The Diplomat Versus the Enforcer Part 2: Working Towards a Common Goal

In part 1 of this blog post, I wrote about the U.S. Government’s balkanized approach to crypto regulation, including a lack of legislation from Congress. But all is not lost. From the various Congressional and regulatory pronouncements, we can start to see a unified path forward. Given the current regulatory state, the CFTC, SEC, and Congress need to engage in more regulatory diplomacy and find some common ground to move things forward.

The Soft Side of Enforcement

Although the SEC continues to implement a rigorous enforcement plan against the digital asset markets, its leading general has pivoted to a more diplomatic approach ever since the proposal of the Lummis-Gillibrand Bill, which illustrated Congress' (or at least the lobbyists and their client’s) displeasure with the SEC's approach. At the SEC Speaks Conference in September 2022, Chairman Gensler acknowledged that it was Congressional action that addressed the abuses in the securities markets that led, in part, to the Great Depression. In his speech "Kennedy and Crypto," Gensler argued that "[n]othing about the crypto markets is incompatible with the [federal] securities laws. That includes securities and intermediaries in the crypto market."

While presenting at the SEC’s annual conference in Washington, DC—the SEC Speaks—Gensler argued hard for more regulatory authority. He boldly stated that "[o]f the nearly 10,000 tokens in the crypto market, [he believes] the vast majority are securities." He designated the other tokens as "non-security tokens" and acknowledged that, while they were small in number, they represented "a significant portion of the crypto market's aggregate value." In other words, Chairman Gensler was willing to cede oversight of cryptocurrencies such as Bitcoin and Ethereum, but he wanted oversight over most of the remaining tokens. He then outlined his legal analysis for why the SEC should be the primary regulator—the Howey test. The bottom line is the SEC has and continues to, view most digital assets as investment contracts because they are investments in which investors expect to derive profits from the efforts of others in a common enterprise. To all the lobbyists and entrepreneurs arguing against SEC oversight, Gensler’s message was simple: "Not liking the message isn’t the same thing as not receiving it." He wants digital asset firms to register their businesses and products with the SEC—presumably before Congress can pass legislation that awards oversight to the CFTC.

Chairman Gensler then offered his carrot in exchange for the stick. He said the SEC was willing to be flexible and work with entrepreneurs on disclosure and other regulations. Gensler also explained why various market intermediaries should be registered with the SEC, likening them to exchanges, broker-dealers, and other entities regulated by the SEC. The not-so-subtle hint was clear-work with us or we’ll go after the gatekeepers.

Both the CFTC and SEC agree on many of the underlying weaknesses in the digital asset market that need to be addressed. First, the digital asset markets have a high degree of retail participation, which means protections for such investors should be established. Second, digital assets are often custodied at non-banking entities, which exposes such assets to fraud and other forms of misuse (e.g., FTX unregulated lending of assets to affiliated trading firms). Third, trading often involves leverage, which is particularly dangerous given the propensity of these markets to swing wildly. Finally, there is a high degree of interconnectedness between the trading platforms and other market participants, represented by cross-ownership, non-transparent lending, and more. In his testimony before Congress, Chairman Benham outlined the following areas that need regulatory oversight:

• Custody
• Leverage
• Trade settlement
• Conflicts of Interest (e.g., fraud, manipulation, front-running, wash sales, and other misconduct)
• Data reporting
• Cybersecurity
• Retail protections

Benham further argued that most digital assets are commodities, and, therefore, the CFTC should be the primary regulator with the National Futures Association ("NFA") (the CFTC's version of the SEC's Financial Industry Regulatory Association ("FINRA")). The CFTC touted its ability to adapt to evolving financial markets, referencing its handling of 95% of swap regulations after the 2008 financial crisis. Chairman Benham also noted that since 2014, "the CFTC has brought almost 60 enforcement digital asset related cases, including a recent matter involved a $1.7 billion fraudulent bitcoin scheme." He also referenced the agency’s hiring of specialists, its formation of internal task forces, and its restructuring of its financial and technology innovation hub.

CFTC Commissioner Kristin Johnson expanded on some of these areas when she reestablished the CFTC's Market Risk Advisory Committee ("MRAC"). During the committee's meeting on September 28, 2022, Commissioner Johnson discussed "The Future of Finance," including the growth of "non-intermediation—a market structure that removes intermediaries that have historically facilitated activities such as the clearing and settlement of market transactions." Johnson noted that the rise of digital asset markets ushered in a new area of retail participation in leveraged and complex transactions that do not provide the safeguards of traditional asset classes available to such investors. During her opening remarks, Commissioner Johnson noted that "[e]merging technologies often don’t fit neatly into either the Commission’s traditional areas of responsibility or that of other regulators like the [SEC]." She then noted Congress’ efforts to bring clarity to the regulatory framework surrounding these technologies and their underlying asset classes.

Like Chairman Behnam's earlier presentation to Congress, Commissioner Johnson noted that congressional efforts under the Lummis-Gillibrand Bill and DCCPA establish six core principles of regulation.

1. Consumer and investor protection
2. Promoting financial stability
3. Countering illicit finance
4. U.S. leadership in the global financial system and economic competitiveness
5. Financial inclusion
6. Responsible innovation

Johnson noted that an effective regulatory framework around these principles would require participation by the SEC, CFTC, Consumer Financial Protection Bureau ("CFPB"), and Federal Trade Commission ("FTC").

Even Chairman Gensler acknowledges that the CFTC may need expanded power to regulate the non-security tokens and related intermediaries. In his speech at the 2022 SEC speak, he said as much and expressed his support that Congress would grant the CFTC authority over this limited number of tokens with extremely high market shares. He even acknowledges that the CFTC and SEC have worked cooperatively in the past on dual registrants that are registered with both agencies. But Gensler is facing some resistance from within the SEC’s own ranks, most notably Commissioner Mark Uyeda, who was recently appointed to the Commission. In his own remarks at the SEC Speaks, Uyeda suggests that Gensler’s agenda is not effectively prioritized, cost-efficient, or appropriate for the SEC. Uyeda suggests that the SEC has used enforcement to regulate matters that are better determined by Congressional legislation and that such an approach, at a minimum, shortcuts the rulemaking process. Commissioner Uyeda argues that the SEC should be approaching the crypto issue by engaging with Congress and market participants after Congress has determined the statutory scope of the SEC’s authority to regulate these products. Once established, Uyeda believes the SEC should engage in a robust rulemaking process that promotes engagement between the SEC and market participants. As he states, the use of regulation-by-enforcement establishes the Commission’s policies "[w]ithout the benefit of comments from crypto investors and other market participants, [which prevents the SEC from considering] their perspectives in developing an appropriate regulatory framework."

The Emergence of a Regulatory Framework

The most likely outcome of the current Lummis-Gillibrand Bill and DCCPA is a federal law that grants the CFTC and NFA the authority to regulate the spot markets of cryptocurrencies and the derivative futures and options markets on these assets and the platforms that transact in these instruments. The SEC will likely retain jurisdiction over digital assets that are like equity securities issued by operating or investment companies and debt instruments; the SEC will also retain oversight over the platforms that trade in these instruments. Some digital asset platforms or issuers may find that they are regulated by both the CFTC and the SEC, similar to registered investment advisers that are also commodity pool operators or commodity trading advisors under the CFTC. The Consumer Financial Protection Bureau ("CFPB") will have authority over investment productions offered to retail consumers, including debt instruments and other forms of borrowing, while the FTC will regulate entities that develop the underlying technology.

Areas of commonality in the regulatory landscape will include:

• Custody and segregation of customer assets;
• Compliance with anti-money laundering and similar rules;
• Disclosure requirements, which will be enhanced for retail investors;
• Clarity around bankruptcy protection for such assets and customers;
• Cybersecurity and other operational rules, including trade settlement;
• Conflict of interest rules; and
• Data reporting to the various government entities.

Like the Dodd-Frank Act, Congress will require that the orchestra of agencies work together to harmonize their rules. Given that Congress is unlikely to pass comprehensive legislation in 2024 and the agencies will need a few years to establish their rules, harmonization will likely not occur before 2030.

John Clayton and Timothy Massad, former Commissioners at the SEC and CFTC, respectively, have noted that the lack of regulatory clarity is allowing crypto firms to avoid the cost of compliance, even though most of the tradeable tokens are securities. Messrs. Clayton and Massad suggest that:

1. All crypto intermediaries should implement basic customer protections, specifically: (1) segregation of customer assets from firm assets; (2) limits on lending; restrictions on conflicts of interest (e.g., operating conflicting businesses); (4) prohibitions against fraud and manipulation, including insider trading; and (5) corporate governance requirements.
2. Congress and the regulators should establish rules for stablecoins, which have exceeded $50 billion in market value and pose systemic risks to the financial stability of the global economy.
3. The regulators should continue to rigorously enforce existing laws.

Building Trust in Crypto

By focusing on these common areas—custody and segregation of client assets, restrictions on lending and conflicts of interest, and corporate governance requirements—either Congress or the regulators could lay the foundation for effective regulation of crypto markets without overly burdening the industry. While some players will choose to exit the crypto space rather than comply with regulations, the result will be a safer, sturdier, and more trusted ecosystem for remaining market participants.

If you or your firm are entering the cryptocurrency space and want to make sure you have an experienced legal team behind your back, contact Joot. The Joot compliance team knows crypto and will make sure you and your investors are protected.