US Cryptocurrency Regulation: Policies, Regimes & More

us cryptocurrency regulation

Over the past few years, cryptocurrencies have gained maximum momentum. Their adoption rate is increasing exponentially with no signs of stopping. As a consequence, the Fintech enterprise is experiencing massive transformation, and its effects ripple across multiple industries.

Let’s just wind the clock back to 2009.

The inception of Bitcoin was just the primum movens, the initial force that triggered massive innovation in a field previously unknown to humankind. The success of cryptocurrencies has been such that today, the total market cap is equating $740 billion, with more than 1400 different crypto-coins and tokens, and tens of thousands, possibly even millions of new jobs created.

At this point, it’s safe to say that cryptocurrencies are not going anywhere.

A prime example of Laissez-faire capitalism with all of the good and bad traits that come with it — the untamed rivalry on the cryptocurrency battleground is more than a mere competition of the technological kind. It’s a testing ground for monetary models and socio-economic theories that will serve as a subject to scientific studies in the years to come.

However, while the technical properties of this novel phenomena are well instituted, the legal framework remains unclear. Cryptocurrencies raise a number of legal challenges for the lawmakers, starting from the threat of money laundering, taxation, regulation of foreign exchange trading to their legal status as securities, commodities, digital property or some other novel form of assets.

  1. What’s the Difference Between Cryptocurrencies and Money?
  2. What’s the Relation Between Monetary Policy and Cryptocurrencies?
  3. The US Cryptocurrency Regulation at a Federal Level
    1. Uniform Regulation of Virtual-Currency Business Act
    2. The Anti Money Laundering Regime
    3. The Investment Regime
      1. The SEC
      2. The CFTC
    4. The Tax Regime
  4. The Case Law of Cryptocurrencies
    1. SEC v. Shavers
    2. US v. Faiella
    3. The US v. Petrix
  5. Regulations Influence Bitcoin Volatility

The pseudo-anonymous and anonymous nature of these virtual currencies make them attractive for criminals, and their decentralized nature makes them a real headache for any form of government control.

This article aims to clarify the legal regulations surrounding Distributed Ledger Technology and virtual currencies in the USA focusing mainly on the federal level of regulation and the most relevant examples of case law.

What’s the Difference Between Cryptocurrencies and Money?

us cryptocurrency regulation

 

Contrary to popular belief, the terms “money” and “currency” are not synonyms, and this becomes exceptionally clear after we briefly examine the legal nature of cryptocurrencies.

A cryptocurrency is a form of virtual currency that uses encryption techniques as means of securing the verification of transactions of value. Although a universal definition of money has yet to be devised, money has traditionally been endowed with three functions: a unit of account, a means of exchange, a measure of value and store of value.

For money to be considered currency, it must have the status of legal tender. In the United States, the federal government has the sole power to bestow the status of legal tender upon monetary objects. The U.S Constitution bestows upon Congress the exclusive power to “to coin Money, and regulate the Value thereof.”

This was defined by the Supreme Court as:

“...to determine what shall be lawful money and a legal tender is in its nature and of necessity a governmental power. It is in all countries exercised by the governments’. It followed that Congress had the power (and, it may be added, the sole power) ‘to issue obligations of the United States in such form, and to impress upon them such qualities of money…as accord with the usage of sovereign governments. The power…was a power universally understood to belong to sovereignty.”

As of this moment, no national law except Japan’s endows cryptocurrencies with the status of legal tender. Therefore, legally speaking, they can’t be considered currencies- at least not in the USA. In addition, due to the high price volatility of cryptocurrencies at the moment, their function as a “store of value” is compromised.

Nevertheless, a small amount of case law in the USA, namely the cases US v. Faiella and the US v. Ulbricht, suggest that the courts consider bitcoins (read decentralized cryptocurrencies) as both “money” and “funds” for certain purposes under federal law.

What’s the Relation Between Monetary Policy and Cryptocurrencies?

“Consensus = rules without rulers”- Andreas Antonopoulos

The monetary policy put simply, is the way Central Banks control the money supply. The monetary policy is regulated through modifying interest rates, adjusting the mandatory bank reserves (how much money the banks are required to keep in their vaults), and buying or selling government bonds.

Central Banks, however, can only control the money (the national fiat currency) they issue. In the US, the Federal Reserve Bank is in charge of the monetary policy and the Dollar is the only national currency with legal tender.

Decentralized cryptocurrencies circumvent the traditional financial systems and, because of this, nation-states have no control over them. In a sense, decentralized cryptocurrencies have their own, fixed monetary policy, determined by the protocol rules. They validate and settle transactions by reaching a network-wide consensus following rules set in code.

The fact of the matter is these could hypothetically affect the quantity of money if more dollars keep being exchanged for bitcoins without being exchanged back into fiat. They could potentially affect the rate of circulation of money, if the increase in the use of Bitcoin leads to a decrease in the need for holding dollars.

Eventually, this process may lead to the fragmentation of the economy’s currency system. At the current level of adoption, cryptocurrencies have no significant impact on Federal Reserve’s ability to conduct monetary policy, but their exponentially growing rate of adoption might be a cause for concern.

On the other hand, state-issued cryptocurrencies are a far superior way of regulating monetary policy. The Federal Reserve Bank is already thinking about creating its own centralized digital currency running on blockchain technology. Having a single well-defined and stable currency as a medium of exchange, unit of account and store of value is an essential component of a stable national economy.

That being said, we should take into account that every transaction on the blockchain is linked together and kept forever on an immutable ledger. That’s a very powerful tool of financial surveillance, and we, as citizens, need to be aware of that threat.

The US Cryptocurrency Regulation at a Federal Level

federal laws

 

Thus far, the government of the United States has not exercised its constitutional power (as it usually does with financial regulation) to regulate blockchain technology and cryptocurrencies to the exclusion of states. This means that states remain free to enforce their own legislation — and several have already done so.

Arizona, for example, passed the Arizona House Bill 2417 regulating blockchains and smart contracts on March 29, 2017. Vermont passed a bill recognizing the admissibility of data embedded on the blockchain as evidence in court without the need for authentication. Delaware has also taken affirmative action embracing blockchain technology. However, this article won’t go into detail of the lex cryptographia in every single state, but rather I will focus on the federal, public law of cryptocurrencies.

Uniform Regulation of Virtual-Currency Business Act

The most recent development on a Federal level has been the drafting of the Uniform Regulation of Virtual-Currency Business Act (URVCBA) by the Uniform Law Commission (ULC) on October 9, 2017.

The ULC is a body of legal experts ranging from practicing lawyers, judges, legislators and legislative staff and law professors, who have been appointed by state governments to research, draft and promote enactment of uniform state laws in areas of state law where uniformity is desirable and practical.

The URVCBA endeavors to create a statutory structure that aims to improve the unification regulations across the states. It does not regulate cryptocurrencies as such, but rather “virtual currency business activity.”

The ULC defines virtual currency business activity as:

(1) the exchange of virtual currencies for cash, bank deposits, or other virtual currencies;

(2) the transfer from one customer to another person of virtual currencies; or

(3) certain custodial or fiduciary services in which the property or assets under the custodian’s control or under management include property or assets recognized as “virtual currency.”

The URVCBA is a draft document intended to provide further guidance to state regulators and should not be seen as regulation by itself.

The Anti Money Laundering Regime

Money laundering is defined as the process of disguising the illegal origin of funds (“dirty” money) and making them legal (“clean” money). The process typically involves three steps: placement, layering, and integration. According to government agencies, cryptocurrencies are increasingly being used for money laundering.

I bet you didn’t know this:

Because Bitcoin is only pseudo-anonymous, the more sophisticated criminals used services like mixers, tumblers, the TOR network and other anonymity enhancing services to further protect their identity. Today, with cryptocurrencies like Monero, Zcash or Dash that completely solve the anonymity problem for the people who use them, money laundering has never been easier.

In the United States, the primary AML and CTF legislation is commonly known as the Bank Secrecy Act (BSA), and FinCEN as its primary enforcing agency. The BSA applies to banks and non-bank financial institutions like casinos, securities, and money service businesses.

In March 2013, FinCEN issued interpretive guidance to clarify the BSA in the case of cryptocurrencies. A convertible virtual currency as defined by FinCEN is “a medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency” and “has an equivalent value in real currency, or acts as a substitute for real currency.” FinCEN characterizes Bitcoin as a decentralized virtual currency for purposes of the BSA.

The guidance clarifies that a user who obtains convertible virtual currency and uses it to purchase real or virtual goods or services is not considered an MSB (money services business). However, FinCEN believes that administrators or exchangers of centralized virtual currencies and exchangers of decentralized virtual currencies are money transmitters and are therefore subject to the BSA. This means that cryptocurrency exchanges are required to register with FinCEN and comply with strict regulatory rules.

On January 30, 2014, FinCEN issued a document clarifying the application of its regulations to virtual currency mining, stating the following:

To the extent that a user mines Bitcoin and uses the Bitcoin solely for the user’s own purposes and not for the benefit of another, the user is not an MSB under FinCEN’s regulations, because these activities involve neither “acceptance” nor “transmission” of the convertible virtual currency and are not the transmission of funds within the meaning of the Rule.

Investment Regime

  • The SEC

The cryptocurrency investment legislation in the US boils down to opinions and statements from the relevant regulatory agencies explaining how the existing laws and regulations apply to this new phenomena.

The securities and commodities regulations focus on two different legal issues involving bitcoin: (a) investments purchased with bitcoins; and (b) investing in bitcoins.

The Securities Exchange Commission (SEC) has the authority to regulate securities and securities-based derivatives as well as their respective markets. The primary legislation regulating securities is the Securities Act of 1993.

The first legal issue of whether investments purchased with bitcoins are considered to be securities is resolved. Both federal and state courts (SEC v. Shavers) hold such investments as securities and consider it irrelevant whether the investments are purchased with cryptocurrency or fiat currency.

The second legal issue is best explained by the most recent Statement on Cryptocurrencies and Initial Coin Offerings:

“On cryptocurrencies, I want to emphasize two points. First, while there are cryptocurrencies that do not appear to be securities, simply calling something a “currency” or a currency-based product does not mean that it is not a security. Before launching a cryptocurrency or a product with its value tied to one or more cryptocurrencies, its promoters must either (1) be able to demonstrate that the currency or product is not a security or (2) comply with applicable registration and other requirements under our securities laws.”- Jay Clayton, SEC Chairman

He then proceeds to explain that…

“It has been asserted that cryptocurrencies are not securities and that the offer and sale of cryptocurrencies are beyond the SEC’s jurisdiction. Whether that assertion proves correct concerning any digital asset that is labeled as a cryptocurrency will depend on the characteristics and use of that particular asset.”
Those are:
  1. It is an investment of money
  2. There is an expectation of profits from the investment
  3. The investment of money is in a common enterprise
  4. Any profit comes from the efforts of a promoter or third party

According to a Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO concludes that the “DAO Tokens are securities” and that “foundational principles of the Securities Laws apply to Virtual Organizations or Capital Raising Entities making use of distributed ledger technology.”

  • The CFTC

The CFTC (Commodity Futures Trading Commission) is the regulatory body responsible for overseeing the on- and off-exchange trades of futures contracts. The primary statute that gives power to the CFTC is the Commodity Exchange Act (the “CEA”). The CFTC has oversight over futures, options, and derivatives contracts, regardless if they involve virtual currencies or not.

The CFTC regulates bitcoins as a commodity since 2015, and therefore any fraud or manipulation involving cryptocurrencies in interstate commerce falls under its authority.

In the CFTC Primer on Virtual Currencies issued on October 17, 2017, the CFTC states that there is no inconsistency between the SEC’s position that some virtual currencies can be securities and the CFTC’s position that virtual tokens may be commodities or derivatives contracts depending on the facts and circumstances. They add: “The CFTC looks beyond form and considers the actual substance and purpose of an activity when applying the federal commodities laws and CFTC regulations.”

Bitcoin derivatives were introduced to the cryptocurrency market with great success in October 2017 by LedgerX, a CFTC-regulated Swap Execution Facility (SEF), and Derivatives Clearing Organization (DCO. Later that year the CFTC allowed the CBOE exchange operator to trade Bitcoin futures. On the 17th of December, The CME Group (their much bigger rival and the world’s leading derivatives marketplace) announced the introduction of bitcoin futures trading on their markets.

The Tax Regime

tax regime

 

To make things even more confusing, after security and commodity, IRS adds another classification of virtual currencies.

In late March 2014, the IRS issued a guidance that explained how existing general tax principles apply to virtual currencies like Bitcoin. The IRS has determined that bitcoins are “property” for tax purposes.

According to the IRS, the use of virtual currency is a realization event, and the amount realized is the fair market value of the property received. Also, the sale of virtual currency results in a taxable gain or loss that is calculated by subtracting the seller’s basis from the amount realized in any sale.

The characterization of the gain or loss is based on whether the seller is an investor holding virtual currency as a capital asset (capital gain or loss) or engaged in a trade or business where the seller holds the virtual currency as inventory or other property (ordinary income or loss).

Individual miners are required to include the fair market value of the mined virtual currency as of the date of receipt of their gross income. Furthermore, if the miner engages in the mining activity in the course of its trade or business and not as an employee, the taxpayer is required to pay self-employment tax on the net earnings from such earnings.

Until recently, there was a loophole in the legislation that most of the investors in cryptocurrencies exploited. The Section 1031 of the Internal Revenue Code provides tax-free treatment of transactions that are of “like kind.” This means that if you sell your car for cash, you’ll have to pay capital gains tax on the difference between proceeds and the tax basis of the property.

If you exchange your car for another one, you don’t pay taxes. Cryptocurrency investors argued that all cryptocurrencies are “like kind” and that if you buy Ethereum or Monero with Bitcoin, you’re just exchanging one “property” for another.

However, Congress made changes to the Section 1031, and the “like kind” part has been limited only to real property. This means that with the new regulation, every time you spend, sell or exchange your cryptocurrency for another one, you trigger potential taxation. In fact, every time you use a cryptocurrency to buy goods or services, the IRS views that as “disposition of assets” and you have to pay capital-gains tax. The free ride is over.

Having said that, if you have used a cryptocurrency exchange platform in the United States, just pay your taxes. The IRS just won a court case against Coinbase, requiring it to disclose information on all users who exchanged more than $20.000 worth of crypto between 2013 and 2015. The IRS is cognizant of the fact that there’s major tax evasion going on in the US cryptocurrency scene and it plans to stop it.

Long story short, never “steal” from the government. They have guns. Lots of them.

The Case Law of Cryptocurrencies

legal-cases

 

The most pre-eminent case in the USA relating to cryptocurrencies is the SEC v. Shavers. This case was launched in the federal court for the Eastern District of Texas where Trendon Shavers, the first defendant and founder of the Bitcoin Savings and Trust, was accused of fraudulently acquiring 700.000 bitcoins, worth $64 million at the time of the arrest.

Bitcoin Savings and Trust was a Ponzi scheme which guaranteed to give investors 7% weekly return on their investment in bitcoins. Shavers claimed before the court that since the business received bitcoins, there was never an investment of money which is a required element of the Howey test for investment contracts. The court concluded that bitcoins, in fact, met every criterion of the Howey test, and therefore they can be recognized as money or funds.

Here’s what the jury had to say:

“It is clear that Bitcoin can be used as money. It can be used to purchase goods or services, and as Shavers stated, used to pay for individual living expenses. The only limitation of Bitcoin is that it is limited to those places that accept it as currency. However, it can also be exchanged for conventional currencies, such as the U.S. dollar, Euro, Yen, and Yuan. Therefore, Bitcoin is a currency or form of money, and investors wishing to invest in BTCST provided an investment of money”- Amos L Mazzant, Texas judge

The US v. Faiella criminal case in the Southern District of New York is one of the first cases to address the nature of bitcoin as it applies to money transmitter and money laundering laws. The defendants Robert Faiella and Charlie Shrem were taking cash deposits, exchanging them for bitcoins and transferring the bitcoins to user accounts on the Silk Road dark web marketplace. Faiella argued in his defense that Bitcoin is not money, that operating a Bitcoin exchange does not constitute transmitting, and that he was not a money transmitter.

US District Judge Jed Rakoff rejected the motion request, concluding that “Money in ordinary parlance means ‘something generally accepted as a medium of exchange, a measure of value, or a means of payment.’ Bitcoin clearly qualifies as ‘money’”

Both Faiella and Shrem plead guilty to all charges.

If you think the two cases previously mentioned finally settled the matters of the legal nature of bitcoins, think twice. The US vs. Petrix is a case filed before the United States District Court in New York where Petrix, the defendant, is accused of running an unlicensed money transmitting business violating the 18 U.S.C. 1960. Just like the in the previously mentioned cases, the defendant argued that Bitcoin is not money, but rather private property like precious metals and that the business he operated doesn’t fall under Section 18 of U.S.C. 1960.

The Government argued that Bitcoin is just the latest example of a “medium of exchange” that Section 1960 was written to regulate and that the defendant is guilty of running a money transmitting business. Petrix filed a motion to dismiss the accusation, and after the Court held an oral argument and considered both parties’ arguments and papers, the Magistrate Judge Hugh B. Scott granted Petrix’s motion.

Although the US vs. Faiella was listed in the cases that were cited in this featured case, the judge didn’t treat Bitcoins as money and granted Petrix’s motion which further demonstrates the complicated legal nature of cryptocurrencies.

Regulations Influence Bitcoin Volatility

If you’re feeling confused after reading this article and you don’t know what to make of it, don’t beat yourself up. As the article demonstrated, the legal nature of cryptocurrencies is a very complicated phenomenon that lawmakers and judges have never faced before.

Everyone has their own opinion; the SEC considers virtual currencies as securities under certain circumstances; the CFTC considers them commodities while the IRS taxes them as property. Some judges clearly categorize virtual currencies as funds and money while others are not so sure about it.

Although different agencies in the US took the initiative to regulate certain aspects of cryptocurrencies, it looks like the wait-and-see approach is still the lawmaker’s modus operandi. That being said, every stakeholder involved in the blockchain industry needs to keep a close eye on the development of the relevant laws and regulations.

The cryptocurrency markets are very volatile and very sensitive to good or bad news of any kind. As we saw in the past few days, markets dropped by almost 30% because of China’s decision to ban cryptocurrency exchanges, South Korea’s mixed messages on a crackdown of exchanges and France’s latest tax evasion moves…

It’s clearly evident that one good or bad move on the regulator’s side can cause big disturbances in the markets. Nobody knows how the governments around the world will deal with this disruptive technology in the future. Whatever happens, keep your eyes open because history is in the making.


Feature image by Alexei Vella

Image sources: 1, 2, 3, 4

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