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Crypto “at a Crossroads” between the SEC and CFTC

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SEC Chairman Gary Gensler pursues the most aggressive agenda in decades, and the top targets are digital assets. “Crypto is at a crossroads,” says the General Counsel of Coinbase, as Gensler’s SEC fights the Commodities Futures Trading Commission (CFTC) for jurisdiction over crypto. Meanwhile, economists and businesspeople fear the victims will not be white-collar criminals but rather U.S. businesses and American competitiveness. 

Speaking at the Practising Law Institute on September 8, Gensler reiterated his intention to make all token issuers register with the SEC as securities platforms, dashing entrepreneurs’ and investors’ hopes for additional guidance or exceptions for startups.

On September 15, Gensler testified in front of the Senate Banking Committee, the same day CFTC Chairman Rostin Behnam also made his pitch for crypto jurisdiction before the Senate Committee on Agriculture, Nutrition, and Forestry. It’s as if the two men are in competition, and that’s because they are, although neither will say so outright.

Gensler: Don’t ask what the rules are!

Democratic Senators congratulated Gensler on causing Wall Street to plead for mercy, while Republican Senators chastised him for increasing the cost of doing business in the U.S. Senator Pat Toomey quoted Bloomberg’s apt description Gensler’s approach: “Chairman Gensler’s posture is that he should be in charge of writing the rules for crypto but not write them. I just don’t see how that can work.

Senator Toomey distinguished tokens saying that they have, “varying degrees of decentralization, they usually do not have a financial claim on the issuer, and typically can be settled in real-time without intermediaries. These are very major and important differences from traditional securities and they merit a clearly stated and tailored regulatory framework.”

When Toomey asked Gensler about how he decides whether a token is “centrally controlled or decentralized” like bitcoin or ethereum, Gensler skirted the question entirely and refused address it, carefully avoiding any mention of decentralization.

Instead, he broadly described an investment with the expectation of profit in a “common enterprise” with “a group of individuals” which notably would include bitcoin and ethereum, as well. When Toomey pressed Gensler to answer the question of how a developer could sufficiently decentralize their enterprise, Gensler retreated into the tenets the Supreme Court set forth in the Howey test (which we previously discussed here).

CFTC Chairman Behnam seemed to have the wind at his back with multiple bills in Congress aiming to give his agency jurisdiction to regulate crypto. After visiting various senators in their offices, he promised a slow and thoughtful approach, a marked distinction from Gensler’s hawkish heavy-handedness. Behnam also asked for a 35% increase in his agency’s budget for the first three years while the CFTC settles into the market for digital assets.

Meanwhile, top officials are speaking out of the side of their mouths in an attempt not to step on any toes, but for the attentive observer, it’s plain that Chairman Gensler has incurred blame for the current state of regulatory confusion and dispute over the crypto space. However, it depends on who you ask because according to many officials, academics, and pundits, there is no confusion and no dispute. And I almost forgot, despite a bland White House Fact Sheet on “Responsible Development of Digital Assets,” there are still no customer protections!  

A Very Stable Understanding

According to Stephen Diamond, an associate law professor at Santa Clara University, there is no regulatory confusion and the notion that the SEC should clarify which cryptocurrencies are securities is a “distraction.” 

During a “Crypto Policy Symposium,” on September 5, Diamond proclaimed, “An Oscar should go to whomever first coined ‘regulatory clarity’” because “There is regulatory clarity—it’s fairly straightforward and it’s been in place for a long time. Hopefully, there won’t be any dramatic shift to redefine this very stable understanding of financial markets.” 

He’s referring to laws made last century on how to determine if an investment is a security. According to Chairman Gensler, it makes sense to regulate digital assets with the Securities Act of 1933 and the Howey test from a 1946 Supreme Court case, ostensibly because although it was a half-century before the invention of computers, fraud already existed and investors needed protection.   

For the former chief of SEC office of internet enforcement John Stark, the SEC is doing right by investors to crush digital assets and any company that deals in them. Answering the accusation that the SEC is stifling innovation, Stark compared the current imbroglio to the 90s-era SEC enforcement against internet companies.

There was lots of talk that we were ‘stifling technology’ then,” he said during the Crypto Policy Symposium, adding, “We weren’t stifling anything, we were getting bad actors out of the way so technology could flourish. Not so with crypto, because there’s no good in it. We’re stifling fraud, crime, chicanery and thievery.” 

One can imagine Stark saying much the same back in the 90s of early internet companies, but let’s dig deeper into this “very stable understanding of financial markets.” 

“No customer protections” 

Tellingly, Democratic Congressman Raja Kristnamoorthi, chair of a key House oversight panel, wrote an open letter to federal regulators with pointed criticism of Gary Gensler between the lines.

Kristnamoorthi wrote: “Without clear definitions and guidance, agencies will continue their infighting and will be unable effectively to implement consumer and investor protections related to cryptocurrencies and the exchanges on which they are traded.” 

It was clear to anyone paying attention that he was referring to the infighting between the CFTC and the SEC over who regulates crypto. It’s pretty bad when an official in your own party calls you out, but it also shows the depth of the disagreements in the U.S. government regarding the regulation of digital assets. U.S. government entities have been arguing about this for at least five years, and somehow the rules haven’t been clarified. 

When asked by CNBC back in May if there was “some disagreement” between the CTFC and the SEC regarding who should be in charge, CFTC Chairman Rostin Behnam demurred, asserting that he “wouldn’t say there’s disagreement,” since “each is trying to do what’s best,” and that the two agencies have a “great relationship, historically.” 

I mean, who hasn’t touted their historically great relationship with their spouse? I suppose that referring to your historically great relationship is Beltway Speak for “we’re on the rocks.” Notably, Behnam acknowledged that the non-disagreement was “an age-old issue” and admitted, “there really are no customer protections right now.” 

If there’s a “very stable understanding” of crypto’s place in capital markets, yet there are “no customer protections,” and two agencies are engaged in an age-old war over jurisdiction, something is very wrong here. 

On September 15, Senator Toomey asked Chairman Gensler about how he decides whether a token is “centrally controlled or decentralized” like bitcoin or ethereum, Gensler skirted the question entirely and refused address it, carefully avoiding any menion of decentralization. Instead, he broadly described an investment with the expectation of profit in a “common enterprise” with “a group of individuals” which notably would include bitcoin and ethereum, as well.

When Toomey pressed Gensler to answer the question on how a developer could sufficiently decentralize their enterprise, Gensler retreated into the tenets the Supreme Court set forth back in the 1940s with the Howey test. It was painfully clear that Gensler was protecting his territory and that any token developer that wants to escape SEC oversight will be obliged to pull a Satoshi and disappear into the wind forever.  

Who’s the Boss? 

Although everyone insists that there’s nothing to see here, Chairman Gensler felt it necessary to publish an op-ed in the Wall Street Journal, entitled “The SEC Treats Crypto Like the Rest of Capital Markets.” The article was clearly a defense of Gensler’s approach to the space, on the heels of various high-profile departures, including the SEC general counsel Robert Stebbins and several other attorneys who spent decades at the SEC, but who insisted it had nothing to do with Gensler’s leadership. It was the “natural time” for them to leave. 

On July 25, 2022, Chairman Behnam addressed the Brookings Institution on the future of crypto regulation, saying, “…market regulation and financial supervision in the U.S. often relies on the development of cooperative arrangements between regulators—a challenge given jurisdictional inexactitudes and sometimes imprecise or nonexistent statutory authority.” 

Ah, so the SEC and the CFTC are having a “challenge” to work out a “cooperative arrangement.” Behnam’s remarks suggest that the CFTC feels that there are thousands of digital assets that should fall within its jurisdiction, but Gensler insiststhe vast majority are securities,” aggressively staking his agency’s claim to the majority of the crypto pie. 

The Strange Case of the Dueling Chairmen

Behnam went on to argue that the first bitcoin binary options were established under the CFTC’s direct oversight remit in 2017 and that at the time, he had urged action to provide legal certainty for market participants about the process to evaluate new products in the emerging asset class. 

It certainly sounds like Behnam is saying he was right back in 2017, and none of this mess would have happened if people had just listened to him. Instead, we got hand-wringing over American innovation and competitiveness, which led to a stalemate and a collective non-decision to just let it ride.  

Interestingly, Gensler was previously chairman of the CFTC, telling the Senate Banking Committee, “I chaired the CFTC. I love the [CFTC]… I love the SEC. [Along with the Treasury], they are like my three daughters!” It was an odd joke, to be sure, especially after he later said his three daughters keep him up at night. Although intimately acquainted with the regulatory purview of all three agencies, he hasn’t shied away from attempting to elbow the CFTC out of the crypto space. 

Typically, the SEC makes rules when there are market failures, support from industry experts, or mandates by Congress. Recently, the SEC is making new rules because of Gensler’s whims rather than any of those ostensible needs or causes, and unsurprisingly, the SEC’s economic justifications, churned out by the economic analysis division at twice the rate of the last administration, are getting shot down by courts. In addition, for many of its new rules, the SEC has cut the normal comment period for public feedback in half from 60 days to 30 days.  

Meanwhile, Gensler refuses to clarify how the SEC decides to enforce rules governing the crypto space, despite profuse begging by industry executives. Instead, the SEC files lawsuits against the biggest players, numbering over 200 since 2017. 

Gary defends himself, observers call for his resignation

Gensler tweeted a link to his WSJ op-ed and was met with a boisterous response of memes and deep fakes with his face. Some tweets pointed out his hypocrisy in denying a BTC spot ETF. 

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Gensler’s argument that digital assets don’t deserve special treatment is suspect considering the SEC recently denied asset manager Grayscale’s request to convert its Grayscale Bitcoin Trust to a spot Exchange Traded Funds (ETFs), which could reduce volatility and deepen liquidity in the market by bringing in more institutional investors. This move led the WSJ editorial board to accuse the SEC of holding investors hostage.  

With 16 such denials since the first attempted ETF registration in 2013, the SEC’s overt hostility and hypocrisy are puzzling, considering it already allowed several bitcoin futures-based ETFs to launch. Furthermore, several spot-based ETFs already exist in Europe, Canada, and Australia, all of which tend toward greater protection of retail investors.  

Others persisted in asking for clarity about which tokens are securities and which are commodities. 

As the backlash against Gensler’s op-ed gathered steam, Forbes published a potent opinion piece entitled “Gary Gensler: Resign,” on August 28, but the very next day, Forbes scrubbed the article, although the piece captured the sentiments of many industry professionals, including Dizer Capital founder Yassin Mobarak

As observers accused Forbes of censorship, Forbes put the piece back up with a new title and a note that the “analysis” of the previous piece could be confused with “news.” 

DeFi rules v. TradFi rules

In his op-ed, Gensler called for greater disclosure in the crypto space, referring to the now-infamous cases of Voyager Digital and BlockFi, where a lack of transparency caused massive losses to investors when asset values collapsed. Arguing that digital currency businesses try to hide behind different labels, he accused BlockFi of obscuring its true intentions. 

The company had borrowed more than $10 billion in crypto assets from 570,000 investors, offering them a variable interest rate in return. That made its lending product offered to investors, called BlockFi Interest Accounts, a security. BlockFi then pooled these assets, packaged them into loans to institutional borrowers, and invested funds in other securities. That made it an investment company.” 

Stu Alderoy, the general counsel of Ripple Labs, fired back that with the SEC’s “shakedown” of BlockFi, “Consumers weren’t protected, they were left holding the bag.”  

Gensler, a former partner at Goldman Sachs, suggests that crypto should be regulated the same as cars or Florida orange trees, or any other asset. He recently argued (in a hip video posted by the SEC on Youtube) that cryptocurrency exchanges should segregate investors’ assets and market-making activities like stock exchanges, which would stop exchanges from betting against their clients using inside information.  

That sounds great, but it’s especially complicated for exchanges and lending platforms to follow the same regulations at TradFi (Traditional Finance) institutions, such as KYC (know your customer) and AML (anti-money laundering) rules, when the users are globally distributed and use anonymous wallets. Critics worry that if the major exchanges must comply, crypto customers may be driven to obscure DeFi platforms where their activities will be less secure. 

Regardless of the labels, Gensler asserted on September 8 that exchanges must separate their services, so they can’t be both brokers and dealers. Whew, what a relief for retail investors! I’m so glad that Coinbase will be obliged to follow regulations like Goldman Sachs does. You know, like betting against the bundles of bad debt Goldman created and sold to unsophisticated clients or, say, upgrading a stock’s rating to “buy” only hours before the announcement of a massive sale of that stock, run by Goldman.

Now, Coinbase will have to make the same smirking references about a mythical Chinese Wall that we all pretend exists between Goldman’s trading desks and investment bankers and throw giant bags of cash at the SEC without admitting guilt when the truth that there’s no Chinese Wall becomes embarrassingly obvious.

“Bad Cop” SEC v. “Good Cop” CFTC

Gensler said the SEC would serve as the cop on the beat, which the crypto community took as a threat from a bad cop. The CFTC is seen as the good cop, perhaps because its commissioners have pledged that each crypto must be considered individually and that a 1933 law may not be the best for new technology. 

Crypto investors might also prefer the CFTC because it is a smaller agency that is understaffed and seen as weaker than the SEC.

Carol Van Cleef, who leads the blockchain and crypto practice at the Bradley law firm in Washington told Forbes: “[The CFTC is] undermanned and would be totally overwhelmed without a substantial allocation of new funding from Congress.

It’s unlikely that one agency is gonna take over the whole space, and it certainly seems like the SEC doesn’t want to offer regulatory clarity. 

Kathy Kraninger, former director of the Consumer Financial Protection Bureau (CFPB), told Cointelegraph that no agency would be granted total control over the digital asset space, specifying “It’s not going to be in the SEC’s interest or its nature — or certainly its chairman’s current posture — to come out and say ‘oh yeah, let me give you all the criteria for what a security is that is going to answer everybody’s questions. That’s just not going to happen and I can see why in some respects why the industry says it wants that, but if it got that, it also could be hugely detrimental.”  

The responsibility to clearly delineate the roles of the different agencies in the space may fall in the lap of Congress, which Gensler called upon to resolve the “totally-not-a-conflict” happening between the SEC and the CFTC.

Jeremy Hogan, a Florida lawyer who focuses on cryptocurrency, made an excellent point:

Congress joins the regulatory party

According to The Digital Commodities Consumer Protection Act of 2022, a recent bipartisan Senate bill, the CFTC will oversee digital commodity transactions and registration of platforms, but the bill doesn’t offer a definition of WTF a “digital commodity” is, apparently deferring to uhhh… whatever the SEC and the CFTC think the definition should be. Nailed it, Congress!!!

On the other hand, the bipartisan Responsible Financial Innovation Act would cede authority over digital assets and “ancillary” tokens that do not offer ownership in a business to the CFTC.

Gensler said that he welcomes legislation that expands the authority of the CFTC as long as it doesn’t “inadvertently undermine securities laws.” While being questioned by the Republican sponsor of the bill, Senator Lummis, Gensler acknowledged that they might differ on the list of disclosures that crypto companies should be obliged to make, but that the list for a crypto company will be different from that which a large multinational company would make.

However, crypto enthusiasts should be careful what they wish for because operating in legal gray areas has been advantageous for digital assets. Ignoring the threats of the SEC, many projects have raised billions of dollars, a small pittance of which they eventually use to console an angry SEC.

That may be a better strategy than consulting with the SEC from the start because many projects have tried and received no help or cooperation from SEC staff, leading them to flounder into failure. This poor record should change in the near future since the SEC is opening a new office expressly to deal with reviewing crypto company filings. Gensler has instructed the staff to be “flexible” with token issuers.

Outside the USA, DeFi might be the only remaining jurisdictional hiding place for future digital token projects because, according to Kathy Kraninger, “regulators across the globe are really going to struggle with [it]” to figure out who is supposed to be the cop on the beat.

However, those crypto companies offering broker-dealer services and fund advisory are doubly screwed because they will be obliged to register with both the SEC and the CFTC. Whatever happens in Congress, it certainly seems like the days of Wild West laissez-faire in the crypto space are coming to an end, which is good news for investors.

Author: Tim Tolka, writer, journalist, and BI researcher

The editorial team at #DisruptionBanking has taken all precautions to ensure that no persons or organizations have been adversely affected or offered any sort of financial advice in this article. This article is most definitely not financial advice.

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