Blockchain Trends And Developments In The USA - Fin Tech

Blockchain in the USA - an Introduction

The global pandemic presented significant opportunities - and potential pitfalls - in the ever-expanding blockchain universe. As the world continues to fight the grasp of COVID-19, we appear to be entering a time of even greater economic uncertainty, due in part to global inflation, supply chain breakdowns, severe political polarisation and war. Even against this backdrop, three trends and developments are expected to continue shaping the blockchain and digital asset landscapes in the year ahead:

burgeoning NFT enforcement;
continued focus on sanctions enforcement, particularly with respect to Russia; and
continued interagency turf battles, even amidst greater efforts at US government co-ordination.

Burgeoning NFT Enforcement

While blockchain and cryptocurrencies have steadily matured into the mainstream over the past decade, there is a relatively new digital asset on the block: non-fungible tokens (NFTs). Just as crypto was met with massive regulatory uncertainty in its infancy, NFTs are now experiencing the same growing pains. Although NFTs and the concept of tokens representing unique physical assets have existed in some form since at least 2014, the NFT market exploded in 2021, generating an estimated USD25 billion in sales in that year alone. That extraordinary growth and the continuing evolution of NFT applications present new challenges for state and federal regulators, who are just beginning to scrutinise NFT transactions through the lens of existing regulations.

NFTs are not only individually unique assets - they are also unique in the digital asset world, which means a number of complex legal regimes can apply to their creation, sale and exchange. In many instances, the application of such regimes to NFTs can resemble a square-peg-round-hole exercise. To assess the applicability of the various legal regimes, several critical questions must be asked (for an analysis of these questions in the retailer context, see "NFTs for Retailers: A World of Promise and Peril" (12 January 2022), available at www.steptoe.com).

First and foremost, is your NFT a security?
Will the issuance, sale or exchange of NFTs make you a "money transmitter" subject to Financial Crimes Enforcement Network (FinCEN) requirements and state laws?
Is your NFT a commodity subject to Commodity Futures Trading Commission (CFTC) regulation?
Could your NFT project implicate economic sanctions laws?
Do intellectual property laws apply?

While the Securities and Exchange Commission (SEC) has aggressively sought to enforce the federal securities laws against issuers of other digital assets, it has not yet initiated an enforcement action against the creator of an NFT or the operator of a platform that facilitates the sale of NFTs. But such enforcement seems inevitable and even imminent, in light of the skyrocketing consumer interest in NFTs and the increasing complexity of NFT transactions. Indeed, the SEC is reportedly investigating NFT creators and marketplaces for potential securities violations, including issuing demands for information on specific NFTs and other token offerings to assess whether "certain non-fungible tokens... are being utilised to raise money like traditional securities" (see www.bloomberg.com). The SEC is reportedly also taking a particular interest in how fractional NFTs are being utilised.

Although the SEC has not yet taken formal action, there have been some recent public actions by other agencies. For example, on 24 March 2022, a government task force (including the Department of Justice (DOJ), Internal Revenue Service (IRS), US Department of Homeland Security and US Postal Inspection Service) brought charges against two individuals for conspiracy to commit wire fraud and money laundering in connection with an alleged million-dollar NFT fraud. According to the complaint, the defendants promised that purchasers of their "Frosties" NFTs would be eligible for certain holder rewards, including giveaways, early access to a metaverse game and exclusive mint passes for upcoming seasons. However, rather than providing the benefits advertised to the NFT purchasers, the defendants transferred the proceeds to various digital wallets under their control - an alleged example of what is often characterised as a "rug pull", a scam in which a developer promotes a token or other crypto project to purchasers but absconds with the proceeds. According to Chainalysis, "rug pulls" resulted in USD2.8 billion in losses in 2021, representing 37% of all money lost in crypto-related scams (see blog.chainalysis.com).

In addition, at the state level, Texas and Alabama regulators recently issued unprecedented cease-and-desist orders against a Cyprus-based group selling NFTs to fund the development of virtual casinos in the metaverse. The state regulators allege that the activity constituted sales of unregistered securities because the NFTs entitle owners to various benefits, including a pro rata share of profits generated by the casinos. According to a statement issued by the Texas State Securities Board, the company and its founders marketed their NFTs - which they named "Gambler" and "Golden Gambler" - as investment opportunities and promised potential buyers a share in virtual casino profits, forecasting as much as USD81,000 annually. The statement further claims that the company told potential buyers that its NFTs were not regulated as securities because securities laws did not apply to NFTs.

Continued Focus on Sanctions Enforcement

There is a continuing push by federal regulators to prevent the use of cryptocurrencies to circumvent US sanctions, or evade them entirely. These efforts have come into even greater focus in 2022 with Russia's invasion of Ukraine. Lawmakers and regulators have expressed concern that cryptocurrencies could be used by Russian actors to evade sanctions against the Russian Federation and associated individuals. Despite a strong desire by federal regulators to prevent attempts to circumvent sanctions using cryptocurrencies, their ability to do so remains limited, leading to an increased reliance on the private sector to identify evaders, with its greater sophistication and access to information.

Regulatory response to Russian sanctions

In direct response to the invasion of Ukraine in late February 2022, the US government issued a wide range of new sanctions and export control measures targeting Russia. Federal regulators - particularly those within the DOJ and the Department of the Treasury - have since taken steps to clarify and flex their authority to enforce sanctions compliance with a crypto nexus.

For its part, the DOJ has indicated that it will focus enforcement efforts on any use of cryptocurrencies to evade sanctions. On 2 March, the Attorney General announced the launch of Task Force KleptoCapture, an interagency law enforcement task force dedicated to enforcing Russia-related sanctions and restrictions. The mission of the Task Force includes "targeting efforts to use cryptocurrency to evade US sanctions, launder proceeds of foreign corruption, or evade US responses to Russian military aggression." Moreover, sources inside the department have indicated that the DOJ will also investigate and prosecute cryptocurrency exchanges, among other entities, that enable (even unknowingly) wealthy Russians to hide or launder their assets.

The Treasury Department has been active as well. For example, on 11 March, the Office of Foreign Assets Control (OFAC) issued FAQ 1021, reiterating that the prohibitions contained in the Russia Harmful Activities Sanctions Regulations and other Russia-related sanctions apply to virtual currency transactions. FAQ 1021 warns that "OFAC is closely monitoring any efforts to circumvent or violate Russia-related sanctions, including through the use of virtual currency, and is committed to using its broad enforcement authorities to act against violations and to promote compliance."

FAQ 1021 further explains that all US persons (including virtual currency exchanges, virtual wallet hosts and other service providers, such as those that provide nested services for foreign exchanges) are generally prohibited from engaging in or facilitating prohibited transactions, including virtual currency transactions in which blocked persons have an interest, and transactions involving the Central Bank of the Russian Federation, the National Wealth Fund of the Russian Federation or the Ministry of Finance of the Russian Federation.

Likewise, on 7 March, FinCEN issued an alert warning US financial institutions about the efforts of foreign actors to evade US economic sanctions and trade restrictions related to Russia and Belarus, and the increased risk of Russia-related ransomware campaigns. FinCEN acknowledged that it is unlikely that the Russian government can use cryptocurrency to mitigate or circumvent the impact of sanctions in any meaningful way, and FinCEN has not yet seen any examples of such activity.

However, the alert specifically addresses the potential use of "convertible virtual currency" (CVC) for sanctions evasion and Russia-related ransomware attacks, and provides instructive red flags, which are of particular relevance for money services businesses (MSBs) and other FinCEN-regulated financial institutions undertaking CVC transactions. The alert warns that sanctioned persons, illicit actors and their networks or facilitators may attempt to use CVC and anonymising tools to evade sanctions and protect their assets around the globe.

Accordingly, FinCEN strongly encourages financial institutions that have information pertaining to CVC flows, including exchangers or administrators of CVC, to:

be mindful of efforts to evade expanded US sanctions and export controls related to Russia and Belarus;
submit Suspicious Activity Reports (SARs) as soon as possible for any such conduct;
undertake appropriate risk-based due diligence of customers;
voluntarily share information with other financial institutions consistent with Section 314(b) of the USA PATRIOT Act; and
consider using tools to identify assets that must be blocked or frozen under applicable sanctions.

OFAC sanctions guidance

Prior to Russia's invasion, in October 2021 OFAC published sanctions compliance guidance for the virtual currency industry, stressing that "the growing prevalence of virtual currency ... brings greater exposure to sanctions risk." Coming in the immediate wake of the Anti-Money Laundering Act of 2020, and in the context of the US government's effort to curb ransomware attacks, the guidance is the latest indication that regulators are increasingly focused on cryptocurrencies in the context of sanctions compliance and enforcement. It seeks to help companies comply with OFAC rules, not only by explaining sanctions requirements and procedures, but also by setting forth best practices for compliance.

As a threshold matter, OFAC makes it clear that cryptocurrency companies conducting business in the US are treated the same as any other US company transacting in traditional currencies when it comes to compliance with OFAC sanctions. The guidance outlines the obligations that exist with respect to blocking, rejecting and reporting transactions where sanctioned parties are involved. The guidance also explains that, while failure to comply could lead to penalties, co-operation with OFAC and efforts to build a compliance programme would be mitigating factors when determining penalties for potential violations.

Consistent with the OFAC framework issued in May 2019, the best practices guidance offers a five-pronged approach when developing an adequate compliance programme, including the following basic components, each of which are described in some detail in the guidance:

management commitment;
risk assessment;
internal controls;
testing/auditing; and
training.

In light of the ever-growing role that digital assets play in the global economy and the consequences for sanctions compliance, OFAC's guidance stresses that all companies participating in the virtual currency industry, or that are otherwise exposed to virtual currencies, should have a "risk-based" sanctions compliance programme.

Continuing Agency Turf Battles Despite Efforts to Increase Co-ordination

While it is a commonly cited myth that the digital asset space is the "wild west", the reality is quite different. Far from having no sheriff in town, there are actually multiple sheriffs in town, each vying for control over its turf - or its perceived turf.

While the SEC aggressively pursues regulation of cryptocurrencies as securities, the CFTC thinks they are commodities and digital asset derivatives. Whereas FinCEN treats cryptocurrencies as the functional equivalent of money, a separate branch of the Treasury, the IRS, believes they should be treated as a form of property. Even the Federal Deposit Insurance Corporation (FDIC) has laid at least some claim to regulatory authority over stablecoins and their issuers.

And more sheriffs are coming. In early November 2021, the President's Working Group on Financial Markets (PWG), the Office of the Comptroller of the Currency (OCC) and the FDIC issued a report calling for legislation that would enable federal oversight of stablecoin issuers, custodial wallet providers that hold stablecoins, and others (eg, certain DeFi products, services and arrangements related to stablecoins). The report also indicated that, in the absence of new legislation, federal regulators could step in through the Financial Stability Oversight Council (FSOC), which could designate certain stablecoin activities as "systemically important" payment, clearing and settlement activities, thereby enabling additional federal oversight.

With that many sheriffs seeking to enforce competing sets of rules comes a lack of consistent guidance, clarity and predictability. Cryptocurrency companies - both those wishing to do business in the United States and those seeking to avoid the US market - are faced with an uncertain and frustrating regulatory environment. Despite FinCEN's admirable efforts over the past decade to provide affirmative guidance and advisory opinions to companies operating in this space, most other agencies have unfortunately taken a "regulation by enforcement" approach, which trend is expected to continue in 2022.

There is perhaps no greater example than the SEC, which continues to try to stake its claim as the chief digital asset regulator. Over the course of the last year, the SEC brought more than two dozen enforcement actions, and is seeking additional staffing resources for its crypto enforcement unit. Public statements by SEC Chair Gary Gensler continue to signal an expansive view of the SEC's jurisdiction in the digital asset space. For example, in remarks before the Aspen Security Forum in August 2021, Gensler stated: "I believe we have a crypto market now where many tokens may be unregistered securities, without required disclosures or market oversight... Make no mistake: it doesn't matter whether it's a stock token, a stable value token backed by securities, or any other virtual product that provides synthetic exposure to underlying securities. These products are subject to the securities laws and must work within our securities regime." Moreover, in January 2022, Gensler reiterated the SEC's aggressive stance on crypto-related enforcement, stating: "[T]o the extent that folks are operating outside the regulatory perimeter, but are supposed to be inside, we will bring enforcement actions."

Not to be outdone by the SEC, the CFTC also continues to mark its territory, already bringing a number of enforcement actions in the first half of 2022. In February, Chairman Rostin Behnam - just one month after his swearing in - called on Congress to pass a law that would allow the CFTC to regulate cash markets for certain types of cryptocurrencies, which would supplement the CFTC's existing authority to police the derivatives markets. Notably, Chairman Behnam also suggested that his agency is in a better position than the SEC to regulate tokens such as bitcoin and ether.

But amidst these regulatory turf battles, there appears to be some recognition on the part of the Biden Administration that this regulatory climate fails to serve the interests of industry, the government or the public.

Presidential Executive Order on Digital Assets

On 9 March 2022, the White House issued an Executive Order on Ensuring Responsible Development of Digital Assets, representing the first-ever attempt at a "whole-of-government" approach to examining the risks and benefits associated with digital assets. The Executive Order requires certain federal agencies to broadly review their policies related to digital assets, with a focus on six key areas:

consumer and investor protection;
financial stability;
illicit finance and national security;
US competitiveness within the global financial system;
financial inclusion; and
responsible innovation.

This balancing of competitiveness, inclusion, stability, protection and innovation is noteworthy, and also recognises that digital assets are more than simply investments.

Although the Executive Order does not prescribe any specific policy positions or require agencies to adopt particular rules, it directs a process of agency co-ordination and collaboration to assess digital asset risks and benefits, and associated policy proposals. To that end, the Executive Order requires the production of 14 reports, assessments, frameworks and other written work products, with deadlines ranging from 60 to 210 days. A wide array of government agencies are involved, including the Departments of Commerce, Energy, Homeland Security, Justice, Labor, State and Treasury, as well as the Office of Management and Budget, the Environmental Protection Agency, the CFTC, the Consumer Financial Protection Bureau (CFPB), the FDIC, the Federal Reserve Board of Governors, the Federal Trade Commission, the FSOC, the Office of the Comptroller of the Currency, the Office of Science and Technology Policy, the SEC and White House offices. Notably, the National Security Council and the National Economic Council will co-ordinate these government-wide activities.

Furthermore, the Executive Order addresses several prominent digital asset market areas, including the following.

US Central Bank Digital Currencies (CBDCs): the Executive Order places urgency on the need to explore the development of a potential CBDC - the "digital dollar".
Measures to protect consumers, investors and businesses: the Executive Order calls on regulators to "ensure sufficient oversight and safeguard against any systemic financial risks posed by digital assets", and directs consultation among various cabinet departments, independent regulatory agencies, federal banking agencies and the CFPB in an effort to harmonise regulatory approaches.
Financial stability, mitigating systemic risk and strengthening market integrity: emphasising the critical role financial regulators play in promoting a stable financial system, the Executive Order calls on the Treasury Department to develop policy recommendations on cryptocurrencies and other digital assets to provide oversight protections and safeguard the integrity of financial systems.
Limiting illicit activity: in an effort to deter criminal activity involving digital assets, the Executive Order expresses the need for an "unprecedented focus of co-ordinated action" among federal agencies.
Fostering international co-operation and US competitiveness: the Executive Order emphasises the need to promote the US as a leader in the global financial system, including in the development of digital assets, and tasks the Department of Commerce with establishing a framework to "drive US competitiveness and leadership in, and leveraging of, digital asset technologies."

While the Administration's recognition of the need for a more co-ordinated policy agenda is a positive step, it is critically important that this policy agenda is developed with the benefit of significant industry input. As FinCEN's experience demonstrates, open dialogue with industry fosters more informed, more effective regulation, promotes compliance and public safety, and encourages innovation.

National Cryptocurrency Enforcement Team

On 17 February 2022, the DOJ announced the selection of Eun Young Choi to serve as the first Director of its National Cryptocurrency Enforcement Team (NCET). The NCET, which was established in 2021, "will identify, investigate, support and pursue the department's cases involving the criminal use of digital assets, with a particular focus on virtual currency exchanges, mixing and tumbling services, infrastructure providers, and other entities that are enabling the misuse of cryptocurrency and related technologies to commit or facilitate criminal activity." The NCET will also lead the DOJ's co-ordination efforts with other domestic and international law enforcement partners, regulators and private industry to combat the criminal use of digital assets (see "Justice Department Announces First Director of National Cryptocurrency Enforcement Team" (17 February 2022), available at www.justice.gov).

In the first half of 2022 alone, the DOJ has already announced indictments and guilty pleas in more than ten crypto enforcement actions, ranging from elder financial fraud to fraud involving NFTs. Most notably, in February DOJ announced the arrests of Ilya Lichtenstein and Heather Morgan, a husband and wife duo accused of conspiring to launder the proceeds of 119,754 bitcoin (valued at the time of the couple's arrest at approximately USD4.5 billion) that were stolen during the 2016 hack of Bitfinex, one of the world's largest virtual currency exchanges. At the time of the arrests, the DOJ announced the seizure of more than 94,000 of the bitcoins stolen from Bitfinex during the hack (valued at over USD3.6 billion) - the largest seizure in DOJ history (see "Two Arrested for Alleged Conspiracy to Launder $4.5 Billion in Stolen Cryptocurrency" (8 February 2022), available at www.justice.gov).

Conclusion

The year ahead is expected to bring even greater regulatory and enforcement activity in all corners of the digital asset space, with particular attention focused on NFTs and sanctions-related matters. While the Biden Administration's Executive Order recognises the need for a more co-ordinated US government approach to the digital asset space, the jurisdictional turf battles that have characterised US regulation show no signs of abating, and will continue to be a challenge to industry participants operating, or seeking to operate, in the United States.

Originally Published by Chambers and Partners.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

United States: Blockchain Trends And Developments In The USA