Crypto Regulation: Who’s On First

WASHINGTON, DC – Back in February the CFA Institute Systemic Risk Council (SRC) urged congressional and regulatory action on Stablecoins. In a letter to Treasury Secretary Janet Yellen and members of the Financial Stability Oversight Council (FSOC), we urged the group to act on growing risks to U.S. financial stability posed by unregulated crypto assets, in particular the wild west of stablecoins. We noted the report by the President’s Working Group in the U.S., recommending that Congress address mounting crypto risks by passing new legislation that would address needed regulations on stablecoin products in particular. 

The SRC strongly supported the need for a prompt legislative response, but worried Congressional delays would make it necessary for other regulators and policymakers to simultaneously pursue the other routes. We proposed a two-pronged strategy that included FSOC moving quickly to designate stablecoins as systemically important payment, clearing, and settlement activities, while various FSOC member agencies, including the banking regulators, the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) would use their existing enforcement authorities to regulate stablecoins and other crypto assets where indicated. Importantly, the SRC asked that FSOC members work more collectively within the U.S. but also with global regulators to reduce fractionalized approaches to destabilizing crypto activities that can quickly and easily migrate cross border. To date, progress on these fronts remains slow.

Congress: Active, But Passive

For its part, Congress has been on a torrid, but ineffectual pace to introduce dozens of bills and resolutions covering all corners of the crypto phenomenon. From draft legislation on stablecoins, to a new securities law regime covering digital assets, legislative jaw boning has led to few changes. Since passage of the Infrastructure and Investment Jobs Act in 2021, the crypto industry recognized the potential for new laws to favor and give credibility to emerging technologies and crypto products. While nothing of note has passed congressional muster, the number of lobbyists tossing money and legislators coveting the title of crypto innovator has been fascinating political theatre.

Many of the crypto “assets” being produced are ill conceived and not ready for conventional markets. Meanwhile, regulators have generally struggled to keep up with rapidly emerging technologies that support these new products. There is a growing fear of politicians playing into the commercial interests of crypto industry players seeking limited oversight and regulation. To make matters even more challenging, the complexity of what falls under the crypto asset “umbrella” is formidable. It includes central bank digital currencies, stablecoins, thousands of individual e-tokens like bitcoin and related futures contracts and Exchange Traded Funds. There are also a growing array of private and public companies involved in the crypto infrastructure and operational space. These business “nodes” as the SEC refers to them, are the physical and virtual components that develop blockchain and other technologies and the platforms that facilitate trading, clearing and custody of crypto assets. Many of these virtual players are located offshore and can migrate, sometimes stealthily, to various jurisdictions around the globe. So far, lots of political talk but little action

The Fed: Wrong Onus

As noted, the variety of government authorities in addition to Congress that are eyeing the crypto space closely include the U.S. Federal Reserve (“Fed”). In a recent statement they alerted member banks “that prior to engaging in any crypto-asset-related activity, banks must ensure such activity is legally permissible and determine whether any filings are required under applicable federal or state laws.”

Among other things, the Fed noted that supervised banks wishing to undertake crypto-asset-related activities inform their lead supervisory point of contact before engaging. The Fed notice acknowledges the potential opportunities of the crypto sector to better serve customers but warned “… crypto-asset-related activities may also pose risks related to safety and soundness, consumer protection, and financial stability.”

Oddly, the onus is on the member bank to decide whether they have adequate risk management and internal control systems to conduct crypto-asset activities in a “safe and sound manner”. The member is also obligated to ensure such activities are consistent with all applicable laws, including applicable consumer protection statutes and regulations. This makes it sound like all necessary laws and rules are already in place and that the member bank simply needs to confirm their crypto readiness with relevant supervisors. This conflicts with the view that the needed regulations – both extensions of existing rules and a potentially redesigned set of crypto specific rules are still missing. The SRC has heard many calls for a regulatory design that addresses the novel technology risks, additional complexity of various crypto activities and can account for a highly fractionalized, 24/7 cross-border market.

Bank Regulators Receive Conflicting Signals

Last November, the FDIC and Fed released an interagency statement regarding their crypto-asset policy initiative, pledging to provide greater regulatory clarity over the year ahead. Then in early 2022, lawmakers sent a letter to the Office of the Comptroller of the Currency (OCC) directing it to coordinate more with the Fed and FDIC. 

It also directed the OCC to withdraw several interpretive letters issued since 2020 which permitted banks to engage in crypto-related activities such as offering crypto custody, holding stablecoin reserve deposits and facilitating stablecoin payments. Congress worried that the OCC letters effectively permitted banks to engage in crypto activities without proper oversight and risk management systems necessary to deal with a unique set of crypto-specific risks that “have grown more severe in recent months”.

Securities Regulators Step Up Too

Meanwhile, the Chairman of the SEC, Gary Gensler, and the Chairman of the Commodity Futures Trading Commission (CFTC), Rostin Behnam, both members of the FSOC, were on the regulatory move. In their discussions with our Systemic Risk Council, they confirmed that the task of crypto oversight is high on the list of priorities for them and all global market regulators.

Both are already using many touch points on crypto regarding regulated futures contracts, regulated ETF funds and the many publicly traded companies who are in the crypto infrastructure space. Understandably, there are various turf issues among an entire network of global regulators scrambling to address emerging products and technologies affecting cross boarder markets.

Both the SEC and CFTC are quickly moving to understand and sort out the regulatory considerations, including those pertaining to various Blockchain and other technology players key to trading, clearing and custody. These so called “nodes” are not generally covered by securities law unless they are public companies, and many include risky and unregulated lending platforms that facilitate lending /borrowing the vast universe of alt coins. 

Both agencies noted they are doing their best under current regulatory authority and enforcement powers but acknowledged there are regulatory nuances and gaps that must be addressed as crypto activities expand. Most importantly the interplay and boundaries of jurisdictional authority must be clear and collaborative among U.S. regulators.

Who’s On First?

The forgoing exemplifies the uncertain and disjointed nature of the U.S. effort around crypto oversight. It feels like the policy version of the famous Abbott and Costello bit -Who’s on First. If only it were that amusing.

As these new assets and markets continue to pick up steam, the critiques of FSOC members and Congress for moving too slowly have ramped up the timeline for action. The latest Fed guidance reiterates this new vigilance, noting they closely scrutinize crypto asset developments and supervised bank participation, given the increased systemic risks posed by crypto assets. 

Our Council has heard the crypto viewpoints and cautions many times and from many experts. One thing is certain -this new crypto world is a complicated topic for markets and regulators to digest. For its part, the investment management industry is trying to establish if and which parts of the crypto industry will become established and a part of traditional asset / investment strategies. 

Meanwhile, regulators want to encourage innovation but ensure market integrity and investor protection. Most important, regulators desperately want to avoid another moment. Finally, for investors of all sorts there is a very strong fear of missing out, given the trading volatility and remarkable gains made possible in various crypto assets. 

No matter your perspective, there must be a sense of market integrity and regulatory certainty. All players must have confidence in how various assets are structured, documented, traded, cleared and held in safe custody. To become mainstream, these markets and assets must bridge the current gap in transparency, accountability and regulatory certainty. Whether crypto refers to a theoretical CBDC, an Alt coin of mysterious value or an NFT representing ownership in digitized art, your bravery will not decide your fortune. Common sense, clear regulation and proper market structure will.

Paul Andrews is Managing Director for Research, Advocacy, & Standards for CFA Institute. Paul is also a current member of the CFA Institute Systemic Risk Council. Previously he was Secretary General of the International Organization of Securities Commissions (IOSCO), Vice President and Managing Director, International Affairs, of FINRA and Senior Managing Director, Business Operations – Europe, at Nasdaq Europe.

EDITOR’S NOTE: This article first appeared in Nasdaq on 26 September 2022.