Amanda Colding (J.D. Candidate, Class of 2024) is a contributing editor. Her interests include private-sector international law, human rights law, gender-based violence advocacy, refugee rights, and youth and disability rights. Amanda holds a B.A. in English from Spelman College in Atlanta, Georgia, where she studied abroad in Durban, South Africa, for a semester. Before law school, Amanda served as a Freedom Corps Fellow at the Working Families Party and a coach for Progressive Pipeline’s cohort of fellows. Currently, she works as the team coordinator for the International Human Rights Law Clinic and will be working with the United Nations in Geneva, Switzerland, next semester. She speaks French at an intermediate level.
New Global Market Emerging and Potential Challenges
With the rise of cryptocurrency and digital assets, there is excitement and cultural buzz that makes crypto platforms like Bitcoin gain popularity. Yet with the rush to use these financial platforms, there has not been a full, in-depth assessment of the risks crypto poses to the economic market, according to CFTC Commissioner Christy Goldsmith Romero at the 2022 International Swaps and Derivatives Association's Crypto Forum 2022. Goldsmith Romero compared the state of unregulated crypto markets today to the profound lack of awareness regulators had in 2008 of market risks from unregulated companies and products. She was not the only one to compare the state of digital assets today to the 2008 financial crisis; Acting Chief of the Office of the Comptroller of the Currency Michael Hsu also drew this comparison.
Today, the financial market is shifting from traditional financial assets and institutions to digital asset trading platforms and services. Although this economic shift comes with new technological innovations, the drawbacks of this new developing system pose regulatory challenges for traditional financial institutions and banks. There are rising concerns about potential financial crises surrounding unregulated digital assets and the unassessed risks behind digital asset trading platforms.
The concerns that digital markets could present the same risks and issues that gave rise to the 2008 financial crisis are rooted in, as Goldsmith Romero put it, “opaque, complex, leveraged, and unregulated products, underappreciated risk, a lack of confidence that underlying assets are stable or of high quality, and lots of connections between market participants” One of the main factors that contributed to the widespread nature of the 2008 crisis was contagion risk, which occurs when a financial crisis spills into multiple different markets or regions on a domestic or international level because of the interdependency between markets.
There have already been instances of contagion risk among collapsing digital asset trading platforms. For example, there was the case of TerraUSD, a stablecoin explicitly designed to hold its value at one United States Dollar. In May, an overall plummet in cryptocurrency values undermined TerraUSD’s supposedly stable value, causing it to collapse and taking its sister token, LUNA, with it. Due to TerraUSD’s collapse and a resulting lack of confidence in stablecoin from investors, Tether, the world’s largest stablecoin whose value is pegged 1-to-1 to the US Dollar, sank below its $1 value. The collapse of both LUNA and TerraUSD and Tether’s reduction of its total market capitalization by $9 billion emphasizes the risks that come with “a lack of confidence, run risk, and contagion risk.” Contagion risk also impacted Three Arrows Capital, a cryptocurrency hedge fund, which defaulted on loans to Voyager Digital, a cryptocurrency brokerage service, which in turn ultimately filed for bankruptcy. Three Arrows Capital also caused the financial distress for three different lenders including Genesis, BlockFi, and Blockchain.com as well as the failure of Celsius Network, another crypto lender. These lenders had to liquidate positions and halt lending.
What is the Global Economy Doing to Combat These Potential Pitfalls?
On a global scale, many countries have come together this year under the Organization for Economic Cooperation and Development (OECD) to create a proposal for a transparent financial system known as the Crypto Asset Reporting Framework (CARF). Under these global guidelines, countries will come together to collectively contribute to cross-border tax information exchanges for digital assets. As of October 10, 2022, CARF has been finalized and presented to G20 finance ministers and Central Bank Governors, but implementation will ultimately be left to each local jurisdiction. The CARF system ensures the exchange of this information on a reciprocal basis, especially information from decentralized financial systems which lack a centralized intermediary.
One reason behind different countries seeking global tax transparency from financial institutions is that these decentralized financial systems can be exploited if there aren’t mechanisms to monitor whether funds originate from illegal activity or are intending to go toward funding criminal activity. According to the U.S. Department of Treasury, crypto-assets and markets that are unregulated can breed fraud, abusive market practice, and theft: “Certain practices in the crypto-asset ecosystem have resulted in financial harm to consumers, investors, and businesses, unfair and inequitable outcomes, and damage to the integrity of the market…of the $14 billion in crypto-asset-based crime in 2021, theft rose by over 500% year-over-year to $3.2 billion in total…the Federal Trade Commission (FTC) had more than 46,000 reported incidents of fraud between January 1, 2021, and March 31, 2022, with people claiming losses that exceeded $1 billion worth of cryptocurrencies.”
The U.S.’s Prior Unilateral Approach to Global Data Exchanges
Although there is an international effort to create a more regulated market and a unified global standard for regulating digital assets, it is unclear whether the United States will join its global partners in adopting this framework. CARF works toward creating a more regulated digital assets market through tax transparency specifically by increasing tax administrations’ visibility on tax relevant activities and helping to determine whether associated tax liabilities are appropriately reported and assessed. To date, the U.S. has not provided reciprocity when enforcing the Foreign Account Tax Compliance Act (FATCA) among its global counterparts. FATCA “requires foreign financial institutions to disclose information on US taxpayer accounts to the IRS or face a 30% withholding tax on payments from the U.S.” When this legislation was initially introduced, the U.S. Department of the Treasury (Treasury) announced that Washington was willing to enter into intergovernmental agreements to reciprocate the collection and exchange of information of accounts in U.S. financial institutions, especially of foreign persons living in the U.S. Yet, in practice, the IRS has not been able to share account balances because no mechanism required U.S. banks to report foreign individuals bank account balances to the IRS. The resulting unilateral exchange created tensions amongst different global powers including EU members for data privacy reasons.
As opposed to when the United States agreed to FATCA, this time Washington is not guaranteed to have the same power or ability to conduct these unequal data exchanges, especially when it comes to cryptocurrency and digital assets.
Possible U.S. Approaches
Washington maintains three options to regulate digital assets domestically and internationally.
One of those options is to continue to use the FATCA framework and incorporate digital assets into its legislation. If the U.S. were to amend FATCA, the government would then have to renegotiate current bilateral intergovernmental agreements which have received global criticism for the lack of reciprocity.. This poses an issue for renegotiation purposes especially because, as stated by Jon Feldhammer of the law firm Baker Botts LLP, “the U.S. government was very heavy-handed with the world in order to get FATCA done. It wasn't a situation where the U.S. reached out to the world to come together and agree on a solution to a worldwide tax evasion problem…accordingly, some countries may be hesitant to renegotiate…including those with crypto exchanges that rely on the U.S. account holders.”
The United States also has the option to create a parallel tax system which incorporates digital assets into its framework that would work alongside FATCA. To create a parallel system that enhances cross-border tax transparency, Washington would have to enter into multiple intergovernmental agreements to ensure that foreign law allows foreign financial institutions to comply with reporting standards. This would be in consideration of the fact that the U.S. government no longer has the capacity to withhold source income for non-compliant parties, according to Paul Millen, a prominent international tax lawyer based out of Zurich, Switzerland: “the U.S. lacks the heavy stick it had available for FATCA—i.e., U.S.-source income withholding on noncompliant parties — that allowed that regime to be set up unilaterally." The U.S. was able to require withholding on payments to foreign financial institutions under FATCA due to the large indictment of a Swiss bank, Credit Suisse, for helping United States taxpayers evade taxes abroad. This happened for years through illegal cross-border banking activity including the filing of false returns and other documents with the IRS. As a result, the U.S. Congress passed FATCA to require citizens to self-report foreign assets over $50,000.
The third option is for Washington to join its global partners in a reciprocal exchange of information to maintain uniform international standards when regulating digital assets under CARF. According to Denise Hintzke, managing director in the financial services tax practice at Deloitte, “joining other countries in adopting CARF rules could allow for a consistent system.” Having the U.S. join the global market economy along with 38 member states of the OECD and the G20 will enhance global transparency on equal footing. This would contribute to the emerging international law surrounding digital assets and tax transparency which each country could acknowledge and adopt into their domestic law. Hintzke supports “[the] idea of the U.S. participating in CARF [which] would actually make sure that everything was more standard around the world.” Washington has a chance to contribute to cross-border cooperation and substantiate an area of international law that regulates an emerging market based on the digital asset industry.
Indications of a U.S. Decision
Treasury recommended legislation in the Green Book for the 2023 fiscal year (released in March 2022) that allows the IRS to share digital asset information globally through a system that is similar to FATCA. The recommendation states that the Secretary of the Treasury has the authority to implement regulations to allow for an international automatic exchange of information that includes providing foreign individuals bank account balances under FATCA. This indicates that the U.S. might be moving in the direction of creating its own parallel system based on multiple intergovernmental agreements.
Push for U.S. International Cooperation
Ultimately, the United States would contribute to overall transparency and uniformity in digital markets if it chooses to adopt CARF. Doing so would bring legitimacy to the regulatory framework for digital assets, while also establishing Washington’s willingness to join its global peers in combatting tax evasion, money laundering, and terrorist financing on an international scale. Creating a system of global transparency in the digital asset financial system would strengthen the global economy and prevent harm like the 2008 financial crisis. The U.S. has the opportunity to participate in a global community that cares more about the health of the global economy than maintaining unilateral power.
If the United States chooses not to adopt the CARF framework, it leaves the global market and its peers vulnerable to exploitation. Choosing to maintain its non-reciprocal approach to regulating digital markets would create a gap in protection. Joshua Smeltzer, a partner-elect at the law firm Gray Reed & McGraw LLP, said that “without reciprocity, you create that hole where the system can be abused.” Although there have been amendments to federal Internal Revenue Code 6045 to ensure that brokers have to report digital assets on the IRS form that records customer gains and losses during the tax year (1099-B), this does not extend to data collection on foreign individuals living in the U.S. which the government can send to foreign governments. Hintzke commented that, "‘those 1099[-B] rules do not address what would be still [sic] a really big hole’—either for foreign people who invest in digital assets in the U.S. or vice versa.” Leaving the developing and volatile digital part of the market unprotected and unregulated creates a dangerous situation for both Washington and the global economic market. Although the United States has been a global leader in financial security, the decision to commit to non-reciprocal efforts and unilateral agreements between its partner countries puts its own citizens at risk for substantial financial harm.