Kevin Werbach Comprehensive Testimony on Crypto Regulation

House Joint Economic Committee Hearing; “Demystifying Crypto: Digital Assets and the Role of Government.”; Testimony by Kevin Werbach, Professor of Legal Studies and Business Ethics, Director of the Blockchain and Digital Asset Project, The Wharton School, The University of Pennsylvania, . November 17, 2021, https://www.jec.senate.gov/public/_cache/files/bccfc06e-6756-47bd-a075-acb5087a9e2c/werbach-testimony.pdf

Thank you for the opportunity to speak before you today. I am the Liem Sioe Liong/First Pacific Company Professor, and Chair of the Department of Legal Studies & Business Ethics at The Wharton School, University of Pennsylvania. I also direct the Wharton Blockchain and Digital Asset Project. Much of my work involves policy implications of emerging technologies. In the late 1990s, I served as Counsel for New Technology Policy at the Federal Communications Commission. For the Obama Administration, I co-led the review of the FCC for the Transition Team, and then served as an expert advisor to the FCC and National Telecommunications and Information Administration. For a number of years, blockchain and cryptocurrencies have been a growing focus of my research. I published a book, The Blockchain and the New Architecture of Trust, in 2018.1 Since 2017, I have led workshops bringing together academics, industry legal experts, and regulators from across the federal government, as well as Europe and Asia, to discuss public policy questions around digital assets. My team recently published two reports on decentralized finance in collaboration with the World Economic Forum, DeFi Beyond the Hype2 and The DeFi PolicyMaker Toolkit. 3 I created Wharton’s blockchain and cryptocurrency course for MBA and undergraduate students, 4 and I am academic director of Wharton’s forthcoming online executive education program on Economics of Blockchain and Digital Assets.5 I. Introduction You are taking on an important task in seeking to understand the benefits, costs, and regulatory aspects of cryptocurrencies.6 Blockchain technology, and the decentralized asset ecosystems it enables, could well represent the most important developments in information technology since the internet. Blockchain could be the basis for fundamentally re-wiring the global financial system in beneficial ways, and for re-designing the digital platform economy that impacts the daily life of billions of people.7 The potential exists to use distributed ledgers and digital assets not only to improve the efficiency of many kinds of transactions, but to make markets more fair, inclusive, open, and transparent. At the same time, there is no question these same technologies can be—and are—used by criminals, fraudsters, and other bad actors. There are serious risks involved in digital asset-based markets, some of which have already produced large losses for participants. And it is important to distinguish potential from reality. These are still, in many ways, immature technologies. Scalability, security, and interoperability remain huge challenges, especially as adoption grows. There are important questions about energy usage of proof of work networks, which are beyond the scope of this hearing. And blockchain is not the right solution for every problem. In certain situations, blockchains may inspire the incorporation of cryptographic techniques and data structures into fundamentally centralized databases. In others, the traditional architecture is the best one, at least for now. Finally, while there are many fascinating projects exploring the potential of mechanisms such as decentralized organizations and cryptocurrency payments to enable new kinds of communities, empower individuals, or circumvent authoritarian regimes, the bulk of economic activity around digital assets today is for financial speculation. Holdings of most significant digital assets are highly concentrated, with privileged actors including developers and early investors often holding a disproportionate share. And there are major questions about market manipulation underlying the entire digital asset trading market.8

Let me be clear. These problems do not mean that digital assets should be dismissed, regulated out of existence, or treated as an inherently noxious development. There is real value being created, in many different ways. The twin revolutions of Satoshi Nakamoto’s Bitcoin whitepaper and the smart contract technology of Ethereum have unleashed a Cambrian Explosion of experimentation and innovation. Virtually every major firm in financial services, and most other industries, is now looking at where blockchain and digital assets might provide opportunities to do what they do better, or do new things they cannot do today. And this is a global phenomenon.

It is essential for market participants and policy-makers to see both the positive and the negative aspects of digital assets, so that they can set a course to accentuate the benefits while limiting the harms. Regulation and innovation are not necessarily in conflict. In many cases, regulatory action to address abuses and provide clarity to market participants is an important, or even necessary, condition for long-lasting, productive or transformative innovation. This is not to say that all regulation is well-designed or well-implemented. But we have centuries of evidence that unregulated financial markets produce catastrophic boom-and-bust cycles and severe abuses that undermine their welfare-maximizing potential.

A quarter century ago, I served as a member and editor for the White House working group that drafted the Framework for Global Electronic Commerce, a seminal report that set out the United States Government’s approach to the emerging phenomenon of the internet. n9 I also wrote Digital Tornado: The Internet and Telecommunications Policy, a 1997 Federal Communications Commission working paper that explained how the internet would transform the communications sector and identified the regulatory challenges that would pose. n10 The steps taken by the U.S. Government in the late 1990s facilitated the incredible growth of the digital economy. However, what is important to understand is that the policy adopted then was not that the internet should be a totally unregulated space, or that the harms it brought should be disregarded because of its benefits. While the Framework opposed “undue restrictions” on e-commerce, it also identified the need for a “predictable, minimalist, consistent and simple legal environment for commerce.” n11 That is what you, and other policy-makers, should be seeking today for cryptocurrencies and digital assets.

The central thesis of my book is that blockchain is not the end of trust; it is a new, decentralized form of trust. It is a scary thing to exchange your dollars for a currency issued by no one, or to buy a virtual asset whose value is represented on a decentralized network, or to devote your time and energy to a community whose rules are enforced entirely through software executing automatically on a blockchain. The success or failure of the blockchain economy, or Web 3 as some would prefer, depends on trust. What government does–and doesn’t do–will play a significant role in shaping that trust.

1. Regulation of Digital Assets
2. Development of Digital Asset Markets

The digital asset sector has seen extraordinary growth over the last decade. Within the last year alone, cryptocurrency market capitalization has grown fivefold, from $578 billion in November 2020 to $3 trillion in November 2021. n12 Daily trading volume far exceeds $100 billion. n13 There is now a thriving industry of decentralized applications (DApps) enabled through blockchains in a plethora of industries, from finance services to supply chains to fine art. DApps are created using smart contracts, which are a form of software code that executes immutably according to its specified parameters on a blockchain network.

The underlying blockchain market is developing rapidly as well. n14 Bitcoin (BTC) is the oldest and most valuable digital asset, still preeminent in payments and trading, but until recently the Bitcoin network did not offer robust capabilities for DApps. n15 Ethereum, whose native Ether (ETH) token is the second most valuable, is the most popular platform for smart contract and DApp development, especially for decentralized finance (DeFi). Today, Ethereum handles more than a million transactions daily. n16 Over the past twelve months, it has settled more than $6 trillion in transactions. n17

There are, however, several competing public blockchain networks that claim to improve on Ethereum’s functionality, including Solana, Algorand, Avalanche, DFinity, Tezos, EOS, Hedera Hashgraph, and Cardano. Some of these are gaining real developer traction and user adoption due to Ethereum’s current performance limitations and high transaction (“gas”) costs. And there are many more cryptocurrencies than blockchains; more than ten thousand, in fact. n18 This is because it is easy to create a virtual “token” on top of a smart contract blockchain, leveraging the underlying network security but providing different functionality. The number of tokens has doubled since last year, n19 and the trend is toward further growth. n20

Of the $3 trillion market value of digital assets, about half is Bitcoin and one-fifth Ether. n21 The term “cryptocurrency” is sometimes limited to tokens that can effectively serve as money, and sometimes limited to the native asset of a blockchain network. The general term “digital assets,” or in some international regulatory contexts, “virtual assets,” encompasses all such tokens cryptographically secured on a blockchain ledger. Beyond payments, tokens can represent voting rights, for example, for members of a Decentralized Autonomous Organization (DAO) in the form of governance tokens. Other use cases include stablecoins, which can be pegged to less volatile fiat currency or other assets, and Non-Fungible Tokens (NFTs), which can represent anything from tickets that give access to events, to ownership of digital land or unique collectible artworks to even characters in games and digital identities.

Decentralization is a fundamental attribute of blockchains and digital asset or smart contract-based markets. What makes a blockchain different from a traditional database is that no central actor can issue, block, or change transactions on their own. Decentralization is a powerful force for both freedom and economic efficiency. It’s the reason this country has thrived with a political system that gives every citizen a vote in electing our government, and an economic system driven by the self-interested actions of independent market participants. However, a more decentralized system is not always better; nor is it always desirable. And we don’t have a rigorous language for describing what “more decentralized” means in any event.

I would urge you to ignore the simplistic characterizations of blockchains and digital assets as necessarily creating a zero-sum competitor to existing firms, industries, or even governments. We heard this with the internet too. Yet the New York Times, JP Morgan, ATandT, and Microsoft are still here, albeit changed in important ways. And of course, the United States of America is still here. The choice we face is not blockchain vs. traditional software, nor is it Bitcoin vs. the U.S. dollar. It is the question of what kind of blockchain-enabled and digital asset-powered future we will experience, and how this new world will interact with and, in some ways, transform the old one.

1. The Regulatory Landscape

Broadly speaking, cryptocurrencies raise three major categories of regulatory consideration:

1. Consumer/investor protection
2. Financial crime
3. Macroprudential and monetary policy Consumer/Investor Protection

The first category relates to concerns about fraud, market manipulation, deception, information asymmetries, hacks, and excessive or hidden risk. The basic financial regulatory response to these concerns is the registration, disclosure, and market surveillance regime of the 1933 and 1934 Securities Acts. Outside of financial services, agencies such as the Federal Trade Commission take actions against unfair or deceptive trade practices, and the Department of Justice pursues those who defraud consumers or investors. There have been numerous cases where digital asset market participants have been defrauded, had funds stolen, or have suffered catastrophic losses because they took risks they did not understand or could not withstand.

Financial Crime

The digital asset market today is still small relative to the universe of financial asset classes. However, this market is no longer small in absolute terms. The attributes that make cryptocurrencies valuable for legitimate uses also make them attractive for criminals, money launderers, sanctioned nations, terrorists, and others who are appropriately excluded from the global financial system. Over the past decades, a sophisticated national and global regime of anti-money-laundering and countering the financing of terrorism (AML/CFT) rules, as well as industry compliance practices, have been put into place. While highly imperfect, these mechanisms serve important objectives.

Macroprudential and Monetary Policy

Finally, as the size of digital asset markets increases, and instruments such as stablecoins and central bank digital currencies become a greater component of the monetary system, financial policy makers will need to consider them in assessments of systemic risk. They may also need to take into account the impacts that privately issued digital assets have on nations’ ability to exercise monetary policy, a topic that has already been raised in connection with Facebook’s Libra (now Diem) proposal. n22

Enforcement Challenges

In the cryptocurrency sector, there are two main problems in applying established rules. The first is categorization difficulty. The securities regulation regime depends on classification as a security or investment contract, for example. Applying the Howey and Reves frameworks in the digital asset context can be challenging. The second is that blockchain networks are decentralized, global, and typically reference participants through addresses not inherently associated with real-world identities. These factors create practical enforcement challenges even when there are clear cases of harms. Regulators also need to consider the magnitude of harms relative to benefits of unconstrained experimentation, the balance between case-by-case post hoc enforcement and prospective rules, as well as whether to take action against those who actively facilitate but may not directly commit violations.

1. U.S. Regulatory Activity n23

Federal digital asset regulation in the U.S. to date has involved a number of agencies and offices: the Financial Crimes Enforcement Network (FinCEN), Office of the Comptroller of the Currency (OCC), and Internal Revenue Service (IRS) in the Treasury Department, the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), and the Federal Deposit Insurance Corporation (FDIC). There has also been activity in a number of states, and several bills introduced in recent sessions of Congress, which I will not cover here.

FinCEN classifies virtual currencies as “money” for transmission purposes and in 2020 proposed a rule that would impose recordkeeping, reporting, and customer identity verification requirements on large virtual currency transactions. n24 Recent FinCEN actions have built on the precedent of the $110 million fine against the exchange BTC-e in 2017. n25 In addition, FinCEN’s enforcement focus has noticeably extended to penalties against individual persons. A pair of prominent enforcement actions have targeted over-the-counter exchange activities by individuals who failed to register with FinCEN, implement an anti-money laundering program, and institute a reporting regime. n26 One of the actions included related criminal proceedings for money laundering of illicitly obtained bitcoin funds. n27

Similar to FinCEN, the CFTC maintains a broad conception of its regulatory authority–if an active futures market exists for a digital asset, it is within the CFTC’s purview. The CFTC has plainly stated that it has standing to regulate bitcoin and other virtual currencies in futures or options contracts, as well as any transactions involving margin financing or fraud. n28 Selfcertifications of both the CME and CBOE, as well as a 2018 suit, legitimized this authority. n29 The CFTC has issued three order filings in 2021, including a $6.5 million monetary penalty against the exchange Coinbase for an alleged wash trading scheme. n30

The SEC’s framework for analyzing digital assets is based on the longstanding Howey test for classifying securities. n31 A 2018 statement by then Corporation Finance Director Bill Hinman stated that Bitcoin and Ether were sufficiently decentralized that they did not appear to meet the requirements of securities classification at this time. n32 A second functional prong developed following a pair of no-action letters issued by the SEC. The agency has indicated that when a coin exclusively derives its value through operations on an already developed platform, there is no capacity to achieve investment returns. As a result, the coin functions as a “utility” within the platform and not a security. Few virtual currencies fall within these exceptions and the SEC regards most initial coin offerings (ICOs) as security issuances. n33

To date, the SEC has issued over seventy enforcement actions against token issuers. Arguably, none are more significant than its 2020 action against the digital platform Ripple. The SEC claimed that Ripple’s issuance of the digital token XRP constituted an unregistered securities offering totaling approximately $600 million. n34 The case, which has not yet gone to trial. could clarify the regulatory landscape for virtual currency offerings. New SEC Chairman Gary Gensler recently urged Congress to clarify the SEC’s regulatory authority over digital assets, in particular exchanges, claiming the breadth of the industry is outpacing the SEC’s purview. n35

There is a growing emphasis on banking and depository institutions serving as custodians, issuers, or redemption agents for virtual currencies. A series of interpretive letters by the OCC indicates that commercial and savings banks may implement traditional banking services for virtual currency holdings. The FDIC has requested comments on the potential for digital assets to integrate into the activities of financial institutions. n36 The Federal Reserve Board and the Financial Stability Oversight Council (FSOC) are also looking at potential oversight of stablecoins.

Finally, the IRS treats virtual currencies as property for income tax purposes. n37 The IRS has not provided clear guidance on whether certain virtual currencies and positions are commodities under Internal Revenue Code provisions. In the past, the IRS has deferred to the CFTC’s classification, and will likely impose commodity tax treatment on virtual currency transactions designated by the CFTC. n38 Following a 2016 report by the Treasury Inspector General, the agency has worked to build a more cohesive policy for addressing tax compliance and underreporting of virtual currency transactions. n39 Similar to a 2016 petition filing directed at Coinbase, n40 the IRS has issued a summons demanding the information of consumers transacting large sums on the Circle, Poloniex, and Kraken platforms. n41

1. Global Regulatory Environment

Significant differences in regulatory approaches to cryptocurrencies exist worldwide as governments grapple with the fast-paced development of the digital asset sector. While El Salvador has made bitcoin legal tender, n42 China banned trading of cryptocurrencies and declared cryptocurrency mining illegal. n43 Other countries have attempted to craft bespoke legal regimes that attract blockchain-based service developers.

Among the most aggressive jurisdictions are Switzerland and Liechtenstein. While Switzerland has amended its existing legislation, n44 Liechtenstein has introduced an entirely new law. Liechtenstein in fact became the first country to comprehensively pass regulation for the token economy, which entered into force in January 2020. n45 The Liechtenstein Blockchain Act allows any right or asset to be tokenized. n46 In September 2020, the Swiss Parliament passed new regulations for blockchain technology, which entered into force in two phases in 2021. n47 The new Swiss DLT Act amends several civil laws, financial market laws, and also securities law to provide a legal basis for trading rights through “electronic registers”, as it introduces ledger-based securities that are represented on blockchains. n48 It further introduces special provisions for the treatment of crypto-based assets in case of bankruptcy, and also establishes a new authorization category for DLT trading, a DLT license.

In the European Union (EU), Member States have implemented regulatory requirements relying on guidelines such as the Financial Action Task Force (FATF)’s guidance for virtual asset service providers (VASP) n49 in 2019 and the EU’s 5th Anti-Money Laundering Directive (AMLD5), n50 which has been enforced since 2020. n51 AMLD5 requires exchange services between “virtual currencies” and fiat currencies, as well as custodial wallets, to be registered with an EU Member State. Countries such as Gibraltar n52 and Malta have adopted crypto-friendly regimes for VASPs licensing. n53 Gibraltar, for example, in 2017 introduced a tailored license for fintech firms using blockchain technology. n54

To bring more clarity and provide a harmonious EU-wide approach, the European Commission proposed a new regulatory framework for digital assets as part of the European Union’s Digital Finance Strategy. The soon to be ratified proposal for Markets in Crypto Assets (MiCA), n55 aims to establish a common approach to digital assets beyond the existing rules for securities. Under MiCA, businesses issuing digital assets or serving as VASPs need to acquire a license in one EU Member State, which then becomes valid in all the EU. The proposal includes safeguards to address potential systemic risks, especially in relation to categories of digital assets, such as stablecoins.

In Asia, regulatory approaches vary widely. Japan, which once was home to Mt Gox, the biggest crypto exchange which handled 80% of global bitcoin trading before it went bankrupt due to a major hack, was the first country in the world to define a crypto exchange business in 2017 and legally define “virtual currency”. n56 Singapore, considered one of the crypto-friendliest nations and home to many startups, continues to attract crypto related business and already regulates crypto currency exchanges under the Payment Services Act. n57 Whereas in other parts of Asia, such as South Korea and Hong Kong, the cryptocurrency industry is facing new restrictions. n58

This is not a comprehensive global survey. And there are many details necessary to effectively compare policies across jurisdictions. I describe these global activities in part to illustrate that many other nations, including significant American competitors, are taking the digital asset phenomenon seriously. They are adopting distinctive approaches based on their own policy objectives and existing legal or regulatory structures. The U.S. should do the same.

III. DeFi Regulation

One of the most significant and rapidly growing parts of the blockchain sector is Decentralized Finance (DeFi). DeFi refers to financial services, and associated activity such as price feeds, with three distinctive characteristics: (i) trust-minimized execution and settlement on a permissionless blockchain; (ii) non-custodial treatment of assets; and (iii) software-based implementation that is open, programmable, and composable. n59 DeFi poses particularly acute challenges for regulators and policy-makers. Some of these relate to questions about securities rules or tax treatment for digital assets that have been under discussion and subject to regulatory pronouncements for years. Others are entirely new.

1. DeFi Benefits and Risks

Total value locked (TVL) in DeFi, representing the value of digital assets which are committed as liquidity or collateral for DeFi services, went from roughly $1 billion in late 2019, to more than $10 billion in mid 2020, to $110 billion in November 2021, n60 with further growth projected. n61 Centralized cryptocurrency exchanges, such as Bitfinex, have started offering bridges between their custodial trading platforms and DeFi offerings. n62 DeFi developers and others are also looking at ways to connect DeFi with traditional finance (TradFi) institutions and markets. For example, payment processors are partnering with DeFi applications to enable direct purchases of stablecoins, n63 and brokerages are starting to offer clients crypto wallets to access the DeFi ecosystem. n64

DeFi taps into the desire for an open, inclusive financial system that operates globally. A fully transparent system with no central authority, where users have ultimate control over their assets and can borrow, lend, trade, save and invest freely. The fact that the DeFi ecosystem is fully digital and typically operates on the shared trust infrastructure and standards of a particular blockchain ledger means that services can be modified and combined far more easily than in traditional finance. Increasing the velocity of assets and unlocking potential opportunities to earn yields or obtain capital efficiently has the potential to increase the risk-adjusted returns available to market participants.

As with other digital asset-based markets, DeFi also poses significant risks. In The DeFi Policy Maker Toolkit, a collaboration of the Wharton Blockchain and Digital Asset Project and the World Economic Forum, we identified five major categories of DeFi risks: n65

Financial: Depletion of funds due to market activity of other users, including rapid price declines, failure of liquidity, or strategic behavior.

Technical: Failures of the software systems supporting transaction execution, pricing, and integrity. These include issues such as smart contract vulnerabilities, poorly written smart contracts, failures of price oracles, or failures of the underlying blockchain settlement process.

Operational: Failures of the human systems for key management, protocol development, or governance. These include problems with updates or forks, key management for users and governance participants, and how to resolve disputes.

Legal Compliance: Use of DeFi to engage in illicit activity or to evade regulatory obligations.

Emergent: Macro-scale crashes due to the interaction, scaling, and integration of DeFi components. These risks become particularly worrisome as DeFi services plug into each other, and into traditional financial services markets, with limited visibility into the full set of interconnections.

In some cases, DeFi mitigates risks that are a serious problem calling for regulatory involvement in traditional finance. For example, with fully collateralized or over-collateralized DeFi transactions, there is not the counterparty risk that parties will not actually have the capital they claim to have. Positions are visible on the blockchain, and cryptographically secured. In other cases, DeFi generates risks that have no analogue in the established environment. A software error in a traditional derivatives trade, if identified, can be the basis for legal redress or rolling back a transaction. DeFi is based on immutable execution of smart contracts, which can make even obvious mistakes nearly impossible to fix, unless some anticipatory mechanism is put into place.

DeFi market participants, services such as smart contract auditors and DeFi insurance providers, and regulators are actively working to evaluate and address many of these risk categories. A full discussion of the state of play is beyond the scope of this testimony. More to the point, many of these risks involve the kinds of technical issues best addressed by expert agencies or departments within the scope of their mandate. The question for the Congress is whether, and if so how, to alter the statutory framework.

1. DeFi and Regulating Decentralized Systems

DeFi squarely poses the challenge of how it may be possible regulate decentralized systems. A custodial cryptocurrency exchange has a corporate structure, headquarters, management team, and typically licenses or registrations. A decentralized exchange functioning as an automated market maker (AMM), or other on-chain DeFi protocol, need only be software code in the form of smart contracts running on a distributed blockchain network. If the code allows transactions that violate U.S. law, such as sending funds to sanctioned entities or transacting in unregistered securities, the question arises as to how those regulations could be enforced. No natural person or firm needs to be involved for the code to execute and process a trade. Furthermore, if a regulator wished to take enforcement action, there would appear to be no person or firm to take action against.

While this may sound like an insoluble problem, it is likely to be manageable in practice, if regulators adapt their approaches and focus on the objectives of legal requirements. There are three points of contact that deserve consideration as means of addressing potential regulatory concerns about DeFi: stablecoins, app platforms, and token issuance.

Stablecoins

DeFi services are heavily dependent on stablecoins. This is partly because DeFi, being constructed of smart contracts running on blockchains, cannot directly interface with off-chain payment mechanisms. There is no way to take out a DeFi loan involving traditional U.S. dollars, or interfacing directly with traditional payment rails. Instead, DeFi uses digital assets that are functionally equivalent to those dollars.

The vast majority of stablecoin activity today is associated with centralized stablecoins, most notably Tether (USDT), USD Coin (USDC), and Binance Dollar (BUSD). n66 Facebook’s proposed Diem platform, formerly Libra, would also operate in a centralized fashion. Such operators maintain reserves of high-quality liquid assets as backing for the stablecoin. The stablecoin may be manifested as a token on multiple blockchains. However, those tokens are always associated with an identifiable entity that is subject to licensure and regulatory oversight. The exception is Tether, which has an obscure management structure. Tether claims to do no business in the United States, even though it is widely available through U.S.-based exchanges.

Today, centralized stablecoins are not subject to a consistent regulatory framework in the U.S. Some have obtained state money transmission licenses. n67 Others have state trust licenses. n68 Circle has announced plans to become a regulated full-reserve bank. n69 Avanti Bank and Trust plans to launch a stablecoin connected to a Wyoming-chartered Special Purpose Depository Institution.70 And as noted, Tether, the largest stablecoin by assets, is not currently regulated in the U.S. at all.71 The proposed STABLE Act would require all stablecoins to be regulated as banks, n72 while Cornell law professor Dan Awrey proposes that they be treated as money market funds. n73

Clarifying the regulatory context around stablecoins, and ensuring that they are subject to appropriate obligations, is a critically important step for policy-makers and regulators. n74 A run on a major stablecoin could be devastating for digital asset holders, and could have spillover effects into the larger financial system. Similarly, if the allegations of insufficient backing, fraudulent statements, and market manipulation against Tether turn out to be accurate, it could undermine trust in the entire digital asset trading market, given how deeply embedded Tether is in that market. There are important issues in deciding the proper structure of stablecoin regulation to address these public policy considerations, while not overly restricting innovative activity or excessively compromising Americans’ financial privacy. Therefore, I will not advocate for a specific solution here.

Any stablecoin regulatory framework must consider not only investor protection, market integrity, and financial stability, but also the potential role of stablecoins as DeFi onramps and offramps. If stablecoin operators are all treated as a virtual asset service providers subject to antimoney laundering obligations such as Know Your Customer (KYC) rules, that would provide a check that funds entering or leaving the DeFi ecosystem will associated with known, non-sanctioned individuals or entities. It would also provide an aggregation point for law enforcement agencies to monitor activity, with the assistance of sophisticated blockchain analytics tools. While this alone would not eliminate concerns about DeFi being used for criminal activity, it might ameliorate them to a material extent. n75

An open question is whether stablecoin regulations would go beyond sanctions enforcement and standard anti-money laundering checks to, for example, incorporate blacklists of transactions with non-compliant DeFi protocols. Such a move could significantly increase regulators leverage against decentralized DeFi protocols. However, it would also raise concerns about pushing activity to unregulated or offshore alternatives, as well as privacy concerns. The technical and policy aspects of such a step should be carefully considered.

App Interfaces

The second point of potential regulatory oversight for DeFi is the centralized component of major services. While the smart contracts themselves run on decentralized blockchains such as Ethereum, users often access their functionality through traditional websites. For example, Uniswap allows users to trade tokens on its Uniswap.org website, by connecting a wallet such as Metamask. This website is operated by the company Uniswap Labs which employs developers and can make changes to the code. For example, Uniswap delisted approximately 100 tokens in July 2021, including synthetic stock tokens, which would represent unauthorized unregistered securities transactions. n76 Users cannot now trade those tokens through the Uniswap app. They can, however, still send them programmatically to the Uniswap smart contract.

Because Uniswap Labs, the company clearly controls the website and develops the end-user app, it has significant legal exposure to illicit or non-compliant activity they facilitate. Explicit declarations by regulators of their intent to take action against DeFi app providers if they fail to meet certain obligations could therefore have a significant impact, even when the protocols themselves are nominally decentralized. Due consideration should be given to the burdens such obligations would impose, and the possibility that DeFi app providers will either move to another jurisdiction or shift away from a corporate form to a decentralized autonomous organization (DAO) structure. Such steps, however, are not costless, nor do they necessarily eliminate regulators’ ability to act.

The significance of platform-targeted enforcement depends on how much activity flows through the website or consumer-facing app, and how much is directly sent through the smart contract. n77 The app interfaces are more user-friendly, and therefore tend to be used by less-sophisticated and smaller-scale DeFi market participants. Most retail investors, even those who express a commitment to the ideals of decentralization, tend to care more about user experience. After all, centralized platforms dominate social media and investment services. A more decentralized system, all things being equal, is usually harder to use, or worse on some other dimension. The slow processing speed and limited capacity of Bitcoin compared to traditional payment networks is an example. There are technical tradeoffs involved in building effective decentralized systems, and mechanisms to hide the resulting complexity from end uses often wind up recreating new points of gateway control. All this suggests that regulation of application platforms–in other words, the more centralized component of DeFi services–could have significant effects, especially for the more vulnerable investors who are a source of particular concern.

The other side of the coin is how sophisticated an institutional actors will respond. There is some evidence that, although there is a significant and active retail DeFi community, including aggressive risk-taking “degens,” it is actually dwarfed by institutional-scale activity. The gas costs of every transaction on Ethereum, which is still the dominant platform for DeFi activity, can easily exceed $100, which limits the scope of small-scale trades. n78 Independent of that fact, the kinds of complex capital allocation and yield generation activities that DeFi offers, as well as the opportunity to trade large amounts of assets with limited “slippage” (corresponding price movement), appeal particularly to sophisticated traders. A recent Chainalysis report found that over 60% of DeFi volume was in transactions exceeding $10 million. n79

On the one hand, sophisticated traders may be better able to, or more interested in, finding ways to transaction without going through central gatekeepers or subjecting themselves to regulatory controls. On the other hand, many of these are regulated actors, or affiliated with regulated institutions. Regulators know who they are, and they will not engage in DeFi activities that expose them to major compliance risk. Recognizing how much capital that might flow into DeFi is controlled by institutional actors subject to regulatory obligations, DeFi service have begun to provide tailored offerings that meet their compliance obligations. For example, Aave, one of the largest DeFi lending platforms, has created a separate set of collateral pools, called Aave Arc, which are only accessible to verified liquidity providers that are identified through KYC. n80 Again, the fact that DeFi services are moving in this direction on their own suggests that, as regulators more clearly identify concerns and paths to compliance, major segments of the DeFi market may adapt in ways that make enforcement more feasible.

There will always be some actors in DeFi, and in the blockchain world more generally, who are committed to evading legal obligations. They may do so for strong ideological reasons, because they see significant profit opportunities, or because they provide services to criminals and other illicit actors (or themselves fit into that category). However, enforcement need not be perfect to be effective. There are non-compliant actors in the traditional financial system as well. Most market participants, especially those seeking to become large and successful, do not aspire to target the market of criminals, terrorists, and sanctioned nations. They want to attract large numbers of users. Those users, in turn, want platforms they can trust. They are used to relying on the protections of legal enforcement and consumer protection measures, rather than hoping for honor among thieves. If the burdens of regulatory compliance are not excessive, therefore, the larger DeFi market participants in particular are likely to accommodate them.

This is true even though blockchains are global. There is increasing coordination among major nations around regulatory approaches to blockchain-based systems, starting with financial crime guidelines under the Financial Action Task Force (FATF). Large financial markets are moving to harmonize their rules–with the exception of China, which is imposing considerably more stringent restrictions on its local digital asset economy. Small countries that seek to attract capital with loose regimes run the risk of being sanctioned or cut off from the global financial system. Again, this process is messy, but fundamentally resembles broader efforts to harmonize requirements for increasingly global financial services activity that have been ongoing for decades.

Token Issuers

A final opportunity for regulatory engagement with DeFi is in the tokens that power these services. Tokens do not appear from nowhere. Once they are issued and accessible through blockchain networks, it may be impossible to point to any entity managing them or controlling their distribution. However, there is always a point in time at which tokens are issued. And there is an entity that structured the token issuance, initiates it, and often promotes it or connects it to other deliberate activities.

The moment of token issuance, therefore, is an important regulatory opportunity. It is the point at which there is likely to be some identifiable actor who must engage with the blockchain and the outside world. The first major wave of enforcement actions against blockchain-based services followed the 2017 boom in Initial Coin Offerings (ICOs), in which developers pre-mined tokens and issued them to raise funds for new applications or networks. Even when a token is not a security subject to registration requirements, however, the point of issuance is still the moment at which it is easiest to assess and implement regulatory obligations.

It is not surprising, therefore, that the MiCA framework under development by the European Union focuses heavily on requirements for token issuers. n81 I am not advocating that the U.S. take exactly the same steps as Europe; there are issues with the MiCA rules and the overall legal framework is somewhat different. However, it is a model that bears studying on this side of the Atlantic.

1. The File-Sharing Analogy: Intent Matters

In considering novel developments such as the rise of blockchain and digital asset markets, it is often helpful to look back to historical analogies. In the case of DeFi, important precursors are the rapid rise–and equally rapid fall–of peer to peer (P2P) file sharing applications. While the story is a familiar one in technology circles, the legal resolution of the P2P file-sharing challenges is not as well remembered. And it turns out to be directly relevant to DeFi.

P2P file-sharing threatened to undermine the economic foundations of the music industry, and other media industries as well.. .or perhaps merely to transform them. It all started with Napster, written by college student Shawn Fanning, and launched in 1999. Within a few months, Napster had more than 20 million downloads and 4 million songs in circulation. n82 These are astronomical numbers considering how much smaller the internet was at that point. App store ecosystems, or even smartphones, did not exist, and most internet users were still on dial-up connections over the telephone network. Napster and other P2P file-sharing applications took off primarily because they allowed people to access commercially-released music for free. At the time, the only way to purchase recorded music was on physical media such as CDs. Streaming was negligible and record labels refused to license online distribution of songs. With Napster, a user could freely download any songs shared by other users of the peer-to-peer network. The music industry saw it as an existential threat.

Napster posed an issue similar to the one we now face with DeFi: how to regulate decentralized activity? The legal issue in the earlier case was copyright infringement rather than financial regulation, but the structure of the problem was the same. Napster itself did not distribute any music. It did not store any music on its servers. It did not create or control the network through which users traded music. It merely distributed software, which connected itself to a dynamic decentralized network by finding other users of the software online at the same time. Napster and its defenders argued that Napster was not, in fact, contributing to infringement; it only provided a neutral tool that could be used to exchange any files of the user’s choosing.

The record industry sued Napster, and the case went to the United States Court of Appeals for the Ninth Circuit. n83 Napster lost. The court found that even though Napster did not itself store or transfer music files, Napster maintained a central database of all content accessible on the network at any time. Napster users contributed their own list of files automatically to this database, which other users referenced to identify what was available where. As a result, Napster knew exactly what was being traded on its network. It could clearly see that the vast majority of the activity involved illicit sharing of licensed content. Furthermore, Napster was essential to this activity. Without the dynamic database that Napster maintained, the file sharing network could not operate. In other words, Napster was essentially a DINO–decentralized in name only. It effectively maintained control of essential elements of the network, and therefore could be held legally responsible for the network’s activity/ Napster was quickly shut down. n84

There are today similar DeFi services that are decentralized in name only. Some of these simply associate with the name DeFi for marketing reasons, without having any real decentralization compared to more established services. DeFi Money Market (DMM), for example, was styled as a centralized lending pool that would aggregate participants’ capital and pay them interest. n85 It was in fact a fraud. Even as described, however, DMM was centralized: the operator of the pool controlled all the assets. The SEC had little difficulty taking action against DMM. n86

There are likely to be many more DeFi services that are similarly centralized in practice, or that maintain a significant amount of central control. The SEC in 2018 took action against EtherDelta, an early decentralized exchange (DEX). n87 EtherDelta, like today’s DeFi AMMs, did not take custody over users’ assets. However, it was controlled by a single developer who controlled the order book, listings, and access to the system. The SEC had little difficulty going after EtherDelta for impermissibly trading unregistered securities.

The more interesting parts of the P2P file-sharing story are what happened after Napster. Newer file-sharing applications architected themselves to remove the central control point that doomed Napster. These apps, most famously Kazaa but also including Grokster, LimeWire, and others, built up the database of available songs in a decentralized way, through direct communications between users’ software. There was no central database, and therefore the application developer could not directly see what users were transferring. Nor could the app distributor blacklist certain files. It had no direct control.

Nonetheless, the distributed P2P file-sharing services also lost in court. In MGM v. Grokster, the Supreme Court concluded that they were, like Napster, legally responsible for the activity on their network. n88 The legal theory in this case was that, even though these services did not see or allow each individual infringing transfer, they knew and encouraged the creation of a marketplace that was dominated by infringement. In other words, Grokster and Kazaa “induced” the illegal activity. Their marketing materials, business models, internal communications, and the obvious evidence of the market dynamics made clear that the file-sharing applications developers were not just innocent bystanders.

Further reinforcing this test, there was no legal action taken against BitTorrent, a P2P filesharing protocol optimized for distribution of video. Even though at one point upwards of one third of all internet traffic globally involved BitTorrent transfers, n89 and most of them were not licensed by the content owners, BitTorrent the company did nothing to induce such activity. It merely disseminated open-source software. Its own business was built around offering content owners the ability to distribute licensed video with protections against infringement. n90

The important point here is that the “why” of activity matters. Even when not explicitly spelled out in the laws or regulation, intent is a significant factor that regulators and enforcement agents consider in deciding whether to take action, and that courts consider in resolving cases. This is relevant in the blockchain context as well. For example, an alarmist study found that the code for child pornographic images, in text form, had been embedded in the Bitcoin blockchain, and suggested that miners might be subject to criminal prosecution for possessing such material. n91 No such prosecutions have occurred. Law enforcement officials understand the distinction between actors who contribute to the scourge of child sexual abuse and those, who through no fault of their own and with no ability to remove it, happen to store data that could theoretically be reconstructed into an illicit image. n92

One of the important questions for DeFi services will be why they decentralize. There are many legitimate reasons to do so. Decentralization removed power from intermediaries who extract rents, making services cheaper and more broadly accessible. It can make services more efficient while also making them more inclusive and equal. It can make systems more robust and secure, while drawing powerfully on the contributions of more participants. In these cases, the regulatory challenges DeFi poses are unintended side effects. In other cases, however, such as the Kazaa/Grokster architecture, decentralization is a deliberate means of avoiding legal obligations. If breaking the law is the primary benefit of decentralization, which otherwise creates difficulties for the service, it is fair to ask whether regulators should defer action in the name of “innovation.” Certainly, there will be many cases where intent is not obvious. That should not prevent use from identifying those where it is.

1. Recommendations

The rise of digital assets, and the overlapping trends increasingly described as Web 3, is not a fad. These are volatile markets that have crashed before and will crash again. There is a good deal of irrational exuberance in the current crypto market, or rational exuberance about shortterm speculative profits that are nonetheless not sustainable or generalizable. And as detailed earlier, there are serious risks and abuses associated with cryptocurrencies which policy-makers must address. None of this, however, calls into question the basic value proposition for blockchain as a foundational technology and digital assets a means of powering financial and other services.

Congress should take a three-pronged approach to the regulatory questions that cryptocurrencies raise. This is in addition to the normal oversight process for the various agencies addressing issues under their jurisdiction, and coordination with the Executive Branch. The three components of an effective approach are capacity building, addressing “low hanging fruit” aggressively, and engaging in a long-term examination the existing financial regulatory legal regime.

1. Capacity Building

The first step is to recognize that cryptocurrencies and blockchain pose thorny new challenges which regulators may be ill-prepared to address. There are also important questions relevant to the future of DeFi and other digital asset-based markets where even experts in the industry do not have good answers. Steps should be taken to improve the state of knowledge, and where possible to provide breathing space and help policy-makers gain a greater understanding of market dynamics.

One part of this step is to ramp up public research and development efforts, as well as experimentation by government agencies with blockchain-based solutions. There are many important research questions related to blockchain and cryptocurrencies that have not been subject to sufficient academic attention, especially regarding the business and financial dynamics rather than purely the computer science foundations. Public funding of research and government operating as a convenor of public sector, private sector, and academic experts should both receive higher priority, given the potential importance of digital assets and blockchain.

Other countries provide significant support for research and development in this area. For example, the European Union has funded blockchain research for several years through its Horizon 2020 initiative, as well as other mechanisms. n93 The EU Blockchain Observatory and Forum n94 and European Blockchain Service Infrastructure n95 are convening experts, developing standards, and coordinating responses to important issues. Chinese officials often describe blockchain as part of the country’s “New Infrastructure” strategy, along with other strategic technologies such as 5G wireless and artificial intelligence. n96

At the same time as government supports external research, agencies need to build the internal capacity to address tricky cryptocurrency-related questions effectively. Some mechanisms that have proven effective in similar contexts include: n97

Specialized regulatory units. A targeted group with qualified staffing, such as the SEC’s FinHub, can serve as an initial gateway to gain experience in new technology, interact with the industry and provide guidance. This knowledge can be shared with policy-makers and actions may include issuing non-action letters under existing regulatory regimes.

Incentivizing information flow. Disclosure is one of the most common tools of financial regulation. Even when the applicability of existing disclosure requirements on DeFi platforms is uncertain, efforts to encourage broad and consistent information disclosure may prove fruitful for regulatory analysis.

Regulatory sandboxes. Policy-makers may decide to establish regulatory forbearance programs such as sandboxes, where companies may test and operate their technology in a limited scope and therefore with limited regulatory risks. The sandbox gives start-ups a chance to address regulatory compliance concerns and gives regulators a better understanding of the risks and benefits of a new space.

Coordinating government action. In some cases, it may be useful to bring together different government entities for a harmonized response. Such efforts are already underway, through vehicles such as the President’s Working Group on Financial Markets, the Financial Stability Oversight Counsel, and the digital asset policy “sprint” between the OCC, FDIC, and Fed. More coordination will likely be valuable, however, including coordination with state authorities and regulators outside the U.S.

This list is not intended to be comprehensive. Nor does it presuppose any policy outcomes. The point of all the ideas listed in this section is to improve both the process and the substance of regulatory engagement with blockchain and digital asset firms, whatever direction that engagement takes.

1. Short-Term: Low-Hanging Fruit

The blockchain sector is developing and growing fast. Some needed policy actions do not require significant gestation and debate; they should be adopted as quickly as possible.

First, there are a number of situations where laws and regulations were written with language that fails to effectively accommodate digital assets and the distinctive features of blockchain-based systems. These are generally situations of un-intended consequences. Unclear or ill-fitting statutory language creates impediments for market participants that do not service any public policy objective.

In preparation for this testimony, I surveyed several legal experts from different areas of the digital asset space, and asked them what “low-hanging fruit” Congress could address in the near term. The following is a non-exhaustive list:

* The Infrastructure Investment and Jobs Act includes language classifying digital asset service providers as “brokers” subject to IRS reporting requirements. As drafted, it could cover actors, such as cryptocurrency miners, who have no means of complying and do not function as intermediaries targeted by the language. A bipartisan amendment was offered to address this oversight. Despite no direct opposition, it was not included in the final bill.

* The Infrastructure bill also included language incorporating digital assets into Section 6050I of the Internal Revenue Code, which requires those making transactions over $10,000 in their “trade or business” to report the counterparties’ social security number and other personal information. Without clarification or narrowing, this could sweep in a great deal of transactional activity that does not require reporting in the analogous situation involving traditional assets.

* Under current IRS guidance, any cryptocurrency transaction, even for payments, can constitute a taxable event. A de minimis exemption has been proposed in multiple sessions of Congress, but has not been adopted.

* Section 409A of the Internal Revenue Code provides exemptions for compensation involving “service recipient common stock” and “incentive stock option” plans, but does not appear to address the equivalent scenario in which compensation is provided on a deferred and scheduled based in the form of tokens.

There are other areas which, though somewhat more complicated, call for rapid action to resolve significant market uncertainty or address under-regulated activity. I have already mentioned one: implementing a consistent regulatory structure for stablecoins. Others include:

* Allocation of authority over digital assets between the SEC and CFTC, given the ambiguity of when these assets function as securities, commodities, or something else, and the confluence of spot and derivatives markets.

* Clarity on the definition of a qualified custodian for digital assets. Custody of digital assets is very different at a technical and operational level from custody of traditional financial assets. However, the market has become far more sophisticated in custody solutions than a few years ago.

* A pathway for a digital asset firm to gain broad access to the banking system, FDIC insurance, and payments networks, including Federal Reserve master account. There are many appropriate reasons for banks and bank regulators to be concerned about risks of digital assets. That does not mean that mechanisms for addressing those risks can never be identified.

At the same time such efforts are underway to facilitate legitimate digital asset activity, significantly stronger action must be taken against the bad actors. There is no reason for firms to make efforts to comply with the rules if they see that others who demonstrably do not suffer no ill consequences. Put simply, there is a great deal of obvious fraud and regulatory avoidance in the blockchain world. There has been for some time.

While a few fraudulent actors have been subject to enforcement actions, many have not. Limits on enforcement resources and the difficulty of successfully bringing cases are certainly part of the explanation. It is infeasible to pursue every case that appears to involve illicit activity. However, regulators and law enforcement should prioritize large and visible cases of fraud and theft, and seek to set examples. If funding is the limiting factor, the Congress should consider additional appropriations.

At the same time as action is taken against the obvious bad actors, investigative resources should be devoted to the large players in the blockchain ecosystem who have been credibly accused of market manipulation, such as Tether and Binance. n98 Most of these purport not to operate in the U.S.; some claim to have no headquarters at all; others shift between jurisdictions whenever questions are raised about their activities. Any enforcement action will therefore require significant cooperation with foreign law enforcement authorities. The effort is worth it. In the current environment, regulated U.S.-based actors transact with, and apparently derive significant benefits from, these offshore entities. In other situations, individual and firms take steps to nominally remove themselves from the U.S., while still enjoying the benefits of citizenship and easy access to U.S. capital markets.

Such conduct blurs the distinction between compliant and non-compliant service providers, and calls into question the integrity of the entire market. It may turn out that, after investigations, there is smoke but not fire. If that is the case, termination of investigations should help bring confidence to the market. If, on the other hand, even a portion of the allegations of systemic manipulation are true, many investors and other market participants are being taken advantage of, at massive scale. And it is only a matter of time before the shell game ends, with potentially disastrous consequences.

1. Re-Thinking Financial Regulation

Long-term, I do not think we can escape from the conclusion that blockchain and digital assets, along with other fintech developments, will contribute to a fundamental reshaping of our financial markets, and have major impacts in many other domains.

The fact that the relevant laws and, in many cases, judicial decisions establishing common-law doctrines, are decades old, is not itself a problem. We venerate the Constitution because its broad language can be interpreted to address issues the Framers themselves would never experience. It makes no sense to adopt new laws, and narrowly tailored laws, for every significant technological change. Laws and rules that are technology-specific tend to advantage or disadvantage one technological approach, which should not be the role of government, and quickly become outdated as newer technologies emerge.

However, there are situations where laws or regulatory structures do need to be re-evaluated. There is broad consensus, for example, that the accredited investor regime is an increasingly poor fit for the current investing environment, a problem that digital assets magnify. More generally, information disclosure, the centerpiece of the securities regulatory structure, means something different in a blockchain context where all transactions are transparent and cryptographically guaranteed although interpreting the transaction data and associating it with market participants may be more challenging than in traditional finance. And the highly fragmented financial regulatory structure that is almost entirely unique to the U.S. deserves a closer look in an era of digital convergence. A structure of multiple specialized agencies has benefits, but it also creates opportunities for regulatory arbitrage and confusion.

In 1996, after several years of effort, Congress passed the Telecommunications Act, which rewrote the outmoded Communications Act of 1934. There are many problems with the 1996 Act, not the least that it failed to anticipate how important the internet would become in the communications, media, and technology sectors. However, we would be worse off trying to regulate today under the old law, which could barely be stretched to cover cable television. At some point, frameworks that poorly fit new technologies are, in effect, no longer technology neutral.

The re-think I am describing will take time. It will address many issues beyond blockchain.

Some of the necessary changes are along the lines of the previous section, going more to clarifying language for a new context than changing the basic regulatory structure. Others, however, are deeper. The exercise of identifying high-level public policy goals, studying best practices for addressing them, balancing competing interests, and setting forth a modern framework will produce benefits in itself. And if successful, it could position the U.S. to maintain its leadership in the global financial system as it moves through its next technological transition.

1. Conclusion

I have attempted to set out a series of actions that Congress, agencies, Executive Branch Departments, and the Federal Reserve could take to address the dangers of cryptocurrencies and digital assets while both recognizing and facilitating their benefits. This list is not comprehensive; nor does it entirely represent a divergence from current approaches. There is significant activity underway in individual agencies and through coordination efforts such as the President’s Working Group on Financial Markets. Legislation has been introduced in many of these areas, and other legislative proposals are no doubt under development.

Perhaps the most important point to make is that, for all the rhetoric about how the U.S. is losing out to more tolerant jurisdictions, or to China’s aggressive state-led central bank digital currency, the reality is that America is one of the largest and most important markets for development of blockchain technology and activity in the digital asset economy. Many of the key development teams and companies are based in the U.S. or have significant presence here. That is true of an even larger percentage of the investment and market activity. The U.S. is the most sophisticated and most advanced capital market in the world, and also the home of a large percentage of the world’s most important technology firms. The factors that have put the U.S. in such a prominent position do not disappear in the blockchain world. While it is true that the global nature of blockchains and their ability to remove barriers to participants allows individuals from anywhere in the world to contribute, that is a dynamic leading U.S.-based firms have taken advantage of for a long time.

Of course, we cannot assume that the U.S. will always and automatically be a leader on the blockchain sector, or any other sector. China’s multi-pronged efforts to develop blockchain as a strategic technology and to bend digital assets into a state-superintended environment should not be dismissed. Nor should initiatives in Europe and in jurisdictions such as Singapore, Japan, Russia, and elsewhere be ignored. We need to do what worked so successfully in the early days of the commercial internet: articulate policy goals; clarify where uncertainty is an unnecessary check on innovation; take action where it is warranted; and adapt both our policy tools and our legal structures to take into account the deep changes underway.

There are many hard questions still to resolve, and many pieces to the blockchain regulatory puzzle. That should not stop us from moving forward to realize the incredible potential that digital assets and blockchain present.

n1 Kevin Werbach, The Blockchain and The New Architecture of Trust (The MIT Press 2018).

n2 Wharton Blockchain and Digital Asset Project, DeFi Beyond the Hype (2021), https://witpr.wharton.upenn.edu/wp-content/uploads/2021/05/DeFi-Beyond-the-Hype.pdf.

n3 World Economic Forum and Wharton Blockchain and Digital Asset Project, Decentralized Finance (DeFi) PolicyMaker Toolkit (2021), https://www.weforum.org/whitepapers/decentralized-finance-defi-policy-maker-toolkit.

n4 See LGST 244x/644x Blockchain and Cryptocurrencies: Business, Legal, and Regulatory Considerations, https://apps.wharton.upenn.edu/syllabi/2019C/LGST644401/.

n5 See Wharton Executive Education, Economics of Blockchain and Digital Assets, https://www.blockchain.wharton.upenn.edu/.

n6 As described below, I will primarily use the general term “digital assets,” because most of the tokens discussed are not intended to be employed as currencies.

n7 Kevin Werbach, Blockchain: The Last, Best Hope for Open Data, NESTA (September 11, 2020), https://www.nesta.org.uk/report/blockchain-last-best-hope-open-data/.

n8 See John M. Griffin and Amin Shams, Is Bitcoin Really Untethered?, 75 J. of Finance 1913 (2020); Jacob Silverman, Is Tether Just a Scam to Enrich Bitcoin Investors?, New Republic (Jan. 13, 2021), https://newrepublic.com/article/160905/tether-cryptocurrency-scam-enrich-bitcoin-investors.

n9 See President William J. Clinton and Vice President Albert Gore, Jr., A Framework for Global Electronic Commerce (1997), https://clintonwhitehouse4.archives.gov/WH/New/Commerce/.

n10 See Kevin Werbach, Digital Tornado: The Internet and Telecommunications Policy (1997), https://www.fcc.gov/reports-research/working-papers/digital-tornado-internet-and-telecommunications-policy.

n11 See Framework for Global Electronic Commerce (1997), supra note 8.

n12 See Yvonne Lau, Cryptocurrencies hit market cap of $3 trillion for the first time as Bitcoin and Ether reach record highs, Fortune (Nov. 9, 2021), https://fortune.com/2021/11/09/cryptocurrency-market-cap-3-trillion-bitcion-ether-shiba-inu/.

n13 Patricia Kowsmann and Caitlin Ostroff, $76 Billion a Day: How Binance Became the World’s Biggest Crypto Exchange, Wall Street Journal (Nov. 11, 2021).

n14 I focus here on public permissionless blockchains. There are also permissioned networks and consortia built on platforms such as R3 Corda and Hyperledger Fabric. These are important in the enterprise blockchain market, but generally do not create platforms for third-party DApps and publicly accessible cryptocurrencies.

n15 A recent upgrade, Taproot, increases Bitcoin’s capability to support smart contracts. There are also platforms built on top of Bitcoin, such as RSK and Stacks, which offer some of this functionality. See, e.g., Arijit Sarkar, BREAKING: The Bitcoin network welcomes Taproot soft fork upgrade, Cointelegraph (Nov. 14, 2021).

n16 See Ethereum Daily Transactions Chart, https://etherscan.io/chart/tx.

n17 See Samyuktha Sriram, Ethereum Settles Over $6 Trillion In Transactions In Last 12 Months, Benzinga (Oct. 5, 2021), https://www.benzinga.com/markets/cryptocurrency/21/10/23234548/ethereum-settles-over-6-trillion-in-transactions-in-last- 12-months.

n18 According to coinmarketcap there are more than 14,000 cryptocurrencies. See CoinMarketCap, https://coinmarketcap.com/ (visited Nov. 12, 2021).

n19 See CoinMarketCap, https://coinmarketcap.com/.

n20 On the Ethereum blockchain the number of new addresses is increasing daily. See Ethereum Unique Addresses Chart, https ://etherscan.io/chart/address.

n21 See Top 100 Cryptos by Market Cap, OnChainFX, https://onchainfx.com/ (visited Nov. 12, 2021).

n22 Ryan Browne, Here’s why regulators are so worried about Facebook’s digital currency, CNBC.com (September 19, 2019), https://www.cnbc.com/2019/09/19/heres-why-regulators-are-so-worried-about-facebooks-digital-currency.html.

n23 This subsection is adapted from testimony I gave this summer to a legislative hearing before a committee of the Pennsylvania State Assembly on July 19, 2021.

n24 Requirements for Certain Transactions Involving Convertible Virtual Currency or Digital Assets, 85 FR 83840 (Dec. 23, 2020) (to be codified at 47 C.F.R. pts. 1020, 1022).

n25 In the Matter of BTC-E a/k/a Canton Business Corp. and Alexander Vinnik, Assessment of Civil Money Penalty, FinCEN (July 26, 2017), https://www.fincen.gov/sites/default/files/enforcement_action/2020-05-21/Assessment%20for%20BTCeVinnik%20FINAL2.pdf.

n26 See Press Release, U.S. Dep’t of Just., ‘Bitcoin Maven ‘ Sentenced to One Year in Federal Prison in Bitcoin Money Laundering Case (July 9, 2018), https://www.justice.gov/usao-cdca/pr/bitcoin-maven-sentenced-one-year-federal-prison-bitcoin-money-laundering-case; see also In the Matter of Eric Powers, FinCEN (Apr. 18, 2019), https://www.fincen.gov/sites/default/files/enforcement_action/2020-05-21/Assessment%20Eric%20Powers%20Final%20for%20Posting%2004.18.19.pdf.

n27 Judgment, United States v. Theresa Lynn Tetley, No. 17-cr-00738 (C.D. CA 2018), https://storage.courtlistener.com/recap/gov.uscourts.cacd.695757/gov.uscourts.cacd.695757.45.0_1.pdf.

n28 See In the Matter of Coinflip Inc., CFTC (Sept. 17, 2015), https://www.cftc.gov/sites/default/files/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfcoinfl iprorder09172015 .pdf.

n29 See CFTC v. McDonnell, 287 F. Supp. 3d 213 (E.D.N.Y. 2018); see also Press Release, CFTC, CFTC Statement of Self-Certification of Bitcoin Products by CME, CFE and Cantor Exchange (Dec. 1, 2017), https://www.cftc.gov/PressRoom/PressReleases/7654-17.

n30 See Press Release, CFTC, CFTC Orders Coinbase Inc. to Pay $6.5 Million for False, Misleading, or Inaccurate Reporting and Wash Trading (Mar. 19, 2021), https://www.cftc.gov/PressRoom/PressReleases/8369-21.

n31 See SEC FinHub, Framework for “Investment Contract” Analysis of Digital Assets (Apr. 3, 2019), https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets.

n32 See Bill Hinman and Valerie Szczepanik, Statement on “Framework for ‘Investment Contract’ Analysis of Digital Assets,” SEC (Apr. 3, 2019), https://www.sec.gov/news/public-statement/statement-framework-investment-contract-analysis-digital-assets.

n33 See Oversight of the Securities and Exchange Commission, Before the S. Comm. on Banking, Housing, and Urban Affairs, 116th Cong. (2019) (statement of Jay Clayton, Chairman, SEC).

n34 See Complaint, SEC v. Ripple Labs, Inc., Bradley Garlinghouse, and Christian A. Larsen, No. 20-cv-10832 (S.D.N.Y. 2020), https://www.sec.gov/litigation/complaints/2020/comp-pr2020-338.pdf; see also Press Release, SEC, SEC Charges Ripple and Two Executives with Conducting $1.3 Billion Unregistered Securities Offering (Dec. 22, 2020), https://www.sec.gov/news/press-release/2020-338.

n35 See Oversight of the Securities and Exchange Commission, Before the Subcomm. on Fin. Serv. And General Govt. of the H. Appropriations Comm., 117th Cong. (2021) (statement of Gary Gensler, Chairman, SEC).

n36 See Press Release, FDIC, FDIC Issues Request for Information on Digital Assets (May 17, 2021), https://www.fdic.gov/news/press-releases/2021/pr21046.html.

n37 See IRS Notice, Guidance for Individuals and Businesses on the Tax Treatment of Transactions Using Virtual Currencies (Apr. 14, 2014), https://www.irs.gov/pub/irs-drop/rr-19-24.pdf; see also IRS Notice, Frequently Asked Questions on Virtual Currency Transactions (Oct. 9, 2019), https://www.irs.gov/pub/irs-drop/rr-19-24.pdf.

n38 See New York State Bar Association Tax Section Report, Report on the Taxation of Cryptocurrency (Jan. 26, 2020), https://nysba.org/app/uploads/2020/03/Report-1433.pdf.

n39 See Treasury Inspector General for Tax Administration, As the Use of Virtual Currencies in Taxable Transactions Becomes More Common, Additional Actions are Needed to Ensure Taxpayer Compliance (Sept. 21, 2016), https://www.treasury.gov/tigta/auditreports/2016reports/201630083ir.pdf.

n40 See United States of America v. John Doe, No. 16-cv-06658-JSC (N.D. CA 2017).

n41 See Press Release, U.S. Dep’t of Just., Court Authorizes Service of John Doe Summons Seeking Identities of U.S. Taxpayers Who Have Used Cryptocurrencies (Apr. 1, 2021), https://www.justice.gov/opa/pr/court-authorizes-service-john-doe-summons-seeking-identities-us-taxpayers-who-have-used-0; see also Press Release, U.S. Dep’t of Just., Court Authorizes Service of John Doe Summons Seeking Identities of U.S. Taxpayers Who Have Used Cryptocurrency (May 5, 2021), https://www.justice.gov/opa/pr/court-authorizes-service-john-doe-summons-seeking-identities-us-taxpayers-who-have-used-1.

n42 See Nelson Renteria et al., In a world first, El Salvador makes bitcoin legal tender, Reuters (June 9, 2021), https://www.reuters.com/world/americas/el-salvador-approves-first-law-bitcoin-legal-tender-2021-06-09/.

n43 See Alun John et al., China’s top regulators ban crypto trading and mining, sending bitcoin tumbling, Reuters (Sept. 24, 2021), https://www.reuters.com/world/china/china-central-bank-vows-crackdown-cryptocurrency-trading-2021-09-24/. There are some indications that the ban on mining may be subject to reconsideration.

n44 See Swiss Confederation Federal Act on the Adaptation of Federal Law to Developments in Distributed Ledger Technology of 25 September 2020,https://www.sif.admin.ch/dam/sif/en/dokumente/Blockchain/blockchain_dlt_gesetz.pdf.download.pdf/DLT%20Federal%20Act.pdf.

n45 See Press Release, Government Principality of Liechtenstein, Liechtenstein Parliament approves Blockchain Act unanimously (Oct. 3, 2019), https://www.regierung.li/en/press-releases/222958/?typ=contentandnid=11164. See The Token and Trusted Technology Service Provider Act (TVTG), https://www.gesetze.li/konso/2019301000. The English version of the Blockchain Act, including the government consultation report, can be accessed at https://nlaw.li/25.

n46 Id.

n47 See Press Release, Swiss Confederation Federal Council, Federal Council brings DLT Act fully into force and issues ordinance (June 18, 2021), https://www.efd.admin.ch/efd/en/home/the-fdf/nsb-news_list.msg-id-84035.html.

n48 See Swiss Confederation Federal Department of Finance, Digitalisation, Blockchain – Brief Summary, https://www.efd.admin.ch/efd/en/home/digitalisierung/blockchain.html.

n49 See FATF’s Guidance for a Risk-Based Approach – Virtual Assets and Virtual Asset Providers, https://www.fatf-gafi.org/media/fatf/documents/recommendations/RBA-VA-VASPs.pdf.

n50 See Directive (EU) 2018/843 of the European Parliament and of the Council of 30 May 2018 amending Directive (EU) 2015/849 on the prevention of the use of the financial system for the purposes of money laundering or terrorist financing, and amending Directives 2009/138/EC and 2013/36/EU, https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32018L0843andfrom=EN.

n51 As a directive, it leaves EU countries the freedom to create their own laws to achieve the directive’s goals. See generally, https://europa.eu/european-union/law/legal-acts_en.

n52 Note that upon UK’s withdrawal from the EU, Gibraltar as a British Overseas Territory also ceased to be part of it, but it retains a special status regarding negotiations between the EU and the UK, requiring the involvement of Spain. See La Moncloa, Spanish Government on Brexit and resulting consequences regarding Gibraltar, https://www.lamoncloa.gob.es/lang/en/brexit/gibraltar/Paginas/index.aspx.

n53 See Sandali Handagama, Europe’s MiCA Crypto Rules Are Coming Soon. Here’s Why They Matter, Coindesk (Nov 2, 2021), https://www.coindesk.com/policy/2021/! 1/02/unpacking-europes-looming-mica-crypto-regulation/.

n54 See Huw Jones, Gibraltar launches financial services license for blockchain, Reuters (Dec. 14, 2017), https://www.reuters.com/article/us-gibraltar-regulator-blockchain-idUSKBN1E81JO.

n55 See European Commission COM(2020) 593 final, Proposal for a Regulation of the European Parliament and of the Council on Markets in Crypto-assets, and amending Directive (EU) 2019/1937, https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A52020PC0593.

n56 See Sygna Blog, Guide: Japan Crypto Asset Regulation, https://www.sygna.io/blog/japan-crypto-asset-regulation-guide/.

n57 See Monetary Authority of Singapore (MAS) Payment Services Act, https://www.mas.gov.sg/regulation/acts/payment-services-act.

n58 See Mercedes Ruehl and Leo Lewis, Stakes Rise for Singapore’s Big Crypto Bet, Financial Times (Sept. 30, 2021), https://www.ft.com/content/1f948b38-2061 -416d-951d-69415b879c17.

n59 See DeFi Policy-Maker Toolkit, supra note 3 at 21 et seq.

n60 See Total Value Locked (USD) in DeFi, https://defipulse.com/.

n61 See, e.g., Ethan Wu, Why DeFi could be an $800 billion industry next year, according to a crypto expert, Businessinsider (Aug. 19, 2021), https://markets.businessinsider.com/news/currencies/defi-crypto-800-billion-industry-billionaire-decentralized-fmance-vesper-2021-08.

n62 See Tom Farren, Bitfinex launches the first L2 bridge from CeFi to DeFi, Cointelegraph (Sep. 23, 2021), https://cointelegraph.com/news/bitfinex-launches-the-first-l2-bridge-from-cefi-to-defi.

n63 See Adrian Zmudzinski, DeFi Leader MakerDAO Partners With Simplex to Create a Dai Fiat On-Ramp, Cointelegraph (Mar. 3, 2020), https://cointelegraph.com/news/defi-leader-markerdao-partners-with-simplex-to-create-a-dai-fiat-on-ramp.

n64 See Robert Stevens, Robinhood Crypto COO, CTO Hint That DeFi Features Are Coming, Decrypt (Sep. 26, 2021), https://decrypt.co/81946/robinhood-crypto-coo-cto-defi-tools.

n65 See DeFi Policy-Maker Toolkit, supra note 3 at 13 et seq.

n66 See Top Stablecoin Tokens by Market Capitalization, CoinMarketCap, https://coinmarketcap.com/view/stablecoin/.

n67 The USDC Stablecoin’s issuer Circle, for example, is regulated by FinCEN as a Money Services Business and holds money transmitter licenses in several states. See Circle US Licenses, https://www.circle.com/en/legal/us-licenses.

n68 E.g., Paxos Standard (PAX) and the Gemini Dollar (GUSD) are Trust companies regulated by the New York State Department of Financial Services (NYDFS). See Press Release, NYDFS, DFS continues to foster responsible growth in New York’s FinTech industry with new virtual currency product approvals (Sept. 10, 2018), https://www.dfs.ny.gov/reports_and_publications/press_releases/pr1809101.

n69 See Jeremy Allaire, Our Journey to Become a National Digital Currency Bank, Circle Blog (Aug. 9, 2021), https://www.circle.com/blog/our-journey-to-become-a-national-digital-currency-bank.

n70 See Nate DiCamillo, Unpacking the Avit, Avanti Bank’s New Digital Asset Being Built With Blockstream, Coindesk (Aug. 12, 2020), https://www.coindesk.com/business/2020/08/12/unpacking-the-avit-avanti-banks-new-digital-asset-being-built-with-blockstream/.

n71 Tether and Bitfinex were sued by the New York Attorney General and agreed to pay a $18.5 million fee for fraudulent activity. The settlement included a commitment that the entities would cease operations in New York. See Press Release, Letitia James NY Attorney General (Feb. 23, 2021), https://ag.ny.gov/press-release/2021/attorney-general-james-ends-virtual-currency-trading-platform-bitfinexs-illegal.

n72 See, Stablecoin Classification and Regulation Act of 2020 (US Congress H.R.8827), https://www.congress.gov/bill/116th-congress/house-bill/8827/text?r=1ands=1. See also Press Release, Congresswoman Rashida Tlaib (MI-13), Tlaib, Garda and Lynch Introduce Legislation Protecting Consumers from Cryptocurrency-Related Financial Threats (Dec. 2, 2020), https://tlaib.house.gov/media/press-releases/tlaib-garcia-and-lynch-stableact.

n73 See Dan Awrey, Bad Money, 106:1 Cornell Law Review 1 (2020); Cornell Legal Studies Research Paper No. 2038, https://ssrn.com/abstract=3532681.

n74 See Kevin Werbach, Comments regarding Docket No. OP-1747, Proposed Guidelines to Evaluate Requests for Accounts and Services at Federal Reserve Bank (Letter, July 9, 2021), https://www.federalreserve.gov/SECRS/2021/July/20210721/OP-1747/OP-1747_070921_138743_356123729916_1.pdf.

n75 There are also stablecoins which operate as entirely smart contracts, rather than through fiat backing. The most prominent of these is MakerDAO, which has $19 billion in assets. There are many others, which either use collateral in the form of digital assets to back the stablecoin or dynamically increase and decrease supply to keep the price stable. Several algorithmic stablecoins have failed to maintain their peg during periods of market volatility or due to deliberate attack, although others have so far managed to avoid that outcome. These on-chain stablecoins raise similar regulatory challenges as DeFi services such as AMMs and lending engines. Although, perhaps ironically,MakerDAO’s collateral has become increasingly dominated by USDC, a fiat-backed stablecoin, which may make it less difficult to address from a regulatory perspective. See Dai Stats, https://daistats.com/#/overview.

n76 See Martin Young, Uniswap delists 100 tokens from interface, including options and indexes, Cointelegraph (July 26, 2021), https://cointelegraph.com/news/uniswap-delists-100-tokens-ffom-interface-including-options-and-indexes.

n77 Uniswap reportedly has more volume directly through the smart contract than through the consumer-facing app, users can also execute transactions by the interface of other DeFi applications, such as the DEX aggregator 1inch. It is early, however, to make definitive judgements, given how fast the DeFi market is growing and changing.

n78 There are ways to keep some transactions off-chain. Scaling solutions for Ethereum, such as sidechains and layer-2 “rollups,” as well as alternative blockchains such as Solana and Avalanche with lower transaction costs, may remove this impediment to small-scale DeFi activity. Exactly how and how quickly, though, remains to be seen.

n79 See Osato Avan-Nomayo, Institutional investors dominated the DeFi scene in Q2: Chainalysis report, Cointelegraph (Sept. 8, 2021), https://cointelegraph.com/news/institutional-investors-dominated-the-defi-scene-in-q2-chainalysis-report.

n80 Tim Copeland, DeFi Permissioned DeFi platform Aave Arc gears up for launch, The Block (September 27, 2021), https://www.theblockcrypto.com/linked/118822/permissioned-defi-platform-aave-arc-gears-up-for-launch.

n81 The other major category in MiCA are virtual asset service providers, primarily for financial crime prevention.

n82 See Napster: 20 million users, CNN Money July 19, 2000), https://money.cnn.com/2000/07/19/technology/napster/index.htm.

n83 See AandM Records, Inc. v. Napster, Inc., 239 F.3d 1004 (9th Cir. 2001).

n84 The service had a second life as a tool for licensed music distribution, but never regained its prior success.

n85 See Gregory Keough et al., DeFi Money Market Ecosystem – Earn Interest on Digital Assets Backed By Real-World Assets Represented On-Chain, Whitepaper (Feb, 2020), https://defimoneymarket.com/files/DMM-Ecosystem.pdf.

n86 See Press Release, SEC, SEC Charges Decentralized Finance Lender and Top Executive for Raising $30 Million Through Fraudulent Offerings (Aug. 6, 2021), https://www.sec.gov/news/press-release/2021-145.

n87 See Press Release, SEC, SEC Charges EtherDelta Founder With Operating an Unregistered Exchange (Nov. 8, 2018), https://www.sec.gov/news/press-release/2018-258.

n88 See MGM Studios, Inc. v. Grokster, Ltd., 545 U.S. 913 (2005).

n89 See CacheLogic says 35% of all Internet traffic is now BitTorrent, ZDNet (November 4, 2004), https://www.zdnet.com/artide/cachelogic-says-35-of-all-intemet-traffic-is-now-bittorrent/.

n90 Ironically, the BitTorrent company was eventually purchased by Tron, a blockchain network. See Ingrid Lunden, BitTorrent is selling for $140M to Justin Sun and his blockchain startup Tron, TechCrunch (Jun. 18, 2018), https://techcrunch.com/2018/06/18/bittorrent-tron/.

n91 See Hamza Shaban, People are using bitcoin’s system to share child pornography, researchers say, The Washington Post (Mar. 22, 2018), https://www.washingtonpost.com/news/the-switch/wp/2018/03/22/people-are-using-bitcoins-system-to-share-child-pornography/.

n92 See Kevin Werbach, Arvind Narayanan and James Grimmelmann, Why Porn on the Blockchain Won’t Doom Bitcoin (Wired Online, March 29, 2018), https://www.wired.com/story/why-porn-on-the-blockchain-wont-doom-bitcoin/.

n93 See European Commission on Shaping Europe’s digital future, Blockchain funding and investment, https://digital-strategy.ec.europa.eu/en/policies/blockchain-fundmg.

n94 European Commission initiative EU Blockchain Observatory and Forum, https://www.eublockchainforum.eu/.

n95 European Commission on Shaping Europe’s digital future, European Blockchain Services Infrastructure, https://digital-strategy.ec.europa.eu/en/policies/european-blockchain-services-infrastructure.

n96 See Jane Wu, Blockchain as an Infrastructure: A Deep Dive Into China’s DLTStrategy, Cointelegraph (Jun. 23, 2020), https://cointelegraph.com/news/blockchain-as-an-infrastructure-a-deep-dive-into-chinas-dlt-strategy.

n97 This list is derived from a section of the DeFi Policy-Maker Toolkit, see supra note 3.

n98 It is for regulators and law enforcement to decide whether these allegations are accurate. I raise them to note that they are long-standing and not unsupported by available evidence. See supra notes 8, 71. Furthermore, even if cryptocurrency markets do not constituted trading in securities, that does not mean that market integrity concerns should be ignored.

Read this original document at: https://www.jec.senate.gov/public/index.cfm?a=files.serveandFile_id=BCCFC06E-6756-47BD-A075-ACB5087A9E2C

 

ALSO:

 

Regulatory proposals

House Joint Economic Committee Hearing; “Demystifying Crypto: Digital Assets and the Role of Government.”; Testimony by Peter Valkenburgh, Director of Research, Coin Center, Washington, DC Congressional Documents and Publications. November 17, 2021

 

All I’m going to tell you is that we’ve finally built a tool that can make money work without banks, n8 make organizations work without corporations and courts, n9 make sharing and transacting online work without Big Tech, n10 and that because of that change there’s a better chance that tomorrow’s misfits will be able to speak, share, and innovate.

This truly American ideal, however, isn’t about anarchy. It’s about opportunity and equality under the law. Bitcoin and follow-on cryptocurrencies are not unregulated. n11 Sensible, technology-neutral regulations have protected consumers n12 and investors, n13 and prevented money laundering and illicit finance. n14 The American approach is to regulate activities, not to ban or blacklist the publishing of new ideas and tools.

Anyone can freely write and share the open source software that makes these technologies work, and any prior restraint on sharing that expressive content violates our First Amendment rights. n15 However, if you promise an investor you’ll invent and build them a new, future cryptocurrency, we expect you to register as the issuer of a security. n16

No one is made to open their homes and private bitcoin wallets to a search by the police without a warrant. n17 But if you provide a service to help people buy and sell bitcoin as a third party, you are expected to know your customers and apply anti-money laundering controls. n18

There are some gaps in America’s crypto public policy. The gaps are not, contrary to popular belief, a central bank digital currency gap with China. The CCP is more interested in banning permissionless tools like Bitcoin n19 and substituting a surveillance tool n20 that will give them even more control over the misfits within their borders. We should not emulate that policy.

The gaps are much more mundane; they deal with securities and commodities futures policies and tax issues. Below we will discuss them in turn by category.

1. Securities and commodities futures policy

On the margin, securities and commodities futures laws can be improved and there are well-drafted bills in the House that address those issues. They fall into two major baskets: clarity for the developers of new cryptocurrencies and cryptocurrency secondary market oversight.

1. Clarity for developers of new cryptocurrencies.

First, pre-sales of future cryptocurrencies, often called “initial coin offerings” or “ICOs”, already meet the definition of securities and, indeed, investors protections and disclosures afforded by the securities laws are sensible and should be fairly applied in the context of promises of future cryptocurrencies. However, once a cryptocurrency has launched, the application of securities laws is no longer appropriate. n21 Once the network has launched, anyone can participate in maintaining the ledger and anyone can see and propose changes to the cryptocurrency’s protocol software. n22 As such, information asymmetries meant to be addressed by securities laws disclosures are no longer present and no person or persons is in a position to make disclosures on behalf of the open network. While other investor protection measures may continue to apply and remain relevant and appropriate, the disclosure regime inherent in securities issuance regulation is a poor fit. n23

Nonetheless, there can be some ambiguity regarding whether a newly developed cryptocurrency continues to meet the flexible definition of a security even after the software has been developed and the network is live. We believe that the SEC has avoided overbroad interpretation of this ambiguity thus far but prefer a legislative solution for the long term.

Chairman McHenry has introduced a safe harbor for developers of new cryptocurrencies n24 based on an earlier proposal from SEC Commissioner Hester Peirce. n25 Under the proposal, if developers pre-sold a new cryptocurrency in a manner compliant with securities laws n26 and if they register under the safe harbor provisions, which require sensible, technology-appropriate disclosures, n27 then the SEC will commit to forbearance for three years. This approach has the advantage of not altering the necessarily flexible n28 definition of a security in the law while also providing some assurance that innovators acting in good faith will not be the target of a surprise enforcement action. Congressman Emmer has introduced a bill that would subtly alter the definition of securities to limit its applicability such that it could not include truly open source, open network cryptocurrencies. n29

2. Secondary market supervision.

While cryptocurrency exchanges here in the U.S. are currently regulated as state money transmitters n30 or state chartered banks or trust companies, n31 these regulatory forms focus primarily on prudential and consumer protection controls (e.g. minimum capital and permissible investment requirements) rather than market integrity (e.g. prevention of market manipulation and systemic risk). The SEC and CFTC both have competency supervising trading venues for market integrity but neither has jurisdiction over trading venues dealing exclusively in cryptocurrencies (the CFTC supervises commodities derivatives markets while the SEC supervises securities markets; cryptocurrency exchanges are typically commodities spot markets only n32). Last session, Chairman Conoway introduced legislation that would grant the

CFTC authority to supervise cryptocurrency spot markets. n33 It provides a flexible approach that would make CFTC regulation optional but would require that newly launched cryptocurrencies (where early investors may exert outsized market power) must initially be traded to the retail public only on CFTC supervised exchanges. n34

1. The Infrastructure Investment and Jobs Act

The recently passed infrastructure bill included rushed language that could unintentionally stifle innovation and invade personal privacy. In the Senate there was a bipartisan solution with widespread support but procedurally it was impossible to implement before the bill’s passage. n35 Ideally, new legislation would address two problems:

1. “Broker” definition and third party reporting.

The infrastructure package amended the definition of “broker” in the tax code. n36 This definition determines who must perform third party reporting of capital gains. n37 The new definition should be tightened so that it could not inadvertently place reporting obligations on persons within the cryptocurrency ecosystem who have neither customers nor any reason to obtain private information about other cryptocurrency users. It is entirely reasonable to expect custodial cryptocurrency exchanges to do third party tax reporting. However, it is inappropriate to ask non-custodial persons such as cryptocurrency miners and software developers to surveil persons who are not their customers. n38

2. 6050I reporting.

The 6050I provision of the U.S. tax code obligates businesses to file reports (including names and Social Security numbers) about their counterparties whenever they receive more than $10,000 in cash. n39 Amendments in the infrastructure package will require similar reporting when businesses receive more than $10,000 in cryptocurrencies. n40 Typically Coin Center does not object to equal treatment of cash and cryptocurrencies, but the [Sec.]6050I reporting provision is a draconian surveillance rule that should have been ruled unconstitutional long ago.

Warrantless private data collection is tolerated under the fourth amendment when it is performed by third parties (e.g. banks or money transmitters) who have obtained that information from their customers voluntarily and retained that information for a legitimate business purpose. n41 6050I reports are just as intrusive of personal privacy as the warrantless data collection performed by banks and other third parties but, in the case of a 6050I report, there is no third party and therefore the third party doctrine of the 4th Amendment could not possibly exempt the search from a warrant requirement. Under 6050I, one person to a two person transaction is obligated to collect sensitive information from her counterparty and hand that to government officials without any warrant or reasonable suspicion of wrongdoing. In the case of two persons exchanging two different cryptocurrencies, they each would have to report on the other. The law literally asks one American citizen to inform on another if the transactions in which the two are engaged are “business” and if they take place using cash or cryptocurrencies. We believe that a constitutional challenge to 6050I will eventually succeed in overturning the requirement, however we prefer a legislative fix.

1. Other issues

Existing IRS policy leaves taxpayers uncertain of their obligations with regard to cryptocurrency transactions. Three common sense measures can be taken by congress to address this issue.

1. De minimis tax exemption from capital gains treatment.

Every time a cryptocurrency user purchases a good or a service using cryptocurrency she will have a taxable event. She must account for any capital gains or losses in cryptocurrency from the time she first purchased the cryptocurrency to the time she used it to purchase a good or service. While this is reasonable for large purchases with substantial gains, it imposes unreasonably high transaction and accounting costs for small transactions. A similar problem existed for purchases made using foreign currency and Congress passed a de minimis exemption from capital gains treatment for transactions where the gain is less than $300. n42 A similar exemption should exist for cryptocurrency transactions. In the House, Representatives DelBene and Schweikert have introduced legislation that would create that exemption. n43

2. Clarity for assets derived from cryptocurrency forks

Cryptocurrency networks can fork when disparate factions of network participants cease to agree regarding the foundational rules of the cryptocurrency protocol’s software. n44 After a fork occurs, users who had cryptocurrency before now may have access to cryptocurrency on both sides of the fork. If they had previously held their cryptocurrency directly (by personally controlling the private keys that correspond to addresses on the cryptocurrency network) they would be able to use these keys to spend cryptocurrency on both sides of the fork. If, on the other hand, a user has entrusted a company to secure their cryptocurrency, then they will have access to cryptocurrency on both sides of the fork if, and only if, their service-provider chooses to support both forks. In either case, spending cryptocurrency on one side of the fork does not spend cryptocurrency on the other side. Therefore, the taxpayer will have obtained access to new assets more akin to a stock split than a trade. However, the open nature of cryptocurrency networks and network software means that this split could occur by virtue of the actions of anyone on the network with sufficient followers to go their own way. Moreover, the user may be unaware of the split and may have no knowledge that their private keys can access a new forked asset.

If a cryptocurrency user sells some of their forked assets they likely owe capital gains, that much is clear and uncontroversial. However, there are several additional questions: did the fork itself create an income event for cryptocurrency users or is it more like a stock split which is not treated as income? What is the basis for the forked asset; is it a zero-basis windfall or a division of the asset’s previous value like a stock split? Representative Emmer has introduced legislation that would create a safe harbor from penalties for taxpayers who made a good faith effort to pay taxes related to forked assets in the past, despite the lack of clarity. n45 It would also instruct the IRS to not treat forks as income events in and of themselves because that policy would create unreasonable liabilities for taxpayers. n46 As mentioned, a taxpayer may not even be aware that a fork has occurred and may take no action to claim newly forked assets. No tax should be owed under those circumstances and liabilities should apply later, when the taxpayer exercises dominion and control over the assets by selling them.

3. Taxation of mining and staking rewards

The IRS has determined that cryptocurrency mining and staking rewards should be taxed as income when they are generated. n47 For the reasons below, this is a bad policy and should be corrected by Congress.

Cryptocurrency stakers and miners dedicate costly computing resources to securing and sharing the public data that makes these technologies work, the public blockchains of Bitcoin, Ethereum, and other permissionless networks. In return, the protocols are designed to allow these participants to create new units of cryptocurrency according to set release schedules. This is the incentive that makes an open network viable; if there was no reward to honest participation, then some other mechanism, like permissioning which computers can and cannot have access, would be required to secure the data.

These rewards are not, however, equivalent to being paid wages for labor. There’s no person or company that is making a payment, the “payment” is the creation of new property by mixing one’s own labor with one’s own property. The better metaphor for these rewards would be to liken them to crops growing on one’s property. Every additional ear of corn in one’s field is a windfall to be certain, but taxing them at the moment of their creation would be an absurdity and an accounting nightmare. In that context we tax the farmer when she sells her corn at market for a profit. Cryptocurrency rewards from staking and mining should be treated the same. Treating them like income creates perverse incentives to sell the new cryptocurrency immediately as it is produced in order to cover tax liabilities. Any delay could risk a decline in the market price and an inability to cover past nominal income tax obligations. Moreover, some cryptocurrency networks afford several thousand small rewards every day; taxing each at its moment of creation with its own unique accounting basis is a recipe for complexity and poor compliance.

The simple solution is simply to tax the sale of mining and staking rewards rather than taxing their creation as income. If the early Internet is any indication, simplified tax regimes do not mean less revenue for governments. Quite the opposite, as clear rules lead to better compliance and the growth of profitable industry here in America rather than abroad.

4. Safe harbor for non-custodial uses

State money transmission licensing laws are broadly drafted and carry harsh penalties for failure to comply. There is no reason for these laws to ever apply to persons who facilitate cryptocurrency use but who do not hold other people’s coins. Only custodians present a risk of loss that would be sensibly addressed through licensing. n48

But clarifying this particular interpretation of each state’s unique money transmission statute is a slow and inconsistent process, even with great model legislation from the ULC available. n49 A federal safe harbor would instantly make the entire U.S. a welcoming home for developers and technologists who are designing, building, and operating the fundamental infrastructure behind cryptocurrency and open blockchain networks. n50 To that end, the Blockchain Regulatory Certainty Act sponsored by Reps. Emmer and Soto would create a safe harbor from state licensing requirements for non-custodial entities in the cryptocurrency space. n51

There’s no reason why America can’t continue to be a home for permissionless innovation while also enriching its treasury. We did it with the early internet and we will do it again with cryptocurrency networks.

n1 Coin Center is an independent nonprofit research and advocacy center focused on the public policy issues facing cryptocurrency technologies such as Bitcoin. Our mission is to build a better understanding of these technologies and to promote a regulatory climate that preserves the freedom to innovate using open blockchain technologies.We do this by producing and publishing policy research from respected academics and experts, educating policymakers and the media about blockchain technology, and by engaging in advocacy for sound public policy.