Navigating Blockchain Compliance

Navigating Blockchain Compliance

With blockchain compliance regulations still evolving, many clients ask whether compliance can be simplified. The cryptocurrency industry is still in the early stages of maturation, which creates legal uncertainties moving forward.  However, at the pace of development within the industry, regulators and courts struggle to meet the developments with a cohesive legal framework that market participants can follow.

To help navigate these complexities, this article outlines the key legal issues related to blockchain activities that businesses should consider to ensure compliance in their operations. We also highly recommend collaborating with a legal team experienced in blockchain and its associated legal challenges, such as the team here are Scarinci Hollenbeck, for more comprehensive guidance.

Brief Background on Blockchain Technology

Compliance necessitates a comprehensive understanding of blockchain technology by all stakeholders. Simply put, blockchain is a decentralized software that tracks and validates data, storing it in blocks that are chronologically linked in an immutable chain. The data blocks are linked together through the use of a cryptographic “hash” of the previous block, a timestamp, and transaction data.

Blockchain is revolutionary because it eliminates the need for a third-party intermediary to manage, monitor, or oversee transactions to validate individual transactions. Instead, all nodes within the blockchain ecosystem simultaneously receive the same continuous stream of data and updates, enabling both private and anonymous data transmission.

While blockchain is best known for its utilization in virtual currencies like Bitcoin, the technology also underpins a wide array of additional products and services, including:

• Smart contracts;
• Crypto exchanges;
• Decentralized autonomous organizations (DAOs);
• Decentralized apps (DAPPs);
• Initial coin offerings (ICOs);
• Non-fungible tokens (NFTs) and other tokenized assets;

Blockchain Legal Issues: Compliance Issues Unique to Businesses Utilizing Blockchain

Compliance challenges for blockchain usage can vary significantly depending on their specific role within the ecosystem. For instance, the legal concerns of an NFT marketplace are not the same as those of a tokenization platform or wallet software developer. However, there are several key blockchain legal issues that marketplace participants should consider. Although not an exhaustive list, the following points provide a starting framework for analysis:

Securities Registration

A primary compliance concern for many participants in the blockchain industry is whether their digital assets qualify as securities. The Securities and Exchange Commission (SEC), along with courts and other regulators, uses the “Howey test” to determine this classification. According to the U.S. Supreme Court’s decision in SEC v. W.J. Howey Co., an “investment contract”—a type of security—is defined as a contract, transaction, or scheme in which (i) a person invests money in a common enterprise; (ii) there is a reasonable expectation of profits; and (iii) those profits are derived from the entrepreneurial or managerial efforts of others.

The SEC generally concludes that digital assets meet the first two criteria, so the analysis often hinges on the third factor: whether a purchaser has a reasonable expectation of profits or financial returns derived from the efforts of others. To assist in this evaluation, SEC guidance outlines characteristics that indicate a purchaser is relying on the “efforts of others.” These characteristics include scenarios where a promoter, sponsor, or other third party, known as an “Active Participant” (AP), plays a central role in the ongoing development of the network or digital asset, and where the AP has a managerial role in making key decisions about the network or the attributes that the digital asset represents.

The SEC’s framework also specifies factors that suggest a reasonable expectation of profit. These include situations where the digital asset grants the holder rights to share in the enterprise’s income or profits, or to benefit from capital appreciation of the asset; where the asset is transferable or traded on a secondary market or platform, or is expected to be in the future; and where there is little correlation between the purchase price of the digital asset and the market value of the goods or services it can purchase.

If you are considering engaging in the offer, sale, or distribution of a digital asset, it is crucial to determine whether federal securities laws apply. If they do, you must either register your activities or qualify for an exemption from registration to avoid issues moving forward. 

Licensing Requirements

Many states have implemented laws mandating that certain businesses utilizing blockchain obtain an appropriate license. Notably, New York was one of the first states to regulate the digital currency industry, introducing the “BitLicense” rules in 2015 under the oversight of the New York State Department of Financial Services (NYSDFS). To conduct virtual currency business activities in New York, entities must apply for a BitLicense or obtain a charter under the New York Banking Law, with the necessary approval to engage in virtual currency operations.

Pursuant to 23 NYCRR 200.2(q), virtual currency business activities fall into one of five categories: (i) receiving virtual currency for transmission or transmitting virtual currency; (ii) storing, holding, or maintaining custody or control of virtual currency on behalf of others; (iii) buying and selling virtual currency as a customer-facing business; (iv) performing exchange services as a customer-facing business; or (v)controlling, administering, or issuing a virtual currency.

Given the varied and complex nature of state licensing requirements, it is crucial for businesses that utilize blockchain to thoroughly review the regulations in every state where they offer products or services to ensure compliance. 

Data Protection and Cybersecurity

While data protection and cybersecurity are critical for all businesses, they are particularly vital for those operating in the blockchain industry. Despite relying on cryptographic technologies, blockchain’s large-scale architecture, decentralization, and openness also make it vulnerable to unique cyber threats. The consequences of security breaches can be severe; for instance, in 2023 alone, hackers stole an estimated $1.7 billion from cryptocurrency platforms.

To safeguard against such risks, businesses leveraging blockchain technology must implement robust cybersecurity policies and procedures. This includes conducting comprehensive risk assessments before adopting blockchain technologies and proactively mitigating any identified threats to business operations.

In addition to cybersecurity, entities in the blockchain industry must rigorously evaluate their data privacy risks. The inherent transparency of blockchain technology presents distinct challenges in maintaining data privacy. Consequently, businesses must take proactive measures to protect customer privacy, such as incorporating features that conceal underlying user data. Moreover, market participants must determine their compliance obligations under the growing number of data privacy laws, including the General Data Protection Regulation (GDPR) and the California Consumer Privacy Act (CCPA).

Anti-money Laundering (AML) and “Know Your Customer” Requirements (KYC)

Cryptocurrency exchanges, wallets, and other businesses operating within the cryptocurrency industry must ensure strict compliance with Anti-Money Laundering (AML) and Know Your Customer (KYC) requirements. These regulations are designed to prevent the use of digital currencies in illicit activities such as money laundering, terrorist financing, sanctions evasion, and other financial crimes.

Participants in these markets are generally held to the same AML standards as those managing traditional currencies. In the United States, the primary legal framework for AML regulations is established by the Bank Secrecy Act (BSA). This framework outlines critical requirements, including reporting, recordkeeping, and the development of AML programs. The BSA is enforced by the Financial Crimes Enforcement Network (FinCEN), with support from other financial regulators.

An entity’s specific AML obligations depend on the nature of its business. For example, entities subject to BSA regulations are typically required to implement risk-based AML programs with minimum standards designed to deter money laundering, file Suspicious Activity Reports (SARs), and maintain robust customer identification programs. Additionally, cryptocurrency exchanges operating in the U.S. must register with FinCEN.

The inherent anonymity of blockchain technologies presents unique challenges to AML compliance. However, failure to adhere to these regulations can result in severe penalties. For instance, in 2022, Bittrex was fined over $24 million by the Office of Foreign Assets Control (OFAC) and FinCEN for non-compliance with the BSA, AML regulations, and other related laws.

Key Blockchain Compliance Questions You Should Be Asking

Effective blockchain compliance necessitates a comprehensive understanding of the regulations applicable to your business, identifying potential risks, and determining the most effective strategies to mitigate liability. To assess your risk, consider the following key questions:

• Have you properly documented the relationships among all parties involved, such as the blockchain network, the network operator, and its participants, through legally enforceable contracts?

• Are there specific regulatory licensing requirements applicable to your industry, product, or service?

• Are there any regulatory disclosure obligations that must be met?

• Is your product or service subject to regulation in multiple jurisdictions?

• How will you ensure compliance with applicable Anti-Money Laundering (AML) and Know Your Customer (KYC) requirements?

• What measures have you implemented to mitigate data protection and cybersecurity risks?

• Is your product or service subject to regulations such as the General Data Protection Regulation (GDPR) or the California Consumer Privacy Act (CCPA)?

• Do you have established policies and procedures to regularly audit the effectiveness of your compliance initiatives and make necessary improvements?

Scarinci Hollenbeck Understands Your Compliance Challenges

Compliance within the various industries in which Blockchain operates presents significant challenges, as market participants must adhere to existing regulations while also managing the business risks associated with a rapidly evolving regulatory landscape. The attorneys in Scarinci Hollenbeck’s Blockchain Offerings, Cryptocurrency Defense & Investigations Practice work closely with clients to develop robust compliance programs that protect against enforcement actions and potential liabilities, while still enabling them to capitalize on business opportunities. Our experience and understanding of the blockchain industry empower our clients to swiftly and cost-effectively adapt to regulatory changes to stay ahead of the competition.