Regulators once again offered piecemeal guidance, while focusing on risks and enforcement. Meanwhile, innovation and institutional adoption took off.
Last year, Latham & Watkins sounded a hopeful note that 2020 would provide a clearer vision than 2019 for the regulation of digital assets in the US. In the wake of the emergence of COVID-19, priorities changed, along with forecasts and expectations. The second and third quarters of 2020 had regulators of all stripes in triage mode, and any attention they may have directed at cryptoassets was understandably shelved. On the other hand, far from sidelining digital asset growth, the pandemic appears to have spurred further innovation and adoption. Regulators are now continuing to reckon with an asset class that remains without a comprehensive regulatory framework in the US.
A Proposed Safe Harbor for Tokens
One of the more interesting digital asset discussions of 2020 happened early in the year, before the then emerging pandemic shifted collective focus elsewhere, and deserves renewed consideration:
- On February 6, 2020, SEC Commissioner Hester Peirce unveiled a Token Safe Harbor Proposal in a speech at the International Blockchain Congress. Commissioner Peirce’s proposal would provide a time-limited exemption for token-based projects that seek to raise capital to develop decentralized networks. The safe harbor would permit fledgling networks to operate unburdened by the onerous registration provisions of the US federal securities laws until they reach network maturity defined as either decentralization or token functionality. (See Taking the Scarlet Out of the Letters I-C-O.) Commissioner Peirce has stated publicly that she intends to refresh the proposal to version 2.0 at some point in 2021, and with a changing of the guard at the SEC in the wake of crypto-skeptic Chairman Jay Clayton’s resignation, perhaps the proposal will garner further attention.
SEC Activity Was Mostly Unremarkable, With the Exception of a Significant Year-End Surprise
There was far less focus by the SEC on digital asset matters in 2020 than there was in 2019, which saw quite a few instances of guidance, no-action relief, and enforcement. Nevertheless, there were some notable developments in 2020, including a leap forward on custody of digital asset securities:
- On January 14, 2020, the SEC’s Office of Investor Education and Advocacy issued an Investor Alert to urge investors to use caution before investing in so-called “initial exchange offerings” or “IEOs” through online trading platforms. In a bolded highlight in the Alert, the SEC stated without qualification that “there is no such thing as an SEC-approved IEO.”
- In 2020, a handful of high-profile enforcement actions by the SEC against digital asset firms were both initiated and concluded. On March 24, 2020, the US District Court for the Southern District of New York sided with the SEC and granted an injunction prohibiting Telegram Group Inc. and TON Issuer Inc. (together, Telegram) from delivering US$1.7 billion worth of Telegram’s digital token, Grams, to 175 entities and high-net-worth individuals. Going through each prong of the Howey test, the court reached the conclusion that the Telegram scheme constituted an investment contract, requiring either registration or an applicable exemption in order to comply with the federal securities laws. (See Telegram: Court Halts Grams Delivery.) On October 21, 2020, the SEC secured another major victory with regard to an unregistered securities token offering. The US District Court for the Southern District of New York entered a final judgment on consent against Kik Interactive Inc. to resolve the SEC’s charges that Kik’s unregistered offering of digital Kin tokens in 2017 violated the federal securities laws. These cases represent the final stake in the heart of the Simple Agreement for Future Tokens (SAFT), though some market participants continue to utilize structures that are uncomfortably close to these now-discredited forms of fundraising. In addition, on December 22, 2020, the SEC filed a complaint against Ripple Labs Inc., alleging that its ongoing offering of digital XRP tokens constituted an unregistered securities offering to investors.
- On July 6, 2020, asset management firm Arca announced that the SEC granted it approval under the Investment Company Act of 1940 to issue shares of a closed-end US Treasury fund in the form of digital securities. While the advent of ArCoins was not a watershed moment — that would be when an exchange-traded fund finally obtains the SEC’s blessing to hold cryptocurrencies or stablecoins as underlying assets — the share delivery via ArCoins deserves distinction as a digital asset milestone. By offering shares in the Arca US Treasury Fund as ArCoin tokens and the ability to transfer these digital securities peer-to-peer over a blockchain, Arca effectively removed financial intermediaries from a long-standing equation in the investment universe. This sidesteps the current lack of a marketplace of broker-dealers who are approved to engage with and custody digital asset securities. (See SEC Greenlights Investment Fund Delivered in Security Tokens.)
- On September 25, 2020, the SEC issued a no-action letter granting more leeway to registered alternative trading systems (ATSs) that settle trades involving digital asset securities, certain conditions permitting. The no-action relief is intended to reduce operational and settlement risks that ATSs face in providing noncustodial digital asset services, including settlement of trades involving virtual currencies, coins, and tokens. (See Settlement of Digital Asset Trading Just Got Easier.)
- On November 19, 2020, the SEC issued only its third no-action letter to date for digital tokens, clearing the way for the software development company IMVU Inc. to sell VCOIN, an ERC-20 token, as a transferable non-security to its global platform users. Unlike the SEC’s prior no-action relief, the VCOIN no-action relief for the first time permits VCOIN users to transfer the token outside of its closed platform to non-users and for any VCOIN holder to be able to exchange the token for fiat currency from the token issuer. While the VCOIN model is not itself ground-breaking, there is value in understanding it and divining the SEC’s trajectory in this area, as the regulator gradually becomes more permissive. (See A VCOIN for Your Thoughts: Ethereum-Based Token Wins SEC No-Action Relief.)
- On December 3, 2020, the SEC’s Strategic Hub for Innovation and Financial Technology, commonly referred to as FinHub, was made a stand-alone office within the SEC. FinHub is at the forefront of SEC efforts to encourage responsible innovation in the financial sector, “including in evolving areas such as distributed ledger technology and digital assets.” This is a positive development for the crypto space generally as the new structure provides direct access to the SEC staff for industry and the public, with FinHub leadership reporting directly to the SEC chairperson.
- On December 23, 2020, the SEC issued a statement with embedded no-action relief (Custody of Digital Asset Securities by Special Purpose Broker-Dealers), outlining how broker-dealers must operate when acting as custodians of digital asset securities in order to minimize risk to investors and avoid enforcement action. The guiding principle behind the measures is to mitigate the risk of the loss or theft of digital asset securities and the impact such an event would have on broker-dealers, their customers and counterparties, and other market participants. The recommended steps and no-action relief clear the way for special purpose broker-dealers to custody digital asset securities by establishing exclusive possession and control of the assets in compliance with the Customer Protection Rule. (See SEC Issues Guidance for Broker-Dealer Custody of Digital Assets.)
The OCC and CFTC Stepped Up
While 2020 was not exactly a banner year for the SEC in terms of digital assets (and at this point, only a comprehensive framework for digital asset securities and approval of a Bitcoin ETF will earn the SEC that accolade), anyone watching this space cannot have failed to notice that the Office of the Comptroller of the Currency (OCC) and the Commodity Futures Trading Commission (CFTC) stepped into their respective digital limelight:
- On July 22, 2020, the OCC issued Interpretive Letter #1170, giving national banks and federal savings associations (FSAs) the greenlight to provide customers with custody services for cryptocurrencies and digital assets that are not broadly used as currencies (collectively, cryptoassets). The letter, which operates as guidance only rather than an official rulemaking, was addressed to an unspecified recipient bank seeking to offer cryptoasset custody services as part of its existing custody business, but applies to national banks and FSAs of all sizes. (See From Safe Deposit Boxes to Cold Wallets, Bank Custody Evolves.)
- On September 21, 2020, the OCC issued Interpretive Letter #1172, giving national banks and FSAs the greenlight to hold deposits that serve as reserves for the underlying assets backing certain “stablecoins” on behalf of customers. According to the letter, national banks and FSAs are granted this expanded authority to hold stablecoin reserves if certain conditions are met. The SEC’s FinHub issued a statement in the wake of the letter, reminding market participants to perform a careful regulatory review of all digital assets under consideration. A facts and circumstances analysis is critical to determining whether the registration, reporting, and other requirements of the federal securities laws are implicated. (See Banks Can Hold Stablecoin Reserves, OCC States in Crypto-Friendly Letter.)
- However, not everyone has welcomed the OCC’s 2020 cryptoasset supportive actions. In a November 10, 2020, public letter to Acting Comptroller of the Currency, Brian Brooks, six Democratic members of Congress rebuked “the OCC’s excessive focus on crypto assets and crypto-related financial services” and “unilateral actions in the digital activities space.” Further, in a December 4, 2020, letter, House Financial Services Committee Chairwoman Maxine Waters called on then President-elect Joe Biden to rescind the OCC’s cryptoasset guidance. Whether such sentiments or increased pressure on the Biden Administration will result in a reversal of these crypto-friendly efforts remains to be seen. On the other end of the spectrum, some in Congress have lauded the OCC’s actions, and have called on the SEC and the Financial Industry Regulatory Authority (FINRA) to follow suit with similar clarifications on cryptoasset custody.
- On February 10, 2020, the CFTC’s Division of Swap Dealer and Intermediary Oversight (DSIO) issued a statement supporting responsible digital asset product innovation, including in relation to the pooled investment vehicles seeking exposure to digital assets and digital asset derivatives. The statement indicated the division’s desire to do its part “to help market participants to ensure that these innovations can develop in a way that is consistent with the law,” and included an offer to assist innovators with the evaluation of new digital asset products that may not be subject to existing specific CFTC disclosure requirements and disclosure document review by the National Futures Association (NFA). (See A CFTC Helping Hand: DSIO Offers to Review Digital Asset Products.)
- On June 24, 2020, the CFTC’s final interpretive guidance concerning the “actual delivery” of digital assets became effective. Absent qualifying for the “actual delivery” exception, retail transactions in commodities (including digital asset commodities) entered into or offered on a leveraged, margined, or financed basis are regulated as if they are futures contracts and can only be offered by registered intermediaries and on registered exchanges. The guidance clarifies the CFTC’s understanding of when a transaction results in actual delivery of a digital asset within 28 days and is thereby excepted from these requirements. The guidance takes a functional approach to the term “actual delivery” and articulates the view that actual delivery will have occurred in relation to digital assets when, within 28 days, (1) a customer secures possession and control of the entire quantity of the digital asset commodity, as well as the ability to use the entire quantity freely in commerce; and (2) the offeror, counterparty seller, and any affiliates thereof no longer retain any interest in, legal right to, or control over the digital asset commodity. (See What the CFTC Interpretation of “Actual Delivery” Means for Crypto.)
- On July 8, 2020, the CFTC published the agency’s 2020-2024 Strategic Plan. Of note for the digital asset space was one line in the 14-page report. Strategic Goal 3 (“Encourage innovation and enhance the regulatory experience for market participants at home and abroad”) includes Strategic Objective 3.4: “Address the risks and opportunities arising from ‘21st century commodities.’ We [the CFTC] will develop a holistic framework to promote responsible innovation in digital assets.”
- On October 21, 2020, the CFTC’s DSIO issued CFTC Staff Letter No. 20-34, clarifying its views on the acceptance, holding, and reporting of virtual currency (e.g., Bitcoin or Ether) in segregated accounts by futures commission merchants (FCMs) and the development of appropriate risk management programs in relation thereto. Specifically, the advisory relates to virtual currencies deposited by customers with FCMs in connection with physically delivered futures contracts or swaps. Due to the “custodian risk” associated with holding virtual currency as segregated funds, the Advisory lays out specific guidance for FCMs on virtual asset acceptance and custody, and their responsibility to implement appropriate policies, procedures, and oversight programs. (See CFTC Adds Another Building Block to Its Digital Asset Framework.)
- On December 17, 2020, the CFTC’s innovation office, LabCFTC, released a Digital Asset Primer, building on LabCFTC’s earlier 2017 Primer on Virtual Currencies and continuing its efforts to inform the public, policymakers, and industry stakeholders about new technologies and innovations. The Digital Asset Primer provides a convenient distillation of the CFTC’s current approach and thinking in relation to digital assets and digital asset markets.
FinCEN Casts a Shadow
In mid-2020, the Financial Crimes Enforcement Network (FinCEN) indicated that it was continuing its efforts to enforce obligations related to anti-money laundering (AML) and countering the financing of terrorism, with an increased focus on financial institutions transacting via emerging payment systems, including virtual currencies. FinCEN is prioritizing the mitigation of risks related to digital assets, while recognizing the importance of cooperation between the government and the private sector.
- On October 27, 2020, FinCEN and the Federal Reserve Board issued a proposed rule that would amend the recordkeeping and travel rule regulations under the Bank Secrecy Act. The proposed rule would lower the applicable threshold for the obligation on financial institutions to collect, retain, and transmit certain information related to fund transfers and transmittals from US$3,000 to US$250 for international transactions. The proposed rule specifically states that the reduced threshold would apply to transactions involving convertible virtual currencies, as well as transactions involving digital assets with legal tender status.
- On December 23, 2020, FinCEN issued a proposed rule that would impose significant new obligations on market participants in the cryptocurrency and digital asset market. The proposed rule “would require banks and money service businesses to submit reports, keep records, and verify the identity of customers in relation to transactions involving convertible virtual currency or digital assets with legal tender status held in unhosted wallets, or held in wallets hosted in a jurisdiction identified by FinCEN.” Industry feedback on the proposed rule was overwhelmingly critical. On January 14, 2021, FinCEN announced that it was extending what was viewed by market participants as an unduly abridged comment period (originally, 15 days from date of publication). The extension may indicate that, on matters related to the AML regime, the Treasury is “continuing its active engagement with the cryptocurrency industry” in good faith. (See FinCEN Looks to Rein In Cryptocurrency Transactions.)
- In a related development, on January 1, 2021, Congress enacted the National Defense Authorization Act for Fiscal Year 2021, an omnibus bill that includes the Anti-Money Laundering Act of 2020. Several provisions of the Act serve to update the existing AML regime in order to help safeguard the financial system from developing threats and account for emerging technologies and payment methods, such as virtual currencies. The Act expressly includes financial institutions and businesses engaged in the exchange or transmission of “value that substitutes for currency” — such as cryptocurrencies — within the scope of regulated entities. (See The Anti-Money Laundering Act of 2020: 5 Key Takeaways.)
Enforcement Remains a Top Priority
Regulators continued to pursue enforcement in the digital asset space, with heightened focus on AML concerns.
- On October 8, 2020, the US Attorney General’s Cyber-Digital Task Force of the Department of Justice (DOJ) published a white paper titled “Cryptocurrency: An Enforcement Framework” (the Report), which gives a detailed overview of legitimate uses of cryptocurrencies, the risks of illicit cryptocurrency activity, and related federal enforcement challenges and response strategies. The Report devotes extensive space to elaborating on the DOJ’s approach to multi-agency collaboration, which involves parallel or joint investigations and enforcement against individuals and entities for infractions involving cryptoassets. Insofar as the Report provides a roadmap of the DOJ’s priorities for cryptocurrency enforcement, all market participants in the cryptocurrency space should be aware of its contents and the government’s evolving expectations for risk management and controls. (See DOJ’s Evolving Framework for Cryptocurrency Enforcement.)
- According to its 2020 Enforcement Report, published on December 1, 2020, the CFTC’s Division of Enforcement continued to aggressively prosecute misconduct involving digital assets that fit within the Commodity Exchange Act’s definition of “commodity.” In conjunction with the division’s Digital Asset Task Force, the CFTC brought a record-setting seven cases involving digital assets in FY2020, including a case in which the defendants allegedly targeted churchgoers and misappropriated US$28 million in connection with purported Bitcoin investments, and a matter in which a foreign trading platform was offering illegal leveraged transactions in Ether, Litecoin, and Bitcoin.
CBDCs and Institutional Adoption
- While other jurisdictions are testing and nearing the launch of their own central bank digital currencies (CBDCs), the US Federal Reserve is still in the early stage/“hypothetical” phase of researching a digital dollar, while also debating its utility.
- The number of institutions that announced significant adoption of blockchain technology, digital asset investing, custody, collateralization, trading, settlement, and indexing are too numerous to discuss. In the context of regulatory development, this increased institutional uptake signals a higher perception of legitimacy, and heralds the arrival of significant, established financial industry players who are demanding guidance and clarity from regulators.
- In a Miracle on 34th Street-sized example of institutional adoption, the Salvation Army announced on December 17, 2020, that it would accept Bitcoin and Ether for charitable donations.
Will 2021 Prove to Be a Lucky Year for Digital Assets?
If nothing else, 2020 accelerated popular comfort with and uptake of digital innovation, from virtual office solutions to digital financial services such as remote banking and contactless payments. Accommodative central bank policies have depressed the US dollar and buoyed mainstream and alternative assets (including Bitcoin and other cryptoassets) to all-time highs as investors search for yield. Institutional adoption of blockchain innovation and support for cryptoassets has accelerated beyond most expectations, as capital-rich firms seek a technological edge and high-growth opportunities. All of which is to say that, taken as a whole, the various unintended consequences of the pandemic may force regulators to finally take digital assets seriously as an asset class worthy of a comprehensive regulatory framework. The market simply cannot thrive under conditions of ambiguity and uncertainty. At some point — perhaps this year? — regulators will have to reckon with the inevitable intertwining of markets and blockchain innovation. It may not be overly optimistic to envision a lucky ’21.