The Challenges of Regulating Cryptocurrency

On September 14th, the new chair of the Securities and Exchange Commission, Gary Gensler, appeared before the Senate Banking Committee to talk about how his agency planned to handle the financial markets during his term. He praised the American financial system, discussed the future of corporate bonds, and ruminated on how the rules of the stock market might be modified to make it more efficient. Soon, he turned to cryptocurrency markets, which are notoriously volatile, and adopted a darker tone. “Frankly, as I’ve said before, I think it’s more like the Wild West,” Gensler said. On another occasion, he had described cryptocurrency investments as “rife with fraud, scams, and abuse.”

Gensler’s comments came after several years of a fraught relationship between the agency he now heads and the market for digital coins, tokens, and virtual currencies such as bitcoin, which are created using cryptography, and many of which reside on giant, decentralized electronic ledgers that use blockchain technology. The S.E.C. has so far failed to keep up as thousands of tokens and digital currencies have been introduced, and new companies and platforms have emerged to help store and trade them. The lack of regulations over this burgeoning area has created an opening for widespread fraud; in May the Federal Trade Commission reported that consumers lost more than eighty million dollars on cryptocurrency-investment scams between October, 2020, and March, 2021, more than ten times the amount lost during the same period in the prior year. (Two million of it was lost to scammers impersonating Elon Musk.) Gensler now faces the challenge of clarifying how the nascent market will be regulated in the future. The stakes are also high for the crypto industry: until it becomes a part of the regulated economy, it will be associated with a notion of criminality.

Gensler, who is sixty-three, has a long history in government and on Wall Street—a common résumé for officials selected for important economic posts. He spent eighteen years at Goldman Sachs, where he worked as a mergers-and-acquisitions banker and became one of the firm’s youngest partners, at age thirty. He was nominated by President Bill Clinton to be an Assistant Secretary of the Treasury. In 2009, President Barack Obama named Gensler to be the chair of the Commodity Futures Trading Commission, which regulates the derivatives markets. After leaving the C.F.T.C., in 2014, Gensler worked as a professor at M.I.T.’s Sloan School of Management. During his time there, much of his teaching focussed on cryptocurrency. His first class, “Blockchain and Money,” covered the development of blockchain and its potential uses.

One of the biggest questions facing the industry is whether tokens—which are tradable assets that may serve as the units which denominate cryptocurrencies but can also represent other things of value—qualify as securities; if so, they would be subject to securities laws and regulations. And if they aren’t securities, what are they? The answer to that question would help determine which other agency might have oversight of them. To many in the field, the messages coming from the S.E.C. in the past few years have been confusing.

One securities lawyer I spoke with, Nick Morgan, who is a partner at Paul Hastings, recalled that, around 2017, as a frenzy of initial coin offerings—a fund-raising strategy for cryptocurrency that resembles an I.P.O.—was in full swing, a client came to his law firm wanting to know what the S.E.C. thought about I.C.O.s, and whether the agency considered digital coins to be under its purview. Morgan said, jokingly, that his first question was, “What’s an I.C.O.?” He quickly learned that there was little S.E.C. guidance available. “What would be useful for everyone to know is, what are the characteristics of a digital asset that is not a security? It would be useful to draw that line,” Morgan said. “I was a little hopeful, given Gensler’s technical background, that he might be the person to say, ‘Here is the boundary of the S.E.C.’s jurisdiction, and if you designed a token this way, that would be outside our jurisdiction.’ ” But, he added, “I don’t think it’s going to happen.”

During a speech in early August, at the Aspen Security Forum, Gensler offered some thoughts on the matter. “Those tokens being offered, many of them are offered and sold as security,” he said. “There’s actually a lot of clarity on this front.” Gensler then reaffirmed a statement made by his predecessor, Jay Clayton, at a Senate hearing: “To the extent that digital assets like I.C.O.s are securities—and I believe every I.C.O. I’ve seen is a security—we have jurisdiction and our federal securities laws apply.” But some may still feel that the details remain fuzzy.

One way to understand what the S.E.C. thinks about a particular matter is to look at the enforcement cases it brings, which help define what activities violate securities laws. Last December, the S.E.C. filed a lawsuit against Ripple, a cryptocurrency company, alleging that it had conducted an “unregistered securities offering” by raising $1.3 billion through sales of a token called XRP. According to the agency’s complaint, XRP is a security, and the company should have registered its offering and sale to the public with the S.E.C. Ripple argues that XRP is a currency, which would make it subject to different laws and regulations overseen by different agencies—such as the Office of the Comptroller of the Currency or the Financial Crimes Enforcement Network, which are both part of the Treasury Department. Ripple has taken to Twitter to defend itself, in addition to making its arguments in court. Part of its strategy seems to involve trying to embarrass the S.E.C. over the agency’s apparent contradictions surrounding cryptocurrencies. In 2018, an S.E.C. official named William Hinman told an audience at a conference that, based on his understanding, one of the best-known cryptocurrencies, ether, was not a security and shouldn’t be regulated like one. The trading price of ether went up in the coming hours, and actors in the cryptocurrency world seized on the comments, which they interpreted to mean that many other cryptocurrencies were likely not securities, either. Ripple has argued in court that XRP should be treated the same way as ether. It has also urged that some of the S.E.C.’s internal documents pertaining to what is, or is not, a security should be handed over as part of the case in order to be used in the company’s defense.

More recently, the S.E.C. has expressed interest in the workings of Coinbase, one of the largest cryptocurrency exchanges, where people can buy and sell cryptocurrencies. Coinbase went public earlier this year, and in June it announced plans for a product it called Lend, which would have enabled owners of cryptocurrencies to loan them out and be paid interest on the loans. On September 7th, Coinbase announced in a blog post that the S.E.C. had threatened to sue the company over Lend, alleging, the post said, that the offering involved a security. According to the company, its executives had been “​​proactively engaging” with the S.E.C. for six months, to clarify the legal standing of its projects, but it “didn’t get much of a response.” It also said that the S.E.C. had so far refused to clarify whether it considered the act of lending cryptocurrency a security, or whether the cryptocurrency itself was the security, and any other aspects of its reasoning. (The S.E.C. said that it could not comment on issues involving specific companies.) On September 17th, Coinbase announced that it was cancelling the Lend program.

While the agency takes its time setting clear rules, the industry is left continuing to guess. This might be just the way the S.E.C. wants things to be. “That’s the best position for them to be in,” Morgan said. “The moment they identify, or a court identifies, the characteristics of an asset that’s beyond the S.E.C.’s jurisdiction, everyone will say, ‘O.K., we’ll do it that way.’ And they don’t want that.”