Jake Chervinsky, general counsel at Compound, goes over a plethora of crypto regulatory issues, such as those related to securities law such as the SEC vs. Kik case, Ripple, stablecoins, no-action letters, Blockstack and more. We also discuss whether there should be one regulator for crypto matters in the US, whether it makes sense to create a new category for digital assets instead of applying laws for securities, commodities, etc., to digital tokens, and why he thinks Libra will likely not launch in its proposed form. He also gives his odds on a Bitcoin ETF being approved soon, talks about the tension between privacy and financial regulation and reveals what he thinks is the biggest regulatory issue in DeFi that no one’s talking about.
Thank you to our sponsors!Crypto.com: https://www.
Jake Chervinsky: https://twitter.com/
Unchained interview with Compound CEO Robert Leshner: https://unchainedpodcast.com/
Unchained with Ted Livingston of Kik about its intention to fight the SEC in court: https://
Kik’s Wells response: https://www.kin.org/
SEC no-action letter to Quarters: https://www.coindesk.com/sec-
SEC Commissioner Hester Peirce on the first no-action letter for a token: https://www.sec.gov/
Unconfirmed episode on Blockstack’s Reg A+ filing: https://
Decrypt article on issues with issuing a token under Reg A+: https://decrypt.co/7839/
Jeremy Allaire’s testimony to Congress: https://www.banking.
Unchained interview with Jeremy Allaire on regulations: https://
Push for new crypto regulations: https://www.wsj.com/articles/
Sanctions coming to crypto: https://www.coindesk.com/get-
Hi, everyone. Welcome to Unchained, your no-hype resource for all things crypto. I’m your host, Laura Shin. In case you haven’t heard, I have another crypto podcast called Unconfirmed. It’s shorter and newsier and comes out Friday’s. If you haven’t taken a listen, go check it out.Kraken
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My guest today is Jake Chervinsky, general counsel at Compound. Welcome, Jake.
Hey, Laura, thanks for having me.
You’ve become known on Crypto Twitter for your incisive commentary on crypto legal and regulatory issues. How did you come to be involved in this space?
Great question. So, I actually got interested in crypto mostly as a personal passion back in, I would say, early 2017, and you know, really didn’t think I was going to turn it into a profession or do any legal work in the space, but I was actually getting information myself about the crypto industry from Crypto Twitter.
It’s a very interesting place but a great resource to find out what’s going on, and I came to realize, as I consuming news there, that there were a lot of people who are very important figures in the industry who were asking fairly basic questions about the application of rules and regulations to the industry, but they weren’t getting any answers, and it seemed like there just weren’t any lawyers who were willing to get involved on Twitter and talk to these people about what they were seeing, and so, I decided to jump in and play that role myself.
So, I think the first time I actually tweeted something that got some attention was about a year ago when everyone was talking about the VanEck bitcoin ETF proposal, and everyone thought at the time that the ETF proposal was going to get ruled on by the SEC within like 45 days of when it was first filed, and of course, that’s not how the SEC operates, so I jumped in just to explain, sort of in general, how these ETF approval process works, and overnight, I think I went from 300 followers to about 3,000, and I guess the rest is history.
I love it. Crypto Twitter is so active, and I also had a similar story with my following. Just people are hungry for information, but can you also describe your legal background? Because I actually think it intersects really interesting with a lot of the issues in crypto.
Yeah, definitely. So, I graduated from the George Washington University Law School and went straight to a very large law firm called Baker McKenzie. I was working in their compliance and investigations practice and also doing some litigation, so a lot of my work was around risk assessments and compliance strategy dealing with anti-money laundering and anti-corruption issues, mostly for multinational corporations but also for some individuals, so a lot of work around the finance industry, around financial services.
I did that for a couple of years, and then left to take a federal clerkship, a position in the chambers of a federal district judge in Los Angeles, and then, after I completed my one-year term clerkship, moved on to a different firm, Kobre and Kim, where I was doing a lot more litigation and especially government enforcement defense, so responding to subpoenas from regulatory agencies like the SEC and the CFTC, defending individuals and companies prosecuted for crimes by the Department of Justice and then also doing some civil litigation around that, much of it dealing with the financial services industry.
So, yeah, definitely, my experience sort of primed me to deal with some of these sticky and novel legal issues that we’re handling in the crypto industry.
You just mentioned the SEC, and obviously, that’s been such a huge issue in this space, meaning how the SEC regulations intersect with the CryptoCs, so I want to ask about one of the major topics there, and we’re going to kind of go into a lot of SEC issues, just to start. What do you think of SEC versus KIK? Which side, to you, has the better case?
That’s really hard to say. You know, it’s always hard to give an opinion about a case that is at such an early stage because there are so many facts out there that we just don’t know, and I mean, that’s the beauty of the litigation process in the American justice system is it’s designed to get all those facts out as time goes on, so you know, I’ll give you that disclaimer, that you know, who knows how this will all turn out.
I guess, for me, the question is more a legal one than a factual one. There’s not a whole lot of dispute about what KIK did or why. I think all of the questions are about how the federal securities laws apply to these public token sales. So, I think that the case is a really great opportunity to dive into the Howey Test and look at some of the nuance of the different prongs of that test and how they come out when you’re talking about tokens with very different types of characteristics.
So, you know, I think, in many ways, it’s going to come down to how the court decides to interpret the Howey Test, and there’s really no way to predict how that’s going to go, so you know, it’s kind of hard to answer that question.
Do you think it was smart of KIK, though, to not come to an agreement with the SEC and to force things into court?
Also, really tough to say because we don’t know what kind of offer they were made. So, I guess stepping back for a second…the assumption with any type of government enforcement action like this is that there’s a whole lot of discussion between the target of an investigation, in this case KIK, and the enforcement agency, here the SEC, before you ever see something like a public complaint filed in a federal district court, and almost always, those discussions result in some kind of settlement offer from the SEC.
So, you know, depending on what the SEC offered KIK to make this whole situation go away, it’s really hard to say whether they made a good or a bad decision by deciding not to take it and by deciding to move forward with this openly-contested proceeding.
The interesting thing, though, that they decided to do was to make this whole process public, which is very unusual. So, in almost all circumstances, these investigations, whether it’s the SEC or some other regulatory enforcement agency, these investigations are kept confidential, and we, the public, usually don’t find out about them until there’s been a settlement, and a settlement is announced by both sides.
And in this situation, KIK decided instead of letting this whole process stay confidential, they actually published some of the materials from the investigation and from the negotiation process. What they published is called a Wells Response, which is basically their argument to the SEC of why they should not be targeted for an enforcement action. That is a very unusual thing to do, sort of like an open challenge to the enforcement agency to go after you, and that, I think, was an interesting and very unusual tactical decision.
And was it smart in your opinion?
I mean, it depends, again, on what kind of offer they were made. My guess is they refused to accept whatever offer they were given by the SEC, either because the dollar amount was too high or because the SEC wanted to require them to do something that they felt they couldn’t do, like register their token and treat it as a security, which has all these other follow-on impacts, like needing to do disclosures and needing to do auditing and needing to treat the token itself as a security, which means that there are some restrictions on how it can be transferred.
So, you know, all these sorts of things, I’m guessing, that KIK wasn’t willing to do. I guess I would say I have never advised a client to publish a Wells Response, and I’m not sure that I would have advised KIK to do that because, basically, what you’re doing is the equivalent of slapping the SEC in the face with a white glove and saying I challenge you to a duel.
There’s no way you’re not going to get targeted for an enforcement action once you’ve done that, and why KIK didn’t want to just stay quiet, like the dozens and hundreds of other companies that issue tokens and have survived without being targeted for an enforcement action, I’m not totally sure, so you know, as a lawyer, I hesitate to pass judgement on the advice or work of other lawyers, but I would definitely say it’s an unusual and usually not advisable strategy to take.
And why do you think the SEC chose to go after KIK, as opposed to something like Ethereum, which is so much bigger, and they’ve kind of hinted that they had an unregistered securities offering as well. Is it literally…like I was also trying to figure out how important the fact is that KIK did its token sale after the DAO report was…like, is it simply that, you know, Ethereum did this well before the DAO report would have given any clarity or guidance?
Yeah, I think you’ve nailed it, and the SEC has said this in a number of the orders that they’ve issued settling other enforcement actions, so like the Paragon and Airfox and Gladius settlements, which were other token issuers that the SEC worked out a deal with.
Basically, what they said was the reason that this violates the securities laws, in part, is because the token was issued after the Dow report came out, and as of the time that the Dow report came out, everyone in the industry should have known that doing one of these public token sales was going to be treated as a securities issuance, so I think the big reason why the SEC would go after a company like KIK and not something like the Ethereum Foundation or anyone involved in the Ethereum sale is just a matter of time and the fact that Ethereum came out before the Dow report.
I would also say, though, the reason the SEC goes after KIK as opposed to the other hundreds of companies that have put out tokens after the Dow report, I think, is exclusively because of KIK publishing their Wells Response. You know, I think that, if any other company had done what KIK did, they also would have been targeted for an enforcement action, and we all know that there are lots of other companies that the SEC has sent subpoenas to, that the SEC has been investigating, that have gone through the Wells process and have sent Wells Responses to the SEC but have not been targeted for a public enforcement action, and I think that’s just because they played by the traditional rules of the road here in Washington, DC, which is you don’t publicize these things because, if you do, you force the SEC’s hand.
Yeah. Something that I find interesting about this case is, like, I feel like it’s not a perfect example for the SEC, and I feel like KIK isn’t a perfect example for the crypto industry, so, in that regard, I feel like it’s a good case for kind of getting into the weeds a little bit.
Let’s talk about the no action letters that the SEC has issued. So far, they’ve issued two for tokens that a lot of people are saying didn’t even need no action letters, such as SEC Commissioner Hester Peirce, who said in this speech “this transaction is so clearly not an offer of securities that I worry the staff’s issuance of a digital token no action letter, the first and so far only such letter, may in fact have the effective broadening the perceived reach of our securities laws.”
She was talking about the TurnKey Jet no action letter. Do you agree with her on that? Like, how useful do you think these no action letters have been?
I completely agree with her. I think that the no action letters are basically useless. I think there’s two ways of looking at it. There’s an optimistic view, and there’s the pessimistic view, which is, frankly, the one that I take, but just for fun, let me articulate the optimistic view, which is that the SEC is trying to work with people who want to issue tokens, and that by doing these no action letters, the SEC is essentially saying, look, we’re willing to work with you if you’re willing to work with us, and we’re willing to tell you that we’re not going to go after you for issuing a digital asset, so please come work with us, and just like these other companies that got these no action letters, maybe we’ll give one to you, too, and that, I think, would be a very positive sign.
That’s not really my view. My view is the second version, which is the message that the SEC sends by doing these no action letters is, basically, these are the only types of digital assets that we are confident do not warrant an enforcement action, and when I say these types of digital assets, what I mean is tokens that basically don’t resemble a crypto currency in any way that we would think of them. Right?
Both of the no action letters that we’ve gotten have been for what looks like a reward point system, not that different from typical airline miles, where the tokens are truly pegged, one-to-one to a dollar or to a specific amount of fiat currency, not through some kind of reserve system or algorithmic system, rather because the company issuing the token says literally this is worth one dollar, or this is worth one quarter.
The tokens are not transferrable. There’s no trading or exchange of those tokens. They’re useful only within this very closed system that the issuing company has created, and that, basically, doesn’t offer any of the interesting characteristics of what we think of when we talk about crypto currencies, so to me, the message from the SEC is either we’re not comfortable approving anything that you guys actually think is interesting, or we just haven’t gotten there yet, so you know, I don’t take it as a very encouraging sign.
One thing that the SEC has done, however, is that they’ve given their blessing to a couple of tokens who registered under the Reg A+ offering, which is what enables even non-accredited investors actually to participate in these sales. One was for Blockstack, the other for the PROPS token, which is used in the YouNow app, and I was wondering though, like, what does it mean for a blockchain-based network to have a token that’s a security? Like how does that affect (a) the functioning of the network, and then (b), the ability even for these tokens that start this way to actually become utility tokens?
Great questions. I think, in general, we’re going to have to wait and see what the real impact is and whether it’s even possible for a token to exist in a meaningful way as a security. I think, in terms of how it affects the network, the main restrictions, especially if you’re talking about Reg A+, is restrictions on how the tokens can move between different individuals.
So, there’s a rule under the federal securities laws that, for most types of securities, you need either a broker/dealer or some kind of transfer agent whenever you’re moving a security between two parties. Obviously, very different from the type of decentralized crypto network that we think of when we talk about digital assets. So, there’s a question for these Reg A+ tokens, whether it makes any sense to have them regulated as securities when they can’t really be used in a way that you think of traditional crypto currencies or typical crypto currencies being used.
In terms of whether they can sort of decentralize their way out of securities status, I definitely think that’s the goal. I know, at least for Blockstack, which was the first Reg A+ qualification, that their leader, Muneeb Ali, has definitely said the goal is, at some point, to decentralize this network to where the token is no longer a security.
I think the question there is how will we know when the token has reached that point. At what stage does Blockstack no longer need to comply with all of those obligations under the securities laws to do auditing and disclosures and manage the network in a compliant way, and I think that what seems like great progress now may turn into just a different problem in some number of months or years when a company like Blockstack wants to say to the SEC, look, we think this network is decentralized now. We don’t want to treat this token like a security anymore, and then, the SEC does what they’ve done for most tokens that have come out in the last couple years, which is they’ve said, well, we’re not so sure about that. We’ll think about it, but we’re not really going to give you an answer. Do what you want, and if we want to launch an enforcement action after the fact, then we’ll do so.
So, I think that, you know, it’s nice to see some progress on the Reg A+ front, but I think it just opens up a whole new can of worms that we’re going to have to deal with down the road.
Yeah, I was reading that Decrypt Media article that I think interviewed you for this story, and they were pointing out that, even just simple things, like how do you distribute the tokens to minors on the network, becomes like a huge hassle in this kind of situation, and so, that’s so fundamental to things like network security and all kinds of issues, so it is somewhat confounding.
Right. That’s a great point, and the way Blockstack is trying to get around that is by issuing all new tokens into a separate…basically an Astra account…and are not going to distribute those tokens to minors until they have completed KYC checks, and so, again, that doesn’t really look like the type of decentralized crypto network that we’re used to.
Let’s also talk about Ripple, which is another one of these tokens that falls into this camp of tokens, where it’s not clear whether it’s a security, and Ripple is facing multiple lawsuits to that effect. You’ve tweeted about this a lot. What do you think are the different ways that various suits could play out? And what do you think is most likely to happen?
So, right now, Ripple is the defendant in a nationwide class action in the Northern District of California. The class action asserts that XRP is a security, that Ripple violated the federal securities laws by failing to register XRP before promoting and selling it, and that this illegal conduct continued until at least 2017 when Ripple was continuing to sell XRP, and I think, as far as we know…
They still sell it.
…they are still doing that today.
Right. So, you know, that’s kind of an interesting point.
They made something like $200 million on it last quarter.
So, look, it’s interesting in a way because, until we have some resolution to the securities class action or the SEC decides to take some action against Ripple, basically nothing happens to them. They can just keep operating the way that they’ve been operating from the start.
So, how does the class action resolve, and then what happens with the SEC? So, the class action is still in its very earliest stages, and Ripple has very good lawyers who have executed a very effective delay strategy to drag out this class action as long as possible.
It started with almost a year-long argument about whether the case should go forward in state court or federal court, and it literally took almost a year before the case finally landed permanently in federal court, and now, we’re sort of working through the early stages of the class action process.
We have now officially appointed class counsel, so the lawyers who represent the putative class, which means the alleged class…it doesn’t actually become a class until after a motion for class certification is filed and then a judge may grant that motion, so, the next stage is for the new class, the putative class, to file a consolidated complaint, so they’re going to have to file yet again another complaint setting out all of the allegations about how Ripple allegedly violated the federal securities laws.
After that, Ripple will have an opportunity to file either an answer or, more likely, a motion to dismiss the complaint in which they will argue that, even if you accept that every fact alleged in the complaint is true, it still doesn’t add up to a technical, legal violation of Section 5 of the Securities Act of 1933, which is the basis for this suit.
And then, there will be arguments about that motion for probably months, if not another year, and assuming that the class survives that motion to dismiss, then we have a very long and drawn out discovery process. We have the motion for class certification that I mentioned. We could have a motion for summary judgment, which is an argument that, based on all of the facts that were disclosed during the discovery process, there is no material dispute regarding the facts, and as a matter of law, Ripple should win this suit.
So, we have to litigate that out. That probably takes another six months to a year. So, you can see that this is a very long process that I think is not likely to resolve at any point soon. Probably, the way it ultimately resolves is after one of those rulings on one of those big, important motions, like the motion to dismiss, the sides get back together and start talking about settlement, and ultimately, Ripple has to pay a certain amount of money to the class in order for the class to just drop the suit and disappear.
So, I think probably, in the end, that’s how the class action gets resolved, through a settlement, not something that is really going to affect XRP or resolve this question about whether XRP is a security.
I would assume that the SEC won’t take any action against Ripple until the class action is resolved, so I think the SEC is probably just sitting back, waiting and watching to see what happens in the class action, and then, once it resolves one way or another, then maybe the SEC jumps in to say, okay, now we think that Ripple violated the securities laws, so we’re going to launch our own enforcement action or reach our own settlement, or I guess, in theory, they might decide, you know what, we don’t think that Ripple violated the law, or we just don’t care, so, we’re going to leave this alone.
So, I think, probably, that’s how it plays out, and it’s going to take years before we have an answer to those questions.
Wow. That’s intense, although I guess, if we’re saying that they made $1.1 billion from selling the tokens, they have plenty of money to fund all that litigation.
All right, so, I actually also wanted to ask about another kind of big trend that raises questions around securities law, which is stable coins. I know there’s multiple models of stable coins. In which cases do you think they are likely to run afoul of securities laws and in which cases do you think they’re probably okay?
So, I think the only case where it’s fairly certain that there are securities issues around stable coins is with a model like Basis, so you’ve probably heard about Basis, originally called Basecoin, which had an algorithmic model that would try to maintain a dollar pegged for its stable coin, through the issuance of bond shares, and I forget now exactly how it worked, but basically what they were doing was explicitly issuing types of tokens that were designed to be securities, that were designed to be shares, equity shares, in this system.
I think that, if you’re trying to design a stable coin that explicitly uses the issuance of a security in order to make sure that you maintain your peg, you’re going to have some securities issues, and sure enough, Basis, at least reportedly, decided, after talking to the SEC, that the way that they had designed their stable coin model was going to violate the securities laws, and they didn’t want to try going through the process of registration or compliance, so they ended up shutting down the entire project.
I think that it’s an open question in terms of whether any other model of stable coin could qualify as a security. When you’re thinking about investment contracts, which is the type of security that we think about the most in the crypto industry, it’s kind of hard to frame any stable coin as an investment contract, just because there cannot, by definition, be an expectation of profit by purchasing a stable coin.
So, if you look at these fiat-backed stable coins like USDC, for example, it’s pretty hard to argue that that is an investment contract. There are, of course, other types of securities other than investment contracts, like demand notes, which is another type of regulated security under the 1933 Act, and there are some similarities between stable coins and what you might think of as a demand note, but you know, I think it’s going to take a long time for us to really figure out how we want to treat stable coins, and I think that the spirit of securities regulation, the policy goals and the reasons why we want to impose these compliance obligations on securities issuers, just don’t make sense in the context of stable coins, so I would imagine that, even if you could spin up a hyper technical/legal argument why a fiat-backed stable coin qualifies as a security, I don’t think it makes a lot of sense to do that, and I think, eventually, we’ll get clarity around that.
Yeah, I’ve seen in different interviews that Valerie Stepanick, who’s the crypto czar at the SEC, has kind of indicated that she thinks a lot of these do run afoul of securities laws, and I’m interested to dive more into that, but yeah, I agree, so something like Basis is pretty obvious, but the others I’m curious to know what they think.
All right, so…there are just so many questions to ask about. So, we’re just going to take a quick break to hear from the sponsors who make this show possible, but right after the break, we will talk about all things Libra and KYC/AML and all kinds of other issues.Crypto.com
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And back to my conversation with Jake Chervinsky. You’re someone who lives and breathes crypto, but you also live in DC, and you understand the ins and outs of that world down there, so I’m so curious to hear your take on the week one Federal Reserve Chair. Jerome Powell, you know, mentioned that the coin is like digital gold and that President Trump tweeted about the coin in Libra, and Treasury Secretary Steve Mnuchin gave a press conference on crypto currencies, and then, of course, the Senate and the House held hearings on Libra.To you, as somebody who knows that world, like what did you think was the significance of all that activity?
It was very crazy around here because crypto really took over Capitol Hill for a couple of weeks. It was very interesting to see people who usually don’t talk about these issues starting to wrap their minds around what digital assets mean and how to approach regulation and also the development of new legislation and policy toward crypto.
I thought that the main takeaway is really just the acceleration of the timeline for the crypto industry to grapple with these issues. As a result of Facebook jumping into the position of at least arguing that they are going to launch a crypto currency, my personal opinion about Libra is that it really isn’t a crypto currency at all, and I’m not the only one who thought that. That was kind of the mission for most of the crypto world here in DC was to run around, telling as many people as would listen about the differences between true crypto currencies like Bitcoin and a digital currency like Libra, which really functions in a very different way.
I thought that, by the time that process was done, there were some very positive signs, from Congress at least if not some of the folks in the executive branch and Chairman Powell, about embracing the promise of crypto currency and the benefits that it can offer.
So, you have Facebook arguing that they should be able to launch a new, fairly centralized payment system where folks’ personal data would be exposed to a variety of corporations and where those corporations would get to decide who can participate and who can’t, and there was a lot of pushback on that from Congress, which I think is very positive and is a good sign for the crypto industry because what we can do…and this is very much how DC works…is we can then sort of slide in and say, hey, Congress, you’re really concerned about these big corporations being in control of a new payment system. Well, let us show you our decentralized, open version of what they promise, which has all of the benefits but not the drawbacks.
So, I thought that was very positive. You know, obviously less positive in terms of the President’s tweets and Secretary Mnuchin’s statements about crypto currency, both Bitcoin and then also comments about Libra, but you know, honestly, I think that that in many ways is more of a political issue between the President and the Fed, and crypto sort of got wrapped up in a fight between President Trump and Chairman Powell over what should happen with interest rates, and so, when Chairman Powell said, well, there is some value to something like Bitcoin as digital gold. There may be some reason why we should consider this as a positive force.
I think the immediate reaction from President Trump was simply to take the opposite side and to say something negative about crypto currency in response. I’m not sure that’s really his position, and I’m not sure that he would hold it strongly if there were some other reasons why crypto would benefit the country or his personal political position, but definitely a very interesting couple weeks here in DC.
You made the point in the tweet after the labor hearings that crypto, so far, is not a partisan issue, so you know, you just mentioned kind of how politics may have affected Trump’s tweet, but for Congress right now, how do you think the lack of partisanship will affect their approach to crypto?
Well, I think it can go one of two ways. I think either eventually crypto will be adopted by one party, and then, a very sort of typical but reflexive action for DC, the other party will have to run away from crypto just to show its distinction from the opposite party. If the Republicans like something, the Democrats have to dislike it, and the same the other way around, so I think that is one possibility.
I hope that we will be able to avoid that, but I do think that, if one party were to really, in a full-throated manner, embrace crypto currency, then the other party would probably have to run away from it, and it would become a partisan issue.
I think the second and what I hope is the more likely scenario is that we’re able to build a consensus across the aisle in favor of innovation and also in favor of the characteristics and the aspects of crypto currency that not only benefit the US but also benefit both political parties, and I think this is something that both Coin Center and the Blockchain Association are doing a really fantastic job with, which is articulating to both political parties the argument in favor of crypto currency that speaks to them, and it’s really two very different arguments.
So, if you’re talking to a Republican politician, you’re going to tell a very different story than if you’re talking to a Democratic politician. For a Republican, you’re probably talking more about monetary economics and sound money, and you know, it’s things like auditing the Fed tend to play a lot better with a Republican audience.
When you’re talking to Democrats, you talk a lot more about Wall Street and things that politicians, like Elizabeth Warren or Bernie Sanders, are trying to get at from a very different perspective, which is breaking up the big banks and preventing them from continuing this sort of rent-seeking behavior that they’ve been using to make quite a lot of profit at the expense of the public for a very long time.
So, there’s different arguments that I think can get both parties to align behind a pro-crypto stance, and it’s just a matter of whether we can get to that point before crypto becomes one of these sort of toxic political issues where one party likes it, so the other party has to hate it.
You kind of mentioned that there is this argument going that, if US regulators are too restrictive to crypto, innovation will move out of the US. Do you think that both lawmakers and regulators find that argument compelling or that they would care?
I definitely think it’s a compelling argument. In many ways, it’s the most compelling argument when it comes to politics. So, you know, there’s a saying in politics…it’s the economy, stupid. Everything ultimately comes back to the strength of the economy and creating jobs.
So, I think that, if you can tie the innovation and the crypto industry to the creation of jobs in the US, and also, overly restrictive regulations to the loss of jobs and a negative impact on the US economy, then you can definitely convince regulators and politicians that they should allow this industry to grow and develop in the United States.
I think the problem right now is that it’s sort of hard to articulate a strong argument why innovation in the crypto industry will contribute to the US economy or will create jobs because, right now, there aren’t, frankly, that many folks who are working in the crypto industry. It’s still very small. The economic impact is also still fairly small, and it’s a little bit hard right now to show actual proof about how allowing this technology to develop and grow in the US will benefit politicians in terms of convincing their constituencies that the politicians are doing a good job for them.
So, I think it might take a while before we can really articulate that position effectively, but again, you know, this is why I’m thankful for folks like Jerry Brito at Coin Center and Kristin Smith at the Blockchain Association who are spending all their time, day in and day out, trying to figure out how to articulate that argument better than I can, so I do think that it will be effective in due time.
Let’s talk about AML/KYC issues, and why don’t we start with Libra?
I saw in a tweet you pointed out that David Marcus had said that Libra would handle those kinds of things but that other wallets might not. So, in general, how do you think AML/KYC should be handled when it comes to Libra? As you pointed out, it isn’t exactly like the other crypto currencies.
Yeah, it’s hard to say. I mean, first of all, I’m not sure that Libra will ever launch, so it may be that that question never really needs an answer.
You really think that it may never launch?
I think it’s practically certain that it will not launch in the form that it was proposed. I think there’s too much pushback, frankly, from regulators all over the world. It’s not just the US. There are so many people who have come out and said we don’t trust Facebook to manage our money that I think Facebook will eventually, if they are able to launch something, will be forced to simplify the system in a whole lot of ways to make it look a lot more traditional and a lot less interesting than it already is, which, in my view, is not terribly interesting anyway.
Yeah, that’s kind of my take on what happens with Libra in the end.
Oh, wow. Okay. Well, so, then let’s go to a stickier issue because you did also tweet that complying with the anti-money laundering laws and know your customer laws is even harder in crypto, so how do you think it should be handled there?
Yeah, it’s a very tough questions because the true answer is it kind of can’t be handled in the traditional way, so if you want to comply with traditional anti-money laundering requirements, what you need to be able to do is you need to be able to perform customer due diligence and know your customer diligence on every single person who has access to the system.
That is, in many ways, the opposite of how a crypto network functions, which is that a crypto network is permissionless. It’s not supposed to require that people satisfy certain criteria or prove their identity in order to access the system. So, in a way, crypto is sort of anti-AML by its inherent nature.
I think that the way that this will be handled and is being handled now is that anti-money laundering controls are implemented at the on ramps and off ramps with fiat currency, so, if you’re an exchange that allows people to get access to crypto currencies because you’re taking their dollars or their euros or their pounds or what have you, then you are going to be required, as that on ramp, to perform customer due diligence, and the same thing is true for the off ramps.
If you are taking crypto currency from people and giving them fiat currency in return, you’re going to have to do some form of KYC. I don’t really think that there is a way to enforce AML requirements on transactions that are purely within a crypto network. Technologically speaking, it’s just not possible unless those transactions are going through an intermediary, like a transaction from one exchange to another exchange on behalf of a shared customer.
But otherwise, I think we’re going to have to really grapple with this question of will governments be okay with and will they be able to wrap their mind around a new financial system that is inherently resistant to identifying all the individuals who are using that system, and that’s a very hard issue but definitely one that we need to address.
Yeah, and I think Shapeshift would be another example where they’re just allowing crypto-to-crypto trades, but even then, you know, they now started requiring accounts and things like that, so I think it’s not even necessarily about exchanging fiat with crypto, right?
Yeah, I think that’s right, and I think that, ultimately, essentially, any intermediary that is holding digital assets on behalf of a customer will eventually be required to perform some type of KYC, and I think that, in many ways, that might be good enough for governments. I don’t think that they will try to destroy crypto networks just because it is possible to have non-KYC transactions outside of the context of those third-party intermediaries, but essentially, I think that, if you take custody of a customer’s crypto, you’re going to have to identify that customer, and you’re going to have to be subject to some type of compliance and reporting requirements to the government, whether that’s in the US or in any other developed country.
So, a lot has been made over the years about how all these different regulators treat crypto currency differently. Like, the IRS treats crypto currency as property, the CFTC as a commodity. FinCEN considers it money. Obviously, some of these tokens, as we’ve been discussing, are considered securities by the SEC. And then, there are these other jurisdictions. Recently, in Unconfirmed, Jeremy Allaire was talking about how they are launching a subsidiary in Bermuda, which has laws specific to digital assets. Some other jurisdictions that are doing the same are like Switzerland, Singapore, etc.
Do you think that the US, just like these other jurisdictions, should create laws specific to digital assets, rather than trying to fit existing laws around securities, commodities, etc. to crypto currencies?
At this point, I don’t think that’s necessary. I mean, you know, we’re still trying to figure out, I think at this point, what digital assets are actually good for, right? So, we haven’t really figured out are digital assets good vehicles for issuing securities or not? Are they good vehicles for tokenizing other real-world interests, like the title to a car or the deed to a house, or you know, any other number of things that you might consider doing with digital assets?
I think until we figure out what this stuff is actually good for, aside from money, which I think at this point, we’ve basically figured out that blockchains are really good for money. Until we figure out what else they might be good for, it would be a mistake to create any new types of regulatory regimes or laws around digital assets, and I think a good example of this is the Token Taxonomy Act, which is, you know, an interesting proposal that was submitted by, I think, Representative Davidson to create a new definition for a digital token and then exclude that definition of a digital token from the jurisdiction of the SEC, right? So, basically, say digital tokens, by definition, are not securities.
I think that would be a mistake, and the reason I say that is because there are some digital tokens that, fundamentally, are securities and should be treated that way, and that’s why we see some companies doing these token issuances and seeking qualification under Regulation A+ or that are viewing those tokens very much as equity interests that would normally be regulated by the federal securities laws.
So, I think to say we are in a position now where we understand this technology and the value of it well enough that we can create brand new laws to govern how it will develop I think is a mistake. So, I wouldn’t say it will never be a good idea, but I think, right now, any jurisdiction that is creating laws specific to the crypto industry is doing so, not because it’s the best policy position or because they really understand the safest and most intelligent way of regulating this industry. Rather, it’s a commercial effort. It’s basically marketing to try to attract as much attention and as much business activity as possible, and for a jurisdiction that’s a little bit smaller and is looking to get an edge and maybe is otherwise struggling in terms of its economy or in terms of attracting outside investors, that makes a lot of sense. But for a very well-developed and maybe the foremost capital market in the world, for the United States, I think it’s too soon for us to do something like that.
And what about how some of these other jurisdictions just have one regulator for crypto? I’ve had so many different entrepreneurs, and Jeremy Allaire’s testimony to the Senate also mentions this, that it’s just so much easier to deal with. Do you think the US should adopt that approach?
I think it might make sense to have a regulator that focuses on digital assets, but again, I think it might be a mistake to say we’re going to create one new entity. That entity will handle everything imaginable that can be done on a blockchain, because, again, you could have digital tokens that, indeed, are securities, and if they are securities, then the SEC should have jurisdiction over them, and similarly, you could imagine creating a token…and I think there are some companies that are doing this now…that resembles a futures contract or some other type of derivative like a swap or something else that the CFTC would have jurisdiction over.
And in the same way, I think it would be a mistake to say, well, if this was in traditional finance, the CFTC would have jurisdiction, but because we’re doing it on a blockchain, we’re going to deprive the CFTC of jurisdiction and give only this brand new regulator the ability to regulate this type of token.
So, I think, ultimately, what we would end up with, if we created a brand new entity, is just another alphabet soup agency that we in the industry have to deal with, in addition to the existing regulators that we’re already talking to. So, I think that be probably a step backward, not forward.
Okay, we’re going to try to move through a whole bunch of topics slightly quickly. Let’s just talk about taxation. How do you think crypto currencies or crypto assets should be taxed?
I think the most important thing right now that we need is a de minimis exception for small transactions in crypto currencies. So, I think that, you know, we’ve, for a very long time, talked about using Bitcoin to buy your everyday cup of coffee, and you know, we’re thinking about this similarly now with Stablecoins, whether they’re algorithmic like DAI or fiat-backed, like USDC, that we want to be able to transaction day-to-day with these instruments.
And until there is a di minimis exception, that’s really not possible, so I think, if I could wish for one thing to change in the tax code, that would be it. Beyond that, I think, probably they should be treated just like any other investment asset, you know, in terms of the capital gains structure, but you know, as a non-tax lawyer, I guess I’ll leave that to the experts.
You work in DIFY. What do you think are the main regulatory issues in the DIFY space that people are not thinking about?
I think that we’re still not clear on the obligations of a software developer that writes a piece of software and then launches it on a decentralized crypto network and no longer has control over the functioning of that piece of software. You know, we have been having this discussion for a while now about whether coders should be treated as fiduciaries, and most people, I think, view this somewhat skeptically because we’ve never treated coders as fiduciaries before, right?
If a piece of software doesn’t give you exactly what you’re looking for, you really can’t go and sue the software developer and say you owed me a fiduciary duty of care, and you violated it by not producing the software in a particular manner, but we are now dealing with a brand new type of financial system where there’s more at risk, and so I think there’s a new discussion to be had about how we treat coders who are producing software that then gets launched onto these decentralized systems.
There was a lot of buzz about Bakkt when it was announced last year, but licensing and some other, I think, regulatory issues have caused delays. Recently, they did announce that they started accepting user acceptance testing, but they still don’t have all the regulatory approvals in place to take the platform live. Can you explain what needs to happen for an exchange like Bakkt to get the approvals that it needs and why there’s been so many delays?
Sure. So, Bakkt, right now is just waiting on one thing, which is approval of its limited purpose trust company, and they’re waiting for the New York Department of Financial Services to approve that charter. You know, in the first instance, if you are an exchange and you want to list a futures contract, which what Bakkt wants to do, you’re subject to the CFTC’s jurisdiction, so you need to have a designated contract market. You need to have a clearing house, and you need to get CFTC approval for those things, and then, also you need to certify whatever the specific futures contract is that you want to list on your market.
Bakkt has already gone through all of those hurdles with the CFTC, so as far as the CFTC is concerned, Bakkt is ready to go as soon as they get approval from NYDFS for their trust company, and the purpose of the trust company is to warehouse the actual bitcoin that will underlie the physically settled futures contracts that Bakkt wants to launch. So, they’re just waiting for DFS approval.
The last I had heard, the issues with DFS were really just around sort of the nuts and bolts of the proposal for the trust company. I think there was some concern that maybe the amount of money that Bakkt was going to put into that company to guarantee the assets was too low. I think they were proposing $35 million as the guarantee, and maybe DFS wanted it to be more than that, so it’s really just those kinds of issues.
There’s no reason in my mind to think that Bakkt won’t eventually succeed. DFS has already approved a number of other trust companies just like the one that Bakkt is trying to get for other companies, including crypto companies like Gemini, which has one of these trust companies and others, so, I think it’s just a matter of time.
In your previous gigs as a lawyer, I believe you focused quite a bit on market manipulation, and that’s one of the reasons that the SEC has cited for not approving a bitcoin ETF. How big of an issue do you think that is in crypto, and how do you that can be resolved to the SEC’s satisfaction?
Yeah, I did. I actually had a couple of cases where I defended individual traders and trading firms that were prosecuted for market manipulation, so I have a fair amount of experience in the area, and I think, just looking at the crypto market, manipulation is still a pretty significant issue and one that we need to get a handle on, not just because it’s a main issue that’s holding up ETF approval, but also because there are a lot of really sophisticated institutions and other firms that just don’t want to get involved in this space until the sort of Wild West of the manipulated markets gets under control.
I think that to get there a couple of things need to happen. I think, first of all, some federal agency needs to have jurisdiction over spot markets, meaning the markets where actual digital assets are traded, not just futures contracts, and right now, there is no federal agency that has regulatory authority over those spot markets.
The CFTC only has jurisdiction over futures exchanges. The SEC only has jurisdiction over securities exchanges, so the spot markets are really out there on their own. I’ve heard some talk in DC about the CFTC being granted authority over those spot markets. I think that would go a huge way toward eliminating market manipulation and making people more comfortable with this space.
And then, I think the second thing is…and I hate to say this as a former white collar criminal defense attorney…but I think that the government needs to show some type of enforcement interest toward these traders who are manipulating these markets, and I think what’s holding them up right now is that they really don’t have access to the trading data that they typically need in order to launch these types of enforcement actions or prosecutions, but once they’re able to get more of that information and identify who the players are who are spoofing or wash trading these markets, for example, or who are perpetrating pump-and-dumps or the opposite of a pump-and-dump, which is a short-and-distort.
I think, once they get that kind of information, we’ll start seeing more prosecution from the Department of Justice, and we’ll start seeing more enforcement activity from both the SEC and the CFTC, and I that will send a signal to traders who think that these markets are open for manipulation. It will send the message that they should probably look somewhere else.
So, it seems like, based on that answer, that probably the coin ETF is fairly far off?
Yeah. I have to say I think that, both because of the market manipulation issue, which really hasn’t made much progress in 2019 and also because of the custody issue, which Chairman Clayton has recently started talking about a lot more. I don’t think we’re going to see an ETF approved this year, unfortunately.
Privacy coins. How did those mix with the world of financial regulation?
Not particularly well, as you might expect. Yeah, look, you know, we have a financial system that is designed around the principle that all transactions should be open for government surveillance, for the purpose of allowing law enforcement to identify and prosecute criminal conduct, and this is really how law enforcement has developed over the second half of the 20th century and certainly through the beginning of the 21st century, which is the principle all crime is most likely committed so that the criminal can make money.
And in order to get benefit from making money through criminal activity, you have to integrate that money into the financial system so that you can spend it on goods and services. And so, if we just create this really strong walled garden of the financial system so that we can stop those criminals from getting their illicit proceeds into the system or detect them when they do, that’s going to be the best way to detect and prosecute and ultimately stop crime.
Privacy coins are the opposite of that, right? Privacy technology really stops the government from having insight into financial transactions, whether they’re legal or not, and I think that this is an issue that hasn’t really come to the forefront yet because, you know, we see our politicians in these hearings talking about Libra and really just starting to grasp what a crypto currency is.
I think it’s going to take a while longer before they start to understand what privacy technology is, and at the same time, they’re being told by law enforcement that bitcoin isn’t a concern because, from a criminality perspective, the blockchain is open and transparent and auditable, and really, if the FBI had its way, every criminal would do all of their transactions on bitcoin because it’s so easy for them to trace those transactions.
So, I think there’s not a lot of concern about this right now, but I think that, as the use of privacy technology increases, it’s going to be an issue that we have to deal with.
You know, there’s a sort of…I mean, tangentially related, a similar conundrum, I feel like, where…you know, we were talking about the KYC/AML laws, and I noticed that Jeremy Allaire, in his testimony to the Senate, pointed out that these Fed F rules that require the exchanges to send information to each other about who’s transacting, that those basically could potentially lead to privacy breaches, and you know, there’s this news recently that broke about the Capital One hack, and I just skimmed this article about the hacker, but apparently, I think she was like mentally unstable, and she even went online by the moniker Erratic, so I was just like, oh, great. Okay, as more people get coding skills but then maybe they’re not like fully with it or whatever, like are we really going to want to have all this stuff that’s like managed in these honey pots?
And so, I felt like that was another way…I mean, the privacy coins versus financial regulation. It’s like kind of different but sort of similar in that there’s like pros and cons on each side, and it’s not really easy, but you know, with blockchain, if you could use this technology to enable people to have control of their data, then you wouldn’t have so many of those honey pots.
Yeah. I completely agree, and I think that is the very difficult and very nuanced but also very practical conversation that we have to have, which is privacy has benefits, and it has drawbacks, but if you watch…you know, there’s this new documentary that just came out on Netflix called The Great Hack. Maybe you’ve heard of it.
It goes through the story of Cambridge Analytica, and I won’t bore everyone with the details, but definitely go watch it if you can. What is does is really shows us, when we don’t have control over our data, and when we don’t have privacy, how much damage can be done when you can put together different data points for specific individuals and how a company like Cambridge Analytica can get access to our data and then use it to persuade human behavior on a global scale, and that’s a really scary thing.
And when you think about it in terms of government actors…you know, you look at a country like China, where the social credit system is based largely on harvesting data from citizens and then using that data to decide who’s a good citizen and who’s a bad citizen and restricting their rights based on their activity.
It’s the same thing when we talk about financial information because how we spend our money strikes really to the core of who we are. It’s as personal as any kind of data possibly could be, and so, there are great benefits in allowing technologies that improve privacy and not just because there are criminals who are going to use it, and it’s going to make it easier for them to buy drugs on the dark net. That’s not the point.
There are all of these other very important benefits of privacy technologies, and I think that we’re going to have to have that discussion about those benefits outweighing the potential drawbacks of reducing the effectiveness of this surveilled walled garden financial system that has allowed law enforcement to detect criminal conduct in the past.
GitHub recently geofenced its platform off from Iranian citizens due to sanctions and you’ve written an essay last fall about sanctions enforcement in crypto. How do you think this issue will play out in the crypto space?
Well, I’m hearing that there will be a public enforcement action from OFAC, which is the enforcement agency that enforces trade sanctions related to the crypto industry at some points, within the next few months. So, I think this is actually going to happen pretty quickly.
The title of the article that you mentioned was something like Get Ready for Crypto Sanctions Enforcement, and I think that we’re pretty close to that happening, but you know, just like we’ve talked about the potential use of an open, permissionless system to transact across borders and potentially to enable some types of criminal activity that would be harder to do through the traditional financial system, crypto also allows people to evade trade sanctions.
There’s really no way to get around that fact. If you want to send value to someone in North Korea, it is simply easier to do that on a crypto network than it is to do it through some other system, and that’s something that I think OFAC and the government in general is struggling with, and I think that they’re coming up with some pretty helpful guidance about what they expect from companies especially who are processing transactions on crypto networks.
But definitely, this is just one of these issues that we’re going to have to struggle with in the sense that the rise of a new financial system that is open and permissionless and based on crypto networks decreases the effectiveness of the trade sanctions regime that the US government has used to influence foreign policy for quite a long time.
So, we’ve covered a ton of topics concerning regulation and crypto, but are there any others that you feel like people in crypto aren’t thinking enough about that you want to talk about?
No, I think that lightning round pretty much covered all the very interesting subjects that are coming up. It’s definitely not boring to be a crypto lawyer these days.
Yeah, or a crypto journalist. All right, well, where can people learn more about you, and I guess Compound also, though we didn’t really go into Compound?
Yeah, well, so, folks can check out Compound on our website…compound.finance… We are building a decentralized protocol for autonomous interest rate markets on the Ethereum blockchain. If you want to find me, just catch me on Twitter. I’m @JChervinsky. If you’re interested in my random thoughts about law and politics and how they apply to crypto, you can find me there.
Yes, and people can also listen to my interview with CEO Robert Leshner of Compound from last fall to learn more about Compound.
All right, great. Well, thanks so much for coming on Unchained.
Thanks for having me.
Thanks so much for joining us today. To learn more about Jake and Compound, check out the show notes inside your podcast player.
If you’re not yet subscribed to my other podcast, Unconfirmed, which is shorter and a bit newsier, be sure to check that out.
Also, find out what I think are the top stories in crypto each week by signing up for my weekly newsletter at Unchainedpodcast.com. Unchained is produced by me, Laura Shin, with help from Fractal Recording, Anthony Yoon, Daniel Nuss, and Rich Stroffolino. Thanks for listening.