What Can Regulators Do About Crypto?

The recent collapse of FTX has cryptocurrency investors floundering to salvage their assets and regulators trying to rectify the harm brought about in a murky regulatory environment.

If crypto were government currency being issued by banks, or if it were securities where FTX were a registered securities exchange, then the type of risky lending that FTX did to its affiliate, Alameda Research, would be blatantly unlawful and customer deposits would have been protected by numerous statutes and regulations.

Instead, the Securities and Exchange Commission and the U.S. Department of Justice are trying to right a wrong using the limited regulatory tools at their disposal. The Justice Department is pursuing claims of criminal fraud, and the SEC is investigating potential securities law violations.

But Wall Street regulators and investigators should also be focused on preventing and protecting investors from future wrongdoing and risk.

Here’s what I believe policymakers and regulators can do:

1) The SEC should say which cryptocurrencies are securities.

The SEC should state, via either regulation or guidance, to which cryptocurrencies securities laws apply. Right now, it’s assuming that most cryptocurrencies satisfy the Howey Test, making them securities. The Howey Test is a four-prong test to determine whether a transaction qualifies as a security. The four elements are: (1) an investment of money, (2) in a common enterprise, (3) with the expectation of profit, and (4) to be derived from the efforts of others. When these elements are satisfied, the transaction is considered a security.

Investors need transparent, consistent guidance that explains why certain cryptos are or are not securities under this test. Such clarification would help promote predictable application of the law. Plus, it would be preferable to the current landscape of demonstrating what the rules are via the latest enforcement action.

2) The SEC should definitively state that it will regulate crypto as it does other securities today, instead of exhibiting its views via enforcement actions.

Regulating crypto through enforcement has now become a long-standing pattern and has effectively made securities laws apply to crypto, a reality the industry must accept. Plus, in light of recent fraud, regulating crypto through securities laws is necessary for investor protection.

It seems the current tailwind is likely to culminate in regulations for crypto on par with those for securities today. Further, such regulations are better for the development of the asset class and industry players in it as they would bring clarity to the current regulatory conditions for crypto.

The SEC has been cracking down on crypto, bringing about 100 crypto enforcement actions since its first in 2013. The bulk of these actions occurred in more recent years. For instance, there was only one action in 2016 compared with the 19 actions brought in 2022.

The 2016 action focused on bitcoin market participants SecondMarket Inc. and Bitcoin Investment Trust, charging them with manipulative activities relating to a securities offering and resulting in a fine of $54,000. By contrast, a September 2022 action ordered Sparkster, Ltd. and its CEO, Sajjad Daya, to pay a fine of $35 million. The fine was paid to a harmed investor fund for the unregistered offering and sale of crypto assets.

In fact, the majority of crypto enforcement actions brought by the SEC have been for the unregistered offering and sale of crypto assets, manifesting SEC chair Gary Gensler’s belief that many cryptocurrencies are, in fact, securities and should, therefore, be registered with the SEC.

Just last week, the SEC charged Terraform and its CEO, Do Kwon, with violating antifraud statutes by misleading investors and for participating in unregistered transactions.

Another type of securities violation that the SEC has investigated in relation to crypto is insider trading. In July 2022, the SEC brought an action against Ishan Wahi, an employee of Coinbase COIN. Wahi repeatedly tipped the timing and content of upcoming listings and made a profit of $1.1 million. Even though Coinbase is not registered as a securities exchange, the SEC sent a signal that insider trading in crypto is not permitted.

Likely emboldened by these victories, the SEC has pursued claims that blur the securities status of crypto even further. When reality TV star Kim Kardashian was charged earlier this year for promoting crypto tokens on social media without disclosing she had been paid for this, the SEC essentially applied the conclusion that the coin is a security in fining Kardashian since securities regulations require disclosure of payments for endorsements. Kardashian agreed to settle the charges and pay $1.26 million in penalties, disgorgement, and interest.

With these types of enforcement actions, the SEC is demonstrating that it is willing and able to bring actions against crypto players for traditional securities violations and that it has power over the crypto enforcement market. Yet, a clear statement detailing why certain coins, such as bitcoin, are not considered securities by the SEC, while others are, has not been provided to investors.

3) The SEC should prioritize investor protection in considering future regulation.

On Feb. 15, the SEC voted 4-1 to propose changes to the obligations of Registered Investment Advisors relating to the custody of alternative assets, including crypto, managed by an investment advisor. The proposal amends the current rule to include “funds, securities, and other positions held in a client’s account” to the definition of an asset that it would require investment advisors to maintain with a qualified custodian. Because most crypto assets trade on platforms that are not qualified custodians, if an advisor manages such assets, the advisor would be in violation of the proposed rule.

The proposal demonstrates that the SEC is moving toward making rules when it comes to crypto, rather than what commissioner Mark Uyeda called a historic use of “enforcement actions to introduce novel legal and regulatory theories.” While the specific investor protection benefits of this rule are still to be illuminated through comment, surely telling investment advisors what is expected of them proactively is preferable to punishing them later for not being diligent regarding crypto assets when they did not expect to be responsible for them in the same way as established securities.

Firms Should Prepare for Cryptocurrencies to Be Regulated by Securities Laws

True investor protection involves proactively creating a predictable regulatory regime—not reacting to punish once investors have already been harmed and the harm cannot be fully remedied. Firms are likely best off preparing for a world where most to all cryptocurrencies will be regulated by the securities laws, and the SEC should state as much directly and formally. The SEC should also consider whether and how new regulations are needed for investor protection, given how much it has managed to do under existing securities regulations.

Editor’s note: Jasmin Sethi is associate director of policy research at Morningstar. The views expressed here are her own.