How SEC Regs Will Change Cryptocurrency Markets

Following the bankruptcies of FTX, BlockFi, Voyager Digital, and other cryptocurrency platforms, the U.S. Securities and Exchange Commission (SEC) ratcheted up its enforcement of anti-fraud and securities regulations in the crypto scene. The results suggest that finding cases wasn’t difficult: in 2023 alone, the SEC took 26 cryptocurrency enforcement actions.

Critics in the industry charge that these moves are overreach. But officials at the financial watchdog say the crypto sector has forced its hand. The SEC says it made these and other recent crypto-related moves to prevent fraud, reduce market manipulation, and force more disclosure from cryptocurrency holders and exchanges. “We have worked thoughtfully and incrementally in this space,” SEC enforcement division director Gurbir Grewal said at a Rutgers University event in mid-2023. After initial investigations and civil actions, “you’d also see compliance” by others, “but we’re not seeing that in this space, so we had to change strategies.”

Below, we guide you through the powers the SEC has over cryptocurrencies, how it has used that authority thus far, and what its stepped-up enforcement within this space means for the future of these digital assets.

Advantages of Cryptocurrency

One reason for cryptocurrency’s enduring popularity is its promise to decentralize money and trade. According to proponents, digital currencies might lead to less control and regulation by entities like the SEC, central banks, and other political institutions. Advocates argue that this, in turn, will lead to a more equitable or “democratic” financial ecosystem. Also, blockchain encourages trust among those in the market without needing external enforcement, as with fiat currencies, since its underlying technology can’t be changed and is transparent to those with the expertise.

There are billions of unbanked or underbanked individuals globally estranged from the conventional banking system because of geographical remoteness or lack of documentation. Cryptocurrencies could allow these individuals to make transactions, save, and access credit. In addition, crypto tends to have lower transaction fees than traditional banking systems, a benefit for individuals and businesses.

That cryptocurrencies offer a new asset class also entices many investors. The meteoric rise in the value of some cryptocurrencies has provided prospects for solid returns, albeit with a lot of volatility. In times of economic uncertainty or lower interest rates, the cryptocurrency market has been considered the place to invest when diversifying a portfolio and hedging against traditional financial market risks.

Reasons for SEC Enforcement of Cryptocurrencies

SEC Chair Gary Gensler has said that some of the major crypto exchanges “are likely trading securities” and thus need to register with the SEC. “When a new technology comes along,” Gensler said, “our existing laws don’t just go away.” Gensler has also urged more enforcement of stablecoins and other crypto tokens.

In 2022, the SEC increased the size of its Cyber Unit by 66%, from 30 to 50 officials, and renamed it the Crypto Assets and Cyber Unit as it expanded its crypto enforcement efforts. The many cases brought after this expansion suggest the unit has its work cut out for it. Notoriously a crypto-sceptic, Gensler has repeatedly told interviewers since the January 2024 launch of spot bitcoin exchange-traded funds (ETFs) that “the whole field is rife with abuses and fraud.”

Cryptocurrencies come under the SEC’s authority if they meet the Howey test. This standard is derived from a 1946 Supreme Court case about orange groves and has since been used to differentiate the sale of securities from other purchases​. The court ruled that a contract falls under the SEC’s jurisdiction if someone invests “money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”

Regulators want to increase protections for investors, keep markets stable, and bring more transparency to a rapidly evolving digital landscape. Here’s a breakdown of the rationale behind the SEC stepping up its enforcement over cases involving cryptocurrencies:

Investor Protection

• Fraud prevention: Cryptocurrency markets are still relatively new and have been associated with many frauds and scams. SEC enforcement could deter fraud and protect investors from bad actors.
• Disclosure standards: By regulating crypto markets under securities laws, the SEC is hoping to make these enterprises provide more accurate and thorough information to the public, enabling investors to make more informed decisions.

Market Integrity

• Price manipulation: The anonymity and lack of regulation in cryptocurrency markets make them susceptible to manipulative practices. SEC oversight could help curb such practices to secure fair prices.
• Market surveillance: Monitoring the crypto markets for unusual activities could help maintain market integrity and investor trust.

Legitimacy and Adoption

• Legal framework: Falling under the SEC’s regulations could legitimize cryptocurrency enterprises and attract more traditional investors and institutions, potentially leading to broader adoption.
• Innovation and competition: By creating a level playing field, SEC enforcement could encourage innovation and competition, which are essential for the crypto sector’s long-term sustainability and growth.
• Money laundering and terrorism financing: By enforcing anti-money laundering (AML) and counterterrorism financing (CTF) regulations, the SEC and other agencies could address two major public concerns about cryptocurrencies.

Regulatory Clarity

• Defining boundaries: The SEC’s involvement could help determine the boundaries between traditional securities and crypto assets, providing much-needed clarity for entrepreneurs and investors.
• Compliance standards: Establishing compliance standards can help crypto enterprises follow widely known regulations and cut legal uncertainties.
• Cross-border collaboration: Cryptocurrencies are without borders, so international cooperation and enforcement could help address challenges common to regulators worldwide.

The Howey Test Meets Crypto

The Howey test is a U.S. legal principle for determining whether a financial arrangement qualifies as an investment contract and is subject to regulatory requirements. The Howey test has become a cornerstone in the SEC’s assessment of various financial instruments and arrangements, including cryptocurrencies and initial coin offerings (ICOs).

The test stems from SEC v. W.J. Howey Co., a 1946 U.S. Supreme Court decision establishing the criteria. The Howey test has become a central one for those in the financial sector, including the burgeoning cryptocurrency space, since it decides what, if any, regulations apply to specific entities. Here are the four criteria under Howey:

1. Money is invested: Something of value is put at stake.
2. There is a common enterprise: The investment must be in a common enterprise, although courts have had varied interpretations of what that means.
3. Those involved hope to profit: At least one of the parties must anticipate potential profits from the investment. This is typically where the efforts of a third party—the promoter or a third party affiliated with the promoter—significantly affect the value of the investment.
4. The profits come from the work of another: Essentially, investors are reliant on the actions of others to generate a return on the value they put in.

For example, suppose you invest in a real estate investment trust (REIT), which pools money to buy, manage, and sell real estate. The REIT is managed by a team of real estate professionals, the third party under the Howey test. It decides which properties to buy, how to manage, and when to sell them. Your expectation of a profit largely depends on the real estate expertise and the efforts of this management team. The REIT meets the Howey test criteria because 1) you invested money, 2) your investment is in a common enterprise (the REIT), 3) you set out to profit, and 4) the third party does the work.

So, once the SEC determines a cryptocurrency or token is a security and falls under its regulatory purview, this has far-reaching implications. The issuer must then follow SEC regulations that come with extensive reporting and transparency requirements.

Potential SEC Actions on Crypto

The SEC has a broad set of regulatory tools that can be tailored to address cryptocurrencies’ unique characteristics and challenges. Here are the types of regulations the SEC could adapt to the crypto market:

• Registration requirements: It could mandate the registration of cryptocurrency exchanges and tokens. This would confirm that these platforms and their offerings adhere to the disclosure, reporting, and operational standards of traditional financial entities.
• Disclosure standards: Establishing robust transparency rules could help confirm that crypto enterprises give investors comprehensive and accurate information. This includes publishing details about financials, business operations, and the risks associated with the crypto assets they deal in.
• Anti-fraud and price manipulation measures: The SEC’s enforcement of anti-fraud measures to deter deceptive practices and safeguard the integrity of the crypto markets. This includes rules to curb practices like wash trading and pump-and-dump schemes.
• Investor education and protection initiatives: It could broaden its efforts to apprise investors of the unique risks associated with cryptocurrencies. The SEC could also put in place ways to address investor crypto-related grievances and disputes to boost investor confidence in these markets.
• Cybersecurity regulations: Given the digital nature of cryptocurrencies, imposing rigorous cybersecurity regulations on crypto platforms could help protect these markets against hacks and data breaches.
• AML and CTF regulations: Collaborating with other regulators to enforce AML and CTF regulations to…