In the last couple of days, embattled cryptofinance company BlockFi has been hit with cease and desist notices from three different state regulators for its BlockFi Interest Account, or “BIA,” product – first, in its home state of New Jersey and today, we learn, Alabama and Texas as well. It seems likely more states and eventually the federal regulators will follow.
“But BlockFi offers interest accounts just like I have with my bank,” I hear you say, “as do many other DeFi businesses in crypto. It seems these products are offered everywhere in crypto. But I’ve had a bank account for years and my bank isn’t being hauled over the coals by state regulators.”
So what’s going on? Is this a one-off instance of regulatory overreach or misinterpretation of crypto by legacy regulators, or is it a sign of things to come for all “decentralized” lenders selling investment products across state lines in the United States?
Before we answer that question, it’s important to do a quick review of the rules regarding securities regulation in the U.S. The principal statutes governing securities transactions are the Securities Exchange Act of 1934 and Securities Act of 1933, Section 5 which says “unless a registration statement is in effect as to a security it shall be unlawful… to make use of any… communication in interstate commerce… to sell such security” unless an exemption applies.
In English, Section 5 means that you have to have a set of offering documents and those offering documents need to be registered with the U.S. Securities and Exchange Commission (SEC) before you can sell a security to the investing public.
There are a number of exemptions to this requirement. Most frequently encountered in cryptoland are Section 4(a)(2) exemptions for transactions not involving any public offering and Rule 506 exemptions for private placements to accredited investors.
Securities laws are designed to capture myriad arrangements where investors give money to a manager and expect to receive a return. For this purpose, the Securities Act and the Exchange Act define a “security” broadly as being “any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest... transferable share...investment contract… or, in general, any interest or instrument commonly known as a ‘security.’”
The term “investment contract” is also construed broadly, beginning with the 75-year-old decision in SEC v. W.J. Howey Co. and its eponymous “Howey Test.” This test was described by the Supreme Court as embodying “a flexible rather than static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek to use the money of others on the promise of profits.”
“But wait,” you say, “I have just such an arrangement with my bank. I give it money, it manages the money and it gives me a return. So why isn’t my checking account a registrable security?” That’s a good question, one the Supreme Court answered in Marine Bank v. Weaver in 1982.
The facts of Weaver do not bear repeating save that the case involved a $50,000 FDIC-insured CD issued by a bank, allegations of false advertising and the history of securities law. In a decision that both clarified and generalized the Exchange Act, the Supreme Court opined that the definition of “security” is context dependent.
Since bank deposits and CDs are not commonly known as or treated like securities, it was therefore unnecessary to treat them as such, due largely to the near-zero risk of default on such instruments rendering them as not security-like when considered in context.
This explains why Alabama appears to be treating BlockFi’s BIA as an investment product. It refers to the BIA not as a deposit account but a product which “BlockFi allows investors to purchase” – terminology which is not used to describe the opening of current accounts.
The bank deposit carve-out in Weaver is not expressed to apply to shadow bank alternatives where federal guarantees do not exist, and there is an increased element of risk.
Granted, the current enforcement actions we’ve seen to date – from Alabama, Texas and New Jersey – are state law enforcement actions and will, accordingly, be governed by state and not federal law. I consider it highly improbable that the federal regulator, which so far this week has avoided joining the party, is going to sit on the sidelines for too much longer.
BlockFi could certainly adjust its product offering to sell it only to certain states if there are particular states with rules that permit it to sell the BIA without registration. For now, however, the BIA is offered to persons nationwide. Sales to date likely fall under federal jurisdiction, as do other products sold by other DeFi companies on a 50-state basis.
This could mean that the end-state of U.S. regulation in this area, on a nationwide basis and in states following the federal rules, might be that fixed-income DeFi regulatory products, BlockFi included, will be required to register products like the BIA before selling them to the public.
Such regulatory treatment is likely to limit substantially the availability of the BIA to U.S. customers, render products like the BIA uneconomical to offer in states requiring registration, render the UX of such products utterly terrible, and present the daunting possibility that existing DeFi banks may have a difficult regulatory climb ahead of them unwinding their current, noncompliant, businesses.
This could either end in discontinuation of the products in the U.S. (the more likely result), or securing a federal bank charter and offering federally insured cryptocurrency products (without enlightened federal regulators and legislative changes, i.e. under the status quo, less likely).
This does not mean that all crypto-denominated loans are or should be treated as registrable securities. For example, Section 4(a)(2) of the Securities Act exempts securities which do not form part of any public offering from the registration requirement as one might see with, for example, a one-off, privately negotiated business to business cryptocurrency loan not made in the ordinary course of either company’s business. Similarly we might see something like a BIA offered in a regulatory-compliant fashion via the Rule 506(c) private placement exemption that is generally advertised.
It will be interesting to see whether and when the SEC takes a view on the BIA. What is clear to me as a legal observer is that the BlockFi situation is fundamentally a more borderline case than the last big set of securities questions that our industry encountered in the wake of the 2017 ICO boom.
To the extent that cryptocurrency begins to be used as actual money, it will eventually make sense for the treatment of cryptocurrency deposits at fractional-reserve crypto banks to be aligned with the treatment of fiat currency at fiat banks.
One advantage of regulatory change along these lines, unlike, say, the token issuance safe harbor proposals (in relation to which the effects of adoption would be wholesale evisceration of any ability to enforce federal securities laws in the crypto arena), BIA-type products seem more amenable to tailored exemptions that would allow them to be offered with sufficient levels of investor protection.
Provided adequate prudential supervision and hedging, it’s conceivable that BIA-type products could exist and be regulated like CDs or deposit accounts.
I suspect that cryptocurrency adoption needs to go through a few more exponential doublings before it makes political sense for the SEC and legislators to seriously explore what a legislative regime around crypto-denominated accounts will look like. Given that crypto’s growth rate – in terms of aggregate number of users – is faster than that of the internet, the sooner this happens the better off we will all be.