Cryptocurrency Laws and Regulations
Generally speaking, cryptocurrencies are digital assets that function like virtual currencies. They can be used to transact for goods and services, but they are also often held as investments. Cryptocurrencies are not the equivalent of U.S. or foreign government-issued money, although their value may be pegged to such legal tender (called “fiat”).
Cryptocurrencies use cryptography to secure transactions. These transactions are verified and stored on a distributed ledger, like a blockchain. Distributed ledgers store information on multiple separate but connected devices. Data is created independently for each node in the network and can be checked against other nodes. Theoretically, distributed ledgers are less vulnerable to fraud and cyberattacks because of their decentralized character.
Some of the largest issues with cryptocurrency are regulation and consumer protection. Even though they use distributed ledgers, cryptocurrencies remain susceptible to fraud such as investment schemes, price and market manipulation, unregistered exchanges involved in fraud, and insider trading schemes. Another issue with cryptocurrency is its volatility. This poses a serious risk when using cryptocurrency for transactions, since a sudden change in value could lead to a steep over- or underpayment.
A stablecoin is a cryptocurrency with a value pegged to a more stable asset, like gold or the U.S. dollar. Stablecoins decrease the risk to buyers and sellers by ensuring that the value of the cryptocurrency remains relatively stable throughout a transaction. However, even stablecoins have faced issues. TerraUSD, an algorithmic stablecoin that was intended to always be worth one U.S. dollar, collapsed in May 2022. Instead of backing TerraUSD with the U.S. dollar, an algorithm determined when to create or destroy it and its related token, Terra (Luna), to keep its price steady. But when the cryptocurrency market fell drastically, the algorithm could not keep up. The collapse is now the subject of a U.S. Justice Department investigation.
Regulating the Sale of Cryptocurrency
Cryptocurrency sales are regulated if they constitute the sale of a security under state or federal law. Securities law is primarily federal, and most of it stems from the Securities Act of 1933 and the Securities Exchange Act of 1934. However, there are some state laws that also regulate securities. These are sometimes called “Blue Sky” laws.
A security subject to regulation by the SEC is an investment of money in a common enterprise with the expectation of profits from the efforts of others. Whether an offering is considered an investment contract is determined by its character, rather than its label. These principles come from the cases of SEC v. W.J. Howey Co. and SEC v. C.M. Joiner Leasing Corp., respectively.
Regulated securities must either be registered with the SEC or fall under a registration exemption. Offerings that fall under a federal exemption are subject to fewer restrictions if they are made to certain accredited investors, such as people with a net worth of over $1 million excluding their home. Securities that fall under a federal exemption may still be subject to state securities law.
Securities must also generally be sold by a broker-dealer licensed with the SEC and a member of the Financial Industry Regulatory Authority (FINRA), and they must be traded on a licensed securities exchange or alternative trading system (ATS) approved by the SEC. The SEC has proposed amendments to the Exchange Act to redefine and broaden the definition of the terms “exchange” and “dealer,” which could expand the Act’s application.
For now, whether cryptocurrencies are in fact securities remains to be seen. Coinbase, one of the largest cryptocurrency exchanges in the world, was told by the SEC in March 2023 that it could face enforcement action related to violations of securities law. Many cryptocurrency firms and industry participants believe that they are not covered by the SEC’s existing regulatory authority and that cryptocurrencies are not securities, but the SEC appears to believe that it does have that authority to an extent.
Cryptocurrency sales may also be regulated if they constitute a money transmission under state law or a money services business (MSB) under federal law. MSBs that are money transmitters are required by FinCEN regulations to implement anti-money laundering and anti-terrorist financing programs.
The CFTC has the authority to regulate derivative contracts, such as futures, options, and swaps, that reference the price of a crypto asset constituting a commodity. It can additionally regulate market manipulation attempts concerning crypto assets constituting commodities.
Federal Law and Cryptocurrency Going Forward
A handful of bills have been proposed on the federal level dealing with digital assets and cryptocurrency. The Responsible Financial Innovation Act (RFIA) would provide a regulatory framework for digital assets and characterize the jurisdiction of the SEC and CFTC over digital assets. The Toomey Stablecoin Bill would provide a regulatory framework for stablecoins in particular, distinguish stablecoins from securities so long as they do not offer interest, and establish privacy protections for stablecoin transactions. Finally, the Virtual Currency Fairness Act would exempt from taxes small personal virtual currency transactions for goods and services under $50.
The administration of President Joseph Biden has also released an Executive Order that addresses potential digital asset risks and encourages responsible growth. It asked for reports from the Treasury Department regarding the potential implications and outcomes of digital asset use and how consumers may be protected, among other things. Three Treasury Department reports issued in response to the executive order noted that some crypto-asset risks are unique to crypto assets, while others are a heightened version of risks found in traditional financial markets and could affect consumers, businesses, and investors. These risks include operational failures, market manipulation, fraud, theft, and scams.
The Federal Reserve is currently researching the implications of a potential U.S. central bank digital currency (CBDC), although there are no current plans to officially launch one.
Tax Law and Cryptocurrency
The IRS treats digital assets like cryptocurrency as property. Cryptocurrency transactions generally must be reported on federal tax returns. A taxpayer who sells or exchanges cryptocurrency held as a capital asset will be subject to capital gains tax. Reportable and taxable gains and losses can result from transactions such as exchanging cryptocurrency for goods or services, earning cryptocurrency by mining, or trading cryptocurrency for another cryptocurrency or fiat, like the U.S. dollar.
For example, taxpayers who receive cryptocurrency as payment for services must report these earnings. The fair market value of the cryptocurrency at the time received, as measured in U.S. dollars, is subject to federal income tax withholding, Federal Insurance Contribution Act (FICA) tax, and Federal Unemployment Tax Act (FUTA) tax, and it must be reported on a W-2. Similarly, cryptocurrency payments valued at $600 or more to an independent contractor in the course of a trade or business generally must be reported to the IRS and the recipient.
Effective January 2024, the Infrastructure Investment and Jobs Act (IIJA) requires brokers to report capital gains and losses of crypto assets and requires businesses to report digital asset transactions larger than $10,000 to the IRS, as they would for cash transactions.
State Cryptocurrency Regulation
State governments have also taken steps to regulate cryptocurrency and blockchain technology. In some cases, state laws exempt cryptocurrencies from securities-related or currency transmission-related laws. Wyoming, a state that has shown interest in encouraging innovation in cryptocurrency and blockchain technology, passed a law establishing a new type of cryptocurrency bank. Utah will accept digital assets like cryptocurrency as payment to certain government agencies. California and New York have introduced similar bills. Meanwhile, Arizona introduced a bill to include Bitcoin in its definition of legal tender.
In other cases, states are passing laws to limit cryptocurrency activities. Many states require a license to transmit cryptocurrency. Tennessee generally prohibits local governmental entities from paying funds in the form of cryptocurrency. New York allows virtual currency businesses to apply for a limited purpose trust company charter or a “BitLicense,” but it has placed a two-year moratorium on certain cryptocurrency mining operations that cause pollution through excessive electricity use.
Some states have also adopted Article 12 of the Uniform Commercial Code (UCC) governing digital assets (“controllable electronic records”). Many have established commissions to further investigate cryptocurrency and blockchain technology.
Cryptocurrency is a new and evolving financial technology. While there are many potential issues with it, there are also many potential benefits. States and the federal government likely will continue to issue new guidance and propose new legislation regulating cryptocurrency to ensure that cryptocurrency can be purchased and used in a way that is safe and useful.
