SEC Ramp Up Means Increased Enforcement Coming To Crypto Platforms, DeFi Exchanges And NFTs – Fin Tech

Crypto Trading and Lending Platforms

Gensler has instructed SEC staff to work on a number of projects
related to trading platforms. The first project Gensler mentioned
is getting these platforms registered and regulated, just like
stock exchanges. In Gensler’s view, these platforms play roles
similar to traditional regulated exchanges and investors should be
protected in the same way. Gensler added that platforms that meet
the “gold standard” of SEC regulations will promote
investor confidence and help crypto markets function.

Second, Gensler has also directed the SEC to consider how best
to register and regulate platforms that trade both crypto commodity
tokens and crypto security tokens. Specifically, Gensler has asked
SEC staff to work directly with the Commodities and Futures Trading
Commission (CFTC), which has authority to regulate crypto commodity
tokens, on how to jointly regulate platforms that trade both types
of tokens.

Third, Gensler has asked SEC staff to work with platforms that
take custody of cryptocurrency in order to register and regulate
those platforms to ensure the protection of customers’
assets.

Finally, because many platforms may also act as market makers
trading for their own accounts on the other side of customers,
Gensler has asked SEC staff to consider whether it would be
appropriate to segregate out market making functions.

As an example of what the future will likely hold for crypto
trading and lending platforms, Gensler highlighted the SEC’s
recent settlement with crypto lending platform BlockFi for
allegedly failing to register its offering of its retail crypto
lending product, as required by the federal securities laws, among
other alleged federal violations. As part of the settlement, in
addition to paying a large fine, BlockFi agreed to bring its
business into compliance with federal securities laws. Gensler
believes this settlement shows the Commission’s willingness to
work with platforms on their compliance efforts.

Stablecoins

During his speech, Gensler also took aim at stablecoins. As
stablecoins are pegged to reserve assets such as the U.S. dollar,
Gensler believes stablecoins raise public policy considerations
around financial stability and monetary policy, including
uncertainty over whether they have sufficient backing. He noted
that “stablecoins are so integral to the crypto ecosystem that
a loss of the peg or failure of the issuer could imperil one or
more trading platforms, and may reverberate across the wider crypto
ecosystem.” Gensler also flagged that stablecoins potentially
permit illicit activity, such as money laundering, tax evasion and
sanction avoidance, because they provide users with a pathway to
avoid the traditional banking system. Finally, Gensler suggested
the need for additional oversight over stablecoins for investor
protection. As the three largest stablecoins were created by
trading or lending platforms themselves, he believes there are
conflicts of interest and market integrity questions.

Tokens

Last of all, Gensler addressed crypto tokens, noting that
“[w]hen new technology comes along, our existing laws
don’t just go away.” Gensler rejected the notion that most
of these tokens are like “digital gold” or that they
operate like money. Instead, he contended that most crypto tokens
are in fact securities under the federal securities laws from the
1930s, which have been amended many times with Congress painting
with “an even wider brush.” Gensler
highlightedSEC v. W.J. Howey Co., 328 U.S. 293
(1946), in which the Supreme Court established what is now known as
the “Howey Test.” Under the Howey Test, an investment
contract exists where there is the investment of money in a common
enterprise with the reasonable expectation of profits to be derived
from the efforts of others. Gensler believes the Howey Test applies
to many crypto tokens because entrepreneurs are raising money from
the public by selling crypto tokens, with the expectation that
managers will build ecosystems where the tokens are useful, thereby
drawing more users to the projects. And if these crypto tokens are
securities, issuers of these tokens must comply with the SEC’s
rules around offerings.

Crypto Exchanges and Tokens

The announcement of the dramatic expansion of SEC
Enforcement’s Crypto Assets and Cyber Unit along with
Gensler’s recent comments mean we will see more activity from
the SEC, in the form of regulations and/or enforcement actions,
targeted at crypto platforms, stablecoins and tokens. Put simply,
Gensler believes that crypto platforms are like traditional,
regulated stock exchanges and that investors should be protected
the same way when trading cryptocurrencies. Gurbir Grewal, the
Director of the SEC’s Division of Enforcement, echoed this
belief in the announcement of the unit’s expansion, noting that
“[c]rypto markets have exploded in recent years, with retail
investors bearing the brunt of abuses in this space. . . . The
bolstered Crypto Assets and Cyber Unit will be at the forefront of
protecting investors and ensuring fair and orderly markets in the
face of these critical challenges.” As such, we can expect to
see more settlements, like the BlockFi settlement, in which
platforms are charged with failing to register.

As to the tokens themselves, while Gensler noted that the SEC
would evaluate each token on a case-by-case basis, he made clear
that he believes most are investment contracts
underHoweyand must also be registered with the
SEC. Stablecoins in particular will be subject to enhanced scrutiny
because of concerns that they permit illicit activity and also
concerns that they are not, in fact, pegged to value of the
underlying currency.²

DeFi Exchanges

Although not the primary focus of his comments, Gensler also
addressed DeFi platforms in his comments at UPenn. DeFi platforms
are generally peer-to-peer marketplaces where financial
transactions (often cryptocurrency trading and lending) occur
between two parties, presumably without any kind of intermediary.
While discussing crypto trading and lending platforms, Gensler
quipped that he was addressing these platforms “whether they
call themselves centralized of decentralized (DeFi).” Gensler
also noted that, ironically, the DeFi platform market is actually
quite centralized. This indicates that Gensler is suspicious that a
number of DeFi platforms are decentralized in name only. Gensler
has expressed skepticism of DeFi platforms in the past because
“[t]here’s still a core group of folks that are not only
writing the software, like the open source software, but they often
have governance and fees[.] There’s some incentive structure
for those promoters and sponsors in the middle of this.”

Taken together, Gensler’s comments indicate the SEC will
probe whether these exchanges are decentralized and whether they
are offering unregistered securities. The SEC brought its first
action related to DeFi last year when it charged two individuals
and their company for misleading investors about their operations
and profitability of their DeFi business.³We can
expect to see similar SEC actions in the future.

NFT Markets

Finally, while Gensler did not directly address NFTs, his
remarks should serve as a warning to NFT markets, especially given
recent reports that the SEC has been scrutinizing this space and
the SEC listing NFTs as a priority for the expanded
unit.⁴Gensler’s broad reading of the Howey
Test seemingly brings a numbers of NFTs and NFT exchanges into the
SEC’s purview. Importantly, in his UPenn speech, Gensler stated
that “many entrepreneurs are raising money from the public by
selling crypto tokens, with the expectation that the managers will
build an ecosystem where the token is useful and which will draw
more users to the project.” Under this broad definition of a
security, it seems likely that many NFT projects that offer users
more than just a basic JPEG image would be considered securities
offerings. For example, one popular NFT provides owners of the NFT
membership in an exclusive community with “perks.” These
perks can include exclusive chat platforms, tokens, merchandise and
games. If these additional perks add value to the NFTs due to the
efforts of the project’s developers, especially in terms of
resale value, it’s hard to see how they do not fall under
Gensler’s definition. If these projects are selling securities,
then it follows that the NFT exchanges that list these tokens are
also selling securities and must register with the SEC.

Other NFT platforms arrangements may face a similar fate. A
number of NFT platforms permit users to take out loans using their
NFTs as collateral. This arrangement is quite similar to the
arrangement BlockFi had with its users, which led to BlockFi’s
recent settlement with the SEC for offering unregistered
securities. In addition, one of the largest NFT markets recently
delisted an NFT that entitled holders to share in the casino
profits generated by the NFT’s developers, following cease and
desist orders from the states of Texas and Alabama against the
developers for offering unregistered
securities.⁵From these reports, it appears that
NFT platforms are already selling securities, which will likely
attract attention from the SEC.