On Our Radar: Crypto Legislative, Regulatory and Enforcement Roundup

Fast-moving events in the financial markets are underscoring the need for a workable digital asset legislative and regulatory framework. With the recent collapse of  Signature Bank and Silvergate Bank, two financial institutions synonymous with “innovation” lending, the broader digital asset investor community is in turmoil.

Ongoing volatility continues to reduce overall crypto market value (by over $2 trillion since 2021) and leaves crypto businesses exposed to additional risk. Federal and state regulators have ramped up enforcement efforts in response. Such volatility is the backdrop to this latest roundup on crypto developments.

Legislative Developments

U.S. federal legislators continue to engage in multiple efforts on crypto-assets. On the Senate side, Senators Cynthia Lummis (R-Wyo) and Kirsten Gillibrand (D-NY) will reportedly reintroduce a “slimmed-down” version of their 2022 Responsible Financial Innovation Act and the Digital Commodities Consumer Protection Act in April. The bill would bring digital assets within the regulatory “perimeter” and direct the CFTC to take the lead. Senator Elizabeth Warren is reportedly set to re-introduce the Digital Asset Anti-Money Laundering Act, a bill that would prohibit financial institutions from using digital asset mixers and other means to facilitate illegal and anonymous transactions. (An analytics firm determined that, in 2022, “total cryptocurrency value received by illicit addresses reached $20.1 billion.”) Also in play is the Stablecoin Trust Act, yet to be introduced this term, that would establish a comprehensive regulatory framework for stablecoins that would explicitly allow both “state-and federally chartered entities” to engage in the activity.

Under Republican leadership, the House Financial Services Committee has taken up a series of bills affecting crypto, including (i) the Keep Your Coins Act, which “preserve an individual’s right to privacy when transacting with digital assets,” (ii) the Financial Technology Protection Act, which would encourage new financial technologies to combat terrorism and other illicit activities; (iii) the Blockchain Regulatory Certainty Act, which would “exempt blockchain developers and providers of blockchain services that do not take control of consumer funds from certain financial reporting and licensing requirements;” and (iv) the Keep Innovation in America Act, which would “amend the digital asset reporting provisions in the Infrastructure Investment and Jobs Act.” The bill would modify the definition of “broker” to exclude those who provide facilities in which others effect sales, or who help operate an exchange but who maintain no records on the terms of the sales. The bill also “sets guardrails around the definition of digital asset,” and requires a study “on the treatment of digital assets as cash for purposes of reporting requirements.”

Regulatory Developments

Banking regulators have been highly visible over the past few months raising significant concerns about crypto risks spreading to other sectors of the financial markets and highlighting gaps in current regulation. On January 3, 2023, the Federal Reserve, the FDIC and the OCC issued a joint statement to banking organizations on the risks of engaging in crypto assets related services. These include risks on custody practices, redemptions, and ownership rights, and concentration risks within the crypto-asset sector. In a second joint statement issued on Feb. 23, 2023, the Fed, FDIC, and OCC alerted banking organizations of crypto asset liquidity risks resulting from unpredictable and potentially unstable crypto deposit inflows and outflows. The agencies cautioned banks to establish and maintain effective risk management and controls to cover these liquidity risks.

Additional notable regulatory actions by the Federal Reserve include two significant decisions (in January and February) in which a state-chartered crypto firm was denied applications to offer its customers financial services in both dollars and digital assets through the federal reserve system. The message is that the bank regulators are not yet ready to incorporate crypto into the traditional banking system.

Chairman Jerome Powell testified to that fact, in a March 7, 2023 Hearing before the Senate Banking Committee. He asserted that “there are real concerns about permissionless public blockchains, and the reason is that they've been so susceptible to fraud, to money laundering and all of those things.” He emphasized that stablecoins are not tools "consistent" with sound banking, stating “Like everyone else we’ve been watching what’s been happening in the crypto space and what we see is quite a lot of turmoil, we see fraud, we see a lack of transparency, we see run risk, we see lots of things like that… What we’ve been doing is making sure that the regulated financial institutions that we supervise and regulate are careful and taking great care in the ways they engage with the whole crypto space."

In another significant agency action affecting crypto, on Feb. 15, 2023, the SEC proposed significant amendments to the Custody Rule, which would require holders of crypto assets and crypto asset companies to register with the agency. The rule would expand the definition of "asset class" to include crypto-assets that are not categorized as funds or securities.

Enforcement Developments

Regulators have pursued aggressive enforcement actions consistent with this rhetoric in light of significant market implosions such as those of FTX exchange and the stablecoin TerraUSD. (The SEC filed over 30 significant cases and imposed $242 million in monetary penalties in 2022. See also, SEC 2022 Enforcement Report.) Recent cases include “staking” claims against a crypto exchange, false and misleading statements by celebrities on social media, insider trading (together with the DOJ), recordkeeping and disclosure failures, conflicts of interest and failures to register a securities offering.

The CFTC pursued cryptocurrency derivatives claims, failure to register and unlawful commodity transactions. The CFTC is poised to exceed the 18 actions it brought in 2022. The Treasury Department has also pursued crypto firms for anti-money laundering and sanctions violations, and the IRS has made clear that it will pursue tax evaders after determining that crypto-assets were capital assets for the purpose of imposing capital gains treatment upon sale.

The amped up activity has led crypto advocates to complain the agencies are regulating by enforcement and stifling innovation. SEC Chair Gary Gensler’s response is that “the cryptocurrency industry is playing a game with his agency,” and that crypto companies “are well aware of what they have to do to operate legally within the U.S. but they’ve decided not to do it.”  

Ongoing State Legislative Activity

The states are not waiting for federal legislators or regulators to craft a comprehensive framework on crypto. The National Conference of State Legislatures tracks these crypto-legislative initiatives and reports that thirty-seven states have now “addressed legislation regarding cryptocurrency, digital or virtual currencies and other digital assets in the 2022 legislative session.”

Two prominent approaches on the registration and regulation of crypto – New York (through the issuance of BitLicenses) and recent efforts by New Jersey (Bates has a comparison of the two here) – increasingly appear to be models for other state legislators who are looking for consistency across jurisdictions for crypto businesses based in their state. (See e.g. remarks from David DeCarlo, Illinois’ first regulatory innovation officer.)

Conclusion

The turmoil in the financial markets that cater to crypto and the continuing meltdowns in crypto exchanges and firms represent a defining moment in the evolution of blockchain products and services. Ongoing volatility, highlighted by legal and enforcement developments in the earlier failures of FTX Exchange, Genesis Global, BlockFi Inc. Celsius Network, Voyager Digital, TerraUSD and Three Arrows is affecting investor sentiment and enhancing risk. Federal and state leaders are pouncing on that volatility and are rushing to address the risk.

In testimony before the House Financial Services Subcommittee on Digital Assets and Financial Technology, Peter Grewel, Chief legal Officer at Coinbase, urged the legislators to pass comprehensive legislation that “will result in rules for the intermediaries that provide access to digital assets in order to enable responsible innovation, ensure consumer protection, and safeguard our national security interests.” He argued for a legislative path to (i) protect consumers, (ii) regulate trading and markets, (iii) list new security tokens and raise capital and (iv) ensure financial stability by embracing a faster and cheaper payments system in stablecoins. Whether a divided Congress and ambitious state representatives can make that happen is still uncertain. The need to make that happen is not. Bates will keep you apprised.

Bates Group has been a trusted partner to our non-banking financial institutions and financial services clients and their counsel for over 40 years, delivering superior quality and results on a cost-effective basis. With a full professional staff and a roster of over 175 financial industry and regulatory compliance experts, Bates offers services in AML and compliance, regulatory enforcement and internal investigations, litigation consultation and testimony, forensic accounting, damages, and big data consulting.

Bates Group's MSB, FinTech and Cryptocurrency team provides a full suite of Bank Secrecy Act, Anti-Money Laundering and Office of Foreign Assets Control (BSA/AML/OFAC) compliance consulting services, state money transmitter licensing acquisition and maintenance support, independent reviews, and corporate compliance training.

To learn more about our services or to talk to one of our professionals, contact Bates today.