Brian Armstrong, CEO and Co-Founder of Coinbase has set out a ‘blueprint’ for restoring trust in the cryptocurrency industry in the wake of FTX’s leverage and solvency issues which ultimately caused its collapse in November 2022 and diminished overall trust in the crypto industry.
In this article, we set out Armstrong’s views on what crypto market regulation should look like with the main aim, he explains, to achieve regulatory clarity while preserving decentralised crypto innovation.
Armstrong says that implementing effective regulation should not be delayed by trying to achieve a legislative formula which is comprehensive and perfect, when it is more important to provide easy and simple regulatory clarity sooner rather than later.
Armstrong’s ‘blueprint’ for effective crypto regulation is centred on the following three themes:
- providing regulatory clarity for centralised actors;
- ensuring a level playing field; and
- allowing innovation to happen in decentralised crypto.
Create regulatory clarity for centralised actors
First and foremost, Armstrong believes that regulatory clarity is required for ‘centralised actors’ (stablecoin issuers, exchanges, and custodians) in the crypto industry because these are the actors whose actions pose the most risk of consumer harm.
Traditional finance is regulated by ensuring that intermediaries operate fairly, and this same principle, Armstrong argues, should be applied to the crypto market where there are intermediaries, and therefore there is no need to ‘reinvent the wheel’ in developing crypto regulation, as the ideas can be borrowed from traditional financial services regulation.
Armstrong sets out the foundations of a sensible regulatory framework which should apply to each centralised actor (which we summarise below).
- Laws and regulations which relate to stablecoin issuers, should require the following:
- stablecoin issuers to register as a trust;
- ensure that stablecoin issuers are to only invest in high-quality liquid assets;
- undergo rigorous annual audits, which provide transparency that customer funds are held in appropriate reserve assets and separate from corporate cash;
- establish reasonable controls, and board governance;
- meet basic cybersecurity standards; and
- establish a blacklist capability to meet sanctions requirements.
- Laws and regulations which relate to exchanges and custodians, should require/address the following:
- implement robust know-your-customer (KYC) and anti-money laundering (AML) policies and procedures;
- establish a federal licensing and registration regime that allows you to get one license and serve an entire country;
- require strong consumer protection rules, such as disclosure of risks, and transparency around fees and conflicts of interest;
- create effective minimum standards for safeguarding clients’ assets; and
- prohibit market manipulation, and other forms of market misconduct.
- Laws and regulations should provide clarity around which crypto assets are considered securities (or alternatively commodities).
To provide clarity as to which crypto assets should be considered a security, Armstrong says legislation should provide a legal test which requires a series of determinative questions to be satisfied to be able to label a crypto asset a security. The legal test should include questions of the following nature.
Was there an investment of money?
If the crypto asset issuer hasn’t sold the asset for money for the purpose of building a project, it’s not a security.
Is the investment in a common enterprise?
For a crypto asset to be a security, it must be controlled and operated by a centralised organisation like a company. If a project has become sufficiently decentralised, it’s not a security.
Is there an expectation of profit?
If the primary purpose of the crypto asset is some other form of utility (voting, governance, incentivising actions of a community, etc) then it is very unlikely to be considered a security.
Are the profits to be derived primarily from the efforts of others?
If the expectation of profit primarily comes from participants who are unaffiliated with the issuance of the asset, then the project is sufficiently decentralised and would not be considered a security.
As Armstrong notes, the industry is primarily focused on trading crypto commodities today, as opposed to securities. However, as we have seen from recent American litigation such as the SEC v LBRY case (which we discussed in a previous article), the failure to identify which crypto assets are securities, and which are commodities, can lead to uncertainty in the industry. The SEC v LBRY case offers some judicial guidance as to what factors courts may look at in determining whether a crypto asset is a security, which are similar to the factors Armstrong has identified, but that case also shows that clearer regulation is required. For example, SEC v LBRY demonstrates how a coin which has a purported utility function can still be determined by a court to be a security.
Enforce a level playing field
Armstrong identifies that a separate issue to implementing effective regulation was the regulators’ ability to efficiently enforce the regulation and investigate companies that are offshore.
This, Armstrong argues, has created an adverse incentive for crypto companies to serve broad swaths of the world from favourable jurisdictions overseas, while companies that try to follow the rules onshore are penalised. This results in incentivising companies to operate offshore and out of the jurisdiction of relevant law enforcement.
FTX.com was a good example of this, being based out of the Bahamas due to weak KYC controls, while serving customers in many other countries.
Armstrong suggests that countries which adopt crypto laws need to ensure that such laws are not only enforced domestically but also with companies abroad that service its citizens. Where a country’s regulator does not have this authority, they should seek to work with international law enforcement.
Let innovation happen in decentralised crypto
While Armstrong is firm in his view that regulation in the industry is paramount, this view is balanced by the need to ensure the ability for crypto technology, which underpins decentralised finance, smart contracts, and self-custodial wallets, to innovate without too much red tape.
Armstrong states that the role of financial regulators should be limited to centralised actors in cryptocurrency (see our discussion above), where additional transparency is needed.
In other words, regulators should not overstep and seek to impose unnecessary and costly compliance regimes on decentralised technology and software which facilities crypto transactions because:
- the very fact this technology is decentralised (eg smart contracts and DeFi) means that it is inherently transparent without the need for regulations; and
- this would inhibit innovation in these areas due to the increase cost of complying with regulations.
Current state of play
The European Union (EU) has implemented crypto asset laws. The EU voted to enact licensing regime for persons and entities that are engaged in the issuance, offer and admission of crypto-assets and any related services to residents of the EU (read our discussion in: ‘MiCA: EU introduces world-first crypto-asset licensing regime’).
In mid-2022, the United Kingdom’s Treasury introduced the Financial Services and Markets Bill. The Bill comes in the wake of guidance by the International Organisation of Securities Commissions and the Committee on Payments and Market Infrastructures on how to regulate systematically significant stablecoin arrangements in line with the Principles for Financial Market Infrastructures.
Similarly, US policymakers released a bill in late 2022 for the purposes of creating a regulatory framework for ‘payment stablecoins’. The bill specifies that stablecoins are not securities and are not the responsibility of neither the SEC nor the CFTC. The bill also introduces a licencing regime for institutions who wish to issue stablecoins.
The Australian Government has considered the regulation of crypto assets and decentralised autonomous organisations as part of the Australian Law Reform Commission is inquiring into the potential simplification of laws that regulate financial services (read our analysis in: ‘ALRC comments on regulation of crypto assets and DAOs’). However, to date no draft legislation has been released that specifically addresses crypto regulation.
What does this mean
The crypto industry as a whole has been unfavourably affected since the FTX collapse. This has led to a movement within the industry to petition for clear, enforceable regulation by governments in order to regain the trust of the market.
It would seem that many governments are now aware of the risks of an unregulated crypto industry on the wider financial system and are turning their minds to how to best implement effective legislation.
We encourage you to read the Australian chapter of the Lexology Getting The Deal Through Fintech 2023 publication, which is also written by Partner John Bassilios, our Fintech and Blockchain Lead (and Blockchain Australia Director).
This article was written with the assistance of Max Ding, Law Graduate.