How SEC Regs Will Change Cryptocurrency Markets

Distrust of governments' traditional role as issuers of so-called "fiat money" has fueled the phenomenal growth of cryptocurrency markets in recent years. Now that growth is rapidly educating the crypto industry about another key government function—that of regulating financial markets and securities trading.

The U.S. Securities and Exchange Commission (SEC) is leading the push to subject cryptocurrency markets to the full spectrum of financial regulations the agency oversees. In April 2022, SEC Chair Gary Gensler said the top five exchanges accounting for 99% of cryptocurrency trading "likely are trading securities" and should have to register with the SEC and comply with applicable laws. Gensler also urged increased enforcement of financial regulations for stablecoins and other crypto tokens. And in May 2022, the SEC announced it would increase the staff of its Cyber Unit from 30 to 50 and rename it the Crypto Assets and Cyber Unit to bolster the enforcement of regulations in cryptocurrencies.  

The SEC's enforcement push will fundamentally change how cryptocurrency markets work. Here are three major changes to expect sooner than later.

New Tokens May Face Regulation

The SEC made its stance on tokens clear during the initial coin offering (ICO) boom in 2017, when it concluded DAO tokens were investment securities. In 2020 the SEC sued Ripple Labs Inc. and two of its executives, alleging Ripple violated securities laws by selling the XRP token without complying with registration and disclosure requirements for securities offerings. Many ICO issuers have been fined or settled out of court.

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 finance (DeFi) to nonfungible tokens (NFTs).

Like the ICOs, many of the new projects appear to sidestep securities laws either because they have no central administrator or because the tokens represent collectibles 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 in August 2021 by settling with platform DeFi Money Market over allegations it handled sales totaling more than $30 million of digital tokens that should have been registered as securities. The project's two founders agreed to disgorge $12.8 million and to pay fines of $125,000 each.

In February 2022 BlockFi Lending LLC agreed to pay $100 million in a settlement with the SEC and 32 states for failing to register as securities its BlockFi Interest Accounts, which paid a variable interest rate on cryptocurrency loans. BlockFi also agreed to register a new lending product with the SEC.

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.

In his April 2022 speech, SEC Chair Gensler said most crypto tokens likely qualify as investment contracts under the Howey Test definition set out in a U.S. Supreme Court ruling: "an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others."

While the SEC has yet to announce any enforcement actions targeting NFTs specifically, it has reportedly subpoenaed NFT creators as part of its probe.

Exchanges May Have to Register as Broker-Dealers

In a hearing before the Senate Banking Committee in September of 2021, Gensler said crypto exchanges should have to register as securities exchanges. He repeated the call in April 2022. "These crypto platforms play roles similar to those of traditional regulated exchanges. Thus, investors should be protected in the same way," Gensler said.

Crypto exchanges have been historically opaque, allowing their operators to generate profits without regulatory oversight or accountability. 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 adopt technology systems to make their order books audit-compliant. They would also face strict rules on order execution to prevent market manipulation.

In his speech in April 2022, Gensler highlighted the exchanges' crypto custody issues as another concern following thefts of more than $14 billion in crypto assets during 2021.

In the past, many exchanges have chosen to avoid U.S. regulation by locating abroad and rejecting U.S. customers. However, many exchanges accept compliance as the cost of access to the lucrative U.S. market. Some cryptocurrency exchanges, such as Coinbase have sought to comply with SEC rules by acquiring U.S.-registered broker-dealers.

Stablecoins May Face Greater Scrutiny

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

The May 2022 collapse of the Terra (UST) algorithmic stablecoin has heightened concerns about other stablecoins and their regulation. Backers of Tether (USDT), the largest stablecoin, paid $18.5 million in a settlement with the New York Attorney General in 2021 and incurred a $41 million fine by the Commodity Futures Trading Commission the same year over allegations they misrepresented its reserves. Tether now publishes limited details about its reserves holdings daily.

"What backs these tokens so we can make sure that these holdings can actually be converted to dollars one-to-one?" Gensler asked in April 2022. Stablecoins may pose systemic risks to the crypto ecosystem and beyond while facilitating money laundering and sanctions evasion, the SEC chair added.

Since the SEC considers crypto exchanges de facto securities brokers, it is also likely to view most stablecoin trades as securities transactions. Although the SEC has not yet launched litigation, the regulator has indicated it may be among the government agencies probing Tether.

The Bottom Line

In announcing recent crypto settlements, the SEC has taken pains to underscore its willingness to work with co-operative industry participants. The goal, Gensler has noted, is to extend to crypto the investor protections that have ensured the success of U.S. securities markets. The growing number of regulatory settlements by cryptocurrency companies suggests that message is starting to resonate.

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.