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The rapid development and adoption of the crypto marketplace across institutional, corporate, and retail investor markets have been growing at a speed well beyond regulatory efforts to keep up. In fact, this rapidly changing landscape has led to a flexing of regulatory muscles between different agencies in defining terms and drawing lines of authority – all while the trend toward cryptocurrency investing accelerates.
To take a deep dive into these regulatory issues, we reached out to Institute member Bo Howell, Founder and CEO of Joot - a FinTech company that provides web-based compliance technology and services to registered investment advisers, broker-dealers, and funds. He’s also the owner of FinTech Law, a technology-driven law firm focused on financial services and technology companies. Fresh from publishing a detailed series of blog posts and articles on the crypto regulatory landscape and speaking as a panelist at last year’s NSCP National Conference, Bo offers his practical perspective and thoughts on where we are and where we are going with the evolving regulatory issues around the crypto marketplace.
Hortz: How did you personally get more involved in the cryptocurrency area?
Howell: Like most people, I had heard of cryptocurrencies but had not participated in the asset class. In 2021, I had a legal client that wanted to launch one of the first mutual funds to investment primarily in Bitcoin futures. I used that opportunity to learn more about the crypto space, including some certifications from Coursera. I even took time to build a mining computer and join a mining pool. Pro tip: these energy hogs can replace a small space heater in your home! I also scored some dad points shortly after getting up to speed in this space when my 18-year-old and 13-year-old sons separately talked to me about crypto (a strong indicator that the asset class is now mainstream). They were impressed that (1) I had heard about numerous cryptocurrencies, (2) I actually owned a few, and (3) I had built a mining machine!
Since late 2021, my clients and I have had numerous discussions about the crypto regulatory space with senior staff members at the SEC. I also started blogging on the topic. Since then, I’ve worked with RIAs and investment companies that are introducing cryptocurrencies as an asset class, advised startups that are looking to leverage blockchain technology in their businesses, and more. Over the next few months, I will be presenting continuing education courses for lawyers on the topic, speaking at ABA events on the matter, and working with Joot and FinTech Law clients to manage the regulatory landscape.
Hortz: Can you give us some examples of the types of abuses and scams that have happened in the crypto space?
Howell: Cryptocurrency is a boon for scammers because many market participants do not fully understand the underlying technology or marketplace. From October 2020 through April 2021, the FTC fielded nearly 7,000 reports from consumers about scams. The median loss reported for these scams was $1,900. The FTC cautions people interested in cryptocurrencies to look for obvious signs of a scam, such as someone insisting on cryptocurrency for payment, a guarantee you’ll make money, or a promise of guaranteed returns and big payouts. Scammers also make big claims but do not provide details about how the investment works or where your money is going.
As a result of persistent fraud in the marketplace, regulators are focusing more attention and resources on protecting investors. The SEC has brought numerous enforcement actions against players in the crypto and decentralized finance (DeFi) space. For example, the SEC settled an enforcement action against a DeFi platform and its executives for unregistered securities sales of more than $30 million and misleading investors. Blockchain Credit Partners used smart contract and DeFi technology to sell two types of digital tokens: mTokens and DMM governance tokens (DMG). The mTokens paid fixed interest and the DMG tokens purportedly gave holders certain voting and profit-sharing rights. The DMG tokens were meant for resale in a secondary market. The SEC found that the tokens were investment contracts under the Howey Test, which turns any contract, scheme, or transaction into a security if there's an investment of money in a common enterprise with a reasonable expectation of profit from the work of others. Therefore, the offerings should have been registered under the Securities Exchange Act of 1934.
More recently, the SEC brought a civil lawsuit against Ryan Ginster for engaging in two unregistered and fraudulent securities offerings. In SEC v. Ryan Ginster, the staff alleged that Mr. Ginster sold about $3.6 million in Bitcoin through multiple coin exchanges, promising unrealistic rates of return. Mr. Ginster then converted about $1 million of the Bitcoin into cash and used it to pay personal expenses. In a press release, Michele Wein Layne, Regional Director of the SEC's Los Angeles Regional Office, stated that “[i]ndividuals who hide behind the anonymity of cryptocurrency transactions to defraud investors should expect that the SEC will trace their illegal activity and hold them accountable for their actions.”
On December 2, 2021, the SEC brought another crypto-related enforcement action, this time for a foreign scheme that allegedly defrauded retail investors of more than $7 million in two unregistered digital asset securities offerings. This time, the case was brought by the SEC’s Cyber Unit, a specialized unit within the SEC’s Division of Enforcement. In the press release, Kristina Littman, Cyber Unit Chief, reiterated that the SEC “will continue to detect and pursue those that seek to victimize investors in the digital asset space.”
Hortz: What are the investor protection gaps regulators are most concerned with?
Howell: Last summer, SEC Chair Gary Gensler spoke at the Aspen Security Forum on the current state of U.S. crypto asset regulation. In his speech, Mr. Gensler acknowledged the contributions crypto assets and blockchain technology have made to financial and monetary innovation. But he also noted the immediate need for investor protection considering the hype, frauds, scams, and abuses in the crypto asset space that have harmed investors. In particular, Mr. Gensler warned about significant investor protection gaps with respect to foreign and decentralized crypto trading platforms that fail to prohibit U.S. investors from participating. He noted that some products, such as mutual funds that invest in Bitcoin futures, include the significant investor protections provided by the Investment Company Act of 1940, but he stressed that further congressional action is needed to close regulatory gaps regarding crypto assets.
Hortz: What are the key regulatory issues related to registered crypto funds?
Howell: The novelty of crypto-based funds and their potential risks mean they must undergo regulatory scrutiny by the SEC’s Division of Investment Management, which reviews all new mutual fund and ETF filings. To meet these regulatory requirements, the fund’s sponsor, its legal counsel, and other service providers must respond to numerous comments and requests for information from the SEC and its staff. As registrants navigate the regulatory gauntlet, they’re likely to encounter 10 key issues, each of which I walk through in a recent blog post:
- Fund name and strategy
- Investments in other pooled investment vehicles
- Liquidity and capacity constraints
- Concentration
- Valuation
- Leverage
- Roll strategy (futures funds only)
- Extreme market conditions
- Derivatives risk management
- Environmental impact
To date, the SEC has not permitted any registered investment company to invest directly in cryptocurrencies on a principal basis. And the only crypto derivative that’s permitted as a primary investment in registered funds is CME Bitcoin futures. I believe CME Ethereum futures will be next, but there are some technical and market hurdles that need to be cleared before registered funds can primarily invest in that asset.
Hortz: Please share with us your experiences in helping one of your fund management companies register a Bitcoin futures fund. Are there any differences or steps you must take for crypto versus other mainstream fund products?
Howell: Given the novelty of digital assets in mainstream capital markets, launching the product required close engagement with the SEC. At the end of the day, we were successful in launching the fund because IDX Advisors and the fund’s administrator were familiar with both digital asset markets and the regulatory landscape, and they were able to demonstrate that this type of fund was ready for a mutual fund structure. It also helped that a few other products launched shortly before ours, including the ProShares Bitcoin Strategy ETF (BITO).
But launching the product wasn’t easy. The SEC staff is still learning about these asset classes and developing regulatory policies to address them. The staff’s initial concern focused on the underlying market, primarily liquidity. But crafting disclosure for Main Street investors was also challenging. First movers need to lead a significant education effort because investors are still developing crypto literacy. We worked closely with SEC staff to make sure the investment and risk disclosure were complete, accurate, and easy for Main Street investors to understand.
Additionally, the current regulatory rules were not written with digital assets in mind. It’s challenging to take rules written in 1940, 1975, and even 10 or 20 years ago for traditional assets like equity or debt and make them work for newer asset classes like cryptocurrencies, non-fungible tokens, and DeFi products. Market participants need to engage with the SEC staff and help craft a regulatory framework that works for market participants, regulators, and investors.
Hortz: Can you give us your perspective on this apparent battle between the SEC and the CFTC over who regulates the growing crypto marketplace?
Howell: Currently, the SEC and the CFTC are racing to be the preeminent regulator of cryptocurrencies and crypto-related assets. The CFTC claims that crypto derivatives like futures and options are a commodity interest regulated by the Commodity Exchange Act of 1934, a law that was created long before crypto. Because of a lack of legal authority over currencies, the CFTC is trying to regulate derivatives of cryptocurrencies, but not the currencies directly. Unlike currencies, which are regulated by the Federal Reserve and Treasury Department, futures, options, and derivatives fall under the CFTC’s authority. The CFTC can regulate futures and options markets but not “spot” markets, where commodities (like soybeans and copper) are traded directly. Most digital coin exchanges are considered spot markets.
The SEC is staking its claim on the definition of a security, which includes investment contracts as established in the 1946 Supreme Court case of SEC v. Howey. Oddly, the SEC has already said that Bitcoin and Ethereum, the two largest cryptocurrencies by market size, are not securities. But the SEC is trying to regulate initial coin offerings (ICOs), which would apply to any new cryptocurrencies hitting the market, not those already in circulation. The SEC is also going after DeFi products related to lending and borrowing crypto on decentralized platforms. Since these instruments are more akin to debt, they’re more clearly in the SEC’s purview. And the SEC is going after crypto-related companies that have issued stock or other securities to investors. Those securities offerings, whether registered or unregistered, are also clearly in the SEC’s authority.
Hortz: What do you see as the way forward on all these issues?
Howell: The fact remains that digital assets like cryptocurrencies don't fit neatly into the SEC’s regulatory framework. It’s a bit of a stretch to conclude that cryptocurrencies are a security, but digital assets that represent interests in startups, companies, and the like look more like securities. The rising popularity of decentralized autonomous organizations (DAOs) as investment clubs is another area where securities law and crypto assets cross paths. Regardless of the accuracy of the SEC’s position, the crypto markets will see increased government regulation in the years to come, and many participants welcome it - as trust grows in these markets, more investors will participate. One group that would welcome crypto clarity is registered investment advisers, whose clients are increasingly interested in cryptocurrencies as part of their investment portfolio.
Hortz: Any recommendations or advice you can offer any advisers or fund managers looking to develop crypto investment products?
Howell: Learn. Learn. Learn. RIAs and fund managers can’t simply chase another hot investment product. They need to have a working knowledge of how the underlying technology works, the risks to that technology (e.g., a blockchain fork or pending upgrade to the protocol), and the property rights attached to digital assets. Since digital assets are not tangible, often the only underlying property rights are intellectual property rights. If a crypto asset is supposed to represent an “ownership” interest in an underlying company, you may need more documentation than a simple token purchase to evidence ownership of the underlying asset (e.g., a smart contract).
Additionally, advisers need to understand whether a crypto asset is a security offering and, if so, whether it should be registered under the Securities Act of 1933. RIAs and fund managers need to avoid investing client assets in unregistered offerings because such offerings have a heightened risk of fraud or may be subject to SEC enforcement actions.
Other areas that can trip up product sponsors include anti-money laundering regulation and cybersecurity requirements needed to protect assets. All these regulatory issues need to be considered before developing and launching a product or investing client assets in cryptocurrencies and other digital assets.