Crypto regulation has long been a point of contention within the cryptocurrency community, but the need for common sense rules has never been clearer.
The recent drama surrounding the crypto firm BlockFi Inc. is Exhibit A.
On Tuesday, the New Jersey Bureau of Securities issued a cease-and-desist order to BlockFi regarding the interest-bearing accounts it offers (known as BlockFi Interest Accounts).
The New Jersey regulator's order says the BIAs are in fact unregistered securities and as such violate that state's securities laws. The press release that announced the order supplied further reasons for the legal action.
"Cryptocurrency investment products offered and sold on decentralized finance platforms carry significant risks, even beyond those associated with the volatility of cryptocurrency," said Kaitlin Caruso, Acting Director of the Division of Consumer Affairs. "Platforms like BlockFi may mirror the traditional financial structures that we know and trust, but in reality, they can leave investors extremely vulnerable."
Events moved quickly from there. On Wednesday, the Alabama Securities Commission echoed New Jersey's action. It gave BlockFi 28 days to explain why it should not be required to cease the sale of unregistered securities in that state.
On Thursday, Texas joined the party. The Texas State Securities Board also filed a cease-and-desist order against BlockFi. In that case, the company has until an October hearing to respond to the allegations of selling unregistered securities.
So far, BlockFi is the only company affected. And so far, the crypto community has showed little concern - many regard BlockFi as a shady operation that deserves this smack on the knuckles.
But that's dangerously short-sighted. Plenty of other crypto companies offer interest on crypto deposits, including Celsius and Nexo, as well as exchanges like Coinbase and Kraken. Their offerings are, from a regulatory standpoint, no different than what BlockFi is doing.
That means the actions against BlockFi could foreshadow a much wider crackdown on interest-bearing accounts at crypto companies. Such a crackdown would jeopardize many crypto businesses and disrupt the crypto markets.
But it didn't have to be this way...
Why Crypto Firms Are Treated Differently
What BlockFi and other crypto companies are doing isn't all that extraordinary. This isn't some wild new innovation like NFTs (non-fungible tokens).
Basically, they take deposits from customers and then use that money to generate profits. The interest payments are a portion of the profits.
The companies generate profit in several ways. Mainly, they loan out money at a higher interest rate than they pay on the customer deposits. They charge fees. They also earn profits through investing the customer deposits.
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If all this sounds familiar, it should. Banks have been doing it for decades - and it's all perfectly legal.
So what's the issue with crypto companies doing it? And since when is offering an interest-bearing account considered the sale of unregistered securities?
Good questions. Let me explain what's going on.
Savings accounts and certificates of deposits at banks are considered among the sleepiest, safest of investments. Very low risk and very low returns. Almost no one thinks of them as securities, and regulators do not treat them as such.
But the truth is, interest-bearing savings accounts and CDs both technically fit the definition of a security.
In particular, they fit the Security and Exchange Commission's definition of an "investment contract" - a type of security.
The definition is known as the Howey Test. Here it is in a nutshell: Something is an "investment contract" if it meets these four criteria: (1) It is an investment (2) in a common enterprise (3) with an expectation of profits (4) which are derived solely from the entrepreneurial or managerial efforts of others.
This is exactly why BlockFi is getting pelted with cease-and-desist orders.
Banks get a pass mainly because the interest-bearing products they offer are insured by the Federal Deposit Insurance Corporation (FDIC). That protection, in the eyes of the regulators, exempts savings accounts and CDs from being treated as securities.
The New Jersey order makes it plain that the lack of insurance is the key issue:
"The BIAs are not protected by Securities Investor Protection Corporation (the 'SIPC') or insured by the Federal Deposit Insurance Corporation (the 'FDIC'). The BIAs are subject to additional risk, compared to assets held at SIPC member broker-dealers, or assets held at banks and savings associations, almost all of which carry FDIC insurance. Nor are they registered with the Bureau or any other securities regulatory authority, or exempt from registration. Despite the additional risk, and lack of safeguards and regulatory oversight, as of March 31, 2021, BlockFi held the equivalent of $14.7 billion from the sale of these unregistered securities in violation of the Securities Law."
What's concerning is that BlockFi is not an exception. In fact, no crypto-based entity offering interest-bearing accounts has FDIC insurance. They're not eligible.
So it will probably only be a matter of time before waves of cease-and-desist orders start hitting other crypto firms.
The government should have fixed this years ago...
How Crypto Regulation Has Failed
This situation is not like what happened with initial coin offerings back in 2017. ICOs were clearly securities, and the SEC predictably moved against them.
What BlockFi and other crypto companies are doing really is no different than what banks do. It's just that they're doing it with cryptocurrencies instead of the U.S. dollar. And because of that, they can't get the FDIC insurance required to offer interest-bearing accounts legally.
One question that begs answering is why states have chosen now to act. BlockFi was founded in 2017, as were Celsius and Nexo. These companies and others have offered interest on deposits for several years. (And we're not talking bank interest rates - we're talking 5%, 8%, even 12% returns.)
So the regulators have had plenty of time to work out a solution. They haven't. Sure, they've talked about it. They've held hearings. But nothing has been done. Instead, we have states issuing cease-and-desist orders.
Clearly, this could have been handled better.
One solution could be extending the FDIC jurisdiction to cover crypto companies. Or regulators could create a sister agency to the FDIC just to deal with crypto companies.
Such an agency would be good for crypto. The FDIC, after all, doesn't just insure deposits. It also oversees the banks "for safety and soundness and consumer protection." The banks need to comply with FDIC rules - and pay premiums - to qualify for the insurance the agency provides.
Of course, a crypto version of the FDIC would only insure U.S.-based companies. But it would alleviate much of risk that has regulators so worried. And it would bring the added benefit of helping consumers know which companies to trust with their money.
Such an agency could possibly also grant charters to crypto financial institutions, although that authority may need to remain with the Office of the Comptroller of the Currency and the states (as it does with banks).
Regardless of the details, I'm sure the crypto companies would readily agree. Most have made the effort to obtain money transmitter licenses in each state in addition to complying with other relevant regulations. They'd likely welcome a crypto version of the FDIC.
Unfortunately, the authority would have to come from Congress, which created the FDIC in 1933.
The other option is having the companies register their interest-bearing accounts as securities, which strikes me as needlessly complicated.
We have a proven model in the FDIC that's worked for decades. That's the best way to move forward.
But the government can't afford to dawdle any longer. Crypto is attracting billions of investment dollars now. It's not going away. All of us - the companies like BlockFi as well as U.S. consumers - need and deserve regulatory clarity.
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About the Author
David Zeiler, Associate Editor for Money Morning at Money Map Press, has been a journalist for more than 35 years, including 18 spent at The Baltimore Sun. He has worked as a writer, editor, and page designer at different times in his career. He's interviewed a number of well-known personalities - ranging from punk rock icon Joey Ramone to Apple Inc. co-founder Steve Wozniak.
Over the course of his journalistic career, Dave has covered many diverse subjects. Since arriving at Money Morning in 2011, he has focused primarily on technology. He's an expert on both Apple and cryptocurrencies. He started writing about Apple for The Sun in the mid-1990s, and had an Apple blog on The Sun's web site from 2007-2009. Dave's been writing about Bitcoin since 2011 - long before most people had even heard of it. He even mined it for a short time.
Dave has a BA in English and Mass Communications from Loyola University Maryland.