🤿 Sunday Deep Dive: Crypto’s Downfall - Where Legal Fits In

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Financial reform always seems to follow a screw-up. The Glass-Steagall Act and the U.S. Security and the Exchange Commission (SEC) both came about in response to the devastating Wall Street Crash of 1929. The reformative Dodd-Frank Act followed the financial crisis of 2007/2008. Experts are wondering if the crypto crash of 2022 will be the event that triggers industry reform and fast-tracks regulations that authorities have been threatening to introduce for years.

Big changes seem imminent but what exactly they will be and how they will impact the crypto industry is not yet clear. Companies who engage with crypto will be looking to their legal teams for guidance on navigating this high-risk, fast-evolving, and sometimes unchartered territory. One legal recruiter says that 10-15% of all recent placements have been in the crypto or fintech sectors as firms scramble to deal with new regulations. Here’s the lowdown on crypto’s recent downward spiral, how it played out, and what it could mean for legal.

Terra terror: how it all started

The price of a single Terra token is supposed to be $1. All the time. That consistency is one of the major selling points of so-called stablecoins, a class of cryptocurrencies that are pegged to a fiat currency or commodity. On May 7, however, Terra, which is controlled by an algorithm — mysteriously became untethered from the dollar. On May 9, it fell to 35 cents. Its sister currency, LUNA, soon crashed from $80 to a few cents. The two currencies went kaput just weeks after they were valued together at almost $60B.

  • No one knows who caused the algorithm to glitch but theories online include collusion on the part of hedge funds Blackrock and Citadel Securities (both have denied the claims) and a plot by an unknown “evil genius”. Fingers are of course also pointing at the currency’s creators — Terraform Labs. South Korean authorities have launched an investigation into the organization for violating financial regulations, Terraform’s entire in-house legal team has abandoned ship and, in case that wasn’t enough drama, an employee is being investigated for personally embezzling Bitcoin from the company. The company attempted a resurrection at the end of May with LUNA 2.0 but it didn’t take long for that currency to plummet too. It looks like they’ve come to the end of the road.
  • The collapse of Terra and Luna had tragic real-world consequences. Some 280kpeople were impacted in South Korea alone. People lost their life savings. Some feared they would become homeless. Moderators of the r/TerraLuna sub-Reddit shared suicide prevention helpline numbers as members shared their losses. The misery didn’t stop with Terra-Luna. Panic sent the whole market tumbling. Bitcoin’s price dropped from $38k on May 4 to 28k on May 11 — its lowest price since 2020. Across the crypto industry, $1.5 trillion has essentially vanished.

SEC Chair Gary Gensler previously described cryptocurrency markets as the Wild West. The jaw-dropping losses of the Terra-Luna crash might make stricter regulation seem like a no-brainer but, if we stick with Gensler’s metaphor, this ain’t crypto’s first rodeo. The price of bitcoin plummeted by 80% in 2018 and yet the space is still more or less overrun by bandits. Maybe this time around, the sheriff will fire some shots.

Wicked ways in the Wild West

A group of concerned techies has penned a letter to Congress warning them against the narrative that crypto is a “positive financial innovation”. They urge lawmakers “to resist pressure [to] create a regulatory safe haven for these risky, flawed and unproven digital financial instruments.” Here are just a few reasons why crypto-skeptics are appealing for more oversight.

  • The bad guys: The untraceable(ish), decentralized nature of crypto makes it a useful tool for money laundering, ransomware attacks, bribery, terrorist fundraising, and dark web criminality. But then again, fiat currency doesn’t exactly have a clean record.
  • Consumer protections: If you put your money in the bank, it’s (usually) covered by insurance. Banks will help you reclaim misdirected payments and there are authorities that work to prevent fraud. There are also rules about how financial institutions advertise, what products they offer and what info they provide. Very little of that applies to crypto.
  • Dodgy advertising: In a recent newsletter, we wrote about celebrities like Larry David and LeBron James pushing crypto on Super Bowl ads, despite possible conflicts of interest. This is possible because promoting crypto and NFTs occupies a legal gray zone. Kim Kardashian is among celebs being sued in a class-action suit for allegedly using misleading marketing to inflate the price of EthereumMax. Cryptocurrency exchange Binance also found itself in hot water after it was revealed they marketed Terra to users as a “safe” investment (yikes!).
  • Reserve-ations: Stablecoins attempt to maintain price stability through one of two methods: a) algorithms that manage the supply of tokens and b) asset reserves. The implosion of Terra casts serious doubt on the reliability of algorithms but asset reserves don’t seem fully trustworthy either. Stablecoin Tether is supposed to have $1 in the bank for every token but in 2019, New York state found that for periods it had no reserves at all. A price slip from $1 to 95 cents in May led to fresh fearsabout their reserves.

All these shenanigans were one thing when crypto was seen as a super high-risk, fringe investment but now it’s mainstream. More than 10% of American adults own at least one cryptocurrency. That figure will climb to 19% by the end of the year. And among millennial parents, crypto ownership is already at 29%. Those who choose to ignore the trend are not necessarily safe either. There’s a looming danger that crashes in cryptoland could spill over into the rest of the financial system and cause things to really hit the fan.

Not so fast

The absence of regulation in this space is not simply for lack of will. There are several factors that make it really challenging for authorities to bring crypto in line with other financial products:

  • Geography: You can walk into the physical building where the Bank of America is headquartered. There’s no doubt about what jurisdiction its activities fall under. The location of Binance’s headquarters, on the other hand, is a mystery — making it a bit tricky to keep them in line. Crypto issuers are also able to take advantage of regulatory arbitrage which is when jurisdictions compete to offer the laxest regulatory environment to attract businesses.
  • Anonymity: Satoshi Nakamoto is the pseudonym used by the creator/s of Bitcoin but their real identity has never been verified. BuzzFeed recently sparked uproarwhen they ‘outed’ the formerly anonymous creators of Bored Ape Yacht Club, a collection of ape cartoons that sell for hundreds of thousands as NFTs. Slapping legal consequences on crypto masterminds is a bit like trying to give a speeding ticket to Santa Claus.
  • Scope and the rate of change: There are over 18k cryptocurrencies in circulation. That doesn’t even cover the array of digital assets (EFTs and NFTs) available to investors. Things change fast, with new trends emerging on platforms like Reddit rather than traditional financial media. Regulators have a lot of unfamiliar ground to cover and they’re playing catchup.
  • The danger of killing the industry: Bitcoin emerged after the 2007/8 financial crisis as a reaction to the perceived untrustworthiness of the established financial industry. Part of crypto’s appeal is that it is ‘liberated’ from traditional financial systems. Heavy regulation could kill crypto’s spirit and stymie innovation, making it less fun and perhaps less lucrative. On the other hand, regulation could build trust and legitimacy, spurring investment from more conservative investors.
  • Privacy: Given the number of bad guys doing bad things, making crypto more transparent seems like a great idea. But greater transparency could wipe out another major draw of crypto. There are some good non-criminal reasons for wanting a payment to be difficult to trace. In countries with oppressive governments, crypto can offer freedom from repressive monitoring.
  • Regulators won’t play nice: SEC Commissioner Hester Peirce said of crypto that regulators all want to “plant their flag and get a little piece of that regulatory pie.” The Commodities Futures Trading Commissions (CTFC) treats bitcoin as a commodity but the IRS says it is property.
  • The mystery of regulation: Blockchain attorney Marco Santori has describedcrypto as a “regulatory platypus” since it doesn’t fit into any one category. Charles Hoskinson, founder of cryptocurrency Cardano, says that authorities are used to dealing with financial assets as either securities, commodities, or currencies … but crypto can be all three.

The rules so far

One of the major decisions facing regulators is whether to apply existing rules to crypto or to design new bespoke rules. Most countries deal with crypto using a patchwork of authorities who offer broad guidelines using existing laws. Crypto is typically recognized as property but not as legal tender and is taxed accordingly. Crypto exchanges are required to register with authorities and meet some basic anti-crime requirements.

In the United States:

  • The SEC is the authority that throws its weight around most in the crypto space. Anything classified as a security is within the SEC’s remit. There’s been a lot of confusion around what is and isn’t a security but the SEC says the Howey Test can be used to determine whether a crypto asset falls into that category. It has successfully charged crypto creators for not registering tokens. The cases to watch are the SEC’s lawsuit against Ripple, and their investigation into Binance — both of which could set precedent.  
  • The CTFC has said that some tokens like Bitcoin and Ether are commodities and not securities and should therefore be under their jurisdiction. The agency has been described as having a “do no harm” approach to crypto regulation.
  • Crypto exchanges must register with the Financial Crimes Enforcement Network (FinCEN) and meet anti-money laundering (AML) and combating the financing of terrorism (CFT) obligations including the Travel Rule.
  • The IRS considers cryptocurrency to be property, so income and capital gains tax rules apply. Biden also introduced new rules in November’s bipartisan infrastructure bill which means that exchanges must notify the IRS directly of crypto transactions.
  • Individual states have even passed their own laws and regulations which Bloomberg has collated into a handy list.
  • There’s a lot more nitty-gritty you can get into. For example, ICOs (a form of cryptocurrency used to raise capital) are only subject to regulation if they are issued as security tokens rather than utility tokens. You can read the details here.

Some countries have taken more unusual action. China has banned crypto exchanges and bitcoin miners from operating in the country. Egypt has banned all crypto trading for religious reasons and El Salvador has gone in the other direction and adopted Bitcoin as legal tender (a move viewed by most as a terrible idea).

What’s on the horizon

Tighter regulations are already having an impact. Crypto exchange Binance recently announced that they are changing their ways in order to get licenses from regulators. Crypto libertarians will be disappointed to hear that Binance now has a “traditional corporate structure” and will soon be going public with its location. Crypto firms have also started hiring normal, boring compliance people … just like other less sexy companies. More change is coming.

The European Union has laid out the first multinational regulatory framework for crypto with its Markets in Crypto Assets regulation (MiCA). Once MiCA goes live (which will be soon):

  • Non-EU crypto service providers will need to apply for a “passport” that will allow them to operate in the bloc and will come with a host of compliance requirements.
  • Crypto issuers will have to be licensed and meet certain requirements, such as “fair, clear, and not misleading” marketing.
  • Stablecoin issuers will have to demonstrate a minimum level of reserves.

Legal experts anticipate that the new framework will keep lawyers very busy.

In the United States:

  • The Fed may issue its own digital currency.
  • The SEC is expanding its Cyber Unit, so a crackdown on securities-related misbehavior can be expected.
  • The Justice Department has launched a task force to tackle crypto crime.
  • There could be more action around private or unhosted crypto wallets. FinCEN wants crypto exchanges to collect the names and addresses of anyone transferring crypto to a private wallet in order to prevent money laundering but the proposed regulation is controversial.
  • The White House has initiated a government-wide effort to solve problems in the crypto industry.
  • This week, senators introduced a bill that proposes light regulation that would encourage growth in the crypto industry. It’s one to watch.
  • Lawmakers are not the only ones with ideas. Crypto companies have put forward over 150 new laws in 40 states this year.

What GCs can do

Louis Legot, a partner at Foley & Lardner says that “Businesses that fail to evolve will cease to be competitive.” Legal teams can help businesses to navigate the risky business of crypto without missing out on the opportunity to be a part of this exciting new field. Here are 3 ways to get involved.

  1. Compliance: Make sure your business is ticking all the boxes with regard to money laundering regulations and tax reporting requirements. When in doubt, approach regulators for clarity.
  2. Regulation monitoring: Keep up to date with constantly changing state, federal, and international laws.
  3. Sharpen up your technical knowledge: You don’t need to understand all the ins and outs of every crypto asset but a base level of technical knowledge will help legal teams understand, weigh up, and communicate the level of risk involved with different activities.

The r/TerraLuna sub-Reddit is no longer full of doom and gloom. Investors have nursed their wounds and are ready to put their money on the next big thing. The broader crypto industry, however, is a bit more reticent than it was 6 months ago. It remains to be seen whether it will regain its momentum. If it does, GCs should be prepared to engage in more activities that set their risk-radar flashing.