Crypto Crackdown: Regulating a Post-FTX World

The following alert is included in Insights 2023, a collection of articles and videos addressing important emerging legal issues in the year ahead.

What happens to crypto if the SEC leans harder on enforcement to regulate the market?

The question of what will happen to the crypto market in 2023 if courts rule that digital assets are, in fact, securities, emboldening the SEC, is no longer the question. Or at least not the only question, because, securities or not, investigators and regulators— at both the federal and state levels—will not hesitate to pursue any company in the cyberworld.

The SEC hasn’t waited for any court to rule on crypto, and after the astonishing collapse of FTX in November, no regulatory agency will hesitate to investigate any entity in the digital asset world. The SEC, for one, had already been taking a hard line, initiating enforcement actions across broad parts of the industry. And, in 2023, all regulators—the DOJ, the CFTC, FinCEN, the CFPB, and the IRS—are likely to continue the aggressive crack down.

Cries that the SEC is “regulating through enforcement” instead of by rules and regulations will be heard again in 2023, though new rules and regulations are unlikely to be forthcoming.

Why? First, there are so many people losing so much money in crypto that calls to investigate and enforce will drown out those demanding new regulations; and second, the SEC likes the rule it has: Howey, a four-prong test based on a 1946 Supreme Court case, is what now determines whether an asset is a security and subject to SEC oversight. And even if the SEC did fire up its regulation machine tomorrow, nothing would likely be adopted in 2023.

In fact, the SEC has doubled down on enforcement, beefing up its crypto staffing—even hiring blockchain experts—and in light of FTX’s demise, more investigators are surely on the way. There are whole swaths of the crypto business that haven’t been intensely investigated…yet. At the dawn of the crypto-universe, investigators had easy picking: the fraudsters, dissemblers, and get-rich-quick schemers were not hard to spot. With the collapse of Terra, Celsius, and FTX—which many had thought was the golden child of crypto— regulators will now likely take a hard look at everyone, giving no one the benefit of the doubt.

The industry has lost two-thirds of its value in one year—from US$2.25 trillion in December 2021, to less than US$800 billion in December 2022. For a time, many questioned whether the train had left the station: surely regulators would not take action that would threaten a US$2 trillion-plus industry. Now, consumers and investors have taken heavy losses and Congress and others are questioning where were the regulators. If there’s ever a time to act, it is now.

In 2022, regulators accused crypto companies of, among other offenses, offering unregistered securities, manipulating the market, and trading unregulated derivatives—standard operating procedures in the crypto world. As enforcement ramps up, who will stop the regulators? Certainly not those who lost money or government officials acting on behalf of those who lost money.

This is not to say that the agencies will have smooth sailing in 2023. Lawyers representing digital asset projects are more and more sophisticated, and projects whose very existence are threatened will have no choice but to push back against the regulators.

With the frenzy of enforcement to come, there will surely be a regulators’ turf battle. It is also possible that the turf will relocate—to, say, somewhere warmer. There are places such as Bermuda and the Bahamas with climates more receptive to digital products, where there is less to fear from US regulators. But as losses mount in the midst of a crypto winter, warm places may be harder and harder to find.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. William K. Pao, an O'Melveny partner licensed to practice law in California, Scott Sugino, an O'Melveny partner licensed to practice law in California and Illinois, and Bill Martin, an O'Melveny counsel licensed to practice law in New York, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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