In written and oral testimony presented Tuesday to the United States Senate Committee on Banking, Housing, and Urban Affairs, Chairmen Jay Clayton and J. Christopher Giancarlo of the Securities and Exchange Commission and Commodity Futures Trading Commission, respectively, presented an optimistic view of the power of financial and technological innovation with blockchain-based applications. At the same time Clayton and Giancarlo warned of the regulatory enforcement penalties that await those market participants who fail to follow federal securities and commodities laws and regulations. They further cautioned investors in these markets about the limited investor protections that the Commissions can offer in certain circumstances.
Both the SEC and CFTC are optimistic about the power of innovation blockchain or distributed-ledger technologies in the U.S. financial markets.
Clayton was particularly optimistic that “developments in financial technology will help facilitate capital formation,” which will enable the SEC – and market participants – to better monitor transactions, holdings, and obligations (including credit exposures), and other market activities. Giancarlo, for his part, emphasized the possibility of a technological solution to the “age-old ‘double-spend’ problem” – the need for “a trusted, central authority to ensure that an entity is capable of, and does, engage in a valid transaction.”
Both stressed that cryptocurrency and blockchain-based markets were in their infancy, and still quite small compared to the larger markets as a whole. The chairmen observed that the market capitalization of Bitcoin was not even as large as a single large cap business like McDonalds, and the total value outstanding of all virtual currencies was about $365 billion – compared to, for example, about $8 trillion for the total value of gold. As an asset class, then, cryptocurrency is punching above its weight in terms of the publicity, compared to its relative size.
However, both chairmen saw a lot of promise to distributed-ledger technologies, including in far-flung fields as smart contracts, transactional efficiencies arising from disintermediated financial transactions, and even refugee tracking. Giancarlo noted that one advantage of a distributed ledger technology is better access to information, and hypothesized that if markets had real-time information available on a distributed ledger about their credit exposures in 2008, different decisions might have been made during that financial crisis.
But perhaps most of all, bitcoin and other cryptocurrencies, and the technology on which they are based, represent the promise of future development. Bitcoin may be, as Giancarlo said, a little bit of everything – a medium of exchange, a source of account, a store of value. But many investors are buying in on the promise that the technology will develop, and as Giancarlo continued, they intend to “HODL” (which Giancarlo described as Twitter terminology meaning “hold on for dear life,” although the term originated with a hastily-typed misspelling), because of the promises of the technology.
Emphasis on compliance, and warning to the markets
Because of this enthusiasm, and the desire to protect retail investors from the potential harms of markets that are not fully regulated, both chairmen warned that their enforcement arms would be coming down on non-compliant securities offerings and outright frauds.
Clayton stated that most so-called “initial coin offerings” (ICOs) have been noncompliant with the securities laws. “Simply calling something a currency or a currency-based product does not mean that it is not a security,” he said. “If it functions as a security, it is a security.” Prospective purchasers are being sold, he explained, on the potential for tokens to increase in value by reselling the tokens on a secondary market or to otherwise profit from the tokens based on the efforts of others, which are “key hallmarks of a security and a securities offering.” As he put it, ICOs should be “regulated like securities offerings – end of story.”
Giancarlo said that the CFTC’s recently formed virtual currency task force recently brought three civil actions against alleged fraudsters, and stated – several times – that there were more actions to come.
Finally, both issued warnings to the “gatekeepers” in the markets:
- Brokers, dealers and other market participants that allow for payments in cryptocurrencies, allow customers to purchase cryptocurrencies (including on margin), or otherwise use cryptocurrencies to facilitate securities transactions should exercise particular caution, including ensuring that their cryptocurrency activities are not undermining their anti-money laundering and know-your customer obligations.
- Entities who operate systems and platforms that effect or facilitate transactions in cryptocurrencies should be wary of operating unregistered exchanges or broker-dealers in violation of the securities laws.
In a “note for professionals,” Clayton warned that “those who exercise semantic gymnastics to avoid having a coin being a security are squarely in the crosshairs of our enforcement division.” He told Sen. Elizabeth Warren (D-MA) that there are gatekeepers who have “not done their job,” once again sounding a warning bell for professionals – lawyers, accountants, underwriters, promoters (including celebrity endorsers), sellers, and the like.
The big fear: integration, before a crash
The ghosts of past market disruptions hovered over the hearing. As Sen. Jack Reed (D-RI) put it, bitcoin is just one cryptocurrency, but there are many others. Reed found their expansion “eerily reminiscent” of the technological development in the late 1990s that exploded 10 years later. Sen. Mark Warner (D-VA) wondered if the potential growth in cryptocurrencies meant that there was a potentially systemic relevant event that should be elevated for consideration by the Financial Stability Oversight Council.
Clayton and Giancarlo view their overarching mission as protecting the integrity of the markets, and their comments made clear that they have the financial crashes of 2008 and 2001 firmly in memory. The intention of the SEC and CFTC is to avoid a situation where a crash in cryptocurrency markets, which have been more volatile than many other asset classes in the last year, leads to a more widespread financial collapse.
Indeed, Giancarlo’s own statement that instant informational awareness on a blockchain could have helped better decision-making in the 2008 financial crisis was an implicit reminder that when complex and opaque financial products are integrated into the financial system, a downturn in those financial products can have a leveraged effect on the system as a whole.
After all, the liquidity crisis beginning in August 2007 led to a re-examination of the many asset-backed securities on financial firms’ books, which led to a subsequent realization that many entities were significantly over-leveraged in those assets through complex financial instruments in ways they did not fully comprehend. Financial regulators want to avoid a repeat situation, where cryptocurrency becomes integrated into the broader financial economy and over-leveraged before it is truly understood, and a downturn in one area infects the broader market.
To that end, the chairmen reiterated their current study of the market, and their desire to allow innovative financial technology to develop, but in a carefully considered manner. Clayton stressed that the SEC has not yet allowed cryptocurrency exchange traded funds (ETFs) because there are a number of issues that need to be examined and resolved first, including issues surrounding liquidity, valuation and custody of the funds’ holdings, as well as creation, redemption, and arbitrage.
While the CFTC has allowed bitcoin futures to trade, Giancarlo emphasized that bitcoin futures are quite different from bitcoin itself, as they are fully transparent to the regulator and traded on regulated exchanges. Further, he said, by allowing bitcoin futures, the CFTC gained data on underlying spot markets that it would not otherwise have had.
Both chairmen recognized that while their regulatory and enforcement authority is broad, it has its limits. As Clayton put it, the SEC regulates securities transactions and certain individuals and firms who participate in our securities markets. It does not, however, have direct oversight of transactions in currencies or commodities, including currency trading platforms.
Complementing that statement and highlighting other regulatory gaps, Giancarlo said that “the CFTC does not have regulatory jurisdiction under the [Commodities Exchange Act] over markets or platforms conducting cash or ‘spot’ transactions in virtual currencies or other commodities or over participants on such platforms.” More specifically, the CFTC does not have authority to conduct regulatory oversight over spot virtual currency platforms or other cash commodities, including imposing registration requirements, surveillance and monitoring, transaction reporting, compliance with personnel conduct standards, customer education, capital adequacy, trading system safeguards, cyber security examinations or other requirements.
The chairmen stated that they are working together, and with others in the federal government – including the Federal Reserve, the Treasury Department’s Financial Crimes Enforcement Network (FinCEN), and state regulators – to understand and fill in any regulatory gaps. Further, the SEC is working with the International Organization of Securities Commissions (IOSCO) to identify gaps in international and transnational law.
Clayton said that they were not making a request for expanded jurisdiction at today’s hearing, but at the behest of Committee Chairman Sen. Mike Crapo (R-ID), they would revert to the Senate Banking Committee with any recommendations for additional or refined legislation if they viewed that as necessary.
As for future enforcement: more is on the way. Giancarlo repeatedly made clear that additional actions are on the horizon for the CFTC. Clayton did not specifically state that more SEC actions are forthcoming, but he reminded the Committee that there is a typical “latency” of 22-24 months for SEC enforcement actions – and that “not one” of the ICOs that issued coins in 2017 had registered with the SEC. As such, one should expect additional enforcement actions from the SEC as well.
In sum, the SEC and CFTC are taking a balanced approach: allowing innovation, while closely monitoring for frauds and systemic risks, and coordinating with other U.S. federal regulatory authorities and foreign authorities. Cryptocurrency enthusiasts may believe that the regulators do not fully understand the new technologies, and cryptocurrency skeptics may feel that they are not acting quickly or harshly enough to crack down on perceived wrongdoing. But Clayton and Giancarlo appear to be thinking deeply about cryptocurrency issues, and engaging in the necessary conversations and work around this burgeoning and potentially economy-changing technology.
Jason Gottlieb is a partner at Morrison Cohen LLP, specializing in business litigation and regulatory enforcement in securities, commodities, and cryptocurrency. Jason runs the MoCo Cryptocurrency Litigation Tracker, a resource for keeping tabs on regulatory actions, litigation, and regulatory pronouncements on cryptocurrency.