Laws and regulations are not enacted in a vacuum.

The Regulatory Loop

  1. There is a social, political, economic or statutory pressure on a regulator that it really ought to regulate a certain transaction or object. Some terrible harm will come to pass if someone doesn’t do something.

  2. The regulator agrees it ought to regulate.

  3. The regulator leans on its prior jurisdictional hooks to try to squeeze the transaction or object under its authority. As we will discuss, the SEC will call the activity the sale or offer for sale of an investment contract; the CFTC a futures contract; the IRS income.

  4. Regulation is passed.

  5. The market restructures the object or transaction to avoid or minimize the effect of the regulation.

  6. Courts may intervene to modify or cancel the regulation.

And back to the beginning.

Regulatory Dynamics

From this perspective, it is a mistake to only study cases to understand how cryptocurrencies might be regulated. Commonly practitioners ask each other “is this a regulated transaction? What is the test we should apply?” Rather, we encourage the reader to consider regulations in the context of the regulatory loop. First ask, does an agency feel it ought to regulate a transaction. Why? How far the agency goes in stretching its available tools depends on how much pressure it feels to regulate.

We will study a variety of tests from U.S. agencies. The tests that survive the longest are those that prioritize intent over structure. For example, the IRS relies on a principle that it may tax “income from whatever source derived”. There’s no amount of restructuring a cryptocurrency income source that can make it not income.

By contrast, since Howey, investment contracts are those where there is an expectation of profit derived “from the efforts of others”. This phrase alone is greatly responsible for the Distributed Finance (DeFi) industry, where smart contracts were restructured and distributed to fully separate expectation of profit from control. The contemporary SEC interest in regulating DeFi is a reaction to market conditions, that were a reaction to SEC regulations, that were a reaction to a feeling of pressure to regulate, which pressure arose in part from market conditions, etc.

There is a delicate balance between the regulated industry and the regulator. If the cost of complying with a proposed regulation is so high that it makes a transaction unprofitable, the regulated industry will complain and attempt to petition the agency to pass something more workable. For example, many are currently petitioning the IRS over its capital gains treatment of cryptocurrency sales. It will be very difficult for cryptocurrency to gain widespread adoption if every purchase of coffee with Bitcoin requires a taxpayer to personally account the transaction to the IRS.

We assume both the regulator and the regulated are acting in good faith, are ethical, and neither want to cause harm. The biggest culprit in bad regulations is usually bad information. New technologies, like cryptocurrency, can be difficult to understand. This lack of understanding may lead to higher perceptions of harm, which in turn create greater pressure on agencies to act. The key to better regulations, and tighter regulatory loops, is simply education. As technologies become more widely understood, equilibiria are reached.