The Diplomat Versus the Enforcer Part 1: The Waves of Regulatory Diplomacy
Cryptocurrency is currently an incredibly hot topic. For better or worse, the public’s eyes have been transfixed on the crypto industry and the potential regulation from the United States government. I’ve previously written about how the U.S. Securities and Exchange Commission (the “SEC”) and Commodities Futures Trading Commission (the “CFTC”) are competing for jurisdiction over cryptocurrencies and their issuers. While the SEC has taken a more active enforcement role against such issuers and assets, the CFTC seems content to issue regulatory statements and wait for Congressional authority.
In the Weeds of Regulatory Diplomacy
Congress appears to appreciate the CFTC’s approach, as the Responsible Financial Innovation Act introduced by Senators Cynthia Lummis and Kristen Gillibrand (the “Lummis-Gillibrand Bill”)—introduced in June 2022—and the Digital Commodities Consumer Protection Act of 2022 (“DCCPA”), a bipartisan bill introduced in August 2022 by the U.S. Senate Committee on Agriculture, Nutrition, and Forestry (the same committee that oversees the CFTC), favored the CFTC over the SEC. The Lummis-Gillibrand Bill proposed the concept of ancillary assets as a means of defining oversight of digital assets and cryptocurrencies as securities or commodities, splitting regulatory authority between the CFTC and the SEC. Similarly, the DCCPA would give the CFTC jurisdiction over digital asset sport market transactions by expanding the definition of “commodity” under the Commodity Exchange Act (the “CEA”) to include “digital commodities,” such as cryptocurrencies. The DCCPA would also require digital commodity platforms to register with the CFTC (as opposed to the SEC) as either a digital commodity broker, digital commodity custodian, digital commodity dealer, or digital commodity trading facility. Collectively, the new law would also require compliance with CFTC rules and principles regarding conflicts of interest, abusive practices, cybersecurity, business continuity and disaster recovery plan, protection of customer funds, and financial integrity between market participants.
In August, CFTC Chairman Rostin Benham commented on the DCCPA, the digital commodity regulation legislation introduced by Senators Debbie Stabenow (D, Michigan) and Boozman (R, Arkansas). Chairman Benham promoted the legislation, which would award more authority to the CFTC, stating that “[w]e are at a critical inflection point where new legislative authority is needed to clarify ambiguities and provide a regulatory framework to the digital commodity market that protects customers, provides market integrity and certainty and ensures financial stability.” CFTC Commissioner Kristin Johnson echoed Chairman Benham’s statements, noting that she “look[s] forward to working with Congress, [her] colleagues at the CFTC and [her] fellow regulators to develop a regulatory infrastructure that achieves effective customer protections and market integrity standards.”
A few weeks later, Commissioner Johnson provided the opening remarks at the CFTC’s Office of Minority and Women Inclusion (“OWMI”) Roundtable on Digital Assets and Financial Inclusion. She noted that since the rise of cryptocurrencies following the 2008 whitepaper published under the pseudonym Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System, many underserved racial and ethnic minorities have participated in the cryptocurrency market as a means of achieving financial inclusion or improving their fragile financial circumstances. Commissioner Johnson then discussed the volatility of crypto markets and the frequent occurrences of crypto winters, which harm such communities. She noted that well-tailored, carefully crafted regulations would stabilize and protect these markets, but that such regulation should be tech-neutral and should not exacerbate the financial exclusion of vulnerable communities.
During her introductory remarks, Commissioner Johnson noted that the United States should have a seat at any table discussing digital assets, given the preeminence of U.S. commodity and derivatives markets. Presumably, this was a nod to the fact that the largest digital asset exchanges are located and operated outside the U.S., in a direct attempt to avoid regulation that many crypto participants find stifling and burdensome. Commissioner Johnson attempted to alleviate concerns over U.S. regulation by suggesting that CFTC if selected as the principal regulator of digital assets in the U.S., would take a “principles-based approach to regulation that allows for innovation and growth, while also providing necessary customer protections through aggressive enforcement of the Commodity Exchange Act and [CFTC] regulations.” Commissioner Johnson’s remarks can be interpreted as a comparison to the approach of Chairman Gary Gensler and the SEC, which has spent more time and energy regulating through enforcement as opposed to industry and Congressional engagement. In other words, Commissioner Johnson presents the CFTC as the good cop and the SEC as the bad cop on the U.S. federal beat.
Cracking Down on the Crypto Currencies
"A good plan, violently executed now, is better than a perfect plan next week." - General George S. Patton
While the CFTC was engaged in regulatory and congressional dialogue, the SEC continued to live up to its tough cop reputation by bringing additional enforcement actions against crypto-related firms. On August 1, 2022, the SEC charged 11 people in a $300 million crypto pyramid scheme related to the digital platform Forsage. In a typical Ponzi scheme structure, Forsage’s Russian-based founders and U.S.-based promoters touted Forsage.io as a platform for facilitating smart contract transactions on the Ethereum, Tron, and Binance blockchains. The scheme started in 2020 and was deemed a fraud by the Philippine Securities and Exchange Commission in September 2020 and Montana’s Commissioner of Securities in March 2021. Nevertheless, the founders and promoters continued to promote the scheme on YouTube and social media.
A few weeks later, the SEC brought an enforcement action against the founder of Dragonchain for operating an unregistered crypto asset securities offering. You can read more about the unregistered offering in my blog post, Slaying the Dragon. On September 14, 2022, the SEC charged Chicago Crypto Capital, LLC, and others with defrauding investors through an unregistered offering of crypto securities assets. The SEC claimed that the firm and its salespeople operated as unregistered broker-dealers when they offered and sold NYX tokens to 100 people with little to no experience or knowledge of crypto assets. On September 19, 2022, Sparkster settled an SEC action that alleged Sparkster and its CEO participated in an unregistered offer and sale of crypto asset securities from April 2018 through July 2018., and failed to disclose payments to crypto influencers who promoted the tokens; Sparkster settled the matter for $35 million. Although Sparkster settled the charges against it, Ian Balina, the promoter who failed to disclose his 30% bonus for promoting the scheme, had not settled the SEC charges that Balina violated federal securities laws; the matter against Balina is ongoing. On September 28, 2022, the SEC announced charges against The Hydrogen Technology Corp. and its former CEO for market manipulation of crypto-asset securities. The Hydrogen case is related to HYDRO, a digital token created by Hydrogen that was airdropped and promoted through various bounty programs. Hydrogen then engaged a South African firm to create the appearance of robust market activity for the token using bot-driven trading schemes. The SEC alleged that the offering was an unregistered securities offering and that the bot-driven trading scheme amounted to market manipulation. On September 30, 2022, the SEC filed a civil lawsuit against Arbitrade Ltd. and others for a crypto asset pump-and-dump scheme. Throughout these last few months, the SEC has remained a hardline enforcer on a crypto crackdown.
Although it was busy with Congressional testimony in September, the CFTC was not idle on the enforcement front— it brought two cases highlighting its approach to regulating enforcement. First, the CFTC brought an administrative case against bZeroX operated as an unregistered futures commission merchant by offering leveraged and margined retail commodity transactions in digital assets and failing to comply with customer identification rules under the Bank Secrecy Act. Second, the CFTC filed a federal court case against Ooki DAO, the successor to bZeroX that violated the same laws. The latter case is interesting in that it seeks penalties against a digital autonomous organization (“DAO”), which by its nature is not controlled by any one person or entity. As part of the transfer of assets from bZeroX to the Ooki DAO, the founders of the underlying blockchain protocol claimed that the entity would be “enforcement-proof.” The CFTC disagreed and is arguing that the DAO is an unincorporated association and that Bean and the founders were participating members and, therefore, liable for the DAO’s violations.
While the CFTC touts that it’s brought nearly 50 enforcement actions related to digital assets over the past few years, those enforcements pail when compared to the rigorous pace of SEC enforcement actions. After doubling the size of its Crypto Asset Enforcement Unit in May 2022, the SEC has brought numerous actions each month since. The commission even touted its crypto-focused efforts in its 2022 summary of enforcement activity, highlighting cases against BlockFi, Forsage, Ishan Wahi, JPMorgan Securities, UBS Financial Services, TradeStation Securities, and Morgan Stanley Smith Barney.
But again, the approach of the CFTC has been fundamentally different from that of the SEC. While the SEC is content to regulate through enforcement, the CFTC has taken a more diplomatic approach. In September, the SEC was busy touting its enforcement credentials, but the CFTC was sitting in front of Congress to discuss the DCCPA. Chairman Benhman reminded Congress that when he presented to it in February, he stated that the “unique characteristics of the growing digital asset industry necessitated a comprehensive federal regulatory regime.” Whereas the CFTC was willing to wait for Congress to proceed, the SEC was forging ahead on its own.
In Part 2 of this blog, I’ll discuss areas of convergence where the CFTC and SEC can work together to develop basic crypto regulation and protection of consumer assets; I will also discuss what a future regulatory framework may look like, and why getting to effective regulation may be simpler than it seems.
As always, if you or your firm are diving into the deep end of crypto and need a helping hand to guide you through the waters, contact Joot. Our team knows crypto and can help you navigate these stormy waters.
Stay tuned for part 2!