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Who Can Regulate the Crypto Market?

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What You Need to Know

  • The crypto market encompasses many different types of assets.
  • The SEC and CFTC have authority over some assets, but there are regulatory gaps.
  • New legislation may be needed to develop new rules, or the FSOC created under Dodd-Frank may suffice.

A hearing Wednesday of the House Subcommittee on Oversight and Investigations showed just how difficult it is to regulate the cryptocurrency and crypto asset markets.

There were the usual differences in opinion about regulation between Democratic and Republican members of the subcommittee, which is a unit of the House Financial Services Committee, although at least one Republican member noted the need for more clarity about regulations. More striking were the discussions about all the components of the crypto market and the limits of current federal regulation, which may require legislation to expand.

It’s Complicated

There are multiple cryptocurrencies like Bitcoin and Ethereum and many more; also stablecoins such as Tether, which are supposed to be pegged to external currencies but don’t always perform that way — Tether failed that test — and initial coin offerings (ICOs), used by startups to raise funds to develop crypto products or services.

In addition, there are crypto exchanges for trading of these assets and crypto custodians for storage, which now include traditional financial firms like Fidelity; and major banks like Morgan Stanley and Goldman Sachs are developing ways for their clients to invest in cryptocurrency.

Some of those assets are regulated, at least partially by federal agencies. The Securities and Exchange Commission, for example, regulates most ICOs but, according to SEC Chairman Gary Gensler, does not have the authority to regulate crypto exchanges. The Commodity Futures Trading Commission oversees Bitcoin futures, but it has limited antifraud and anti-manipulation authority over spot and forward markets of cryptocurrencies, including Bitcoin.

Crypto exchanges are subject to rules from the Treasury Department’s Financial Crimes Enforcement Network (FinCEN), which oversees anti-money laundering (AML) and know-your customer (KYC) obligations. State agencies can also impose AML and KYC obligations, which is what the New York Department of Financial Services has done for New York businesses  involved in the crypto market and firms that sell crypto assets to New York residents.

The Regulatory Picture

There are regulatory gaps concerning cryptocurrencies and assets.

SEC Chairman Gary Gensler has said the SEC lacks the authority to regulate crypto exchanges and Congress needs to provide it.

At the House subcommittee hearing, attorney Christine Parker, a partner at Reed Smith who specializes in regulatory matters related to digital assets, commodities and derivatives, noted, “As a commodity and unlike a security, the purchase and sale of Bitcoin (i.e., spot/cash and forward trades) is largely unregulated at the federal level.”

Sarah Hammer, a managing director of the Stevens Center for Innovation in Finance at the Wharton School, said, “While the SEC has applied securities regulation to dozens of ICOs based on the Howey test [a test that determines what qualifies as an "investment contract," based on Supreme Court decision], there is still a lack of clarity as to whether it applies to a number of cryptocurrency transactions that currently do not comply with SEC registration and disclosure obligations.”

She supports the development of “clear, sufficient and appropriate” regulatory framework for cryptocurrencies developed under the leadership of the Financial Stability Oversight Council, which is led by the Treasury secretary and includes heads of major financial and banking agencies, including the SEC, CFTC, Federal Reserve Board and FDIC, in coordination with state regulators and consultation with international standard-setting bodies.

How far any regulation reaches will also be an issue for regulators. Another panelist at the hearing, Alexis Goldstein, director of financial policy at the Open Markets Institute, was especially concerned with systemic risks posed by private entities like hedge funds, which are only lightly regulated but are becoming increasingly active players in the crypto market.

“The lack of reporting by private funds on their cryptocurrency positions will make it difficult for regulators to determine if this market creates systemic risk concerns,” said Goldstein, who worked at Merrill Lynch equity derivatives sales and trading desks during the 2008 financial crisis. She said the “opaque trading in cryptocurrency today” reminds her of that time.

Goldstein also raised issues of concentration of crypto holdings by a handful of holders, the high levels of leverage in the crypto market and the hacking of some decentralized finance (DeFi) platforms.

Peter Van Valkenburgh, director of research at the Coin Center, a nonprofit research and advocacy organization focusing on policy issues facing the crypto market, disagreed with the other panelists about the need for more regulations.

“We don’t need new regulations,” said Van Valkenburgh. “The onramps and off-ramps” where people buy and sell Bitcoins for dollars and store them are already heavily regulated, said Van  to Van Valkenburgh, whose organization is supported by Twitter CEO Jack Dorsey, Galaxy Digital, Grayscale and other crypto firms. In addition, said Van Valkenburgh, the “scarcity of Bitcoin is secured by transparent peer-to-peer accounting technology” and the blockchain, which makes fraud “trivially cheap to detect and absurdly expensive to commit.”

Is Legislation Needed for Crypto Regulation?

Ultimately Congress may decide if more regulation of the crypto market is needed and what form that should take.

There are currently several bills that have passed the House and await Senate action. They include the Eliminate Barriers to Innovation Act of 2021 (H.R. 1602), which requires the SEC and CFTC to establish a digital asset working group to ensure collaboration between regulators and the private sector to foster innovation, and the Consumer Safety Technology Act (H.R. 8128), which includes two blockchain bills and directs the secretary of Commerce and the Federal Trade Commission to study and report on the use of blockchain technology and digital tokens.

But even if these bills pass, there won’t be decisive action for a while. Studies take time, as does the implementation of their recommendations, which may involve legislation.

“Ultimately Congress will need to pass legislation to create comprehensive and meaningful regulation of the crypto spot markets and to create a global framework to determine the regulatory characterization of digital assets,” said Reed Smith’s Parker, a former legislative counsel to Sen. Chuck Schumer, D-N.Y., now the Senate majority leader.

Hammer said Dodd-Frank already provides the authority with the creation of the FSOC, which has “the authority to evaluate and coordinate policymaking for cryptocurrency.”