🎬 Setting the Scene: Where does crypto stand today?
A primer on the core crypto legal concepts & the current state of affairs
👋 Hi, we’re Inesha & Reshini. We write this newsletter as a lawyer 👩🏽⚖️ & a former policy advisor 👩🏽💼 at U.S. Treasury who have been involved in crypto these last few years. Crypto forces us to reexamine our thinking on so many of the foundations of American law – from how we conceptualize property, to how we organize capitalist enterprises, and define what constitutes a security. Yet there is a dearth of lawyers who are smart on crypto. And a dearth of crypto folks who understand American law. We want to bridge this divide. 🤝
We hope you’ll invite us into your 📥 inbox to share lessons on core legal concepts in crypto + updates on what’s going on in U.S. crypto law & policy. 🏛
Follow along on Twitter @TheLawLayer & please don’t hesitate to reach back with feedback or questions on Twitter @ineshap or @reshinip. 💬
🛸 Imagine you’re an alien dropped on Earth with the mission to understand where U.S. earthlings stand on crypto regulation & report back. Here’s what you should tell your superiors.
The year is 2023. Humans live in civilizations called “countries” and the United States of America one just had the craziest year in crypto yet. The previous year, earthlings saw the highest highs and the lowest lows in web3, including the downfall of major presences like Terra-Luna, FTX, Celsius, and 3AC.
Here’s where we stand.
The beginning of 2022 started right after the market cap of crypto exceeded $3 trillion. 🚀 Both bitcoin (BTC) and ether (ETH) were performing well, DeFi protocols were expanding, and NFTs were booming. Many venture capital firms, as well as institutional businesses, were wading into the web3 world.
But, by the end of Q2, the crypto market cap had fallen 📉 over $1 trillion as interest rates increased and investors shifted to lower-risk asset classes. Innovations in crypto like the algorithmic stablecoin Terra became de-pegged from the US dollar as investors fled the market, creating an implosion that put the entire market under extreme pressure.
During this time, significantly over-leveraged hedge funds, like Three Arrows Capital (3AC) — that suffered gigantic losses 🙅🏽♀️ from the Terra implosion — defaulted on loans they owed to centralized finance (CeFi) institutions. The funds users had injected into those CeFi platforms were frozen due to bankruptcy filings, which meant companies like Celsius and Voyager Digital that had promised high yields actually returned huge losses for retail investors. Nothing seemed illegal, though, just ⚠️ classic mismanagement of funds and miscalculation of risk-taking ⚠️, which has happened in different asset classes long before crypto ever existed.
After the stumbles over the late spring and early summer, crypto seemed to be gaining steam again 🚂 heading into the fall. Ethereum successfully transitioned its original proof-of-work blockchain to a proof-of-stake one, rendering it 99% more environmentally-friendly, as well. FTX’s CEO, Sam Bankman-Fried, was seemingly single handedly restoring confidence in the crypto markets by bailing out financially struggling firms, lobbying passionately on the Hill, and generally voicing his strong belief in the future of crypto.
However, FTX itself blew up 🌋 after questions of its solvency surfaced from its main competitor, Binance, right before Election Day. In the matter of hours, billions of dollars in market cap and personal wealth evaporated as fraudulent financial practices of commingling customer deposits and funds were uncovered within the firm. The crypto market crashed and confidence in the entire system was shaken, both in retail, but also in DC.
🥁 As we march into 2023 — now that we finally (!) have a Congress sworn in — there is no doubt that regulation is on everyone’s mind. All of the bankruptcies, fraud, and general lack of guidance in crypto markets has incentivized operators and legislators alike to bring about some much-needed clarity.
Here’s a round-up on what’s coming down the pike.
🔒 Securities vs. commodities. The biggest showdown of crypto regulation to date. The Securities Exchange Commission (SEC) — led by trigger-happy Gary Gensler — has been vocal about its perceived authority in the digital assets realm, asserting that “the vast majority” of tokens are securities and “are covered under the securities laws” since they are “investment contracts” under the Howey Test. Who’s Howey, you ask? Luckily for you, that’s the subject of our next dispatch. 😉
On the other hand, the Commodities Futures Trading Commission (CFTC) and many legislators are vying for most digital assets to fall under CFTC jurisdiction. The DCCPA (proposed by Stabenow [D-MI] & Boozman [R-AR]), the Responsible Financial Innovation Act (proposed by Lummis [R-WY] & Gillibrand [D-NY]), and the Digital Commodity Exchange Act (proposed by Thompson [R-PA-15] & Khanna [D-CA-17]) — to name a few — are all bills on the Hill 🏛 right now that argue digital assets are mostly commodities, not securities. Want to understand the nuance here? This is exactly what our next two dispatches investigate. We’ll keep you apprised of how this debate unfolds as the legislative session develops.
There’s also important legal action evolving on this front. SEC won the LBRY case in a summary judgment last year (it was decided that the LBRY token was indeed a security), but the Ripple case expects a verdict from the Judge soon. There are some other cases 💼 in progress that have notable implications for the categorization of digital assets as securities, like SEC v. Gemini & Genisis and SEC v. Wahi et al that we’re also keeping our eyes on and will make sure you are, too!
🪙 Stablecoins. Many say stablecoins are the digital asset expected to be regulated first. Especially after the Terra-Luna collapse last year, which seems to forbode the outlaw of algorithmic stablecoins (what’s that? stay tuned to find out!), regulators are antsy to get a grip. The McHenry (D-NC-10) & Waters (D-CA-43) bill is anticipated to be introduced this session, even with McHenry taking over the helm from Waters of the House Financial Services Committee.
These digital assets are also the web3 vehicle that by and large boast the highest adoption rate. Last year, stablecoins saw $7.4T in transactions (for reference, MasterCard - the 2nd-largest credit card issuer in the world - only processed $2.2T). Some expect stablecoins to soon surpass the transactions of all four major credit card issuers 💳, especially as they pick up steam in emerging markets as a viable alternative to volatile currencies.
📈 CeFi. As aforementioned, FTX collapsed at the end of last year. As a centralized exchange of crypto assets, the company is not DeFi; however, because it operates in the crypto world, the regulation is opaque. Nonetheless, it seems rather certain that fraud was committed and customer deposits were used in unsanctioned ways. 👀 As this drama continues to play out (SBF was formally charged by the DOJ in mid-December), there may (should!) be implications for centralized exchanges of crypto moving forward.
👯♀️ DAOs. According to Consensys, a decentralized autonomous organization (DAO) is a “community-led entity with no central authority. It is fully autonomous and transparent: smart contracts lay the foundational rules, execute the agreed upon decisions, and at any point, proposals, voting, and even the very code itself can be publicly audited.”
So far, Wyoming is the only state that allows DAOs to incorporate as legal entities. But, DAO aficionados are awaiting the decision in Ooki DAO v CFTC with bated breath, as the decision could imply that all token-holders could be held liable for violations of various statutes. ‼️ Don’t worry, we’ll keep you up-to-date on this case as it develops.
We’re also always monitoring developments 🔍 in NFTs (digital property rights, anyone?), as well as crypto bills in Congress and legal cases with web3 implications to keep you all updated & at the cutting edge of the crypto x law intersection.
We’ll see you in 2 weeks as we dive right into the case law underpinning securities & how it may be relevant for crypto.