Road to Success

Blockchain in the USA – an Introduction

The global pandemic presented significant opportunities – and
potential pitfalls – in the ever-expanding blockchain universe. As
the world continues to fight the grasp of COVID-19, we appear to be
entering a time of even greater economic uncertainty, due in part
to global inflation, supply chain breakdowns, severe political
polarisation and war. Even against this backdrop, three trends and
developments are expected to continue shaping the blockchain and
digital asset landscapes in the year ahead:

• burgeoning NFT enforcement;




• continued focus on sanctions enforcement,
  particularly with respect to Russia; and




• continued interagency turf battles, even amidst
  greater efforts at US government co-ordination.

Burgeoning NFT Enforcement

While blockchain and cryptocurrencies have steadily matured into
the mainstream over the past decade, there is a relatively new
digital asset on the block: non-fungible tokens (NFTs). Just as
crypto was met with massive regulatory uncertainty in its infancy,
NFTs are now experiencing the same growing pains. Although NFTs and
the concept of tokens representing unique physical assets have
existed in some form since at least 2014, the NFT market exploded
in 2021, generating an estimated USD25 billion in sales in that
year alone. That extraordinary growth and the continuing evolution
of NFT applications present new challenges for state and federal
regulators, who are just beginning to scrutinise NFT transactions
through the lens of existing regulations.

NFTs are not only individually unique assets – they are also
unique in the digital asset world, which means a number of complex
legal regimes can apply to their creation, sale and exchange. In
many instances, the application of such regimes to NFTs can
resemble a square-peg-round-hole exercise. To assess the
applicability of the various legal regimes, several critical
questions must be asked (for an analysis of these questions in the
retailer context, see “NFTs for Retailers: A World of Promise
and Peril” (12 January 2022), available at www.steptoe.com).

• First and foremost, is your NFT a security?




• Will the issuance, sale or exchange of NFTs make you
  a “money transmitter” subject to Financial Crimes
  Enforcement Network (FinCEN) requirements and state laws?




• Is your NFT a commodity subject to Commodity Futures
  Trading Commission (CFTC) regulation?




• Could your NFT project implicate economic sanctions
  laws?




• Do intellectual property laws apply?

While the Securities and Exchange Commission (SEC) has
aggressively sought to enforce the federal securities laws against
issuers of other digital assets, it has not yet initiated an
enforcement action against the creator of an NFT or the operator of
a platform that facilitates the sale of NFTs. But such enforcement
seems inevitable and even imminent, in light of the skyrocketing
consumer interest in NFTs and the increasing complexity of NFT
transactions. Indeed, the SEC is reportedly investigating NFT
creators and marketplaces for potential securities violations,
including issuing demands for information on specific NFTs and
other token offerings to assess whether “certain non-fungible
tokens… are being utilised to raise money like traditional
securities” (see www.bloomberg.com). The SEC is reportedly also
taking a particular interest in how fractional NFTs are being
utilised.

Although the SEC has not yet taken formal action, there have
been some recent public actions by other agencies. For example, on
24 March 2022, a government task force (including the Department of
Justice (DOJ), Internal Revenue Service (IRS), US Department of
Homeland Security and US Postal Inspection Service) brought charges
against two individuals for conspiracy to commit wire fraud and
money laundering in connection with an alleged million-dollar NFT
fraud. According to the complaint, the defendants promised that
purchasers of their “Frosties” NFTs would be eligible for
certain holder rewards, including giveaways, early access to a
metaverse game and exclusive mint passes for upcoming seasons.
However, rather than providing the benefits advertised to the NFT
purchasers, the defendants transferred the proceeds to various
digital wallets under their control – an alleged example of what is
often characterised as a “rug pull”, a scam in which a
developer promotes a token or other crypto project to purchasers
but absconds with the proceeds. According to Chainalysis, “rug
pulls” resulted in USD2.8 billion in losses in 2021,
representing 37% of all money lost in crypto-related scams (see blog.chainalysis.com).

In addition, at the state level, Texas and Alabama regulators
recently issued unprecedented cease-and-desist orders against a
Cyprus-based group selling NFTs to fund the development of virtual
casinos in the metaverse. The state regulators allege that the
activity constituted sales of unregistered securities because the
NFTs entitle owners to various benefits, including a pro rata share
of profits generated by the casinos. According to a statement
issued by the Texas State Securities Board, the company and its
founders marketed their NFTs – which they named “Gambler”
and “Golden Gambler” – as investment opportunities and
promised potential buyers a share in virtual casino profits,
forecasting as much as USD81,000 annually. The statement further
claims that the company told potential buyers that its NFTs were
not regulated as securities because securities laws did not apply
to NFTs.

Continued Focus on Sanctions Enforcement

There is a continuing push by federal regulators to prevent the
use of cryptocurrencies to circumvent US sanctions, or evade them
entirely. These efforts have come into even greater focus in 2022
with Russia’s invasion of Ukraine. Lawmakers and regulators
have expressed concern that cryptocurrencies could be used by
Russian actors to evade sanctions against the Russian Federation
and associated individuals. Despite a strong desire by federal
regulators to prevent attempts to circumvent sanctions using
cryptocurrencies, their ability to do so remains limited, leading
to an increased reliance on the private sector to identify evaders,
with its greater sophistication and access to information.

Regulatory response to Russian sanctions

In direct response to the invasion of Ukraine in late February
2022, the US government issued a wide range of new sanctions and
export control measures targeting Russia. Federal regulators -
particularly those within the DOJ and the Department of the
Treasury – have since taken steps to clarify and flex their
authority to enforce sanctions compliance with a crypto nexus.

For its part, the DOJ has indicated that it will focus
enforcement efforts on any use of cryptocurrencies to evade
sanctions. On 2 March, the Attorney General announced the launch of
Task Force KleptoCapture, an interagency law enforcement task force
dedicated to enforcing Russia-related sanctions and restrictions.
The mission of the Task Force includes “targeting efforts to
use cryptocurrency to evade US sanctions, launder proceeds of
foreign corruption, or evade US responses to Russian military
aggression.” Moreover, sources inside the department have
indicated that the DOJ will also investigate and prosecute
cryptocurrency exchanges, among other entities, that enable (even
unknowingly) wealthy Russians to hide or launder their assets.

The Treasury Department has been active as well. For example, on
11 March, the Office of Foreign Assets Control (OFAC) issued FAQ
1021, reiterating that the prohibitions contained in the Russia
Harmful Activities Sanctions Regulations and other Russia-related
sanctions apply to virtual currency transactions. FAQ 1021 warns
that “OFAC is closely monitoring any efforts to circumvent or
violate Russia-related sanctions, including through the use of
virtual currency, and is committed to using its broad enforcement
authorities to act against violations and to promote
compliance.”

FAQ 1021 further explains that all US persons (including virtual
currency exchanges, virtual wallet hosts and other service
providers, such as those that provide nested services for foreign
exchanges) are generally prohibited from engaging in or
facilitating prohibited transactions, including virtual currency
transactions in which blocked persons have an interest, and
transactions involving the Central Bank of the Russian Federation,
the National Wealth Fund of the Russian Federation or the Ministry
of Finance of the Russian Federation.

Likewise, on 7 March, FinCEN issued an alert warning US
financial institutions about the efforts of foreign actors to evade
US economic sanctions and trade restrictions related to Russia and
Belarus, and the increased risk of Russia-related ransomware
campaigns. FinCEN acknowledged that it is unlikely that the Russian
government can use cryptocurrency to mitigate or circumvent the
impact of sanctions in any meaningful way, and FinCEN has not yet
seen any examples of such activity.

However, the alert specifically addresses the potential use of
“convertible virtual currency” (CVC) for sanctions
evasion and Russia-related ransomware attacks, and provides
instructive red flags, which are of particular relevance for money
services businesses (MSBs) and other FinCEN-regulated financial
institutions undertaking CVC transactions. The alert warns that
sanctioned persons, illicit actors and their networks or
facilitators may attempt to use CVC and anonymising tools to evade
sanctions and protect their assets around the globe.

Accordingly, FinCEN strongly encourages financial institutions
that have information pertaining to CVC flows, including exchangers
or administrators of CVC, to:

• be mindful of efforts to evade expanded US sanctions
  and export controls related to Russia and Belarus;




• submit Suspicious Activity Reports (SARs) as soon as
  possible for any such conduct;




• undertake appropriate risk-based due diligence of
  customers;




• voluntarily share information with other financial
  institutions consistent with Section 314(b) of the USA PATRIOT Act;
  and




• consider using tools to identify assets that must be
  blocked or frozen under applicable sanctions.

OFAC sanctions guidance

Prior to Russia’s invasion, in October 2021 OFAC published
sanctions compliance guidance for the virtual currency industry,
stressing that “the growing prevalence of virtual currency …
brings greater exposure to sanctions risk.” Coming in the
immediate wake of the Anti-Money Laundering Act of 2020, and in the
context of the US government’s effort to curb ransomware
attacks, the guidance is the latest indication that regulators are
increasingly focused on cryptocurrencies in the context of
sanctions compliance and enforcement. It seeks to help companies
comply with OFAC rules, not only by explaining sanctions
requirements and procedures, but also by setting forth best
practices for compliance.

As a threshold matter, OFAC makes it clear that cryptocurrency
companies conducting business in the US are treated the same as any
other US company transacting in traditional currencies when it
comes to compliance with OFAC sanctions. The guidance outlines the
obligations that exist with respect to blocking, rejecting and
reporting transactions where sanctioned parties are involved. The
guidance also explains that, while failure to comply could lead to
penalties, co-operation with OFAC and efforts to build a compliance
programme would be mitigating factors when determining penalties
for potential violations.

Consistent with the OFAC framework issued in May 2019, the best
practices guidance offers a five-pronged approach when developing
an adequate compliance programme, including the following basic
components, each of which are described in some detail in the
guidance:

• management commitment;




• risk assessment;




• internal controls;




• testing/auditing; and




• training.

In light of the ever-growing role that digital assets play in
the global economy and the consequences for sanctions compliance,
OFAC’s guidance stresses that all companies participating in
the virtual currency industry, or that are otherwise exposed to
virtual currencies, should have a “risk-based” sanctions
compliance programme.

Continuing Agency Turf Battles Despite Efforts to Increase
Co-ordination

While it is a commonly cited myth that the digital asset space
is the “wild west”, the reality is quite different. Far
from having no sheriff in town, there are actually multiple
sheriffs in town, each vying for control over its turf – or its
perceived turf.

While the SEC aggressively pursues regulation of
cryptocurrencies as securities, the CFTC thinks they are
commodities and digital asset derivatives. Whereas FinCEN treats
cryptocurrencies as the functional equivalent of money, a separate
branch of the Treasury, the IRS, believes they should be treated as
a form of property. Even the Federal Deposit Insurance Corporation
(FDIC) has laid at least some claim to regulatory authority over
stablecoins and their issuers.

And more sheriffs are coming. In early November 2021, the
President’s Working Group on Financial Markets (PWG), the
Office of the Comptroller of the Currency (OCC) and the FDIC issued
a report calling for legislation that would enable federal
oversight of stablecoin issuers, custodial wallet providers that
hold stablecoins, and others (eg, certain DeFi products, services
and arrangements related to stablecoins). The report also indicated
that, in the absence of new legislation, federal regulators could
step in through the Financial Stability Oversight Council (FSOC),
which could designate certain stablecoin activities as
“systemically important” payment, clearing and settlement
activities, thereby enabling additional federal oversight.

With that many sheriffs seeking to enforce competing sets of
rules comes a lack of consistent guidance, clarity and
predictability. Cryptocurrency companies – both those wishing to do
business in the United States and those seeking to avoid the US
market – are faced with an uncertain and frustrating regulatory
environment. Despite FinCEN’s admirable efforts over the past
decade to provide affirmative guidance and advisory opinions to
companies operating in this space, most other agencies have
unfortunately taken a “regulation by enforcement”
approach, which trend is expected to continue in 2022.

There is perhaps no greater example than the SEC, which
continues to try to stake its claim as the chief digital asset
regulator. Over the course of the last year, the SEC brought more
than two dozen enforcement actions, and is seeking additional
staffing resources for its crypto enforcement unit. Public
statements by SEC Chair Gary Gensler continue to signal an
expansive view of the SEC’s jurisdiction in the digital asset
space. For example, in remarks before the Aspen Security Forum in
August 2021, Gensler stated: “I believe we have a crypto
market now where many tokens may be unregistered securities,
without required disclosures or market oversight… Make no
mistake: it doesn’t matter whether it’s a stock token, a
stable value token backed by securities, or any other virtual
product that provides synthetic exposure to underlying securities.
These products are subject to the securities laws and must work
within our securities regime.” Moreover, in January 2022,
Gensler reiterated the SEC’s aggressive stance on
crypto-related enforcement, stating: “[T]o the extent that
folks are operating outside the regulatory perimeter, but are
supposed to be inside, we will bring enforcement actions.”

Not to be outdone by the SEC, the CFTC also continues to mark
its territory, already bringing a number of enforcement actions in
the first half of 2022. In February, Chairman Rostin Behnam – just
one month after his swearing in – called on Congress to pass a law
that would allow the CFTC to regulate cash markets for certain
types of cryptocurrencies, which would supplement the CFTC’s
existing authority to police the derivatives markets. Notably,
Chairman Behnam also suggested that his agency is in a better
position than the SEC to regulate tokens such as bitcoin and
ether.

But amidst these regulatory turf battles, there appears to be
some recognition on the part of the Biden Administration that this
regulatory climate fails to serve the interests of industry, the
government or the public.

Presidential Executive Order on Digital Assets

On 9 March 2022, the White House issued an Executive Order on
Ensuring Responsible Development of Digital Assets, representing
the first-ever attempt at a “whole-of-government”
approach to examining the risks and benefits associated with
digital assets. The Executive Order requires certain federal
agencies to broadly review their policies related to digital
assets, with a focus on six key areas:

• consumer and investor protection;




• financial stability;




• illicit finance and national security;




• US competitiveness within the global financial
  system;




• financial inclusion; and




• responsible innovation.

This balancing of competitiveness, inclusion, stability,
protection and innovation is noteworthy, and also recognises that
digital assets are more than simply investments.

Although the Executive Order does not prescribe any specific
policy positions or require agencies to adopt particular rules, it
directs a process of agency co-ordination and collaboration to
assess digital asset risks and benefits, and associated policy
proposals. To that end, the Executive Order requires the production
of 14 reports, assessments, frameworks and other written work
products, with deadlines ranging from 60 to 210 days. A wide array
of government agencies are involved, including the Departments of
Commerce, Energy, Homeland Security, Justice, Labor, State and
Treasury, as well as the Office of Management and Budget, the
Environmental Protection Agency, the CFTC, the Consumer Financial
Protection Bureau (CFPB), the FDIC, the Federal Reserve Board of
Governors, the Federal Trade Commission, the FSOC, the Office of
the Comptroller of the Currency, the Office of Science and
Technology Policy, the SEC and White House offices. Notably, the
National Security Council and the National Economic Council will
co-ordinate these government-wide activities.

Furthermore, the Executive Order addresses several prominent
digital asset market areas, including the following.

• US Central Bank Digital Currencies (CBDCs): the
  Executive Order places urgency on the need to explore the
  development of a potential CBDC – the “digital
  dollar”.




• Measures to protect consumers, investors and
  businesses: the Executive Order calls on regulators to “ensure
  sufficient oversight and safeguard against any systemic financial
  risks posed by digital assets”, and directs consultation among
  various cabinet departments, independent regulatory agencies,
  federal banking agencies and the CFPB in an effort to harmonise
  regulatory approaches.




• Financial stability, mitigating systemic risk and
  strengthening market integrity: emphasising the critical role
  financial regulators play in promoting a stable financial system,
  the Executive Order calls on the Treasury Department to develop
  policy recommendations on cryptocurrencies and other digital assets
  to provide oversight protections and safeguard the integrity of
  financial systems.




• Limiting illicit activity: in an effort to deter
  criminal activity involving digital assets, the Executive Order
  expresses the need for an “unprecedented focus of co-ordinated
  action” among federal agencies.




• Fostering international co-operation and US
  competitiveness: the Executive Order emphasises the need to promote
  the US as a leader in the global financial system, including in the
  development of digital assets, and tasks the Department of Commerce
  with establishing a framework to “drive US competitiveness and
  leadership in, and leveraging of, digital asset
  technologies.”

While the Administration’s recognition of the need for a
more co-ordinated policy agenda is a positive step, it is
critically important that this policy agenda is developed with the
benefit of significant industry input. As FinCEN’s experience
demonstrates, open dialogue with industry fosters more informed,
more effective regulation, promotes compliance and public safety,
and encourages innovation.

National Cryptocurrency Enforcement Team

On 17 February 2022, the DOJ announced the selection of Eun
Young Choi to serve as the first Director of its National
Cryptocurrency Enforcement Team (NCET). The NCET, which was
established in 2021, “will identify, investigate, support and
pursue the department’s cases involving the criminal use of
digital assets, with a particular focus on virtual currency
exchanges, mixing and tumbling services, infrastructure providers,
and other entities that are enabling the misuse of cryptocurrency
and related technologies to commit or facilitate criminal
activity.” The NCET will also lead the DOJ’s co-ordination
efforts with other domestic and international law enforcement
partners, regulators and private industry to combat the criminal
use of digital assets (see “Justice Department Announces First
Director of National Cryptocurrency Enforcement Team” (17
February 2022), available at www.justice.gov).

In the first half of 2022 alone, the DOJ has already announced
indictments and guilty pleas in more than ten crypto enforcement
actions, ranging from elder financial fraud to fraud involving
NFTs. Most notably, in February DOJ announced the arrests of Ilya
Lichtenstein and Heather Morgan, a husband and wife duo accused of
conspiring to launder the proceeds of 119,754 bitcoin (valued at
the time of the couple’s arrest at approximately USD4.5
billion) that were stolen during the 2016 hack of Bitfinex, one of
the world’s largest virtual currency exchanges. At the time of
the arrests, the DOJ announced the seizure of more than 94,000 of
the bitcoins stolen from Bitfinex during the hack (valued at over
USD3.6 billion) – the largest seizure in DOJ history (see “Two
Arrested for Alleged Conspiracy to Launder $4.5 Billion in Stolen
Cryptocurrency” (8 February 2022), available at www.justice.gov).

Conclusion

The year ahead is expected to bring even greater regulatory and
enforcement activity in all corners of the digital asset space,
with particular attention focused on NFTs and sanctions-related
matters. While the Biden Administration’s Executive Order
recognises the need for a more co-ordinated US government approach
to the digital asset space, the jurisdictional turf battles that
have characterised US regulation show no signs of abating, and will
continue to be a challenge to industry participants operating, or
seeking to operate, in the United States.

Originally Published by Chambers and Partners.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
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