Article by John Joy, Managing Attorney, FTI Law.
Last year a digital currency based on the Netflix series ‘Squid Game’ soared in popularity among retail investors. The website promoting the coin was littered with grammatical errors and, while the site was only three weeks old, its promoters managed to raise $3 million from investors before they pulled out their funds and the price collapsed dramatically. Events like this have made cryptocurrency a prime target for regulators and there is no shortage of interested parties. With both the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) vying for the role as the new crypto-sheriff in town, we take a look at the issues that may decide the race to regulate crypto and give our prediction on who comes out as top dog (the SEC).
1. The Case For The CFTC As The New Crypto Regulator
The CFTC largely draws its power from the Commodity Exchange Act of 1934 and the Commodity Futures Trading Commission Act of 1974. These laws give the CFTC power to regulate the trading of “commodities.” Importantly, the CFTC considers Bitcoin and many other cryptocurrencies to be commodities, which gives the CFTC a seemingly good legal basis to claim the title of primary regulator. However, when it comes to the trading of commodities, the CFTC has varying powers depending on whether the trading occurs on the ‘spot’ or the ‘futures’ market. If you’re unfamiliar with these terms, here’s a brief overview:
- The ‘spot’ market is a market where commodities, like Bitcoin, are bought and sold for immediate (“on the spot”) delivery. An example of a spot market for cryptocurrency would be a place where people can trade dollars for Bitcoin, with the Bitcoin being immediately delivered to a person’s online wallet or account. Most apps and websites which let consumers buy cryptocurrency would be considered spot markets and Coinbase is the most popular one in the U.S.
- The ‘futures’ (or ‘derivatives’) market is a market where contracts for future delivery of commodities, like Bitcoin, are bought and sold. In this market, a person does not obtain a commodity at the time of the transaction, they obtain a contract for future delivery of the commodity. A good example of a futures market for cryptocurrency is the Bitcoin futures market operated by the Chicago Mercantile Exchange. In that market, contracts usually specify that the Bitcoin will be delivered in 6 months.
In terms of regulation, the CFTC has limited authority to regulate the spot market and has admitted it can only intervene in the spot market to prevent fraud or manipulation. This means the CFTC cannot impose broad restrictions on who can participate in the spot market or rules regarding how trading occurs. On the other hand, when it comes to the futures market, the CFTC has broad power to regulate, including setting rules for the participants, the exchanges and the intermediaries in the market. Anyone who wants to trade Bitcoin futures in the U.S. is going to have to deal with CFTC regulation, but spot markets and their participants can largely avoid CFTC regulation if they steer clear of fraud and manipulation. For main street investors, it’s more likely that they will be purchasing cryptocurrency through a spot market and as a result, their trading is less likely to be regulated by the CFTC. However, retail investors can still rely on the CFTC to step in when fraud and manipulation occurs, and the CFTC has already demonstrated that it’s not shy about bringing crypto enforcement actions. For example, in August 2021, the CFTC fined BitMEX $100 million for trading Bitcoin derivative products without Anti-Money Laundering (AML) or Know-Your-Customer (KYC) controls. The CFTC has also brought enforcement actions against My Big Coin Pay and Coin Drop Markets for fraud. The CFTC model of crypto regulation is an attractive one for main street investors as it suggests that the CFTC won’t be focused on setting rules for their trading activity, but will still have the responsibility of prosecuting fraud and manipulation. For more sophisticated traders who trade futures, the CFTC is likely to be a much bigger part of their lives, as the CFTC has already set rules and regulations for crypto futures markets.
2. The Case For The SEC As The New Crypto Regulator
As the CFTC regulates commodities, the SEC regulates “securities.” However, the SEC has admitted that neither Bitcoin or Ethereum are securities. This is important because Bitcoin and Ethereum are the two largest cryptocurrencies by market cap, and they act as a model for thousands of other cryptocurrencies. At first glance, you might think that the SEC will have a tough time convincing anyone it can regulate cryptocurrencies, but what the SEC lacks in legal authority, it makes up for in regulatory appetite. As the SEC can’t claim that many cryptocurrencies are securities, the SEC has cleverly identified other aspects of the crypto ecosystem (“cryptosystem”) where the SEC has a much better argument that securities are involved. Rather than regulating the trading of any single cryptocurrency, by regulating important areas of influence, the SEC may be able to exercise significant power over the use of cryptocurrency. To use an analogy; the SEC might not be able to act as the crypto-sheriff, but if it controls all the gun stores in the town, it can still wield a lot of power.
i. Initial Coin Offerings (ICOs)
The best example of an area of influence the SEC has targeted is initial coin offerings (ICOs). An ICO is where people purchase a cryptocurrency that has yet to be released or traded on an open market. Often ICOs are used to raise the capital needed to develop a cryptocurrency or the infrastructure it needs to operate. Just like an IPO for shares, there are contracts that govern who get coins and how many they get. These contracts give the SEC just enough room to argue that ICOs involve securities, and thus can be regulated by the SEC. The SEC first claimed authority to regulate ICOs in 2018, and this claim has been reiterated earlier this year by the current SEC Chairman, Gary Gensler. While Bitcoin and Ethereum are long past their ICOs, there have been hundreds of ICOs in 2021, giving the SEC a bounty of opportunity to regulate how new cryptocurrency is marketed and sold to investors. This is a key area of influence as it allows the SEC to exercise control over all new entrants to the U.S. crypto market.
ii. Decentralized Finance (DeFi)
Another area of influence the SEC has claimed is Decentralized Finance (DeFi). DeFi is a system that allows people to borrow and lend cryptocurrency on decentralized platforms (i.e., platforms that are not controlled by any one entity or person). DeFi is seen as a key development in the cryptosystem as it allows people with cryptocurrency to access financial products that are similar to those offered by traditional banks. As DeFi involves lending, it is a great fit for the SEC’s regulatory power, as the definition of a “security” includes debt instruments (anything that allows you to lend or borrow). This gives the SEC an unimpeachable basis for asserting their authority in this area and the SEC has publicly stated that DeFi platforms come under their jurisdiction. While the SEC hasn’t issued specific rules for DeFi platforms yet, these are likely not far off.
iii. Stablecoins and more
In terms of wider regulation of the cryptosystem including stock-backed tokens and stablecoins, Chairman Gensler summed up the SEC’s position neatly in August: “It doesn’t matter whether it’s a stock token, a stable value token backed by securities, or any other virtual product that provides synthetic exposure to underlying securities. These products are subject to the securities laws and must work within our securities regime.” In addition to this declaration, Gensler has openly asked Congress for more power to regulate cryptocurrencies, showing that if the SEC doesn’t already have the powers it needs, it’s going to go and get them.
3. Why The SEC Will Win The Race To Regulate
While the SEC’s legal basis for the role of crypto-regulator is shaky compared to the CFTC’s, the question of who is going to win the race to regulate is not going to be decided by legal text alone. More likely, the question will be influenced by strategic and industry dynamics, and these indicate that the SEC will prevail.
i. The SEC’s Enforcement Appetite
History tells us that a weak legal basis will not stop the SEC from trying, and succeeding, to prosecute crypto cases. This can be seen from the SEC’s prosecution of cases involving the Foreign Corrupt Practices Act (FCPA) which have been widely criticized as pushing the limits of jurisdiction and flat-out lacking a legal basis. The SEC’s approach to the FCPA is an ominous sign for anyone who thinks that the SEC will stand down from crypto regulation because there is doubt over their jurisdiction to prosecute. The SEC’s current lawsuit against Ripple is a good example of the SEC pushing its jurisdiction, and even if Ripple come out with a victory, that won’t be the last time the company crosses swords with the SEC given its plan to go public. In addition to an insatiable appetite for enforcement (the SEC has already brought dozens of crypto enforcement actions, and has yet to lose a single case) the SEC has almost eight times the headcount and budget of the CFTC. The SEC in a much better position to investigate and bring complex enforcement actions without having to wait for Congress to provide the resources. The resource factor alone has given the SEC a significant head start on the CFTC and allowed the SEC to bring enforcement actions where the CFTC might have looked like the obvious candidate.
ii. Companies Want To Be Regulated By the SEC
Before you scoff at the suggestion that a company would want to be regulated by the SEC, remember that most companies dream of going public. Going public not only means access to capital, but also that the SEC gets far-reaching powers to regulate the behavior of the company, even the tweets of its CEO. While there are only a handful of public companies specializing in crypto, the many private companies who want to go public may think twice before making an enemy of the SEC by challenging their authority to regulate them.
iii. When Not Invited, the SEC Gatecrashes
Even if the CFTC is nominally crowned the primary crypto regulator, it won’t stop the SEC from muscling in any chance it gets. In other areas where regulators believed they had de facto exclusive jurisdiction, the SEC has gatecrashed the party. Take for example “economic sanctions”, which are issued and enforced by the Office of Foreign Asset Control (OFAC) with the assistance of the DOJ. In 2019, enforcing sanctions was a task exclusively thought to belong to OFAC and the DOJ. However, that changed when the SEC brought an enforcement action against Quad/Graphics Inc. for violations of OFAC sanctions (among other things). Not only was this a case where the SEC was moving in on another regulator’s turf, but also, the DOJ had already investigated Quad/Graphics and declined to bring charges. While both agencies use different legal standards, the SEC made a bold assertion of authority based solely on the fact that Quad/Graphics was a public company. If the enforcement of sanctions is anything to go by, any crypto regulator who is not the SEC may find the role a little cramped when it comes to overlapping jurisdiction.
In the race to regulate cryptocurrency there is certain to be some areas of overlapping authority, but strategy, resources and industry dynamics will determine who becomes the de facto crypto-regulator. As the SEC has the appetite, resources and industry dynamics in its favor, it won’t be long before it emerges the winner. As more crypto companies mature and seek access to capital markets, it is unavoidable that the SEC will become the defining regulator in this space.
About the Author
John Joy is the Managing Attorney and founder of FTI Law, a law firm that focuses on representing FCPA whistleblowers. John is a New York whistleblower attorney who has worked for almost a decade on financial crime and regulatory cases around the globe. When working on cryptocurrency issues, John and FTI Law work with Elementus, the first institutional-grade crypto forensic solution.