Original Source: Tao of the Metaverse
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（from Introducing the 2022 State of Crypto Report）
Since the Web3 project is based on the characteristics of anonymity and decentralization of the blockchain, and the current application scenarios of the Web3 project are mainly in the financial field or have financial attributes, it is very easy to cause incorrect information between the project party and investors. etc., leading to fraud and market manipulation. What's more serious is that some Web3 project transactions (cross-border transactions) can easily bypass customer verification (KYC) and anti-money laundering (AML) regulations, providing financing channels for criminals and terrorism. These problems have brought unprecedented challenges to the existing financial supervision of the US government.
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1. Regulatory framework during the "Wild West" period
As of the end of 2022, the financial supervision of Web3 digital assets in the United States has not yet formed a unified regulatory framework, presenting a "multiple supervision" situation, and jointly supervised by the federal and state levels of the United States. The current SEC chairman Gary Gensler said at the Aspen Securities Forum in 2021 that the current market situation is somewhat similar to the "Wild West" period [2], calling on Congress to give the SEC more regulatory authority to regulate the market. In general, the main reason for the current regulatory situation is the complexity of Web3 digital assets, which can be summarized as follows:
1. There are many types of digital assets, and the definitions of each department are not uniform. Taking Bitcoin, Ethereum, and other virtual currencies as examples, it involves regulatory entities in different fields such as commodities (CFTC), securities (SEC), currency (FinCEN), and property (IRS).
2. The life cycle of digital assets involves many stages, such as mining, issuance, storage, trading, transfer, lending, derivatives, arbitrage, etc., and the application scenarios of digital assets are also different, such as consumption, investment, money laundering, hacking activities , terrorism financing, etc., all of which cannot be classified into a unified regulatory framework.
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2.1 SEC
The United States Securities and Exchange Commission (SEC) is an independent agency and quasi-judicial agency directly under the US federal government established in accordance with the US Securities Exchange Act of 1934. Supervision and management work is aimed at protecting the interests of investors, promoting the formation of capital, and maintaining the fair and orderly operation of the securities market.
The current chairman of the China Securities Regulatory Commission, Gary Gensler, has repeatedly stated in public that, except for absolutely decentralized virtual currencies such as Bitcoin and Ethereum, the virtual currencies issued by most other projects should be regarded as "securities". Apply for registration with the SEC or apply for an exemption. The purpose of such strict supervision is not to maintain the authority of the institution, but to protect investors, but to enable the industry to develop soundly in the long run. The SEC requires the issuer to disclose complete and non-majorly misleading project information to investors, so as to reduce the information gap between the issuer and investors and protect investors for their investment decisions. The information disclosure system is one of the cores of the Securities Law.
Against this background, the SEC issued a guidance document titled "Framework for "Investment Contract" Analysis of Digital Assets" [3] on April 3, 2019, The purpose is to help issuers or other entities engaged in digital asset business to analyze whether their digital assets belong to "investment contracts" and should be included in the definition of "securities", so that they need to comply with the relevant regulations of the SEC and fulfill their compliance obligations.
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2.1.1 Judging whether it belongs to "securities"
As far as digital assets are concerned, it is crucial to clarify whether the issuance and sale of digital assets are "Investment Contracts", which are included in the definition of "Securities" and are included in the supervision of the SEC scope. When it comes to "securities", it is inevitable to avoid the "Howey Test". The Howey Test is a standard used by the U.S. Supreme Court in its 1946 decision in the case SEC v. WJ Howey Co. [5] to determine whether a particular transaction constitutes an "investment agreement." Section 2 of the U.S. Securities Act of 1933 defines what a "securities" are, a very broad definition that includes stocks, bonds, and other forms of profit-sharing agreements, and it also includes "investment agreements." So, if a particular transaction satisfies the criteria of the Howey test, then the transaction is considered a "securities" under the U.S. legal system and is subject to the relevant provisions of the U.S. Securities Act of 1933 and the Securities Exchange Act of 1934.
In SEC v. WJ Howey Co., Howey devised a business model in which it sold citrus orchard land to a buyer and then leased back the land from the buyer. Howey was responsible for the citrus orchard land. Buyers do not need to take care of the land themselves, and passively share the profits through the operation of Howe. The SEC then sued OmniVision, arguing that the transaction constituted an investment agreement that falls within the category of "securities" as defined by the U.S. Securities Act. The court used the landmark "Howey test" to determine whether the transaction constituted a security.
In short, securities are investors who passively participate in other people's business through money investment, and expect to gain benefits through the efforts of others. If there is no effort or failure of other people's efforts, the investor will face The risk of loss of investment amount (there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others). To judge whether the issuance or sale of virtual currency meets the criteria of the "Howey Test", the SEC also gave the same three conditions in the "Analysis Framework":
1. The Investment of Money. In addition to the conventional definition of "money (usually currency)" that we can understand, other definitions of "money (Money)" specifically specified by the SEC include but are not limited to: (i) investors through the completion of specific tasks (Bounty Program) (ii) Investors receive virtual currency rewards through Air Drop, Because the issuer aims to facilitate the circulation of its virtual currency in this way. It can be seen here that the SEC has expanded the definition of "Money" to meet the different scenarios of virtual currency issuance and circulation.
2. Common Enterprise. Generally speaking, the issuer will issue a white paper to explain its purpose of raising funds, such as building a Layer One public chain, which is the common cause of the investor and the issuer. But for Bitcoin, a project without a specific and clear purpose (common cause), the SEC does not classify it as a "securities."
3. The investment has reasonable expected benefits, and the expected benefits come from the efforts of others (Reasonable Expectation of Profits Derived from Efforts of Others). This has always been the most controversial point, and the SEC gave the following explanations in its "Analytical Framework" to help analyze:
(i) Reliance on the Efforts of Others. The "others" here refer to project parties, promoters or core contributors who have provided important management and business functions for the success of the project? (Active Participant), and this effort will directly affect the success or failure of the common cause, and investors only need to pay money for investment, and do not actually participate in the operation and management of the project. Fortunately, the SEC's interpretation of Active Participant is closer to the centralized project side, rather than the core contributors in the decentralized organization, otherwise it would be terrible!
(ii) Reasonable Expectation of Profits. The SEC pointed out in the analysis framework that if there are the following behaviors, it is likely to meet the definition of "reasonable expected benefits": the capital appreciation of virtual currency, or the holding of virtual currency can enjoy similar dividends, profit distribution, or the virtual currency held is greatly increased. It is beyond the scope of reasonable use by investors, or the project party/AP can profit by holding virtual currency (refer to the subsequent SEC V. LBRY case), or the project party/AP can make virtual currency through direct or indirect marketing value-added behavior.
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Interestingly, a16z pointed out in his article "Principles & Models of Web3 Decentralization" [6] that the Web3 project can achieve legal decentralization (Legally Decentralized) by satisfying the following two points: (i) Information on all operations and management of the project are transparent and available for everyone to check at any time (through a transparent blockchain distributed ledger); (ii) without additional management efforts from a centralized team to drive project success or failure (through smart contracts, decentralized economic model and DAO to achieve). On this basis, if the project proceeds with ICO or similar behaviors, it may be considered that it does not meet the "common cause" proposed in the "analysis framework" and "the investment has reasonable expected benefits, and the expected benefits come from the efforts of others". conditions.
Both the SEC and the federal court have emphasized that the Howey test is flexible enough to accommodate a variety of business models designed to leverage other people's money based on the promise of profits. In other words, the SEC and courts are likely to interpret the facts broadly to ensure that the transaction likely satisfies the Howey test as well as every aspect of the analytical framework. As the court said in the SEC v. WJ Howey Co. case: "For the factual basis, the form can be ignored, and the focus is on the economic model and business model of the project."
Let’s look at a recent case of SEC v. LBRY Inc. [7], the court made a ruling in favor of the SEC, which further expanded the authority of the SEC. LBRY is a decentralized digital content sharing platform. LBRY did not issue its virtual currency through ICO, but retained 40% by itself, and the remaining 60% was used for users of the LBRY ecosystem. Users can purchase and trade on the exchange . The SEC believes that LBRY's handling of its virtual currency meets the definition of a "security." The court also recognized the SEC's point of view and held that: (i) LBRY's public statements made potential investors aware of the objective fact that investing in virtual currencies has potential value;
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2.1.2 Registration or exemption
According to the U.S. Securities Act, there are only two compliance methods for the issuance or sale of all securities: (i) register the securities with the SEC; or (ii) apply to the SEC for exemption from registration of securities. For virtual currency projects that pass the Howey test, the SEC's securities registration is not suitable, because this form will bring huge costs and strict disclosure requirements. Therefore, the SEC's registration exemption has become an ideal compliance path for virtual currency projects. Currently, project parties can register for exemptions in accordance with Regulation D, Regulation A+, Regulation S and other relevant regulations [8].
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Reg S: For issuance outside the United States, one is to issue and trade outside the United States; the other is that the object of issuance must not be a U.S. citizen.
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2.2 CFTC
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As early as 2015, in an enforcement action against Coinflip, Inc. [9], the CFTC defined Bitcoin as a “commodity” under the CEA (CEA Section 1 a ( 9) of the Act defines"commodity" to include, among other things, "all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in." The definition of a「commodity」is broad […] Bitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities.」）。
Coinflip,Inc. operates a bitcoin financial trading platform called Derivabit, which matches bitcoin options contracts for investors. During the operation period, it failed to comply with the CEA and CFTC regulatory requirements to fulfill its compliance obligations, and was punished by the CFTC for regulatory enforcement. In addition, the current CFTC chairman Rostin Behnam also stated that the CFTC’s regulatory framework already has the ability to supervise most virtual currencies in the digital asset market, including Bitcoin and Ethereum. In the column of Digital Assets on the CFTC’s official website, information about digital assets (mainly involving virtual currencies) was also released, clearly telling the public that digital assets, including all virtual currencies, are “commodities.”
2.2.1 Regulatory compliance for "commodity" futures trading
According to Article 1 a (9) of the CEA, the commodity under the CEA is a very broad definition, which includes not only physical commodities, but also intangible commodities, as well as rights and interests similar to carbon emission rights (…all other goods and articles...and all services, rights, and interests...in which contracts for future delivery are presently or in the future deal in). In addition, multiple judicial cases in the United States have also determined that virtual currency is a "commodity" under the definition of CEA, and must comply with CEA and related laws and regulations and be subject to CFTC supervision.
On this basis, if the transaction of virtual currency satisfies: (i) the transaction object must be a "non-eligible contract participant" (non-eligible contract participant) as defined by CEA; (ii) the transaction is carried out in the form of margin or leverage (on a leveraged or margined basis); and (iii) the commodity has not been "actually delivered" within 28 days, then the transaction will be defined as a "futures" under CEA Section 2(c) 2D transaction (a contract of sale of a commodity for future delivery), then the result is that the trading platform and the institution engaged in the transaction must abide by the CEA and related laws and accept the supervision of the CFTC.
In a recent CFTC v. Ooki DAO enforcement case [11], CFTC not only supervises within its inherent jurisdiction, but also intends to extend the subject of responsibility to members of DAO. Ooki DAO is a decentralized autonomous organization. Members of the DAO organization operate and manage a decentralized DeFi protocol called bZx through proposals, voting and other means.
The CFTC believes that the digital assets (virtual currency) traded by the bZx agreement belong to the "commodity" under the CEA. In addition, the transactions conducted by the bZx agreement belong to the "futures trading" defined by the CEA, so the actual controller and operator of the bZx agreement must Comply with CEA and related laws and regulations and accept the regulation of CFTC. Since Ooki DAO has never been registered with the CFTC, the CFTC accused Ooki DAO of violating the relevant laws and regulations of the CEA and CFTC by providing illegal leverage and margin transactions to US residents.
2.2.2 Exploring the supervision of DAO
The CFTC's allegation of violating futures trading qualifications in this case is not new. It is worth noting that the CFTC is also holding members involved in Ooki DAO voting governance to take personal responsibility. The regulatory logic of CFTC is as follows:
First, according to federal law, Ooki DAO meets the definition of an unincorporated association, which consists of the following four aspects: (1) a voluntary group of persons; (2) no organizational documents ( without a charter); (3) formed by mutual consent; (4) for the purpose of promoting a common objective.
Second, the CFTC has determined that members of for-profit unincorporated organizations need to bear personal responsibility for the actions of the organization, based on relevant federal laws and a series of state jurisprudence on partnership laws. This differs from a legal entity such as an LLC or Corp which is able to separate entity liability from individual liability, which is fatal to a DAO. The CFTC compares the centralized entity to the Ooki DAO organization, that is, the LLC and the DAO also control the bZx protocol, the LLC governs the bZx protocol through member voting, and the Ooki DAO also governs the bZx protocol through member voting. Therefore, the CFTC stated that once OOKI virtual currency holders affect the outcome of the Ooki DAO governance proposal through governance currency voting, then the Ooki virtual currency holders can be identified as voluntarily participating in Ooki DAO governance and need to be responsible for DAO's actions. personal responsibility.
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2.3 FinCEN
The Financial Crimes Enforcement Network (FinCEN) was established in 1990. After the 9.11 incident in 2001, it was incorporated into the U.S. Department of the Treasury and became its subsidiary agency due to the requirements of the American Patriot Act. FinCEN is mainly responsible for supervising and implementing anti-money laundering (Anti-Money Laundering (AML)), combating the financing of terrorism (Combating the Financing of Terrorism (CFT)) and customer due diligence (Know-Your-Customer (KYC)). Work, on the one hand, is responsible for preventing and punishing domestic and foreign money laundering activities, combating terrorist financing and other financial crimes, and on the other hand, is responsible for collecting and analyzing financial transaction information, and tracking suspicious persons and activities by studying the mandatory disclosure information of financial institutions.
FinCEN's rights come from the US Bank Secrecy Act (Bank Secrecy Act, BSA), and FinCEN regards virtual currency as "currency (value that substitute for currency and are therefore "monetary instruments" under the BSA)" [12]. According to "Application of FinCEN's Regulations to Certain Business Models Involving Convertible Virtual Currencies" [13] issued by FinCEN on May 9, 2019, it clarifies the virtual currency "management party" that provides services to Americans (such as virtual currency issuance parties, ICO-related project parties) and "converters" (such as CEX, DEX and other virtual currency exchanges), if they meet the definition of "Money Transmitter", they belong to the Money Service Business Enterprise (Money Service Business) under the BSA. , MSB).
Therefore, all entities engaged in virtual currency trading business need to comply with BSA and related financial regulatory requirements and fulfill their compliance obligations. FinCEN's compliance obligations include a series of requirements to register with FinCEN according to BSA, report to FinCEN, accept FinCEN's supervision, establish a corresponding anti-money laundering compliance system, collect customer information, and report suspicious financial activities.
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That is to say, any subject who wants to carry out compliant virtual currency trading business in the United States (currently mainly involved in the field of exchanges) needs to apply to FinCEN for MSB registration and implement a comprehensive anti-money laundering risk assessment and reporting mechanism, especially It involves the cross-border transfer of funds, the exchange of virtual currency, legal currency, stable currency, etc. Huobi Exchange (Huobi?), recently acquired by Sun Cut, announced in 2018 that it had obtained a US MSB license. In addition, according to the New York Times, Twitter recently submitted a registration document to FinCEN to become an MBS for its entry into the market. Paving the way for Web3 payments.
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2.4 OFAC
In contrast, OFAC, which is also part of the U.S. Department of the Treasury, has broader regulatory authority derived from the International Emergency Economic Powers Act (IEEPA) passed in 1977. OFAC supervises all financial transactions in the United States and can sanction any A person, entity or country that poses a threat to national security.
The Office of Foreign Assets Control of the US Department of the Treasury (OFAC), established in 1950, is an agency under the US Department of the Treasury. Its mission is to manage and implement all US national security and foreign policy-based Economic and trade sanctions, including financial sanctions against all terrorism, transnational drug and narcotics trade, and proliferation of weapons of mass destruction. Although OFAC has a relatively small reputation, it has great power. It usually issues sanctions lists against countries, entities or individuals, and imposes penalties for violations of OFAC regulations and transactions with countries, entities or individuals on the sanctions list. At the same time, it is authorized by special legislation All foreign assets in the United States can be controlled and frozen.
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Let’s look at the Tornado Cash case again [16]. In August of this year, OFAC’s official website showed that Tornado Cash provided materially assistance, sponsorship, or financial and technical support for illegal online activities in the United States and abroad. Since its creation in 2019 Since then, it has been used to launder more than $7 billion worth of virtual currency, including providing support to entities and individuals on the OFAC sanctions list. These actions may pose a major threat to the national security, foreign policy, economic health, and financial stability of the United States. Therefore, Sanctioned by OFAC.
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2.5 IRS
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3. The Web3 financial supervision plan that is brewing
"Ensure that the Web3 revolution happens in the United States!" This is the cry of U.S. Republican Congressman Patrick McHenry at the digital asset hearing at the end of 2021. Provide the necessary clear definition on innovations, which will promote the vigorous development of the Web3 market, and protect investors and consumers by formulating clear rules to prevent fraud and manipulation [18].
Indeed, it can be seen that U.S. regulators have only brought digital assets into their respective jurisdictions at first, and now also include operators and issuers derived from digital assets into regulation, and are constantly exploring regulatory paths. However, the problem is that for the technological innovation of Web3, the U.S. regulators have not given a clear definition of the concepts and scope of responsibilities of many emerging subjects such as DeFi, DAO, and decentralized smart contracts, which has resulted in further regulation. When exploring the path, it is easy to cause panic in the Web3 industry, and even worry that further regulatory measures will curb the development of Web3 technological innovation, especially OFAC's "one-size-fits-all" sanctions against privacy application coin mixers like Tornado Cash. Therefore, it is very important to adopt a regulatory method that can not only encourage technological innovation, but also curb illegal activities and protect the interests of investors.
"Ensure that the Web3 revolution happens in the United States!" This is the cry of U.S. Republican Congressman Patrick McHenry at the digital asset hearing at the end of 2021. Provide the necessary clear definition on innovations, which will promote the vigorous development of the Web3 market, and protect investors and consumers by formulating clear rules to prevent fraud and manipulation [18].
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The United States is worth looking forward to in terms of perfecting supervision. After many efforts, "ensure that the Web3.0 revolution takes place in the United States" has become the consensus of the US decision-makers. In June 2022, U.S. Republican Senator Cynthia M. Lummis from Wyoming State submitted a legislative proposal called the "Responsible Financial Innovation Act" (Responsible Financial Innovation Act) [19] (currently still in the committee deliberation stage ), the bill can be combined with the current law to create a more comprehensive regulatory framework for digital assets, trying to "pragmatically" respond to the current problems in digital asset financial supervision, aiming at consumer protection, regulatory transparency, promotion of financial innovation and Balanced market flexibility.
The bill makes a clearer division of the regulatory scope of SEC and CFTC and the definition of digital assets, and also provides taxation on digital assets, payment stablecoins, digital asset exchanges, digital asset service providers, digital asset self-regulatory associations and financial The Innovation Advisory Committee and others have made provisions. It can be said that this bill is currently the most comprehensive digital asset regulatory bill in the United States, and its regulatory framework and ideas are worth learning.
In addition, the White House also released the "First-Ever Comprehensive Framework for Responsible Development of Digital Assets" [20] on September 16 this year, aiming to promote multi-sectoral cooperation and provide a clearer direction for the supervision of digital assets. At the same time, we see that international financial organizations such as the Financial Stability Board (FSB) and the IMF are preparing to establish a regulatory framework for digital assets [21].
This current period of the Web3 "Wild West" is very much like the period after the 2008 financial crisis and before the introduction of the Dodd-Frank Act [22] in 2010. The Dodd-Frank Act rebuilds the US financial order from the perspective of preventing financial systemic risks and protecting the interests of consumers, hoping to restore confidence in the US financial system.
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Fourth, write at the end
Although the U.S. Congress is currently piled up with dozens of bills on digital assets to be considered, with the emergence of many black swan events in the digital asset market in 2022, especially after the FTX thunderstorm, it will inevitably accelerate the further improvement of Web3 financial supervision in the United States The determination to promote technological innovation while combating crimes and to ensure that the Web3 revolution takes place in the United States.
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