Cryptocurrency exchanges and blockchain trade groups are preparing to mount legal challenges to the Treasury Department’s new proposal to boost disclosures on “unhosted” crypto wallets unaffiliated with a financial institution.
The proposal would require banks and money services businesses dealing in crypto, including exchanges like Coinbase and Circle, to collect and report on crypto owners who use wallets that aren’t held by any custodian.
Unhosted wallets, sometimes referred to as “self-custodied,” are a type software that secures the private cryptographic keys necessary to use digital currencies like Bitcoin or Ether. They are often located on a crypto user’s computer or mobile device.
Implementing the proposal—viewed by some industry players as a political parting shot by outgoing Treasury Secretary Steven Mnuchin, a cryptocurrency skeptic—could unfold slowly, given anticipated legal challenges.
The policy debate over fine-tuning regulations on peer-to-peer cryptocurrency transactions will also likely spill over into the next administration, as the use of such payment methods will inevitably increase as tech continues to revolutionize the financial world.
The focus on unhosted wallets “is as much a position statement as it was a proposal,” said Gregory Lisa, a partner at Hogan Lovells LLP and former Financial Crimes Enforcement Network interim compliance and enforcement director.
Crypto companies say the proposal imposes greater reporting requirements on them than exist for banks handling traditional money transactions.
Treasury issued the proposal on Dec. 18 with a Jan. 4 comment deadline. The industry widely expects Treasury will look to finalize it before President-elect Joe Biden is inaugurated Jan. 20.
Treasury’s allotment of just 15 days over the holidays to file comments could give companies a line of legal challenge under the Administrative Procedure Act.
“There’s a procedural challenge and a substantive one,” said Jake Chervinsky, general counsel at Compound Labs Inc., a San Francisco-based cryptocurrency company. Chervinsky is helping coordinate the Blockchain Association’s plans to fight the rule in court.
Coinbase and Circle have also tweeted that they’re considering litigation.
Treasury’s FinCEN, which would oversee compliance with the rule, said the abbreviated comment period was justified to prevent money launderers and other bad actors from moving their crypto assets from regulated banks or exchanges to dark corners of the crypto ecosystem.
The agency invoked “substantial national security” and foreign policy concerns to avoid a more typical 60-day comment period for a significant rulemaking. Bad actors can exploit unhosted crypto wallets to evade anti-money laundering (AML) record-keeping and reporting requirements. That possibility increases “risks to AML and combatting the financing of terrorism,” FinCEN said in the proposal.
Courts typically give deference to agencies on matters involving national security. But Treasury had multiple meetings with industry groups since May 2019 about the issue, showing there’s no real emergency behind the rulemaking, Lisa said.
“It was a real process foul and any judge who looks at this is going to be skeptical from the outset, just given the optics and the background,” Lisa said.
The rule calls for banks that deal in crypto and crypto exchanges to collect and keep records on transactions of $3,000 or more in a 24-hour period between their account holders and unhosted wallet counterparties, including names and physical addresses. Information on transactions involving unhosted wallets that exceed $10,000 must be reported to FinCEN.
Similar reporting requirements would apply to transactions involving financial institutions not subject to the Bank Secrecy Act and located in Burma, Iran, or North Korea.
Treasury’s proposal is vague, jeopardizes financial privacy, and adds new compliance burdens and concerns, Chervinsky said.
The reporting requirements could also push more crypto transactions to use unregulated, off-shore exchanges, making it harder for law enforcement to investigate illicit activity, Peter Smith, CEO of Blockchain.com, one of the largest unhosted wallet software providers, said in a Dec. 23 blog post.
The proposal comes as Mnuchin winds down his tenure. But few signs point to the Biden administration abandoning the issue, if it’s not finalized before Jan. 20.
“There’s some thought this is something FinCEN is committed to and has buy-in from all levels of the agency, despite how it’s being rolled out,” said Laurel Loomis Rimon, a partner at O’Melveny & Myers LLP and former Justice Department assistant U.S. attorney, during a webinar Tuesday.
As the crypto market has grown in sophistication and variety, FinCEN has continued to find ways to integrate digital assets into the financial system and craft regulations.
The proposal, “while not perfect, indicates FinCEN’s trying to patch cracks” in how digital assets fit into the Bank Secrecy Act’s definition of monetary instruments, said Michelle Gitlitz, global head of Crowell & Moring’s Blockchain and Digital Assets practice.
The proposal is likely to be part of a broader trend in 2021 focused on robust AML compliance for the digital asset industry, Gitlitz said.
“It’s one more thing to add to the list to make sure they comply, with very serious impact if they don’t,” she said.