Regulatory scrutiny continues to increase across financial regulators worldwide. Binance has voluntarily ended its sale of tokenized stocks following scrutiny of their product in Hong Kong and Germany, and more general warnings from regulators in the UK, Canada, and Japan. U.S. financial regulators continue to meet and speak about the cryptocurrency markets. And in the last week, two state-level law enforcement in the U.S. (Alabama and New Jersey) have directed their attention at BlockFi, with the New Jersey Attorney General calling their crypto lending accounts unregistered securities, and ordering the firm to stop offering the product in the state.
President’s Working Group on Financial Markets Meets to Discuss Stablecoins
On July 19, the President’s Working Group* on Financial Markets met to discuss stablecoins. Stablecoins are digital assets that claim to be pegged to a fiat currency, typically the US Dollar, and can be redeemed on a 1:1 basis.
The President’s Working Group first announced in December that regulators would meet to “examine the current regulation of stablecoins, identify risks, and develop recommendations”, and published a four page statement outlining key regulatory and supervisory issues for stablecoins. This week, the Treasury Department clarified the Working Group would prepare a written report “in the coming months” with recommendations on addressing any risks stablecoins.
The meeting comes on the heels of a paper by Fed economist Jeffery Zhang and Yale researcher Gary Gorton called “Taming Wildcat Stablecoins,” which compares stablecoins to the unregulated "wildcat banks" of the pre-Civil War period.
*The President’s Working Group is made up of the heads of the Treasury, the Federal Reserve, the SEC and the CFTC (or their designates).
CFTC Commissioner Berkovitz Notes Contracts Traded on Unregistered Exchanges Are Unlawful
On July 20, CFTC Commissioner Dan Berkotvitz gave a keynote address to Solidus Labs’ DACOM DeFi 2021 conference.
Speaking about DeFi and regulation, Commissioner Berkovtiz noted that it’s not only unlawful to trade futures (and other derivatives) on an unregistered market; entering into the contract itself is also unlawful.
Berkovtiz said in the past, the Commission hadn’t “gone after” individuals that entered into such illegal contracts, instead pursuing the unregistered exchange. But he flagged this as a risk of DeFi itself; that the lack of intermediaries means that “market participants” must cope with the regulatory system “on their own”. He noted this risk will be a barrier to major financial institutions who wouldn’t want to “take legal risks of trading contracts that are unlawful”
The whole speech is worth watching, but here is a partial transcript:
“It’s not as if you can take the intermediaries out and there's no regulation. There will still be regulation of the market participants and they will be left to cope with the regulatory system on their own.
The Commodity Exchange Act and our regulation don't just make it unlawful to trade a futures contract not on a registered market. Now typically, that prohibition, we have enforced it against would-be exchanges or entities that are performing the function of an exchange that are not licensed. So we're saying “you are offering futures contracts in an unlicensed platform” and therefore we bring enforcement actions. And we've done that for cryptocurrencies--unlicensed trading of options, unlicensed trading of futures. We'll go after the person that's essentially operating an unlicensed exchange.
But at the same time that contract itself -- it's unlawful to enter into the contract. The participant who is entering into the futures contract -- that's an illegal contract. We typically have not gone after those individuals. We'll go after the person who's facilitating the trading.
So now in a DeFi--if you have a system where you take out the intermediary, and you just have a bunch of people trading contracts, those contracts are still in violation of the Commodity Exchange Act.
I don’t think, in the long run -- and some of your previous panelists were referring to this -- If you want to get institutional liquidity and make the financial markets work for mainstream America-- for american businesses and american consumers -- you have to solve the problem of the legality of the contracts. You have to trade contracts in a legal manner.
Because businesses and consumers and major financial institutions aren't going to be able to trade or won't want to take legal risks of trading contracts that are unlawful under our statutes. There's the problem of the intermediaries, but there's also the underlying problem of it's not just the intermediaries that are regulated; it's the instruments themselves and the people trading them as well.”
SEC Chair Gensler warns
In a speech before the American Bar Association on July 21, SEC Chair Gary Gensler implied that stablecoins and tokenized stocks may be security-based swaps, and subject to the SEC's registration requirements and trade reporting:
"I’d briefly like to discuss the intersection of security-based swaps and financial technology, including with respect to crypto assets. There are initiatives by a number of platforms to offer crypto tokens or other products that are priced off of the value of securities and operate like derivatives.
Make no mistake: It doesn’t matter whether it’s a stock token, a stable value token backed by securities, or any other virtual product that provides synthetic exposure to underlying securities. These platforms — whether in the decentralized or centralized finance space — are implicated by the securities laws and must work within our securities regime.
If these products are security-based swaps, the other rules I’ve mentioned earlier, such as the trade reporting rules, will apply to them. Then, any offer or sale to retail participants must be registered under the Securities Act of 1933 and effected on a national securities exchange.
We’ve brought some cases involving retail offerings of security-based swaps; unfortunately, there may be more."
New Jersey Attorney General Says BlockFi is Offering Unregistered Securities; Issues Cease and Desist
On July 20, the New Jersey Attorney General announced they’d issued a cease and desist order against BlockFi, ordering the crypto platform to stop offering its BlockFi Interest Accounts (BIA) to New Jersey residents.
(You may remember BlockFi from the time it accidentally paid out its users rewards in Bitcoin instead of dollars).
Politico's Kellie Mejdrich pointed out that this New Jersey action may provide hints as to the SEC's enforcement approach on crypto, given that the former New Jersey Attorney General Gurbir Grewal just left to become the head of Enforcement at the SEC:
BlockFi, in addition to allowing users to buy and sell cryptocurrency, also offers users interest on their cryptocurrency, advertising on its website (as of July 22, 2021) that “With a BlockFi Interest Account (BIA), your cryptocurrency can earn up to 7.5% APY.”
The Attorney General found that these BlockFi Interest Accounts are unregistered securities under New Jersey law. (N.J.S.A. 49:3-49(m))
Acting Attorney General Andrew Bruck said in a press release:
“Our rules are simple: if you sell securities in New Jersey, you need to comply with New Jersey’s securities laws. No one gets a free pass simply because they’re operating in the fast-evolving cryptocurrency market. Our Bureau of Securities will be monitoring this issue closely as we work to protect investors.”
The cease and desist order points to BlockFi’s promotion of itself as a regulated entity, but hasn’t followed New Jersey securities laws:
The BFI Website claims that BFI is a “US regulated” entity, and that “[BlockFi] play[s] by the rules, to the benefit of [BlockFi] and [its] clients.” While certain of BlockFi’s loan products appear to be licensed under various state licensing requirements for money services businesses or money transmitters, the BlockFi BIAs are not currently registered with any federal 11 or state securities regulator, or exempt from registration – as required by law, even though the BIAs are “securities” and subject to such requirements. 30.BlockFi fails to disclose to BIA Investors that its BIA product is not currently registered by federal or state securities regulatory authorities, even though the BIA is a “security” and should be registered as such.
BlockFi is by no means the only cryptocurrency firm offering crypto lending. For example, Coinbase has partnered with Compound to allow its users to earn interest on their cryptocurrency, raising questions about whether Coinbase and other firm's interest product offerings are also unregistered securities in the state of New Jersey – or beyond.
Alabama also warns BlockFi over unregistered securities
On July 21, a day after the NJ AG released its cease and desist order against BlockFI, the Alabama Securities Commission said in a press release that they’d given BlockFi 28 days to “show cause why they should not be directed to cease and desist from selling unregistered securities in Alabama.”
From the press release (emphasis mine):
"The Alabama Show Cause Order alleges that BlockFi, Inc. (“BlockFi”), through its affiliates BlockFi Lending, LLC (“BlockFi Lending”) and BlockFi Trading, LLC, has been funding its cryptocurrency lending operations and proprietary trading at least in part through the sale of unregistered securities in violation of the Securities Law.
“There are thousands of entities registered with the ASC, as required by law, to sell securities to the people of Alabama,” said Director Borg. “Most of those registered to sell securities live outside of Alabama, but anyone offering securities must be registered before making an investment offer to an Alabama resident.”
The ASC action comes amid rising concerns over the proliferation of decentralized finance platforms like BlockFi that seek to reinvent traditional financial systems such as banks and brokerages for digital asset investors. Borg said “Recognizing that technology has created a new financial frontier, Alabama has recently developed new regulations in the digital currency space. Unlike traditionally regulated banks and brokerage firms, investors’ losses are not insured against or protected by the Federal Deposit Insurance Corporation (FDIC) or Securities Investor Protection Corporation (SIPC). As new developments occur, ASC is committed to ensuring that Alabamians are aware of the risks in this new financial space and have full protection under our laws. Further, these decentralized finance platforms, which are not currently registered or licensed, present a heightened risk of loss to investors.”
Meanwhile, international regulators continue to heat up their cryptocurrency scrutiny:
Hong Kong’s SCF Warning on Tokenized Stocks, Binance’s Lack of Registration
On July 16, Hong Kong’s financial regulator SFC issued a warning about Binance and tokenized stocks, which they note “are likely to be ‘securities’ under the Securities and Futures Ordinance (SFO)” and that marketing or distributing them requires a license.
Binance voluntarily ends tokenized stocks
Binance has been the subject of scrutiny by multiple international financial regulators, which I discussed here. They include Germany’s BaFin, Japan’s Financial Services Agency, and the UK’s FCA. Further, Binance voluntarily left Canada after the Ontario Securities Commission pursued legal action against other crypto exchanges (KuCoin, Poloniex, and ByBit).
On July 17, following the action by Hong Kong’s SFC, Binance announced it would stop offering tokenized stocks for purchase immediately, and would be ending all support for tokenized stocks in mid-October:
“Effective immediately, stock tokens are unavailable for purchase on Binance.com, and Binance.com will no longer support any stock tokens after 2021-10-14 19:55 (UTC).”
While Binance is exiting the market, several crypto exchanges and DeFi platforms still allow users to trade tokenized stocks, including FTX, Bittrex, and kwenta.io.
EU Proposes Ban on Anonymous Crypto Wallets
On July 20, the EU introduced a proposal to add Know Your Client (KYC) requirements to all crypto wallets, effectively prohibiting anonymous crypto wallets. The proposal was a part of a larger package of reforms that would create a new entity dedicated to Anti-Money Laundering (AML) and Combating Terrorist Financing (CTF).
From the European Commissions’ press release on the proposal:
“Full application of the EU AML/CFT rules to the crypto sector
At present, only certain categories of crypto-asset service providers are included in the scope of EU AML/CFT rules. The proposed reform will extend these rules to the entire crypto sector, obliging all service providers to conduct due diligence on their customers. Today's amendments will ensure full traceability of crypto-asset transfers, such as Bitcoin, and will allow for prevention and detection of their possible use for money laundering or terrorism financing. In addition, anonymous crypto asset wallets will be prohibited, fully applying EU AML/CFT rules to the crypto sector.”
The earliest the proposal could be implemented is 2024, according to Bloomberg:
The package would have to be approved by the European Parliament and the European Council, which can be a lengthy process. The EU said its aim is to make the new anti-money laundering body operational starting in 2024.