How SEC Regs Will Change Cryptocurrency Markets

A major reason for the phenomenal growth of cryptocurrency markets in recent years has been the absence of clear regulations. That might change soon. Increasingly, the U.S. Securities and Exchange Commission (SEC) is providing broad hints of its intent to enforce regulations on the space. 

Following the 2017 DAO report, the SEC warned that it regards many cryptocurrencies as investment securities, especially those issued in an initial coin offering (ICO). Security trades are strictly regulated, meaning that anyone who issued, sold, or even traded these tokens could be in violation of investment laws. While technology and trends change quickly in the blockchain space, securities laws do not.

For example, Ripple is now deep in litigation surrounding its XRP token, which it continued to sell on the market after the SEC issued its warning. Many ICO companies have been fined or settled out of court.

The entry of the SEC will fundamentally change the way in which cryptocurrency markets work. Here are three changes to expect in the coming years.

Key Takeaways

  • In 2017, the Securities and Exchange Commission warned that many blockchain tokens represented investment securities, which must be registered with the SEC.
  • Many crypto issuers have already been subject to SEC enforcement.
  • Gary Gensler, Chairman of the SEC, has indicated that many crypto exchanges should register with the SEC as securities trading platforms.
  • Stablecoins may also face regulatory scrutiny, since they are likely to be involved in securities trades.
  • While there are many new types of tokens to invest in, they are still subject to securities laws.
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What Is Cryptocurrency?

New Tokens May Face Regulation

Although the SEC has directed most of its enforcement actions against ICOs, recent years have seen the introduction of new types of blockchain tokens, from decentralized lending (DeFi) to nonfungible tokens.

Many of the new projects appear to sidestep existing regulations, either by working without a central operator ("decentralization") or because the tokens represent something innocuous, like in-game objects or digital artworks. However, to the extent that these tokens are sold as investments, they are still subject to securities laws.

The SEC announced its first enforcement action in the decentralized finance space on Aug. 6, 2021, with charges against the platform DeFi Money Market. The project's founders agreed to disgorge more than $12 million in illegal gains, as well as comparatively modest fines of $125,000 each.

Although sometimes marketed as collectibles, artworks, or in-game objects, NFTs may be subject to securities laws if they are purchased as investments.

Regulators may soon bring securities laws to bear on NFTs as well. Hester Peirce, one of the more crypto-friendly commissioners on the SEC, has warned that some NFTs could get investors in trouble with the law–especially when they begin trading fractionalized shares of a token. While the SEC has yet to announce any enforcement actions, at least one NFT operator is facing litigation from investors who believe they were sold unregistered securities.

Exchanges May Have to Register as Broker-Dealers

In a hearing before the Senate Banking Committee in September of 2021, Gary Gensler, Chairman of the SEC, suggested that crypto exchanges should have to register as securities markets. "Make no mistake," he told the committee. "To the extent that there are securities on these trading platforms, under our laws they have to register with the commission unless they qualify for an exemption."

Crypto exchanges have been historically opaque, allowing their operators to generate profits without accountability before governments or their customers. Many exchanges have been accused of wash trading, front running, or freezing customer balances.

If registered with the SEC, crypto exchanges would be forced to record their trades and adopt technology systems to make their order books audit-compliant. They would also face strict rules on order execution to prevent market manipulation.

In the past, many exchanges have chosen to avoid U.S. regulations by moving abroad and restricting access to American customers. However, many exchanges accept compliance as the cost of access to the lucrative U.S. market. After it was accused of insider trading, Coinbase, North America’s largest cryptocurrency exchange, was the first major trading venue to fall in line and register as a broker-dealer.

Stablecoins May Face Greater Scrutiny

Another likely focus for regulators is stablecoins, blockchain tokens whose value is pegged to the dollar or other fiat currency. Most stablecoins back their peg by keeping large reserves of cash, treasuries, or other low-risk assets.

However, some stablecoin issuers have been accused of manipulating the market, by buying cryptocurrency in order to raise prices. In October of 2021, Tether, the largest stablecoin, was fined $41 million by the Commodity Futures Trading Commission for misrepresenting the nature of its reserves. Although ostensibly backed by cash, a substantial portion of tether's reserves consisted of unsecured debt, third-party bank accounts, and other cryptocurrencies. The settlement followed similar litigation by the New York Attorney General's office.

3.87%

The amount of cash backing in Tether (USDT)'s reserves, as of May 13, 2021.

Stablecoins may also attract the attention of the SEC. Since the Commission considers crypto exchanges as de facto securities brokers, that means the majority of stablecoin trades are also securities transactions. Although the SEC has not yet launched litigation, the regulator has indicated that it may also be investigating the largest stablecoin.

Investing in cryptocurrencies and other Initial Coin Offerings ("ICOs") is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein. As of the date this article was written, the author owns 0.01 bitcoin.

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