- Luiza Coelho da Rocha
A Future of Uncertainty in Crypto Regulation
The days when investing in cryptocurrencies was an unknown, risky venture reserved for the most daring investors are long gone. According to a recent Pew Research study, nine in ten Americans have heard of cryptocurrencies, and 16 percent have invested, traded, or utilized cryptocurrencies directly. In Europe, according to estimates from the European Securities and Markets Authority, the market capitalization of all crypto assets has surged eightfold over the past two years, as of the beginning of 2022. Other markets are following suit, with an estimated 320 million crypto users globally. Not only has cryptocurrency transformed the concept of money, but it has also changed the way people spend and invest; it has even ventured into traditional banking activities – an industry long dominated by well-established players – by offering alternative and more profitable ways to borrow and save. Essentially, crypto has fundamentally altered the financial services industry by introducing new, more accessible investment options.
As is customary with disruptive technologies, financial regulators have fretted over effective ways to regulate crypto. The first stage in regulating a financial instrument is understanding its legal essence, which allows for the identification of the specific set of regulatory rules that apply to it. Historically, crypto assets have fallen into three main categories: payment tokens, which may be used as currency and to store value; utility tokens, which represent the right to purchase specific products; and security tokens, which provide equity-like investments in particular enterprises. Although they help regulators understand how the assets operate in the real world, these labels are not static, since a single token may perform different functions at different times. As a result, whenever there is doubt as to which rules apply to a specific token, the function executed by the token at the time – whether payment, utility or security – should be considered rather than its name.
Due to their characteristics, crypto tokens will often fall within the definition of “investment contracts”, one of the forms of securities mentioned in Section 2(a)(1) of the Securities Act of 1933, thereby making them subject to the Securities and Exchange Commission's oversight and monitoring. An “investment contract” is an intentionally broad concept that has been evaluated on a case-by-case basis since the 1946 Supreme Court decision in SEC v. Howey. In the original case, individual investors entered into a series of contracts for the purchase of plots of land where oranges were to be grown, as well as for the cultivation and management of the property by a third-party service, whose work would be responsible for generating profits. Based on these facts, the Court devised the “Howey Test” to assess the existence of an investment contract. To pass the test, an investment must (1) be a monetary investment (2) in a common enterprise (3) with a reasonable prospect of profits (4) to be earned from the efforts of others.
While digital currency and orange groves may seem to be unrelated, the SEC has established a strong case for requesting that digital coin offerings be registered as securities offerings since most crypto investments satisfy the Howey factors (they engage in an exchange of "value" – money for cryptocurrency – in a common venture in which investors' financial success is linked to the offeror's effort). With this broad net, as SEC Chair Gary Gensler underlined in his most recent statement on the matter, the SEC has been able to assure the market of its overall oversight of crypto tokens since its inception.
Although the Howey Test guidelines have established the SEC’s regulatory authority over tokens that fall under the “investment contract” definition, in a recent turn of events, both the Senate and the House of Representatives introduced legislation to give the Commodity Futures Trading Commission (CFTC) a role in regulating transactions of two of the market’s most popular crypto assets, Bitcoin and Ethereum.
A case-by-case review of each investment, as it is done today, does not convey an accurate set of rules on which crypto service providers can rely, but the new bills do little to create more certainty in defining whether crypto assets are securities or commodities. When it comes to their authority over financial services, the SEC and the CFTC already share hazy and ill-defined boundaries. Given that most crypto services deal with a variety of assets that may now be classified as securities or commodities under the new proposed rules, this new regulatory framework has the potential to increase the business and compliance costs associated with determining which sets of rules, if not both, apply.
One of the challenges exacerbated by this current legislative attempt is the inherent difficulty in regulating crypto assets due to their functional characteristics. An ad hoc evaluation of the function of the asset is primarily based on the assumption that if it talks and walks like a security, it is a security. It is an imperfect assessment, but it remains the most compatible technique developed thus far to determine which jurisdiction the transaction falls under, considering that crypto services and products not only come in a variety of shapes and sizes, but also evolve relatively quickly to keep up with accelerating market trends.
To complicate matters further, most crypto transactions occur in a decentralized environment, making regulation considerably more difficult. Financial operations that take place in the absence of traditional intermediaries and are backed only by computer programming platforms that validate transactions via collaborative efforts are especially challenging to monitor. While regulators often rely on the gatekeeper as a central point of information to safeguard market integrity, accessing focal information that may be used to track and prevent fraud is significantly more difficult in the absence of this figure.
With the current level of complexity and the rate at which financial services such as crypto assets evolve, one should consider whether the new legislation’s rigid regulatory approach is preferable to one that is flexible. For the time being, it appears that policymakers are failing to deliver the precise regulatory oversight they seek by failing to define the particular category into which every individual asset fits, although this may not even be the optimal standard. Consumer protection and market stability are common and legitimate reasons for regulating financial services, yet legislators and regulators appear to be focused on adapting traditional regulatory standards to new technology while overlooking the opportunity to consider innovative approaches to govern disruptive technologies that do not jeopardize market innovation.
Luiza Coelho da Rocha is an LL.M. candidate at NYU, where she also serves as a Graduate Editor for the NYU Journal of Law & Business and as the Brazilian Legal Society's Communications Officer. Before attending NYU, Luiza worked at a top boutique firm in Rio de Janeiro focusing on investment funds, securities law, and strategic corporate litigation. She is also a member of the Brazilian Bar Association's Capital Markets Commission.