The Ongoing Absence of Crypto Legislation and Regulation in the U.S.
SEC Chairman Gary Gensler’s Job Is to Create Clarity, Not to Retroactively Enforce
The collapse of FTX, the cryptocurrency exchange, has led to calls for greater regulation of the crypto market, which some argue poses a threat to the U.S. dollar. However, caution should be exercised to ensure that rushed legislation does not make the situation worse. While the sudden death of FTX has been compared to the collapse of Lehman Brothers, the fact that crypto is not integrated with traditional finance means that the pain has not spread beyond those invested in crypto. Legislation that legitimizes crypto could lead to future failures disrupting broader economic growth and even necessitating government bailouts. The proposed bills that extend government safety nets to stablecoins could potentially put governments and central banks on the hook in the event of future stablecoin runs. Critics argue the bipartisan Digital Commodities Consumer Protection Act (DCCPA) could kill decentralized finance (DeFi) in the U.S. However, supporters of the bill have state that the collapse of FTX reinforces the need for more federal oversight of the crypto industry.
The DCCPA seeks to amend the Commodity Exchange Act to provide oversight of the crypto spot market to the Commodity Futures Trading Commission (CFTC), which primarily focuses on financial derivatives such as futures contracts. Crypto broker-dealers would need to register with the CFTC and comply with the regulatory requirements, including maintaining a relationship with the CFTC, keeping good records, appointing a chief compliance officer, and preventing fraud, deceit, and manipulation. They must also have adequate financial resources to hold customer funds in a way that minimizes the risk of loss or unreasonable delay in accessing customer property, with strict prohibitions on investing customer funds in anything other than U.S. Treasuries or other high-quality liquid assets. The bill is backed by Senate Agriculture Committee Chairwoman Sen. Debbie Stabenow and Sen. John Boozman and is facing scrutiny due to FTX’s collapse, which was a major lobbying force behind the legislation. The split between the SEC and CFTC reflects their struggle to regulate the market effectively.
FTX’s extensive lobbying efforts in support of the DCCPA have raised concerns among critics of the bill, including SEC Chair Gary Gensler, who has warned that the legislation is “too light-touch.” The bill would allow crypto trading platforms to self-certify if the tokens on their platforms comply with financial regulations, a process that opponents argue would restrict decentralized finance networks while empowering centralized operations like FTX. While Congress has introduced over 50 bills related to digital assets, blockchain technology, and other crypto sector policies, the Digital Commodity Exchange Act of 2022, the Lummis-Gillibrand Responsible Financial Innovation Act, and the DCCPA of 2022 are the most notable. All three bills aim to have the CFTC as the main regulator and overseer for cryptocurrencies, unless they are defined as securities, in which case they would remain under the purview of the SEC. The bills cover topics such as the regulation and registration of digital commodity exchanges, the tax treatment of digital assets, and consumer protection standards.
Former CFTC Commissioner Brian Quintenz has advocated for cryptocurrency exchanges to self-regulate, arguing that it offers a way to protect customers from fraud within the ecosystem. Self-regulating industry associations for other markets, such as the National Futures Association for commodities traders and the Financial Industry Regulatory Authority for securities, have helped spur growth in their respective markets. The crypto industry prefers the CFTC to take the lead in regulation rather than the SEC, which has been criticized for aggressive enforcement actions. While the FTX collapse increased pressure to act, there is no consensus on what regulatory action should be taken, and the legislative process is likely to be slow. However, there may be a simpler and faster way to improve regulation by establishing a joint self-regulatory organization (SRO) between the SEC and the CFTC. This organization would develop standards on issues like asset protection, governance, risk management, fraud prevention, and more, which would apply to all intermediaries regardless of the tokens they trade.
Establishing an SRO for the cryptocurrency market could create greater investor confidence and regulatory certainty for members. However, developing these standards would require a deep understanding of securities and derivatives market rules, as well as crypto technology and market structures. While some hardcore crypto skeptics argue that the limited contagion from the FTX collapse is evidence that crypto should not be regulated, others point to the need for regulatory enforcement to protect investors from scammers and fraudsters.
Despite the rise of cryptocurrencies, crypto companies continue to avoid U.S. jurisdiction. They do so by moving offshore and geo-blocking Americans, which prohibits those located in the U.S. from accessing their platforms. However, this is not a hermetic seal against anyone with a VPN. Although the absence of legislation and regulation doesn’t mean the law surrounding crypto is stagnant, it continues to develop through litigation and the interpretation of various enforcement actions. Yet, true clarity will come through legislative action. FTX’s collapse has complicated the path to congressional action, and draft bills are under renewed criticism for granting primary regulatory jurisdiction to the CFTC instead of the SEC. With the frenzy of enforcement to come, there will surely be a regulators’ turf battle, and it is possible that the turf will relocate to warmer places such as Bermuda and the Bahamas where there is less to fear from U.S. regulators.
Lawmakers are now questioning how regulators allowed the crypto industry to operate with so little scrutiny for so long and why the political and consulting class accepted and even courted Bankman-Fried’s intrusion into Democratic Party politics, even after he admitted to the scam. Bankman-Fried and FTX helped launch the Association for Digital Asset Market (ADAM), which pushed to position the CFTC as its exclusive regulator. However, larger questions still remain, such as why the regulatory system is failing to provide protection for investors, and how the absence of legislation and regulation is contributing to the development of a parallel financial system. In the aftermath of the collapse of FTX, there is a call for greater transparency and regulation, with stablecoins and exchanges like FTX needing to be brought under regulators’ purview.
Calls for new rules to protect consumers are growing louder. However, creating a separate structure for regulating and supervising crypto will only make the financial system less safe, for two reasons. Firstly, it will encourage banks to purchase crypto assets and lend against them as collateral, making the banking system vulnerable to plunging market values. Secondly, new rules will lead to a migration of financial activity from traditional finance to the still less regulated, but newly sanctioned, crypto world. Instead, clarity in regulating the crypto market is needed, with adequate liquid resources to ensure the platform can return the customer’s assets upon request and keeping the environment where customer assets are custodied, including digital wallets, secure. FTX investors may have been better prepared if the FDIC had alerted them to the risks posed by FTX.
The U.S. Securities and Exchange Commission’s (SEC) policy of “regulation by enforcement” has created little clarity for the market or investor protection in the digital asset industry. Two successive chairmen, Jay Clayton and Gary Gensler, stated that every digital asset, except bitcoin, is a security and should register at the SEC like a stock. However, the details end there unless one ends up on the wrong side of an SEC lawsuit. The SEC expects a quick settlement from parties it charges, and parties that challenge the SEC need financial reserves, top-notch lawyers, and years of patience for litigation to play out in court. The SEC claims this approach would protect investors, but that didn’t work out for FTX. A series of regulatory mishaps and wealth-destroying events created the current “crypto winter.” The harm to U.S. investors from the alleged theft of FTX customer assets by Sam Bankman-Fried is likely to be enormous. FTX’s retail investors were left helpless. They deserve to know why the SEC failed to be the “cop on the beat.”
SEC Chairman Gary Gensler claims that FTX was “out of compliance” and needed to “come in and register” with the SEC. Regrettably, the SEC never published the required registration forms, guidelines, or instructions, nor a clearly articulated explanation of how such regulatory deterrence would protect investors.
Gensler states “Today’s charges [against FTX] build on previous actions to make clear to the marketplace and the investing public that crypto lending platforms and other intermediaries need to comply with our time-tested securities laws. Doing so best protects investors. It promotes trust in markets. It’s not optional. It’s the law. I believe that securities law is quite robust and covers much of the activity, not only of the tokens but particularly the intermediaries in crypto securities.”
Gary Gensler is most responsible for everyone losing their money. The SEC’s policy of “regulation by enforcement” has resulted in confusion and harm to the market, rather than clarity and protection for investors. Gensler’s job is to create clarity, not to retroactively enforce.