The rise of cryptocurrencies and digital assets1 in the financial markets, including the investment management industry, has given rise to a crucial question: which federal regulator – the Securities and Exchange Commission (SEC) or the Commodities and Futures Trading Commission (CFTC) will be primarily responsible to regulate the use of crypto and crypto-related activities? SEC Chair Gary Gensler has stated that “[crypto] products are subject to the securities laws and must work within our securities regime,”2 while then CFTC Commissioner Quintenz expressed that “the SEC has no authority over pure commodities or their trading venues, whether those commodities are wheat, gold, oil…or crypto assets.”3 In this article, we provide a high-level overview of the SEC’s and CFTC’s current jurisdiction over and treatment of crypto, and discuss recent enforcement actions involving crypto and the potential significance thereof to other market participants.
1. SEC Jurisdiction
The SEC has the authority to govern “securities”4, which has been defined to include, among other things “investment contracts.” Notably, “currency” is not a security. To the extent that a form of a digital asset is determined to be a note, investment contract or other type of security, it would be subject to SEC oversight and applicable securities laws.
Whether a digital asset is considered an investment contract depends on the test outlined by the U.S. Supreme Court in SEC v. W.J. Howey.5 In this case, the Supreme Court found that an “investment contract” exists where (i) there is the investment of money; (ii) in a common enterprise; (iii) with a reasonable expectation of profits to be derived; (iv) from the efforts of others. The Court emphasized that the determination of whether an investment contract exists lies in the circumstances surrounding the contract and the manner in which it is offered, sold, or resold.
The Howey test was emphasized by then Chair Clayton in his February 2018 speech before the Senate Banking Committee on digital assets.6 Later that year, then Director of the SEC’s Division of Corporate Finance William Hinman applied the Howey7 test to crypto. Like the Court, he emphasized that for digital assets specifically, the SEC looks to the nature of the transaction rather than the item being sold – and whether the Howey factors are present – to determine whether there is an investment contract. He noted that digital assets that are sold “as part of an investment; to non-users; by promoters to develop the enterprise – can be, and, in that context, most often is, a security – because it evidences an investment contract.”8 He further noted that networks on which a coin is sufficiently decentralized, that is where the purchasers no longer reasonably expect a person to carry out essential managerial efforts, do not represent investment contracts.
It is important to note that the SEC’s views on its ability to regulate crypto have not changed in recent years. SEC Chair Gensler continues to urge legislators to grant the SEC more scope to oversee crypto in an effort to enhance investor protection. He has also stated, ““It doesn’t matter whether it’s a stock token, a stable value token backed by securities, or any other virtual product that provides synthetic exposure to underlying securities. These products are subject to the securities laws and must work within our securities regime…”9
2. CFTC Jurisdiction
In contrast to the SEC, the CFTC has full regulatory authority over derivatives transactions (including swaps, futures, and options), and more limited authority to regulate fraud and manipulation in commodities markets. The CFTC made its first official statement on its jurisdiction over digital assets in 2015. Later, in 2016, the CFTC cemented its position in an enforcement action stating that, “bitcoin and other virtual currencies are encompassed in the definition [of commodity] and properly defined as commodities, and are subject as a commodity to the applicable provisions of the [Commodity Exchange] Act and [CFTC] Regulations.10 Then Chair Heath Tarbert expanded upon this definition in October of 2019 stating that, “it is my view as Chairman of the CFTC that Ether is a commodity.”11 Additionally, in a recent case in the Southern District of New York, the court found that “Bitcoin, Ether, Litecoin, and Tether tokens, along with other digital assets, are encompassed within the broad definition of “commodity” under Section 1a(9) of the [Commodity Exchange] Act.”12
As a result, it is widely accepted that established and broadly decentralized virtual currencies, like Bitcoin and Ether, are “commodities” and not currencies. Efforts to categorize these cryptocurrencies or others as “currencies” generally will not withstand regulatory scrutiny because they are goods exchanged in a market for uniform quality and value and thus fall both within the common definition of commodity and the Commodity Exchange Act’s (CEA) definition of commodity.13 It is important to note that the “jurisdictional authority of CFTC to regulate virtual currencies as commodities does not preclude other agencies from exercising their regulatory power when virtual currencies function differently than derivative commodities.”14
Even though the CFTC has determined that virtual currencies are commodities, the CFTC’s jurisdiction over virtual currency markets is limited to policing fraudulent and manipulative activities in interstate commerce. Beyond this type of enforcement authority, the CFTC does not generally oversee virtual currency transactions or exchanges that do not involve margin, leverage, or financing, and cannot, for example, require a spot crypto exchange to register with the CFTC. As a result of the above, the CFTC is said to have “enforcement jurisdiction” over cryptocurrency and digital assets, but not “registration jurisdiction.” A spot cryptocurrency product is generally a product that results in actual delivery of the cryptocurrency within a particular market’s spot delivery period. An example of a U.S.-based spot market is Coinbase.
Despite the CFTC’s lack of registration jurisdiction over spot markets, to the extent that a cryptocurrency product in a spot market provides for margin or leverage and is offered to retail customers, the product would generally be considered a futures contract subject to CFTC jurisdiction.15 Specifically, to the extent that spot trading provides for margin and is offered to retail U.S. persons, it falls under the CFTC’s broader and more onerous registration jurisdiction.16
Additionally, there is further heightened regulatory scrutiny with regards to margined or leveraged products. Recently, CFTC acting Director of Enforcement Vincent McGonagle stated, “In the digital asset space, we’ve brought several actions against entities where they’re offering digital assets, Bitcoin or others on a margin or finance basis…and those products should be on an exchange.”17
CFTC Chair Rostin Behnam recently stated that, “I look forward to working with this [Senate Agriculture] Committee to reexamine – and, if appropriate, expand – the CFTC’s authority to ensure both the benefits and promise of the emerging digital asset market and the underlying technology can be harnessed without undue harm to customers and financial market stability.”18 Chair Behnam also stated during the confirmation hearing that the recent enforcement actions were the “tip of the iceberg.” This means there are several other enforcement cases in the CFTC’s docket, which will become public upon the filing of such enforcement cases.
II. SEC AND CFTC ENFORCEMENT ACTIONS
i. Ripple Labs, Inc.
In 2020, the SEC initiated an enforcement action against Ripple Labs Inc. (Ripple), alleging that the sale of Ripple’s digital token (XRP), worth a notional amount of approximately US$1.3 billion, was an unregistered securities offering.19 The SEC alleged that Ripple distributed billions of dollars’ worth of XRP as employee compensation in lieu of cash in order to finance its business. Ripple provides block chain-based networks that facilitate low-cost payments between financial institutions. XRP is a digital asset that is used to represent the transfer of value across networks.
Specifically, the SEC claims that XRP is a security whose offer and sale can be made only pursuant to a statutory prospectus and an effective registration statement, and that because Ripple did not file a registration statement its investors have a rescission right. The SEC alleged that XRP met the Howey test by claiming that “the principal reason for anyone to buy XRP was to speculate on it as an investment,” that Ripple reflected a common enterprise, and that investors reasonably expected to profit from those efforts. It also claims that, because Ripple did not provide a registration statement, it made material misstatements and omissions of information that is required of securities issuers when soliciting public investment. While the case is still ongoing, in January 2022, the judge presiding over the case did grant Ripple’s request for privileged SEC documents, which reflect the SEC’s determination on its classification of XRP as a security.
The final outcome of the Ripple case, whether it will result in XRP’s classification as a security or not, will have significant implications for the SEC’s jurisdiction over digital assets. Along with the BlockFi action, below, the Ripple determination (when final) is expected to provide much-needed clarity to crypto market participants on when a digital asset would…