Q1 2021 in Review

FinCEN and FATF push AML regulation, the Biden administration staffs up, Bitcoin ETF hopes rise again, Robinhood hints at a bright future for DeFi, and more.

Welcome to Crypto Law & Policy, a newsletter analyzing the most significant legal, regulatory, and policy developments in the crypto industry.1

For this first entry, I’ve prepared a review of the entire first quarter of 2021, which was an unusually busy time for crypto. Going forward, I plan to write monthly reviews to keep the news fresh and the amount of content reasonable.

My goal is to help you stay informed about important news items and trends related to crypto law and policy. I hope you find this useful and look forward to your feedback.


FinCEN decides against midnight rulemaking

It feels like ages ago, but we entered 2021 in the midst of a controversy over FinCEN’s attempt to force through a proposed rule expanding AML regulation in the final days of the Trump administration—a practice known as midnight rulemaking.

The rule sought to impose new recordkeeping and reporting obligations on financial institutions for transactions involving non-custodial wallets. For transactions over $3,000, institutions would have to collect the name and address of both their customer and their customer’s counterparty. For transactions over $10,000, institutions would also have to file a CTR (a currency transaction report) with FinCEN.

The proposal wasn’t a total surprise—it followed a global trend among policymakers in favor of expanding AML regulation to cover transactions between regulated entities and non-custodial wallets. It was also widely understood as a personal project of U.S. Treasury Secretary Steve Mnuchin, who had criticized Bitcoin as a tool for criminals and promised to impose “significant new requirements” on crypto companies.

The vast majority of the crypto industry and community strongly opposed the rule, myself included. As a matter of process, it was unjust (and perhaps a violation of the Administrative Procedures Act) for FinCEN to allow only fifteen days for public comment on a brand new rule over Christmas and New Year’s Eve. As a matter of substance, it was unwise (and perhaps unconstitutional) for FinCEN to propose a rule restricting financial privacy rights and increasing compliance costs without actually helping law enforcement detect and prosecute illicit activity.

Despite the short timeframe, thousands of comments were filed in response to the rule. Many industry heavyweights lodged their objections, including exchanges like Coinbase and Kraken, banks and fintechs like Fidelity and Square, venture capital firms like a16z and Paradigm, think tanks like Coin Center and the EFF, trade groups like the Blockchain Association and the Chamber of Digital Commerce, elected officials like Rep. Ted Budd (R-NC) and Rep. Bill Foster (D-IL), academics like Neha Narula, Patrick Murck, Matthew Green, and Eran Tromer, and dozens more.

The concept of a crypto CTR was unpopular, but it was the idea of turning KYC (know-your-customer) into KYCC (know-your-customer’s-counterparty) that generated the most outrage and united the crypto world in opposition to the rule. By the middle of January, FinCEN had received roughly twice as many comments on this proposal as it had on all of its other proposals since 2008 combined.

Ultimately, the comments proved effective. Though it was rumored that Sec. Mnuchin planned to implement the rule days before leaving office, on January 14, FinCEN extended the public comment period by 45 days, citing “the robust responses already provided.” The extension served to delay the proposal into the Biden administration and well past the end of Sec. Mnuchin’s tenure.

FinCEN issued a second extension on January 26, and then the comment period closed in relative quiet at the end of March. For now, we’re stuck waiting to see what FinCEN will do next. It’s still possible that the rule could be adopted in full, but it seems more likely that support for the rule left the Treasury Department along with Sec. Mnuchin. Lately, FinCEN appears more focused on designing a crypto CTR and less focused on requiring institutions to do KYCC.

In my view, this is a huge success story. When we started the year, there was a very real chance that FinCEN might implement burdensome new regulations within a matter of weeks and without properly addressing the concerns of U.S. citizens and companies. Three months later, FinCEN has refrained from taking any hasty action, backed away from the idea of KYCC, and engaged in constructive dialogue with the industry.

No matter what happens next, this is a win—a case study in effective advocacy2 and proof of the industry’s growing maturity and influence in Washington, D.C.

That’s not to say the issue of AML regulation is anywhere near settled. FinCEN does seem likely to move forward with a crypto CTR despite industry opposition. Beyond that, it’s hard to know what to expect from the Treasury Department now that it’s under new leadership. Aside from a brief response during her nomination hearing, Sec. Janet Yellen hasn’t said much about her views on crypto, so we’re still waiting to see how she and Dep. Sec. Wally Adeyemo decide to approach the space.

FATF publishes draft guidance on VASPs

In case anyone didn’t get their fill of AML policy after the FinCEN saga, the FATF surfaced on March 19 with a draft update to their guidance on virtual assets and VASPs (virtual asset service providers). The draft represents a significant expansion of the FATF’s prior recommendations.

As Coin Center explained, the FATF’s earlier guidance on VASPs published in June 2019 treated crypto companies the same as traditional financial institutions, imposing AML obligations only on intermediaries with independent control of customer funds. The FATF’s new draft guidance would expand the definition of a VASP far beyond custodial intermediaries, also capturing non-custodial actors and market participants.

To be fair, the draft could have been worse. The FATF could’ve taken a harder stance on privacy and self-custody, such as by recommending a total prohibition on transactions between VASPs and non-custodial wallets. Thankfully, the FATF didn’t go that far.3 The draft also recognizes a few important points, such as that software developers aren’t VASPs just because they develop code (¶ 68), and that miners aren’t VASPs just because they create and broadcast blocks containing transactions (¶ 69).

Yet, the draft does call for member countries to vastly expand the scope of their AML regulations, with particularly troubling implications for DeFi. The draft contemplates treating any number of DeFi market participants as VASPs (¶¶ 72-79), and even seems to reject the very concept of a decentralized financial protocol:

“The FATF takes an expansive view of the definitions of VA and VASP and considers most arrangements currently in operation, even if they self-categorize as P2P platforms, may have at least some party involved at some stage of the product’s development and launch that constitutes a VASP” (¶ 75).

Reading between the lines, the draft says a lot about the FATF’s struggle to reconcile traditional AML regulations with the emergence of DeFi protocols. The former relies on deputizing custodial intermediaries to surveil and censor customers’ transactions, while the latter is designed specifically to enable complex financial activity without relying on intermediaries. At one point, the FATF articulated this point directly:

“Moreover, full maturity of these protocols that enable P2P transactions could foreshadow a future without financial intermediaries, potentially challenging the effectiveness of the FATF Recommendations” (¶ 35).

It’s worth noting that the draft guidance is still subject to change, and may look different when it’s finalized in June. The FATF is accepting comments until April 20 and seeking input from industry leaders. Let’s not get our hopes up for a substantial improvement in the next two months, though—the FATF isn’t a democratically-elected body and doesn’t answer to anyone but itself.

Before you get too worried, remember that the FATF only makes recommendations, not laws. Even if the draft guidance is finalized exactly as-is, it won’t have any effect until and unless it’s implemented by one or more of the FATF’s member countries.

From the US perspective, I have trouble believing the United States would or could implement the FATF’s new recommendations. In addition to directly contradicting FinCEN’s May 2019 guidance, the draft’s restrictions on free speech and financial privacy are likely unconstitutional. Plus, the United States has a habit of taking what it likes from the FATF and leaving the rest—for example, we still haven’t implemented the FATF’s recommendations related to lawyers, accountants, and real estate agents, even though they were finalized nine years ago in 2012.

The Biden administration starts taking shape

On January 20, the inauguration of President Joe Biden brought an end to a Trump administration that approached crypto with a curious mix of scattered support, benign neglect, and overt hostility over the past four years.

Some champions for the industry did emerge in that time, such as SEC Commissioner Hester Peirce, CFTC Chairs Chris Giancarlo and Heath Tarbert, Acting Comptroller of the Currency Brian Brooks, and several members of both the House and Senate.

But new antagonists appeared too, including Sec. Mnuchin, SEC Chair Jay Clayton, and Rep. Brad Sherman (D-CA) to name a few. For his part, President Trump tweeted that he was “not a fan” of crypto and reportedly ordered Sec. Mnuchin to “go after” Bitcoin. All in all, the Trump administration wasn’t particularly friendly to crypto.

The Biden administration brings a fresh opportunity for the United States to revise its approach and—hopefully—to develop a coherent national strategy that balances the importance of innovation with the goals of regulation and enforcement. Whether or not the administration seizes that opportunity will depend in large part on who takes leadership positions at key agencies with jurisdiction over crypto—for starters, the Treasury Department, the SEC, the CFTC, and the OCC.

President Biden has selected Janet Yellen to head the Treasury Department and Gary Gensler to take over at the SEC, but he hasn’t announced picks for the CFTC or the OCC yet. Also important are the high-ranking officials who work under these figureheads—for example, Treasury Dep. Sec. Wally Adeyemo and FinCEN Acting Director Michael Mosier will play outsized roles in the development of AML policy.

It’s too early to draw any conclusions about how the Biden administration will view crypto. It’ll take some time for President Biden’s remaining nominees to complete the confirmation process, hire staff, and get up to speed on the issues. Until then, we’ll be waiting to see who the champions and antagonists of the next four years may be.

Bitcoin ETF proposals return in force

Ever since the Winklevoss twins submitted the first Bitcoin ETF proposal in 2013, the crypto industry has been trying (and failing) to convince the SEC to approve an ETF. The last round of ETF proposals ended with the SEC rejecting a proposal from Bitwise on October 9, 2019. A new round has just begun.

In the past, the SEC has rejected Bitcoin ETF proposals like the Winklevoss Bitcoin Trust due to concerns over market manipulation. Specifically, the SEC has said that Exchange Act § 6(b)(5) requires ETF sponsors to get “surveillance-sharing agreements with a regulated market of significant size” to ensure that the ETF is appropriately designed to “prevent fraudulent and manipulative acts and practices.”

Back then, the problem for ETF sponsors was that no regulated market of significant size even existed, since bitcoin was largely priced on unregulated derivatives exchanges like BitMEX. Despite creative efforts by sponsors like Bitwise and VanEck to satisfy the SEC’s concerns, the regulators just couldn’t get comfortable with bitcoin’s market structure as of October 2019.

Eighteen months and one pandemic later, a lot has changed. Bitcoin’s market demand has skyrocketed along with its price; respected investors and corporate treasurers view it as a legitimate inflation hedge; some ETFs that look much riskier have been listed (BUZZ) and others have been destroyed (USO); and the SEC may take a more positive view of bitcoin under Gary Gensler than it did under Jay Clayton. All told, I agree with Bloomberg’s Eric Balchunas that the SEC should approve a Bitcoin ETF this year.

First up is a proposal from VanEck, published in the Federal Register on March 15. That puts the SEC’s final deadline to approve or deny the ETF at November 10, with several intermediate deadlines in between. Right now, I’d give this better than even odds to get approved in early November, just in time for Thanksgiving.

Robinhood becomes a case study for DeFi

For a week in January, all anyone could talk about was the soaring price of GameStop stock ($GME) and how a group of traders on the Reddit forum r/wallstreetbets had coordinated a massive short squeeze against hedge funds shorting $GME.

Then suddenly, all anyone could talk about was how Robinhood—the favorite trading platform of r/wallstreetbets—had restricted $GME trading so that its customers could only sell the stock but not buy more of it. Robinhood’s decision triggered a backlash leading to congressional hearings and a formal apology.

DeFi supporters seized on the event as an example of how neutral, decentralized protocols could address the shortcomings of legacy markets. Robinhood was blamed for preventing customers from trading $GME, but nobody can prevent users from accessing a DeFi protocol. Robinhood was accused of caving to pressure from business partners like Citadel, but self-executing smart contracts can’t be pressured.

Perhaps most interesting, Robinhood explained that it had to restrict trading because of SEC-mandated net capital requirements, which might have forced Robinhood to deposit more capital in its clearinghouse than it had available. CEO Vlad Tenev later suggested that transitioning from T+2 to real-time settlement could fix this problem. “Technology is the answer,” he said.

Although Vlad didn’t mention DeFi specifically, it might provide exactly the solution he’s looking for—reducing the need for net capital requirements by mitigating counterparty risk through transparent, atomic settlement between buyer and seller.

Needless to say, we’re nowhere near replacing our securities settlement infrastructure with DeFi rails, but for policy purposes, it helps to have a case study as popular as this one to explain the potential benefits that DeFi can deliver to financial markets.

In other news…

  • OFAC settled an enforcement action against Bitpay for apparent sanctions violations, alleging that the firm allowed persons in sanctioned jurisdictions to transact with merchants on its platform. Bitpay agreed to pay $507,375 to settle the action, which came shortly after OFAC’s settlement with BitGo on similar grounds in December. It’s no surprise to see OFAC getting more involved with crypto sanctions enforcement. Thankfully, both actions provide helpful guidance for other crypto companies looking to satisfy OFAC’s compliance expectations.

  • In the long-running trend of countries threatening to ban crypto and then not following through, India was reportedly considering a bill to criminalize all crypto-related activities in mid-March. As of this writing, the bill still hasn’t been released to the public. Some observers don’t believe India will ultimately take such a draconian approach, noting that Minister of Finance and Corporate Affairs Nirmala Sitharaman has spoken positively about crypto. Time will tell.

  • The industry made progress toward mainstream adoption of stablecoins as the OCC authorized banks to use them for transaction settlement and Visa became the first major payments network to support settlement with USDC. It’s unclear if the OCC’s guidance will survive scrutiny from Biden officials or if Visa’s offering will gain traction, but regardless, both developments signal increasing comfort with stablecoins among institutional compliance departments.

  • News leaked of an ongoing CFTC investigation regarding Binance and its alleged practice of offering non-compliant derivatives products to US traders. The allegations somewhat resemble those about BitMEX last October, which resulted in both a CFTC enforcement action and a DOJ criminal prosecution. Binance is one of several exchanges known for pursuing a strategy of so-called “regulatory arbitrage,” a concept that US regulators are unlikely to credit.

  • The NYDFS investigation into USDT finally came to an end with a settlement in which Bitfinex and Tether admitted to no wrongdoing, but agreed to pay $18.5 million in penalties and provide quarterly reports on the holdings backing USDT. The settlement—which suggests that the NYDFS didn’t uncover evidence of overt fraud worth pursuing further—came as a surprise to some observers who had accused Tether of market manipulation and insolvency in recent months.

  • Bittrex became the latest exchange to delist assets with privacy-preserving features, including Monero and Zcash. Bittrex didn’t give a reason for the removals, leaving the crypto world guessing as to what caused the move. Top theories included the substantial compliance costs required to offer these assets, regulatory pressure in the wake of the DOJ’s Enforcement Framework, or NSLs (national security letters) provoking the decision. Other exchanges continue to offer these assets, however—including major players like Gemini and Kraken—so the future of privacy-preserving assets may not be as grim as it appears.

  • Ripple fought the war over XRP’s security status on multiple fronts, waging separate battles against the SEC, crypto companies, and one of its own investors. As the SEC’s enforcement action moved forward with pretrial motions, the lead investor in Ripple’s Series C round—Tetragon Financial Group—tried and failed to redeem its Ripple shares for cash. Meanwhile, companies like Coinbase and Grayscale stopped offering XRP to avoid committing violations of their own.

  • The SEC continued its slow and steady pace of ICO enforcement with a new action against token issuer LBRY, Inc. The case was criticized by securities lawyers across the spectrum as “unjust” and “unfair,” with many agreeing that the SEC was in the wrong—as a matter of policy, if not as a matter of law. LBRY plans to fight the case and launched a new website to keep the public informed.

  • For the first time, high-ranking government officials openly discussed the benefits of DeFi. In a Financial Times piece in January, Comptroller Brian Brooks explored the potential for DeFi to fight discrimination and fraud in the financial system, and told us to “get ready for self-driving banks.” Then, in a speech entitled “Atomic Trading” in February, SEC Commissioner Hester Peirce said that “DeFi’s promises of democratization, open access, transparency, predictability, and systemic resilience are alluring.”


Closing thoughts and looking forward

The regulatory environment around crypto is heating up as the asset class rises in geopolitical and macroeconomic importance. Policymakers worldwide are starting to struggle with big questions about topics like monetary sovereignty and financial integrity, resulting in more attention from international bodies like the FATF. The industry’s response to the FATF’s draft guidance is the policy issue that I’ll be watching and working on most closely this month.

Thank you for reading the first edition of Crypto Law & Policy—I’ve only just started experimenting with the newsletter format, so let me know your thoughts in the comments or on Twitter. I want to make this space as helpful as possible, so please tell me what you want to read here. See you soon for the April review!

1

This content is provided for information purposes only. It is not and should not be relied upon as legal advice. I am not your lawyer. If you need help with a legal or regulatory issue, hire your own.

2

For example, one of the most effective elements of the industry’s strategy was preparing for litigation in the event that FinCEN implemented the proposed rule. Both Coin Center and the Blockchain Association identified separate and independent grounds for a lawsuit and made sure FinCEN knew that a legal challenge was certain. Comment letters can definitely be persuasive, but the threat of litigation is even harder to ignore.

3

It did come close, however. Although the draft guidance doesn’t recommend a prohibition, it does suggest that member countries evaluate the risk of peer-to-peer transactions, and if they find those risks “unacceptably high,” to consider “denying licensing of VASPs if they allow transactions to/from . . . unhosted wallets” (¶ 91).