To date, conscientious traders of digital assets and cryptocurrencies have mostly sought regulatory refuge under the quilt of state money transmission laws.
In the not-too-distant past, business was primarily limited to exchanging fiat currencies for virtual currencies, such as bitcoin and ether. Driven by law enforcement and consumer protection concerns, numerous state regulators decided that only licensed money transmitters could engage in those activities. Concluding that virtual currencies presented a unique set of regulatory considerations, New York state hatched the BitLicense. Thus, in order to operate on a national scale, crypto exchanges and trading businesses have had to secure dozens of separate state permits — a complicated and expensive process that hardly promotes regulatory efficiency.
Times have changed quickly, though, and digital asset markets have witnessed the rapid rise of the initial coin offering, or ICO. As a particularly effective means of raising substantial capital for start-up companies, ICOs have lately captured the SEC’s attention — with the agency insisting that most of the marketed tokens constitute “investment contracts,” and thus “securities” under the 1933 Securities Act. Because the sale of unregistered securities is a serious violation of federal law, the SEC has recently launched numerous ICO investigations and enforcement actions. This aggressive campaign seems like an effort by the SEC to corral digital asset traders into its jurisdiction.
In fact, there is an emerging turf battle, which can lead to no good. On the one hand, SEC Chairman Jay Clayton has observed that “many U.S.-based cryptocurrency platforms have elected to be regulated as money transmission services,” and therefore “the currently applicable regulatory framework for cryptocurrency trading was not designed with trading of the type we are witnessing in mind.” The obvious implication of Chairman Clayton’s remarks is that, in order “to get protections offered by the federal securities laws and SEC oversight when trading digital assets that are securities, investors should use a platform or entity registered with the SEC, such as a national securities exchange, alternative trading system . . . , or broker-dealer.”
On the other hand, the Treasury Department’s Financial Crime Enforcement Network has now taken the position that “under existing regulations and interpretations, a developer that sells convertible virtual currency, including in the form of ICO coins or tokens, in exchange for another type of value that substitutes for currency is a money transmitter.” The same conclusion applies to an “exchange that sells ICO coins or tokens, or exchanges them for other virtual currency, fiat currency, or other value that substitutes for currency.” Although FinCEN’s regulations exempt entities registered with the SEC from having to register with FinCEN as a money services business, that exemption does not necessarily extend to requirements set by state money transmission laws.
The Uniform Money Services Act, which has been enacted by Alaska, Arkansas, Texas, Hawaii, Iowa, North Carolina, Puerto Rico, South Carolina, the U.S. Virgin Islands, Vermont and Washington, expressly exempts SEC registered broker-dealers and clearing agencies from money transmitter license requirements. Many other state statutes, however, provide no such exception. And despite the apparent lack of any state law precedent for requiring SEC registered broker-dealers to register as money transmitters, it is entirely unclear whether state regulators will deal with the trade of digital assets differently. For example, several legal practitioners have noted that New York’s BitLicense regulations do not contain an exemption for registered broker-dealers, and thus “it is not clear whether and to what extent registered broker-dealers that engage in Virtual Currency Business Activity are exempt from licensing and other requirements” contained in the BitLicense rules.
Chairman Clayton has committed “to exploring . . . whether increased federal regulation of cryptocurrency trading platforms is necessary and appropriate.” In that regard, the SEC would do well to consider preempting by regulation the application of state money transmitter laws to SEC registered broker-dealers and other trading platforms. In the spirit of incremental reform, though, this suggestion applies only to digital assets that qualify as securities under federal law. Other virtual currency businesses — more akin to traditional money transmission — may be better regulated as money transmitters. Time will tell, and there is presently no compelling reason to disrupt the regulatory framework that has evolved to govern these businesses.
Importantly, there is little downside to this measured approach. Under SEC supervision, broker-dealers and other registered entities already must meet strict anti-money laundering and consumer protection requirements. These are the primary concerns addressed by state money transmission regulators, so substituting the SEC as the watchdog would keep these important safeguards in place.
Finally, such preemptive intervention could also create several significant benefits. First, it could provide regulatory clarity, assurance and stability to a young and rapidly growing sector of the financial services industry. Second, it could ease the regulatory burden conceivably imposed by numerous state supervisors and thereby better promote innovation in the nation’s capital markets. And third, it could serve as an effective carrot in supplementing SEC’s enforcement efforts — the promise of a single regulator in place of a balkanized regime could be a serious boost to the SEC’s registration of digital assets and those trading in them.
In the meantime, conscientious traders of digital assets and cryptocurrencies — those who want nothing more than to comply fully with applicable regulatory requirements — are left to navigate ambiguous rules. Some categorical guidance from the SEC soon would be greatly appreciated and constructively utilized.