## Regulatory and legal considerations *Session 2 - Cryptoeconomics and protocol case studies (Vac Business Workshop, Dec 2021)* --- ## Starting point - Different regulation for different jurisdictions - Moving fast and changing frequently - Wild west, but some regulation is clear - What exist today that is relevant? - Disclaimer: Not legal advice, IANAL Note: A bit of a battle field, active negotiation Moral vs legal dimension, natural law takes arguably takes precedence but often there are some gotchas in the law to be careful of Regulation carries different degrees of "weight" Which jurisdictions? US, EU important. CH not much rule of law, too random. Singapore, Switzerland yes, but also influnced by some of this such as FATF. Also many subtleties, and you can see this with how e.g. Binance has been shopping for a good jurisdiction. --- ## Focus today - US Howey test (Supreme Court) - FATF (guiding recommendations) - EU (proposed legislation) - Zcash and AML - Layer 2, DeFi --- ## Cryptowars 2.0  Note: In the 90s there was a war on cryptography export Now HTTPs is everywhere Somewhat similar situation now Secure messaging, try to ban in Australia, UK --- ## Howdy, Howey US framework for determining if cryptocurrencies are **securities** and will be regulated as such Note: You don't want to be classified as a security Based on Supreme Court precedence, wildly applied --- ## Howey test - four prongs - Investment of money - Common enterprise - Expectation of profits - Derived from the efforts of others Note: Based on how something is used, not "what it is" Means contradictory conclusions, "bitcoin is a commodity" (CFTC), "property" (IRS), "virtual currency" (FinCen), "money used for money transmission" (state money transmission regulators) Economic circumstances rule here Things move slow! Many ICOs block US IPs for this reason. Who controls asset? Gold just exists, similar with Bitcoin and Ethereum. Belongs to p2p public network. --- ## Howey: Investment of money - Distribution - sale? airdrop? mining/validation? - Is the thing developed already or a pre-sale? - Airdrops - no risk of initial investment Note: If sale of token this prong is satisfied Mining, Proof-of-burn, airdrop, reward for contributing resources to network --- ## Howey: Common enterprise - Horizontal or vertical commonality complex - Horizontal: Price of token up for you and me? - Not vertical: Buying Bitcoin from 1/N miner, individual P&L - Vertical: Pro rata sharing of profits, profit-development linkage - Decentralized network or centralized entity responsible? Note: Federal court disagreement re horizontal/vertical Pro rata sharing of profits, get part of profit of 'enterprise' Buying Bitcoin fromin miner friend, assuming multiple miners the money isn't pooled with rest of network Centralized entity who accepted investments based on promises and responsible for future efficacy Subtle, your Bitcoin and my Bitcoin rise in value equally (horizontal commonality), but vertical might be different (P&L for miners) Decentralizred network no funds are pooled to build, but if all devs are employed by same for-profit company, stronger case for horizontal Profit-development linkage: devs hold many tokens/distribute pre-mined then stronger case for vertical commonality Vertical commonality riskier in cryptocurrency networks; mismatch with law --- ## Howey: Expectation of profits - Many people buy as investment - Distribution - **Functionality** - if used to grant access to platform case for profits poor Note: New tech, much of value speculative. People might buy as investment regardless of intent. Distribution - pegged value means expectation of profit unlikely. If done to grant access to some tool or platform, case for profits poor. Used as resource, app tokens, gas --- ## Howey: Efforts of 3rd party - Test focuses on correlation - do profits mirror promoter/issuer? - Bitcoin trust minimized, many miners - Ex: issuer-backed non functional tokens, pre-ales, permissioned consensus, small/non-transparent dev community Note: Do profits mirror promoter or issuer? Bitcoin relies on miners but not any individual miner, spread out. Similar to saying person owning land relies on deed clerk at courthouse to generate profit. Transparent - need to make sure properly decentralized, hard to update software --- ## Howey test - alt view  --- ## Howey - some takeaways - Highly decentralized - Initial distribution fair - Functional: use-value vs profit-value Note: All four prongs have to be satisfied --- ## Can a security become a non-security? - Many ICOs fit Howey test, big in 2017 - Functionality test - how functional? - Decentralization - how decentralized? - "Ether too decentralized to be security" - Goal: protect investors --- ## FATF - Financial Action Task Force - Informal, international, not law, can pressure - Expansive approach Note: They issue recommendations, deals with financial survelliance international, informal, pressure Pressures non-compliance with black lists etc --- ## VASP - Virtual asset service provider - Travel rule Note: VASP similar to security, you ideally don't want to be it Think of it as a mini bank with a lot of requirements Amount of data to be surveilled with travel rule E.g. from A to B need to do KYC --- ## FATF guidance: good - VASP: means controlling VA, not "facilitating" - Publishing code out of scope - Travel rule for e.g. miner fees not included - "Unhosted wallets" (self-costody) not in scope Note: Coincenter, like EFF for cryptocurrency, acting in public interest in public policy related to crypto regulation in US This means validators not in scope Travel rule miner fee/validation, nightmare if you need to do some form of KYC in BTC/ETH, not realistic --- ## FATF guidance: bad and ugly - When not between two VASPs, similar to cash - unclear if this is view - Verbose, hard to understand, not crypto-native, weasel words - DeFi - if possible to change parameters you might be VASP - Confusing - control a VASP with governance tokens? Note: See Coinbase fight with SEC re lending project. Also Uniswap Labs US entity, delisted some stuff in interface. --- ## VASP - functional owner/operator test - Automated != Decentralized - Significant control or influence? - Stablecoins - issues and gov bodies might be VASP --- ## EU Council Report *Proposal for a Regulation Of The European Parliament and of The Council on Markets in Crypto-assets, and amending Directive (EU) 2019/1937"* Note: EU report but likely spillover (Brussels effect) --- ## EU report tldr - NFT, utility token, self-custody wallets: no regulation - Stablecoins: very strict regulation - Other crypto assets: some regulations - Exchanges/Custodians (centralized): strict regulation - DeFi: unclear/ no regulation (yet) Note: Other crypto assets means payment tokens w/o stable value, not utility tokens Crypto assets service providers providing interest on stablecoins, regulation (unclear implications) --- ## Zcash and Tornado Cash compliance - Zcash compliant with all major regulations - How does this work with private transfers? - Facilitate "travel rule" with encrypted memo field between VASPs Note: Payment disclosure when necessary with encrypted memo field. Global AML/CFT, FATF Rec, EU/US ML. Link originator to beneficiary Tornado Cash has similar compliance tools NYFDS gave Gemini permissions to provide custodial and listing FinCen has written more here, concern is being seen as a money transmitter --- ## L2 and DeFi: the cake is a lie!  Note: - The cake is a lie! Layer 2, DeFi and upgradability --- ## Upgradability  Note: Makes sense for high risk, new tech, a sense of control But this control is a double-edged sword - act as VASP? --- ## Who is in control? - Upgradable contracts - in control and act as VASPs? - L2 single sequencer (Optimism, ZKSync) - Uniswap delisted unregistered securities (tokenized stocks) Note: L2 Optimism single sequencer ZKSync trustless but also single operator (dutch non profit) Americans investing with expectation of profit problematic Doubly in Uniswap UI since they are US company --- ## L2 and DeFi - good - Tornado Cash and Uniswap - no admin or upgradability - ENS passed control from multisig to ENS DAO - More decentralized => Less likely to be considered security Note: Decentralized sequencer on roadmap Governance tokens? More decentralized better... --- ## Misc thoughts - Token has functionality on day 1, doing something useful - No single operator of service - Governance token, protocol providing remuneration directly - No profit kickback Note: Ensure doing something useful (staking, validating) on day 1 Sufficiently decentralized No profit kickbacks like stock --- ## References [Report Framework for Securities Regulation of Cryptocurrencies (Coincenter 2018)](https://www.coincenter.org/framework-for-securities-regulation-of-cryptocurrencies) [Utility Token Offerings: Can a Security Transform into a Non-Security?](https://digitalcommons.law.byu.edu/cgi/viewcontent.cgi?article=3232&context=lawreview) [The long-awaited FATF crypto guidance is not as bad as it could have been, but still flawed](https://www.coincenter.org/the-long-awaited-fatf-crypto-guidance-is-not-as-bad-as-it-could-have-been-but-still-flawed/) --- ## References (cont) https://www.trmlabs.com/post/trm-talks-fatfs-crypto-guidance-what-did-we-learn [Summary of EU Council report (Proposal for a Regulation Of The European Parliament and of The Council on Markets in Crypto-assets, and amending Directive (EU) 2019/1937"](https://old.reddit.com/r/CryptoCurrency/comments/r218s7/the_most_important_piece_of_regulation_on/) --- ## References (cont 2) https://www.fincen.gov/sites/default/files/2019-05/FinCEN%20Guidance%20CVC%20FINAL%20508.pdf https://www.perkinscoie.com/images/content/2/3/v7/237411/Perkins-Coie-LLP-White-Paper-AML-Regulation-of-Privacy-enablin.pdf https://z.cash/compliance/ --- ## Q&A