2024 has picked up where 2023 left off, with several notable developments related to blockchain and digital assets across various disciplines. In this Blockchain Bulletin, we highlight certain actions by the U.S. Securities and Exchange Commission (SEC or Commission), the Financial Industry Regulatory Authority (FINRA), the Internal Revenue Service (IRS), the Hawaii Division of Financial Institutions, and the Consumer Financial Protection Bureau (CFPB). For more resources on blockchain and digital assets, visit Sidley’s Blockchain Legal Launch Pad.
Sidley Blockchain Bulletin — February 2024
1. SEC Discusses Application of New “Dealer” Rules to Crypto Asset Markets
2. FINRA Presents Initial Findings on Crypto Asset Communications, After Highlighting Crypto Assets in Annual Regulatory Oversight Report
3. The SEC Approves the Listing and Trading of “Spot” Bitcoin Exchange-Traded Products
4. SEC Continues Active Enforcement Against Blockchain Products
5. IRS Announces Businesses Do Not Need to Report Certain Digital Asset Transactions (Yet)
6. Hawaii Changes Course on License Requirement for Crypto Businesses
7. ICYMI: CFPB Defines Crypto Assets as “Funds” in Larger Participant Rulemaking
SEC Discusses Application of New “Dealer” Rules to Crypto Asset Markets
On February 6, 2024, the SEC adopted rules defining activity that requires registration as a “dealer” with the SEC (see the Sidley Update here). The SEC’s adopting release (the Dealer Release) makes clear that the rules apply to trading activities related to crypto asset securities (including activities involving automated market makers (AMMs) and decentralized finance (DeFi) protocols), despite comments received that requested exclusions or limitations from the proposed rule. While the rule is intended to clarify what the phrase “as part of a regular business” means within the statutory definition of a “dealer,” the rules provide little certainty for crypto market participants.
- First, on the threshold question is whether a crypto asset is a security, the Dealer Release states that “to the extent there is a question as to whether a particular crypto asset is an investment contract that is a security, the analysis is governed by the test first articulated by the Supreme Court in SEC v. W.J. Howey Co.” As many market participants are undoubtedly aware, the application of the Howey test to transactions in crypto assets is far from straightforward given pending court cases on this issue.
- While the Dealer Release explains how certain key terms in the rules are to be interpreted, it does not explain how those terms apply to crypto markets. For example, the Dealer Release states that the term “trading interest” means (i) an “order” as the term is defined under 17 CFR 240.3b-16(c) or (ii) any nonfirm indication of a willingness to buy or sell a security that identifies the security and at least one of the following: quantity, direction (i.e., buy or sell), or price. However, in a response to a commenter who asked whether participants in an AMM liquidity pool, by leaving their assets in the pool and thereby exposing those assets to sale at the pool’s prevailing exchange rate, are expressing a “trading interest,” the Dealer Release simply states that whether a particular activity gives rise to “dealer” activity “requires an analysis of the totality of the particular circumstances.”
- Notwithstanding the SEC’s view that many DeFi protocols meet the definition of an “exchange” under the Securities Exchange Act of 1934 (see the Sidley Update here), the rules purposefully use the broader term “trading venue” to capture current and future “technologies and venues” that may not meet the definition of an exchange. The Dealer Release, again, states whether “a particular structure or activity in the crypto asset securities market, including the so-called DeFi market, involves a trading venue is a facts and circumstances determination.”
- Although the Dealer Release itself is silent on the application of the rules to AMMs, SEC staff did elaborate on it during the public meeting on February 6, 2024, where the Commission approved the rules. SEC Commissioner Hester Peirce asked how, if an AMM is simply software, it could be expected to register as a dealer. Haoxiang Zhu, SEC Director of the Division of Trading and Markets, warned that caution is needed when using such labels as “AMM,” which could refer to the software or the assets in a liquidity pool. Director Zhu explained that persons depositing tokens into liquidity pools would be dealing because there would be bid/offer prices, based on the AMM’s bonding curve, and they would be earning revenue based on the bid-ask spread. When pushed by Commissioner Peirce on whether that meant the software developers who write AMM code would not need to register, Director Zhu noted that it depends on the specific facts and circumstances but implied that a software developer who did not engage in any trading activity would not be required to register.1
- Finally, the rules state that there is no presumption that a person is not a dealer if they do not meet one of the new tests set forth in the rules. Participants will therefore still need to analyze their activity under prior SEC guidance and precedent, and applicable case law, to determine whether the activities may otherwise implicate the definition of a dealer. To that end, the Dealer Release notes the SEC’s belief that “some primary liquidity providers in crypto asset markets may already be dealers under the [Securities Exchange Act of 1934].”
Market participants that meet the definition of a “dealer” will be subject to SEC Rule 15c3-1 (the Net Capital Rule), which requires broker-dealers to maintain an amount of net capital that meets or exceeds their minimal net capital requirement at all times.2 The Dealer Release briefly discusses the impact of holding crypto assets on a broker or dealer’s net capital requirements under the Net Capital Rule, stating that “crypto assets that are not securities would be subject to a 100% deduction when computing net capital” while also suggesting crypto assets that are securities may be subject to haircuts as securities with a “limited market” (as defined by the Net Capital Rule). As noted by the Dealer Release, crypto assets that are not securities would not contribute to a broker-dealer’s net capital, but borrowing to fund such holdings may contribute to a broker-dealer’s aggregate indebtedness and require additional capital to reduce the entity’s ratio of net capital to aggregate indebtedness.3
There are certain carveouts from the rule, including an exclusion for persons that have or control total assets of less than $50 million that the Dealer Release says could potentially apply to crypto market participants.
For the first time, FINRA included a five-page section dedicated exclusively to crypto assets in its annual Regulatory Oversight Report (see the Sidley Update here).4 Two weeks later, on January 23, 2024, FINRA provided an update on its findings from an ongoing targeted sweep exam of firm practices regarding retail communications concerning products and services related to crypto assets (the FINRA Exam Update).
FINRA launched the examination in November 2022, requesting member firms to provide all retail communications made from July 1, 2022, through September 30, 2022, that “refer to, relate to, or concern a Crypto Asset or a service involving the transaction or holding of a Crypto Asset.” According to the FINRA Exam Update, FINRA reviewed over 500 communications, identifying potential violations of FINRA rules (such as Rule 2210) in approximately 70% of them. Potential violations included the failure to differentiate clearly between products and services offered by directly by members and those offered by third parties (including member affiliates), and false statements regarding the nature of crypto asset-related investments and misleading comparisons, among other things. The FINRA Exam Update refers to these findings as “initial themes” and notes that FINRA may provide additional information at a later date.
Retail communications should be fair and balanced and not misleading, but FINRA rules also require that retail communications “provide a sound basis for evaluating the facts” of any products and services discussed. The FINRA Exam Update suggests this may entail explaining “how Crypto Assets work” and explaining “technical terms” such as “blockchain” and “decentralized platform.”
The FINRA Exam Update includes key questions for member firms to consider, both when reviewing and supervising retail communications concerning crypto assets and when developing new or modifying existing policies and procedures.
The SEC Approves the Listing and Trading of “Spot” Bitcoin Exchange-Traded Products
On January 10, 2024, as has been widely covered, the SEC approved rule change applications filed by multiple national securities exchanges to list and trade exchange-traded products (ETPs) that invest directly in bitcoin (listen to this episode of Sidley’s Mutual Fund Minute podcast for additional background). Although the price of bitcoin has generally remained steady and even decreased following the approval, billions of dollars of inflows and trading volume suggest the market so far has reacted favorably to the bitcoin ETPs. However, in a statement accompanying the SEC’s approval, Chair Gary Gensler highlighted the risks associated with bitcoin and noted that “existing rules and standards of conduct will apply to the purchase and sale of the approved ETPs. This includes, for example, Regulation Best Interest when broker-dealers recommend ETPs to retail investors as well as a fiduciary duty under the Investment Advisers Act for investment advisers.” This is consistent with FINRA’s focus on retail communications, discussed above. While there have been proposals to launch ETPs offering leveraged and inverse exposure to bitcoin, and ETPs that invest directly in ether, it is likely that we can expect to see increased focus from regulators on how broker-dealers and advisers screen potential investors for suitability for these products (see, e.g., the discussion of FINRA and retail communications above).
SEC Continues Active Enforcement Against Blockchain Products
Two recent enforcement actions demonstrate the SEC’s continued focus on the crypto asset space. These actions serve as a reminder to crypto market participants than an “investment contract” may exist even where there are no allegations that any particular crypto asset is a security.
First, on January 29, 2024, the SEC filed a complaint in federal district court in the District of Maryland against two individuals for their involvement in an allegedly “global, crypto asset-related, multi-level marketing pyramid and Ponzi scheme” that was featured in an episode of an Amazon Prime documentary series called Next: Blockchain. According to the complaint, the defendants offered so-called “membership”
packages promising passive returns, purportedly derived from the project’s crypto asset mining operations, among other things. Interestingly, the scheme also involved the use of a crypto asset issued by a nondefendant co-founder; however, the SEC did not allege that token to be a security.
Then, on February 7, 2024, the SEC announced settled charges against TradeStation Crypto, Inc., for the unregistered offer and sale of an “interest feature” on user crypto asset accounts. The same day, the North American Securities Administrators Association announced a joint settlement with eight state securities regulators against the company for the same product. This is not the first time the SEC and state regulators have brought enforcement actions for unregistered securities offerings involving crypto lending programs (see the Sidley Update here regarding BlockFi’s settlement in February 2022). The SEC found that accounts with an interest feature constituted investment contracts in part because the “returns earned by each investor were a function of the pooling of the loaned crypto assets and the ways in which TradeStation deployed those loaned assets.” TradeStation, who is an affiliate of a FINRA-member broker-dealer, voluntarily discontinued the interest feature accounts on June 30, 2022.
IRS Announces Businesses Do Not Need to Report Certain Digital Asset Transactions (Yet)
On January 16, 2024, the Treasury Department and IRS issued an announcement postponing the requirement to report certain receipts of digital assets under Section 6050I of the Internal Revenue Code (the Reporting Announcement).
Section 6050I requires businesses that receive more than $10,000 worth of cash in one or more related transactions to report such transaction(s) on Form 8300 (Report of Cash Payments Over $10,000 Received in a Trade or Business). In 2021, the Infrastructure Investment and Jobs Act expanded the definition of “cash” for this purpose to include “digital assets,” effective beginning January 1, 2024.
Despite the effective date, no final regulations or IRS forms have been published to implement the expanded reporting requirement. Proposed regulations published on August 29, 2023, would clarify the meaning of the term “digital assets” for these and certain other purposes, but those regulations have not been finalized. Further, Form 8300 has not been revised to accommodate reporting of digital assets, nor has any other form been published to satisfy this reporting requirement.
In light of the absence of applicable guidance, the Reporting Announcement provides that digital assets need not be included when determining whether cash received has a value in excess of the $10,000 reporting threshold until the Treasury Department and IRS publish regulations under Section 6050I to implement the reporting of digital assets.
Hawaii Changes Course on License Requirement for Crypto Businesses
Prior to August 2020, companies engaged in virtual currency transmission in Hawaii were required to obtain a state money transmitter license and to effectively post duplicate “permissible investments” against digital assets held for customers. In August 2020, Hawaii created a regulatory sandbox, the Digital Currency Innovation Lab, allowing certain companies engaged in digital asset activities in Hawaii to operate without a money transmitter license while the Hawaii legislature considered a number of bills that would amend the Hawaii Money Transmitters Act to specifically include virtual currency transmission. However, the Hawaii legislature has neither amended the Money Transmitter Act nor adopted a virtual currency-specific licensing regime, and the sandbox will end on June 30, 2024.
In a surprising turn of events, Hawaii has announced that “digital currency companies will no longer require a Hawaii-issued money transmitter license to conduct business within the state. The companies will be able to continue transaction activity as an unregulated business.” Interestingly, while noting that federal laws and regulations may still apply to such companies, Hawaii specifically referenced the SEC and FINRA in addition to requirements set forth by the Financial Crimes Enforcement Network.
ICYMI: CFPB Defines Crypto Assets as “Funds” in Larger Participant Rulemaking
On November 7, 2023, the CFPB issued a proposed rule that would allow it to supervise certain “larger participants” that provide funds transfer and wallet functionalities through digital applications for consumers’ general use. The proposed rule would apply to nonbank payments companies that offer digital wallets or person-to-person payments through mobile and web applications (subject to certain conditions and exclusions). Although the proposed rule is not specifically directed at digital asset companies, the CFPB states its view that digital assets would be within the scope of the rule — and are within the scope of the Consumer Financial Protection Act (CFPA) more generally. According to the proposing release, “the CFPB believes that, consistent with its plain meaning, the term ‘funds’ in the CFPA is not limited to fiat currency or legal tender and includes digital assets that have monetary value and are readily useable for financial purposes, including as a medium of exchange.” This broad assertion of the scope of the CFPA will have significant implications for CFPB oversight of digital assets activities well beyond the proposed rule itself.
1However, the SEC recently found that certain blockchain-based software implementations were required to register with the SEC as investment companies. See In the Matter of Barnbridge DAO (Dec. 22, 2023).
217 CFR 240.15c3-1.
3See Dealer Release at note 573 and accompanying text.
4A copy of the complete 2024 Regulatory Oversight Report is available at https://www.finra.org/rules-guidance/guidance/reports/2024-finra-annual-regulatory-oversight-report.
Knowledge Management Lawyer Daniel Engoren contributed to this Sidley Update.
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