Cryptocurrency 101: The basics of risks and regulation for in-house counsel

Cryptocurrency is hot and getting hotter every day. Crypto ads are everywhere, including prominent placements during the 2022 Super Bowl. Digital crypto assets have crossed the $3 trillion mark and continue to climb, gaining the acceptance of ever larger swaths of mainstream America — you can even find crypto ATMs. While there have been some recent major corrections in the marketplace, most experts expect that the trajectory of cryptocurrency will continue its explosive pace over the next several years.

One reason for the rocket-fueled growth is the relatively lax regulatory environment over the past five years or so. Of course, like the gold rush of the 1800s, the wild west nature of cryptocurrency could not last forever. It was only a matter of time before regulators started to dive into how best to regulate this new currency. As we hit the halfway point of 2022, there are a number of new laws coming online or under consideration both at the federal and state level. In-house counsel should have a basic understanding of cryptocurrency, the risks, and the legislative and regulatory landscape here in the United States — this article covers all three.

Cryptocurrency 101: Understanding the basics

To understand the current state of laws and regulations — existing and proposed — you must start with a basic understanding of cryptocurrency. Simply put, cryptocurrency is a digital, or virtual, currency that utilizes complex cryptography to create secure, encrypted assets and a blockchain distributed ledger to store them. The currency is commonly referred to as “coins” or “tokens”; the most popular being “Bitcoin.” The currency is literally a series of algorithmic transactions stored on the distributed ledger which, in turn, is recorded in multiple locations at the same time so there is no central data store — that is, it is not a currency issued by banks or governments.

Users store their coins in a digital wallet that is encrypted and accessible only through passwords and other security measures. Anyone, anywhere, can transfer their coins to pay for goods and services purchased from anyone who accepts the currency. It is all completely digital with no “physical” money to hold. As transactions are made, they are recorded on the distributed ledger. 

As you can see, part of the problem with cryptocurrency is the difficulty in explaining what it is or how it works. This drawback alone has kept many individuals and businesses from investing in or using and accepting digital currency and — more importantly — has drawn the attention of regulators looking to protect unsophisticated investors from a nascent monetary technology backed by tremendous hype and with huge financial implications for the unwary or uneducated.

What are the risks of cryptocurrency?

As with anything new, there are risks. To start, the current cryptocurrency market is highly volatile. It has soared and fallen — sometimes on the same day. For example, the collapse of the allegedly “stablecoin” TerraUSD has spooked cryptocurrency investors and left many wondering if there is another high on the horizon or whether this is the future of cryptocurrency for the near term. Since regulators are still catching up to the market, cryptocurrency is ripe for fraud and abuse. Indeed, it already has a reputation as the preferred money for ransomware criminals, the “dark web,” money laundering, and other unsavory practices. 

Similarly, because these are technology-based assets, cryptocurrency can be — and have been — hacked and stolen. Moreover, unlike a bank account, if you lose the password to your digital wallet, you are literally out of luck and can never recover your coins or investment. Lastly, while growing in popularity and acceptance, it is still difficult to spend your cryptocurrency on everyday transactions. All of these risks must be considered by in-house counsel as their companies contemplate how best to get in — or stay out of — the crypto market.

An overview of crypto regulation

The rise in popularity of cryptocurrency, coupled with its risks and somewhat shady reputation, has grabbed the attention of regulators, both at the federal and state levels. Regulation so far is mixed — regulations both to promote and rein in cryptocurrency. Here are four areas to pay close attention to in the near future.

• Executive Order regulating cryptocurrency activities. On March 9, 2022, President Biden signed an Executive Order on Ensuring Responsible Development of Digital Assets. It is the first “whole-of-government” approach in the U.S. to develop and regulate cryptocurrency activities. The Order covers six areas:
• Consumer and investor protection
• Financial stability and systemic risk
• The prevention of illicit finance
• U.S. leadership and competitiveness
• Financial inclusion
• Responsible innovation

While the Order does not set out a comprehensive regulatory framework, it directs parts of the federal government to issue reports and recommendations on potential regulatory and legislative actions. This will mean heightened action by the Treasury Department (OFAC), the Financial Stability Oversight Council, the Commerce Department, and the Federal Reserve — the latter tasked with the potential development of a U.S. central bank digital currency.

Other agencies implicated include the FDIC, CFPB, FTC, DOJ, and SEC.

• SEC action regulating crypto exchanges. It’s no surprise, but the SEC is already undertaking action, looking to expand investor protections in the cryptocurrency market. The SEC plans to register and regulate crypto exchanges, which take possession of their customers’ coins and are a ripe target for hacker attacks. Any such regulation should help increase market stability, stabilize values, and reduce fraud — all good things for this nascent technology.
• IRS cryptocurrency disclosure requirements. While the SEC thinks of crypto as securities, the Treasury Department thinks of it as currency, meaning the IRS sees it as taxable income and requires that investors disclose cryptocurrency activity on tax returns. This means both business and individual investors need to be aware of how their crypto activity can trigger tax liability.
• State governments see economic benefits to cryptocurrency-friendly legislation. While the federal government tends to be the most visible, the lack of comprehensive federal action on cryptocurrency over the past few years has left plenty of space for state governments to step into the void. In fact, many states are falling over themselves to be seen as “crypto friendly” and hoping to reap the benefits of a booming marketplace integrated into their economies. 

Armed with powerful lobbyists, cryptocurrency companies are looking to smooth the path for their offerings, positing over 150 pieces of cryptocurrency-related legislation in 40 states in 2022 alone. The proposals range from exempting cryptocurrency from securities laws to avoiding laws aimed at curbing money laundering to declaring coins as legal tender that can be used to satisfy debts. Still, it’s not all smooth sailing for cryptocurrency companies. States are also looking to regulate mining centers — supercomputers located in a data center where digital currency is created and mined. 

The book on cryptocurrency is just starting to be written. How crypto fares in terms of success, usefulness, and acceptance by “Main Street USA” depends in large part on how the regulatory aspects play out. If regular investors feel it is a safe investment, it will thrive and businesses will need to adjust accordingly. If not, then cryptocurrency will remain a small part of the marketplace, playing on the fringes but never crossing into wide acceptance. 

Regardless, in-house counsel will need to monitor these developments and ensure their companies are well placed to deal with cryptocurrency in whatever forms emerge over time. If you have Practical Law, you can monitor these developments and stay abreast of the latest news by using the Crypto Toolkit and Tracker.  The answers you need are just a click away.