The Securities and Exchange Commission (SEC) announced today that it would hire 20 additional positions to the Crypto Assets and Cyber Unit (formerly known as the Cyber Unit) within the Division of Enforcement, increasing the number of dedicated positions to 50. The “Crypto Unit” is tasked with protecting investors in crypto markets and from cyber-related threats.  With more personnel and resources available, the SEC believes the unit will be “better equipped to police wrongdoing in the crypto markets” while still staying involved in disclosure and controls issues with respect to cybersecurity.

According to the release, the 20 additional hires will include supervisors, investigative staff attorneys and fraud analysts, with a focus on investigating securities law violations in: crypto asset offerings, exchanges, and lending and staking products; decentralized finance (“DeFi”) platforms; non-fungible tokens (“NFTs”); and stablecoins.

As we stated in a recent post, statements and proposals by financial regulators suggest that providers should expect more scrutiny and additional compliance hurdles going forward.

What does this mean?

• More investigation and enforcement in the future: The obvious upshot of this announcement is that the SEC will have more resources and staff to conduct investigations and launch enforcement actions against individuals and entities in the crypto asset space that may have violated federal securities laws. The SEC’s release trumpets its record of 80 enforcement actions since 2017 related to fraudulent and unregistered crypto assets offerings and platforms, with many actions relating to the issuance of new tokens and cryptocurrencies.

• Not just low-hanging fruit: With more resources and staff available, it’s likely that the Crypto Unit will have the bandwidth to undertake more intensive investigations, going beyond cases of outright investor fraud in the sale or promotion of cryptoassets and perhaps into more nuanced areas of enforcement of DeFi platforms, NFTs (and fractional NFT offerings), and stablecoin disclosures and reserves.

• More technology resources for investigations and risk prevention: With the hiring of more fraud analysts, the Crypto Unit will have additional resources to deploy its array of software and AI-based programs to conduct deep analysis on crypto markets and company disclosures. Back in 2017, an SEC Acting Chief Economist spoke about the Commission’s use of AI and machine learning algorithms to detect potential misconduct and patterns of fraud and to monitor markets.  Fast forward to 2021 when the SEC, for example, awarded a contract to a blockchain security firm to assist in deep analysis of smart contracts and blockchain transactions.

• Additional clarity? The greater potential for investigations and enforcement may bring additional compliance burdens onto companies in the crypto space. But while we wait for legislative solutions in Congress (and whether several crypto-focused proposals outlined by SEC Chair Gary Gensler will be adopted), the expected uptick in enforcement and investigation of cryptoasset practices will hopefully bring more regulatory clarity to certain discrete areas.

Preparing for the future – where will the scrutiny fall?

One would expect that the Crypto Unit may bring enhanced scrutiny to crypto asset exchanges. In remarks from August 2021, Chair Gensler pointed out that crypto trading and lending platforms undoubtedly are trading unregistered securities:

“The world of crypto finance now has platforms where people can trade tokens and other venues where people can lend tokens. I believe these platforms not only can implicate the securities laws; some platforms also can implicate the commodities laws and the banking laws. A typical trading platform has more than 50 tokens on it. In fact, many have well in excess of 100 tokens. While each token’s legal status depends on its own facts and circumstances, the probability is quite remote that, with 50 or 100 tokens, any given platform has zero securities.” [emphasis added]

Moreover, in a speech given in April 2022 about crypto markets, Chair Gensler stated that crypto exchanges and DeFi platforms “likely are trading securities” as “many of the tokens trading on these platforms may well meet the definition of ‘securities.’”  Gensler even noted that he had asked staff to work on “a number of projects related to the platforms.”  In the same speech, he reiterated his urging to crypto exchanges and DeFi platforms to come in and register with the SEC much like traditional financial exchanges, thereby increasing trust in the crypto markets and improving investor protections.  Large trading platforms have generally bristled at registering with the SEC (and the additional federal oversight that comes with it), claiming they are not involved in the trading of securities.

Reading the tea leaves from Chair Gensler’s April remarks, one might also see the bulked-up Crypto Unit taking a closer look at crypto custody arrangements (given the number of cyber hacks against crypto platforms) and also conducting additional oversight of stablecoins, given their growth and pivotal role in the crypto ecosystem.  Of course, the SEC will continue to examine unregistered token sales.

In the end, crypto may offer new avenues to raise capital or trade, but in the SEC’s view, such transactions should not be conducted without adequate investor and market protection. Thus, with the SEC’s announcement regarding new hires in the Crypto Unit, a wide array of crypto asset providers should take the time to examine potential securities law issues that may be bubbling under the surface.

And hopefully, and to end this post on an optimistic note, greater attention from regulators will provide clarity and certainty to the burgeoning crypto ecosystem, so that companies and investors can move forward with an understanding of the rules of the road.