Over the last year we have seen an awkward dance of U.S. government engagement in the cryptocurrency space. However, over the course of one hot July week, we saw all three branches engage in significant, and potentially transformative, ways that could have a lasting impact on the future of crypto policy making in America.
The Judicial Branch Finds That Not All Token Are Securities
First, on Thursday July 13, the judiciary stepped into the fray when the U.S. District Court for the Southern District of New York granted partial summary judgment in favor of Ripple, in its litigation with the SEC, holding that the company did not violate the Securities Act by selling its XRPXRP token on public exchanges.
What does the decision mean for the future of crypto regulation in the United States? Attorney Kayvan B. Sadeghi of Jenner & Block told me, “The Ripple decision will have far reaching effects on the SEC’s crypto enforcement agenda for the foreseeable future. The court clearly rejected a core tenet of the SEC’s effort to regulate crypto secondary markets. The SEC cannot simply treat tokens as securities.”
Regardless of the partial nature of the win in which the Court found that XRP sales constituted securities transactions when the sale is accompanied with specific promises tying the future performance of the token with the seller’s actions as a part of an investment contract, the Court’s decision potentially began the process of clearing up a question that has plagued crypto in the U.S. for years – that is, how do we define certain digital assets and what financial regulator, if any, will have jurisdiction. For Sadeghi, an expert on legal issues in the crypto space, this decision could kick things over to the legislative branch.
“Hopefully this decision will help everyone realize that the best path forward is responsible legislation tailored to this asset class,” Mr. Sadeghi added.
The Legislative Branch Releases New Crypto Oversight Bill
The courts were not the only branch exploring the issue of who may regulate the crypto space last week. On Wednesday July 12, Senators Cynthia Lummis, a Republican from Wyoming, and Kristen Gillibrand, a Democrat from New York, relaunched cryptocurrency legislation that would hand primary oversight of digital assets to the Commodity Futures Trading Commission.
Interestingly, the bill, like the District Court decision in Ripple, states broadly that assets that don’t give an investor a clear financial interest in a business should not be considered securities even if they “benefit from entrepreneurial and managerial efforts that determine the value of the assets.” The bill, therefore, puts oversight of most crypto tokens within the purview of the CFTC.
While the bill calls for customer assets to be fully segregated, stablecoins to be issued only by regulated financial institutions, and, for the first time, addresses decentralized finance, the hallmark of the bill is its attempt to separate CFTC and SEC regulatory duties.
In addition to the Lummis/Gillibrand bill there also appears to be movement on stablecoin legislation from the House Financial Services Committee. As Ron Hammond, Director Of Government Relations at Blockchain Association, told me, “Nearly 6 years after the first bipartisan crypto bill was introduced in Congress, it seems the House Financial Services Committee is slated to advance comprehensive legislation on stablecoins and market structure.” Mr. Hammond highlighted the bi-partisan nature of the work and signaled the importance of things moving from the executive branch to the legislative branch, “Congress understands that regulation by enforcement and a patchwork of court decisions are no substitute for a clear legislative framework,” he added.
The Executive Branch Focuses On Criminal Abuse Of NFTs and DeFi
While executive branch action in the crypto space is most associated with a litany of enforcement actions – including the SEC’s case against Ripple – we have also seen law enforcement continue to go after criminals seeking to use cryptocurrencies to launder illicit proceeds. Last week, the United States Attorney’s Office for the Southern District of New York brought key cases against illicit actors who have attacked and abused the cryptocurrency ecosystem.
First, on Monday July 10, the U.S. Attorney’s Office and the FBI announced the indictment of a Moroccan man for stealing over $450,000 in crypto and NFTs by spoofing the NFT marketplace OpenSea. According to the indictment, the spoofed website was purposefully designed to look like the legitimate OpenSea login page in order to trick unsuspecting victims into thinking they were interfacing with the real OpenSea. However, when victims entered their login credentials or other private information on the spoofed site, their credentials were automatically sent to an email account controlled by the defendant allowing the defendant to steal crypto and NFTs. One victim from New York unwittingly provided the defendant access to 39 NFTs including a valuable “Bored Ape Yacht Club” NFT.
The next day, on Tuesday July 11, the U.S. Attorney’s Office, alongside Homeland Security Investigations and IRS-Criminal Investigations, announced the indictment and arrest of a trained security engineer in the first criminal case involving an attack on a smart contract operated by a decentralized exchange. The hacker exploited a vulnerability in one of the exchange’s smart contracts stealing approximately $9 million.
The case is unique in a number of ways. First, it is the first criminal prosecution of a DeFi hack. Second, it is rare to make an arrest in this sort of cyberattack given that many cybercriminals reside in rogue states like Russia or North Korea as opposed to New York City where the arrest in this case took place.
Finally, the case is notable for the sophistication of the attack, the laundering and the law enforcement response. The defendant allegedly exploited the smart contract associated with the exchange by providing false data to make it appear that he had supplied a large volume of liquidity to the exchange, which he had not actually done. As a result, the defendant fraudulently received substantial fees from the target. Additionally, after figuring out how to exploit the exchange’s smart contract, the defendant allegedly used funds from “flash loans” to make a series of deposits into the exchange, generating additional fraudulent fees. The defendant then created another fraudulent account on the exchange and further manipulated the smart contract so he could quickly withdraw the principal funds from the exchange. The defendant then laundered the funds across chains, through mixers, privacy coins and other obfuscation techniques.
However, law enforcement was able to use blockchain intelligence to track and trace the funds building to a warrant where authorities were able to obtain off chain information such as web searches – the defendant searched “can I cross border with crypto,” “how to stop federal government from seizing assets,” and “buying citizenship”; and he visited a website titled “16 Countries Where Your Investments Can Buy Citizenship . . .” – connecting him to the crime.
While each of these cases would have been significant in their own right, they are extraordinary in combination. The cases involve emerging technology – DeFi and NFTs – and demonstrate a U.S. law enforcement commitment to ensure that illicit actors don’t take advantage of the cryptocurrency space. The cases also show a clear move from BitcoinBTC to a more diverse and complex ecosystem of illicit actors attacking DeFi and moving funds across blockchains.
Most importantly, however, perhaps these cases, and the continued effort by law enforcement and regulators to go after the illicit underbelly of the crypto ecosystem, previews a future in which legislation – like Lummis/Gillibrand and stablecoins – and court decisions like Ripple combine to build a legal framework as DOJ, Treasury and others focus on illicit actors who seek to undermine this new financial system.
While we are in for years of appeals in the Ripple case and seemingly endless debate and discussion over Lummis/Gillibrand, stablecoins and beyond, there is no doubt that one hot July week, in which each branch of the U.S. government dug into key questions around cryptocurrencies, could have a lasting impact on an ever evolving space.
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