Tides of Digital Asset Regulation
In the past 12 months, there has been a flurry of statements, rhetoric, proposed legislation, and legal proceedings relating to digital assets in the US. Politicians, the CFTC, the SEC, and state regulators have stepped forward with increasing frequency with comments and legal actions addressing digital assets. The undertones of each piece hint at the future of digital asset regulation. Making sense of conflicting perspectives of US regulators is a daunting task for firms that service the digital asset industry. Further complicating the unknown is the risk of non-compliance. To date, US regulators have been less than forgiving if a firm crosses a line they didn’t know existed. How do we prepare for the future given the foundational uncertainty?
What we DON’T know:
The fundamental question that underpins the bulk of the uncertainty is the line between a security and a commodity. We know that some digital assets will be deemed securities, and some will be deemed commodities. Where this line gets drawn is the big question. And without a clear separation, service providers are tasked with the impossible: staying on one side of a line that can’t be seen.
In reading through the proposed legislation, the federal thought pieces, and legal actions that have been put forward thus far, we don’t believe there ever will be a truly clear line. The nature of digital assets enables structures that don’t fit neatly in our pre-defined boxes that we have created to enable rules and regulations. Digital assets can take on forms that have characteristics of commodities, securities, both, or neither.
The other big unknown is what regulation will look like, and which regulator(s) will enforce it. No current rulebook adequately addresses digital assets. The CFTC, SEC, FINRA, and various state banking regulators have all put forth statements regarding the enhancement of digital asset regulation subject to their perceived jurisdiction. The problem is, if the lines between the various regulatory frameworks are unclear, how can new rules be written? How will new rules address asset types than cannot be clearly defined?
Unfortunately, it does not appear that these fundamental questions will be answered any time soon. It seems there will always be ambiguity, and that it will be up to the service providers to draw the lines on their own but have a backup plan if they get it wrong.
What we DO know:
The fundamental framework we know is not going to change without a crisis. If history teaches us anything about financial service legislation, our government is only re-active regarding fundamental change. We expect the US regulators to remain the same, and each agency will prepare their respective regulatory statutes to address digital assets subject to their jurisdiction over time.
We expect the CFTC to adopt regulation that aligns more closely with traditional securities regulation; specifically, expect more rules that address sales practice, insider trading, customer disclosure.
We expect the SEC to continue to regulate by enforcement. While not ideal for any industry participant, this has clearly been where the SEC has placed their efforts. While unfair for the service providers and asset managers caught in the crosshairs, these cases will help bring clarity to where the line between security and commodities lies. Further, it is the SEC that currently has the power to draw the line. The approach most participants have taken thus far is to consider all digital asserts commodities unless they (or the SEC) think the asset in question might be a security.
AML regulations, either through the various states, or through FinCEN will further develop to address the risks present in digital assets. Responsibility for these regulations is likely to be placed downstream. Entities with digital asset “custody” and others subject to AML regulations (Money Services Business, etc.) will contractually require their business partners that are closer to the client (e.g. traders, advisors, fintech providers) to perform the various AML tasks including customer identification, suspicious activity reporting, and know your customer, to mitigate their own AML risks.
If recent cases tell us anything, service providers, notably the larger ones such as exchanges, will need to be able to address all current forms of regulation, as they cannot be sure which side of the line they are on at any given time.
The downstream effects of being accused of crossing the line are immense. For example, consider a digital asset exchange accused by the SEC of dealing in a security without being registered as a broker dealer. The options are grim at best.
- The exchange could settle with the SEC and cut ties to the digital asset in question. Sanctions for this would be quite severe to the exchange. This approach would not protect the firm from the next asset that the SEC takes an issue with. In fact, the sanctions will continue to grow as the scenario plays out again.
- The exchange could also split the house and register as a broker-dealer. The downsides to this approach are cost, time, and operational complexity. While the SEC has been focused on finding digital assets securities, they have not provided much guidance for the properly registered firms that intend to transact in them or advise on them. Operationally, the industry has been split from the very beginning. Very few service providers can operate effectively in both digital assets and traditional finance. For an exchange to “move” a digital asset over to a FINRA member broker-dealer would entail a host of service provider changes, and leading to operational cost and risk to the firm, and a bad experience for the client.
- The third scenario is to fight the SEC and use their own ambiguous “Howey test” against them. While this may work in the beginning, as case law is developing, it will be harder to do over time as case law is developed.
These scenarios also pose problems for the multitude of service providers and asset managers that rely on the custodians. How will their business be affected if the custodian must re-classify a digital asset? Will they lose access? Are they properly registered to continue to service the asset? What will their client’s experience be? Will their regulators allow them to do business with such a vendor?
How to prepare for the unknown
The regulatory statutes in place today are so far apart that it would not make sense to combine commodities and securities under one roof. Separate entities will need to be created to address separate regulations. As AML regulations increase, custody requirements become clearer, and issuer due diligence standards are adopted, a determination will need to be made at the top of the house to place the digital asset in the appropriate entity or avoid it entirely. It does not seem likely that a clear line will be drawn anytime soon, or ever. What is more likely, however, is that specific cases will come out and aid in making these determinations, although it will be far from comprehensive.
As an industry, we see this framework being the one area where we can combine notes and adopt a structure than much of the industry can get behind. Today, that determination is essentially a “Howey test”, and there are disparate models out there from various industry participants. However, we expect many more facets to come into play as new rules are written and/or cases are settled from the multiple regulators involved.
This may be a bold prediction, but we expect that eventually digital asset service providers subject to regulation by the CFTC, SEC, FINRA, FinCEN or the various states to move toward a hybrid model where they can advise, transact, and service digital assets on both sides of the fence. This will take time, and likely start with the exchanges and custodians, as they have the scale and footprint to manage both sides. Customers will inevitably demand it and the regulators will collectively push them there. It will also become harder for larger firms, like exchanges, to stay on just the securities or commodities side of the regulation unless their digital asset selection is quite limited.