Federal Preemption or States’ Rights? Crypto Advocates Clash Over Regulatory Approaches

It is easy to think of the most prominent blockchain advocates as a united front, whose ranks are tightly closed in the face of the common enemy — a horde of fierce crypto critics, unwieldy regulators, anti-money laundering zealots, “bitcoin is a scam”-ers, and the stakeholders of the old, centralized financial system. On this battlefield, the crypto camp’s fundamental positions are aligned, and its strategic goals are clear. However, in the times of armistice, blockchain champions get together by the campfire to ponder the important details of their common cause, and — astonishingly — at times, they disagree.

This time around, the metaphorical campfire was lit at the MIT Technology Review's Business of Blockchain 2019 conference, which took place on May 2 on the premises of the Massachusetts Institute of Technology’s Media Lab. One of the panels saw Caitlin Long — the woman who is spearheading Wyoming’s transformation into what she herself called the “Delaware of crypto law” — have a deferential yet rather intense exchange with Coin Center’s director of research, Peter Van Valkenburgh, one of the industry’s most eloquent speakers who is known for many notable deeds — for example, standing up for crypto to a bully last October.

The panel, which also featured MIT professor and former Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler, was on crypto regulation, and the main point of contention was whether it is better done on the federal or state level. While they were ultimately concerned about the same thing — i.e., the backwardness of the United States’ regulatory environment that can chase promising startups away to more friendly jurisdictions — Long and Van Valkenburgh offered two drastically different visions of the best way to go about the issue.

Hurdles on all levels

The tension over the boundaries of federal vs. state authority has informed American politics since the foundation of the republic. In the realms of commerce and finance, a relative balance was achieved when the states assumed jurisdiction over the “consumer-facing” commercial law while the agencies of federal government came to oversee operations with more specialized, “institutional” financial instruments — such as securities (Securities and Exchange Commission, SEC), futures and options (Commodity Futures Trading Commission, CFTC), and broad financial crimes (Financial Crimes Enforcement Network, FinCEN).

It has become a truism that, for crypto enterprises in the U.S., navigating the regulatory landscape is about as easy as making it blindfolded through a minefield. All the agencies mentioned above are interested in some subset of digital assets: The CFTC is eyeing smart contract-powered futures options; the SEC is struggling to decide whether all initial token offerings are under its purview, or just some of them; and FinCEN, facing the need to investigate money laundering schemes and shady transactions, understands crypto assets as something it is used to dealing with (i.e., money). In addition, the Internal Revenue Service (IRS) is treating crypto as property for the taxing purposes, which means that capital gains and losses come into play.

To top it all off, individual states have begun to institute guidelines and regulations of their own, with Wyoming blazing the trail by establishing its own classification of tokens. This is not a small deal, either, since companies operating online automatically fall under jurisdiction of every state whose residents they serve — meaning that now they have to comply with state regulations, too.

This chaos is due to the fact that there is no universally agreed-upon, federally enforced definition of a digital asset. While it would come in handy if one existed — for the purposes of delineating the boundaries of different national regulatory bodies’ jurisdiction over different types of tokens — it is also an arduous task to formulate such a definition, let alone to steamroll such a bill through Congress. The last few months saw continuous attempts on behalf of a group of blockchain-conscious members of Congress to introduce more clarity with a bill known as the Token Taxonomy Act.

The crypto community, though, seems to be divided over not just the bill itself but the very idea of a Congress-enacted, binding definition of a digital token with a claim of federal preemption. Some critics point out that, absent a clear understanding of terms and a sufficient corpus of case law on the matter, it is nearly impossible for a bill to define central concepts around crypto assets in a way that would eliminate dreadful ambiguity when enforced. Others, including Caitlin Long, argue that it is not the federal government’s business altogether, and an attempt by Congress to introduce such a taxonomy would amount to an infringement on states’ rights. Long’s talk at the MIT Technology Review event, her polemic with Van Valkenburgh at the panel, and a subsequent interview to Cointelegraph provide a closer look at the “states’ rights” argument that she stands by.

Financializing crypto assets

Put very simply, there are two major elements in regulations that bind financial firms: those related to consumer protection and prudential regulations, which are rules that dictate the need for such firms to be able to handle risks and hold sufficient assets. One of the central theses that Long advanced throughout the conference is that the inadequacy of current U.S. crypto regulation stems from overemphasizing the consumer protection side while ignoring the solvency issues.

In her talk, entitled “The Financialization of Cryptoassets,” Long explained that many digital assets do not qualify as securities, hence they should be treated as property. Commercial law related to property was mainly formulated in the age when all possessions were tangible, which warrants the need for updating this legal area so as to define digital assets — or to “financialize” them.

The key difference between the traditional financial system and blockchain-based systems is the way custody and settlement work. Normally, people do not own the shares in their brokerage accounts. Instead, they own IOUs (“I owe you”) from their brokers, who own IOUs from custodians, etc. With this murky chain of ownership, it is not uncommon that several entities have claims on one asset; it is often impossible to tell where exactly the asset is at the moment; and finally, settlement can take days.

None of these are an issue with digital assets: You can own them directly, they are easily traceable and settlement takes minutes. All that this novel type of property needs is to be treated as such, and to have sound regulation of custody. In Long’s opinion, not only are states in a better position than the federal government to ensure both, but they have the priority to do so.

The panel: state vs. federal

The regulatory panel ensued, now featuring Peter Van Valkenburgh and Gary Gensler alongside Caitlin Long. The Wyoming native kicked off the discussion with the same sentiment that permeated her talk:

“States control commercial law.”

Coin Center’s Van Valkenburgh responded that his uneasiness with state-level crypto regulation comes from the fact that, in many cases, it boils down to states applying archaic money transmitter laws and licensing requirements to crypto businesses. As a result, instead of having just one federal authority to deal with, successful fintech companies that maintain presence in all of the United States have to “have 54 awkward conversations” with regulators instead of just one. And because money transmitter laws are outdated, they also do not do much to protect the customers.

When MIT’s Gensler attempted to dwell on the consumer protection side for a little longer, Van Valkenburgh retorted that state-level regulation is not the sharpest tool to combat things like money laundering, either: When it comes to financial crimes, states cooperate with the federal regulator, FinCEN, who applies federal legislation — i.e., the Bank Secrecy Act. Coin Center’s Van Valkenburgh also argued that managing custodial risks on the state level is not a great idea, since such processes are better handled by specialized federal authorities, such as the SEC or CFTC. In sum, Van Valkenburgh contended that it is better to have a clear-cut, uniform federal regulation than a host of disparate, state-specific regulatory regimes.

Caitlin Long came back, criticizing some hard-regulating jurisdictions like New York that spend extensive resources on consumer protection and anti-fraud regulation of crypto while caring much less about solvency and allowing established financial institutions like Merrill Lynch to get away with trading assets that they do not hold. She described the forthcoming Wyoming crypto custody rules, which she sees as a way to maintain direct ownership of digital assets and preserve the powerful advantage of blockchain-powered systems over traditional finance.

Grounded in the common law notion of bailment, this type of custody will entail handing the keeper possession of the asset, but not the title. Long likened this type of arrangement to valet parking, where the only thing the custodian can do is to take the vehicle to a safe storage space.

Both Van Valkenburgh and Gensler didn’t sound convinced that solving the custody part of the puzzle would automatically resolve all the consumer protection issues. However, Van Valkenburgh begrudgingly conceded that state-level regulation could make sense, but only if every state adopted a “rational approach.” In turn, Long suggested that, “if we do it on federal level through Congress, we will get the worst-case scenario,” to which Van Valkenburgh responded that there seem to be enough reasonable policymakers on the Hill, and that the situation might not be all that grim.

In an interview with Cointelegraph after the panel, Long doubled down on how the egregious Merrill Lynch situation demonstrated New York authorities’ application of double standards: The firm was able to walk away from doing essentially the same that Bitfinex has been recently accused of doing, but with a much harsher potential fallout. The fact that regulators are going much harder on Bitfinex suggests that they might be picking on crypto enterprises. She also drew a line within the crypto industry itself, distinguishing between highly leveraged exchanges, which would be unable to comply with the new Wyoming statutes, and those that are “truly solvent,” and which will likely end up in the state.

Finally, Long commented on Van Valkenburgh’s pro-federal regulation approach, suggesting that:

“That is putting the convenience of large financial institutions in this sector ahead of reality that property laws are purview of the state. It is very unlikely, to be honest, that there’s going to be a federal money transmission statute, because states are going to fight it. It usurps their long-established supremacy over property law and long-established supremacy over commercial law.”

As it is visible in this discussion, sometimes debates over blockchain regulation invoke matters more fundamental than simply the best way to organize socioeconomic relations enabled by new technology. At times these disputes spill over to the contested ground of federal-state government jurisdiction, or to judgments on whether Congress is better equipped to handle certain matters than state legislatures — the issues as deeply ingrained in the political fabric of the U.S. as the antagonism between the democratic and republican principles in its constitution. At this point, it becomes a matter of deep ideological convictions.

On the more practical side, Long’s fresh focus on the balance between consumer protection and prudential regulations with regard to crypto could be a new way for the industry to articulate and frame its policy woes. Another thing to watch for is if, as Wyoming proceeds with its groundbreaking legislation, progressive digital custody lives up to the hopes that the state’s crypto pioneers have set on it.