Executive Summary 

• In early June, the Securities and Exchange Commission (SEC) charged the world’s largest cryptocurrency exchange Binance and America’s largest crypto exchange Coinbase, arguing that several of the digital assets offered on the platforms qualify as securities and that the exchanges must therefore register with the SEC. 

• The SEC has pursued a “regulation by enforcement” avenue that goes after cryptocurrency exchanges – an approach which imbues the industry with uncertainty and could bring the SEC into conflict with firms and other regulatory bodies alike. 
• Congress should consider whether certain digital assets are actually securities and pass legislation to clarify which agency or agencies have the authority to regulate cryptocurrencies and exchanges. 

Introduction 

On June 5-6, the Securities and Exchange Commission (SEC) filed charges against Binance, the world’s largest cryptocurrency exchange; Changpeng Zhao, Binance’s CEO; and Coinbase, the largest cryptocurrency exchange in America. The Binance charges, filed in U.S. District Court for the District of Columbia, allege that Binance entities operated an illegal trading platform, commingled and diverted customer funds, and misled investors about the strength of trading control protocols. By contrast, the Coinbase charges, which were filed in U.S. District Court for the Southern District of New York, do not name the CEO as a codefendant or implicate mishandling of customer assets or questionable risk and security protocols. 

However, in both actions – against Binance and Coinbase – the SEC argues that each platform is operating as an “unregistered broker, exchange, and clearing agency.” In particular, the SEC argues that by earning revenue facilitating millions of digital asset transactions without having registered with and provided financial disclosures to the agency, both exchanges are in violation of U.S. securities law. The SEC has identified ten crypto tokens offered by Binance and thirteen offered by Coinbase – including Solana, Cardano, and Polygon – that they say constitute securities, raising a perpetual question in the cryptocurrency regulation space: are these digital tokens indeed securities, and should they be regulated as such? 

Are Cryptocurrencies Securities? 

SEC Chairman Gary Gensler said, “While each token’s legal status depends on its own facts and circumstances, the probability is quite remote that, with 50, 100, or 1,000 tokens, any given platform has zero securities. Make no mistake: To the extent that there are securities on these trading platforms, under our laws they have to register with the Commission unless they qualify for an exemption.” Which crypto assets can appropriately be called securities is an open question that will continue to ignite debate among firms, investors, and regulators. By the prevailing Howey test, a transaction constitutes an “investment contract” – and therefore must abide by securities law – if it involves “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.” If a digital asset is primarily used to purchase goods and services, or if it is “sufficiently decentralized” such that the network’s fate and operations do not hinge on the actions of a single party or group, the asset would not constitute an “investment contract” and could instead be regulated as a commodity. Regulators including Gensler agree that bitcoin (BTC), the original cryptocurrency and the largest by market capitalization, fits under this first category. On the other hand, if the digital asset does depend on the efforts of a single party or group to maintain the network or issue the native token – such as in the context of an initial coin offering (ICO) or other efforts to raise capital – and investors expect a financial return on the basis of such third party efforts, the asset constitutes a security. 

There are plenty of digital assets that fall into each of these two buckets, but uncertainty about the status of many such assets abounds. At a July 2023 subcommittee hearing, Gensler, in response to a question from Senator Dick Durbin (D – IL), commented that “very few” tokens do not fall under his agency’s jurisdiction, implying that most fell under the purview of securities law and by extent could be subjected to regulations and mandatory disclosures by the SEC. Unsurprisingly, stakeholders and other regulatory bodies like the Commodity Futures Trading Commission (CFTC) may not agree with Gensler’s expansive view of the proportion of digital assets that constitute securities. Moreover, many crypto tokens resemble investment contracts at their inception, as the issuer attempts to raise funds and get the enterprise off the ground, before they morph into self-sustaining decentralized networks of their own. Which agencies should be given the responsibility to oversee these tokens, and at which stages of their evolution? How should policymakers delineate when a token transitions from a security to a commodity? Resolving such instances of “ambiguity on the definitional side” – in the words of Georgetown Adjunct Law Professor Daniel Gorfine – is critical to get over one of the biggest hurdles that plagues the effort of getting crypto regulation right. 

An even more germane question than the security-versus-commodity distinction is who has the authority to settle the dispute. Vesting this decision-making authority in an administrative agency like the SEC – the would-be regulator, which possesses a material interest in arrogating the power for itself – spells trouble and could magnify the issues with the agency’s litigious approach. Instead, Congress should determine the appropriate bucket – security or commodity – into which cryptocurrencies and associated assets should be placed. Because of the relative newness of this asset class, crypto regulation constitutes “unsettled law,” and it is incumbent upon the first branch of government to outline the prerogatives and responsibilities of the agencies that are making claims to regulate it. 

“Regulation by Enforcement” 

The recent actions against Binance and Coinbase are not the opening salvo of crypto enforcement. Rather, they represent the culmination of an ongoing two-year long campaign to indirectly regulate the industry through tough administrative enforcement by the Securities and Exchange Commission (SEC). Chairman Gary Gensler has opined that a great deal of “noncompliance and hype masquerading as reality” inundates the crypto industry, and he accordingly feels the need to tighten the screws on the crucial middlemen of the crypto world: exchanges on which traders buy and sell digital currencies and assets. Especially after the collapse of FTX and the indictment of Sam Bankman-Fried, Gensler has targeted the hubs on which most cryptocurrency transactions occur, spurning the previous approach of acting against individual tokens and their issuers. 

Coinbase CEO Brian Armstrong lambasted the SEC’s “regulation by enforcement” approach, arguing that it deprives the developing industry of much needed clarity and consistency. There is no “clear rule book” of guidelines to delineate which practices are permissible and which will land a trader or exchange on the wrong side of the law. UCLA Law Professor James Park explains, “Instead of passing a regulation that would provide sufficient specificity and give the industry notice, the SEC instead is bringing enforcement actions that are interpreting broadly worded statutory phrases to develop the law case-by-case.” In the absence of a coherent regulatory framework for the asset class, it is impossible to properly gauge the forgone losses in innovation and efficiency from the administrative state’s actions against the crypto sector. What is certain is that heavy-handed enforcement creates a chilling effect that discourages individuals and businesses from holding cryptocurrencies and digital assets. 

Companies and exchanges frustrated by the federal government’s handling of their industry may decide to move abroad to countries with laxer rules or to nations with regulatory systems more hospitable to digital asset innovation. At a hearing hosted by the Senate Appropriations Committee’s Subcommittee on Financial Services and General Government, Senator Bill Hagerty (R – TN) observed that “industry players are migrating overseas to other jurisdictions where rules of the road are clearer for them. And when you think about the rules of the road here in America, the ruleset is anything but clear. And what is occurring here much more often than not is ‘regulation by enforcement’ … [T]hat is creating a great deal of uncertainty in the market. … [W]e’re losing out on technology development and innovation that I would like to see happen here.” 

Omid Malekan of Columbia Business School concurred, remarking that “not a week goes by now that I don’t hear about a startup, an established company, an investment fund actually moving resources offshore. Not theoretically, but them literally saying that we’re opening up an office in X country or applying for a license in Y country. You can actually go on places where crypto companies and protocols list job openings, and increasingly … it literally says, ‘applicants from the United States will not be accepted.’” The exodus of digital asset businesses from the United States is not purely anecdotal. Former Speaker of the House Paul Ryan, who moderated a panel discussion about the economic and national security perils of offshoring cryptocurrency, cited a report that found that the percentage of crypto developers located in the United States is declining at a rate of 2% annually and is currently at 29%, down from 40% five years ago. Both capital and talent are moving offshore in part because the “regulation by enforcement” approach fails to resolve ambiguities in the extant patchwork of laws, rules, and their inconsistent application. 

Policymakers must ensure that the U.S. provides a welcoming and sensible framework for crypto adoption such that capital and talent opt to remain in America and contribute to the financial sector and the economy writ large. Otherwise, the trend in which the U.S. loses market share in blockchain development, stablecoins (the vast majority of which are denominated in the U.S. dollar), and other tokens and digital assets will continue unabated. Moreover, fraud will become more commonplace. As Senator Hagerty intimated, enterprises engaging in illicit schemes – like FTX, which is headquartered in the Bahamas and incorporated in Antigua and Barbuda – move overseas to avoid accountability and compliance standards. Chairman Gensler too acknowledged that “there’s a bit of regulatory arbitrage. I’ll set up in Malta. I’ll set up in the Bahamas. I’ll set up in some tax haven or offshore where they don’t have the robust rules of the road that we have in our securities markets or the robust enforcement we might have around anti-money laundering.” 

Moreover, a case-by-case enforcement approach raises issues concerning overlapping agency jurisdictions. Competing claims to statutory authority for cryptocurrency regulation have precipitated a “turf war” between the SEC and the Commodity Futures Trading Commission (CFTC). Chairman Gensler acknowledged the jurisdictional overlap in his testimony before the Senate Committee on Banking, Housing, and Urban Affairs, but said that the SEC was working closely with the CFTC, its “sibling agency,” as well as the Federal Reserve, the Office of the Comptroller of the Currency (OCC), the Department of the Treasury, and the President’s Working Group on Financial Markets. 

How agencies resolve these conflicts will have profound consequences for the precise way in which the industry is regulated. There are substantive differences in the way the SEC and CFTC would opt to regulate digital tokens. For instance, Gensler’s SEC may decide to regulate Ether (ETH), the native currency of the Ethereum network, as a security, whereas the CFTC has recognized it as a commodity and has permitted registered exchanges within its jurisdiction to list it as an offering. 

Legislative Solutions 

Paul Grewal, Coinbase’s chief legal officer, opined that the solution to crypto sector uncertainty is “not litigation,” but rather “legislation that allows fair rules for the road to be developed transparently and applied equally.” There have been several legislative attempts to develop regulatory frameworks for cryptocurrencies. Members of Congress including Senator Patrick Toomey (R – PA), Senator Bill Hagerty (R – TN), Representative Josh Gottheimer (D – NJ-5), and the leadership of the House Financial Services Committee have proposed ways to regulate stablecoins. Senators Elizabeth Warren (D – MA) and Roger Marshall (R – KS) introduced a bill to require the Financial Crimes Enforcement Network (FinCEN), the Department of the Treasury, SEC, and CFTC to implement rules concerning reporting requirements and protections against fraud, money laundering, and financing of terrorism and trafficking. The Digital Commodities Consumer Protection Act of 2022 – introduced by Senators Debbie Stabenow (D – MI), John Boozman (R – AR), Cory Booker (D – NJ), and John Thune (R – SD) – would vest the CFTC with exclusive authority over the spot market for most cryptocurrencies and blockchain-based assets. 

The Lummis-Gillibrand Responsible Financial Innovation Act – initially introduced by Senators Cynthia Lummis (R – WY) and Kirsten Gillibrand (D – NY) in 2022 as S. 4356 and reintroduced in the 118^th Congress earlier this month – takes a similar approach in viewing most cryptocurrencies as commodities and accordingly establishing a regulatory framework for digital assets under the CFTC. In a nod to SEC concerns that legislation would sap the agency of its necessary enforcement authority, the bill also requires issuers of so-called “ancillary assets” to file disclosures and otherwise comply with SEC rules if those “ancillary assets” are offered alongside the sale of securities through investment contract arrangements. For any issuer that complies with the bill’s periodic disclosure requirements, its “ancillary assets” are presumed to be commodities and not securities unless a federal court finds otherwise. Furthermore, the bill sketches out requirements for depository institutions that issue stablecoins, establishes the tax treatment for digital assets (including treating income accrued from sales as capital gains, and establishing a de minimis threshold of $200 gain on which no tax is levied), addresses decentralized finance, tackles money laundering and consumer protection issues, requires firms to publish risk disclosures for consumers, and clarifies what sorts of assets fall under the purview of the CFTC and which fall under the SEC (including by explicitly codifying the Howey test). Questions remain about whether the CFTC is the appropriate regulator, but a clear distribution of responsibilities among the CFTC, SEC, and other agencies is essential for any legislative solution because regulators would otherwise step on each other’s toes and muddle the regulatory landscape for investors and exchanges. 

Conclusion 

The recent charges against cryptocurrency exchanges Binance and Coinbase are the culmination of the SEC’s recent “regulation by enforcement” campaign. While tackling fraud and wrongdoing in the sector is paramount, this effort has hamstrung the industry by adding uncertainty to exchanges and investors’ calculations. A preferable alternative is legislative action by Congress. Any proposed regulatory framework should create perspicuous guidelines that separate digital assets that are securities from those that are commodities and divide regulatory responsibility between the SEC and the CFTC respectively. Such an approach would simplify hurdles for exchanges and investors, while establishing a coherent system to root out malfeasance and protect those whose money is at stake.