2023 CMC Crypto Playbook: US Crypto Regulations Outlook by APCO

Washington meets the wild west of Crypto

By Jeff Zelkowitz

It’s an odd sight to watch Congressional Democratic and Republican politicians in violent agreement with each other and working together to advance public policy. It’s even more unusual to hear staid financial regulators squabbling in public and talking like a cop on the beat in a particularly tough neighborhood.

Welcome to the world of Washington meets the wild west of Crypto. What is clear is that U.S. policymakers from both major parties want to reinforce American leadership in the global financial system and at the technological frontier – while defending this frontier against bad actors. It is in this context that legislative proposals working their way through Congress and pronouncements and actions emanating from the White House and government agencies are best understood.

The plot of this story is hard to follow, with a large cast of characters and an alphabet soup of agencies. Here’s the U.S. Congressional Research Service’s valuable (and valiant) attempt to summarize where cryptocurrencies fit into our financial regulatory structure:

Currently, there is no comprehensive regulatory framework for cryptocurrencies or other digital assets. Instead, various state and federal financial industry regulators apply existing frameworks and regulations where exchanges or digital assets resemble traditional financial products. As such, regulators may treat digital assets as securities, commodities, or currencies depending on the circumstances. For example, cryptocurrency exchanges are licensed at the state level and register with the U.S. Treasury’s Financial Crimes Enforcement Network as money transmitters for AML compliance. However, application of these frameworks through formal or informal guidance by disparate regulators may make the environment murkier in the event that various overlapping regulators make competing pronouncements. For example, the chairs of both the Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC) have alluded to the fact that some digital assets are commodities and others securities under their respective jurisdictions. Where crypto actors are operating without registering with these agencies, investors do not receive the protections that regulatory compliance provides.

It is in this confusing context that President Biden issued a White House executive order earlier this year that recognized the importance of digital assets and technologies while directing government agencies in his administration to focus on several key priorities for policy development. These include consumer and investor protection, financial stability, illicit finance, financial inclusion, responsible innovation, leadership in the global financial system and U.S. economic competitiveness. Among other things, the executive order cited the regulatory principle of ‘same business, same risk, same rules,’ asserting that cryptocurrencies should not be treated differently or be given loopholes.

Congressional proposals working their way through various committees in the Senate and House of Representatives represent a comprehensive attempt to integrate digital assets into existing laws. I witnessed this outbreak of bipartisan consensus firsthand at the Bloomberg Crypto Summit this summer as Senators Kirsten Gillibrand (D-NY) and Cynthia Lummis (R-WY) of the Senate Banking Committee explained their landmark Responsible Financial Innovation Act.

What struck me was the collegial tone of the conversation and these lawmakers’ efforts to coordinate with others working on these issues on Capitol Hill, notably a House Financial Services Committee bill to regulate stablecoin reserves. They expressed high hopes that something could be done this year on stablecoins as a first step towards more comprehensive action.

Two things have happened to slow this momentum temporarily but that will ultimately bring about a more compliant crypto future.

First, the U.S. midterm elections. It was completely predictable that work would pause during the fall election campaign. The fact that Republicans gained control of the House of Representatives does not seem to alter the bill’s prospects since the incoming Republican committee chair Rep. Patrick McHenry (R-NC) and current Democratic chair Maxine Waters (D-CA) are working together and prioritizing action for next year. Senator Gillibrand also sees prospects for a stablecoin bill out of her committee in coming weeks.

Second, the collapse of FTX. It was not the only crypto failure this year but certainly the tipping point. Explosive revelations come out nearly every day about massive fraud, misuse of customer assets, conflicts of interest between related entities, and non-existent balance sheets or risk management controls. The new CEO overseeing the bankrupt cryptocurrency exchange called FTX a failure of corporate governance worse than Enron: “From compromised systems integrity and faulty regulatory oversight abroad to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.”

Policymakers and regulators are looking for answers and raising questions on what issues and risks need a harder look to understand where proposals they have been working on may need to be beefed up  – especially if Sam Bankman-Fried had provided any input on them. There’s no doubt the hammer is coming down on a range of practices that FTX-affiliated entities engaged in that would never be tolerated in regulated financial services.

In fact, that’s been happening already. While crypto industry players claim the U.S. lacks clear rules and/or that cryptocurrencies should be treated differently to avoid stifling innovation, U.S. regulators including the SEC and CFTC see it differently – and theirs is the view that matters.

The SEC’s position is clear to the point of Socratic logic: The SEC has 90 years of experience regulating securities. Many cryptocurrencies meet the definition of securities. Intermediaries that facilitate cryptocurrency transactions need to know and comply with SEC rules.

Gary Gensler, Chair of the U.S. Securities and Exchange Commission, is blunt about crypto. He describes himself as “the cop on the beat.” Here’s Gensler telling lawbreakers to come out with their hands up: "We brought actions against crypto lending platforms including BlockFi, and we will continue to be a vigorous securities regulator, but I really do suggest to these intermediaries, these storefronts, these casinos, if you wish, to come into compliance, work with the SEC to get into compliance, disaggregate these businesses.”

The SEC applies a decades-old Supreme Court decision known as the Howey test that defines securities as “an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others." Whereas Gensler sees Bitcoin as digital gold that is not controlled by a central entity, he believes most cryptocurrencies are securities.

The SEC’s interpretation has much riding on a court case against Ripple that the agency filed in 2020, charging that its XRP digital tokens are unregistered securities. It has brought several dozen enforcement actions in the crypto space, and this year nearly doubled the size of its enforcement staff in this area.

That the SEC’s actions have roiled the industry is to be expected. That they prompted public criticism from a fellow regulator is unusual, to say the least. The SEC complaint in question alleges that dozens of digital assets, including utility tokens and tokens relating to DAOs, are securities. This action drew the ire of CFTC Commissioner Caroline Pham, who issued a public statement criticizing the SEC for “a striking example of regulation by enforcement.” She chided the SEC about “how critical and urgent it is that regulators work together” and that “regulatory clarity comes from being out in the open, not in the dark.”

The public debate is important because of the perception that the cryptocurrency industry generally favors regulation by the CFTC and is lobbying for legislation that would give the commodities market regulator authority over Bitcoin, Ethereum and other cryptocurrencies.

The Digital Commodities Consumer Protection Act introduced by Senators Debbie Stabenow (D-MI) and John Boozman (R-AR) gives the CFTC jurisdiction over “digital commodities,” and defines that term broadly to capture potentially a lot more than just the top two cryptocurrencies. The bill was met favorably by most of the crypto industry as well as consumer groups when it was announced in August – but that may change in a post-FTX world.

Rostin Behnam, the CFTC’s Chair, has argued that “Bitcoin might double in price if there’s a CFTC-regulated market” and recently suggested that the only cryptocurrency that should be viewed as a commodity is Bitcoin. He has also sought to minimize the CFTC versus SEC debate and draw instead on their commonalities grounded in investor protection, citing decades of regulatory experience in adapting to each new market innovation and learning from each crisis.

In that regard, Behnam asked Congress to plug the regulatory gap he identifies as putting the U.S. public at risk. The CFTC only has authority over derivatives, not cash commodities markets. It has intervened in cash markets to bring enforcement actions in limited cases when there is fraud and manipulation that impacts investors in the derivatives. He asked Congress to give the CFTC authority it currently lacks over digital commodities so it could regulate markets and intermediaries to safeguard investors before the harm has already occurred.

All this is to say that while the system is confusing and imperfect, the overall picture is becoming clearer. There seems to be an appetite and a willingness by policymakers from both parties to get something done. The regulators are demanding action and accountability to protect the investing public, and the failure of FTX has made the public case for regulation better than anything Sam Bankman-Fried did to promote it.

Yet these innovations can potentially address many problems better than the existing financial system and advance goals that are important for policymakers, the American public and U.S. economic and national security interests. Likewise, there are important international considerations for borderless and permissionless systems that people in many other countries around the world depend on to advance values and freedoms that Americans care about deeply.

That means there is still a conversation to be had on shaping the policy framework in which rules create the trust in programmable money, digital assets and blockchain technologies that is essential for the level of market adoption, scalability and real-world utility that are the dream and promise of crypto innovators and their communities.

Jeff Zelkowitz is Executive Vice President at APCO Worldwide. He advises corporate clients on financial, technology and sustainability issues and communications.