Digital Assets Debated

Update 669 — Digital Assets Debated:
Crypto Regulation in the New Congress

The debate in the 118th Congress over whether and how to regulate cryptocurrencies opened yesterday at a Senate Banking Committee hearing. The several bills introduced in the last Congress that attempted to grapple with the question did not come up — they were all introduced before the collapse of FTX and the drama of Sam Bankman Fried (SBF), who had a hand in drafting at least one of them.

Instead, the Committee was fact-finding, examining the digital asset market, its structure and circumstances, the manifold problems of transparency, privacy, consumer protections, and regulatory jurisdiction, and whether existing laws and regulations are sufficient to cover all of the above. Today, we look at this debate and consider how the legislative landscape in this area has shifted since the last Congress.

Best,

Dana

________

This week, the Senate Banking Committee reconvened for its first crypto-based hearing of the 118th Congress. Following a tumultuous year for the digital asset industry – one full of bankruptcies, imperial collapses, and, in some cases, Bahamian prisons – the Committee proved adamant on making crypto regulation a top priority this Congress and kicked off the new year with a thorough exploration of the fatal fallouts and where we go from here.

2022 wrapped up with a series of hearings to examine the FTX collapse and the many factors that lead to the platform’s demise. Although these hearings were a step in the right direction, members were unsuccessful in making any real progress due to time constraints and other external factors. As we step into 2023, Congress is gearing up to find a path forward for the complex industry – one that acknowledges innovation while still placing consumer protection and the sanctity of our financial system above industry needs.

The Hearing — “Fortune Favors Wealthy Insiders”

At the hearing, the first of the year on crypto, the tone was clear: we need rules and we need them soon. The hearing, which examined how time-tested financial safeguards can help against the harms and risks of crypto products, was inquisitive and emphasized the need to instill a comprehensive framework to regulate crypto products.

Committee Chair, Senator Sherrod Brown (D-OH): In his opening statement, Brown recounted the plethora of crypto implosions witnessed over the past year and referred to these crises as “speculative bubbles, fueled by investor euphoria in the promise that “this time is different” – only it never is.” He also inquired about how lawmakers could use existing disclosure principles for crypto markets, as well as the urgency to develop better standards for custody of consumer assets.

Senator Chris Van Hollen (D-MD): Van Hollen offered scrutiny over intersections between crypto and traditional banking systems. There is a real concern that a crypto spiral could infiltrate our existing financial institutions and have major consequences on our markets. Witness Lee Reiners commended the Federal Banking Agencies for their role in limiting the systemic implications of the crypto market’s collapse, but emphasized that the two entities must be kept separate.

Senators Smith (D-MN) and Warren (D-MA): The duo raised concerns over Fidelity’s decision to offer bitcoin in 401k plans and crypto’s overall threat to our national security.

Despite brief quarrels over the capabilities of the existing regulatory agencies, there was an underlying sense of bipartisanship on the matter. The hearing did not produce an immediate remedy, but it did carry the conversation forward and was the first time we’ve heard lawmakers on both sides of the aisle demonstrate real willingness toward regulation.

New Congress, New Priorities, New Subcommittees

The FTX collapse was one of many high-profile fallouts in the industry but left a particularly unique impact on consumers and lawmakers. The crypto exchange, valued at around $32 billion at its peak, was considered to be the most invasive of its kind and secured investments from major venture capital firms in the US and abroad. SBF worked closely with several lawmakers to develop what he insisted were adequate and consumer-forward bills, only to find himself with an $8 billion hole in company accounts and one million customers locked out of their life savings.

Congress has wasted far too much time-fighting crypto “turf wars” and has failed to get down to the substance of the issue. In efforts to aid in their mission, they have taken a number of steps to expedite the process, including but not limited to creating a new Subcommittee on Digital Asset Regulation under House Financial Services.

The Subcommittee on Digital Assets, Financial Technology and Inclusion is intended to provide clear rules of the road among federal regulators and develop policies that promote financial technology to reach underserved communities. The subcommittee will be chaired by Rep. French Hill (R-AR), but we can expect a number of Democratic advocates to push for strict regulations that will prioritize consumer protection. Democratic members of the Subcommittee on Digital Assets include:

Stephen Lynch (D-MA), Ranking Member
Bill Foster (D-IL)
Josh Gottheimer (D-NJ)
Ritchie Torres (D-NY)
Brad Sherman (D-CA)
Al Green (D-TX)
Sean Casten (D-IL)
Wiley Nickel (D-NC)

Details aside, the very conception of this subcommittee underscores just how prominent crypto has become in the regulatory field and demonstrates a sense of urgency from lawmakers on both sides of the aisle. The work here is just getting started and we can only hope this panel will be used to guide the basic principles of regulation that have existed for hundreds of years.

A Reappraisal and Rebalancing Act Ahead

While there is no question that rules are needed, we should find solace in the fact that lawmakers did not rush into passing any of the bills proposed in the last Congress. There were two bills in particular – both products of the upper chamber – that appeared to receive a significant amount of attention but ultimately fell flat due to inherent flaws and lack of support: the Responsible Financial Innovation Act and the Digital Commodities Consumer Protection Act.

Lawmakers must take a step back, recognize why these bills failed, and look to the root of the problem. When drafting legislation, members should consider:

Asset Definition/Jurisdiction – There is currently no clear definition for digital asset securities and commodities, hindering jurisdictional ability and enforcement action;

Crypto Exchanges – Many exchange platforms fail to disclose liabilities, are not vetted by external auditors, and do not provide clarity on which assets have been pledged as collateral loans;

Banking Sector Exposure – Cryptocurrencies and other digital assets pose immense threats to our banking system and must stay separate from these institutions.

Congress should also look toward the SEC’s underrated track record on crypto regulation for guidance. Despite getting a bad rap, a January 2023 report showed that the agency brought upwards of 30 enforcement actions against digital-asset market participants in 2022 – up 50 percent from the year prior. In a nine-year span, the SEC brought “127 enforcement actions” and “imposed approximately $2.61 billion in total monetary penalties, of which $242 million were settlements the agency reached in 2022.”

Chair Gary Gensler has increased his focus on the digital asset industry and has stated his agency is “updating [their] basic rules of the road within the authorities Congress has given [them] and how the courts interpret them.” He has called on intermediaries to come into compliance with the law and register with the SEC, but insists that the industry does not need any specific rulemaking in this arena, stating “nothing about the crypto markets is incompatible with the securities laws.”

In his testimony, Lee Reiners of the Duke Financial Economics Center offered a compelling suggestion to fill the existing regulatory gap we see in spot markets: Congress should carve out crypto from the definition of commodity under the Commodity Exchange Act and include crypto as a new category of security under the Securities and Exchange Act so that it’s clear to everyone that the SEC has exclusive rulemaking authority and jurisdiction over cryptocurrency.

Shared Goals, Shared Governance

Members in the 117th Congress demonstrated their desire to implement regulations around the crypto industry but were ultimately unable to come to a consensus. As we kick off the 118th Congress, it is imperative we have more meaningful conversations about what a proper regime might look like. There are a number of options on how to proceed – including regulating crypto like gambling, utilizing existing regulatory authorities, creating entirely new ones, or banning crypto altogether. The path forward, however, still remains unclear. In looking toward the next steps, lawmakers should consider allocating more funding and resources to the SEC so that the agency can effectively carry out its job and prevent another catastrophe like FTX from happening again in the future.