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By: Elimelech Baruch

Cryptocurrencies have grown into a tremendously valuable asset class, with a total industry value of over two trillion dollars. From humble beginnings on message boards, these revolutionary ideas-qua-assets have become an official currency of El Salvador, with one poll stating that seventy-five percent of financial executives polled agree that cryptocurrency will be a strong alternative to the dollar within 10 years.

The rapid growth seems to have resulted in the government primarily playing catch up so far, busting fraudsters and bringing lawsuits for alleged securities violations. However, more proactive regulation is being called for in order to provide greater protection to consumers and clear guidance for entrepreneurs. Two major examples demonstrate how this lack of clarity has affected businesses: the lawsuits against Ripple Labs and Coinbase. The SEC’s suit against Ripple alleges that all the coins sold by the company were unregistered securities. Coinbase was advertising that it was intending to start a lending service, and was also threatened with a SEC suit for unlicensed security dealing.

Government officials recognize the need to regulate this industry, but confusion reigns as to the basic nature of the regulations. Gary Gensler, the SEC chief, has recently been vocal about this need for additional regulation in the cryptocurrency space. Recognizing the growth of the industry, Gensler called for increased regulation to protect consumers, especially in certain key areas such as stablecoins, so-called “defi lending”, and trading platforms. In a clear announcement of the state of regulatory confusion, Commodity Futures Trading Commission (CFTC) commissioner, Brian Quintenz, responded on Twitter with a call for the CFTC to be placed in charge of regulating the industry; claiming that only the CFTC has control over regulating commodities. The agency that regulates cryptocurrencies goes to the heart of the nature of the assets, and can have serious ramifications to investors, consumers, and creators.

There are three main frameworks that could be applied to regulating cryptocurrencies. The first, and most intuitive option, would be to treat cryptocurrencies as foreign currencies and regulate it just like forex. Although this would have some impact on the exchanges it should likely not have any impact on individual purchasers of bitcoin. However, although this is indeed a choice the government can make, it is unlikely for three reasons. First of all, Forex is not heavily regulated, and it is likely the government will want more control of this new technology in order to protect consumers. Secondly, the way people currently use cryptocurrencies is not for purchasing power—according to only 23,119 businesses currently accept crypto—rather most people who own them seem to be view them solely as an investment, buying and holding for long-term gain. Thirdly, crypto is often created, and designed for use in, the United States which leads to the following issue.

The U.S. government jealously guards its constitutionally endowed power of making money. 18 U.S.C. § 486 makes it a crime to create any alternate currency. This statute is not just an unenforced, out-of-date statute that remains on the books. In 2009 Bernard von NotHaus was arrested and charged under this statute for minting coins and selling them as an alternate currency. In 2014, Mr. von NotHaus was sentenced to six months house arrest.

That statute has an interesting loophole, in that it only applies to currencies made of metal and would not technically criminalize cryptocurrencies. Even the Stamp Act, 18 U.S.C. § 336, which does not limit itself to metals when it criminalizes circulating as currency “notes,” “tokens,” or “other obligations” worth less than one dollar, can likely be interpreted as only referring to physical objects. When these statutes were drafted no one envisioned a non-tangible currency that could compete with the dollar. Even Rand Paul’s 2013 bill that attempted to loosen the government's stranglehold on money and repeal Section 486 did not mention digital currencies; it was not a possibility Washington was ready to deal with. But although these statutes do not explicitly criminalize using cryptocurrencies as currency, they are a clear example of how the government protects its power of coinage. A wary investor needs to take into account the likelihood of the creation of a digital dollar, and the chance the government will try to quash competition to such currency. Although it may be a dim possibility that the government would try to criminalize such a flourishing industry, the potential still exists that if crypto truly is a domestic currency it could become a crime to mine or possess it.

The second framework, which is used by the government in some situations now, is treating crypto like a commodity. This approach creates a somewhat lax regulatory environment in which crypto is growing. However, the third approach some have proposed is that cryptocurrencies deserve to be treated as the more heavily regulated securities. For certain areas of the cryptocurrency industry, they appear to be right.

In SEC v. Howey Co., 328 U.S. 293 (1946), The Supreme Court gave a multi-factor test to ascertain if something is a commodity or a security. An investment is a security when there is an "investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others." These factors appear to be present in many types of cryptocurrency transactions.

First, most transactions involve an investment of money by trading money (either fiat currency or other crypto) for crypto. Second, although various interpretation of “a common enterprise” are used, most situations where multiple people share in a profit, especially if they are relying “on the efforts of others,” will be considered a common enterprise.” Thirdly, as mentioned above, most bitcoin is not used for e.g. buying groceries. Most cryptocurrencies seem to be bought with a “reasonable expectation of profit.” Finally, many types of cryptocurrency transactions seemingly rely on the efforts of others, as follows.

Merely buying and holding digital tokens does not seem to rely on the efforts of others—even if the token relies on blockchain technology to function that is not where the profit comes from. The profit comes from market valuation, which would not be included in the factor of "derived through the efforts of others." However, there are many other aspects of cryptocurrencies that would fulfill the Howey test. For example, many cryptocurrencies are started by teams of people who manage and develop the currency. Similarly, sometimes a company will offer an Initial Coin Offering ("ICO") where investors can buy coins of a nascent cryptocurrency. Alternatively, a creator may choose to make a coin a stablecoin: a coin pegged to the value of an external asset or with the number of tokens created controlled to keep the value steady. Those directors are creating the value of the coins, either by working to create uses for the coin or by controlling the supply of the coin. When this last prong of the Howey test is fulfilled, and investors are relying on a third party (the company starting the currency) to provide profits on their investment, a coin should be considered a security—with all the attendant regulation. This is where the SEC alleges Ripple ran afoul of securities laws.

One final example is the burgeoning field of cryptocurrency lending. Coinbase, the cryptocurrency juggernaut, recently received a cease-and desist letter from the SEC regarding its plans to open a crypto loan service. True ”defi-lending” with no middleman would not ”rely on the efforts of others.” But many such services rely on a company pooling the loan money together, such as Coinbase's plan to bank other's coins or tokens and return profits to the coin owners. This would seem to be a classic example of a security that falls under the SEC's regulation.

One Congressman, Rep. Don Beyer, recently put forth a bill that would solve the jurisdictional dispute. In this bill the SEC and CFTC would share jurisdiction over the crypto space, with the commodity aspects going under the CFTC and the security aspects going under the CFTC. There would also be a joint rulemaking to clarify the status of most crypto assets. It is essential clarity is brought to this space, and the current, outdated, system is not providing the needed guidance to businesses, nor protection to consumers. But this specific, split-the-baby bill seems unwieldy, and has not developed far yet. To be clear, a new bill is not required; the SEC or CFTC, or any other of our existing financial protection agencies, could deem crypto (or aspects thereof) to fall under the scope of their enabling law, and promulgate regulations at any time; and indeed, have already begun doing so.

The regulatory environment is still in flux, but as the cryptocurrency industry’s blossoms grow it is necessary for protective legislation to grow around it. Statements by regulatory officials have left it unclear what form that regulation will take. Cryptocurrency investors or entrepreneurs would do well to prepare for any curve balls that may be thrown their way. Some common practices are almost certainly going to be, or already are, treated by the government as securities and regulated as such. Other practices are currently treated as commodities, and may remain that way. If cryptocurrencies become more fungible and commonly used that still may change and become less regulated as forex, or potentially become banned altogether as an alternate currency. The regulatory future is unclear, and may take a variety of different forms, but it is certain regulatory changes are coming.