to assume that the profits of the U.S. digital asset industry and those wanting to invest in the space might suffer.
Despite this possibility, lawmakers, including Rep. Waters and her colleagues of a similar persuasion, maintain that the need for consumer protections trumps the need to maintain the U.S.’s global dominance in the digital asset space.
When exploring this debate, it’s possible to fall into the trap of assuming that the future of the U.S. digital asset space will be defined by a choice between, on the one hand, SEC regulation with consumer and market protection, and on the other laissez-faire capitalism and the ‘crypto wild west.’ This is not necessarily an accurate description of the situation.
“It’s not as though the choice is between the SEC regulating and no regulation. That’s a false equivalence,” says Breslow. “If early-stage tokens continue to be securities, then they mature out of it. If we end up in the Clayton place, then I think we are in a place where we can look at our existing regulation and go, okay, the securities laws are protecting people from issuers who have not developed coins, and the commodities rules protect them after.”
The suggestion is that if consumer protection is the goal, then keeping as many digital assets as possible under the umbrella of the SEC is not the only route to investor protection. The Commodities Futures Trading Commission (CFTC) also exists, and while it may be considered somewhat of a softer touch than the SEC, it is not sleeping on the job. The CFTC’s Financial Year 2023 Enforcement Results featured “a record setting number of digital asset cases.”
Thus, as Breslow suggests, assets deemed ‘matured’ beyond Security status might be equally well covered by Commodities laws and the CTFC— that is, assuming they fit the definition of a commodity, which is not necessarily a given.
If an asset has matured to the point where it no longer meets the criteria of an investment contract under Howey, it might not be considered a security, but this doesn’t automatically make it a commodity —some utility tokens are considered neither commodity nor security, as it the case for traditional fiat currencies (e.g., the U.S. dollar), which are generally not classified as securities or commodities.
This is to say that wrangling over whether something is a security or commodity might equally result in certain assets falling through the regulatory cracks and even less protection for consumers. However, this is another debate and doesn’t de facto diminish the SEC’s claims regarding the nature of the majority of digital assets on the market.
Ultimately, it will likely be up to either the courts or Congress to decide if the status quo Breslow describes (the current situation but with added clarification on if and when a security becomes a commodity) is sufficient and, if so, to make sure everyone—regulators and companies—abide by it. In terms of Congress, the current stalemate seems set to continue as various digital asset bills painstakingly make their way through a divided House and Senate.
The future of regulation in 2024 and onwards
“I’m really not sure where things will end up given our impasse in Congress,” says Breslow.
But despite this uncertainty, she is not downbeat about the future of the digital asset industry in 2024 and beyond, pointing to the value and utility the sector offers to investors and consumers.
“I am optimistic. I think that crypto has a real place in investment portfolios, in payments for the unbanked, and I think some of the earlier issues that have plagued the industry, including questions of its use in criminal enterprises and so forth, are being addressed,” explains Breslow. “You can see how these wallets are traceable and seizeable, and I think these assets have a role.”
Looking ahead to 2024 and beyond, this last point seems a certainty: digital assets will have a role, thanks to the technological advantages offered by blockchain, such as precise tracking and secure storage of transactions, as well as the ability to seize assets when necessary. Nevertheless, the exact shape of that role in the U.S. remains uncertain, at least for the time being.
Watch: U.S. Congressman Bill Foster on Blockchain Policy Matters
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