Despite recent stalls, digital asset revenue is projected to grow at a compound annual rate of 14% between now and 2027. Non-fungible token (NFT) revenue is expected to surge at an annually-compounded 19% during the same period. As more individuals and organizations hold cryptocurrencies, and as digital assets are traded in more contexts, regulatory bodies are jostling for who should regulate them and how to enforce their use.
In response, organizations across the government should be preparing for new digital asset rules and guidance. As a result, there are some key issues – especially around data structures – that agency and IT leaders should be considering today.
Journey to crypto legislation
In early July, the Senate Finance Committee launched an effort to address uncertainties around the tax treatment of digital assets. The committee is seeking input from industry stakeholders on how the federal tax code can provide clearer guidance on particular transactions involving digital assets.
Sens. Cynthia Lummis (R-Wyo.) and Kirsten Gillibrand (D-N.Y.) reintroduced legislation to create a comprehensive regulatory framework for crypto assets the following day. The revised bill would add anti-money laundering provisions and set aside new resources for enforcement. While the bill is unlikely to become law as it stands, it should drive conversations in Congress on how provisions in other legislation could address industry issues.
Then in late July, the House Financial Services and Agriculture Committees both endorsed the Financial Innovation Technology for the 21st Century Act, which would create a regulatory framework for digital assets. Advancement of the legislation was seen as a victory for the industry, as it would more tightly define the Securities and Exchange Commission’s jurisdiction on crypto matters, but the bill is likely to face headwinds in the Senate.
Most recently on August 25, 2023, the Treasury announced proposed regulations on the sale and exchange of digital assets by brokers, which is a major milestone in the regulation of digital assets. The proposed regulations provide clarity on who qualifies as a digital asset broker, which sales and exchanges must be reported, and how they must be reported to the IRS. The proposed regulations will be open for comment until October 29, 2023, and a public hearing will be held on November 7, 2023, before Treasury finalizes the regulations.
On the enforcement front, since the FTX Trading collapse in November 2022, the SEC has filed charges or taken other action in nearly two dozen crypto-related cases. The IRS has seized some $10 billion in crypto assets since it began investigating digital asset crimes a few years ago.
The good news is that Congress is signaling its intent to establish a framework for where crypto assets fit in the regulatory landscape. That’s a boon to industry because it should relieve enforcement pressure being brought by the SEC and the Commodity Futures Trading Commission (CFTC). It’s also positive for relevant agencies because it will clarify rules and accountabilities. But once legislation is enacted, it will present agencies with challenges around people, processes and technology.
Managing crypto data formats
Agencies will need to field the personnel and implement workflows that ensure they can track and analyze compliance and enforce digital asset rules. They’ll also need to ensure they have the supporting technology infrastructure. Many will likely have to invest in some amount of system modernization.
Currently, digital asset data exists in disparate, nonstandard formats. Centralized exchanges such as Coinbase and Kraken use proprietary data structures, which might differ depending on whether they report to customers or regulators, for example. Participants in decentralized finance (DeFi), which includes on-chain or network-based crypto activity, also have unique data formats.
Some of this data involves basic movements of digital assets on a base layer of a blockchain. However, activity in DeFi or with NFTs often occurs on the second layer of a blockchain, where the specifics of some transactions are harder to see.
DeFi and NFTs are generally enabled through smart contracts or decentralized applications (DApps), which are self-executing programs built on the second layer of a blockchain. They operate autonomously based on a predetermined set of rules executing transactions that do not always appear in blockchain data. From a compliance standpoint, smart contracts and DApps contain valuable data, such as information regarding token issuance or economic activity that impact tax compliance or regulatory review. But currently, organizations such as the IRS, SEC and CFCT have little or no visibility into this information.
The primary issue is that there currently are no standards for how such data should be accessed, captured and reported. Nor is there a standard data model for it. So far, regulatory bodies have dictated a standard for data formatting. It seems more likely, and may be more ideal, that regulators will specify the data they require and then allow industry to determine the standards.
The Infrastructure Investment and Jobs Act (IIJA) could become an inadvertent driver of crypto data standardization. Signed into law in 2021, the IIJA includes provisions that expand tax reporting requirements for certain digital asset transactions. Although the IIJA is intended to apply to tax returns filed after December 31, 2023, the Treasury’s recent regulations will likely not require reporting until January of 2025. The proposed regulations describe what data must be reported to the IRS, likely requiring industry participants to modify their systems to comply. Once finalized, these changes likely will start the push toward data standardization.
The types of data required by the IRS are likely to be similar to what data other agencies, such as the SEC and CFTC, might need. Depending on the scope of entities or platforms the new tax regulations will apply to – centralized exchanges, on-chain marketplaces, DeFi protocols – the new regulations may align with other legislation that is passed for non-tax rules. In that case, the result will be de facto data standardization.
Modernizing for crypto data management
Relevant agencies – the IRS, SEC, CFTC, and Justice Department, among others – will need to be able to receive, validate, correlate and analyze data from a variety of sources. Data standardization will help with this, but data received from different sources likely still needs to be validated as accurate and correlated into a holistic data set for the individual or entity it relates to. Only after these initial steps are completed will an agency be able to analyze that data for compliance or possible enforcement efforts.
Digital asset data is digitally-native, meaning receipt or ingestion of that data will come through some cloud-based service or API connection. Generally, this should make data transmission, management and evaluation easier over time. But in the short-term, legacy technology used by various agencies may struggle to operate efficiently. In the near term, creative solutions will be needed to connect this new data with legacy systems where non-digital-asset data is stored and analyzed for various workstreams.
Digital asset data itself, and the innovation of modern solutions, will also generate cybersecurity issues that need to be considered. Data received by agencies into its own ecosystem or secure cloud-based systems may be easily secured. However, as agencies look to capitalize on the public nature of blockchains, cybersecurity issues may arise if agency systems are attempting to connect directly to open source blockchain networks like Bitcoin or Ethereum.
Agencies may struggle trying to integrate with open source blockchain networks. In addition to cybersecurity concerns, the fast-paced evolution in the digital asset ecosystem means that blockchain networks can change rapidly with new networks being created or lapsing at any point in time. Tracking all of these changes may be too difficult for agencies to tackle with their limited resources besides the fact that understanding the nuanced technological differences of the networks may, in and of itself, be an overwhelming task.
The simplest strategy for agencies may be to partner with a vendor that has an expertise in the area and can manage a secure government cloud environment where on-chain data is available to one or more agencies. Given the data-heavy nature of enforcement, it will be critical for agencies to leverage a vendor that can operate in a cloud environment that meets federal security standards. The secure environment will shield government systems from the fast-paced rate of change and open nature of the digital asset industry.
Agency need for digital-asset-focused technology is near, but any solution must be approached thoughtfully to avoid unexpected costs, unnecessary complexity, and long project timelines. In some cases, system modernization and procurement might be more cost-effective than complex integrations with legacy platforms. In any case, the time to start thinking about digital asset data integration is now, before legislation is passed. A proactive, forward-looking approach will position agencies to fulfill their data needs and maintain their compliance and enforcement missions.
Miles Fuller is head of government solutions for TaxBit.