All Posts
Overview of U.S. Federal Crypto Policy Challenges in 2024
By Chris Hayes
March 25, 2024
Current State of Play
The regulatory environment for blockchain technology and crypto remained challenging in 2023, with the industry operating in a bear market, with tight budgets and low token prices. Now is the time for “building” where strong projects will persevere, new breakthroughs will be achieved, and projects that do not make sense economically will die.
As we move into 2024, the frauds (FTX and Terra) in 2022 are in the rear-view mirror, mainstream Bitcoin ETFs (a.k.a., “ETPs”) have been approved by the SEC (and Ethereum ETFs may be on the horizon), and real-world assets are coming on-chain with renewed excitement. Prices have started to recover and new use cases are emerging in payments and non-fungible tokens (“NFTs”), including partnerships with traditional consumer and financial sector brands.
Most Significant Policy Challenges Facing the U.S. Crypto Industry in 2024
Crypto/blockchain/web3 industry participants face the following policy challenges, reviewed in order of likely importance and impact on the ability of a diverse array of crypto firms to operate in the US market:
- Regulation of Digital Assets/Crypto Tokens
The most critical challenge facing the digital asset market is the classification of various crypto tokens (particularly native tokens to L1 and L2 side chains) and whether they should be considered securities under the federal securities laws. Many crypto tokens, and crypto exchanges that facilitate buying and selling, rely upon the Howey test to determine that their tokens are not required to be registered under the Securities Act of 1933. The compliance controls needed to ensure a token can remain outside being considered as an “investment contract” under Howey are significant, and this issue is currently under fact-specific litigation. L1s and L2s, along with other issuers of crypto tokens, crypto exchanges, stablecoin issuers, NFT issuers and NFT exchanges face significant enforcement risk on these issues with many fungible crypto tokens named as unregistered securities in the SEC enforcement actions and subsequent litigation against Coinbase and Binance. Similarly, most crypto exchanges, including Coinbase, Binance, and Kraken remain in active SEC litigation as unregistered securities exchanges for allowing retail investors to buy and sell these crypto tokens on their platforms. Many “real world asset” (“RWA”) tokens would have less risk because the associated financial products are already registered as securities or investment funds with the SEC but would have potential secondary risk if they are operating on public blockchains with native tokens that are bought and sold by retail customers. Finally, building on the recent approval of spot Bitcoin exchange traded products (“ETPs”), the outcome of digital asset regulation will also shape the ability for other types of ETPs to be approved that invest in other types of crypto tokens, including Ethereum.
Litigation Outlook: L1s and L2s, and crypto exchanges will continue to rely upon legal interpretations of the Howey test, given the lack of strong clarity and finality in the Ripple and Terraform Labs cases. A positive outcome of these cases is that the courts will not consider almost all digital assets to be securities, as has been the SEC’s current interpretation of the law. This may provide some enforcement protection for L1s and L2s, and useful arguments for crypto exchanges in litigation. L1s, L2ss, and crypto exchanges will also have to maintain strong internal compliance protections to ensure they can remain in a defensible position regarding Howey, particularly by ensuring no statements are made by L1 and L2 management to promote specific crypto tokens. Finally, because of the Terra decision, L1s L2s, stablecoin issuers, and crypto exchanges will have additional clarity around stablecoins and their treatment as securities if primarily connected to a savings protocol. This could pose problems for issuers of stables, like USDC, that are paying out yield to investors. L1s, L2s, and crypto exchanges will have to follow closely the remainder of the Ripple litigation and the Coinbase litigation to see if the 2nd Circuit appeal in Ripple or any decision in Coinbase changes the current interpretation.
Legislative Outlook: The legislative outlook for the Financial Innovation and Technology for 21st Century Act (H.R. 4763) (“McHenry-Thompson”) bill is an uphill road. Chair McHenry has highlighted this is a priority for him to finish in the 118th Congress, but the calendar is short, given the upcoming elections in November. Any action will likely have to take place before September. Chair McHenry has also announced his upcoming retirement, and that could impact his potential efforts to attach this to “must pass” legislation in the House. While a House floor vote is certainly possible, the challenges are compounded by the lack of a companion or robust support by the Senate Banking or Senate Agriculture Committee Chairs, who have not expressed interest in taking up any comprehensive crypto legislation. It will be very difficult to attach this legislation to any “must pass” proposal this year, although it will be helpful to move this bill through the House to set it up for reintroduction and broader support in the 119th Congress. This legislation is the only legislation that is likely to deliver regulatory clarity for L1s, L2 side chains, other token issuers, and crypto exchanges, and its chances of enactment this year remain low.
Regulatory Outlook: Although the approval of a spot Bitcoin ETP is positive, Chair Gensler has indicated that further SEC approval of other ETPs based on underlying crypto assets will not be forthcoming. Nonetheless, I expect other applications to be filed for spot Ethereum ETPs in 2024, and there would likely be a favorable outlook for rejected applications should they be contested in federal court.
2. Regulations on Anti Money Laundering/Know Your Customer (“AML/KYC”)
Another critical challenge facing the US crypto industry is proposed legislation to expand the coverage of AML regulation to crypto industry participants not currently covered. This interest has been spurred by the perception that crypto platforms are permitting nefarious actors to circumvent the controls in the traditional financial system. Crypto exchanges and crypto platforms that transmit, convert, or exchange fiat currency with crypto are required to be registered with the Financial Crimes Enforcement Network (“FinCEN”) as money services businesses (“MSBs”), and generally must be licensed at the state level as money transmitters. As part of these regimes, they must implement AML/KYC compliance procedures. Many other crypto platforms, including L1s and L2s, DeFi protocols, NFT platforms, unhosted or self custodied wallet software providers, and non-fiat stablecoin providers, are not subject to FinCEN or state oversight and are not generally obligated to conduct separate AML/KYC reviews. Many of these crypto industry participants operate in a “decentralized” manner and would have significant challenges with conducting AML/KYC compliance on their users, for technological, reputational, or other reasons. In many cases, AML/KYC is best handled at fiat on/off ramps, with those institutions in scope of existing MSB registration requirements. Many of these industry participants, particularly wallet providers, DeFi platforms, and L1s and L2s may be unable to comply with these requirements and continue to operate.
Current Policy Analysis: Many industry participants not conducting AML/KYC on their users are facing significantly increased headwinds from policymakers in Congress and the Biden Administration that are seeking to expand the scope of existing AML/KYC compliance requirements to more crypto industry participants. The Hamas/Israel conflict has resuscitated the AML/KYC debate for crypto. Enactment of either of two legislative efforts (Warren-Marshall; Warner-Rounds) seeking to impose AML/KYC requirements on crypto platforms appears unlikely in the short-term, but their introduction also represents a step backward in the AML/KYC conversation in connection with crypto. This pressure is also increasingly being felt in the DeFi space, with recent Treasury (April 2023) and CFTC (January 2024) reports encouraging greater AML/KYC requirements be imposed on this sector. As these bills and negative press gain momentum, there is the potential that a significant surprise event in the space could precipitate movement more quickly than currently anticipated. There is also the concern that misinformation continues to fester about the use of crypto for terrorism financing/nefarious activities, compared to the traditional finance space. Countering these narratives now will be important for crypto firms to secure and blunt the potential for future vehicles imposing broad AML/KYC requirements on those not already covered. This policy stream presents a significant regulatory risk to the fundamental ability to self-custody assets by users and operate a decentralized network with validators for transactions (key to operating an L1 or L2 side chain).
3. Regulations on Stablecoins
Stablecoins are the backbone of blockchain payment applications and crypto trading in the United States. While they look more like a banking product (with run risk and other similar attributes), they also have risks to being considered as a security under the Howey test. Fiat-backed stablecoins also touch the traditional financial system in many ways, encouraging greater interest by the Biden Administration in creating a regulatory framework to avoid risk and contagion. There are two types of stablecoins – fiat-backed stablecoins, backed by fiat currency in a bank account, or non-fiat backed stablecoins (sometimes referred to as algorithmic stablecoins, but could include many designs).
Current Policy Analysis: Out of all US legislation in the crypto space, the Clarity for Payment Stablecoins Act (H.R. 4766) (or some derivative of it) is the most likely to become law, given that there is a bipartisan consensus that new regulations are needed in the space. Now that the EU and other jurisdictions are moving forward with their own currency denominated stablecoins, there will be increased pressure to defend the US reserve currency by having regulated dollar denominated stablecoins in the market. Paypal’s step to issue their own stablecoin also signals traditional tech and finance players are growing in this space, while major European banks (e.g., Société Générale) move forward with Euro denominated stablecoins, which may put pressure on US banks to be able to enter this market in a regulated way. Circle and Stellar (among others) have been very effective in building an on-the-ground bipartisan campaign in the US to support new legislation on stablecoins. I see the potential for the Clarity in Payment Stablecoins to move forward out of the House and potentially be attached to “must pass” legislation in 2024 although there has been no indication that the Senate Banking Committee under Chair Brown will take up the legislation were it to move to the Senate. Any movement of the legislation will face concern and likely opposition from both traditional banks, and their trade associations (American Bankers Association, ICBA), as well as consumer groups and labor unions on the left. Stablecoins will continue to face regulatory pressure from the SEC in the interim, along with new state-level rules in California and other states that could become more onerous. This pressure could increase, given the December 2023 decision in the SEC v. Terraform litigation and the ability for users to receive yield by holding USDC stablecoins. We are optimistic that this legislation could move in 2024, if prioritized by House leadership, and if further support can be built in the Senate, and with the Biden Administration. Stablecoin issuers appear to be under investigation at the SEC, but the Terraform decision does not change the current enforcement risk faced by issuers. Non-fiat stablecoins will continue to remain outside the regulatory regime and subject to increased enforcement risk.
4. Tax & Payment Regulation
As part of the Infrastructure and Jobs Act (“IIJA”), the Internal Revenue Service (“IRS”) was required to expand the “broker” definition to digital asset transactions (“IRS Broker Rule”). This will require broad new tax reporting requirements for software protocols in the blockchain space, particularly decentralized protocols. Proposed rules were released on August 25, 2023, and the comment period ended in October. The IRS is targeting a release of final regulations sometime in the first half of 2024, with implementation set for January 1, 2025. The Proposed Rule does not provide sufficiently clarity to determine if the entities involved with decentralized protocols would be “Brokers” as they help “effectuate” sales of digital asset tokens that move on top of their chains.
In addition to IRS action, the Consumer Financial Protection Bureau (“CFPB”) proposed rules in November 2023 to expand their supervisory and enforcement authority around large (over 5 million transactions) non-bank providers of domestic digital payments, including those in cryptocurrency or stablecoins.
Current Policy Analysis: The IRS broker rule is expected to be finalized in early 2024, with significant repercussions for a wide variety of crypto industry participants that may be unable to collect the required user reporting information for the IRS, including wallet providers, software developers, DeFi protocols and others. This rule is significantly expansive and poses particular problems for decentralized actors who do not collect this information from their users. The comment period has closed for the Proposed Rule and legislation is not forthcoming to solve these issues. We expect the Final Rule to be problematic for many actors, particularly DeFi protocols. A consortium of industry participants will likely challenge the final rules in litigation in federal court, in a favorable jurisdiction, later in 2024. Increased CFPB involvement in the crypto payment space will open up greater supervisory and enforcement risk for crypto payment applications, which could result in expanded liability for organizations operating in this space.
5. DeFi Regulation
DeFi continues to be a growing focus of policymakers, despite no significant legislative actions on the horizon. The lack of AML/KYC compliance coverage in the industry, and well publicized hacks and use by bad actors has raised the profile of DeFi protocols with policymakers. Recent reports from the Biden Administration, including a DeFi Illicit Finance Report from Treasury (April 2023), and the CFTC (January 2024), have pushed for greater regulation of the sector, in particular in connection with expansion of AML/KYC compliance requirements. The IRS Broker Rule would bring DeFi into scope as proposed, although the industry awaits the Final Rule in early 2024.
Current Policy Analysis: The most significant threat to the DeFi space has been the proposed IRS Broker Definition (which could impose unrealistic reporting obligations on open-source smart contracts where there is no entity to collect the information), and the SEC’s proposed new Definition of Exchange, which could impose requirements that are not possible to be executed by smart-contract and at odds with the decentralized nature of the technology. McHenry-Thompson does not address DeFi beyond requiring a joint study by the SEC and CFTC. We expect to see increased education from the industry, and increased scrutiny around AML/KYC requirements for DeFi protocols in 2024. Barring a major event, however, we do not see major AML/KYC legislation moving before the Presidential election.
6. Regulations on Staking (for Proof of Stake Claims)
Most public L1s or L2s have moved to a proof of stake method for processing transactions on their blockchains (rather than proof of work). Participants can earn rewards for “staking” their native tokens, which is required to effectively operate and secure that specific L1 or L2 blockchain. Staking has faced regulatory scrutiny by the SEC, which has initiated several enforcement actions against third party staking providers, including major crypto exchanges.
Current Policy Analysis: L1s and L2s could be impacted if the interest in token holders to stake their tokens is chilled because of this heightened regulatory scrutiny, impacting the ability to operate the chain effectively. Crypto exchanges remain under regulatory scrutiny for running third party staking programs, with Kraken settling with the SEC, and Coinbase in active litigation. Regulatory certainty for staking would rely similarly on the passage of the McHenry Thompson bill, with the prospects discussed above. Other likely impacts would be a decision in the Coinbase case regarding third party staking activities. We expect this to remain a major issue in 2024, with outcomes driven by the Coinbase SEC litigation.
7. NFT Regulation
NFT issuers and exchanges remain reliant on a Howey analysis for their operations, although there are no active legislative efforts to provide regulatory clarity for NFTs. The SEC has brought a few minor enforcement actions against small players under a Howey analysis, but for the most part, NFTs have remained out of the spotlight. Traditional consumer goods companies as well as crypto native platforms have continued to work quietly in the space, as there is an expanded potential for use of the technology. The IRS has proposed tax treatment for “digital collectibles” in 2023, which has provided an avenue for engagement about the taxation of some times of NFTs.
Current Policy Analysis: NFTs remain outside the purview of McHenry Thompson, which only applies to fungible tokens, but that bill did require a study of NFTs, which could help create a roadmap for regulatory clarity. We expect NFT issuers and exchanges to increasingly come under the purview, particularly if sales volume increases again, and traditional actors create new use cases in the marketplace that peak regulators attention. Otherwise, we expect no significant additional scrutiny to be posed by regulators against these firms.
Have questions about crypto or other pending securities regulations, or want to privately discuss how any of these efforts may impact your organization? Book a private consultation with Chris Hayes here.
This publication provides summary information only and is not intended as legal advice. Readers should seek specific legal advice before taking any action with respect to matters discussed herein.
