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The Future of Digital Assets: Measuring the Regulatory Gaps in the Digital Asset Markets

House Committee on Agriculture, Subcommittee on Commodity Markets, Digital Assets, and Rural Development

House Committee on Financial Services, Subcommittee on Digital Assets, Financial Technology, and Inclusion

The Future of Digital Assets: Measuring the Regulatory Gaps in the Digital Asset Markets

Wednesday, May 9, 2023

Topline

  • Democrats cautioned against transferring more authority to the CFTC because of its funding constraints and voiced concerns about the risk cryptocurrency poses to retail investors.
  • Republicans called for Congress to pass a digital assets framework and warned the U.S. is falling behind other countries in the digital asset ecosystem.

Witnesses

  • Andrew Durgee, Head of Republic Crypto
  • Matthew Kulkin, Partner and Chair, Futures and Derivatives Practice, Wilmer Cutler Pickering Hale and Dorr LLP; former Director, CFTC Division of Swap Dealer and Intermediary Oversight
  • Marco Santori, Chief Legal Officer, Kraken Digital Asset Exchange
  • Daniel Schoenberger, Chief Legal Officer, Web3 Foundation
  • Timothy Massad, Research Fellow, Harvard Kennedy School Mossavar-Rahmani Center for Business and Government and Director, M-RCBG Digital Assets Policy Project
  • Michael Blaugrund, Chief Operating Officer, New York Stock Exchange

Opening Statements

Subcommittee on Commodity Markets, Digital Assets, and Rural Development Chair Dusty Johnson (R-SD)

In his opening statement, Johnson said digital assets and blockchain technology hold real promise, but noted current federal laws and regulations provide few rules of the road for those who want to engage with these emerging technologies. He explained the current uncertainty does not serve the marketplace, and discussed how the CFTC and SEC’s conflicting enforcement decisions create further confusion.  Johnson said Congressional action is essential to provide clear rules of the road, noting most of the G20 countries are ahead of the U.S. in the digital asset ecosystem. He concluded by reaffirming that the U.S. must remain the leader in financial and technological innovation.

Subcommittee on Commodity Markets, Digital Assets, and Rural Development Ranking Member Yadira Caraveo (D-CO)

In her opening statement, Caraveo said the sprawling nature of the digital asset industry highlights the importance of cross jurisdictional communication and coordination, noting the scale of digital asset activities has increased significantly in recent years. She discussed ongoing charges of rampant and willful noncompliance with some of the biggest market participants and said regulatory clarity must also support a robust enforcement regime and prioritize market participants. Caraveo concluded that the CFTC has dutifully exercised their enforcement authorities and called for any digital asset legislation passed by Congress to include a funding mechanism for the CFTC.

Subcommittee on Digital Assets, Financial Technology, and Inclusion Chair French Hill (R-Ark.)

In his opening statement, Hill discussed the lack of a current workable framework for digital asset issuers and intermediaries to be regulated effectively by the SEC or CFTC. He said the U.S. can’t trust offshore crypto exchanges but noted if the U.S. fails to provide a functional framework for digital assets, the U.S. will force this activity to happen in an offshore exchange. Hill concluded the CFTC, SEC, and American consumers will benefit from a digital asset framework.

Subcommittee on Digital Assets, Financial Technology, and Inclusion Ranking Member Stephen Lynch (D-Mass.)

In his opening statement, Lynch cautioned against feeding into an industry narrative about the turf war between the SEC and CFTC, noting the problem with the digital asset industry is not regulatory ambiguity, it is mass non-compliance. He said a new regulatory structure for digital assets would likely undermine existing laws and regulations, adding that creating a new carveout for digital assets seems redundant and unnecessary. Lynch called for the examination of the intermediaries that facilitate these tokens, noting digital asset companies want to serve multiple functions, despite the clear and distinct rules for exchanges, broker dealers, and clearing/settlement agencies. He explained digital asset companies try and flout existing rules by being all of these things at once. Lynch concluded that creating a separate regulatory regime through legislation is not the answer.

Testimony

Andrew Durgee, Head of Republic Crypto

In his testimony, Durgee discussed how 83 million Americans have participated or are currently participating in the digital assets industry. He explained the current system is not working as intended, noting the Biden Administration has not qualified a single digital asset offering. Durgee explained how the SEC’s approval process is incredibly difficult. He said it generally takes about 25-30 years for humans to adopt a new data transfer technology, noting that discussions are just starting about standardization of Bitcoin, which was created 13 years ago. Durgee concluded that the adoption of Bitcoin and digital assets is not a technological problem, but rather a human conditioning issue.

Matthew Kulkin, Partner and Chair, Futures and Derivatives Practice, Wilmer Cutler Pickering Hale and Dorr LLP; former Director, CFTC Division of Swap Dealer and Intermediary Oversight

In his testimony, Kulkin noted the largest digital assets that are traded are commodities, adding the definition of a commodity is intentionally broad. He discussed how the existing framework limits the CFTC’s enforcement authority solely to fraud and manipulation, which he noted is insufficient to adequately protect customers. Kulkin warned that by limiting the CFTC’s oversight of commodity spot markets, market participants are not getting the benefit of basic customer protections. He called on Congress to expand the CFTC’s role to include regulatory authority over the digital commodities spot markets.

Marco Santori, Chief Legal Officer, Kraken Digital Asset Exchange

In his testimony, Santori said we are at an important juncture in the development of U.S. digital asset policy, adding that now is the time for Congress to act. He said gaps in U.S. regulation can be resolved with a clear mandate from Congress that will establish a functional standard and process for drawing clear jurisdictional lines and create a viable path to regulate centralized digital asset exchanges where SEC jurisdiction has been defined by Congress. He also called on Congress to expand CFTC authority to regulate spot digital asset markets and exchanges and mandate interagency cooperation to facilitate coordinated oversight over digital assets and centralized exchanges. Santori concluded by calling on Congress to define transitional arrangements to minimize market disruption and protect retail investors.

Daniel Schoenberger, Chief Legal Officer, Web3 Foundation

In his testimony, Schoenberger said his most important regulatory concern is the classification of tokens, noting Switzerland and the EU created a clear regulatory framework distinguishing between payment tokens, security tokens, and utility tokens. He said a legislative process to reevaluate tokens is necessary, and called on Congress to establish a procedure, through legislation, to authorize regulators to reevaluate the status of tokens. He urged Congress to develop digital assets policy with an approach that recognizes new technologies, noting that applying existing regulation would be inadequate and inappropriate to address an emerging industry and technology.

Timothy Massad, Research Fellow, Harvard Kennedy School Mossavar-Rahmani Center for Business and Government and Director, M-RCBG Digital Assets Policy Project

In his testimony, Massad discussed the frequency of suggestions that Congress should rewrite securities laws to define a category of digital assets that do not constitute securities and give the CFTC jurisdiction over spot market activity involving those assets. He said that while there are different formulations of this approach, the risk in all of these proposals is that creating new regulatory categories of assets might generate more confusion than clarity and lead to disputes over their own meaning that could take years to resolve.  Massad warned that some of these definitions could undermine decades of securities law and jurisprudence.

Massad called on Congress to create a baseline of investor protection by passing a law to mandate that any trading or lending platform that trades or uses Bitcoin or Ethereum must comply with a set of core principles for all tokens traded or used on that platform, unless the platform has already registered with the SEC or CFTC as a securities or derivatives intermediary. He noted the principles would include protection of customer assets, prevention of fraud and manipulation, prohibition of conflicts of interest, adequate disclosure to investors, regular reporting, pre and post trade transparency, risk management and governance standards, among others. Massad said Congress would either direct the SEC and the CFTC to develop joint rules implementing these principles, or the rules could be developed by creating a new self-regulatory organization (SRO) jointly supervised by the SEC and the CFTC.  He noted SROs have been critical to the regulation of our securities and derivatives markets for decades, and there is precedent for SROs registered with both the SEC and the CFTC.

Michael Blaugrund, Chief Operating Officer, New York Stock Exchange

In his testimony, Blaugrund explained the regulatory framework governing national securities exchanges brings transparency and a trusted environment for issuers and investors alike to participate in our financial markets. He noted that as investors increasingly seek exposure to digital assets, it has never been more important to develop a regulatory framework around digital assets that protects the public.   Blaugrund discussed the similarities to the problem that Congress faced nearly 100 years ago which led to the establishment of the Securities and Exchange Act, and explained that the lesson to be drawn from more established markets is clear: the segregation of key functions within the financial markets ecosystem — brokerage, exchange, clearing, and custody — mitigates inherent conflicts of interest, promotes transparency, and facilitates competition amongst service providers.

Blaugrund noted some current digital asset trading models, as witnessed with the collapse of FTX, co-mingle the functions in a way that raises serious questions of risk management, financial resources, and investor protection. He said that if investors could trade digital assets in a similarly regulated exchange environment, many of the problems seen in the last year would not have occurred. Blaugrund said that while there is well-established process to launch a registered exchange, no digital asset trading platforms have followed the existing well-worn path. He noted the exchange regulatory framework represents an established and well-known foundation that can be adjusted to accommodate the marketplace for digital assets.

Blaugrund concluded by outlining several steps government agencies can take, including providing a tailored registration process for investment contract tokens or refining the SEC conditions for Special Purpose Broker-Dealers with a more permanent solution. He said Congress could also provide regulatory relief for exchanges seeking to trade securities or other digital assets that are not considered national market system securities, and permit adjustments to applicable clearinghouse rules to accommodate the clearing of digital asset tokens. His final suggestion was to evaluate reciprocity for SEC-registered broker-dealers, market centers and clearing agencies and CFTC registered FCMs, DCMs and DCOs so that they can effect transactions in commodity tokens.

Question & Answer

Regulatory Gaps

Hill asked which features of digital assets are not contemplated in the existing securities disclosure regime. Santori said the primary gaps exist around risk factors, noting there are also a number of highly technical and digital asset specific characteristics that are not accounted for, like the number of nodes.

Rep. Maxine Waters (D-CA) said American securities laws are the reason U.S. capital markets are the envy of the world. She asked if crypto exchanges are meaningfully different from traditional exchanges in a way that should warrant an entirely new legislative and regulatory framework. Blaugrund said like functions should be regulated in like fashion. He noted digital asset trading platforms have comingled many of the traditional trading functions, which increases risk. Blaugrund said it would be an appropriate posture to bring these platforms up to traditional requirements.

Rep. William Timmons (R-S.C.) said existing securities regulations do not have the flexibility to support blockchain in all of its innovative use cases. He asked if it would be possible for national securities exchanges to list Bitcoin and a security alongside each other. Santori said no, noting the U.S. national securities exchange is not flexible.

Rep. Erin Houchin (R-Ind.) asked how Congress can create a disclosure regime that will solve the problem of information asymmetry. Durgee said the current disclosure regime is contradictory, and warned that until disclosures are made clear, the U.S. will have ambiguous frameworks that forces companies to leave the country. Santori said the U.S. needs to look at Europe’s sensible and tailored approach.

Rep. G.T. Thompson (R-Penn.) asked if a CFTC, SEC joint SRO construct would be an effective or practical solution. Kulkin said he worried creating a new SRO from scratch would take time, and warned that we don’t need to recreate the wheel.

Crypto Skeptics & Fraud

Lynch said every time a crypto firm explodes, people lose trust in our financial system. He noted crypto is a favored tool of criminal enterprises and warned the U.S. should not import crypto’s risk and instability into its financial system.

Rep. David Scott (D-GA) discussed his history of concerns about crypto and the risks it provides for retail investors. He pointed to the countless examples of misuse and abuse, and said investors are being used. Scott said cryptocurrency markets are rife with fraud and volatility, posing all risk and no reward for everyday investors.

Scott argued that digital assets don’t work as a currency, noting Americans have yet to see the supposed benefits of digital assets. He concluded that digital assets do not advance financial inclusion.

Rep. Bill Foster (D-IL) discussed estimates which indicate that anywhere between 50-95% of Bitcoin transactions are fakes and constitute wash trades or other frauds on the market. He asked if anyone on the panel believes it is possible to conduct a well-regulated futures and derivatives market when the underlying asset is subject to this level of market manipulation. Kulkin said these statistics prove the CFTC should have enforcement over the spot market.

Foster asked if there was any other way to prevent wash trades and money laundering other than having both sides of every crypto transaction associated with a traceable digital identity, issued by a government with which the U.S. has extradition treaties. Santori said he would be surprised if wash trades happened in any meaningful way. Foster called for a trusted digital identity associated with every crypto wallet.

Rep. Sean Casten (D-IL) asked if Durgee believed that cryptocurrencies will help close the wealth inequality gap. Durgee said yes. Casten noted if someone had invested in the S&P index over the last five years, their median return would have been 61%. He explained there have been 12 cryptocurrencies that have existed over the same time period, and if someone would have invested in that basket over the same period, they would have lost 46% of your money. Casten said cryptocurrency is not a way to grow wealth.

Rep. Brad Sherman (D-CA) said cryptocurrency is designed to cheat our sanctions and tax laws, and noted all of the money and power in D.C. is on the side of the billionaire crypto bros, because no one is being paid millions to lobby for tax and sanctions enforcement.

Sherman asked if an unregistered exchange where you could buy and sell securities in any other field of our capital markets would be a violation of all of America’s securities laws. Massad said yes.

Investor Protection

Rep. Nikki Budzinski (D-IL) explained that she doesn’t hear a lot about these issues from her constituents and asked how to frame this issue for them. Massad said while this may not be top of mind for all Americans, he was concerned about what he saw when crypto prices rose quickly, and a lot of people thought crypto was a way to make money quickly. He noted a lot of people didn’t understand the volatility of these assets and risk associated with these platforms. Massad said Congress and agencies have an obligation to create investor protections for Americans.

Rep. Frank Lucas (R-Okla.) asked Blaugrund to elaborate on the difficulty of balancing investor protection with investor access. Blaugrund said the segregation of roles is basic risk management and would give investors confidence.

Securities & Exchange Commission & Commodity Futures Trading Commission

Rep. Patrick McHenry (R-NC) said the SEC’s disclosures don’t work for digital assets, and called for the CFTC to have additional authority over non-security digital assets. McHenry said SEC needs to modify its rules for broker dealers and exchanges.

Rep. John Rose (R-TN) asked Kulkin if treating all digital assets as securities and giving the SEC full authority is the right approach. Kulkin said no, citing the need to be thoughtful about which products are commodities.

Hill asked if SEC Commissioner Peirce’s approach to disclosures would be workable. Santori said yes, noting her approach is light years ahead of what exists today.

Caraveo noted that Massad was the Chair of the CFTC when it was implementing Dodd-Frank. She asked Massad if there were similar concerns about the CFTC’s size at that time about the CFTC’s ability to oversee the spot market. Massad said yes, explaining that an agency can’t take on a new area of jurisdiction without new resources. Caraveo noted this is important to point out while agencies are potentially facing budget cuts to agencies across the board.

Lynch noted the CFTC has 600 employees compared to the SEC, which has 4,500 employees. He asked why Congress would take oversight and enforcement away from the much larger and well-resourced SEC and give it to the CFTC.

Lynch asked what measures would be necessary if Congress were to shift or share responsibility to the CFTC?  Massad said neither the CFTC nor the SEC could tackle the digital assets market without significant resources. He said he would prefer a system where the two agencies work through an SRO, explaining that then the industry would have to pay for it. Massad pointed to FINRA as a precedent. Blaugrund said the dual registration of brokers and dealers would be essential.

Rep. Marc Molinaro (R-N.Y.) asked how allowing an entity registered with the SEC to list a commodity for trading would impact the CFTC’s existing enforcement authority. Kulkin said it would be challenging and create a lot of confusion. He noted that if the trading were to take place on an SEC-regulated exchange, it would further restrict the CFTC’s ability to conduct oversight.

Rep. Al Green (D-Texas) noted the Limit, Save, Grow Act would impose a $91 million cut to the CFTC. He asked if this would hurt the CFTC and its functionality Massad said absolutely.

Green asked if there needs to be an increase in the CFTC’s funding. Massad said yes, especially if Congress is increasing the CFTC’s responsibilities. Santori said it would depend on the jurisdiction that is ultimately granted.

Global Competition

Lucas noted other jurisdictions, like the EU, are passing digital asset frameworks. He asked how this would make Congress’ job of writing a framework more difficult. Santori said the U.S. is significantly behind other countries. He noted his firm has made plans to invest in Europe, but faces limits on investing in the U.S. without a comprehensive framework.

Rep. Bryan Steil (R-Wisc.) said the U.S. can’t afford to cede regulation and innovation to other countries.

Steil asked how regulators in Europe view blockchain technology, and if their attitude differs from that of U.S. regulators. Schoenberger said his company made a deliberate decision to be headquartered in Switzerland, where is a much more forward-thinking approach and more clarity.

Steil asked what lessons the U.S. can learn from the EU as we craft our own laws. Durgee said the U.S. should also look at Dubai, Singapore, and South Korea for a wholistic view on how the world is approaching digital assets.

Houchin said digital assets are the new space race, adding there is no reason the U.S. should not lead the way.

Spot Market Regulation

Johnson said Kulkin noted the CFTC should not have broad spot market authority everywhere, but only for digital assets because they are different. He asked Kulkin to explain how digital assets are different.  Kulkin said many of these digital commodities have a very strong retail component, which is different than soybeans or oil. He explained there is a strong retail market, which calls for investor protection. Kulkin said digital assets are also different because they are much newer than other commodities.

McHenry asked what the most important next steps are for Congress. Kulkin said Congress should grant the CFTC oversight over the digital commodity spot markets.

For more information on this meeting, please click here.

For an archive of past SIFMA hearing coverage, please click here.