17 March 2020 - Article
M. Ridgway Barker co-authored this article with Joseph Bambara, CIPP/US.
The year 2020 was a difficult time for businesses across many industries. That said, hope springs eternal as digital assets and crypto-based companies have grown in popularity in 2020. Not only did Bitcoin (“BTC”) surge past its previous all-time high of $19,783.21 to a new high of $28,300 and climbing, but Ethereum (“ETH”), the second-largest digital asset by market cap, launched its Ethereum 2.0 protocol, which hosts the trading activity for most of over 6000 digital tokens in existence today. This Ethereum platform, with its universal token standard (“ERC20”), catapulted the growth of Decentralized Finance (“DeFi”).
DeFi is an umbrella term for a variety of financial applications involving digital assets and Cryptocurrency, which disruptively innovates and virtually eliminates the need for financial intermediaries. DeFi is based on the technology implemented using a blockchain-based ecosystem. It provides the user with full control of their assets. DeFi also referred to as “open finance,” is an ecosystem where blockchains, digital assets, and open protocols are integrated with conventional financial structures. DeFi includes smart contracts and distributed applications (“dApps”) built on a blockchain. Currently, the Ethereum platform, with its ERC20 token standard and a global supply of talented developers, is the primary choice for the DeFi. DeFi has added transparency, stabilization, and efficiencies to international finance. It has enabled decentralized lending, insurance, supply chain, and marketplaces with clearing and settlement functionality. The Ethereum platform has facilitated the use of smart contracts to automate transactions to minimize friction, fees, and interference from central authorities. (Please see our Withers article “Decentralized Finance is on the Rise”)
Surging investor interest in DeFi growth has also reinforced the need for reliable pricing data. The Chicago Board of Exchange (“CBOE”), the largest options exchange in the U.S, will launch Cryptocurrency Indexes in 2021. Standard & Poors Dow Jones has also announced a digital asset index and reported a stake in Lukka, the firm facilitating the product. JPMorgan Chase, one of the world’s largest investment banks, predicts that when family offices, insurance companies, and pension funds decide to enter the world of DeFi, it will result in massive demand for even more DeFi applications. They referenced recent Bitcoin adoption by life insurance company MassMutual. There’s a significant opportunity up for grabs for the US to be the global leader and win this new technological and economic cold war.
Despite these advancements, there are lingering impediments, especially concerning security and regulation. It is a very well-known saying in the cryptocurrency domain: “Not your keys, not your Bitcoins.” This is cautionary advice from one who has seen many traders victimized. If there is one thing that has discouraged investors in the digital asset class, it is the risk of fraud. Even the expert investor can be hacked. On December 16, 2020, Nexus Mutual CEO Hugh Karp has suffered a remote access hack to his computer, resulting in the loss of 370,000 NXM, or approximately $8 million. Perhaps even more troubling is the lack of regulatory adaption of digital assets. It has been an impediment to adoption by traditional investors and service providers. As the market for digital assets grows, the number of trade breaks and security breaches will rise. Infrastructure must mature, making security and regulatory compliance the priorities for trading venues. For instance, there was a massive Bitcoin selloff on the BitMEX exchange in March 2020. Nearly $200 million was liquidated with overleveraged traders unable to move money between networks in time to unwind their positions. With market oversight fragmented and in a state of change, counterparties were unfairly damaged. (Please see our Withers article “Decentralized Finance Needs Regulatory Clarity and Smarter Compliance”)
In response, there are several legislative initiatives in progress, but none has made any significant impact. The 116th U.S. Congress introduced forty bills addressing DeFi, cryptocurrencies, and blockchain. Of the bills introduced, eleven have passed the House of Representatives, and only two have become law. The main objective of a good number of these bills calls for action by the Department of Financial Crimes Enforcement Network (FinCEN) to get smart on DeFi, blockchain, and digital identity technologies, improving their analysis and data distribution between law enforcement bodies. The Financial Technology Protection Act of 2019 (H.R. 56) involved creating an “Independent FinTech Task Force to Combat Terrorism and Illicit Financing.” It offered a reward for terrorists found using digital currencies. The Homeland Security Assessment of Terrorists’ Use of Virtual Currencies Act asks Homeland Security to assess terrorist use of virtual currencies. The Fight Illicit Networks and Detect Trafficking Act or the FIND Trafficking Act was requested by the GAO to examine how the unique characteristics of virtual currencies could be used to track and prosecute the illicit use of Cryptocurrency. Bills that made it out of the House of Representatives include the Blockchain Innovation Act (H.R. 8153), The Advancing Blockchain Act (H.R. 6938), and part of the Digital Taxonomy Act (H.R. 2154). These bills addressed the use of Cryptocurrency by Terrorists, Money Launderers, Human and Sex Traffickers, regulatory clarity for digital asset companies, the use of Blockchain Technology in Government, and the potential for a Digital Dollar. (Please see our Withers article “Does the US Need to Have a Digital Dollar”)
The Stablecoin Tethering and Bank Licensing Enforcement (“STABLE”) Act was written with the intent to prevent abuse, opacity, and the potential risk of a stablecoin-based shadow-banking system. It would impose specific obligations that stablecoins issuers would have to comply with. Issuers would need a federal banking charter as well as establishing full compliance with existing banking regulations. In addition, any stablecoin issuers would be required to obtain the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) approval six months before issuance need to get FDIC insurance. The legislation is pending. Those critical of the STABLE act say it would strengthen the position of the large financial institutions while stifling DeFi innovation: the power of digital assets to put power in individual consumers’ hands and catalyze innovation across payments and other financial services.
It is worth remembering that blockchain and digital asset bills proposed and/or debated by the U.S. Congress during 2020, no substantive legislation has passed as of this writing. Unfortunately, for most of the bills that would impact cryptocurrency use by criminals or improve digital asset regulation, none have successfully become law. For better or worse, the passage of blockchain or digital asset legislation does not seem to be a priority for federal lawmakers. That said, regulatory actions are impacting the cryptocurrency and blockchain industry. They are coming from agencies or the financial regulators themselves. The Department of Justice recently released the ‘Cryptocurrency Enforcement Framework’. (Please see our Withers article “Crypto Crime Enforcement Trends: The US Department for Justice Steps Up”) There have been numerous enforcement actions from the Securities Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC). There have been interpretive letters released by the Office of the Comptroller of the Currency (OCC). The SEC case against XRP has sent shock waves through the crypto community. This latest action against Ripple and XRP is merely targeting the largest digital ledger asset they could have if Ether and Bitcoin are not securities. XRP was the third-largest digital ledger asset by market capitalization. The most likely outcome seems to be a similar civil penalty or settlement depending on whether Ripple is prepared to fight.
There is some regulatory promise for the advancement of digital assets. SEC commissioner Hester Pierce believes the SEC’s approach has been “too slow and too ambiguous.” She advocated for FinHub, an SEC agency encouraging responsible innovation in the financial sector, including in distributed ledger technology and digital assets, digital marketplace financing, and artificial intelligence and machine learning becoming a standalone office. Commissioner Pierce is also an advocate for a regulatory “safe harbor” for digital assets. (Please see https://www.sec.gov/news/press-release/2020-303). As a positive note, engaging with lawmakers and the policymaking process is an important step. Hopefully, it will encourage larger financial organizations to enter the digital asset space.
As we enter the administration transition in 2021, critical appointments to prominent roles in agencies such as the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) will impact digital assets and Cryptocurrency. Regulation and legislation are never perfect initially, just like no idea arrives fully formed and ready for implementation. Writing and proposing legislation should serve as a wake-up call to the digital asset sector at large. Working with, collaborating with, and educating lawmakers and the business community at large are shaping up to be a central theme of 2021 for blockchain and crypto sector advocates.
Ultimately, laws and regulatory action will stabilize, allowing digital assets and DeFi to provide censorship resistance, worldwide participation, and the elimination of trusted third parties within the financial ecosystem. As it matures, the underlying blockchain infrastructure will provide performant, inexpensive transactions/settlement, the immutability of the financial contracts, and the execution of smart contracts. The DeFi ecosystem transparency will support and provide price and market efficiency. DeFi will grow via the network effect, as the rise of innovation, performance, and resulting participation will elevate a vibrant global ecosystem of financial applications. Stay in touch with us at Withersworldwide to learn how to prepare your businesses both technically and legally to safely and efficiently incorporate these emerging technology trends. The Withers team can help their financial partners with the legal and technology expertise to stay ahead of the competition.