Given the substantial growth in digital asset investments this year, intermediaries offering trading and lending services are now the target of regulatory and enforcement focus that we expect will continue in the coming months and years. Recent examples of this increased scrutiny of digital asset service providers and intermediaries include
- Securities and Exchange Commission (SEC) Chair Gary Gensler’s keynote for the American Bar Association Derivatives and Futures Committee, which touched on the regulation of cryptocurrencies, including statements that decentralized finance (DeFi) are implicated by securities laws
- the letter from Sen. Elizabeth Warren, D-Mass., to Chair Gensler requesting further information about the SEC’s authority to regulate cryptocurrency exchanges
- recent actions by state securities regulators against the financial services platform BlockFi related to a digital asset lending program alleging that these products are unregistered securities offerings
- the SEC settlement with Coinschedule, which operated a token-offering website and failed to disclose the compensation it received from token issuers in violation of antitouting provisions
Gary Gensler Keynote Reaffirms Howey and Focus on DeFi
On July 21, 2021, Chair Gensler delivered prepared remarks during the Virtual Derivatives and Futures Law Committee Mid-Year Program. Gensler spoke about security-based swaps and financial technology with respect to crypto assets, stating that “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 platforms — whether in the decentralized or centralized finance space — are implicated by the securities laws and must work within our securities regime.” Chair Gensler continued in the Q&A session after his speech, reaffirming the Howey Test’s1 application to cryptocurrencies. Gensler said that in relation to cryptocurrencies, the SEC’s goal is to protect investors from fraud and manipulation and that they will continue to work with Congress, the Commodity Futures Trading Commission, and others in order to create stronger protections for investors.
Chair Gensler’s comments signal an interest by the SEC in regulating DeFi.2 These are not, however, Gensler’s first statements about DeFi. On May 26, 2021, in prepared testimony before the House Appropriations Committee, Chair Gensler stated that “crypto lending platforms and so-called Decentralized Finance (“DeFi”) platforms raise a number of challenges for investors and the SEC staff trying to protect them.” It is uncertain how Chair Gensler plans to regulate DeFi, but intermediaries offering such services should prepare for upcoming regulations and possibly enforcement actions.
Elizabeth Warren Letter to Chair Gensler Regarding Cryptocurrency Exchange Regulation
On July 7, 2021, Sen. Warren, a member of the Senate Banking Committee, sent a letter to Chair Gensler requesting information concerning the SEC’s authority to regulate cryptocurrency exchanges and questioning whether Congress needs to act to ensure that the SEC has proper authority to regulate cryptocurrency exchanges. Sen. Warren asked Chair Gensler to provide information such as whether “cryptocurrency exchanges are currently operating in a ‘fair, orderly, and efficient’ manner,” whether the characteristics of assets cryptocurrency exchanges “warrant additional investor and consumer protections for cryptocurrency exchanges relative to those provided for traditional exchanges,” and whether “the characteristics of decentralized cryptocurrency exchanges warrant additional investor and consumer protections relative to those needed for centralized cryptocurrency exchanges.”
State Securities Regulators Issue BlockFi Cease and Desist Related to Its Digital Asset Lending Program
Various state securities regulators have announced in July that they are investigating BlockFi for selling interest-earning cryptocurrency accounts.3 Many of these orders center around BlockFi’s offering of interest-earning cryptocurrency accounts, while BlockFi’s website states that it is a U.S.-regulated entity (some of BlockFi’s loan products appear to be licensed under state licensing requirement for money services businesses). BlockFi, however, disagrees with the assessment that its product is a security and believes its product is lawful and appropriate. The use of pooled interest-earning cryptocurrency accounts is a current focus for state securities regulators on the basis that these programs may be unregistered securities offerings.
SEC’s Coinschedule Settlement Highlights Focus on Intermediaries and Need for More Guidance on What Digital Assets Are Securities
On July 14, 2021, the SEC announced a consented-to cease and desist order with Coinschedule for violating Section 17(b) of the Securities Act, which makes it illegal for one to tout securities without disclosing the fact that one is getting paid and how much. Coinschedule.com was accessible in the United States from 2016 to August 2019 and rated digital asset tokens with a “trust score” that Coinschedule claimed reflected its “credibility” and “operational risk,” but Coinschedule failed to disclose that token issuers paid Coinschedule to profile their token offerings. However, a public statement by SEC Commissioners Hester M. Pierce and Elad L. Roisman critiqued the SEC’s failure to “explain which of those digital assets touted by Coinschedule were securities, an omission which is symptomatic of our reluctance to provide additional guidance about how to determine whether a token is being sold as part of a securities offering or which tokens are securities.”
As anticipated, federal and state regulator focus on digital asset securities intermediaries is growing through informal guidance or enforcement inquires. This increased focus on digital asset intermediaries and lending programs means that market participants should be extra diligent with their compliance efforts. While no one factor is dispositive, market participants should review enforcement actions and orders by federal and state securities regulators in this space along with the existing SEC regulations applicable to their products and services in advance of launch.
1 SEC v. W.J. Howey Co., 328 U.S. 293 (1946); see also SEC FinHub’s Digital Asset Framework: A Guide for Issuers and Secondary Trading Markets, Sidley Austin LLP (April 26, 2019), https://datamatters.sidley.com/wp-content/uploads/2019/04/SEC-FinHubs-Digital-Asset-Framework-A-Guide-for-Issuers-and-Secondary-Trading-Markets.pdf.
2 See Alyssa Hertig, What is DeFi, Coindesk (Sept. 18, 2020), https://www.coindesk.com/what-is-defi (“DeFi is short for ‘decentralized finance,’ an umbrella term for a variety of financial applications in cryptocurrency or blockchain geared toward disrupting financial intermediaries. DeFi draws inspiration from blockchain, the technology behind the digital currency bitcoin, which allows several entities to hold a copy of a history of transactions, meaning it isn’t controlled by a single, central source”).
3 The Alabama Securities Commission, the New Jersey Bureau of Securities, and the Texas State Securities Board have all issued orders or notices relating to BlockFi’s alleged use of unregistered securities. Additionally, BlockFi announced that Vermont has issued an order related to this issue, although the details of the order are currently not public. See Disclosures and Complaints, BlockFi, https://blockfi.com/disclosures-and-complaints/ (last visited July 26, 2021).