An analysis of the United States’ troubled digital assets environment, and a comment on a possible solution.
Walker Wambsganss
23 December 2023
On November 11, 2022, cryptocurrency exchange FTX filed for chapter 11 bankruptcy protection. One month later, on December 12, FTX’s CEO, Sam Bankman-Fried, was arrested on charges of criminal fraud, conspiracy and money laundering.
In June of this year, the Securities and Exchange Commission filed multiple lawsuits against Binance and Coinbase for operating as “unregistered securities exchange[s].”
On November 2nd of this year, Sam Bankman-Fried was found guilty on all counts and is set to be sentenced on March 24, 2024.
And, most recently, on November 21, 2023, Binance CEO, Changpeng Zhao, “pleaded guilty to money-laundering” charges levied by the United States Department of Justice and agreed to step down from his chief executive role, and Binance.US was fined $4.3 billion.
This past year has clearly been unkind to the cryptocurrency industry. Within the past calendar year, we have seen more government action exacted upon crypto and digital assets companies than we have ever seen before. The fines given to these companies have ranked among the most expensive in corporate history, and it doesn’t seem like this “crypto winter” will end any time soon.
But many, myself included, have been confused by these recent actions. Isn’t the current United States government the same government that refused to regulate the digital assets and cryptocurrency industries in years past? Major cryptocurrency players like CoinBase and Digital Currency Group have called upon the United States government for years to institute some kind of “regulatory clarity” (Rhodes) for the industry, but it has all but refused. In fact, it seems that the government has been twitchy around the industry since these requests started being made: one minute it would do nothing, for fear of the industry fully decentralizing and slipping out of its hands; the next, it imposed catastrophic fines and punishments on major industry players.
So how do we, as average Americans, interpret the recent government actions against the cryptocurrency and digital assets industries? Better yet, how do future government actions against these industries affect us at a base level?
I’m so glad you asked. In this paper, I aim to summarize the United States’ bout at regulating cryptocurrency. I will do this by first providing a healthy history and context for the subject. Next, I will analyze the United States’ recent actions toward the industry. Finally, I will look at what the future of crypto looks like in the United States and boil it down to how this projection impacts the average American.
This paper contains a lot of crypto jargon and terminology that the uninitiated may have a hard time navigating. When researching for this paper, half the battle was determining what term meant what, so I thought it would be useful for you to have a little dictionary for any uncommon terms that you may see here:
Cryptography – “the process of hiding or coding information so that only the person a message was intended for can read it.” (Fortinet)
Cryptocurrency – “a digital or virtual currency secured by cryptography.” (Frankenfield) Can also be referred to as a “bitcoin” or “coin.”
Self-custody – “when a crypto user takes sole possession of their wallet’s private keys instead of trusting them to an exchange, they are self-custodying their assets.” (BitPay)
The concept of cryptocurrency, as both an idea and a realized medium of exchange, isn’t new. The first recorded mention of a semi-modern cryptocurrency was in 1982, when a cryptographer from UC Santa Barbara named David Chaum published a paper. This paper, titled Blind Signatures for Untraceable Payments, proposed “a new kind of cryptography” which could not only provide financial privacy to the average participant, but it could also prevent the fraudulent use of stolen “payment media” like credit cards or checks. (Chaum) This concept was new – not because it presented a necessarily new form of physical transaction; in fact, it was quite the opposite. Chaum’s proposed “new kind of cryptography” would change the financial game because it would remove the human element.
Transactions, and the currency used in them, would be performed and used solely by and between computers.
Blind Signatures seemed outrageous to the uninitiated. I mean, what even is a transaction, if not for, by and between people alone? Chaum was proposing that this “brave new currency for a brave new world,” as Forbes would later put it, would use the same home computers that rambunctious teens would play Doom on – the very same computers that would crash if they received an email while playing such games. Chaum’s proposal was unique. It was revolutionary. It was a truly American idea.
While the concept was novel, it needed to work outside of a vacuum. Chaum realized this, and he later founded an online payment startup called DigiCash in 1989 while working on a sequel to Blind Signatures.
The venture looked promising at first. By 1990, Chaum had published the Blind Signatures sequel alongside a couple of Israeli computer scientists. This paper would not only provide the mathematical and scientific basis for his digital currency, but it would also go on to be the foundation for DigiCash’s operations. By 1997, DigiCash had not only acquired venture capital funding, but it had also signed a large bank in St. Louis, Missouri as its first client.
However, despite the prior indications of early success, DigiCash disappeared before the end of the millennium.
The question is: why?
Sorry to put you on a cliffhanger, but before I can answer that, we need to review currency at its base level. It will make sense in a second.
You see, currency is great because it can be anything. While the dictionary will confuse you in your quest to find a concrete definition, currency is defined as “something in circulation as a medium of exchange.” (Merriam-Webster)
Technically, you could trade your friend a piece of gum for his extra hot pocket, and that piece of gum could be considered a currency. Likewise, a manufacturing company could trade a forklift for raw materials. That forklift would also technically be considered a currency. The base function of currency is to facilitate the transaction: a transmission of assets from one party to another. Thus, anything which is traded by one party as motivation for another to transact could very well be considered a currency.
However, the thing about currencies is held in one little phrase. My quip about dictionaries aside, all of them are consistent in one thing: they all include some clause that notes the currency as being “in circulation,” as we saw in our Merriam-Webster definition, “generally accepted,” (Oxford) or “used by people in [a] nation.” (LII) These small phrases, just a fraction of a sentence, all connote a social element to each currency – an acceptance of such as a general representation of value. In English, currencies are valuable because we all think of them as valuable.
However, this theory of ‘generally accepted value’ is a double-edged sword. Though all it really takes is a group of people to jointly assign equal value to one uniform thing to make it a currency, that hurdle is, in reality, incredibly high to surpass. A currency can become worthless if not enough people want it. Therefore, for a currency to work, people have to use it. More importantly, for a currency to work, people have to want it.
This duality is precisely what undid DigiCash. While the startup was positioned on the bleeding edge of financial technology and is credited today with having created the world’s first purely digital currency, (Pitta) it had “one problem: nobody wanted it.” (Van Wirdum)
DigiCash and its sibling firms – those like Compaq, CyberCash and First Virtual Holdings – thought that, as commerce became more of a new and digital practice over the years, people who were performing transactions would need an equally new and digital currency to both efficiently and securely buy and sell.
As it turned out, this couldn’t have been a worse miscalculation. People wanted to use stable and proven fiat currencies, such as the U.S. Dollar or the European Union’s Euro. Additionally, Digicash’s key market disappeared when card processors like Visa and Mastercard ended up picking up the bulk of internet sale processing. This swift and total market dominance occurred because both Visa and Mastercard had already moved away from paper-based credit card processing in the 1970s in favor of computer-based card processing – something that we can only assume that Digicash wasn’t aware of. (BeBusinessed) These processing moves allowed both Visa and Mastercard’s entrances into digital sales processing to be relatively simple. This misprojection not only did DigiCash and its sibling firms in, but it also turned the first big crypto eCommerce wave into the first big crypto bust.
As digital commerce evolved, so did cryptocurrencies. As the ‘90s rolled into the 2000s and Y2K fears subsided, several cryptocurrency ideas came and went. The first was BitGold. The idea for BitGold was written in a 1998 white paper by Nick Szabo – one of the earliest players in the modern blockchain environment. While it never developed past the white paper stage, BitGold is today credited as the base of one of the blockchain’s most foundational protocols: proof-of-work.
Another pre-Bitcoin attempt at cryptocurrencies was called “b-money.” b-money was a proposal created by Wei Dai – a computer engineer and cryptographer from the University of Washington. Dai had been inspired by Tim May’s 1998 piece The Crypto Anarchist Manifesto (“TCAM”). TCAM was a small collection of paragraphs that urged individuals to abandon the government and become independent through the anonymity provided by computers. The “become ungovernable” meme comes to mind when trying to best describe this. Dai himself summarizes the Manifesto as a vision where “the government is not temporarily destroyed but permanently forbidden and permanently unnecessary.” (Dai)
While the Manifesto’s vision at world peace was questionable, it did inspire some good foundations for b-money. Dai’s proposal envisioned an “anonymous, distributed electronic cash system,” and it aimed at becoming a common currency that was used for trading commodities, like fiat currencies were doing in the physical world. b-money introduced several pivotal concepts to the digital asset space:
First, Dai proposed that b-money would run by requiring computers to perform the work necessary to keep the currency alive. This is equivalent to servers running websites on the internet today, but, in b-money’s case, it would involve many smaller computers in different locations to perform the same function. This work would then be verified by other computers and would be recorded in a collective ledger. This concept built on Nick Szabo’s “proof-of-work” verification concept.
Second, the work that computers did to verify and perform this work would be rewarded with currency units of b-money. This is similar to rewards given from bitcoin mining.
Third, Dai proposed that there be a transaction-log that would be collectively maintained. This transaction-log would be authenticated with “cryptographic protocols.” (Reiff) This is very similar to the current-day blockchain.
Finally, while transactions would be verified by other computers, nobody would know who made the transactions. Dai made it clear that b-money would make it so that its users would be anonymous.
These ideas added onto Szabo’s basis of proof-of-work authentication while also adding emphasis on decentralization and anonymity and it seemed like there would finally be a successor to BitGold. However, it never happened. This was largely because of problems within b-money’s structure.
The structure of b-money was severely limiting. Dai even noted this in his white paper. One of these problems was the minting of b-money currency. In order for currency to be minted concurrently, “all of the account keepers” would need to “decide and agree on the cost of particular computations.” Dai noted that this method would lead to “unavailable, inaccurate, or outdated” information, “all of which would cause serious problems for the protocol.”
To counter this unreliable protocol, Dai proposed a new one. This new proposal made it so that account keepers of b-money would agree to release a set amount of currency every period – the length of which would be defined on an ad hoc basis. This agreement would be followed by a sequence of events which made up the currency minting process. These steps would be planning, bidding, computation, and money creation.
However, while the proposal was clearly thought out, b-money would eventually end up suffering the same fate as BitGold and DigiCash, as nobody wanted it. This disinterest relegated these early cryptocurrency ideas to the history books as just that: creative yet ultimately non-practical ideas.
And that’s where things stayed – until Halloween of 2008.
On October 31, 2008, a white paper was uploaded to a mailing list discussion centered around cryptography. This whitepaper, authored by a man named Satoshi Nakamoto, announced “a peer-to-peer electronic cash system” called “Bitcoin.”
Later, on January 9th, 2009, the code for Bitcoin would be released to the public, and the first major cryptocurrency was thus born.
Honestly, the intricacies of Bitcoin and its nearly 15-year history are too much to talk in-depth about in this paper, and I already fear I may have already bored you in my exposition of cryptocurrency. So, if you have an acute hankering for the major events of Bitcoin throughout its lifetime, I would encourage you to research it, but you will not find it in this paper.
What you will find in this paper, though, is how the United States has reacted to Bitcoin.
Cryptocurrency has been on the United States government’s radar for some time now. From initial curiosity to recent attempts to define and oversee the crypto sector, the history of cryptocurrency regulation in America reflects a dynamic interplay of technology, investor protection, and regulatory clarity. Exploring this history provides a glimpse into the changing perspectives and approaches taken by U.S. government officials in managing the complexities of the cryptocurrency landscape.
As early as 2013, the Treasury classified cryptocurrencies as a “virtual currency and payment system.” One year later, the Commodity Futures Trading Commission classified crypto as a commodity. The reason why the CFTC classified it this way is about as clear as Ron DeSantis’s campaign platform. Commodities – and consequently the derivative commodity futures – must be governable and enforceable by a governing body. Crypto simply isn’t governable… but I digress.
Regulation didn’t stop in 2014, though. In addition to being reclassified by the CFTC, crypto was also reclassified as property by the IRS that same year. This meant that transactions involving crypto would become taxable, as the IRS recognized cryptocurrency transactions as taxable property transactions – like the sale of toys or electronics – not currency transactions. It was wild. As slow and inefficient as the government is, it sure is good at tracking emerging trends that could generate taxes.
Then, in 2021, an interesting bill passed through Congress. This bill was none other than the 2021 Infrastructure Investment and Jobs Act (HR 3684) – better known as the 2021 Infrastructure Bill. This bill was long and meticulous, as it covered all of the infrastructure investments that the federal government wanted to employ to keep the United States oiled and well-maintained. This being said, it had one section of interest to us: section 80603. This section would add another classification to crypto, so that it would be additionally treated as cash.
The reasoning behind this addition is not totally known, but we can infer a few reasons. Charles Rettig – the Chief of the IRS – urged Congress in June of 2021 to grant the IRS greater authority to “police cryptocurrency.” (Lauder) Additionally, in July of 2021, Sen. Elizabeth Warren (D-MA) pushed Treasury Secretary Janet Yellen in a Financial Stability and Oversight Committee hearing “to identify and remedy risks posed by cryptocurrencies.” (Franck)
Congress clearly listened to Rettig and Warren, as the resulting reclassification clearly placed crypto further under the IRS’s purview. This is because, in addition to the classification as cash, the Infrastructure Bill created reporting standards for brokers and holders of cryptocurrencies, so that all transfers of cryptocurrency between two people must be reported on the tax returns of the transferring parties (see Sec. 80603(B)(1)(a)).
This classification made crypto’s legal position even more precarious. According to the bill, any and all cryptocurrencies were to be treated as cash, but, adherent to previous administrative agency classifications, they were also treated as speculative assets and property such as commodities and commodity futures.
It would be easy to scapegoat this bill as a wicked attempt at dampening the financial privacy of United States citizens, but such a claim would be disingenuous, especially when we look at Senator Warren’s September 2022 letter to Secretary Yellen.
When we put ourselves in legislators’ shoes, it’s pretty easy to see how and why government officials are wary of cryptocurrency: they are worried for the American public. Representatives and senators alike are worried that the untraceable and ungovernable nature of cryptocurrencies leave American consumers and investors in vulnerable positions if bad apples try to take advantage of them using these digital assets. However, as we’ve noted, these officials’ attempts to curtail cryptographic fraud instead created a regulatory overlap that was terribly ambiguous.
However, this overlap creates an interesting dilemma. Let’s say a man named Thomas walks into a bar and is served by a waitress named Anna. Thomas uses a $20 bill to pay for his drinks, but he gives Anna a tip of 50 dogecoin (valued at roughly $4.83 at time of writing). Under federal law, Thomas both just paid and tipped with cash, as both the $20 bill and the dogecoin he gave to Anna are considered equally as such. However, when Thomas tips Anna – assuming she actually accepts it and doesn’t blow him off at the bar – he also creates a reportable event on both his and Anna’s tax returns, as federal law commands that such a transfer be reported as a transfer of a speculative, digital asset.
This example may be imperfect, but can you see the issue? Section 80603 mandates that any and all transfers of assets which were made to be untraceable be reported… and thus traced. But what happens when crypto users decide to simply not report their coins, especially those users who self-custody their digital assets? It doesn’t seem like there’s a clear legal answer for this besides the slapstick charge of ‘federal tax evasion.’
Ultimately, it seems that this section of the 2021 Infrastructure Bill was inserted to make legislative avenues for the IRS to track and tax cryptocurrency transactions. For the governmental purpose of taxation, it worked as planned. The IRS can now track what you transfer and enforce the reporting of such, but this places an unfair onus on individual coin-holders and brokers for reporting transactions that could very well be everyday occurrences. On many counts, this section of legislation is a capricious bout at strong arming disclosure out of a measure of financial privacy.
As much as I would like to add a bit of light to this section – and, trust me, I will soon enough – we need to talk about regulatory actions that were performed outside of the legislative.
As I mentioned earlier, federal administrative agencies have taken ample action against cryptocurrency exchanges. In addition to the CFTC, the SEC has felt more than comfortable in making sure that it keeps crypto under its regulatory purview.
On June 5th, 2023, the Securities and Exchange Commission (“SEC” or “the Commission”) filed multiple charges against Binance – the largest cryptocurrency exchange in the world by market cap according to CoinMarketCap. The next day, on June 6th, the SEC filed more charges against Coinbase – the second largest crypto exchange in the world – by alleging that the company “[operated] as an unregistered securities exchange, broker, and clearing agency.” (SEC)
These lawsuits are labyrinths of legal theories and reasoning, especially the suits against Binance, and I won’t be covering everything about them. But I will be covering the SEC's recent actions and the reasoning behind their "unregistered securities exchange" suits.
At the heart of the Commission’s “unregistered securities exchange” suits is Gary Gensler: the current Chair of the SEC. Gensler has noted in hearings and interviews that he is certain that crypto exchanges hold at least one, if not many, unregistered securities – as defined by the Securities Act of 1933 (the “Securities Act”). As such, he directed the SEC to sue Binance and Coinbase for their violations of both this act and the Exchange Act of 1934 (the “Exchange Act”).
Just so we’re up to speed. The Securities Act defines a security as the following:
“any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘‘security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.” (15 U.S. Code § 77a)
In regular people terms, the term “security” is defined as any asset that can be invested in. This would make crypto a security, as people can invest in a cryptocurrency and sell it for a loss or a gain… right?
Well, not really. Let’s go back to the double cash/speculative-asset treatment that crypto receives. You can’t invest in a dollar, for example; however, you can invest in currency securities that measure the value of a dollar against other currencies. If a cryptocurrency is indeed cash – and therefore a currency – then it could be argued that, when buying a particular coin, you are exchanging a dollar amount for an amount of cryptocurrency of equivalent value. It’s just like exchanging U.S. dollars for British pounds.
Additionally, the definition of a security also implies that something being invested in provides benefits to the asset issuer. While cryptocurrencies have initial human issuers, any and all future issuers of the notable cryptos are the decentralized nodes which verify the blockchain of transactions. There is no entity which benefits from the sale of cryptocurrencies besides the exchanges which broker them. Because of this obvious absence, it is hard to imagine that the definition of a security is consistent with the nature of cryptocurrency.
It seems that the SEC is pushing a narrative in their lawsuits, and I argue that we look at this with skepticism. The narrative in question is that crypto, as digital assets, are always speculative assets. But this raises a few questions. If cryptocurrencies, as digital assets, are always speculative assets, then that very well translates into the notion that all digital assets are speculative. Under that framework, would email accounts and social media accounts, which are classified as digital assets that can hold transactive value, be treated as speculative as well? The official jury is still out, but I say no. The ramifications of treating an entire intangible asset class as speculative are wide-reaching, and the blatant reclassification of such is irresponsible.
If one were to argue that a currency should be rebranded based on its volatility against the dollar, then applying the same logic would lead to designating other volatile currencies, such as the Korean Won or the Mexican Peso, as securities. According to the SEC's perspective, they would then need to be regulated as such and treated as speculative. Such a scenario might highlight perceived inconsistencies in how the United States government handles cryptocurrencies, potentially prompting a reconsideration of its approach.
Balancing investor protection, market stability, and innovation poses a significant challenge for the SEC. While a nuanced approach to understanding and regulating cryptocurrencies is crucial, the SEC’s bout at such uses crypto’s double cash and speculative-asset classification against it with a legal theory which is inconsistent when applied across similar asset classes. I sure wish there was a piece of legislation in the works that had the potential to create a sustainable regulatory environment for digital asset innovation.
Oh wait… there is!
A good writer always follows up on the items that they foreshadow – unless you’re Ridley Scott writing Alien. As such, if we look back a few sections, I alluded to a light at the end of the tunnel. Well, it’s here. I’d like to present to you: the Lummis-Gillibrand Responsible Financial Innovation Act.
The Lummis-Gillibrand Responsible Financial Innovation Act, commonly referred to as the Lummis-Gillibrand Act or the RFIA, is an act that aims to bring more structure and safety to the crypto market. It aims to do so by implementing the following measures:
The RFIA delineates the roles of the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) in regulating cryptocurrencies. Additionally, the Act introduces the Consumer Protection and Market Integrity Authority (CPMIA) for enhanced regulatory clarity around the digital assets environment.
The Act mandates that crypto asset exchanges, excluding fully decentralized protocols, register with the CFTC, enforce their rules, and separate customer assets from exchange assets.
One of the largest stumbling blocks that crypto has is its use by criminals and terrorists as payment for illicit and criminal activities. The RFIA includes provisions that provide enhanced oversight of cryptocurrency ATMs and stricter identity verification requirements for kiosk customers, reflecting a concerted effort to strengthen anti-money laundering initiatives. (Gibson-Dunn)
These are but a few of the measures introduced in the RFIA. While the Act isn’t a one-size-fits-all solution to the United States’ relationship with cryptocurrency, the passage of this Act could vastly benefit the average crypto-holding American by providing a more secure and transparent environment for their investments and transactions.
To sum this all up, the United States has had a rocky relationship with cryptocurrency for the past couple decades – from haphazard reclassifications and subsequent regulatory confusion to expensive court quarrels between the government and crypto companies. However, as we step into an age where financial privacy is taken more seriously and more people than ever look to crypto as a payment solution – as opposed to a valuable novelty – it is crucial that we pave the regulatory way for responsible and sustainable innovation in the largely stagnant financial sector. Thankfully, we have an avenue of legislation on the way that looks to be a large solution. Let’s make sure that we, as citizens, do everything we can to ensure our financial privacy and make sure that it passes.
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