Cryptobanking is happening: Regulations and Opportunities for FIs and Community Institutions

Dr. Russ Hittinger (NetQash)


If your institution doesn’t have a crypto strategy for your FI, you need to develop one now!


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In my previous articles leading up to Cryptocom, Other people’s money…Massive opportunities for Community FIs via Trusted Custodianship of Crypto and Facebook’s Libra & the history of stable value: who decides whether cryptocurrency is “real money?”, I examined two major themes in regards to cryptocurrencies: 1) the current gap in the crypto-space filled by shoddy financial intermediaries and a future for custodianship of digital currencies that could be filled by community FIs and 2) how the recent attention to Facebook’s Libracoin and the question of whether cryptocurrency is “real money” or not reverberates throughout the long history of the shifting definitions of money. In the latter case, I concluded that cryptocurrency is very much “money” and argued that it’s only a question of time until our definitions catch up with reality. Touching on both of these themes, in this article, I’m going to provide a round up of recent developments in the regulation cryptocurrencies: the current pace of regulation suggests that the definition of cryptocurrency as legal money is immanent.


The problem of defining what cryptocurrencies are is inherent to the term itself, where the word “crypto” suggests “hidden” or “secret” and the word “currency” is associated with government issued fiat money— two things that appear to be contradictory. But, as Nathaniel Popper writes in his book Digital Gold, the problem with the name goes back to the fabled pseudonymous founder of Bitcoin “Satoshi Nakamoto” and his partner Martti Malmi, which arose over a geeky conversation about an email list:


“Satoshi [had] pointed to a recent exchange on the Bitcoin email list in which a user referred to Bitcoin as a “cryptocurrency,” referring to the cryptographic functions that made it run. ‘Maybe its a word we should use when describing Bitcoin, do you like it?’ Satoshi asked. ‘It sounds good, Martti relied. ‘A peer to peer cryptocurrency could be the slogan.’”


Thus was born the term “cryptocurrency,” after its cryptographic security features, for which digital money would perhaps be a better moniker. Needless to say, the word itself represents a concept and a reality that the law and regulators were not yet equipped to define until years later, but that is QUICKLY changing both in the United States and around the world. Regulatory clarity is upon us.


One such HUGE development in regulatory clarity seems to have gone largely unnoticed in the United States. In December, the upper parliament of Germany, the Bundesrat, passed a billthat creates a regulatory framework for German states to allow banks in Germany to store and provide financial services in cryptocurrencies starting in 2020. With the help of the new regulation, bank-based crypto-custodianship will exist alongside cryptocurrency exchanges, but function as separate entities to protect consumers from the dangers I previously highlighted in my article “Other people’s money.” As one of the largest economies in the world and the most influential state in the European Union, German legislators, supported by the heads of nearly 200 German financial institutions, are sending a strong message at home and abroad that cryptocurrencies are accepted and that Germany is open for business in financial innovation as a pro-crypto country.


The US Federal government has gotten close to establishing a working legal framework too, but has gotten bogged down in definitional problems.


Problems in defining cryptocurrencies from a regulatory standpoint: commodity, security, or “currency”


A great deal of ink has been spilled on this topic, so we can summarize the regulatory confusion as a question of whether or not a cryptocurrency is actually a security. As you know from Economics 101, a security is a “a fungible, negotiable financial instrument that holds some type of monetary value. It represents an ownership position in a publicly-traded corporation—via stock—a creditor relationship with a governmental body or a corporation—represented by owning that entity's bond—or rights to ownership as represented by an option” (Investopedia). One of the difficulties that clouding the status of cryptocurrencies regards ICOs (initial coin offerings), in which an organization or individuals issue units of cryptocurrency in exchange for fiat money. Is the crypto a commodity or utility token? Or, even if it is those other things too, is it actually tacitly or explicitly a “share” in a business that represents or implies future value or equity/profits to be returned to investors upon redemption of the token? (A commodity or a security could fluctuate in market value; market fluctuation or tradability has nothing to do with the definition).


While there have been many successful models of adopted cryptocurrencies in the “unregulated” world of crypto like Etherium, Litecoin, Bitcoin, and XRP, many other tokens and coins have been offered to buyers that seemed to have functioned rather like stock offerings, and many were awful pump and dump schemes. In other words, the sale of the digital assets functioned more like a capital raise for the creators that would create an expectation of shareholder value and participation rather than the asset functioning as a monetary commodity that is not tied to such an expectation. Lawsuits followed.

Regulators have seen that making this distinction is thus key. How do we tell the difference? The SEC itself has gone to great pains to explain the difference between crypto as a security and crypto as a commodity (while the IRS classifies crypto as a commodity, in so far as it taxes it like property). In its report “Framework for ‘Investment Contract’ Analysis of Digital Assets,” the SEC focuses on running the “Howey test” for the purposes of classifying a particular cryptocurrency:


The U.S. Supreme Court's Howeycase and subsequent case law have found that an "investment contract" exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others. The so-called "Howey test" applies to any contract, scheme, or transaction, regardless of whether it has any of the characteristics of typical securities.The focus of the Howey analysis is not only on the form and terms of the instrument itself (in this case, the digital asset) but also on the circumstances surrounding the digital asset and the manner in which it is offered, sold, or resold (which includes secondary market sales). Therefore, issuers and other persons and entities engaged in the marketing, offer, sale, resale, or distribution of any digital asset will need to analyze the relevant transactions to determine if the federal securities laws apply.


Under federal law, however, three overlapping jurisdictions of the Financial Crime Enforcement Network (FinCEN), the SEC, and the Commodity Futures Trading Commission (CFTC) oversee cryptocurrency. The application of the Howey test determines how any cryptocurrency would be classified and regulated by those bodies. In short, the SEC is authorized to regulate crypto-assets that can be deemed “securities”—instruments like stocks and bonds. And though some cryptocurrencies do classify as securities, the SEC itself has determined that Bitcoin (and presumably many similar tokens), is not a security, meaning that it is unclear if the SEC would be able to regulate it. As Kelly Funderburk explains in the Regulatory Review, the CFTC considers Bitcoin a commodity—“that is, a good that can be purchased and sold, such as oil or gold.” The CFTC therefore has authority to regulate any “derivative” product involving commodities, such as contracting to buy Bitcoin on a future date at a price agreed upon today. But given lack of clear regulation, the CFTC still has “limited authority over trading commodities for cash, and a considerable amount of activity in the crypto-sector actually revolves around buying and selling Bitcoin for cash.” That also means that the SEC lacks such jurisdiction as well.


For this reason, clarity of the sort provided by German regulators to regulating the exchange and custodianship of non-security cryptocurrencies in the banking industry is imperative. In a widely circulated study from the Brookings institution, Timothy Massad of the Kennedy School of Government of Harvard University, has pointed out that that the federal government needs a comprehensive strategy for crypto-regulation that clarifies the regulatory authority of one of these agencies to oversee the cryptocurrency cash market, and the role that financial institutions play in the custodianship and transactions of cryptocurrency.


It is therefore no surprise that new legislation in the US seems to be coalescing around these definitions and moving to fill the regulatory gap.


Wyoming and Colorado: A Federal Model?


Seeking to resolve these messy regulatory gaps, Wyoming was one of the first states to give clarity to the crypto space. In 2018, the Wyoming House passed a bill that classified many cryptocurrencies as “utility tokens,” exempting them from securities regulations— in recognition that not all cryptocurrencies are securities. According to Caitlin Long, of the Wyoming Blockchain Coalition, “The state of Wyoming is the first elected body in the world to define a utility token as a new type of asset class different from a security or commodity…This has been a hot topic in Washington D.C. recently, as the SEC considers cryptocurrencies to be securities, FinCEN says they’re generally money, and the CFTC views them as commodities. Now, however, you have a state coming out and defining utility tokens as a new form of property, and property is generally the purview of state law.” One of the benefits of this law is that it is paving the way for legal charters for banking in cryptocurrencies. Colorado has recently copied this model: Gov. Jared Polis singed a bill last year, the Colorado Digital Token Act, exempting certain cryptocurrencies from securities regulations.


Congress does seem to be catching up. While many bills are circulating capitol hill, the Crypto-Currency Act of 2020 would provide the clarity that the SEC, CFTC, and FinCEN need to create a healthy space for financial innovation in the United States led by FIs as legitimate intermediaries and custodians, while mimicking some of the work already done in states like Wyoming and Colorado. As Forbes reports, the bill would make the CFTC regulator of crypto-commodities, the SEC regulator of crypto-securities, and FinCEN the regulator of crypto-currencies. In particular--to avoid the arcana of legal definitions—this bill would effectively make what we refer to as crypto-currencies, tokens like Bitcoin, Litecoin, Facebook Libra (if ever released) etc. actually either “crypto-commodities” or “crypto-currencies.” You can read more about it here, but the BOTTOM LINE is that very soon congress will provide clear Federal frameworks financial services and banking in cryptocurrencies.


As I suggested at the outset of this cursory review of events related to cryptocurrency and banking, If you don’t have a crypto strategy for your FI, you need to get one now!


For more on this topic and the history of money, sign up for my Cryptocom discussion, Historical & Contemporary Dynamics of Community Flourishing & Digital Economies.

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