Crypto Wallets Are the Next Target of SEC Enforcement Actions?

Cryptocurrency is already “non-compliant,” especially its “business model,” at least that’s what U.S. Securities and Exchange Commission ( SEC ) Chairman Gary Gensler believes.

With this view prevalent among the U.S. agencies responsible for securities regulation, it’s no surprise that enforcement actions involving crypto are at an all-time high.

In just a few short years, we have witnessed the so-called unregulated “Wild West” become the SEC’s “bull’s eye”, with the Commodities and Futures Trading Commission ( CFTC ) and the Department of Justice (DOJ) also frequently coming to “finish the job”.

There is no doubt that these regulators are not hiding anything, at least when it comes to their interest in enforcement.

They have taken steps including going after what they see as top players who may have misled investors or illegally promoted cryptocurrencies. These enforcement actions have attracted mainstream media attention, with some of them being resolved with multi-million dollar settlements.

The most surprising aspect of these enforcement actions, however, is how they were carried out. While one might expect a new wave of legislation aimed at regulating cryptocurrencies and other digital assets, the enforcement actions show that they are still stuck in their ways, based on laws that are, in some cases, 90 years old.

As regulators step up enforcement efforts relying on far-fetched interpretations of existing laws, two questions arise: 1. What’s next for the SEC? 2. Which will be eliminated first, the outdated securities laws or the cryptocurrency industry?

What's the next step? Crypto wallet

After closely watching the actions of regulators, we expect crypto wallets and certain digital asset exchanges to be the next targets.

Based on prior federal enforcement actions and the signals sent by these agencies in the notice, we expect digital asset enforcement to proceed in two ways: The Securities Exchange Act of 1934 (the “Exchange Act”) may be interpreted to cover regulation of crypto wallets, and as broker-dealers and traditional financial institutions subject to anti-money laundering and know-your-customer (AML/KYC) laws, tools such as mixers will face challenges in complying with regulations in the digital asset space.

We predict that the next area of ​​regulation for the SEC will involve regulation of crypto wallets acting as broker-dealers.

This concept was first raised by the SEC in its Wells Notice to Coinbase, which was sent before suing the cryptocurrency exchange. Among other allegations and text raised in the notice and repeated in the lawsuit, the SEC accused Coinbase Wallet (a product that provides users with self-custody services for digital assets) of operating as an unregistered broker in violation of the Exchange Act.

In response to the Wells Notice, Coinbase argued that its wallet product is little more than software and does not perform any of the traditional functions customary to brokerage activities. In particular, the Exchange Act defines a “broker-dealer” as “any platform engaged in the business of effecting securities transactions for others.”

Coinbase reasoned that the wallet could only be used to interface with secondary market transactions, and that from Coinbase’s perspective, these secondary market transactions did not involve investment contracts and therefore were not securities. Coinbase further argued that the 1% fee it previously charged each time the “wallet swap” feature was used (now eliminated) did not change the SEC’s analysis.

The SEC isn’t convinced. The agency sued Coinbase and Binance , alleging that the companies’ wallet services operated as unregistered broker-dealers.

TradFi Trading

The second area where we predict the SEC’s enforcement scope will expand is increased regulation of traditional financial institutions that engage in digital asset transactions. With the growing focus on new crypto tools and services, we expect that designing, implementing, and maintaining compliance systems to comply with AML/KYC laws will pose a huge challenge to these institutions and, therefore, will soon become a target for regulators.

In particular, enforcing AML/KYC laws in the digital asset space will require these institutions to rely heavily on information they have no control over. Take, for example, the proposed internal policy of flagging transactions where more than 10% of the value can be traced back to proceeds from stolen assets.

In reality, a compliance program capable of such labeling would require the cooperation of third parties, which is far beyond the capabilities of most companies in and outside of crypto.

First, whether it is a government entity or a private investigation agency, the theft must be made aware of the theft, and the wallets/tokens involved must be traced and identified. Then a repository must be created to maintain that information. To the extent that multiple such repositories are needed to track the movement of currency associated with many thefts and hacks, this proliferation will only make the problem more expensive to solve. Finally, once a company wants to screen for illegal and problematic transactions, it must screen the data for each transaction, flagging the problematic ones.

At every step except the last, financial institutions must rely on the work of others to generate inputs that help drive compliance programs. This fragmentation makes compliance costly, both in terms of time and money.

Rapid expansion of law enforcement

The scope of crypto enforcement is expanding rapidly, and it has some players thinking about the next steps.

Coinbase CEO Brian Armstrong said during London Fintech Week that due to the lack of “regulatory clarity,” “any direction is open to consideration, including leaving the U.S. or whatever is necessary.” It’s not hard to imagine that most crypto market participants agree with Armstrong when he said, “We just want a clear rulebook.”

But rather than developing a clear set of rules to govern the cryptocurrency space, the various federal agencies responsible for regulation have relied on decades-old laws that, when written, could not have contemplated the technology that digital assets rely on.

In some ways, it begs the question: Are crypto market participants truly setting up their business models to be “non-compliant,” or is the emergence of non-compliance simply a byproduct of regulatory confusion?

While we wait for the regulatory compliance playbook, investors and exchanges should work with legal compliance teams to ensure their transactions comply with the ever-changing interpretations of federal securities laws and banking regulations and their application to the cryptocurrency industry. Each transaction presents unique regulatory hurdles created by federal agencies’ insistence on applying decades-old regulations to a rapidly evolving industry.