SEC's next target for enforcement action: encrypted wallets?

Original author: Partner at Troutman Pepper Law Firm

Original translation: Mary Liu, BitpushNews

Cryptocurrency is now "non-compliant," especially its "business model," at least according to Gary Gensler, the chairman of the U.S. Securities and Exchange Commission (SEC).

Given that this viewpoint is prevalent among U.S. regulatory agencies responsible for securities regulation, it is not surprising that enforcement actions involving cryptocurrency have reached historic levels.

In just a few years, we have witnessed the so-called unregulated "Wild West" become the target of the SEC. In addition to the SEC, the Commodity Futures Trading Commission (CFTC) and the Department of Justice (DOJ) also frequently step in.

There is no doubt that these regulatory agencies are not keeping their interest in law enforcement work a secret.

They have taken measures, including pursuing what they believe to be misleading investors or illegally promoting cryptocurrency by the leading participants. These enforcement actions have drawn attention from the mainstream media, and some of them have been settled through multi-million-dollar settlements.

However, the most surprising aspect of these enforcement actions is how they are being executed. People might expect a new wave of legislation aimed at regulating cryptocurrency and other digital assets, but they would be wrong. These enforcement actions tell people that they are still stuck in the past, as the laws they are based on in some cases have a history of 90 years.

As regulatory agencies rely on strained interpretations of existing laws to intensify enforcement, two questions arise: 1) What is the next target of the SEC? 2) Will the outdated securities laws or the cryptocurrency industry be eliminated first?

What's the next target? Cryptocurrency Wallets

After closely observing the actions of regulatory agencies, we anticipate that cryptocurrency wallets and certain digital asset exchanges will be the next targets.

Based on previous federal law enforcement actions and signals issued by these agencies in notifications, we anticipate that digital asset enforcement will take place in two ways: the 1934 Securities Exchange Act ("Exchange Act") may be interpreted to cover the regulation of cryptocurrency wallets as brokers subject to anti-money laundering and Know Your Customer (AML/KYC) requirements. Mixers and other tools will face compliance challenges in the digital asset field.

We predict that the next regulatory area for the SEC will involve the regulation of cryptocurrency wallets acting as brokers.

This concept was first raised by the SEC in its Wells notice to Coinbase, which was issued prior to the lawsuit against the cryptocurrency exchange. In the notice and the repeated allegations and statements in the lawsuit, the SEC accuses Coinbase Wallet (a product that provides users with self-custody of digital assets) of operating as an unregistered broker, violating the Exchange Act.

In response to Wells' notification, Coinbase argued that its wallet product is just software and does not perform any of the traditional functions typical of brokerage activities. In particular, the "Exchange Act" defines a "broker" as "any platform engaged in securities trading for others."

Coinbase's reasoning is that wallets can only interface with secondary market transactions, and from Coinbase's perspective, these secondary market transactions do not involve investment contracts and, therefore, are not securities. Coinbase further argues that they used to charge a 1% fee every time the "wallet swap" feature was used (which has now been discontinued), but that does not change the SEC's analysis.

The SEC does not believe this. The agency has sued Coinbase and Binance, accusing both companies of operating wallet services as unregistered broker-dealers.

TradFi Trading

We predict that the second area in which the SEC's enforcement scope will expand is strengthening regulation of traditional financial institutions involved in digital asset trading. As people pay increasing attention to new cryptographic tools and services, we expect designing, implementing, and maintaining compliance systems to adhere to AML/KYC laws will pose significant challenges for these institutions, making them a target for regulatory agencies.

In particular, enforcing AML/KYC laws in the realm of digital assets will require these institutions to rely to a large extent on information they cannot control. Taking proposed token trading as an example, where over 10% of the value can be traced back to proceeds from stolen assets.

In fact, compliance plans that can carry out such token tracing will require collaboration with third parties, which is far beyond the capabilities of most crypto companies inside and outside the industry.

First, whether it is a government entity or a private investigative organization, there must be an understanding of the theft and a need to track and identify the wallets/tokens involved. Then, a repository must be created to maintain that information. To some extent, multiple such repositories are needed to track the flow of currencies connected with numerous thefts and hacks, making the cost of solving the problem even higher. Lastly, once a company wants to screen illegal and problematic transactions, it must screen the data for each transaction to flag problematic ones.

Except for the last step, every step requires financial institutions to rely on the work of others to produce inputs that contribute to driving the compliance plan. This decentralization leads to high compliance costs, both in terms of time and money.

Rapidly Expanding Enforcement Scope

The scope of crypto enforcement is rapidly expanding, causing some participants to ponder what comes next.

Coinbase CEO Brian Armstrong said during London Fintech Week that due to a lack of "regulatory clarity," "any direction is on the table, including leaving the US or whatever it takes." It is not difficult to imagine that most participants in the crypto market agree with Armstrong's statement, "We just want a clear rule book."

However, the various federal agencies responsible for regulation have not developed a set of clear rules to govern the crypto industry; instead, they rely on legal provisions from decades ago, which did not anticipate the technologies upon which digital assets depend.

In some respects, it raises a question: do market participants truly set their business model as "non-compliant", or is non-compliance merely a byproduct of regulatory confusion?

While we await regulatory compliance manuals, investors and exchanges should collaborate with legal compliance teams to ensure their transactions comply with federal securities laws and banking regulations, as well as the ever-evolving interpretations of their application in the cryptocurrency industry. Each transaction brings unique regulatory hurdles, resulting from federal agencies' insistence on applying decades-old regulations to a rapidly evolving industry.