New Legal Guide on the Regulation of Digital Assets

8 Min Read By: Charles Mills, Jonathan Marcus, Kathryn Trkla

The American Bar Association’s Derivatives and Futures Law Committee published a first-of-its-kind comprehensive legal guide for practitioners and their clients involved with the fast-developing markets for “crypto” or “virtual” currencies, and the many other types of digital and digitized assets that exist or are recorded on blockchain platforms. The committee’s over 300-page White Paper, “Digital and Digitized Assets: Federal and State Jurisdictional Issues,” reviews the complex web of federal and state statutes and precedents that have been applied to transactions in such digital assets.

The paper was prepared by the Jurisdiction Working Group of the committee’s Innovative Digitized Products and Processes Subcommittee, with contributions from 34 lawyers with expertise in derivatives, securities, FinTech, and related areas of law. The paper summarizes the current interpretations and applications of the federal securities, commodities, and derivatives trading laws, the federal anti-money-laundering statutes, and the state statutes governing money services businesses. It also reviews some of the principal international statutory approaches to regulating crypto assets. Recognizing the complexity and uncertainty of the law in this area, the subcommittee prepared the paper as a service to and resource for practitioners and policy makers. The Commodity Futures Trading Commission (CFTC) included a presentation on the paper at the meeting of its Technology Advisory Committee on March 27th.

Regulators face interpretative obstacles in determining the scope and application of laws that do not envision financial products with the novel, varied, and unique characteristics of digital assets. Recognizing these challenges, the CFTC, the Securities and Exchange Commission (SEC), the Treasury Department’s Financial Crimes Enforcement Network (FinCEN), the Internal Revenue Service (IRS), and state regulators such as New York’s Department of Financial Services (New York DFS) have issued guidance or interpretations concerning application of their rules to digital asset products and market participants. Foreign regulators have done the same. In applying its laws and rules to digital assets, each regulator and standard-setting body must consider the potentially overlapping jurisdiction of other regulators, including cross-border issues.

The paper addresses these themes in eight sections: (1) a factual background describing the various types of digital or crypto assets and blockchain systems; (2) CFTC jurisdiction over digital assets, with an emphasis on virtual currencies; (3) SEC regulation of digital assets under the Securities Act of 1933 and Securities Exchange Act of 1934; (4) regulatory implications under other federal securities laws, specifically the Investment Company Act and the Investment Advisers Act; (5) issues created by jurisdictional uncertainty between the CFTC and SEC, an analytic framework for considering those issues, and potential tools for resolving jurisdictional issues; (6) FinCEN’s regulation of digital assets; (7) international regulation of digital assets and blockchain technology; and (8) state regulation of digital assets. These sections lay out the varying and diverse approaches taken by federal, international, and state regulators with respect to digital asset uses and markets as well as interpretative issues associated with each approach, given that digital asset markets are still in the early stages of development.

Section 1 is a high-level primer on blockchain technology and the different categories of digital and digitized assets and how they function within a blockchain or other electronic ledger. It explains that the absence of uniform definitions for digital assets creates obstacles for regulators in establishing what obligations should apply to these products.

Section 2 provides an overview of the Commodity Exchange Act (CEA) and how the CFTC has applied it to digital assets—with a focus on virtual currencies—and derivatives based on them. It analyzes the potentially broad reach of the CEA’s definition of “commodity” (which covers items one would not expect under a common understanding of the term, such as securities) and the interpretative questions it raises since the CFTC first formally asserted in 2015 that virtual currencies are commodities within its oversight. It analyzes the CFTC’s authority to regulate derivatives on digital assets listed on registered exchanges, swaps on digital assets, and off-exchange leveraged or financed transactions involving digital assets with retail persons, as well as the agency’s anti-fraud and anti-manipulation enforcement authority over digital asset markets. This section also summarizes the current jurisdictional boundaries between the CFTC and the SEC over the various types of financial derivative instruments.

Section 3 explains the application of the Securities Act, the Exchange Act, and SEC regulations to digital assets. It explains the SEC’s treatment of digital assets as securities if they are deemed to be “investment contracts” pursuant to the Supreme Court’s four-part test set out in SEC v. Howey, and the regulatory obligations that apply to issuers and market intermediaries with respect to digital assets that are securities, such as securities registration, reporting requirements and disclosures for issuers, and broker-dealer registration and capital requirements for intermediaries.

Section 4 covers the application of the Investment Company Act and the Investment Advisers Act to investment management activities involving digital assets. Among other things, it summarizes registration requirements for investment companies and for their shares, and explains how the definition of “security” for purposes of determining whether investments trigger investment company status can be broader than the definition in the Securities Act and Securities Exchange Act. With respect to the Investment Advisers Act, the paper explains what constitutes investment advice and summarizes registration requirements and exemptions from registration, and how they can arise in connection with digital assets.

Section 5 analyzes the overlapping and potentially conflicting jurisdiction of the CFTC and SEC and the need for agency guidance to provide a clear and commercially compatible regulatory regime. Recognizing that digital assets can diverge greatly in their characteristics and uses, defying easy “one size fits all” classification, section 5 suggests a framework for applying a jurisdictional analysis to such assets. The discussion includes an explanation of how CFTC and SEC jurisdiction has intersected in the past, and a set of questions for evaluating whether a particular digital asset is within the purview of one agency alone, both agencies together, or neither agency. Section 5 also discusses past instances of jurisdictional debates between the two agencies and how they were resolved. It describes the formal inter-agency process for cooperation mandated as part of the Dodd-Frank Act for clarification of each agency’s jurisdiction over novel products. The paper examines other potential methods to resolve jurisdictional issues without new legislation, including utilizing each agency’s exemptive authority.

Section 5 is particularly timely. SEC FinHub recently issued a “Framework for ‘Investment Contract’ Analysis of Digital Assets” that provides color on how to apply the Howey investment contract analysis to digital assets, and identifies additional considerations for reevaluating whether a digital asset initially sold as a security remains a security in the future. The framework does not address the jurisdictional issues raised in section 5, but may help further illuminate how the SEC and CFTC can jointly address them.

Section 6 explains FinCEN’s regulation of virtual currency issuers and sellers through its authority to regulate “financial institutions” under the Bank Secrecy Act (BSA). These regulations focus on combating money laundering and terrorism financing. This section discusses the scope of FinCEN’s regulatory authority under the BSA and how FinCEN has interpreted the BSA’s term “financial institution” to extend its authority to certain virtual currency businesses deemed to be money services businesses. Those businesses are required to register with FinCEN, submit to examinations by the IRS, and establish an anti-money-laundering program. This section also describes FinCEN’s enforcement actions against virtual currency market participants.

Section 7 provides an overview of international regulations, directives, and guidance regarding virtual currency and other digital asset markets. It discusses European efforts initiated at both the EU level, through EU legislation and European Securities and Markets Authority guidance and statements, and the individual country level. These efforts include compliance obligations under the Markets in Financial Instruments Directive II, the European Market Infrastructure Regulation mitigation requirements, and European Parliament and EU Council amendments to anti-money-laundering legislation to specifically cover cryptocurrency exchanges and custodial wallet providers. Section 7 also summarizes approaches to virtual currency taken by regulators in the United Kingdom, Switzerland, France, Germany, Austria, Slovenia, Malta, Japan, South Korea, Singapore, China, and Australia, and addresses guidance by international bodies such as the International Organization of Securities Commissions, the Financial Services Board, the Financial Action Task Force, and the Bank for International Settlements.

Section 8 discusses key state regulators that also have asserted authority over virtual currency businesses. It focuses on the New York DFS regulations of virtual currency businesses and the requirement that those businesses register for a “BitLicense.” It explains the exemption from BitLicense regulations for virtual currency businesses that are chartered under New York banking law. Section 8 also summarizes the efforts of other states in regulating the issuance of virtual currencies or tokens through initial coin offerings, and an appendix provides a 50-state survey of the state laws and regulations that govern money transmitters and virtual currency regulations (as of January 23, 2019).

The subcommittee is undertaking other projects through its working groups. In addition to the efforts of the Jurisdiction Working Group, the Blockchain Modality Working Group is considering commercial and regulatory issues relating to application of blockchain technology in the financial markets and financial services industry, and the Self-Regulatory Organization Working Group is considering issues for potential implementation of self-regulation with respect to markets for digital assets.

ABOUT THE AUTHORS

Charles Mills

Charles Mills is a partner with Steptoe & Johnson LLP in Washington DC.  He represents and counsels clients with respect to compliance with the laws and regulations governing trading of derivatives,…

Jonathan Marcus

Jonathan Marcus is of counsel at Skadden, Arps, Slate, Meagher and Flom LLP.  He represents clients in financial markets district court and appellate litigation and government enforcement matters before…

Kathryn Trkla

Kathryn Trkla is a partner at Foley & Lardner LLP. She represents futures commission merchants and securities brokerage firms, institutional investors, professional trading firms, commercial hedgers,…

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