Bates Research | 06-06-19
Cryptocurrencies Regulatory Update: FinCEN Guidance, SEC and Commissioner Commentary
The state of play in cryptocurrency regulation continues to reflect legitimate tensions between promoting innovation and entrepreneurship and maintaining sound markets and investor protection.
In previous articles, Bates Research has described some of the definitional challenges that directly affect which agencies govern which crypto assets. For example, the SEC asserts jurisdiction over virtual digital offerings presented as securities (under certain legal tests,) while the CFTC maintains authority when the digital assets present as commodities and options. FinCEN covers digital assets by extending money transmission regulations for businesses subject to Bank Secrecy Act (“BSA”) and Know Your Customer (“KYC”) obligations. State and international regulators sometimes take conflicting positions as they attempt to control how these new technologies may affect their economies. In short, regulators are alternatively encouraging, threatening and enforcing compliance as new business models push the boundaries of traditional commerce.
In this article, we review recent developments including new guidance and a recent advisory issued by FinCEN, anticipated guidelines from the Financial Action Task Force (“FATF”) and the latest developments at the SEC.
FinCEN Issues Guidance and an Advisory
Last month, FinCEN issued interpretive guidance affirming its regulatory approach and warning financial institutions about the threat of virtual currencies used to support criminal activity. Specifically, FinCEN took two steps in order “to provide regulatory certainty for businesses and individuals.” First, the agency consolidated current FinCEN regulations, administrative rulings and preexisting guidance and explained how they apply to “Convertible Virtual Currencies” (CVCs) businesses. Second, FinCEN issued warnings “to assist financial institutions in identifying and reporting suspicious activity related to the criminal exploitation of CVCs for money laundering, sanctions evasion, and other illicit financing purposes.”
The FinCEN guidance starts by defining key concepts including the definition of money transmitters and “money transmissions…that substitute for currency.” This is important, as the definitions serve to distinguish FinCEN’s authority over money services businesses (“MSBs”) from those of the SEC (derived from the definition of “securities”) and the CFTC. (derived by definitions related to commodity futures.)
FinCEN then explains its current regulatory scheme involving money transmission under the BSA. The agency restates key requirements including written AML compliance policies, the collection of KYC information, the monitoring of transactions by a designated officer, the filing of SARs and adequate record-keeping. Remaining sections summarize FinCEN’s most recent guidance on the application of money transmission regulations to transactions denominated in CVC; highlight certain patterns of activity that raise concern and demonstrate how different business models that utilize CVCs are covered. As Director Kenneth A. Blanco stated: “our regulatory approach has been consistent and despite dynamic waves of new financial technologies, products, and services, our original concepts continue to hold true. Simply stated, those who accept and transfer value, by any means, must comply with our regulations and the criminal misuse of any methodology remains our fundamental concern.”
The companion FinCEN advisory provides examples of “prominent typologies” and details some thirty red flags for compliance professionals. The advisory identifies information important to enforcement agencies contained in SARs. The guidance and advisory warns of suspect conduct related to peer-to-peer transactions, custodial wallets, crypto ATMs (physical CVC kiosks), anonymity-enhanced CVC transactions, money transmission performed by internet casinos, decentralized applications (dApps), crypto-payment processors and mining pool operators.
Sigal Mandelker, Under Secretary of the Treasury for Terrorism and Financial Intelligence offered some additional perspective. Of the more than 47,000 SARs received by the Treasury Department since 2013, she said, “half of these SARs were filed by virtual currency exchangers or administrators themselves…. Nobody  wants to see innovative products and services misused to support terrorism and weapons proliferation.”
FATF Interpretive Guidance Coming in June
Expected later this month, the Financial Action Task Force (FATF) will finalize certain updates to its international standards and provide clarifying interpretive notes. Specifically, the intergovernmental standards-setting body will recommend that virtual asset service providers require the identities of both the sender and recipient of every virtual asset transmittal of funds. To date, the industry has not reacted favorably to this recommendation, declaring that bad actors would simply move toward unregulated markets. But as one influencer remarked, stricter standards would “actually legitimize crypto-currencies globally … and set the stage for the conventional financial sector to use the technology, in line with established regulatory frameworks.”
Additional Developments From the SEC
In April, William Hinman (SEC Director, Division of Corporation Finance) promoted a newly published framework “for analyzing whether a digital asset is offered and sold as an investment contract, and, therefore, is a security.” Though the framework is intended to be an analytical tool for assessing whether the securities laws “apply to the offer, sale, or resale of a particular digital asset,” – and officially “not a rule, regulation, or statement of the Commission.” The framework serves as yet another guide by the SEC to define what is and is not within the jurisdiction of the agency and, therefore, whether an entity must register and be subject to applicable registrations. The framework reaffirms that covered entities include those that offer, sell, distribute, market, buy, sell, trade, facilitate exchanges and offer financial services concerning digital assets.
The overall SEC approach, which included the issuance of an SEC registration exemption letter, was criticized by SEC Commissioner Hester Peirce, who compared the agency’s approach to Jackson Pollack splashing paint across a canvas. Though she acknowledged preliminary steps by the agency that provide some clarity on the legal test, she encouraged greater guidance by the regulators and warned that “without a functional secondary market, which encompasses broker-dealers and trading platforms that can legally trade digital securities, and advisers and funds that can buy and hold the assets, the primary market in the U.S. will wither, and retail investors will not enjoy the protection our securities laws offer.”
While there is continuous movement to strengthen the definitions that anchor agency authority and jurisdiction, as evidenced by FinCEN’s new guidance and advisory, the upcoming FATF interpretive guidance, and additional information pushed out by SEC staff, there is also great debate in the market on the slow pace toward a holistic regulatory approach to fintech. Bates will keep you apprised.