/>iOver the past two weeks, several government agencies have expanded their reach into digital assets. Notably, the Commodity Futures Trading Commission (“CFTC”) increased its enforcement jurisdiction into decentralized finance (“DeFi”) providers in potential conflict with the recent ruling in UniSwap as to the liability of protocol developers for actions of their users, and the Securities and Exchange Commission (“SEC”) brought enforcement action against a non-fungible token seller that involved individualized tokens intended to be used as “profile pictures” on social media.
There was also important digital asset news coming out of Congress, with Representative Emmer reintroducing his Central Bank Digital Currency (“CBDC”) legislation in the House, and the SEC Chair testifying in front of the Senate Committee on Banking, Housing, and Urban Affairs.
These developments and a few other brief notes are discussed below.
CFTC Issues Orders Against Operators of Three DeFi Protocols: September 7, 2023
Background: ZeroEx (the developer of 0x Procotol), Opyn, and Deridex all entered into consent judgments with the CFTC after being charged with failing to register as a swap execution facilities and other similar charges. The charges were brought against the U.S. development companies for these DeFi protocols, and all agreed to fines and to implement changes to block access to U.S. users. Commissioner Mersinger was the sole commissioner to dissent to the actions.
Summary: Understandably, these entities chose to settle rather than spend funds litigating against the U.S. government. However, Opyn in particular already had geoblocks against access to U.S. users, had no fees on the user-created leveraged futures contract pools in question and very limited powers over the protocol through the developer multi-signature wallet. It is possible that a challenge by one or all of these entities could have limited the CFTC from pursuing these types of primarily extraterritorial enforcement actions, but that is an expensive fight so the industry is left with still unsettled questions regarding the necessary level of geoblocking for protocol developers and when developers of protocols can be liable for actions of their users.
LBRY Files Notice of Appeal of Summary Judgment: September 7, 2023
Background: LBRY, Inc. has filed a Notice of Appeal of the final judgment entered into against it on July 11, 2023. LBRY, Inc. was the developer of a project which aimed to create a Web3 version of YouTube, where individuals could pay in tokens to upload videos, and others could pay to those creators for access to the videos or to tip their favorite creators. LBRY argued that, under the precedent set in United Hous. Found., Inc. v. Forman, security laws do not apply when a buyer purchases an asset primarily to use or consume that asset. The Court disagreed, siding with the SEC and ruling that nothing in the case law suggested to the Court that a token with both consumptive and speculative uses cannot be a security.
Summary: We covered the LBRY decision on the BitBlog when it was first issued in November of last year. After the ruling, the SEC lowered its requested damages from $44 million to just over $100,000 due in large part to the fact that LBRY did not have any further funds to cover a greater damages award. That raises questions as to who will be funding and litigating this appeal, which has the potential to create a powerful and groundbreaking appellate-level precedent.
House Majority Whip Tom Emmer Reintroduces CBDC Legislation: September 12, 2023
Background: Majority Whip Tom Emmer reintroduced his legislation, the Central Bank Digital Currency (CBDC) Anti-Surveillance State Act, in the House of Representatives. The bill is co-sponsored by 50 other Republicans in the House. The bill prohibits the Federal Reserve from issuing a CBDC directly to individuals, to prevent surveillance into the personal financial information of Americans.
Summary: CBDC’s are hot-button issues, as they are undeniably more efficient than the current system which relies on financial service providers like banks to serve as middlemen between the issuer of currencies and the users of those currencies. However, it also would create a government-controlled single point of financial information which raises obvious security and privacy concerns. It is expected that up to 2% of the global money supply could be tokenized in CBDCs and stablecoins by 2028 so this will remain a hot-button issue as state and private actors determine the best form of digital currencies.
SEC Chair Gary Gensler Testifies to Congress on Digital Assets: September 12, 2023
Background: SEC chair Gary Gensler testified in front of the Senate Committee on Banking, Housing and Urban Affairs on September 12. His opening statement is available here. He has a follow-up hearing before the House Financial Services Committee scheduled for September 27.
Summary: The big news from the hearing was the statement that the SEC was “still reviewing” the Grayscale spot Bitcoin ETF filing after the D.C. Circuit struck down the SEC’s rejection of the Grayscale application. With the Senate largely seen as behind the House in terms of digital asset legislation, it was not surprising that much of the testimony was focused on other aspects of the SEC, including rulemaking regarding environmental disclosures and mutual fund settlement rules. The House Financial Services Committee is expected to cover more digital asset-specific issues when they question the SEC Chair on September 27.
SEC Brings Enforcement Action Against “Profile Picture” NFT Project: September 13, 2023
Background: On September 13, the SEC released a Consent Order for an immediate cease-and-desist along with monetary fines for the creators of the “Stoner Cats” NFT project, through which NFTs were sold to fund the creation of an animated series. Similar to the prior NFT enforcement action, Commissioners Peirce and Uyeda dissented comparing the sales of the NFTs to sales of Star Wars merchandise. The project creators agreed to settle the dispute without admitting or denying any wrongdoing.
Summary: The SEC’s first NFT enforcement action was covered in our last Bi-Weekly update. This most recent action is notable not only because of the names behind the project (Mila Kunis and Ashton Kutcher, among others) but also due to this being the first “profile picture project” named for NFTs which have unique artwork for each token in the collection intended to be used as social media profile pictures. As with any regulation by enforcement, this still leaves questions as to when a product sale is an unregistered security offering as opposed to something more properly under the FTC or other agency’s jurisdictional oversight. Certain aspects of the Order, such as pointing to secondary sales royalties, coordination of verification with secondary sales platforms and the requirement that tokens be “destroyed” rather than prohibited from resale are all potentially problematic features of this Order which could do more harm than good to consumers and artists on a going-forward basis. However, NFT creators should carefully consider how they market their products and how they discuss the use of sales proceeds to avoid potential regulatory pitfalls.
Briefly Noted:
Industry Groups and Participants Write to Senate Regarding Digital Asset Taxation: The Wall Street Blockchain Alliance (of which Polsinelli is a member) submitted the following letter to the Senate in response to its request for the appropriate treatment of digital assets under federal tax law. Polygon Labs and others in the industry also submitted letters.
New York Department of Financial Services (DFS) Updates Listing Guidelines: DFS announced proposals for new guidance for coin listings and a framework for green listed coins that include heightened risk assessment standards for coin-listing policies and tailored, enhanced requirements for retail consumer-facing products or service offerings, along with new requirements for coin delistings. Each regulated virtual currency licensee would need to have these policies approved by DFS. DFS is seeking public comment through October 20. As most of the major US crypto exchanges are regulated by DFS, either as trust companies or through a “BitLicense”, these guidelines could have a significant impact on what coins get listed. This also seems to run counter to recent efforts by the New York Attorney General to further regulate cryptocurrencies and label most of them (including Ethereum) as securities under the Martin Act.
Ethereum Founder Pushes for Compliant Mixing Services: Ethereum founder Vitalik Buterin released a paper with others titled Blockchain Privacy and Regulatory Compliance: Towards a Practical Equilibrium. It argues for the use of a permissioned mixing service, using zero knowledge proofs to only allow participants who confirm their funds were acquired legally to use the service.
IOSCO Issues DeFi Policy Recommendations: The Board of the International Organization of Securities Commissions (IOSCO) issued a consultation report regarding decentralized finance (DeFi). The report was largely written by member organizations, the SEC, so the recommendations largely follow the SEC’s policy recommendations on the subject.
Advocacy Group Files Action to Invalidate Oracle Patent: DeFi Education Fund is petitioning to cancel the patent claiming the invention of oracle-like tech and being used to sue MakerDAO and Compound. You can read a blog post about the challenge here.
Conclusion:
From the CFTC's actions against DeFi protocols to the SEC's groundbreaking enforcement of NFTs, it's evident that the U.S. government is taking significant steps to gain a better grasp on this rapidly evolving ecosystem. What's more, these activities have set the stage for ongoing debates around digital asset taxation, blockchain privacy, and international policy recommendations.
Yet, despite all these regulatory moves, numerous questions remain unanswered. The tension between fostering innovation and enforcing compliance continues to be a pivotal concern. This creates an uncertain environment, not just for entrepreneurs and developers, but also for consumers and investors. As we move forward, one thing is clear: the dialogue between the digital asset industry and regulatory bodies is more crucial than ever. It is this dialogue that will ultimately shape the opportunities and limitations of blockchain technology in the years to come.
