The Future is Uncertain: American Regulators Target Cryptocurrencies

Crypto regulation is coming to the U.S. and is likely to have a significant impact on the future of the industry.

The first key difference to consider when analyzing the current state of the crypto regulatory environment in the U.S. is the difference between governmental legislative and enforcement approaches. This is akin to comparing what the government says with what it does in practice, which is important because the difference between the two approaches provides valuable insight into the government’s true intentions regarding the industry and asset class.

When it comes to the legislative agenda, there has been a significant increase in crypto-related bills over the past year, including Senators Cynthia Lummis and Kirsten Gillibrand and their Responsible Financial Innovation Act, Congressman Josh Gottheimer’s 2022 Stablecoin Innovation and Protection Act, Senator Pat Toomey’s 2022 Stablecoin Act, and the 2022 Consumer Protection for Digital Products Act from Senators Debbie Stabenow and John Boozman. If these laws are enacted as proposed, the crypto regulatory and industrial environment will undergo significant changes, most of which stakeholders in the industry have valued positively.

Perhaps most importantly, the Commodity Futures Trading Commission (CFTC) would take precedence over the Securities and Exchange Commission (SEC) in becoming the primary regulator of the asset class by gaining authority over spot cryptocurrency and derivatives markets. Until recently, this was considered a very welcome change among industry stakeholders who had grown weary of the SEC’s aggressive approach.

Direct Registration with the Federal Reserve

Another major change that would follow if these laws were adopted would be the introduction of significantly stricter rules for the issuance and management of stablecoins. This could lead to an implicit ban on uncollateralized, algorithmic, or ‘endogenously collateralized’ stablecoins and a 100 percent collateral requirement for stablecoin issuers. Stablecoin issuers would likely need to possess banking charters, which are very difficult to obtain, or register directly with the Federal Reserve. This would significantly reduce ‘depeg’ risks in the cryptocurrency market. However, it could also lead to centralization if the space relies too heavily on regulated stablecoin providers.

However, perhaps the most important development on the legislative front is the recent comprehensive framework from the White House for regulating the digital asset space. The framework was released on September 16 after President Biden signed an executive order in March on ‘Ensuring Responsible Development of Digital Assets.’ It consists of positions and recommendations from the SEC, the Department of the Treasury, and several other government agencies on how to regulate crypto assets.

The framework provides the clearest overview to date of how the Biden administration plans to address crypto, including plans to strengthen enforcement measures against illegal practices, pushing users towards government and controlled centralized payment solutions such as FedNow and CBDC.

If the administration begins to fulfill its plans, the U.S. crypto industry will increasingly resemble fintech rather than a movement aimed at creating the alternative financial system it envisioned. By implementing excessively stringent regulatory requirements for the industry, its stakeholders may begin to leave the U.S., leading to an exodus of Web3 talent to crypto-friendly countries.

Regulation through Enforcement

On the enforcement front, there are several critical ongoing cases that could reshape the cryptocurrency landscape in the country, depending on their outcomes. The most widespread of these cases is the SEC’s case against Ripple, in which the agency is suing the blockchain company for allegedly conducting an illegal securities sale. Judging by the latest developments in the case, it is likely to be settled out of court, which would be a significant victory for Ripple and the U.S. crypto industry. For the SEC, losing the case or reaching an out-of-court settlement would significantly hinder its ability to prosecute other crypto companies under the same allegations, granting crypto companies much-needed freedom.

Another critical case is SEC v. Wahia, where the agency is suing a former Coinbase employee and two individuals for insider trading allegations. In a flagrant example, the SEC claims that ‘at least’ nine cryptocurrencies listed on the exchange were securities. If the court accepts this claim, it could have wide-ranging implications for the industry, enabling the agency to prosecute crypto exchanges for the illegal offering of unregistered securities.

In another ongoing case highlighting the SEC’s approach, the agency is attempting to establish its influence over the industry by making broad claims that could have serious implications for the asset class. Specifically, in the SEC’s case against Ian Balina, the agency argues that Ethereum transactions should be considered ‘within’ the U.S. because more Ethereum nodes are located in the U.S. than in any other country.

For this reason, the SEC says, Ethereum should fall under the agency’s jurisdiction. If the court accepts this argument, the SEC could then attempt to assert jurisdiction over all Ethereum transactions involving tokens deemed securities, regardless of the location of other contracting parties.

In yet another disappointing development for the crypto community, CFTC, following the SEC’s lead, is suing a decentralized autonomous organization (DAO) and its token holders on charges of operating an illegal derivatives trading venue. A CFTC victory in this significant case would set a terrible precedent for DeFi protocols and token holders, ensuring they could be held liable for various items. This would effectively devastate DeFi, making it impossible for protocols and DAOs to operate without the risk of criminal prosecution.

Finally, the Treasury Department’s move to sanction the decentralized privacy protocol Tornado Cash stands out as one of the main enforcement measures that have already had an outsized impact on the industry. This move marks the first time a government agency has sanctioned a smart contract, immutable code that lives on the blockchain, and several key blockchain infrastructure providers, such as Alchemy and Infura, which have already complied with the sanctions.

Many crypto legal experts, including the U.S. crypto advocacy organization Coin Center, believe this move is unconstitutional and a gross overreach of jurisdiction, and it will likely be challenged in court. However, if the department wins any challenging lawsuit, the entire crypto industry could suffer, given the doubts about its ability to uphold its core principles such as decentralization, credible neutrality, and resistance to censorship.

Looking Ahead

Depending on whether the recently proposed cryptocurrency laws come into effect and how ongoing court cases unfold, the U.S. crypto landscape could look completely different in a few years from now. The optimistic view is that both the SEC and CFTC lose all lawsuits that could hinder the industry while lawmakers enact more favorable proposed laws that offer clarity regarding regulation.

If this becomes the case, and the odds are quite significant, the U.S. could become the leading global crypto-friendly jurisdiction, supporting the entire global industry.

On the other hand, the worst-case scenario is that lawmakers take too long to enact favorable crypto laws while the SEC and CFTC slowly regulate the space through litigation. This would severely disrupt the growth of the crypto industry and all technological innovations that arise from it. Given the overwhelming political and economic international influence of the U.S., such a scenario would also bode poorly for the global crypto industry. One potential outcome of a harsh regulatory environment is the fragmentation of DeFi into ‘RegFi,’ composed solely of law-compliant protocols, and ‘DarkFi,’ composed of truly decentralized censorship-resistant protocols.