The digital asset market in the United States (“US”) is highly dynamic and continues to evolve and grow. In fact, a 2023 survey done by Coinbase revealed that roughly 20% of Americans own crypto – or over 50 million people – with the market being worth billions of dollars. This makes the US one of the largest and most influential digital asset markets in the world, with no signs of slowing down as new blockchain-based applications, digital assets, and regulatory developments emerge at a rapid pace.
Several Regulatory Bodies
In the US, several regulatory bodies oversee the digital asset market. The Securities Exchange Commission (“SEC”) has jurisdiction over digital assets that are considered securities, including security token offerings (“STOs”). The Commodities Futures Trading Commission (“CFTC”) has jurisdiction over digital assets considered to be commodities. Finally, the Financial Crimes Enforcement Network (“FinCEN”) is responsible for enforcing Anti-Money Laundering (“AML”) and Know Your Customer (“KYC”) regulations for digital assets and digital asset exchanges. However, due to the lack of legal clarity surrounding digital assets and crypto, it is oftentimes difficult to know which agency or agencies’ guidelines and regulations will apply. This is due to the fact that the legal framework that will apply is highly dependent on the classification of the specific digital asset, which is oftentimes unclear and highly debated.
The US Congress has defined digital assets as assets issued and transferred using distributed ledger or blockchain technology. From there, however, things get less clear. For example, digital assets can be securities, currencies, commodities, or property. The determination of which category a specific digital asset falls under is up to judicial interpretation, with generally the same tests applied in each case.
The Howey Test
If a digital asset is considered a security, it will fall under the jurisdiction of the SEC and therefore be subject to the regulations of the Securities Act of 1933 (the “Securities Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”). Courts have traditionally used the Howey Test in determining whether an asset is considered an “investment contract” and, therefore, a security and subject to SEC regulations. The Howey Test, which comes from a 1946 US Supreme Court decision determining when an agreement is considered an “investment contract” and, therefore, a security, contains 4 elements, all of which must be met for a digital asset to be considered a security. The elements of the Howey Test are:
- An investment of money;
- In a common enterprise;
- With a reasonable expectation of profits;
- To be derived from the efforts of others.
For example, when a person purchases stock in a company, they exchange their money for the stock, satisfying element 1. The money the investor exchanges goes to the company, satisfying element 2. Typically, an investor purchases a stock as an investment or with the mindset that they will receive more money back than they put in, satisfying element 3. Element 4 is satisfied in this scenario since the investor is not actually participating in the operations of the company but relying on the employees, management, etc., of the company to increase the value of the stock.
When it comes to digital assets and crypto, much of the debate has been over whether elements 2, 3, or 4 are satisfied. For example, Bitcoin is not considered a security primarily due to the fact that there is no central third-party common enterprise. However, for tokens which have a central team or entity responsible for the development of the token, platform, network, etc., it becomes much harder to argue that there is no common enterprise or reliance on the efforts of others.
Another argument that has been made to avoid SEC regulation is that the tokens being offered are utility tokens, meaning the primary reason a user is purchasing a particular token is for consumptive purposes, as opposed to investment purposes like a traditional security. If the primary purpose of the token is for consumptive purposes, then there is not necessarily an expectation of profit, since the purchaser of the token has no intention of reselling the token. While this argument has garnered some merit, it is by no means a surefire way to avoid SEC regulation or to ensure a token is not considered a security.
If a certain crypto is deemed to be a security, each transaction involving the crypto/token will be subject to the various regulations, disclosure requirements, and reporting requirements imposed by the Securities Act and the Exchange Act in addition to registering any public offering for sale of the tokens or digital assets. That being said, the Securities Act and Exchange Act allow for certain exemptions from the registration requirements imposed on STOs and Initial Coin Offerings (“ICOs”), each with its own limitations and requirements as discussed below.
- Regulation A+ Tier 1: Allows issuers to raise up to $20 million within 12 months of the offering. Additionally, issuers are required to file a Form 1-A with the SEC, a form containing information about the offering and the related risks, use of proceeds, business description, and financial statements, among others.
- Regulation A+ Tier 2: Allows issuers to raise up to $50 million within 12 months of the offering. Tier 2 issuers must also file Form 1-A with the SEC, along with the other documents mentioned above. However, unlike Tier 1 offerings, the financial statements disclosed must be audited in a Tier 2 offering, and there is an investment limit on non accredited investors or individuals who do not have an annual income of at least $200,000 ($300,000 if married) or a net worth of at least $1 million excluding the value of one’s primary home.
- Regulation Crowdfunding (“Reg CF”): Allows issuers to raise up to $5 million within 12 months of the offering. Additionally, there are restrictions on investors, accredited or not. Issuers must also file Form C with the SEC prior to the offering of the securities.
- Regulation D (“Reg D”) is most commonly utilized by smaller, private offerings. Rule 504 of Reg D allows for issuers to raise up to $10 million within 12 months of the offering and requires them to file Form D with the SEC within 15 days of the first sale. Rule 506(b) of Reg D allows investors to raise an unlimited amount of money from an unlimited number of accredited investors and up to 35 non accredited investors while requiring the issuer to file only Form D with the SEC within 15 days of the first sale. Rule 506(c) of Reg D is essentially the same as Rule 506(b), except all investors must be accredited investors.
Digital Asset Exchanges
As far as digital asset exchange treatment in the US goes, the legal status is still evolving. The federal securities laws define an “exchange” as a platform that offers trading in digital asset securities. In general, digital asset exchanges that offer security tokens must register with the SEC and comply with both the Securities Act and the Exchange Act or obtain an exemption. The laws imposed by the Securities Act and Exchange Act require exchanges to provide investors with certain disclosures about the securities being offered for sale. Platforms that offer commodities are not required to register with the CFTC, but they must still comply with certain CFTC regulations.
Generally, these regulations require exchanges to protect customer funds and to prevent market manipulation. Many platforms, instead of registering as an SEC-regulated exchange, are registered as money-transmission services (“MTSs”), which are money transfer or payment operations that are primarily subject to state regulations, as opposed to federal regulations. MTSs, like national exchanges, must register with FinCEN and comply with certain reporting requirements imposed by FinCEN.
In addition to securities and commodities, digital assets can also be classified as property or currency. The Internal Revenue Service (“IRS”) treats digital assets as property for tax purposes. According to IRS Notice 2014-21, digital assets are considered property and not currency. Therefore, digital assets are subject to capital gains tax, and digital asset miners must report their earnings as income.
If a digital asset is considered a currency, it may fall under the jurisdiction of the Department of Treasury’s Office of the Comptroller of the Currency (“OCC”). The OCC has indicated that national banks and federal savings associations can provide custodial services for digital assets, including holding the cryptographic keys associated with the digital assets. The OCC has also issued a joint statement with the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation (“FDIC”) highlighting key risks to banks associated with digital assets and digital asset sector participants. The OCC expects banks that provide digital asset custody services to have adequate systems in place to manage the risks of the activities, including policies, procedures, and management information systems specific to the bank’s custody services.
The future of digital asset regulation in the US is likely to involve further clarification and refinement of the existing regulatory framework. Some potential areas of development include more detailed guidance from regulatory bodies, the introduction of new legislation at both the federal and state levels, and court decisions that provide legal precedents for the classification and regulation of digital assets.
Source: The Tokenizer