The next target of SEC enforcement actions: cryptocurrency wallets?

Author: Partner at law firm Troutman Pepper

Compiled by: Mary Liu, BitpushNews

Cryptocurrency has become "non-compliant," especially its "business model," at least according to Gary Gensler, the Chairman of the U.S. Securities and Exchange Commission (SEC).

Given that this viewpoint is prevalent among the regulatory bodies responsible for securities in the U.S., it is not surprising that enforcement actions involving cryptocurrency have reached historic highs.

In just a few years, we have witnessed the so-called unregulated "Wild West" transform into the SEC's "bullseye," with the Commodity Futures Trading Commission (CFTC) and the Department of Justice (DOJ) also frequently stepping in to "deliver the final blow."

There is no doubt that these regulatory agencies have not hidden their intentions, at least regarding their interest in enforcement actions.

They have taken measures, including pursuing what they believe to be major players that may mislead investors or illegally promote cryptocurrency. These enforcement actions have garnered mainstream media attention, with some actions resolved through multimillion-dollar settlements.

However, the most surprising aspect of these enforcement actions is how they are carried out. One might expect a new wave of legislation aimed at regulating cryptocurrency and other digital assets, but you would be mistaken; enforcement actions indicate that they are still stuck in their old ways, relying on laws that in some cases are 90 years old.

As regulators ramp up enforcement relying on strained interpretations of existing laws, two questions arise: 1. What is the SEC's next target? 2. Which will be phased out first: outdated securities laws or the cryptocurrency industry?

What is the Next Target? Cryptocurrency Wallets

After closely observing the actions of regulatory agencies, we anticipate that cryptocurrency wallets and certain digital asset transactions will become the next targets.

Based on previous federal enforcement actions and signals sent by these agencies in their notices, we expect digital asset enforcement to unfold in two ways: the Securities Exchange Act of 1934 (the "Exchange Act") may be interpreted to cover the regulation of cryptocurrency wallets, as they are subject to anti-money laundering and know your customer laws (AML/KYC) as brokers and traditional financial institutions, while tools like mixers will face compliance challenges in the digital asset space.

We predict that the SEC's next regulatory focus will involve the regulation of cryptocurrency wallets as brokers.

This concept was first introduced by the SEC in its Wells notice to Coinbase, which was issued prior to the lawsuit against the cryptocurrency exchange. Among the other allegations and language raised in the notice and repeatedly mentioned in the lawsuit, the SEC accused Coinbase Wallet (a product that provides users with self-custody of digital assets) of operating as an unregistered broker in violation of the Exchange Act.

In response to the Wells notice, Coinbase argued that its wallet product is merely software and does not perform any traditional functions typically associated with brokerage activities. Specifically, the Exchange Act defines a "broker" as "any platform engaged in the business of effecting transactions in securities for the account of others."

Coinbase's argument is that the wallet can only be used to interface with secondary market transactions, which from Coinbase's perspective do not involve investment contracts and therefore are not securities. Coinbase further argued that a 1% fee was charged each time the "wallet swap" feature was used (which has since been eliminated), but this does not change the SEC's analysis.

The SEC did not buy it. The agency sued Coinbase and Binance, accusing both companies' wallet services of operating as unregistered broker-dealers.

TradFi Trading

We predict that the second area of expanded SEC enforcement will be increased regulation of traditional financial institutions engaged in digital asset trading. As attention grows on new cryptocurrency tools and services, we expect that designing, implementing, and maintaining compliance systems to adhere to AML/KYC laws will pose significant challenges for these institutions, making it a target for regulators soon.

In particular, enforcing AML/KYC laws in the digital asset space will require these institutions to largely rely on information they cannot control. Take the proposed internal policies for tagged transactions, where over 10% of the value can be traced back to proceeds from stolen assets.

In practice, compliance programs capable of conducting such tagging will require cooperation from third parties, far exceeding the capabilities of most companies both within and outside the cryptocurrency space.

First, whether government entities or private investigative firms, there must be an understanding of the thefts, and the wallets/tokens involved must be tracked and identified. Then, a repository must be created to maintain that information. To some extent, multiple such repositories will be needed to track the flow of currencies associated with numerous thefts and hacks, and this diffusion will only increase the cost of resolving the issues. Finally, once a company wants to screen for illegal and problematic transactions, it must screen data for each transaction to tag the problematic ones.

With the exception of the last step, financial institutions must rely on the work of others to generate inputs that help drive compliance programs. This decentralization makes compliance costly, both in terms of time and money.

Rapid Expansion of Enforcement Scope

The scope of cryptocurrency enforcement is rapidly expanding, prompting some participants to consider their next steps.

Coinbase CEO Brian Armstrong stated during London Fintech Week that due to a lack of "regulatory clarity," "any direction is on the table, including leaving the U.S. or anything necessary." It is not hard to imagine that most cryptocurrency market participants agree with Armstrong's sentiment: "We just want a clear rulebook."

However, the various federal agencies responsible for regulation have not established a clear set of rules to govern the cryptocurrency space, instead relying on legal provisions from decades ago, which could not have anticipated the technology underlying digital assets at their inception.

In some respects, it raises a question: Are cryptocurrency market participants truly setting their business models as "non-compliant," or is the emergence of non-compliance merely a byproduct of regulatory chaos?

While we await a regulatory compliance handbook, investors and exchanges should work with legal compliance teams to ensure their transactions align with the ever-evolving interpretations of federal securities laws and banking regulations as they apply to the cryptocurrency industry. Each transaction presents unique regulatory hurdles, stemming from federal agencies' insistence on applying decades-old regulations to a rapidly evolving industry.