Where is the US going with crypto law?
What is the US government’s position on cryptocurrency? The position does not seem to be consistent. Clearly, a fully formulated crypto plan isn’t around yet. First I'll talk about why the US Securities and Exchange commission won’t approve spot Bitcoin ETFs, yet has approved Bitcoin futures ETFs—claiming that it is protecting investors.
Given the likely high costs of a futures ETF product, why is it that the SEC would reject spot bitcoin ETF applications but allow futures ETFs to begin trading? Multiple trusts from Greyscale already offer both Bitcoin and Ethereum at very high expense to the user at 2% and at a substantial discount from the spot price. How does the existence of these spot trusts, yet not allowing spot BTC/ETH ETFs protect investors? GBTC has over 35B in AUM and ETHE has over 13.5 AUM. Is paying more for a trust than an ETF protecting investors, or controlling them through laws requiring outside members of their BOD?
One advantage to trading bitcoin futures as opposed to bitcoin is not having to secure bitcoins directly. Another is the ability to trade on regulated exchanges — especially appealing for certain institutional investors — as opposed to crypto exchanges. Gary Gensler wants to be able to surveil the markets that trade these things. Bitcoin is not regulated, so he has no way to force any market to give data to him,” says Kathleen Moriarty, senior counsel at Chapman and Cutler LLP. She noted that, out of the top five crypto exchanges by volume, only one (Coinbase) was US-based, giving the SEC limited ability to regulate all the markets. That caused him to look for an alternative, which was futures, since they are regulated.
A bitcoin futures ETF, because it is a pool that will hold securities, is classified as an investment company. It must be registered or exempt from the Investment Company Act of 1940, which is meant to protect against predatory investment frauds. It requires, for instance, that the fund have a board with some independent members, that the board have fiduciary duties, and that there’s a robust required regulatory regime to oversee things like managing liquidity, the amount of leverage the pool can take on, the amount of borrowing, etc. “It’s a highly regulated wrapper, with significant amounts of reporting and standardized disclosure, things like that that make it a more seemingly safe vehicle,” says Xethalis. He speculates that the season the SEC went with a Bitcoin futures ETF first is that the Investment Company Act offers greater investor protections and that fiduciary duties exist throughout the chain, and that the CME bitcoin futures market has done pretty well in terms of trading volume, pricing and volume.
The problem with that argument is that it creates a much more complex product. Nor do the actual attractions really even apply to a Bitcoin product that is buying and selling on the spot.
There aren’t good arguments for why the legitimate protections of the ICA are materially better as a tradeoff for the additional complexity of this product.” Moriarty agrees. “From the standpoint of Gary Gensler, chairman of the SEC, his perspective is if you use futures in a ’40 Act structure, the investor is more protected. I guess I can agree with him kind of, in that the ’40 Act has protections that don’t appear when you use a spot-priced product. But I don’t know that they’re that relevant.”
What It Could Take for the SEC to Approve a Spot Bitcoin ETF?
Gary Gensler had made it clear earlier that the regulatory body thinks the crypto market is not mature enough to handle a spot ETF. Now it seems SEC would rather approve an Ether Futures ETF than a spot BTC one.
“Most market participants agree that a spot Bitcoin ETF would be superior to existing futures ETFs, yet SEC approval of the former may be delayed until late 2022 or beyond. Though a spot Bitcoin ETF is possible in 2022, SEC approval may take longer due to concerns about regulation in the underlying Bitcoin market,” The US SEC created history last month when it approved two Bitcoin Futures ETFs nearly four years after the first Bitcoin ETF proposal was made. However, it continues to maintain a similar stance on the spot ETF claiming the market is prone to manipulation. This has got many in crypto riled up given crypto market has breached the $3 trillion mark this year and its institutional demand has also peaked to new highs. So what is the US government going to do moving forward with crypto regulation generally? What is their position? Canada and the Toronto stock Exchange have already gone forward with ETFs for Bitcoin, Ethereum, and a mix of both that will eventually include more than just the two. (Investing in foreign ETFs isn't available through some investment banks in the United States for retail investors.) But the snowball rolling down the hill keeps getting bigger. Despite the new legislation that was just passed as a minor amendment (not open to discussion on the floor of Congress) to Biden’s infrastructure bill, which can conceivably give traditional commercial banks a bite out of all the crypto apples, it seems as though the US is going forward with ‘legalization’ of cryptocurrency brokerages and trading; otherwise, why all the studies into stablecoins and the more sophisticated establishing of rules and regulations into sanctions and penalties for trading crypto with SDN or specific AML for crypto. Also, why bother allowing a futures Bitcoin ETF at all If they were just going to pull the rug out from underneath everyone. The issue will be how much and what will the Securities and Exchange Commission and the US Department of the Treasury through the IRS and OFAC (and other acronym organizations) control or attempt to control the ownership, trade, staking, mining, brokering and everything else associated with not only crypto but also anything even remotely related to decentralized finance.
There is also the United States distaste for not being at the forefront of laws and regulation of new financial instruments. The US wants to be the leader in this that the rest of the Western world follows. At the same time, some other countries specifically wait for the US to set its rules before it does. US banking power and extra territorial jurisdiction is seen by this author every time he opens a bank account or a brokerage account in Thailand when he has to fill out an IRS W-7 for FATCA in a Thai or Cambodian bank.
Two members of the house of representative seek to strike the particularly harmful and rigid reporting requirements, and the definition of who is a ‘broker’ from extending IRS 60501 and 60501(i) in the amendment to Biden’s infrastructure bill with the Keep Innovation in America Act. This had many people in the industry quite worried, including this author who had written a blog entitled, “Scary New Crypto Laws” that can be found on my company's web page or on Twitter at @NAPASolutions for a short, lay person’s version. For a much more thoroughly researched and footnoted analysis from Abraham Sutherland see his handle @abesutherland, a lawyer and professor at the University of Virginia Law School.
But we were pleasantly surprised—I can speak for my office. I can't speak for everyone else, but I think many of us were quite surprised…and by The United States Congress of all things!
For its speed, specifically, following the passing of the infrastructure bill, and for it's completeness in striking down the most terrifying portion of the act, treating digital assets the same as $10,000 cash when it is exchanged. As I described it before, if you've ever seen a movie where an actor is withdrawing $9,900 from multiple banks when he or she is on the run—this is that law. Anything over $10,000 in cash requires the recipient to fill out IRS form 8300 within 15 days, or it is a crime. One of the reasons why we got so upset was that this issue was never debated or brought up at all during the vote by either house. It just sort of snuck in there.
The other reason why I was both shocked and upset was that the failure to report the $10,000 by a recipient of digital assets within 15 days was a felony, and not a misdemeanor like it is for cash. Breaking this law has always been a misdemeanor, not a felony. Why it was deemed necessary to make the failure of reporting $10,000 of digital value compared to cash was never explained.
Also as an attorney, I can't stress hard enough the difference between being charged with a felony and a misdemeanor, or a felony conviction compared to a misdemeanor conviction. And the ensuing attorney costs are at least five times more for the felony…usually. Moreover, you should get a real criminal lawyer when you’re charged with a felony—with misdemeanors, sometimes you can get by with the general practitioner. The cost between these two lawyer’s bills is a gulf—especially when you see that your criminal lawyer charged you double for the time in court, including the time you were sitting outside the court on a bench with him drinking a coffee.
Most of the crimes that come from the Internal Revenue Service (IRS) are only felonies for intentionally evading taxes and intentionally making false statements to the IRS or committing outright fraud against the IRS. Everything else is a misdemeanor. Why failing to report a digital $10,000 value as a felony is very odd. It's interesting. Why bring the hammer down so hard just for digital?
A third effect of this law that was also scary was that it applies to anyone who receives $10, 000, even if it's not theirs. If it is a middleman, held in escrow, or the many functions of digital brokers, digital bankers, and digital platforms, the same reporting requirements apply.
The reporting requirements are very clear: You must inspect an identification document to verify identity with a name, social security number, and address. But it also requires the occupation of the sender, the nature of the transaction (meaning the reason) and other details. At the bottom of the last page of IRS form 8300 has lines for a paragraph. At NAPA, we are first and foremost tax lawyers and accountants. There are not many forms that provide lines for paragraphs.
The IRS also estimates how long all of its forms should take to fill out by the average person. Form 8300 takes an average of 21 minutes. This is for every transaction. Thus, the maximum any individual could do would be three transactions an hour. This also includes NFTs or any digital assets whatsoever, with a definition so broad it might include anything. This would also include exchanges. What we call in the tax code like-kind exchanges.
Let's do a hypothetical to illustrate the weirdness: if I traded you $11,000 worth of Bitcoin and you gave me $11,000 worth of Polka Dot, we would both have to spend 20 minutes filling out IRS form 8300 on each other, verifying each other's identities, social security numbers, addresses, occupations, and other identification details that we get to write in the paragraph lines like a high school exam. You can also be charged with a felony under this law even if you're not aware of the money being sent to you, or if it's a mistake!
Here's another hypothetical: maybe you did very well during COVID like many crypto investors, and you decide it's time for a vacation. You go to Thailand for 3 weeks because you need to unplug. Thailand is good for unplugging—you spend a week in the mountains, a few days in and around Bangkok, and then really relax on the Thai beaches using your phone for only music or reading or taking pics (I found out that I love audiobooks on the beach) but you're basically unplugged.
If you were sent a digital asset valued at $10,000 US dollars when you started your vacation that you were unaware of because you were unplugged, regardless of whether it was a mistake or a transaction you really weren't expecting at the time, when you get home, you have committed a felony for a failure to report in 15 days.
All of the weirdness of these hypotheticals comes from the fact that this law was made in 1984 to curtail large, in person criminal-type cash exchanges. Applying it to decentralized finance three decades later is like chimpanzee smashing the square peg into the round hole for another banana. It just doesn't fit, but he's going to do it anyway because he wants his banana! The other portion that is struck down by The Keep Innovation in America Act was debated, yet still passed. It’s damage to the crypto industry came in expanding the definition of the term 'broker' to mean just about anyone involved in cryptocurrency. Said another way, IRS 60501 left unchanged would require recipients to verify, record, and report the names, addresses, social security numbers, and more from senders. The reporting requirement would be filing an IRS form within 15 days or face felony charges for each transaction. This portion, which was never debated openly, was the really scary one. And it never haven't been discussed in either the House or the Senate was inappropriate and against tradition and custom, as well as probably law, and simply undemocratic.
Most people might be saying, “well, only the super wealthy are trading $10, 000 a day worth of cryptocurrency, so maybe it's a good idea to catch the bad guys.” No. The problem with this is that it's not only the super wealthy, even exchanges of $10,000 worth of cryptocurrency fall under the rule. So seeking a 5% or $500 profit from $10,000 would trigger the law. Furthermore, the definition of the broker was so broad, it included almost everyone. It's difficult to define someone who would never fall into the category as a broker under the original law.
But it looks like it will not become the law of the land as it has been struck and is awaiting further discussion and involvement by the Department of the Treasury and others to (hopefully) make it much more reasonable.
We at Napa, along with a large portion of not only Americans but other citizens of the world, welcome regulation into the decentralized finance world. But it must be reasonable. It must be fair. And it must be on par with the laws for trading currencies and securities and commodities and collectibles. There's no reason for digital assets to have more archaic laws with more severe punishments. I think this comes from the mistaken belief that decentralized finance is for gangsters, Russian hackers, Chinese fraudsters, and American drug dealers.
This is simply not true. Cryptocurrency needs a little bit of an image change. But the government likes its current, slightly dirty image because it allows for more control without much protest. But we are starting to see that this is no longer the case, people have contacted their representatives, and they are fighting to make the laws more reasonable and on par with other investment laws, rules and regulations.
So, what is the United States position on crypto at the end of 2021? Fluid. It’s clear that everyone is still figuring it out. Be patient, and seek counsel if you think anything seems a little bit funny. Because the one thing I can guarantee you personally and from everyone at Napa is that the us is going to increase regulation and oversight of the crypto industry in 2022.