As 2023 Begins, Crypto is Facing Skeptics in Congress and A Comeuppance from Regulators
By Mark Hays
Last week, the Senate Banking Committee held the first crypto-focused hearing of this Congress. The session was meant to explore, in the wake of the FTX scandal, what core financial safeguards would be best suited to tackle the harms posed by crypto assets and actors. Yet, during the hearing, federal regulators were moving to protect consumers, investors, and the financial system from further crypto harms and failures.
The juxtaposition of these two developments arguably sets what will likely be the tone for the rest of the congressional session: regulators acting, while Congress considers whether its best role is to bolster such action or continue to buy the line that crypto’s innovative potential is worth coddling.
First, the hearing. The progress made during it might best be described as two steps forward, one step back. Committee Chair Sherrod Brown (D-Oh.) opened with a blistering critique of the industry’s record, noting only a year had passed since the high of the crypto bull market (and its deluge of expensive crypto Super Bowl ads) and today’s crypto winter, which has laid bare the widespread fraud and manipulation found through the sector: “When it comes to crypto, it turns out fortune doesn’t favor the brave. It favors wealthy insiders.”
As the opening witness, Lee Reiners, Policy Director of the Duke Financial Economics Center, offered a stark indictment of the industry’s failures and flaws. Summarizing from his written statement, he said, “The industry has yet to develop a killer app in its 14 years of existence, and instead has generated billions in losses, scams, hacks, fraud, money laundering and other national security threats, and ransomware.”
Reiners enumerated basic regulatory measures already used in traditional finance that could be applied to the crypto industry that mirror basic investor protections (and that Congress could further reinforce), including requiring firms to:
- Have audited financial statements;
- Provide their books and records on request to a federal regulatory agency;
- Have exchange listing standards;
- Enforce codes of conduct on exchanges with their members;
- Segregate customer assets from firm assets;
- Have rules governing conflicts of interest;
- Maintain net capital requirements to protect consumers and creditors;
- Pay into government-mandated insurance funds that make customers whole if the firm fails or loses customer assets.
These are bread and butter regulatory measures, but so far the crypto industry has largely failed to meet or adopt these standards.
Later in the hearing, Senator Chris Van Hollen (D-Md.) asked the witnesses whether banking regulators had the authority needed to protect the banking system from crypto risks, while Senator Tina Smith (D-Minn.) asked what else Congress and regulators should be doing to learn from the recent crisis and act to prevent future threats to financial stability from crypto. Lastly, Senator Warren (D-Mass.) reiterated bipartisan concerns about crypto’s noteworthy role in facilitating illicit finance, due in part to the industry’s lack of compliance with and lack of enforcement of federal anti-money laundering laws.
This line of inquiry demonstrated that some Committee members rightly see crypto primarily as a risk factor to be contained rather than an innovative new tool to be protected. Even new ranking member Senator Tim Scott (R-S.C.) appeared to give more acknowledgment to the scope of harms perpetuated by the crypto industry than his predecessor, former Senator Toomey (R-Penn.)
In fact, no speakers truly disputed the most basic facts: the crypto crash has harmed many people and a regulatory response to protect consumers and investors is sorely needed. However, a range of tired talking points defending crypto and blockchain were rehashed and reheated as well by some Senators and witnesses in an effort to redirect the conversation away from crypto’s systemic flaws.
For example, hearing witness Linda Jeng, with the Crypto Council for Innovation, focused her comments largely on what she described as the innovative potential of blockchain technology to advance web3 — a still very vague term meant to connote the next phase of development for the internet. Her central argument was that regulatory responses to crypto failures should ‘protect consumers’ but do so without stifling the innovation needed to bring about this vaunted potential.
But, web3 means different things to different people. Sometimes it’s used to describe how blockchain technology (which itself is a relatively old database design model) could change how internet platforms and data are owned and controlled. Other times, the term is used to describe something more like a crypto-fueled metaverse, with crypto assets being used to monetize every interaction on the web.
This reframing is no accident. As other crypto use cases have not panned out, new use cases are created to justify continued spending on crypto ideas. Crypto was originally supposed to be a decentralized currency, then a more diffuse platform for payments, then a vehicle for wealth generation. But, as it stands now, most arguments for web3 appear to amount to little more than hype used to fuel new speculative investment vehicles — many of which mostly benefit venture capital firms and whales that invest early and get out early before such vehicles fail.
But, more to the point, FTX wasn’t building web3, and neither were the other crypto firms that have failed recently. They built financial trading platforms and investment firms (or depending on how you look at it, digital asset-fueled pyramid schemes) that turned out to mirror those found in traditional finance — except for the wholesale problems with management, governance, accounting procedures, custodial practices, and regulatory compliance. You know, the little things.
Talking about web3 won’t solve those problems or make crypto a better bet, but it certainly sounds enticing to some investors or policymakers worried about missing out on ‘the next big thing.’
Another stale argument put forth by industry champions was that a lack of regulatory clarity, guidance, or action precipitated this crisis. During his opening statement, Senator Scott suggested the SEC “has failed to take any meaningful preemptive action to ensure this type of catastrophic failure does not happen again” and suggested the committee needed to hear from Chair Gensler directly as to why the agency (in his view) didn’t use its power to prevent or mitigate the collapse. Senator Bill Hagerty (R-Tenn.) meanwhile, suggested the SEC was somehow also being too aggressive and was seeking to “entirely sever crypto from our financial system” — echoing the contradictory messages from the crypto industry that regulators had been both too soft and too hard on them.
This narrative has been widely challenged. Commentary and analysis has documented the many steps the SEC and others took to hold crypto actors to high standards and prevent ordinary investors from more widespread harm tied to crypto — even when members of Congress were actively pressuring the SEC to stop. And, as Mr. Reiners said in the hearing, “The SEC has been quite clear going back to the Chairmanship of Jay Clayton that most crypto currencies are securities that need to be registered with the Commission…. And, the SEC has filed over 125 enforcement actions [related to crypto] and they haven’t lost a single case.” Regulators aren’t infallible, and more can always be done, but given that we’re talking about crypto, at the very least the SEC isn’t the party to be pointing fingers at.
Nonetheless, while the SEC and other regulators’ actions aren’t “regulation by enforcement” but simply enforcement of existing regulatory requirements, folks in the industry and Congress seeking clarity may need to be careful what they wish for. The SEC (and other regulators) is now moving swiftly to ensure existing regulatory frameworks are applied comprehensively to the crypto sector to prevent further damage and hold non-compliant companies accountable.
Last week, the SEC filed charges against the infamous Terra founder, Do Kwon (and other entities) accusing them of offering unregistered securities, fraud and other claims. Tellingly, the indictment describes Terra’s algorithmic stablecoin UST as a “crypto asset security” which could have regulatory implications for other stablecoin issuers as well.
The SEC also just reached a $30 million dollar settlement with crypt platform Kraken after the SEC claimed Kraken’s staking service — where crypto asset holders allow their tokens to be pooled together to facilitate proof of stake verification methods that approve transactions on a blockchain, in exchange for the promise of a stable return — was in effect offering an unregistered security. Kraken has since suspended its US staking service, and the settlement raised questions about how staking might be regulated on other platforms.
The SEC also issued a Wells notice (indicating the agency’s intent to bring an action) to stablecoin firm Paxos, claiming that the stablecoin BUSD — which is the token used to facilitate payments and trading on Binance’s exchange — is an unregistered security. This development, as well a parallel action taken against Paxos by the New York Department of Financial Services, has led Paxos to stop minting BUSD, which is affecting Binance, the largest crypto exchange, as well as other platforms that trade the coin.
Finally, the SEC also announced an update to existing rules for safeguarding investment advisory client assets that would expand the range of assets which must be held in custody by qualified custodians. Crypto is one such asset, and few crypto exchanges right now qualify as such custodians — arguably one reason why so many crypto firm customers have had their investments lost, stolen, frozen or caught up in bankruptcy proceedings.
These actions taken together — and combined with similar actions taken by banking regulators in the past month — show that patience for the industry’s claims have worn thin, and that regulators are ensuring there’s no lack of clarity on whether crypto firms need to comply with the law. But the arguments for giving crypto special treatment are persistent. At the Senate Banking hearing, several speakers argued that if the US doesn’t create a soft regulatory landing for crypto firms, they will move offshore and create innovative new financial products and services that would compete with the US and undermine its economic and national security.
Of course, many crypto firms already operate from offshore tax havens, which make a good business out of facilitating tax evasion and illicit finance, but don’t often provide a launch pad for many mainstream financial firms. Meanwhile, more enforcement actions are coming in the US and elsewhere, which likely means mainstream investors will be slow to dip their toe in crypto waters for some time. This won’t help, as the industry is already hurting due to a lack of liquidity, especially given that crypto firms often depend on regular infusions of new money to artificially pump up the prices and value of crypto assets.
U.S. financial markets, despite their many flaws, often provide the best options for finding relatively stable and reliable sources of capital for companies and investment opportunities for investors. Robust regulatory measures are a key factor in creating those conditions. Regulatory action shouldn’t be a race to the bottom to accommodate new technology whatever the cost. Regulatory safeguards at their best set a gold standard, meaning those companies that can meet the bar will succeed by providing customers with products that are safe, reliable and have lasting value.
Crypto firms will need to find a real path in the US to meet those standards, or recognize that a business model based on regulatory arbitrage isn’t a lasting, successful or ethical one.
