US Crypto Regulations: A Brief Overview
The United States has been debating crypto regulation for several years, struggling to classify and regulate cryptocurrencies since the emergence of Bitcoin in 2009. In this blog post, we will examine the history of crypto regulation in the US, including the regulatory frameworks implemented and the events that have shaped the current regulatory landscape.
The Early Days of Crypto Regulation in the United States
The US government's first official stance on cryptocurrencies came in 2013, when the Financial Crimes Enforcement Network (FinCEN) issued guidance (FIN-2013-G001) on virtual currencies. The guidance stated that virtual currency exchanges and administrators must comply with anti-money laundering (AML) and Know Your Customer (KYC) regulations.
In 2014, the Internal Revenue Service (IRS) issued a notice (2014-21) stating that virtual currencies should be treated as property for tax purposes. This meant that cryptocurrency transactions were subject to capital gains tax.
The Mt. Gox Scandal and its Impact on Crypto Regulation in New York
In 2014, Mt. Gox, a major cryptocurrency exchange, filed for bankruptcy after losing over 800,000 BTC in February of that year. At its peak, Mt. Gox accounted for roughly 70% of all Bitcoin trading volume. Due to its importance, the shutdown and scandal drew widespread attention and scrutiny from both the public and regulators. It raised questions about the security and stability of cryptocurrency exchanges and highlighted the need for greater regulatory oversight. Further investigations into Mt. Gox revealed that the February 2014 breach was not the first security incident, and that there was a long history of hacks and issues since at least 2011.
In response, the New York State Department of Financial Services (NYDFS) introduced the BitLicense in 2015. The BitLicense is a regulatory framework for businesses that deal with virtual currencies in New York. It requires businesses to obtain a license and comply with AML, KYC, and other regulations.
In terms of NYDFS action, they released a notice regarding the Paxos-Issued BUSD on February 13, 2023 which has now been taken down, but read:
DFS has ordered Paxos to cease minting Paxos-issued BUSD as a result of several unresolved issues related to Paxos’ oversight of its relationship with Binance in regard to Paxos-issued BUSD.
This notice came days after analysts released findings that BUSD was not backed 1:1 at all times, in addition Binance admitting to problems with its BUSD peg.
Crypto Regulation in the United States leading up to the FTX scandal
California: In 2017, the state of California proposed legislation known as the Virtual Currency Act, which would have required businesses dealing in virtual currencies to obtain a license from the California Department of Business Oversight. The bill did not pass. In 2020, Governor Newson signed into law the California Consumer Financial Protection Law (CCFPL) which seeks to create a new arm of government to monitor markets, with a research arm. This will equip regulators with "new tools to shape the regulation of virtual currency"
Hawaii: In 2017, Hawaii passed the Digital Currency Innovation Act, which requires businesses dealing in virtual currencies to obtain a license from the state's Division of Financial Institutions. The law also requires licensees to maintain certain minimum reserves and comply with AML/CFT regulations.
New Hampshire: In 2017, New Hampshire passed legislation known as the Virtual Currency Money Transmitter Act, which requires businesses dealing in virtual currencies to register with the state's banking department and comply with AML/CFT regulations.
Tennessee: In April 2022, Tennessee became the second state in the US, after Wyoming, to create a legal framework for decentralized autonomous organizations (DAOs), a collaborative management structure for legal entities using blockchain technology. The legislation allows Tennessee limited liability companies (LLCs) to register as "decentralized organizations" by adding new elective language in their articles of organization. By providing limited liability protection for DAOs, Tennessee has removed a significant hurdle to the wider adoption of this innovative business structure. Supporters believe that DAO assets under management could grow to $1 trillion over the next decade, making Tennessee's move a potentially significant step towards becoming a blockchain investment hub.
Vermont: In 2017, Vermont passed a law known as the Digital Currency Limited Liability Company Act, which provides a regulatory framework for businesses that deal in virtual currencies. The law requires these businesses to register with the Secretary of State and comply with AML/CFT regulations. DAOs are recognized as legal entities - a type of LLC.
Wyoming: In 2019, the state enacted several laws to support the growth of the virtual currency industry. The Wyoming Money Transmitter Act exempts virtual currency companies from certain money transmitter requirements, while the Wyoming Blockchain Banking Act allows banks to hold digital assets and provide custodial services. The Wyoming Special Purpose Depository Institutions Act created a new type of financial institution that can provide custody and fiduciary services for virtual currencies and other digital assets. The Wyoming Utility Token Act exempts certain virtual currency tokens from state securities laws if they meet certain criteria. These laws have made Wyoming a leader in supporting innovation and investment in the virtual currency and blockchain industries. Wyoming has been at the forefront of creating a regulatory environment friendly to virtual currencies and blockchain technology.
Federal: In 2019, FinCEN released new guidance (FIN-2019-A003) on virtual currencies to align with the Financial Action Task Force's (FATF) issued recommendations. The guidance specified that virtual asset service providers (VASPs) must adhere to anti-money laundering (AML) and know-your-customer (KYC) regulations. Additionally, the FinCEN guidance included requirements related to the Travel Rule, which mandates that VASPs share customer information with other VASPs involved in a transaction. These regulations aim to establish a more consistent global framework for AML/ATF measures in the virtual asset industry.
In 2020, the Office of the Comptroller of the Currency (OCC) issued a letter (#1179) stating that national banks and federal savings associations are permitted to provide cryptocurrency custody services to their customers.
In 2021, the Securities and Exchange Commission (SEC) brought several high-profile enforcement actions against cryptocurrency companies for violating securities laws. The actions sent a clear message that the SEC views many cryptocurrencies as securities and will enforce securities laws accordingly.
2022: Luna/FTX contagion and the effect on regulation in the United States
In May 2022, the Terra blockchain experienced a significant collapse, causing major losses for investors and sparking concerns about the stability of the cryptocurrency ecosystem. The incident began on May 7, with signs of capital flight from the UST stablecoin and continued over the next few days with drops in the UST price and deposits on the Anchor protocol. On May 9, UST lost its $1 peg for the second time, falling to as low as 35 cents. Luna Foundation Guard committed to loaning $750 million of BTC to market makers to defend the peg of UST and another $750 million of UST to be used to buy back BTC after volatility subsides. The situation continued to deteriorate, with the LUNA price falling 96% in a day on May 12 and the Terra blockchain being halted twice due to the threat to network security. The collapse led to major losses for investors, including prominent venture fund Hashed, which reportedly lost over $3.5 billion. During the collapse of UST, the price of Bitcoin, Ethereum and other assets experienced a sharp drop in price, with Bitcoin dropping from $43,000 to $30,000 in just a few hours.
This decline triggered a series of margin calls across centralized exchanges, which in turn led to more forced liquidations of positions held by traders who had taken on too much leverage across Decentralized Finance.
As the liquidations continued, the price of Bitcoin and other cryptocurrencies continued to fall, leading to a "liquidation cascade" in which more and more positions were forced to close out at market prices, exacerbating the downward pressure on prices.
During the Terra collapse in May 2022, FTX made efforts to contain the impact on the broader cryptocurrency ecosystem. FTX CEO Sam Bankman-Fried ("SBF") announced on Twitter that the exchange was backing "any insolvent partner" impacted by the Terra collapse, essentially absorbing losses and preventing the contagion from spreading further.
The move was seen as a proactive effort by FTX to prevent a broader market meltdown and to support the stability of the cryptocurrency industry, making comparisons of SBF to J.P. Morgan during the Panic of 1907. However, it also raised questions about the potential risks associated with FTX's business model and its exposure to counterparty risk.
Some critics argued that FTX's decision to back insolvent partners could set a dangerous precedent, creating moral hazard and encouraging risk-taking behavior by market participants. Others praised FTX for its leadership and willingness to take bold steps to support the stability of the industry.
Within months, any praise would be replaced by condemnation as SBF was a fraud. The FTX scandal, which involved theft of customer's funds, market manipulation and insider trading, drew widespread attention and criticism from both the public and regulators. It yet again raised questions about the security and integrity of cryptocurrency exchanges and highlighted the need for greater regulatory oversight. The scandal may lead to increased scrutiny of cryptocurrency exchanges and a push for stricter regulatory measures in the United States. It also underscores the importance of exchanges prioritizing transparency, accountability, and ethical behavior in order to build trust and credibility with customers and investors.
One proposal is to expand the authority of the Commodity Futures Trading Commission (CFTC), which currently oversees futures trading in cryptocurrencies but has limited jurisdiction over spot trading. Some have suggested that the CFTC should be given broader powers to regulate all cryptocurrency trading, including spot markets.
Others have called for the creation of a new regulatory body specifically focused on cryptocurrencies, similar to the Securities and Exchange Commission (SEC) or the Financial Industry Regulatory Authority (FINRA).
Insights on moving forward
The history of crypto regulation in the United States has been characterized by a gradual shift towards greater regulatory oversight. While there have been criticisms of the current regulatory framework, it has been largely successful in creating a more legitimate and secure industry. At the same time, there are concerns that overly restrictive regulation could stifle innovation and growth in the cryptocurrency industry. Finding the right balance between protecting consumers and fostering innovation will be a key challenge for regulators in the years ahead.
Cybrid is an embedded finance infrastructure provider that fosters innovation, protects consumers, and tackles the complex regulations by prioritizing transparency, accountability, and ethical behavior. By embracing regulation and compliance, Cybrid helps to build trust and credibility with consumers, while also reducing the risks associated with digital currencies. All fiat deposited on the Cybrid platform is held in FBO accounts registered to the end user, meaning even in the event of bankruptcy, assets are returned to their beneficiary. Also, any digital asset on platform is backed 1-to-1. Cybrid's focus on strong internal controls, technical implementation, and compliance protocols ensure incidents like the Mt. Gox and FTX don't occur in the future. Learn from the past, while building for the future!
If you're interested in reading about Canada crypto regulations and their history, check out our blog post here.