Bloomberg Law Analysis

ANALYSIS: A Crypto-Currency Act of 2020? You Cannot Be Serious!

Jan. 13, 2020, 11:38 AM

An eventful 2019 for the cryptocurrency field ended with widespread talk in late December about the potential for a federal law defining categories of crypto-assets and specifying the federal regulatory agencies authorized to regulate them: a Crypto-Currency Act of 2020. The discussion draft of this bill circulated in December cannot be considered a serious legislative attempt yet, however, because it displays a lack of basic understanding of the relevant federal laws and regulatory agencies.

The Crypto-Currency Act of 2020

The not yet introduced House bill follows a previous attempt to address specific issues related to digital currency, the Token Taxonomy Act of 2019, which was introduced in April 2019 but did not move beyond referral to the House Financial Services and Ways and Means committees. Commendably brief at just more than 1,000 words, the Crypto-Currency Act of 2020 would create new definitions for categories of crypto-assets and assign each category to a sole regulator.

“Crypto-commodity,” “crypto-currency,” and “crypto-security” are the main categories. Their sole regulators are the Commodity Futures Trading Commission (CFTC), the Department of the Treasury acting through the Financial Crimes Enforcement Network (FinCEN), and the Securities and Exchange Commission (SEC), respectively.

Stablecoins, the type of crypto-asset thrust into national attention in 2019 by Facebook’s Libra project, are separated into two categories subject to different regulators. A “reserve-backed stablecoin”—which “is a representation of currency issued by the United States or a foreign government” and “is fully backed by such currency on a one-to-one-basis and fully collateralized in a correspondent banking account”—would have FinCEN as its sole regulator. A “synthetic stablecoin”—which “is stabilized against the value of a currency or other asset”—would have the SEC as its sole regulator.

The draft Crypto-Currency Act of 2020 is ambitious in scope and well timed. The Token Taxonomy Act of 2019 aimed narrowly to exclude digital tokens from the definition of a security under existing governing laws of the SEC and also address taxation of virtual currencies. The new draft bill addresses a broader range of crypto-assets and regulatory authorities, as well as stablecoins, which since the announcement of Libra in June 2019 have presented multi-issue, multi-agency regulatory problems. The October 2019 Joint Statement on Activities Involving Digital Assets by the SEC, CFTC, and FinCEN underscored the need to provide clarity on the boundaries between relevant laws and regulatory authorities.

Boundary Issues

The draft bill’s superficially neat categories of crypto-assets and superficially neat division of regulatory authority over them create new problems regarding boundaries, however, making them likely to sow further confusion rather than establish clarity.

Crypto-commodity has a definition that is simple but fraught with issues. Crypto-commodity “means economic goods or services that—(A) have full or substantial fungibility; (B) the markets treat with no regard as to who produced the goods or services; and (C) rest on a blockchain or decentralized cryptographic ledger.”

This definition is remarkably broad, encompassing Bitcoin and all other cryptocurrencies that are not based on reserves of other assets and are traded with their values floating freely. The definition would make the CFTC—“the sole Government agency with the authority to regulate crypto-commodities”—the regulatory authority for most cryptocurrencies. Making the CFTC with its crypto-friendly reputation into the sole regulator of most cryptocurrencies may be the goal of many in the crypto sector, but the draft bill’s attempt has fundamental flaws.

One is that it ignores the CFTC’s actual powers and their legal basis. The CFTC regulates the trading of derivatives—the “commodity futures” in its name—not the trading of commodities themselves. An expansion of the CFTC’s jurisdictional reach may be a valid public policy choice, but it should involve amendments to the Commodity Exchange Act, comparable to the Token Taxonomy Act of 2019’s attempts to amend the SEC’s governing laws. The draft bill attempts to do it with only two single-sentence subsections of a bill that does not refer anywhere to the CFTC’s governing laws.

The definition of crypto-commodity also reacts with the definition of crypto-security to create a potentially combustible mix. Crypto-security is defined as “all debt, equity, and derivative instruments that rest on a blockchain or decentralized cryptographic ledger.” Whoever tossed the word “derivative” into the definition of crypto-security, making the SEC the regulator of derivatives, either was a prankster attempting to set in motion the legislative practical joke of re-igniting long-standing conflicts between the SEC and the CFTC, the regulator of derivatives trading, or has an idiosyncratic understanding of “derivative” that is not the same as its meaning in mainstream finance.

Cryptic Definitions of Crypto-Currency and Crypto-Security

Idiosyncrasy is a likely explanation, given the draft bill’s use of the undefined term “synthetic derivative.” A “synthetic derivative” appears to be a crypto-asset tied to the value of other crypto-assets, as described on page 7 of this Coindesk guide to crypto derivatives, not a derivative as commonly understood; but exactly what “synthetic derivative” means is left unclear in the draft bill. The omission leaves the key definitions of crypto-currency and crypto-security unclear.

Crypto-currency is defined in the draft bill as “representations of United States currency or synthetic derivatives resting on a blockchain or decentralized cryptographic ledger.” This definition of “crypto-currency” would exclude Bitcoin and most other digital currencies, categorizing them as the earlier-discussed crypto-commodities; only crypto-assets based on the U.S. dollar or synthetic derivatives, including stablecoins and other reserve-backed crypto-assets, would be crypto-currencies.

Ironically, the draft bill defines the heretofore obscure concept of a “decentralized oracle” in order to specify a possible mechanism for determining the value of an undefined synthetic derivative. The bill’s drafters are apparently big fans of decentralized oracles and consider them significant enough to attempt to force Congress and federal regulators to spend time considering them.

The synthetic derivative concept also figures prominently in the bill’s definition of crypto-security. The definition includes an exception for synthetic derivatives operated as money services businesses (MSBs) in compliance with the Bank Secrecy Act and “other Federal anti-money laundering, anti-terrorism, and screening requirements of the Office of Foreign Assets Control and the Financial Crimes Enforcement Network,” in addition to its reference to “derivative instruments” as noted above.

That Anti-Money Laundering and Anti-Terrorism Stuff

These definitions of crypto-currency and crypto-security attempt to carve out categories of crypto-assets that only FinCEN, not the SEC or CFTC, will “regulate.” This attempt is problematic for multiple reasons.

FinCEN becoming the sole regulator of cryptocurrencies is a novel idea that is unlikely to have occurred to anyone at FinCEN, since the agency does not regulate currencies. The Bank Secrecy Act and FinCEN’s regulatory authority apply to financial institutions and other entities or individuals that handle transactions, not to the currency or other assets transacted.

Anyone taking the time to review the Bank Secrecy Act and FinCEN‘s regulations, 31 CFR Chapter X, or FinCEN’s guidance on virtual currencies, will search in vain for any indication that FinCEN is regulating either the U.S. dollar or virtual currencies. Congress can give FinCEN that power, but considerable thought and amendments to existing statutes, followed by complicated and time-consuming revisions to FinCEN’s regulations, would be necessary to do it.

Delineating separate regulatory spheres for FinCEN and other agencies contradicts the existing statutory and regulatory scheme in another fundamental way. The Bank Secrecy Act and other laws on anti-money laundering/combating the financing of terrorism (AML/CFT) apply throughout the financial system, and FinCEN has authority to interpret and enforce them across all sectors.

The recent trend of FinCEN concluding few enforcement actions and relying on the primary federal financial regulators to enforce the Bank Secrecy Act, described by Bloomberg Law AML enforcement analytics for 2019, may have misled newcomers to the U.S. AML/CFT scheme to believe that AML/CFT regulation and enforcement are somehow compartmentalized by sector.

Again, Congress can revise the regulatory scheme as it wishes, but a lot more thought on policy and work on legislation will be necessary to do it.

Back to (Your Sandbox) the Drawing Board

If I were former Superintendent of the New York State Department of Financial Services Maria Vullo, I might say to whomever drafted the Crypto-Currency Act of 2020 for Rep. Paul Gosar (R-Ariz.) that they should go back and play in Arizona’s regulatory sandbox. Since I am not, I will say that any attempt to draft a federal cryptocurrency law requires clear and thorough understanding of the policies and laws that it would revise before it could become a serious legislative proposal. Perhaps these drafters will receive such input and come up with a coherent bill later in 2020.

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