How will SEC enforcement actions change the crypto market?

After the bankruptcy of FTX, BlockFi, Voyager Digital, and other cryptocurrency platforms, the U.S. Securities and Exchange Commission (SEC) accelerated its push for the crypto market to accept its full range of financial regulation. In the first half of 2023 alone, the SEC took 24 cryptocurrency enforcement actions.

The SEC said that its recent and other cryptocurrency-related initiatives are aimed at preventing further fraud, reducing market manipulation, and forcing investors and cryptocurrency holders to disclose more relevant information. Industry critics have accused the moves of being too radical. In any case, the SEC’s aggressive enforcement efforts could fundamentally change the way the cryptocurrency market works.

Essentials

• The U.S. Securities and Exchange Commission (SEC) recently increased the number of employees in its cryptocurrency enforcement division by 40%.
• Many cryptocurrency issuers are already subject to SEC enforcement.
• SEC Chairman Gary Gensler called on cryptocurrency exchanges to register as securities trading platforms at the institution.
• Stablecoins and other tokens are also subject to intense regulatory scrutiny.
• The SEC has reached settlements with a number of cryptocurrency companies, indicating that the agency accepts cryptocurrency businesses in certain cases as compliant with securities laws.

Regulators are looking to improve investor protection, stability and transaction clarity in a rapidly evolving digital financial environment. Here is the rationale for the SEC’s enforcement of cryptocurrencies:

Investor Protection

• Fraud prevention: The cryptocurrency market is relatively new and has been associated with many frauds and scams. SEC enforcement can deter fraudulent activity and protect investors from bad actors.
• Disclosure Standards: By bringing the cryptocurrency market into securities laws, the SEC can ensure that these businesses provide investors with more accurate and comprehensive information that will enable them to make informed decisions.

Market integrity

• Price manipulation: The anonymity and lack of regulation of the cryptocurrency market make it vulnerable to manipulation. SEC oversight helps curb such practices and ensure fair prices.
• Market surveillance: Monitoring abnormal activity in the cryptocurrency market helps maintain market integrity and investor trust.

Legality and adoption

• Legal Framework: SEC regulations can legitimize cryptocurrency businesses and attract more traditional investors and institutions, which could lead to wider adoption.
• Innovation and Competition: By leveling the playing field, SEC enforcement can encourage innovation and competition, which is critical to the long-term sustainability and growth of the cryptocurrency industry. Money laundering and terrorist financing: By enforcing anti-money laundering (AML) and counter-terrorism financing (CTF) regulations, the SEC and other agencies can address two major public concerns about cryptocurrencies.

Regulatory clarity

• Defining boundaries: The SEC’s involvement helps define the boundaries between traditional securities and crypto assets, providing much-needed clarity to entrepreneurs and investors.
• Compliance Standards: Establishing compliance standards helps crypto businesses comply with well-known regulations and reduce legal uncertainty.
• Cross-border cooperation: Cryptocurrencies know no borders, so international cooperation and enforcement can help address global challenges.

OmniVision Test with Cryptocurrency

The OmniVision test is a legal principle used in the United States to determine whether a financial arrangement qualifies as an investment contract and should comply with regulatory requirements. The Howey test has become a cornerstone for the SEC to evaluate various financial instruments and arrangements, including cryptocurrencies and initial coin offerings (ICOs).

The test grew out of SEC v. W.J. Howey Co., a 1946 decision by the U.S. Supreme Court that established the standard. The Howey test is crucial for entities in the financial industry, including the emerging cryptocurrency space, as its application greatly affects what regulatory framework, if any, these entities are regulated by. Here are the four criteria for the OmniVision test:

1. Investment of funds: There must be an investment of money or something of value.

2. Joint enterprise: The investment must be an investment in a common enterprise, although the courts have different interpretations of the meaning of investment.

3. Expected profit: At least one party must anticipate the potential profit of the investment. This usually means that the efforts of a third party – the promoter or a third party associated with the sponsor – have a significant impact on the value of the investment.

4. Profits from the efforts of others: Profits must come primarily or exclusively from the efforts of others, not investors. Fundamentally, investors rely on the actions of others to get a return on their investment.

Let’s take an example to illustrate this: Let’s say you invest in a real estate investment trust (REIT) that pools money to buy, manage, and sell real estate assets. REITs are managed by a team of real estate professionals, which is the third party here. It decides which properties to buy, how to manage them, and when to sell. Your expectations of profit largely depend on the real estate expertise and work of this management team. This meets the criteria of the “Howey Test” because: 1) you invested money; 2) your investment is in a common enterprise (REIT); 3) you intend to profit from your investment; 4) The third party does the work.

If the SEC determines that a cryptocurrency or token is a security that falls within its regulatory purview, this will have far-reaching implications for those involved. They may face stricter regulatory requirements and compliance burdens. Therefore, the “Howey Test” is an important legal tool to navigate the complex regulatory environment of the financial and cryptocurrency markets.

The cryptocurrency market is regulated in all aspects

Regulators around the world are working to develop framework rules that balance innovation in cryptocurrency trading with consumer protection and market integrity. Here’s a glimpse of the various cryptocurrency market sectors and how they are regulated:

• Cryptocurrencies like Bitcoin: As a pioneer and most recognized cryptocurrency, Bitcoin can enact regulations focused on its use as a currency or commodity.
• Utility Tokens: Utility tokens provide access to products or services within a blockchain-based platform. Regulations can confirm that these tokens are not hidden securities and comply with consumer protection laws.
• ICOs: Similar to IPOs in the cryptocurrency space, ICOs are under scrutiny for bypassing traditional securities regulation. Regulations may confirm appropriate disclosures and better investor protection and anti-fraud provisions.
• Non-fungible tokens (NFTs): NFTs use blockchain to prove ownership or proof of authenticity of unique items. Regulations may be related to requirements for provenance verification, intellectual property rights, and potential securities classification. DAO: DAOs work through smart contracts on the blockchain, enabling collective and automated decision-making. Regulations may involve governance, legal liability, and registering it as a security.
• Stablecoins: Often pegged to traditional fiat currencies or other assets, stablecoins have received wider attention because they can reduce volatility typically associated with cryptocurrencies. Regulations may cover reserve management, disclosure practices, and treating certain exchanges as banks. The collapse of the Terra (UST) algorithmic stablecoin in May 2022 has increased concerns about other stablecoins and their regulation. Backers of Tether (USDT), the largest stablecoin, settled with the New York attorney general in 2021, paying $18.5 million and was fined $41 million by the Commodity Futures Trading Commission that same year for allegedly lying about its reserves. Tether now publishes limited details about its reserve holdings on a daily basis.
• Cryptocurrency exchanges and wallets: These platforms support the purchase, sale, and storage of cryptocurrencies. Regulations may focus on ensuring better AML and CFT measures, cybersecurity protocols, and consumer protection. For example, exchanges may have to register as broker-dealers and be subject to SEC supervision. If registered with the SEC, cryptocurrency exchanges must adopt technology to make their order books audit-compliant. They will also face strict order execution rules to prevent market manipulation.
• Crypto lending and decentralized finance (DeFi) platforms: Regulations can address licensing, consumer protection, and ensure compliance with AML and CTF laws for DeFi platforms and crypto lending businesses.
• Crypto Asset Management: Managing crypto assets on behalf of investors involves a complex regulatory environment that may be subject to securities laws and other financial regulations.
• Cross-border transactions: Given the global nature of the cryptocurrency market, finding a way to bridge regulatory differences in different countries through international cooperation could help disrupt illegal activities.

Each of these presents unique challenges for regulators. As the cryptocurrency market continues to evolve, adaptable and well-thought-out regulations can encourage consumer protection without eliminating the innovation the industry is known for.