Since the release of Bitcoin in 2009, the use of cryptocurrencies has become more widespread and mainstream. Since then, the market capitalization of the global cryptocurrency market reached its current peak at over $2.9 trillion in November 2021. As of the end of 2022 it had fallen to approximately $798 billion.
Notwithstanding the drop in market value, more and more cryptocurrencies are popping up with over 22,000 cryptocurrencies available for sale on over 500 crypto exchanges. Yet a string of bankruptcy filings by cryptocurrency companies accompanied the precipitous declines in value in 2022. The crypto hedge fund Three Arrows Capital filed on July 1, following the collapse of the so-called stablecoin terraUSD and its sister token luna. Crypto lender Voyager Digital filed on July 6 after its borrower, Three Arrows Capital, defaulted on its crypto loan. Celsius, another crypto lender, filed on July 14. The Bahamas-based exchange, FTX, and its affiliated hedge fund Alameda Research, filed in November after a “run on the bank." Yet another crypto lender, BlockFi filed for Chapter 11 just two weeks later.
The events have resulted in an increased press for Congress to install a regulatory framework for digital assets such as cryptocurrency following the collapse of the cryptocurrency exchange FTX. This paper considers the regulatory schemes currently in place.
Cryptocurrency is “any form of currency that only exists digitally, that usually has no central issuing or regulating authority but instead uses a decentralized system to record transactions and manage the issuance of new units, and that relies on cryptography to prevent counterfeiting and fraudulent transactions." Most cryptocurrencies exist as decentralized networks based on blockchain technology. This technology:
is a shared, immutable chronological record of transactions, frequently referred to as a digital ledger, and a type of distributed ledger technology. Blockchain technology “makes it possible to create a digital ledger of transactions and share it among a distributed network of computers. It uses cryptography to allow each participant on the network to manipulate the ledger in a secure way without the need for a central authority.”
This feature of cryptocurrency provides it with its decentralized structure separate from any central authority, such as a bank or government, which may seek to interfere with or manipulate the currency itself. The cryptocurrency blockchain allows for peer-to-peer participation to verify and conduct transactions; this network of individuals compares the multiple copies of the digital ledger to certify only valid transactions are included within the chain. Every verified transactions makes up a “block” which is then added to the end of the blockchain. The chain then acts as a ledger of transactions that occurred with the associated cryptocurrency and that information is transmitted to all computers within the network. This is what confirms that each digital coin is spent only once.
To date, Congress has not issued any official legislation regarding cryptocurrency. Recently, several individuals in the House and Senate have introduced legislation aimed at addressing the unregulated market of cryptocurrency. These bills are still in the early stages and remain at the “introduction” stage, so there is a long way to go before any become law. However, various regulatory agencies have begun to develop ways to bring cryptocurrency under their regulatory purview. Agencies such as the Commodity Futures Trading Commission (CFTC), the Securities and Exchange Commission (SEC), Financial Crimes Enforcement Network, a bureau of the US Treasury Department (FinCEN), and the Internal Revenue Service (IRS) have all issued guidelines or interpretations regarding cryptocurrency and market participants. Initially, cryptocurrency was only transferred peer-to-peer, but since its rise in popularity most cryptocurrency trading is carried out using “cryptocurrency trading venues” or “exchanges.” This medium of exchange is what concerns regulators the most as it poses the largest risk to the public because of the increased chance of misinformed investors, market fraud and manipulation, destabilization of local and national economies, and the potential use for illicit purposes. The fall of exchanges such as FTX and the Chapter 11 filings of others in the industry such as Cred, Celsius, Voyager, BlockFi, and Gemini has shaken the stability of the markets and increased the rally cries for government involvement.
Cryptocurrencies are labeled either a “commodity, security, currency, [or] property” and regulatory agencies are encouraged to cooperate to ensure “they do not work at cross purposes.” The asset classification of cryptocurrency is unsettled, and which agency and which laws or regulations govern a particular transaction often depends on that classification. The CFTC has purview when the cryptocurrency is classified as a commodity and the SEC controls when it's considered a security. In addition, FinCEN has authority when illicit activity is involved, as does the IRS regarding the filing and paying taxes. Each agency has brought cryptocurrency under its jurisdiction through a patchwork of federal laws and regulations. That patchwork consists of: the SECs use of the Securities Act and Securities Exchange Act, the CFTC's applying the Commodities Exchange Act, FinCEN's using the Bank Secrecy Act, and the IRS viewing cryptocurrency as property for tax purposes.
While the approach of the various agencies to regulating cryptocurrency is evolving, we will try to focus on how these agencies' methods started and have continued to develop with the passage of time and innovation in the technology. We will highlight the different agencies' use of existing federal laws and regulations to bring cryptocurrency under their various jurisdictions. The main focus will be on how the SEC, the CFTC, FinCEN, and the IRS have approached cryptocurrency. First, we will focus the how the SEC regulates cryptocurrency and the developing body of caselaw on the topic. Next, we will discuss the same for the CFTC. Then, we will explain FinCENs use of the Bank Secrecy Act to regulate money service businesses and combat money laundering in the cryptocurrency sphere. Finally, we will attempt to tackle the possible tax implications that the IRS has imposed on cryptocurrency.
History and Where Regulation Stands.
The first of the listed agencies to issue guidance on cryptocurrency was FinCEN in March 2013, and the guidelines described how it would regulate cryptocurrency based on existing money services businesses regulations. Next in July 2013, the SEC brought an action against an individual who ran in a Ponzi-scheme involving Bitcoins but ultimately the case provided little guidance. The court found Bitcoins were “investment contracts” and “securities” for purposes of federal security law but only to the extent the court could exercise subject-matter jurisdiction over the case. In 2014, the IRS issued its first official guidance on virtual currency which detailed the tax procedures for virtual currencies and stated virtual currencies will be treated as property. Finally in 2015, in an administrative decision the CFTC determined cryptocurrencies fit inside the definition of “commodity” under the Commodity Exchange Act and cryptocurrency markets are subject to CFTC jurisdiction.
A. The Securities and Exchange Commission's Approach to Cryptocurrency Regulation.
A report called the DAO Report issued in July 2017 developed the SEC's position on how it may go forward in regulating cryptocurrency. The report confirmed that the agency would apply the tradition test outlined in SEC v. W.J. Howley Co. to cryptocurrency to determine if it is an investment contract and therefore a security. The report expanded upon the groundwork laid out in the Shavers case and found the SEC's authority rests on two federal laws; Section 2(a)(1) of the Securities Act and Section 3(a)(10) of the Security Exchange Act.
The Supreme Court's decision in Howley laid out the test, holding that “a contract, transaction, or scheme whereby a  person invests his money  in a common enterprise and  is led to expect profits  solely from the efforts of the promotor or third party,” is an investment contract. In 2004, the Supreme Court reinforced the use of this test in S.E.C. v. Edwards, which confirmed without a doubt that “the test for whether a particular scheme is an investment contract was established in our decision in S.E.C. v. W.J. Howley Co.” This test is known as the Howley test and is used by federal courts today, and any product or transaction must satisfy all elements of test to be an investment contract.
When the SEC and courts are making a determination if a particular cryptocurrency is an investment contract they look at the substance of the transaction rather than the form it takes. The Howley test is a flexible principle by the SEC and the laws it relies on adapt to meet new and variable schemes concocted by those who wish to use the money of others on the promise of profits. This principle arose from a 1943 Supreme Court decision which found:
[T]he reach of the [Securities] Act does not stop with the obvious and commonplace. Novel, uncommon, or irregular devices, whatever they appear to be, are also reached if it be proved as matter of fact that they were widely offered or dealt in under terms or courses of dealing which established their character in commerce as ‘investment contracts,’ or as ‘any interest or instrument commonly known as a ‘security.’
This principle was solidified by the Supreme Court in 1990 when it found that the purpose of Congress in enacting securities laws “was to regulate investments, in whatever form they are made and by whatever name they are called.”
The Chairman of the SEC in 2017 declared the SECs regulation is mainly focused on companies and individuals attempting to use initial coin offerings (ICO) to raise capital; ICOs involve investors trading either traditional fiat currency or cryptocurrency for a digital asset called a coin or token, by which they are granted certain interests. Many companies' ICOs promote an expected increase in value of the coins they provide and the potential ability to trade those coins on an outside market to make a profit based on the efforts of others. Characteristics of ICOs resemble the definition of a security, in that they act as “certificate[s] of interest or participation” which include “any interest therein or based on the value thereof.”
- Applying the Securities Act Regulations to Initial Coin Offerings.
The Securities Act regulates the offer and sale of securities, including cryptocurrency deemed to be securities, and requires either registration or the reliance on an exemption for the sale of such securities. Section 5 of the Securities Act makes it “unlawful for any person … to offer to sell … any security, unless a registration statement has been filed as to such security,” this the main source of the Securities Act enforcement power. Put plainly, before selling a security a company or individual must register the offering with the SEC or satisfy an exemption.
This enforcement power has been used by the SEC in the last few years on a number of occasions. The first application came in a cease and desist action by the SEC against Munchee, a Delaware app corporation based in California that tried to offer a type of coin to its users that was described in a way in which the tokens would increase in value. In an effort to raise capital to improve their app, Munchee announced it would launch an ICO and offer the tokens to the general public. After the company began selling tokens it was contacted by the SEC, upon which it halted all sales and did not deliver any purchased coins to buyers. In total it raised around $60,000 USD from 40 separate investors. Using the Howley test, the SEC determined the coins being offered were investment contracts and thus considered securities defined by 15 U.S.C.A. § 77b(a)(1) of the Act. Once it was determined Munchee had engaged in the sale of securities it was clear Munchee had violated the registration requirements necessary before offering or selling securities.
More recently, the SEC has brought actions to enforce the mandate set down in what is now called the “Munchee Order”, using the same framework. The SEC successfully brought a preliminary injunction against a technology corporation which attempted to undertake an ICO without a proper registration under the Securities Act. In S.E.C. v. Telegram, the company tried to use a two-step process to avoid making a public offering of its coins by first selling the coins to initial purchasers who would then act as a go between and resell these coins to the general public on a secondary market. In granting the injunction the Court found the SEC showed a substantial likelihood of success the merits of its argument that the coins being offered were “securities” under the Howley test. The Court concluded that the sale and delivery of the offered coins represented a persisting violation of the registration requirement. The same framework was applied again in S.E.C. v. Kik Interactive Inc., where it was found that Kik's initial offer of coins violated 15 U.S.C.A. 77e(c) or Section 5 of the Securities Act.
2. Applying the Securities Exchange Act (Exchange Act) Regulations to Initial Coin Offerings.
The main difference between the Securities Act and the Exchange Act is that the former focuses on the registration of securities, while the latter allows the SEC to “register, regulate, and oversee brokerage firms, transfer agents, and clearing agencies as well as the nation's regulatory organizations.” All broker-dealers, transfer agents, and clearing agencies are subject to the Exchange Act's registration requirements and regulations of such intermediaries that engage in or aid the trading of securities. If any cryptocurrency being offered is found to be a security using the Howley test, then the market intermediaries who act in their capacity with cryptocurrency are subject to this Act.
The main use of the SEC's power in the Exchange Act comes from Sections 3(a)(10) defining securities to include investment contracts, 10(b) forbids the use of manipulative and deceptive devices, and 15(a)(1) the registration and regulation of brokers and dealers. The applicable portions of Section 3(a)(10) is the definition of security which “means any … certificate of interest or participation in any profit-sharing agreement … investment contract … including any interest therein or based on the value thereof.” Section 10(b) makes it unlawful “to use or employ, in connection with the purchase or sale of any security … any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.” Finally, Section 15(a) makes it “unlawful for any broker or dealer … to induce or attempt to induce the purchase or sale of, any security … unless such broker or dealer is registered.”
The SEC brought its first enforcement action against an individual alleged to have acted as an unregistered broker-dealer in an ICO sale and the facilitation of secondary market trading in cryptocurrency tokens. The SEC relied on the findings of the DAO Report findings to reason that the Respondents in TokenLot had violated the Exchange Act. Using the familiar Howley test the SEC determined the Respondents' actions constituted an investment contract and thus were subject to registration requirements.
The SEC's action in TokenLot was quickly followed by legal action using Section 10 of the Exchange Act against an individual who used deceptive means to market a cryptocurrency through an ICO. In Zaslavskiy, the defendant made false assertions in connection with his companies' ICO that caused individuals to invest in a cryptocurrency. In denying Zaslavskiy's Motion to Dismiss the indictment. The district court found that the indictment was facially sufficient and that a reasonable jury could conclude that these facts satisfied the Howley test, and that the Exchange Act as applied was not unconstitutionally vague.
Overall, the SEC has been success in its enforcement and other actions in federal district courts to varying degrees but the main factor throughout is the use of the Howley test to determine whether a cryptocurrency is a security and thus subject to regulation under the Securities Act or the Exchange Act. The Howley test and the flexible nature of the approach to determining what a security is has allowed the SEC to regulate cryptocurrency in the securities market.
B. The Commodity Futures Trading Commission's Approach to Cryptocurrency Regulation.
The CFTC derives its power from the Commodity Exchange Act (CEA) which gives the CFTC oversight jurisdiction over futures, options, and derivative contract transactions involving commodities; this jurisdiction is limited only to enforcement authority. The Commodity Exchange Act defines “commodity” broadly to include, “all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in.” This broad definition has encompassed cryptocurrency because it falls into the category of a derivative. A derivative is a financial contract that “derives its value from an underlying asset,” and cryptocurrencies get their value from the number of individuals transacting on the blockchain.
In a 2015 order, the CFTC found that virtual currencies, including cryptocurrencies fell under the definition of commodity stated in the CEA. In Coinflip, the CFTC took a broad approach to the definition of commodity when finding that Bitcoin was under its definition. The CFTC found the fact that Coinflip was offering option contracts with Bitcoin as the underlying asset which was to be paid for in US Dollars.
In a 2016 another CFTC enforcement action in regards to an online platform that was alleged to be engaged in illegal, off-exchange retail commodity transactions without properly registering with the CFTC. In this action, BFXNA specifically violated both 7 U.S.C.A. §§ 6(a) and 6d of the Commodity Exchange Act because during the relevant period of activity it was not registered and therefore engaged in illicit activity. The platform operated by exchanging US dollars for cryptocurrencies, or cryptocurrencies for other cryptocurrencies. The CFTC used the Coinflip order to ground their jurisdiction and claimed BFXNA was trading in commodities. It found that BFXNA, by operating its website and trading platform through which it offered to enter into, execute, and confirm the execution of financed commodity trades, was in violation of Section 4(a) of the Commodity Exchange Act. The relevant portion of the statute states, “[u]nless exempted by the Commission … it shall be unlawful for any person to offer to enter into, to enter into, to execute … any transaction in … a contract for the purchase or sale of a commodity for future delivery … unless such transaction is conducted … subject to the rules … designated by the Commission.” BFXNA violated the registration requirements of the Commodity Exchange Act because by trading commodity futures it was acting as a merchant and was required to be registered.
The CFTC Chairmen, in 2018, expressed the importance of greater understanding and clarity when it came to cryptocurrency and even pointed the CFTC would attempt a “do no harm” regulatory approach. The Chairmen did make clear that “more attentive regulatory oversight” was necessary in “key areas,” particularly capital requirements, security standards, and the prevention of fraud and manipulation. However, not until 2018, in McDonnell, did the CFTC finally confirm its position that cryptocurrency was a commodity. In that decision the CFTC ruled it had authority to take enforcement action against the contract of sale of virtual currency in interstate commerce. The District Court held that cryptocurrencies may be regulated by the CFTC as a commodity because they act as “goods exchanged in a market for a uniform quality and value.” It reasoned that virtual currency falls within Commodity Exchange Act's definition of commodity as “all other goods and articles … in which contracts for future delivery are presently or in the future dealt.”
The ruling also interpreted Section 9 of the Commodity Exchange Act to grant the CFTC jurisdictional authority against individuals using a scheme to defraud investors through a “contract sale of commodity in interstate commerce.” 7 U.S.C.A. § 9(1) makes it “unlawful for any person … to use or employ, or attempt to use or employ, in connection with any … contract of sale of any commodity in interstate commerce, or of future delivery … any manipulative or deceptive device … in contravention of such rules and regulations as the Commission shall promulgate.” The court reached its decision by finding that the defendants solicited and obtained individual's funds for trading by the defendants, ceased all contact and misappropriated the funds.
Again in 2018, in My Big Coin Pay, Inc., the CFTC exercised its regulatory power against an individual who enticed customers to buy their cryptocurrency by making multiple untrue statements and omitting material facts. The Commission used 7 U.S.C.A. § 13a-1(a), which allows it to “bring an action in the proper district court … to enjoin such act or practice, or to enforce … any rule” when an individual engages in any act in violation of the Commodity Exchange Act. The CFTC specifically alleged violations of 7 U.S.C.A. § 9(1), the Commodity Exchange Act prohibition against manipulation and false information. In finding that My Big Coin's cryptocurrency was a commodity, the CFTC further strengthened its enforcement powers pursuant to the Commodity Exchange Act.
Since its BFNXA order in 2015 through June 2020, the CFTC has brought nineteen enforcement actions. Generally, these actions involve either fraudulent schemes, failure to register with the CFTC, illegal off-exchange transaction, price manipulation, and gatekeepers' violations. With the expanding market of cryptocurrencies the CFTC will continue to play a role in commodity regulation of cryptocurrency.
C. The Financial Crimes Enforcement Network's Approach to Cryptocurrency Regulation.
FinCEN is an agency within the U.S. Treasury Department, and is the top regulatory agency for anti-money laundering law enforcement. The agency primarily relies on the Bank Secrecy Act, the primary U.S. anti-money laundering law. The Bank Secrecy Act is codified at 12 U.S.C.A. §§ 1829b, 1951 to 1959 and 31 U.S.C.A. §§ 5311 to 5332. It considers virtual currencies, which include cryptocurrencies, as currency and monitors the exchange of those currencies between individuals and money services businesses. Money services businesses are defined by FinCEN to include any person doing business as a money transmitter, and a money transmitter is any person that accepts “currency, funds, or other value that substitutes for currency” from one person and gives it to another person. FinCEN authority is limited to enforcing sanctions against criminal punishments, and it cannot regulate or monitor the market. A person who comes under the purview of FinCEN's money service business regulations will likely need to comply with registration, anti-money laundering programs, recordkeeping, monitor and reporting requirements.
As early as 2013 FinCEN issued guidance on how it will approach cryptocurrencies, ultimately asserting its jurisdiction over them through the Bank Secrecy Act. In that 2013 issue FinCEN asserted jurisdiction over cryptocurrencies but officially stated that it did not view cryptocurrency as a legal tender in any jurisdiction in the U.S. However, the report concluded that “administrators” or “exchangers” of cryptocurrencies are subject to money service business regulations as money transmitters. The report explicitly carved out cryptocurrency users from its purview.
Based on the 2013 Report, any entity conducting business as a cryptocurrency exchange needs to register with FinCEN and create an anti-money laundering compliance program. FinCEN issued new guidance in 2019 which confirmed some findings issued in 2013 but mainly updated the agency's approach to cryptocurrency regulation or convertible virtual currency (CVC). The 2019 guidance mainly explained FinCENs views on which business models would be considered money transmitters and which ones may be exempt. Some business models that FinCEN noted will likely qualify as money transmitters are: peer-to-peer exchangers, host wallet providers, CVC kiosks that transfer cryptocurrency for real fiat currency, apps that transmit money for profit or not-for-profit, and payment processing services using cryptocurrency. And specific business models that involve cryptocurrencies that may be exempt from that definition are CVC trading platforms and decentralized exchanges, and cryptocurrency money transmission when raising funds for development.
In 2015, FinCEN brought its first civil enforcement action against a virtual currency exchanger, called Ripple Labs Inc. Ripple was fined $700,000 thousand dollars for selling its cryptocurrency called “XRP” without registering with FinCEN and its failure to implement a proper anti-money laundering program. Ripple complied and agreed to pay a monetary penalty of $700,000 in order to end any potential liability in connection with the Bank Secrecy Act violations, and an additional $450,000 to the DOJ. FinCEN used its authority to investigate money service businesses for adherence with and violations of the Bank Secrecy Act after looking at 31 U.S.C.A. § 5312(a)(2) and finding Ripple to be a money service business. The agency determined that while Ripple was operating it failed to register with FinCEN and thus was open to civil penalties.
FinCEN applied its enforcement powers again in 2017 against a foreign based Bitcoin exchange, called BTC-e, for willfully violating anti-money laundering laws, and fined the company $110 million dollars. BTC-e and its owner were indicted in California for money laundering, conspiracy to commit money laundering, and engaging in unlawful monetary transactions, and operating an unlicensed money transmitting business pursuant to 18 U.S.C.A. §§ 1956, 1957, and 1960 respectively. FinCEN found BTC-e to be a financial institution and money service business and thus subject to its jurisdiction and regulatory power. When BTC-e first started, it offered services that would exchange cryptocurrencies for U.S. dollars. FinCEN found that: “Instead of acting to prevent money laundering, BTC-e and its operators embraced the pervasive criminal activity conducted at the exchange. Users openly and explicitly discussed criminal activity on BTC-e's user chat. BTC-e's customer service representatives offered advice on how to process and access money obtained from illegal drug sales on dark net markets like Silk Road, Hansa Market, and AlphaBay.” These activities were sufficient for BTC-e and its owner, acting as a money service business, to be found in violation of anti-money laundering program requirements and failure to file suspicious activity reports. A transaction is suspicious if it deals in $2,000 dollars or more, involves fraud, is designed to avoid reporting requirements, has no lawful purpose, or involves criminal activity.
FinCEN has been more reluctant than other agencies to take enforcement actions in situations involving cryptocurrency, with only three total enforcement actions taken. The latest action taken was in April 2019 against an individual who was fined for his willful violation of registration and reporting programs while acting as a peer-to-peer virtual currency exchanger, serving as the first of this type of entity being regulated.
D. The Internal Revenue Service's Approach to Cryptocurrency Regulation.
In 2014, the Internal Revenue Service's position on cryptocurrency was that it qualifies as property and so it must be declared when filing for taxes. All applicable tax requirements for normal property apply to cryptocurrencies, so for example a person who receives cryptocurrency as payment for an activity must include its fair market value when calculating gross income. The requirements involve disclosing and describing any virtual currency transactions and reporting the gains or losses associated with the sale of cryptocurrency.
In 2018, the IRS issued a press release to remind individuals that cryptocurrencies were reportable on income tax returns and to announce the establishment of an investigation team to focus on crimes involving cryptocurrencies. Specific guidelines in the 2014 Notice, reinforced by a 2018 reminder, state that taxes are owed on all realized gains of cryptocurrency in the event of a sale of cryptocurrency for cash, the purchase of a good or service with it, and the exchange of one cryptocurrency for another.
The IRS's first real implementation of any sort of specific regulatory authority was in 2016 and involved the popular cryptocurrency exchange Coinbase. In that case the IRS filed a summons to Coinbase asking for information on a certain amount of users. At first, Coinbase refused to respond but ultimately it complied with the order and turned over records of customer between 2013 and 2015.
E. The Executive Branch and Federal Banking Regulators Approach to Cryptocurrency Regulation.
The Biden Administration released an executive order on cryptocurrency and digital assets in early March 2022 that called upon a government-wide approach to determine what policies the United States should take regarding cryptocurrency. The order directs multiple U.S. regulatory agencies to prepare reports and produce their findings to the White House. The reports must include consideration of the implications of development and adoption of digital assets and what changes would occur in the financial market and payment system infrastructure for consumers, investors, and businesses. The reports should also include policy recommendations regarding potential regulation of digital assets and what legislative steps can be taken to further the goal of protecting United States consumers, investors, and businesses.
The White House in mid-September, following submission of the reports, promulgated a comprehensive framework for the development of digital assets. This framework is broad but focuses on seven main categories: protecting consumers, investors, and businesses; promoting access to safe and affordable financial services; fostering financial stability; advancing responsible innovation; reinforcing the U.S. global financial leadership and competitiveness; fighting illicit finance; and exploring a U.S. central bank digital currency. The White House framework is one of the most recent developments in the cryptocurrency regulation conversation but acts only as direction for the numerous regulatory agencies. Congress likely will need to take the lead in regulating this ever-growing area of commerce but until that time the various regulatory agencies will have to make do with their patchwork of enforcement methods.
The three main U.S. banking regulators, the Federal Reserve (the Fed), the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC) have issued guidance relating to digital assets. In response to the volatile activities in the crypto space in 2022, the regulators released a joint statement clarifying the risks crypto assets pose to banking organizations. The statement reassures banking organizations they are not forbidden from providing banking services to customers with crypto assets if the services are conducted in a manner that properly address safety and soundness and consumer protection concerns. It also indicated that banking organizations that are “issuing or holding as principal crypto-assets that are issued, stored, or transferred on an open, public, and/or decentralized network, or similar system is highly likely to be inconsistent with safe and sound banking practices.”
Prior to issuing the joint statement the banking regulators issued their own sets of guidance. The OCC released an interpretative letter explaining the processes a bank may demonstrate that it will engage in crypto related activities in a safe manner. Specifically, a bank must notify its supervisory office and receive a written supervisory non-objection before engaging in crypto related activities. The FDIC released a letter calling for some of the same reporting requirements. The FDIC's letter included risk banking organizations should look for when dealing with crypto-related assets, including liquidity implications for insured depository institutions when crypto assets are involved. Two other risk considerations highlighted are the risks to financial stability, mainly the risk of a run on financial assets backing crypto assets and consumer protection relating to the speculative nature of crypto assets as compared to accepted banking products. Besides the risks associated with crypto-related assets the letter instructs FDIC-supervised banking institutions to notify the appropriate FDIC regional director prior to participating in, or if currently engaged in, a crypto-related activity. The Federal Reserve issued a letter much like the other two agencies pointing out the risks associated with crypto-related assets and the need for banking organizations to notify its lead supervisory point of contact at the Fed before engaging in crypto-related activity.
F. U.S. Bankruptcy Courts and Cryptocurrency Classification Under the Bankruptcy Code
United States bankruptcy courts have been plugged into the middle of the cryptocurrency discussion with the spate of recent bankruptcy filings of cryptocurrency exchanges. The limited case law in this area leaves bankruptcy courts little discretion on how to approach this expanding market. There is no disagreement that cryptocurrency falls with § 541 of the Bankruptcy Code that finds “all legal or equitable interests of the debtor in property as of the commencement of the case,” are property of the estate. A current tension surrounding cryptocurrency and bankruptcy is how to properly classify the particular currency for the purposes of valuation, specifically related to avoidance actions. The debate asks if cryptocurrency should be classified as either a currency or a commodity.
If a bankruptcy court treats cryptocurrencies like traditional currencies, a trustee will typically only recover the dollar value of the cryptocurrency from the date the petitioner filed for bankruptcy. This method ignores any potential fluctuations in the cryptocurrencies' value and caps it early on. Treating cryptocurrencies as a commodity would allow the trustee to recover the actual cryptocurrency itself, rather than just its value, allowing a chance of a larger recovery if the value of the cryptocurrency increases.
Avoidance actions include those for fraudulent transfers. A trustee or the debtor in possession can recover fraudulent transfers made by the debtor within the past two years under the Bankruptcy Code, starting from the filing of the bankruptcy petition, or under similar provisions of state law. This process allows past transfers to be reversed and recovered for the estate if the debtor did not receive a reasonably equivalent value in the transfer, and was either insolvent at the time of the transfer or became insolvent resulting from the transfer. This is the moment that the classification of cryptocurrency becomes very important.
If classified as currency under the Bankruptcy Code, certain cryptocurrency transactions are likely to be categorized as “swap agreements.” Under one kind of a “swap,” the parties enter into a contract under which each agrees to exchange in the future currency for another form of currency. Each party is betting the value of the currency payments it will receive will be more than the value of the currency payments is will be making. A major benefit of structuring a transaction as a “swap agreement” for a party concerned with the financial condition of its counterparty is that the Bankruptcy Code's “safe harbors” for financial contracts exempts swaps from the automatic stay and avoidance actions, unless the transferor intended to hinder, delay or defraud creditors.
Some commentators have suggested that section § 546(g) allows debtors and their counterparties to conduct pre-bankruptcy planning that maximize both a creditor's claims and the debtor's goals without having to worry about the transfers being reversed if determined to be constructively fraudulent. Another benefit for the non-debtor counterparty of currency classification and the swap safe harbor is exemption from the automatic stay. If the transaction is characterized as a swap, a creditor will have the ability to initiate, or continue to litigation against a company to enforce its swap agreements without regard to the automatic stay. Because the safe harbors for financial contracts also allow a non-debtor counterparty to “net out,” the creditor may offset any interest from a swap agreement against any debt that it may owe to the debtor.
On the flip side, cryptocurrency may be classified as a commodity. A commodity is defined as “a basic good used in commerce that is interchangeable with other goods of the same type.” Much like other commodities, cryptocurrencies are interchangeable and uniform, and their value relies on their supply. A commodity classification provides less protections to creditors and gives the estate the power to regain possession of the actual cryptocurrency, even at higher value, and the estates' creditors an increased chance of being made whole. Proponents of this classification rely on Sections 541(a)(6), and 550 to reinforce the assertion that any appreciation of estate property is part of the bankruptcy estate.
One of the few bankruptcy cases that has discussed this distinction for cryptocurrencies is the Hashfast Technologies LLC v. Lowe case decided in 2016 in the Bankruptcy Court for the Northern District of California. The court was tasked to determine whether the chapter 7 debtor fraudulently transferred its Bitcoins, and if so, whether the transferee had to return the coins or their value to the estate. After learning that the debtor had paid a person related to the business in Bitcoin, within a year of the filing, the trustee attempted to reclaim the coins or receive the equivalent value by avoiding the transfer pursuant to 11 U.S.C.A. § 550(a). At the time of the transfer the coins were worth $360,000, but were valued at $1.3 million when the trustee tried to recover them.
Ultimately, the court punted on making a determination about the exact nature of the Bitcoins until the trustee could show that the transfer was fraudulent. The case ended up settling before the court could make that determination. However, the court in its order stated that “bitcoin are not United States dollars,” so at least one bankruptcy court has characterized cryptocurrency as legally different from U.S. currency.
The ever-changing world of cryptocurrency poses unique challenges on a daily basis for U.S. regulatory agencies and bankruptcy courts. For now, most agencies have used existing federal statutes and regulations to try to bring cryptocurrencies within their particular authority. Some have tested their authority and successfully exercised in administrative actions and within district courts across the nation. Current statutes and regulations have been surprising adaptive to the interesting aspects of cryptocurrency. However, until there is a form of new Congressional legislation with an updated understanding of this new form of currency, regulatory agencies will continue to hamstring enforcement through existing laws and regulations. And bankruptcy courts will continue to struggle with the issues.
Reprinted from Norton Journal of Bankruptcy Law and Practice, Vol. 32 No. 1 (March 2023),
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