Key takeaways
- The SEC has recently escalated its campaign against unregistered securities, which they claim put investors in risky situations without enough transparency
- Kraken has shut down its staking service in the U.S. after paying a $30 million settlement to the SEC, causing concerns for other proof-of-stake companies like Ethereum
- The SEC has warned Paxos of its plans to sue them for issuing its stablecoin, BUSD, without proper registration
The U.S. Securities and Exchange Commission recently included the regulation of emerging technologies and crypto assets as one of its 2023 priorities. The SEC intends to examine whether crypto companies meet appropriate standards of care when “making recommendations, referrals or providing investment advice.”
This shouldn’t be surprising after the volatility in 2022, which saw a crypto winter and the bankruptcy of numerous crypto companies. The regulations surrounding cryptocurrency are complicated and often controversial.
What’s tricky about regulating cryptocurrency is deciding what aspects of crypto fall within the SEC’s domain. Are crypto offerings securities? Should crypto companies provide investors with financial information before accepting their money? Regulations may give decisive answers to these questions in the coming years.
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Existing crypto regulations
U.S. legislation first mentioned cryptocurrencies in November 2021. In the Infrastructure Investment and Jobs Act, specific provisions laid out what a digital asset was and defined anyone who transfers a digital asset on behalf of someone else as a broker. This was a controversial move, as it put similar requirements on crypto exchanges as stock brokerages.
As a result of the Act, centralized crypto exchanges are now required to provide investors and the IRS with 1099 forms summarizing the activity of traders. However, this regulation's effect could be favorable for crypto exchanges if investors feel more comfortable investing in the assets. Only time will tell.
The IRS considers “virtual currency” property, which means crypto bought at one price and sold for a higher price can be subject to a capital gains tax. Similarly, you can deduct money lost through crypto trading as a capital loss.
There’s an interesting loophole resulting from this classification. Stocks and other securities are subject to a wash sale rule, which says that if you sell a security at a loss and then quickly repurchase it at a lowered price, you can’t deduct the loss on the sale from your current year’s taxes. A wash sale rule does not currently apply to crypto.
The SEC uses the Howey Test, outlined by the U.S. Supreme Court, in deciding whether something is an “investment contract” and, therefore, a security. The Howey Test holds that a security is an “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.”
When this test applies to crypto remains up for debate.
The Ripple lawsuit
The SEC sued Ripple Labs Inc. in 2020 for selling its XRP token without first registering it as a security. A ruling is expected in the first half of this year and could severely impact the crypto world.
Central to the legal debate is whether XRP should be considered a security. If the court sides with the SEC, crypto exchanges will face more scrutiny from regulatory agencies and will likely have to register as securities if they continue selling within the U.S.
A notable exception is Bitcoin, which the SEC does not consider a security since investors don’t invest money reasonably expecting a profit. If you’re confused by the delineation here, the following example may help to clarify it.
Kraken settlement with the SEC
Earlier this month, crypto exchange Kraken paid a $30 million settlement to the SEC and ended its crypto staking program in the U.S. Staking is a process that involves investors locking up crypto tokens with a blockchain validator to receive new crypto once the validator uses their tokens to validate data for the blockchain.
Since crypto tokens are expensive and most users don’t have enough to stake on their own, Kraken was one of many exchanges to offer a service of pooling multiple investors’ tokens and staking them on their behalf.
This is considered an investment contract by the SEC because investors reasonably expected to receive money from Kraken in exchange for joining the staking pool. With that label, the SEC expected Kraken to make certain disclosures to investors, which they did not.
The SEC’s enforcement action has frightening implications for a company like Ethereum, whose investors also use “staking as a service” options.
Many people have criticized the SEC’s approach, including SEC Commissioner Hester Peirce. He dissented, saying, “Using enforcement actions to tell people what the law is in an emerging industry is not an efficient or fair way of regulating.” Peirce continued, “staking services are not uniform, so one-off enforcement actions and cookie-cutter analysis does not cut it.”
There’s a general sentiment among crypto exchanges that the SEC’s securities regulations are inflexible and not built to accommodate cryptocurrency. We’ll have to wait and see whether the SEC can convince centralized crypto exchanges to register.
Paxos and stablecoins
The SEC has warned crypto firm Paxos of its plans to sue them for issuing Binance USD (BUSD), a token made in partnership with Binance but owned independently by Paxos. BUSD is a stablecoin pegged to the U.S. dollar, which the SEC claims is an unregistered security.
News of this second enforcement action has proven equally controversial as experts debate whether investing in a stablecoin should be considered an investment contract.
Again, the SEC’s complaint is that Paxos did not adequately warn investors of the risks involved in investing in BUSD, nor did it make proper financial disclosures.
Other questions we'll continue to debate in the coming years include what kind of disclosures a crypto issuer should have to make and if they should be held to the same standard as any other public company.
While it’s easy to criticize the SEC as standing in the way of innovation, we’re coming out of a year where investors lost billions of dollars in the crypto space. Crypto’s popularity is shaky, and it’s understandable why the SEC would consider regulations a priority for this industry.
If you’re interested in investing in crypto but don’t want to track daily developments, consider Q.ai’s Crypto Kit, which uses artificial intelligence (AI) to dig into the data and act defensively for you.
The bottom line
With the SEC escalating its campaign of cracking down on crypto companies, we expect to see further regulations in the crypto space in the coming years. Many questions remain about this emerging industry, including whether we should classify “staking as a service” and investing in stablecoins as investment contracts.
Keep an eye out for the ruling in the Ripple case, which we expect to be made sometime this year.
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