The State of Crypto Regulation in the US

American Crypto policy is opening the gates for a technology autocracy.

This blog was originally posted on mirror.

After nearly a year in the bear market and reeling back from the collapses of FTX, Terra-Luna, and $3.8 billion in cryptocurrency exploits, U.S. regulators have made clear that they have their sights set on Crypto.

Who’s leading the charge? The Securities Exchange Commission (SEC), who has chosen to regulate by enforcement as they attempt to monopolize crypto’s regulatory market at the expense of the Commodity Futures Trading Commission (CFTC), which has sided for a commodities driven classification for the burgeoning, and oftentimes nuanced market of digital assets.

However, as the CFTC takes a more modest approach toward regulation by working with traditionalist and crypto-native regulators and private sector entities alike, the SEC has taken thirty actions related to the crypto industry, which resulted in $242 million in monetary penalties and represents a 36% increase over the 22 actions announced in 2021.

So what’s the TLDR, and why does it matter (WDIM)?

• American regulatory actions against crypto is influencing international, western sentiment

WDIM: America’s gradual criminalization of blockchain technology can spread like contagion to other regulatory jurisdictions, forcing innovation to migrate to less regulated markets and lead to shit like this.

• The SEC is regulating by enforcement, targeting centralized staking-as-a-service providers (e.g., Kraken, Coinbase), centralized crypto-lending providers (e.g., Gemini, BlockFi), influencers promoting cryptocurrencies, and believes of all cryptocurrencies (except to BTC) are securities

WDIM: The SEC’s current approach leaves little flexibility for the legal existence of governance tokens, which will force protocol & network-associated development labs & foundations to migrate outside the U.S. and geofence their dApps from American use.

• The OFAC is eroding the transactional freedom of American Web3 participants (i.e., limiting transactional privacy & censorship-resistance

WDIM: American data privacy is already dead. With the death of transactional freedom, the U.S. is looking more like a technology autocracy than a democracy. Additionally, technologies such as zkSnarks are at risk to be legally deployed in the U.S..

• Democratic leaders are leading a anti-crypto campaign

WDIM: Crypto-supporting Americans will become one-issue voters, opting for Independent or Republican candidates which will leave them exposed to social welfare tradeoffs that might not benefit them in the long-term.

A refresher on regulatory actions taken to date

Here’s a quick overview of which regulatory actions have been taken in crypto and how they’re affecting the industry’s potential in the American market.

Staking

Centralized Staking-as-a-Service (SAAS) providers are under fire as the SEC deems the provision of such a service an investment contract. Both Kraken and Coinbase have been served Wells notices. Kraken settled (without admission of guilt) with the SEC for $30M and discontinued their entire U.S. SAAS program in early Q1 FY23, whereas Coinbase, who was served late Q1 FY23, is ready to fight back.

Traditionally, staking is a process that allows selected network participants to participate in the validation of data stored on public blockchain ledgers in return for certain incentives, such as payment of newly minted crypto or fees.

Staking post the “DeFi Summer” in 2020 has been, admittedly, slightly perverted by protocols using the term to rent investor capital to boost secondary market liquidity of their protocol tokens, rather than leverage staking for its original purpose — stakes based validation & security.

However, the SEC is targeting staking-as-a-service (SAAS) offerings of centralized entities (i.e., crypto institutions like exchanges) that are simplifying retail participation in the traditional model of staking blockchain networks (not staking DeFi protocols). The argument?

If a company aggregates investor capital and stakes said capital and takes a fee for providing such a pooled staking service, then what is being offered to said investors is an investment contract security.

Thus, the lawsuit targets the SAAS model, not staking itself. The SEC’s position is claiming that existing securities laws apply to crypto-related financial products.

Fiat-Collateralized Stablecoins

American regulators have focused on enforcing fiat-collateralized stablecoin accountability since FY21, starting with Tether USD (USDT), and, most recently, issuing notice to Binance USD (BUSD). Both stablecoins have strong allegations to be under-collateralized, but American regulatory approach for each has been varied.

USDT — Likely under-collateralized, but regulation has been soft.

Tether UDS (USDT) is the world’s largest stablecoin, currently worth about $79 billion, and serves as a key piece of infrastructure in the crypto ecosystem that facilitates the movement of money around the globe (esp. in emerging markets). There have been longstanding concerns that the stablecoin is not sufficiently backed by reserves — particularly from mid-2019 to early 2021. Additionally, Tether and Bitfinex, a cryptocurrency exchange, have seemingly had an incestuous relationship when it was revealed that Tether Limited is owned by the Hong Kong-based company iFinex Inc., which also owns the Bitfinex cryptocurrency exchange.

Despite many strong allegations undermining the legitimacy of Tether, it still continues to dominate the stablecoin market, and both Tether and Bitfinex reached an $18.5 million settlement with the New York attorney general’s office in Q1 FY21 to end the regulator’s legal probe that had been investigating the firms over allegations that they tried to cover up $850 million in losses. Despite all of this, USDT has largely continued to flourish (particularly outside the U.S. and EU), representing 59% of the stablecoin market by market cap (which increased 7.5% since the SEC issued Paxos a Wells notice).

BUSD — Non-ETH BUSD likely under-collateralized & regulatory ire is ⬆️

Binance US (BUSD) is the world’s third largest stablecoin, currently worth about $7.5 billion. BUSD’s regulatory issues stem from a Wells notice received by Paxos, the company that manages the the stablecoin’s infrastructure and reserves. The notice alleged that BUSD was an unregistered security, and that Paxos needs to stop minting the token until further notice. In response, Paxos, the issuer of Binance USD (BUSD) stablecoin, has burned more than $700 million of BUSD tokens. Paxos also announced it would stop issuing the cryptocurrency amid mounting regulatory pressure, blockchain data shows.

Paxos’ unaudited BUSD holdings report shows that the stablecoin is backed mainly by long-term maturity assets. Just under $3.1 billion is held in short-term U.S. Treasury Debt, which will mature by mid-April 2023. On Feb. 10, $12.5 billion of Paxos’ $16.4 billion BUSD reserves were held in U.S. Treasury Reverse Repurchase Agreements. Only two repurchase agreements mature in 2023 and 2024 — the rest of the $12.5 billion have maturity dates ranging from 2026 to 2052 (1, 2). This is an issue, as it leaves BUSD open to the same bank-run asset-liability mismatch collapse as SVB & Signature Bank.

In January this year, the exchange acknowledged it failed to maintain the reserves of Binance-peg BUSD, a stablecoin it issues on other blockchains whose value is pegged to the Paxos-issued BUSD on Ethereum. Data compiled by blockchain analytics company ChainArgos and analyzed by Bloomberg showed that the Binance-peg BUSD was frequently undercollateralized between 2020 and 2021. On three separate occasions, the gap between BUSD reserves held by Binance and the supply of Binance-peg BUSD surpassed $1 billion.

BUSD as been greatly affected by recent regulatory ire, declining from 12% to 5% of the stablecoin market (by market cap).

Fiat-Collateralized stablecoins might be in trouble

Between the obvious under-collateralized nature of BUSD and USDT, and the concerns of TradFi solvency affecting more regulated and transparent fiat-collateralized stablecoins such as USDC, the outlook for the long-term viability of fiat-collateralized stablecoins, which, by their nature, must be somewhat centralized, is bleak to say the least. In particular, fiat-collateralized stablecoins will have to deal with a ton of oncoming regulation that more decentralized stablecoins (i.e., crypto-collateralized or algorithmic stablecoins) can simply avoid and central bank digital currencies (CBDCs) wont be subject to (as their issuers make the rules).

Transaction Censorship Resistance

On October 15, 2021, the Treasury Department’s Office of Foreign Assets Control (“OFAC”) published tailored guidance for the cryptocurrency industry that highlights sanctions compliance requirements and provides industry-specific advice regarding OFAC’s compliance expectations (the “Guidance”) (1). The Guidance signals the Treasury Department’s efforts to engage with and provide greater regulatory clarity to the cryptocurrency industry, and makes clear that sanctions compliance obligations “apply equally to transactions involving virtual currency and those involving fiat currency.”

OFAC’s new FAQs define the terms “digital currency,” “digital currency wallets,” “digital currency addresses,” and “virtual currency” (FAQ 559) and clarify how U.S. persons can meet their obligations to block virtual currency under OFAC’s regulations (FAQ 646).

FAQ 646 set a new censorship-mandated precedent for all blockchain networks that goes directly against the technology’s censorship-resistant ethos originated by the Bitcoin network. More specifically, the FAQ states:

Once a U.S. person determines that they hold virtual currency that is required to be blocked pursuant to OFAC’s regulations, the U.S. person must deny all parties access to that virtual currency, ensure that they comply with OFAC regulations related to the holding and reporting of blocked assets, and implement controls that align with a risk-based approach.

OFAC’s Guidance introduced the concept of “OFAC-compliant blocks” to blockchain networks for the first time. OFAC-compliant blocks are those that exclude transactions involving parties sanctioned by the U.S. Treasury Department’s Office of Foreign Assets Control. Ethereum network validators (more specifically, the block producers & builders they outsource work to) have been forced to decide whether they oppose or support censorship within the Ethereum community.

Initially, Ethereum’s OFAC-block compliance was quite high, peaked at 79% on Nov. 2021 following the guidance issuance introduced the previous quarter. However, March 2023 data shows that Ethereum’s post-merge OFAC-block compliance has dropped to 33%. Not surprisingly, some of the top-censorship resistance offenders are entities with the most regulatory troubles 🤷 (Celsius Network went bankrupt, Binance under fire by both the CFTC and SEC, Bitfinex settled with New York attorney general’s office).

The real question is — will validators that don’t support OFAC-block compliance be persecuted or not? The fight for censorship-resistance in the U.S. literally depends on it. I hope not.

Transactional Privacy

On August 8, 2022, the OFAC sanctioned virtual currency mixer Tornado Cash, which processed $7 billion in cryptocurrency volume since its creation in 2019. Tornado Cash is a non-custodial Ethereum and ERC20 privacy solution based on zkSNARKs. It improves transaction privacy by breaking the on-chain link between the recipient and destination addresses. It uses a smart contract that accepts ETH deposits that can be withdrawn by a different address. Whenever ETH is withdrawn by the new address, there is no way to link the withdrawal to the deposit, ensuring complete privacy (Tornado Cash Github).

The reason for OFAC’s sanction? A portion of that $7 billion in Tornado Cash’s processed transaction volume was $455 million stolen by the Lazarus Group, a Democratic People’s Republic of Korea (DPRK) state-sponsored hacking group that was sanctioned by the U.S. in 2019, in the largest known virtual currency heist to date. Additionally, OFAC cited Tornado Cash’s use to “launder more than $96 million of malicious cyber actors’ funds derived from the June 24, 2022 Harmony Bridge Heist, and at least $7.8 million from the August 2, 2022 Nomad Heist.”

What OFAC forgets is that technology is amoral, and Tornado Cash is a protocol, not a centralized payment service. It usage by criminals doesn’t deem the protocol a malicious tool. If this were so, cash would be one of the most criminal tools every invented. It is not valid to demonize any technology by its criminal edge cases.

You may ask, “What positive cases could a protocol such as Tornado Cash possibly support?” Well, firstly, Tornado Cash has long-protected the fiscal privacy of individuals and/or entities who prefer not to have their asset-holdings revealed online (since blockchain technology is hyper-transparent).

One may respond, “well, if they have nothing to hide, why does it matter?”

Fiscal privacy matters because it is nobody’s damn business how much money one has on-chain, just as it is no one’s business who you are texting, what your sexual orientation is, or what you ate for breakfast this morning (unless any of those things legitimately threaten the safety and freedom of others).

A proper example is Ethereum’s very own Vitalik Buterin using Tornado Cash to donate to Ukraine. Vitalik Buterin said the need for privacy from Russia’s government led him to use the Ethereum mixing protocol. Seems pretty damn reasonable to want such privacy.

Much like the SEC, the OFAC seems to be taking the regulation by enforcement approach, because it’s easier to do, not because it’s the right thing to do.

Centralized Crypto Lending

The Securities and Exchange Commission (SEC) sued crypto firms Genesis Global Capital, Gemini, and now-bankrupt BlockFi for offering and selling unregistered securities to investors through their centralized, crypto-lending programs. Both crypto-lending programs lent users’ crypto and returned a portion of the profits to after deducting an agent fee.

The precedent set by the SEC, in this case, does appear to be correct, as institutional lending is a heavily regulated activity within the U.S. — crypto or not.

Gemini has officially discontinued its interest-bearing product, Earn, whereas BlockFi agreed to pay $100 million to the SEC to settle charges related to a similar offering of interest-bearing products. Gemini’s crypto-lending woes, however, aren’t resolved with the closure of their Earn program. Users of Gemini Earn have been unable to access funds in their accounts for nearly two months. On Nov. 16, 2022, Gemini suspended Earn withdrawals due to market conditions resulting from the collapse of FTX, as a firm named “Genesis” owed $900 million to Gemini post FTX-collapse, an amount they have recently reached an agreement on to resolve.

Centralized Exchanges

To be candid, centralized cryptocurrency exchanges have been at the center of fraudulent activity within the Crypto space since the very beginning. Not all exchanges are bad actions (e.g., Coinbase, Gemini), but others haven’t had the best track record with American regulators (e.g., Bitfinex).

Aside from the actions taken by the SEC on the SAAS programs of Coinbase and Kraken, the CFTC has recently filed a very serious charge against Binance and Its Founder, Changpeng Zhao, with willful evasion of federal law and operating an illegal digital asset derivatives exchange. The charge claims “the defendants allegedly chose to knowingly disregard applicable provisions of the CEA while engaging in a calculated strategy of regulatory arbitrage to their commercial benefit.” The CFTC seeks disgorgement, civil monetary penalties, permanent trading and registration bans, and a permanent injunction against further violations of the CEA and CFTC regulations, as charged.

Well GOT DAMN. This doesn’t look good for Binance, as both the SEC and the CFTC, who have been dynamically opposed when it comes to their regulatory approaches and philosophies regarding the Crypto markets, both agree that Binance is suspect at best.

The charge is the CFTC’s first enforcement step into the Crypto regulatory ring, and is a much more calculated step then the stomping around the SEC has been doing.

Chinks in regulatory armor

The SEC, which is leading America’s regulatory and political Crypto witch-hunt (with exception to its crypto-lending suits), does comprise of internal dissent from two of the five SEC commissioners. Commissioner Hester M. Peirce dissented from the Kraken settlement, noting that “[i]n the current climate, crypto-related offerings are not making it through the SEC’s registration pipeline.” In other words, Chair Gensler is punishing the crypto industry for not registering when the SEC does not in fact make registration available.

Internal inconsistencies within enforcing regulatory bodies keeps the door open on a more reasonably regulated Crypto future, but dissent is not yet strong enough (at least not publicly) to change a developing, overall negative sentiment about the direct U.S. Crypto regulation is headed. FTX had one thing right, Crypto enterprises need to start lobbying the hell out of Congress if the tides are to change (this time for crypto, rather than for a particular firm’s self-interests).

The TradFi Runaround

Amidst the collapse of several American banks (Silvergate, Signature Bank, Silicon Valley Bank, and teetering First Republic Bank), mainstream media is blaming the “crypto contagion” for introducing systemic risk into the traditional financial system. The claim doesn’t hold water — or, for lack of better words, “the math ain’t mathin.”

The recent banking collapse was caused by the age-old malpractice of financial institutions playing the asset-liability mismatch game, paired with the Fed hiking interest rates 1,900% since FY2020.

Blaming crypto for traditional financing shortcomings (or centralized exchange fraud) is the “TradFi Runaround” needed to prevent further loopholes from being closed that could further restrict tradfi malpractice (i.e., midsized banks flirting with dangerously low, uninsured bank account volumes). Unfortunately, American politicians seems to be falling (or, perhaps, coordinating, who knows) the trick — adding yet another negative signal regarding Crypto regulatory sentiment.

Don’t You Know? Crypto Doesn’t Die.

Regardless of oncoming regulation, there is one undeniable fact: public blockchain technologies with well distributed and diversified validator / full node networks don’t die unless all nodes are destroyed. Thus, Web3 innovation will simply migrate and continue to innovate, not diminish. The one positive signal, aside from the OFAC’s Tornado Cash sanctions, is that decentralized protocols haven’t (maybe, yet) faced the brunt of regulatory ire. The main defendants of regulatory suits and charges issued over the last few years have been centralized exchanges (or crypto-institutions) and/or individual person(s).

Provided that large, public blockchain network communities, such as Ethereum, seem to be sticking by the transparent, censorship-resistant, and secure tenants that inspired the creation of Bitcoin by decreasing OFAC-block compliance and (on behalf of centralized exchanges such as Coinbase) challenging regulation by enforcement, the future of blockchain technology is most likely one that continues to embrace decentralization, rather than protocol-actions-as-a-service (e.g., centralized provider SAAS). By doing so, the community will hit the center target that is, currently, a regulatory loophole as to how government defines what a service provider (particularly a financial service provider) is.

However, if regulatory authorities such as the SEC continue to be bombastic in the way they regulate, rather than finding a middle-ground that equally serves consumer protection and innovation (and acknowledges the horrific track-record of the current system, particularly regarding financial services), the it is likely that core developer teams and foundations associated with decentralized protocols will be persecuted if their protocols provide services that extend American freedom beyond the boundaries of the U.S. government’s comfort.

Widespread access to American data through centralized mobile network, search engine, and social media providers has already proven that there is an appetite for privacy over-reach to fuel mass-surveillance, and it seems that transactional freedom is next on the menu.