As cryptocurrencies become increasingly popular, so do new efforts to regulate them. Since cryptocurrencies do not have a central issuing or regulating authority, and instead use a pseudonymous, decentralized system to record transactions and issue new units, effective regulations are difficult to design. The decentralized nature of cryptocurrency—facilitated by blockchain infrastructure—intends to shield the customer from regulation. To date, regulators have attempted to extend existing regulations around government-backed, or fiat currency, into the cryptocurrency space, an indication of the difficulty they face in regulating these new assets. Further, the impact of this regulation on underlying cryptocurrency technologies will establish the foundation upon which Web3, and the restructuring of the Internet as we know it, are built. This post outlines the challenges that arise in applying existing regulatory approaches to cryptocurrencies.
Anti-crime regulatory efforts primarily work to extend existing anti-money laundering (AML) and know your customer (KYC) regulations for fiat currency into the cryptocurrency space.
AML regulations refer to the activities financial institutions perform to achieve compliance with legal requirements to actively monitor and report suspicious activities. As a component of AML regulation, KYC laws require financial institutions to obtain identifying information for the individuals and companies with whom they do business, and are designed to protect financial institutions against involuntary involvement in fraud, corruption, money laundering, and terrorist financing. Together, KYC and AML regulations aim to reduce suspicious and criminal financial activity. While this blog is not meant to be exhaustive, what follows outlines some of the current efforts to apply KYC and AML regulations to the digital asset ecosystem.
Under the Bank Secrecy Act, the Treasury Department’s Financial Crimes Enforcement Network (FinCEN) regulates money service businesses (MSBs), which traditionally refer to any individual or business engaged in dealing or exchanging currency, check cashing, and/or money transmission. On March 18, 2013, FinCEN incorporated virtual currency into their guidance by expanding the existing definitions of MSBs to include virtual currency exchanges. As a result of this revised guidance, the regulations require all MSBs to conduct a comprehensive risk assessment of their exposure to money laundering, as well as develop, implement, and maintain a written program designed to prevent the MSB from being used to facilitate money laundering and the financing of terrorist activities.
In addition to the FinCEN guidance, all U.S. persons are prohibited from doing business in fiat or cryptocurrency with foreign nationals who are on the Treasury Department’s Office of Foreign Assets Control (OFAC) specially designated nationals (SDN) and blocked entities list. In October 2021, the Department of Justice established the National Cryptocurrency Enforcement Team to tackle complex investigations and prosecutions of criminal misuses of cryptocurrency. The establishment of this team suggests a recognition that fiat and cryptocurrencies cannot always be regulated in the same manner, or that regulators do not understand digital assets well enough to uniformly apply existing rules and regulations.
Most recently, on August 16, 2022, the Federal Reserve directed banking organizations to notify their regulators before engaging in any new activity involving budding crypto or digital asset markets, in order to “ensure that such activities are legally permissible”. The supervisory letter highlighted that banks engaging in these activites face “potential legal and consumer compliance risks,” an indication that the government is poised to crack down further on illegal activity in the digital asset space.
Securities laws aim to establish transparency and auditing around financial assets. As with anti-crime approaches, efforts in this space are largely focused on extending regulations from fiat currency into the cryptocurrency space.
Under the Securities Act, the Securities and Exchange Commission (SEC) has regulatory authority over the issuance or resale of any token or other digital asset that constitutes a security. If a token issued in an initial coin offering, the equivalent of an initial public offering, has “utility” the token is a security regulated under the Security Act. The issuer of a security, or in this case a cryptocurrency, must register the security with the SEC, and submit to an array of reporting, auditing, and security requirements.
Despite the limited regulation in this area to date, new SEC regulations are possible. As more venues begin to accept cryptocurrency, virtual tokens are likely to preserve their value in online spaces, which may be further solidified as the ecosystem expands to welcome Web3 technologies. In August 2022, we began to see hints of this push, with whispers that “every U.S. crypto exchange…are in various stages of being investigated” by the SEC. The recent SEC lawsuit against Ripple for allegedly engaging in an illegal securities offering through sales of XRP also highlights this tension.
There have also been a number of developments in the effort to tax cryptocurrency wealth and transactions.
In March 2014, the IRS declared that “virtual currency” will be taxed as property, not currency. As a result, every individual or business that owns cryptocurrency is required to keep detailed records of cryptocurrency purchases and sales; pay taxes on any transactions made with crypto, including selling crypto for fiat currency; and pay taxes on the fair market value of any mined cryptocurrency as of the date of receipt.
More recently, on August 10, 2021, the U.S. Senate passed the Infrastructure Investment and Jobs Act, a one trillion dollar bill aimed at increasing infrastructure funding over the next eight years. To help pay for these expenditures, the Senate included a provision imposing reporting requirements on cryptocurrency “brokers,” with estimates that such reporting would enable the Internal Revenue Service (IRS) to collect an additional $28 billion in tax revenue over 10 years.
It is also possible that the IRS could use its prior revenue rulings as a basis for taking the position that, for transactions completed on or prior to December 31, 2017, different cryptos are not “property of like kind” under section 1031(a) of the Internal Revenue Code. This would mean that individuals looking to exchange one cryptocurrency for another would be subject to an additional tax.
A very small subset of the population uses cryptocurrency, but a percentage of those users have become incredibly wealthy by engaging in what some call speculative investments. As cryptocurrency becomes more mainstream, it is reasonable to anticipate the same conversations around virtual currency taxation as have occurred about taxes on fiat currency, and to anticipate new regulatory avenues in order to achieve this aim.
There have been a number of efforts to address the environmental strain posed by cryptocurrency mining, which requires an immense amount of energy. Ethereum, the blockchain that supports the cryptocurrency Ether, for example, currently uses 113 terawatt-hours of energy each year—as much power as the Netherlands uses annually. Given that, on average, one kilowatt hour of energy emits 0.85 pounds of carbon, Ethereum’s energy usage can be estimated to result in over 96 billion pounds of carbon emitted per year.
Despite the enormous energy drain, mining regulation today is fairly straightforward––if it is legal to own and use cryptocurrency where you live in the United States, you are also able to mine cryptocurrency in that location. Although we have not seen much regulation around mining to date, it is likely that more such actions are forthcoming as concerns around the climate crisis intensify.
The House Committee on Energy and Commerce, for example, outlined a potential solution to the energy use problem in a January 2017 report, which advocated a transition from proof of work to proof of stake for cryptocurrencies.
Proof of work blockchains pit miners against each other as their computers compete to solve a difficult math problem. The miner that solves the problem first updates the ledger by appending a new block to the blockchain, and gets newly minted coins in return. This requires an enormous amount of computing power and, thus, electricity.
Proof of stake blockchains, by contrast, employ a network of “validators” who contribute—or “stake”—their own crypto in exchange for a chance of getting to validate a new transaction, update the blockchain, and earn a reward. The network selects a winner based on the amount of crypto each validator has in the pool and the length of time they’ve had it there, thereby literally rewarding the most invested participants.
The move from proof of work to proof of stake is contentious, especially among miners who lament a lack of equal opportunity in the proof of stake system. Despite pushback, Ethereum has recently become the first cryptocurrency to make the switch to proof of stake, claiming the transition will reduce its energy consumption by at least 99.95%.
Designed to be Different
Many signs indicate that the hype around and regulation of cryptocurrency is not just a trend that will fade. Although the cryptocurrency market has been extremely volatile in 2022, the market has ballooned in recent years and topped $3 trillion in value in November of 2021, despite only 16% of the American population having bought, sold, or traded cryptocurrency. Volatility is a constant in the cryptocurrency ecosystem, and was influenced by a host of external factors this year, including the Russian invasion of Ukraine, the ongoing Covid-19 pandemic, and high inflation, all of which disincentivize investment in luxury goods and add additional volatility to high-risk investments.
Even in a time of high volatility, investments in cryptocurrencies remain significant, and the market is beginning to bounce back from its June 2022 winter, especially in the wake of bullish signaling from the Federal Reserve around inflation. Further, the value of the market remains significant, and the underlying technologies that allow these currencies to exist are likely to withstand market volatility. This is reinforced by the March 2022 Digital Assets Executive Order, which directs relevant departments and agencies to initiate research into the merits of a U.S. central bank digital currency.
The concept of decentralization significantly complicates cryptocurrency regulation, making it difficult to reign in by simply extending existing fiat currency regulation into the crypto ecosystem. The rise of cryptocurrency represents a foundational shift in the way we understand currency, financial interactions, and the broader economic landscape.
The regulation of cryptocurrency will also ultimately have lasting and far reaching implications as the next iteration of the Internet comes to fruition. Proposals for this new generation of the Internet, such as Web3, rely on many of the same principles and technologies that underpin cryptocurrency. As a result, the regulation of cryptocurrency is about something much larger than the ability to exchange virtual currency—it is the regulation upon which Web3, and the restructuring of the Internet as we know it, may end up being built.