Weather the storm

What are the three key issues for crypto in the year ahead?

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WEATHER THE STORM – What are the Three Key Issues for Crypto in the Year Ahead

19/01/2023

Even in an area known for volatility, 2022 was a doozy for the cryptocurrency industry: the cryptocurrency market lost two trillion dollars in value, one of the largest cryptocurrency exchanges imploded, and even Kim Kardashian encountered the sting of regulatory scrutiny in this space. However, we channel Mark Twain in asserting that rumors of crypto’s death are greatly exaggerated: the blockchain technology that underpins crypto remains revolutionary, institutional investors remain committed to the space, and the industry players who weather the crypto-winter will be well-positioned for the next upswing. Against this backdrop, what three issues will we be watching in the year ahead?

Which cryptocurrencies are securities?

Underlying that simple question is a classic Washington-power struggle. The Securities and Exchange Commission (SEC), eager to assert its primacy in this area, has doubled the size of its crypto-focused staff and renamed it the Crypto Assets and Cyber Unit. SEC Chairman Gary Gensler has asserted that the “vast majority” of crypto tokens are securities. With the exception of Bitcoin, the SEC maintains its position that the sale and promotion of cryptocurrencies are subject to existing SEC rules and regulations. Meanwhile, Commodities Futures Trading Commission (CFTC) Chairman Rostin Behman has asked Congress for authority to regulate crypto spot (cash) markets and argues that a legislative definition is needed to determine which cryptocurrencies are securities because crypto is a new asset class, and currently “[w]e have to rely on 70-year-old case law to determine what’s a security, what’s a commodity.”

With the exception of Bitcoin, the SEC maintains its position that the sale and promotion of cryptocurrencies are subject to existing SEC rules and regulations

SEC v. W.J. Howey Co., the case to which Chairman Behman referred, will take center stage in the first half of 2023. Relying on the definition of an “investment contract” established in Howey, the SEC claims in its ongoing case against Ripple Labs that Ripple and two of its executives improperly traded $1.3 billion in Ripple’s XRP token without registering it as a security. Ripple argues that the SEC has been biased in how it applies the definition of “security” to virtual currencies, and that XRP is a currency, not an investment contract. With summary judgment motions fully briefed, we anticipate the federal district court will rule on the Ripple case in the first half of 2023.

Regardless of the decision in Ripple (which will likely be appealed), we anticipate the SEC will continue to aggressively pursue similar actions. For example, in November 2022, relying on the Howey test, the New Hampshire District Court ruled that the digital asset LBC, offered to purchasers by LBRY, Inc., is an unregistered security. While the Court’s ruling was fact-specific, and its precedential impact is therefore limited, we have little doubt that this will embolden the SEC in its effort to regulate digital asset issuers through enforcement.

How will the regulatory framework evolve?

We anticipate that CFTC Commissioner Behman will get his wish for greater legislative clarity in the coming year. Calls for legislative action have come from many corners. In an October 2022 report examining the potential risks to the traditional financial system from interconnections with crypto-assets, the Financial Stability Oversight Council (FSOC) recommended enacting legislation that addresses regulatory authority over both the crypto spot market and the activities of crypto-asset entities. In its Annual Report, published in December 2022, the FSOC reiterates the need for “legislation relating to regulators’ authorities[.]”  More than 50 Bills related to digital assets are pending before Congress, with at least five placing the balance of regulatory control in the hands of the CFTC.

The FTX collapse will likely serve as a catalyst for legislative hearings on key proposals in the first quarter of 2023

The FTX collapse will likely serve as a catalyst for legislative hearings on key proposals in the first quarter of 2023. FTX’s founder had a hand in drafting one proposed bill and lobbied along with other prominent crypto exchanges to promote the CFTC as the overseer of digital assets, facts that we believe members of the 2023 Congress will take into consideration before enacting new legislation.

Will trust be established in the industry?

One of the hallmarks of the cryptocurrency industry is the freedom from centralized intermediaries to verify financial transactions. Indeed, the brilliance of the Bitcoin blockchain is the transparency of a public distributed ledger to transfer value. In the wake of the FTX implosion, some commentators have disparaged the entire industry. However, the misdeeds of FTX actually contrast with the rigorous security and proof of reserve protocols in place with other industry players. We expect those industry standouts to benefit from increased consumer awareness of these issues.

Consumer awareness may also lead to an increase in consumer-driven litigation. In November 2022, the CFPB released a report examining 8,300 consumer complaints for crypto assets covering the period between 2018 through 2022, with fraud constituting a majority of the complaints. The current administration has encouraged the CFPB and Federal Trade Commission (FTC) “to redouble their efforts to monitor consumer complaints and to enforce against unfair, deceptive, or abusive practices.” Given the volume of complaints, it is not surprising that crypto-related litigation is on the upswing: more than 200 class action lawsuits and other private litigation exist as of October 2022, up more than 50% since the start of 2020, according to Morrison Cohen’s Cryptocurrency Litigation and Regulation Tracker. We expect this trend to continue throughout 2023.

CONCLUSION

In short, the sky is not falling. While the legislative and regulatory musical chairs sort themselves out, industry leaders who have established trust in the crypto community and with the public will be ready to take the industry to new heights following the end of crypto winter.

Meet the author

MEET THE AUTHORS

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Eric Martin

Partner and Global Practice Co-Leader, St. Louis