With this months’ coverage, we are leaving the more technical topics for a change and will provide a high-level overview on crypto regulation. When reading the news, hearing from industry experts, and scrolling though (crypto-) twitter, the topic of regulation in crypto (or perceived lack thereof) is omnipresent and, depending on the source, often biased into certain directions. This piece should provide an overview of some key aspect that are being discussed and argued about, mention some notable ongoing court cases, as well as close with a small examination of regulations in different jurisdictions.
Notable regulatory questions and uncertainties
Since we are dealing with completely new technologies that enabled novel ways to transact value and raise capital, a lot of the uncertainties are related to: 1) the applicability of existing regulations (e.g., regulations related to banks and financial institutions); 2) the extent of applicability, and; 3) how to enforce or amend these regulations to be applicable with new types of transactions and technologies. Some notable topics related for crypto regulation warranting attention are:
- Securities Classification: A key factor is the classification of crypto assets – an important category to define which laws apply and which agencies oversee regulation. Crypto's potential classification as a security can heavily influence its adoption and use because this could impose certain registration, disclosure, and operational requirements – potentially increasing the cost of launching new projects and hindering innovation. On the pro-side, exponents usually mention the arguably greater investor protection.
- AML and KYC: These regulations are key pieces in traditional financial services and hence, there is also a lot of attention by regulators on how to apply these regulations to crypto. The argument usually goes for enhancing transparency and trust by requiring exchanges and wallet providers to conduct thorough identity checks and report suspicious activity. Depending on the politicians in question however, some proposals can have questionable implications for user privacy, security, and financial freedom – in some cases going as far as trying to prohibit the usage of self-custody wallets.
- Taxation: The way cryptocurrencies are taxed varies widely across jurisdictions and can have a significant impact on investment and usage. Clarity is needed on whether crypto assets will be taxed as capital gains, income, or something else entirely.
- Decentralized Finance (DeFi): DeFi platforms and protocols have grown rapidly, and their regulatory status remains a major area of uncertainty. This encompasses a broad range of issues, including whether certain DeFi activities constitute regulated financial services and if yes, how to apply regulation to pieces of code on a blockchain.
As it is often the case with regulation, it is designed to be catching up to technological and societal advancements – which makes sense. Now as the technology matures, jurisdictions have different senses of urgency and sentiment towards crypto, which leads to a greatly varying state of regulation across regions. For now, we will mainly focus on current regulation in the US, as it is arguably the most important market for crypto investors and companies.
US regulation and notable court cases
In the United States, cryptocurrency regulation is still in a state of flux, and the lack of comprehensive federal guidance creates uncertainty for users and businesses. Especially industry experts and pro-crypto politicians argue that there is “a complete lack of regulatory clarity”. Today, it is unclear which agency should regulate crypto assets with candidates being the SEC (securities), CFTC (commodities), or even IRS (property). At the moment, the SEC seems to be at the forefront by claiming all cryptos, except Bitcoin and potentially Ethereum, as securities and therefore, subject to their oversight. However, the industry doesn’t see clear and active guidance by the SEC and many crypto insiders call them out as regulating by enforcement. These actions are also evident in current court cases, such as:
- SEC v Ripple: The most prominent court case is arguably SEC v Ripple Labs. This case centers on whether XRP, Ripple's native digital asset, should be classified as a security. The SEC claimed Ripple's sales of XRP were unregistered securities offerings, while Ripple asserted XRP to be a cryptocurrency, not a security. The case's outcome may redefine how digital assets are classified and regulated. In July 2023, Ripple achieved a partial victory as a judge sided with them that XRP itself is not a security – news which were followed by an immediate pump in XRPs price by around 60%. Despite the ruling, its applicability to other crypto assets remains unclear, given the fundamental design differences between XRP and nearly all other crypto assets targeted by the SEC. Further, the SEC also had a partial victory in the ruling, as the judge ruled Ripple’s XRP sales to institutions to be in fact unregistered security offerings. These sales totaled around $700m. However, XRP secondary sales on exchanges and sales to individuals were apparently not unregistered securities offerings according to the ruling.
- SEC v Coinbase / Binance: More recently, the SEC has sued both Binance and Coinbase within days of each other with the allegation of operating as securities exchanges without registering their business with the SEC. For the lawsuit, a total of more than 20 crypto assets have been brought forward as alleged securities and proving even only one of them to be an actual security could result in a win for the SEC. These allegations have been rejected by Coinbase and Binance, which are mainly arguing along the lines of a general lack of clarity on SEC side, no clear information as to how to register, and how the SEC itself would allow an IPO of an apparently illegal securities exchange.
Taking a broader look at international regulation, there are apparent differences around the globe with some jurisdictions embracing the technology and others more or less [trying to] ban it completely. As it would go beyond the scope of this newsletter, we have linked resources for further jurisdictions below and focus on only a small selection here:
- European Union: The EU's Markets in Crypto Assets (MiCA) regulation aims to provide a harmonized framework for crypto assets across member states. It was approved and is expected to go into effect in 2024. It will be the first legal framework of its kind at such a scale. From an “industry-wishlist” point of view, there might not be everything perfect with it – however, it creates clarity and in fact includes a lot of the elements one would expect to be required for the crypto industry to become more institutional.
- Switzerland: Switzerland has been an early mover in crypto regulation by adopting a regulation based on the principle of technology neutrality – i.e., there are no regulations for the technology itself but for the activities it enables. This approach has led to clarity at an early point in time, without the need to add comprehensive new regulation and without interfering with the innovation in the technology itself. Further, in 2021 the regulatory framework was extended with the DLT Act.
- China / Hongkong: China's approach towards cryptocurrency has typically been restrictive. It has banned Bitcoin mining and in September 2021 outlawed all cryptocurrency-related activities, positioning its state-controlled Digital Yuan for prominence. On the other hand, however, Hongkong introduced a lot of pro-crypto laws recently, including the permission for individual investors to trade crypto assets per June 2023.
With the growing adoption and increasing institutional interest in crypto, the need for regulation is not just inevitable, but desirable. It is needed to ensure a level of stability and trust, mirroring what it does in the traditional financial system. The goal of regulation should be to ensure reasonable investor protection and prevent money laundering, but not at the expense of innovation, privacy, and financial freedom. This ultimately leads to the key challenge of determining what constitutes “reasonable regulation”, and whether existing regulatory frameworks can adequately cover this novel industry. This assessment can be difficult, as some policymakers seem to be either driven by a lack of understanding of the technology, or the immense lobbying power of large financial institutions. These might be inclined to slow innovation through policymaking to keep their powerful positions. Especially the US as the world’s financial center seems to be behind on crypto regulation, given recent advancements in Europe and even China (through Hongkong). It surely seems like the topic of crypto regulation will keep policymakers around the globe busy in the coming years.