Regulation of Cryptocurrency and Initial Coin Offerings (ICOs) in United States (US)
The regulatory position in the US is complicated and cryptocurrency-related activities potentially fall within the jurisdiction of a number of US federal regulators – the Securities and Exchange Commission (the SEC) may regulate them as securities, the Commodity Futures Trading Commission (the CFTC) classifies them as commodities, and the Financial Crimes Enforcement Network (FinCEN) treats them as currency. Crypto assets can also be regulated as “virtual currencies” such that the guidelines of FinCEN apply to “administrators” and “exchangers” which need to be registered with FinCEN as a money service business and comply with regulations aimed at countering money laundering and terrorist financing. FinCEN has brought criminal and civil enforcement actions against cryptocurrency businesses for failure to register and non-compliance with anti-money laundering procedures.
State regulators also regulate various activities, for example, New York’s BitLicence. New York State has been active in terms of regulation and requires any business engaging in the transmission, trading, custody or issue of a virtual currency to obtain a BitLicence. Licensees have to satisfy requirements including a minimum capital requirement and anti-money laundering and know-your client obligations. As at June 2020, the State of New York had issued 25 BitLicences, including to Hong Kong’s XAPO Holdings.
As a result, the jurisdiction of US agencies frequently overlaps and this has led to allegations of excessive and unclear regulation, which is stifling the development of virtual asset technologies.
On 16 November 2018, the SEC issued a Statement on Digital Asset Securities Issuance and Trading  setting out its views on three principal areas relating to digital assets: ICOs, investment vehicles investing in digital asset securities and trading of digital assets.
The SEC has repeatedly stated that virtual assets may qualify as “securities” and that ICOs thus need to comply with US securities laws, in particular the 1933 Securities Act. This is comparable to Hong Kong’s approach which regulates ICOs where the virtual assets constitute securities under the SFO). Accordingly, there are registration requirements (requiring the registration of the ICO as a public securities offering), although exemptions are available under Regulation A+ and D. Blockstack was the first company to conduct an ICO under the Regulation A+ exemption in September 2019.
The SEC has taken enforcement actions against a number of ICOs as unregistered securities offerings. Examples include SimplyVital Inc., ICOBox, and the original landmark case involving the DAO tokens, which we are going to look at in more detail in a moment. However, in spite of SEC statements suggesting that all ICOs are securities offerings, the US enforcement actions based on securities law violations have involved cases where explicit statements were made that token holders could expect to receive a profit. This raises the question of whether it was the explicit promotion of the ICOs as something that would increase in value that resulted in them being targeted by the SEC, rather than their “utility token” features. Without the express statements suggesting the ability to make a profit from the tokens, the ICOs may not have amounted to a securities offering. Comparably, in Hong Kong, the SFC has halted only one ICO – the ICO of Black Cell in March 2018 on the basis that making the tokens available to Hong Kong investors constituted “potential unauthorised promotional activities and unlicensed regulated activities” and that the sale of the tokens in the proposed manner may constitute a CIS. In that case, it was however fairly clear that the tokens were “securities” since they were redeemable for Black Cell shares.
DAO Tokens & the Howey Test
In July 2017, the SEC released a report determining that “DAO Tokens” offered and sold by a “virtual” organisation called the DAO were “securities” under the Securities Act of 1933 and the Securities Exchange Act of 1934. DAO Tokens were offered in exchange for Ether (ETH) and the ETH raised would be used to fund projects.
Under the Howey Test, an investment contract (which is a security) is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.
The DAO met the all the requirements of the Howey test. Purchasers of DAO were found to have invested with a reasonable expectation that they would receive a return in the form of a share of the profits from projects funded by the DAO. The promotional materials informed investors that they would share in the profits of the projects funded by their investment. Token holders could also monetise their investment by reselling DAO tokens in the secondary market. The profits were also found to be “derived from the entrepreneurial or managerial efforts of others” as profits for investors were generated by the managerial efforts of Slock.it and its co-founders in putting forward project proposals. The DAO ICO was however unusual in that it was essentially a tokenised fund and thus fell squarely within the definition of a security.
The regulatory position is less clear in relation to “utility tokens” which proliferated in the wake of the DAO report. Subsequent statements from SEC officials suggested that all ICOs are securities offerings (save for Bitcoin and Ether which are regarded as commodities, as is the position in Hong Kong). However, the SEC have indicated that cryptocurrencies can evolve from being securities to non-securities once the network on which they function is sufficiently decentralised, such that purchasers no longer expect any person or group to carry out essential managerial or entrepreneurial efforts as required by the “Howey test”.
The key feature of a utility token is that rather than entitling holders to a share of the profits from investments, they typically provide a right of access to a specific product or service provided or to be provided by a DLT platform. However, as became clear in SEC enforcement actions, merely calling something a “utility token” does not mean it is not a security if it is in fact marketed as an investment products, as was determined in the enforcement action relating to the Munchee ICO.
Similarly, in Hong Kong, the SFC 2018 statement appeared to recognise that “utility tokens” are not generally “securities” under the SFO. However there is no legal definition of a “utility token” in Hong Kong. Nor is there any Hong Kong case law or guidance from the regulators on the characteristics of an ICO token that might cause it to be considered a security.
SEC Action against Ripple
One of the most high profile recent regulatory actions is the US SEC’s December 2020 action against Ripple and two of its senior executives for allegedly conducting a US$1.3 billion unregistered securities offering of XRP tokens, the world’s fourth largest cryptocurrency by market cap., which were offered to investors in the US and worldwide in 2013 allegedly in breach of the US Securities Act of 1933. Ripple also distributed billions of XRP in exchange for non-cash consideration such as labour and market-making services. Following the announcement, Coinbase, Bitstamp, OK Coin and Hong Kong-based OSL suspended trading in XRP, with XRP subsequently falling by 31%.
The SEC complaint alleges that XRP is an “investment contract” within the Howey Test and is thus a security subject to the registration requirements of the Securities Act. It notes that the “defendants understood and acknowledged in non-public communications that the principal reason for anyone to buy XRP was to speculate on it as an investment.” In particular, in publicly offering and selling XRP, Ripple allegedly promised to undertake significant entrepreneurial and managerial efforts, including to create a liquid market for XRP, which would in turn increase demand for XRP and therefore its price.
Ripple has disputed the allegation that XRP is an investment contract and has described the SEC’s action as an “assault on crypto at large”. Ripple’s main arguments are that:
- XRP is a currency, similar to Bitcoin and Ether, which the SEC has determined are not securities; and
- XRP has a fully functional ecosystem and a real use case as a bridge currency that does not rely on Ripple’s efforts for its functionality or price – it therefor differs from earlier ICO cases which did not have developed ecosystems or an established utility for the digital assets which were sold to purchasers based on promises of profits and ongoing efforts.
A commentator on Forbes noted that the long-term effect of the SEC’s action may be a broader shaking out and differentiation between ICO products and digital tokens resembling the analogue governance models of before versus truly decentralised modes of governance. It could also lead to businesses avoiding the US legal system. Ripple has reportedly been looking for new headquarters outside the US due to the lack of regulatory clarity. Countries under consideration include Japan and Singapore.
Other recent (and high-profile) enforcement actions include those brought against Kik and Telegram. In both cases, the SEC alleged that Kik and Telegram tokens were securities within the meaning of US securities laws, with the token offerings therefore being unregistered securities offerings. Both Kik and Telegram structured their offerings as SAFTs – Simple Agreements for Future Tokens, a concept which attempted to skirt US securities laws by distributing tokens after the launch of the blockchain network (hence the tokens would be considered utility tokens).
In the case of Telegram, the US$1.7 billion token sale was determined to be an unregistered security offering, despite Telegram’s argument that the tokens (Grams) were currency. In agreeing with the SEC that the tokens were securities, the Court determined that there was a common enterprise and that a reasonable Initial Purchaser would have purchased Grams with investment intent and an expectation of profit (citing the testimonies of purchasers and various other facts). It was also found that this expectation was based on the essential entrepreneurial and managerial efforts of Telegram. This finding was based on various facts including that Grams did not exist at the time of the sales, purchasers provided capital to fund the development of the TON blockchain in exchange for the future delivery of Grams, expecting to resell them for a profit, and that the offering materials emphasised Telegram’s commitment to developing the project. The Court further found that Telegram failed to demonstrate that it was exempt from the registration requirements under Regulation D (which provides an exemption for registration of securities offered in private sales to accredited investors). This was based on the finding that Telegram did not intend Grams to remain with the initial purchasers, but intended them to reach the public via post-launch resales by initial purchasers (who the Court found were underwriters).
The Kik decision followed, with the Court largely adopting the same reasoning. The Kik case differs from Telegram’s though as Kik’s tokens (KIN) were offered in both a pre-sale to a limited number of accredited investors and a public sale (which Kik argued were two distinct transactions). The Court ultimately concluded that both transactions were integrated and constituted an unregistered securities offering based on, in short, the fact that Kik pooled the proceeds from its sales of Kin in an effort to create an infrastructure for Kin, and thus boost the value of the investment.
Investment Vehicles Investing in Digital Asset Securities
The SEC November 2018 statement also set out the SEC’s views on funds that invest in digital asset securities, stating that funds investing in crypto assets that are securities must be registered under the Investment Company Act and that the managers of the investment vehicles must observe the registration, regulatory and fiduciary obligations under the Investment Advisers Act. The first “crypto fund” to register was the Arca US Treasury Fund in July 2020, a fund which invests in short-term treasury securities, with investors holding their shares in ArCoins, an ERC-1404 token.
This approach is broadly comparable to Hong Kong’s approach where managers of funds investing 10% or more of their GAV in virtual assets are required to be registered for Type 9, however unlike the US, this applies whether or not the virtual assets are securities or futures contracts. Licensing requirements also apply to the distributors of virtual asset funds which require a Type 1 licence.
Trading Digital Asset Securities
The SEC statement also addressed the trading of digital asset securities, outlining that a trading platform which offers trading of crypto assets which are “securities” and operates as an “exchange” as defined under federal securities laws must be registered with the SEC as a national securities exchange or be exempt from registration. An exemption is available for an alternative trading system which is registered with the SEC as a broker-dealer and becomes a member of a self-regulatory organisation such as the Financial Industry Regulatory Authority (FINRA). FINRA has reportedly only approved a few of the many crypto broker-dealer applications it has received. This is comparable to Hong Kong’s current approach, with the SFC licensing exchanges which trade at least one security token.
Crypto trading platforms are also regulated by other agencies at both federal and state levels, for example a crypto exchange may be subject to regulation by the CFTC if it permits certain regulated commodities transactions or swaps in crypto-assets. FinCEN also requires businesses involved in buying cryptocurrency from or selling it to customers or transferring cryptocurrency on behalf of customers to register with FinCEN as money services businesses.
The latest statement from the SEC came on 23 December 2020 when a statement was issued regarding the custody of digital asset securities by broker-dealers and compliance with Rule 15c3-3 (the Customer Protection Rule). The SEC has long questioned whether digital asset custodians can effectively comply with the Customer Protection Rule and broker-dealer custody was therefore prohibited. The statement is therefore a huge breakthrough as it provides a path for crypto-focused broker-dealers (operating in certain circumstances) to operate free from a possible SEC enforcement action on the basis that the broker-dealer deems itself to have obtained and maintained physical possession or control of customer fully paid and excess margin digital asset securities. The statement is effective for a period of five years while the SEC determines how best to regulate this area.
New rules for crypto wallets were proposed by the FinCEN on 18 December 2020). Following President Biden taking office in mid-January, the proposals were frozen (effected by a general freeze placed on all FinCEN rule making pending review). It is understood that the freeze is not so much aimed at halting the substance of the rules but ensuring that Biden’s appointees have sufficient time to review the rules, with the freeze being effective for at least 60 days from 20 January 2021. The crypto market does however seem optimistic about a clear regulatory framework under the newly elected president.
The new rules are aimed at addressing AML “gaps” in digital asset transactions by imposing obligations on Virtual Asset Service Providers (VASPs). VASPs would be required to record the name and address of wallet owners in the case of deposits and withdrawals exceeding US$3,000 where a non-custodial wallet is involved and VASPs would be required to report any deposit or withdrawal greater than US$10,000 to FinCEN through a currency transaction report (CTR). This would broaden the current AML regime, which only sees record-keeping and reporting requirements imposed on VASP-to-VASP transactions. While different in scope, the focus on tightening AML regulation is also in focus in Hong Kong, which has recently proposed amendments to the AMLO to subject virtual asset exchanges which are not licensed under the SFO to the AML requirements in Schedule 2 of the AMLO.
Criticisms have been voiced by various parties, including eight congress members who sent a letter to the US Treasury Secretary expressing their concerns. It has been argued that VASPs will face practical difficulties obtaining the required information and that it will adversely impact the effectiveness of existing AML regulation, or may simply not tackle the very risks they are seeking to tackle. For example, the new rules may easily be evaded by breaking transactions up into smaller amounts. Others went so far as to suggest that the proposed rules would put a brake on development of the industry in the US completely.
This proposal goes further than the FATF Travel Rule (which we discussed in an earlier webinar) which imposes requirements in relation to the collection, disclosure and transfer of beneficiary information when a VASP is transacting with another VASP.
SEC Statement on “Framework for ‘Investment Contract’ Analysis of Digital Assets
As outlined above, there were a number of SEC enforcement actions involving ICOs which were found to be public offerings of securities conducted in breach of the US Securities Act 1933 since they were neither registered with the SFC nor able to rely on an exemption from the registration requirement. In April 2019, the SEC then issued a Statement on “Framework for ‘Investment Contract’ Analysis of Digital Assets providing guidance on when the offering and sale of a virtual asset will be considered to be an investment contract, and therefore a security. The framework applies the Howey Test (a test to determine whether certain transactions are “investment contracts”) which focuses not only on the form and terms of the virtual asset, but also the surrounding circumstances and the manner of offering, selling and reselling. This is similar to the approach in Hong Kong, where the regulatory treatment of ICOs is also determined on a case-by-case basis depending on an analysis of whether cryptocurrencies are regarded as securities under the SFO. However the issue of whether a cryptocurrency is a “security” has not yet come before the Hong Kong courts.
The most problematic of the Howey test’s three requirements is usually the “reasonable expectation of profits derived from the efforts of others” prong. This gives rise to three main inquiries.
whether (a) a purchaser relies on the efforts of others, in particular the efforts of an active participant (AP) such as a promoter or other third party; and (b) whether those efforts are “undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise”.
the active participant is responsible for the development, improvement or enhancement, operation, or promotion of the network. If the network or virtual asset is still in development or not fully functional at the time of the offer or sale, purchasers would reasonably expect an active participant to further develop the functionality of the network or virtual asset;
essential tasks or responsibilities will be performed or are expected to be performed by an active participant;
the active participant supports or creates a market for, or the price of, the virtual asset;
the active participant plays a leading or central role in decision making or judgement exercising concerning the network or characteristics or rights of the virtual assets;
purchasers reasonably expect the active participant to undertake efforts to promote its own interests and enhance the value of the network or virtual asset.
reasonable expectation of profits – profits can include capital appreciation resulting from the development of the initial investment or business enterprise or a participation in earnings resulting from the use of purchasers’ funds.
rights for holders of the virtual asset to share in the enterprise’s income or profit or to realise gain from capital appreciation of the virtual asset;
the opportunity may result from appreciation in the value of the virtual asset that comes, at least partly, from the operation, improvement or other positive developments in the network, particularly if there is a secondary market that enables virtual asset holders to realise a gain on reselling their virtual assets;
present or future transferability or tradability of the virtual asset on a secondary market or platform;
purchasers’ reasonable expectation that an active participant’s efforts will lead to the virtual asset’s capital appreciation and the realisation of a return;
the virtual asset is offered broadly to potential purchasers rather than being targeted at expected users of the goods or services or those with a need for the network’s functionality;
there is little correlation between the virtual asset’s purchase/offering price and the market price of the goods or services that can be acquired in exchange for the virtual asset;
the virtual asset is marketed in a way that indicates that the virtual asset is an investment or that the holders will be investors or that the proceeds from the sale of the virtual asset will be used to develop the network or virtual asset; and
marketing the virtual asset in a way that emphasises the potential appreciation in the value of the virtual asset or the potential profitability of the network or the availability of a market for trading the virtual asset, particularly where the active participant promises to create or support a trading market for the virtual asset.
the transaction’s economic reality and whether the virtual assets are offered and sold for use by the purchaser. The Howey test is unlikely to be met where the following factors are present:
the distributed ledger network and virtual asset are fully developed and operational;
the virtual asset can be used immediately for its intended functionality on the network;
the virtual asset’s design meets the needs of users and does not encourage speculation as to its value or the network’s development;
the ability of a virtual asset (which is proposed to be a virtual currency) to be used to make payments in different contexts or to act as a substitute for real currency;
the ability of the virtual asset to be redeemed within a developed network or platform for the goods or services.
Where the following factors are present, the more likely it is that a virtual asset purchaser relies on the efforts of others:
Examples of characteristics giving rise to a reasonable expectation of profits include (among others):
Turnkey Jet no action letter
The SEC guidance was released in conjunction with a no-action letter which was sent to Turnkey Jet, Inc. in April 2019 by FinHub’s Chief Legal Advisor agreeing that the tokens used by the business travel start-up were not securities. The reasons given were that (a) the funds raised through token sales would not be used to develop the TKJ Platform, Network or App, all of which would be fully developed and operational by the time the Tokens were sold; (b) the Tokens had an immediate use at the time of the token sale; (c) the Token price was fixed at one USD; (d) the Tokens could only be used for air charter services (e) repurchases would only be made at a discount to the Token price; (e) Turnkey Jet marketed the Tokens in a manner emphasising their functionality rather than potential increase in value; and (f) the Tokens were transferrable only to TKJ wallets and not to wallets outside the network. According to FinHub’s division head, this decision was “easy” to reach as the “the tokens were clearly not intended to be securities”.
The restrictions outlined in the no-action letter mean that it is unlikely to be of benefit to most ICO issues, i.e. those where the funds are used to develop the network and the tokens only have a future use. Another company whose ICO fell foul of US securities laws is ShipChain which was fined US$2.05 million in December 2020 for an ICO conducted in 2017-2018.
In Hong Kong, there have been two statements issued by the SFC relating to STOs (the March 2019 statement on security token offerings) and ICOs (the September 2017 statement on initial coin offerings). However, these are far less detailed than the US SEC’s statement and, except for virtual assets which are essentially digital version of traditional securities (shares, debentures or interests in a fund) provide no real guidance on the circumstances which are likely to make a virtual asset a security. Although the SFC has given general warning statements about ICOs possibly being regarded as securities offerings, it has not specified the particular features which would bring an ICO within the definition of a “security”.
SEC Joint Statement on Activities involving Digital Assets
In October 2019, the U.S. Commodity Futures Trading Commission (the CFTC), the FinCEN and the SEC issued a joint statement to remind persons engaged in activities involving digital assets of their anti-money laundering and counter terrorist financing obligations under the Bank Secrecy Act.
The Bank Secrecy Act (BSA) applies to “financial institutions” such as futures commission merchants and introducing brokers who are required to register with the CFTC; money service businesses as defined by the FinCEN; and broker-dealers and mutual funds obliged to register with the SEC. In the case of financial institutions subject to the BSA, the AML/CFT obligations extend to digital asset activities.
In the US, where a person falls within the definition of a “financial institution,” that person’s AML/CFT obligations under the Bank Secrecy Act will be overseen by either the U.S. CFTC, the FinCEN, or the SEC depending on the activities carried out by the “financial institution.” For example, the AML/CFT activities of a money services business will be overseen by the FinCEN while the AML/CFT activities of a futures commission merchant will be overseen by the Commodity Futures Trading Commission, the Financial Crimes Enforcement Commission and the National Futures Association.
For those who are not regulated (“unregulated individuals and entities”), the digital assets must be carefully analysed in order to assess whether the digital assets are regulated financial assets and whether the digital asset activities would cause them to meet the definition of a financial institution under the BSA (i.e. brokers who do not typically deal with transactions in securities, need to carefully analyse whether the digital assets they transact with are considered securities). The SEC outlined in the joint statement that it is ultimately the facts and circumstances underlying the asset, activity or service, including its economic reality and use, that determines the general categorisation of an asset, the regulatory treatment of the activity and whether the persons involved are financial institutions for the purposes of the Bank Secrecy Act.
Among the AML/CFT obligations which the relevant entities are required to meet is the requirement to establish and implement an effective AML program and record keeping and reporting requirements, including suspicious activity reporting.
The Joint Statement notes that a key factor used to determine whether and how a person must register with the CFTC, FinCEN or the SEC is the nature of the digital asset-related activities that a person engages in. For example, certain “commodity” related activities may trigger registration and other obligations under the Commodity Exchange Act while other activities which involve a “security” may trigger registration and other obligations under the federal securities laws of the U.S.
To date, the SEC has rejected all cryptocurrency ETF applications, citing concerns relating to market manipulation, price volatility, hacking, and custody.
Bitwise would have been the first ever Bitcoin ETF had it been approved by the SEC. However, early last year, Bitwise Asset Management withdrew its application with the SEC for its proposed Bitcoin ETF. One of the biggest obstacles faced by Bitwise was the problem of market manipulation. Bitwise went to great lengths to address the SEC’s concern over market manipulation arguing that the volume data reported by virtual asset exchanges is inaccurate and actual volume is far lower than reported volume; the nature of bitcoin makes it resistant to manipulation since Bitcoin’s price is set on an open market with a global price and the fractured market provides an obstacle to manipulation to the extent there is no central market. Bitwise also emphasised that concerns regarding custody can be dealt with using Cold Storage which involves the creation of private keys on devices not connected to internet and offline storage – pointing out that none of the Bitcoin hackings involved cold storage and further pointed to the existence of regulated, insured third party custodians. Nonetheless, the SEC rejected Bitwise’s application, although the SEC did say that it was going to review the rejected application. Despite this, Bitwise Asset Management still withdrew its application but stated that they remain committed to developing a bitcoin exchange traded product.
Following the recent price surges in Bitcoin, there has been renewed interest in Bitcoin ETFs. On 30 December 2020, VanEck filed an application with the SEC for the VanEck Bitcoin Trust which would invest in bitcoin. This is Van Eck’s third application to date, with the last proposal being a bitcoin futures ETF. On 22 January 2021, Valkyrie Digital Assets, a crypto subsidiary of Valkyrie Investments, then filed an application with the SEC for a Bitcoin ETF. Valkyrie would trade on NYSE Arca and Xapo would custody the Bitcoin, according to the proposal. While the likelihood of the applications being accepted are unclear, it is evident that the environment is now more favourable given the recent growth in the bitcoin market, increased institutional interest and confirmation from the Office of the Comptroller of Currency in July 2020 that federally chartered banks can provide custody services for crypto assets. Additionally, there has been a change in administration at the SEC and in the White House. Gary Gensler has been nominated as the next SEC chair – Gensler is known to be more “crypto-friendly” – and this has imparted hope with some stating that a US Bitcoin ETF is expected in 2021 if Gensler is confirmed as Chair.
In Hong Kong, while distinct from an ETF, the SFC approved Hong Kong’s first-ever bitcoin index fund (designed for institutional investors) in April 2020. The fund was launched by Arrano Capital, the blockchain arm of Venture Smart Asia, and is aiming for a target first-year size of US$100 million (or Hk$780 million).
Virtual Asset Exchanges
Jurisdictions are now required to apply relevant measures under the FATF Recommendations to virtual assets and VASPs. Recommendation 15 explicitly sets out that countries should ensure VASPs are regulated for AML/CFT purposes, and licensed or registered and subject to effective systems of monitoring to ensure compliance with the FATF Recommendations. This recommendation is aimed at preventing the misuse of virtual assets for ML/TF purposes.
The FATF undertook a review after it issued its new guidelines in June 2019 with respect to crypto currency exchanges. The FATF Report on the US found that the US was largely compliant with the FATF Recommendations, stating that:
most of the convertible virtual currency exchanges, administrators and other similar entities are regulated in the US as money transmitters or money service businesses under the Bank Secrecy Act and as such, these entities have to implement AML/CFT programmes;
banks and other persons registered with or regulated by the SEC and CFTC, that engage in transactions denominated in value that substitutes for currency will be subject to the Bank Secrecy Act regulations; and
money service businesses must register with FinCen and renew every two years. In addition, money service businesses must be licensed at the state level. This position differs from Hong Kong where crypto exchanges will currently only be licensed under the Securities and Futures Ordinance where they trade virtual assets that are “securities” or “futures contracts”. These exchanges are subject to the AML and CFT obligations set out in the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (AMLO). Exchanges which trade virtual assets that are not securities will however be required to be licensed and comply with AML and CFT obligations if the FSTB’s November 2020 proposals for these exchanges to be licensed under the AMLO are implemented. Crypto exchanges cannot be licensed as money service operators in Hong Kong.
Ultimately, the FATF noted that the US has met most of the new criteria of Recommendation 15 and that US authorities understand and are aware of the ML/TF risks relating to virtual assets. It considered that the five classes of VASPs were covered under a combination of various pieces of US legislation. However, the FATF found that the definition of VASP does not explicitly include all VASPs solely incorporated in the US but not performing any activity relating to US persons or having a US nexus. As for Hong Kong, a new licensing regime for virtual assets exchanges has been proposed under the AMLO, a regime which aims to implement FATF recommendation 15 in relation to virtual asset exchanges. However, Hong Kong’s proposals are noticeably narrower than FATF’s requirements as they will not cover other categories of VASPs included in the FATF’s definition, such as businesses which provide crypto custody services without operating a crypto exchange platform.
US State Legislation
There is also regulation at the state level in the US. Each of the US states has its own State securities and financial services regulator and many have adopted regulations in relation to crypto currencies. New York has been the most active in terms of regulation, requiring any person (whether an individual or a company) engaging in Virtual Currency Business Activity to obtain a BitLicense. Virtual Currency Business Activity can fall into one of five types of activities involving New York or New Yorkers:
receiving virtual currency for transmission or transmitting virtual currency;
storing, holding, or maintaining custody or control of virtual currency on behalf of others;
buying and selling virtual currency as a customer business;
performing exchange services as a customer business; or
controlling, administering, or issuing a virtual currency.
In the State of New York, virtual currency is defined as: “any type of digital unit that is used as a medium of exchange or a form of digitally stored value” and is “broadly construed to include digital units of exchange that: (i) have a centralised repository or administrator; (ii) are decentralised and have no centralised repository or administrator; or (iii) may be created or obtained by computing or manufacturing effort.”
This definition specifically excludes digital units that (i) are used solely within online gaming platforms, (ii) have no market or application outside of those gaming platforms, (iii) cannot be converted into, or redeemed for, fiat currency or virtual currency and (iv) may or may not be redeemable for real-world goods, services, discounts, or purchases. It further excludes digital units as part of prepaid cards and digital units that can be redeemed for goods, services, discounts, or purchases as part of a customer reward program with the issuer but cannot be converted into, or redeemed for, fiat currency or virtual currency. This is broadly comparable to Hong Kong’s definition of virtual assets.
Licensees are also required to satisfy certain compliance requirements including a minimum capital requirement and anti-money laundering and know-your client obligations. Entities that hold virtual currencies for third parties must hold them on trust with an approved custodian. Depending on their activities, entities holding a Bitlicense may also be required to obtain a New York money transmission licence.
As of 19 June 2020, the State of New York had 25 regulated entities, including Hong Kong-based XAPO Holdings, which was granted a Bitlicense in June 2018.
The Bitlicense has been controversial and a number of crypto businesses left the state citing overly burdensome disclosure requirements and regulatory requirements. This sentiment compares to the current regulatory requirements for the licensing of trading platforms and exchanges in Hong Kong which have also been viewed as excessively burdensome and the first licence for a crypto exchange was only granted in December 2020.
It is also important to note that legislation at the state level in the US differs from state to state which means that businesses with customers in multiple states have to comply with a number of inconsistent, and often burdensome, state money transmission laws. Further, since all virtual assets are treated as currency, the laws potentially apply to all issuers of tokens that have value, and anyone facilitating trading in them.
Proposed Cryptocurrency Act 2020
The Cryptocurrency Act of 2020 was introduced in Congress in March 2020. The aim of the Act is to clarify which federal agencies regulate which type of crypto assets, and to require those agencies to clarify licensing conditions and registration requirements. To date, the only progress is a referral of the bill to the Committee on Financial Services and the Committee on Agriculture. Media reports have suggested that this proposed Act should not be considered a serious legislative attempt as it lacks thorough understanding of the current legislative regime.
The bill defines “crypto-commodity,” “crypto-currency,” and “crypto-security,” proposing that the CFTC be the primary regulator of crypto-commodities, the FinCEN and the Comptroller of the Currency be the regulators of cryptocurrencies, and the SEC be the regulator of crypto-securities and “synthetic stablecoins.” The bill also proposes that FinCEN “shall issue rules to require each crypto-currency (including synthetic stablecoins) to allow for the tracing of transactions in the crypto-currency and persons engaging in such transactions in a manner similar to that required of financial institutions with respect to currency transactions.” Moreover, FinCEN “shall carry out audits of each reserve-backed stablecoin to ensure that each stablecoin is fully backed by currency issued by the United States or a foreign government.”
On the topic of stablecoins, the US President’s Working Group on Financial Markets issued a statement on key regulatory and supervisory issues relating to stablecoins on 23 December 2020 stating that stablecoin arrangements must comply with applicable US legal, regulatory and oversight requirements and emphasising that providers must meet all applicable AML/CFT obligations before products are brought to market. As for the regulation of stablecoins in Hong Kong, they generally fall outside the scope of the SFC’s regulatory ambit, however the FSTB’s proposed definition of virtual assets specifically provides for the inclusion of stablecoins, so provided that the virtual asset business falls under the definition of VASP, the licensing regime will apply.
- C. R. Goforth. “US Law: Crypto is Money, Property, a Commodity, and a Security, all at the Same Time” available at https://ssrn.com/abstract=3272975.