Paul Peter Nicolai
Cryptocurrency Enforcement Has Arrived
Updated: Jan 3
The rise of cryptocurrencies and digital assets has given rise to a crucial question: which federal regulator - the SEC or the CFTC - will be primarily responsible for regulating the use of crypto and crypto-related activities?
The SEC has the authority to govern securities, defined as investment contracts. Currency is not a security. To the extent a digital asset is determined to be a note, investment contract, or another type of security, it would be subject to SEC oversight and applicable securities laws.
Whether a digital asset is considered an investment contract depends on a Supreme Court test that says an “investment contract” exists where (i) there is the investment of money; (ii) in a joint enterprise; (iii) with a reasonable expectation of profits to be derived; (iv) from the efforts of others. The Court emphasized whether an investment contract exists lies in the circumstances surrounding the contract and how it is offered, sold, or resold.
The SEC has applied that test to crypto. The SEC looks to the nature of the transaction rather than the item sold to determine whether there is an investment contract. If digital assets are sold as part of an investment to non-users by promoters to develop the enterprise, they can, and most often are, a security – because it evidences an investment contract.
Networks on which a coin is sufficiently decentralized, where the purchasers no longer reasonably expect a person to carry out essential managerial efforts, are not investment contracts.
SEC’s views on its ability to regulate crypto have not changed in recent years. SEC continues to urge legislators to grant the SEC more scope to oversee crypto to enhance investor protection.
The CFTC has full regulatory authority over derivatives transactions (including swaps, futures, and options) and more limited authority to regulate fraud and manipulation in commodities markets. The CFTC made its first official statement on its jurisdiction over digital assets in 2015. Later, in 2016, the CFTC cemented its position in an enforcement action stating that bitcoin and other virtual currencies are encompassed in the definition of a commodity and properly defined as commodities, and are subject as a commodity to the applicable provisions of the Commodity Exchange Act and CFTC Regulations
By 2019 the CFTC, using a New York court decision that found that Bitcoin, Ether, Litecoin, and Tether tokens, along with other digital assets, are encompassed within the broad definition of a commodity, CFTC said it was widely accepted that established and broadly decentralized virtual currencies, like Bitcoin and Ether, are commodities and not currencies.
The jurisdictional authority of the CFTC to regulate virtual currencies as commodities do not preclude other agencies from exercising their regulatory power when virtual currencies function differently than derivative commodities.
Even though the CFTC has determined that virtual currencies are commodities, the CFTC’s jurisdiction over virtual currency markets is limited to policing fraudulent and manipulative activities in interstate commerce. Beyond this enforcement authority, the CFTC does not generally oversee virtual currency transactions or exchanges that do not involve margin, leverage, or financing and cannot, for example, require a spot crypto exchange to register with the CFTC.
The CFTC is said to have enforcement jurisdiction over cryptocurrency and digital assets but not registration jurisdiction.
Despite the CFTC’s lack of registration jurisdiction over spot markets, to the extent a cryptocurrency product in a spot market provides for margin or leverage and is offered to retail customers, the product would generally be considered a futures contract subject to CFTC jurisdiction. Specifically, to the extent that spot trading provides for margin and is offered to retail U.S. persons, it falls under the CFTC’s broader registration jurisdiction.
There is heightened regulatory scrutiny for margined or leveraged products.
Meanwhile, enforcement has begun.
In 2020, SEC initiated an enforcement action against Ripple Labs Inc. (Ripple), alleging that the sale of Ripple’s digital token (XRP), worth approximately US$1.3 billion, was an unregistered securities offering. The SEC alleged Ripple distributed billions of dollar’s worth of XRP as employee compensation in place of cash to finance its business. Ripple provides blockchain-based networks that facilitate low-cost payments between financial institutions. XRP is a digital asset used to represent the transfer of value across networks.
The SEC claims XRP is a security whose offer and sale can be made only under a statutory prospectus and an effective registration statement. Because Ripple did not file a registration statement, its investors have a rescission right. The SEC alleged that XRP met the investment contract test by claiming that the principal reason for anyone to buy XRP was to speculate on it as an investment, that Ripple reflected a joint enterprise, and that investors reasonably expected to profit from those efforts.
It also claims that because Ripple did not provide a registration statement, it made material misstatements and omissions of information required of securities issuers when soliciting public investment. In January 2022, the judge presiding over the case did grant Ripple’s request for privileged SEC documents, which reflect the SEC’s determination on its classification of XRP as a security.
In February 2022, the SEC charged BlockFi Lending LLC (BlockFi) for failing to register the offers and sales of BlockFi Interest Accounts (BIAs) under the Securities Act of 1933 (Securities Act).20 In addition, the SEC stated that BlockFi met the definition of “investment company” in the Investment Company Act of 1940 (1940 Act) for at least a period but failed to register with the SEC as it was required to do because it issued securities and acquired securities. The failure of an investment company to register with the SEC (absent an exemption or exclusion) has serious consequences, including that all of its contracts are unenforceable.
First, the SEC determined BIAs were sold as securities because (i) BlockFi promised BIA investors a variable interest rate, which was determined by BlockFi periodically, in exchange for crypto assets loaned by the investors, who could demand that BlockFi return their loaned assets at any time, (ii) investors in the BIAs had a reasonable expectation of obtaining a future profit from BlockFi’s efforts in managing the BIAs based on BlockFi’s statements about how it would generate the yield to pay BIA investors interest, and (iii) investors also had a reasonable expectation that BlockFi would use the invested crypto assets in BlockFi’s lending and principal investing activity and that investors would share profits in the form of interest payments resulting from BlockFi’s efforts. As a result, the SEC found BIAs to be investment contracts under the Securities Act. By offering and selling the BIAs to the general public to obtain, crypto assets for the general use of its business and promote the BIAs as an investment, the SEC determined that BlockFi offered and sold securities, thereby acting as an issuer, without filing a registration statement or qualifying for an exemption from the registration requirements, in violation of the 1940 Act.
Additionally, the SEC found that BlockFi’s activities and holdings made it an investment company under the 1940 Act for almost two years.
This law generally defines an investment company as being any issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities and owns or proposes to acquire investment securities having a value of over 40% of the value of the issuer’s total assets on an unconsolidated basis. In the SEC’s view, the fact that BlockFi lent crypto assets to institutional and corporate borrowers, lent U.S. dollars to retail investors, and obtained value by offering and selling BIAs into equities and futures, in addition to its substantial holdings of investment securities (representing more than 40% of the value of BlockFi’s total assets on an unconsolidated basis) caused BlockFi to be an unregistered investment company. As a result, the SEC alleged that BlockFi violated Section 7(a) of the 1940 Act by engaging in interstate commerce while failing to register as an investment company with the Commission.
BlockFi agreed to pay a 50 million penalty to settle the SEC charges and ceased its unregistered offers and sales of BIAs. BlockFi further agreed to attempt to bring its business within the provisions of the 1940 Act within 60 days. BlockFi’s parent company announced that it intends to register under the Securities Act of 1933 the offer and sale of a new lending product.
Although Blockfi is the first case of its kind brought by the SEC concerning a crypto lending platform, it may be a harbinger of things to come, mainly as the SEC has expressed eagerness to regulate the crypto market and recently almost doubled the size of the Division of Enforcement’s Crypto Assets and Cyber Unit.
In September 2021, Coinbase announced that the company was under investigation by the SEC due to its cryptocurrency lending practice. This demonstrates that the cryptocurrency and digital asset markets are under intense scrutiny from regulators.
Further investigations and enforcement actions are pending against Celsius Network LLC, Gemini Trust, and Voyager Digital for similar interest-bearing account offerings.
The CFTC has initiated several enforcement actions related to crypto and has mainly focused on exchanges that offer crypto derivatives to U.S. persons who are not registered with the CFTC.
In October 2020, the CFTC charged HDR Global Trading Limited, 100x Holding Limited, ABS Global Trading Limited, Shine Effort Inc. Limited, and HDR Global Services (Bermuda) Limited’s (BitMEX) owners with illegally operating a cryptocurrency derivative trading platform and with anti-money laundering violations due to providing U.S. persons with crypto derivatives.
Several owners of BitMEX also were charged with related criminal offenses. BitMEX replaced its leadership team after the charges were announced, and its new CEO has recently stated that BitMEX plans to provide spot trading, brokerage, and custody services.
In August 2021, the CFTC announced a consent order in the BitMEX case. Under the consent order, BitMEX paid a $100 million civil monetary penalty and agreed to stop offering futures or other related crypto commodity contracts in the United States until it secures appropriate licensure from the CFTC. BitMEX also agreed to establish sufficient “know your customer” and AML procedures.
Similarly, the CFTC had previously sued Laino Group Limited (PaxForex), an international company registered in Saint Vincent and Grenadines, which operated PaxForex and alleged that its information technology infrastructure had been deployed to data centers in New York and London. In June 2021, the Southern District of Texas entered an order of final judgment against PaxForex for violating CEA provisions regarding retail investors and offering unregistered leveraged transactions in cryptocurrencies. Specifically, the order notes that the website format solicited the U.S.
Customers by providing a drop-down menu with an option of selecting the United States as the customer’s country of residence. The PaxForex website now states that the information is not intended to be addressed to U.S. citizens.
In September 2021, the CFTC settled charges against Payward Ventures, Inc. d/b/a Kraken (Kraken) for illegally offering margined retail commodity transactions (which are presumptively treated as futures contracts unless certain mitigating factors exist) in digital assets, including Bitcoin, and for failing to register as a futures commission merchant (FCM). Specifically, the CFTC alleged that Kraken offered margined digital assets to U.S. customers who were not eligible contract participants on an exchange that was not registered as a derivatives contract market with the CFTC. In the program, Kraken supplied digital assets to customers when they purchased the assets using margin. Kraken then required the customers to exit their positions and repay the assets received to trade on a margin within 28 days. Customers could not transfer assets away from Kraken until they satisfied their repayment obligation, and Kraken could force liquidation if repayment were not made within 28 days. As a result, the CFTC ordered that Kraken pay a $1.25 million civil monetary penalty and cease further CEA violations.
In October 2021, the CFTC issued an order against iFinex Inc., BFXNA Inc., and BFXWW Inc. (d/b/a Bitfinex) for violations of Sections 4(a) and 4(d) of the CEA. Specifically, the CFTC alleged that Bitfinex offered a spot and leveraged, margined, or financed trading in Bitcoin, Ether, and Tether to U.S. customers. The CFTC further alleged that the respondents transacted in retail commodity transactions without registering as an FCM.
The CFTC announced that the Tether stable coin is a commodity, reaffirming that it has enforcement jurisdiction over this type of cryptocurrency. The CFTC ordered that Bitfinex pay a $1.5 million civil monetary penalty and required Bitfinex to implement other systems to prevent unlawful retail commodity transactions.
The CFTC has also initiated enforcement actions related to tokens. On 15 October 2021, the CFTC settled charges against Tether Limited, Tether Operations Limited, and Tether International Limited (d/b/a Tether) for violating the CEA by misrepresenting customers regarding its U.S. dollar-denominated stablecoin Tether. Specifically, CFTC alleged that Tether made misrepresentations to U.S. customers that Tether maintained sufficient fiat reserves to back every one of its stablecoins in circulation one-to-one with the equivalent amount of corresponding fiat currency held in reserves by Tether and that Tether would undergo routine, professional audits to demonstrate that it maintained 100% reserves at all times. The CFTC alleges that, in actuality, Tether failed to maintain fiat currency reserves in accounts in Tether’s name or in an account titled and held in trust for Tether to back every U.S. dollar tether token in circulation. The CFTC has ordered that Tether pay a $41 million fine.
In February 2021, Coinbase reported that it was under investigation by the CFTC for alleged reckless false, misleading, or inaccurate reporting and washed trading by a former employee. In March 2021, Coinbase agreed to a settlement order with the CFTC in which Coinbase did not admit or deny wrongdoing and agreed to pay $6.5 million.