The future of cryptocurrency regulation is an open question. While pending Congressional legislation would make the Commodity Futures Trading Commission the chief regulator, the Securities and Exchange Commission is influentially flexing its muscles.
SEC Chair Gary Gensler has made clear that the agency intends to be the lead regulator of the US crypto market.
Gensler said on Sept. 8 that the SEC will be aggressively policing crypto tokens and intermediaries. And on Sept.19, the agency quietly—but radically—suggested in a lawsuit that it would assume jurisdiction over the entire Ethereum network.
Ether, the second-largest crypto by market capitalization, was previously viewed as a commodity and not within the SEC’s jurisdiction.
These two events may well shape the regulations that crypto companies and users will face in months and years to come. Industry stakeholders and intermediaries will need to adjust to the SEC’s new enforcement tactics and assertion of jurisdiction over the markets.
Crypto Tokens as Securities
Gensler’s comments on crypto tokens indicate that he believes most crypto tokens are securities, and thus need to be registered and regulated.
Gensler has explained that he believes most digital tokens meet the definition of a security under the Supreme Court’s 1946 Howey test, asserting that, in general, “the investing public is buying or selling crypto security tokens because they’re expecting profits derived from the efforts of others in a common enterprise.”
While Gensler has made similar comments before, it is noteworthy that he took the time to address the primary statutes the SEC uses to regulate the traditional financial markets and make clear that he believes they apply with equal force to crypto markets.
Gensler also emphasized that the SEC has been clear about its stance on these issues.
While many in the crypto industry have requested additional regulatory guidance from the SEC, Gensler noted that both he and his predecessor have clearly stated that the SEC considers most crypto tokens to be securities.
Gensler has stressed that the crypto industry needs to ensure that tokens are registered and regulated as securities, where appropriate, and has directed his staff to register and regulate crypto security tokens as securities.
Gensler said “investors deserve disclosure to help them sort between the investments that they think will flourish and those that they think will flounder,” and added that “the law requires these protections.”
Intermediaries Need to Register
Gensler has also said that because many digital tokens constitute securities, crypto intermediaries transacting in securities need to register their various functions with the SEC.
He explained that intermediaries, whether calling themselves centralized or decentralized, match orders in crypto security tokens of multiple buyers and sellers using established non-discretionary methods, and therefore meet the regulatory criteria for being securities exchanges.
Investors in crypto will benefit from the application of “exchange rulebooks that protect against fraud, manipulation, front-running, wash sales, and other misconduct,” he said.
From Gensler’s perspective, crypto intermediaries that engage in the business of effecting transactions in security tokens are brokers. And those that engage in the business or buy and sell crypto security tokens for their own accounts are dealers. Because of this, crypto investors “should get the protections they receive from regulated broker-dealers,” Gensler said.
Crypto intermediaries may provide exchange functions, broker-dealer functions, custodial and clearing functions, and lending functions. Gensler noted that the “commingling of the various functions within crypto intermediaries creates inherent conflicts of interests and risks for investors.”
As a result, the agency chair has directed the SEC to work with intermediaries to register each of their functions with the commission, which could ultimately result in disaggregating these functions into separate legal entities.
Jurisdiction Over Ethereum Network
The SEC has continued to expand its claim of authority over the digital assets market. For example, it issued a cease-and-desist order on Sept. 19 against Sparkster Ltd. for the unregistered offer and sale of crypto asset securities. The SEC also filed a complaint against crypto investor and promoter Ian Balina.
Significantly, the complaint appears to assert jurisdiction over the entire Ethereum network.
The SEC’s complaint against Balina, filed in federal court in Texas, alleges that he failed to disclose that Sparkster had agreed to give him a 30% bonus on the tokens that he purchased as consideration for his promotional efforts.
According to the complaint, the contributions to Balina’s pool were validated by a network of validator nodes on the Ethereum blockchain that “are clustered more densely” in the US, and thus “took place in” the US.
The language in the Balina complaint appears to give the SEC jurisdiction to police all Ethereum network-based projects. This is a tremendous break from the past. Previously, the SEC and the CFTC seemed to agree that Ether is not a security.
Gensler has famously called crypto the “Wild West.” It’s clear the SEC is not waiting for Congress to deputize a regulatory agency to police crypto.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
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Mark Bini is a partner in Reed Smith’s global regulatory enforcement practice in New York. He served as an Assistant US Attorney in the Eastern District of New York and as an assistant district attorney in the Manhattan District Attorney’s Office.
Joanna Howe is a New York-based litigation associate at Reed Smith, focusing on regulatory enforcement and investigations.
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