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Crypto Crash: Why Financial System Safeguards are Needed for Digital Assets

Senate Committee on Banking, Housing, and Urban Affairs

Crypto Crash: Why Financial System Safeguards are Needed for Digital Assets

Tuesday, February 14, 2023

Topline

  • The hearing focused on the impact of FTX’s collapse on the crypto market, how regulators have approached the industry, and what Congress can do to provide regulatory clarity.

Witnesses

  • Lee Reiners, Policy Director, Duke Financial Economics Center
  • Professor Linda Jeng, Visiting Scholar on Financial Technology, Adjunct Professor of Law, Georgetown Institute of International Economic Law
  • Professor Yesha Yadav, Vanderbilt University Law School

Opening Statements

Chairman Sherrod Brown (D-Ohio)

Brown opened the hearing by noting that the crypto industry has imploded and lost $1.46 trillion in 2022. He said the firms that are left have halted customer withdrawals and frozen people out of their money. Brown also cautioned that crypto could have done much more damage if it had migrated into the banking system. He claimed that as crypto firms filed for bankruptcy, regulators and policymakers learned how out of control some of the businesses were. He summed up his stance by noting that crypto catastrophes “exposed what many of us already knew: digital assets, cryptocurrencies, stablecoins, and investment tokens are speculative products run by reckless companies that put Americans’ hard-earned money at risk.”

 

As a result of these impacts, Brown argued that Congress must consider how to protect consumers from unregulated digital assets. He promoted a comprehensive framework to regulate crypto based on six principles of regulation:

  • Clear disclosures and transparency so retail customers and investors can understand how a token or crypto platform works;
  • Prohibitions on conflicts of interest or self-dealing by insiders;
  • Protecting consumer funds by separating them from company assets;
  • Internal governance and risk management to make sure platforms act prudently;
  • Anti-money laundering and fraud prevention to make sure malign actors cannot fund themselves and evade law enforcement; and
  • Oversight and supervision to hold companies accountable.

Ranking Member Tim Scott (R-S.C.)

Scott began by saying that Congress needs to hear from Securities and Exchange Commission (SEC) Chair Gary Gensler soon. Next, he noted that innovation is essential, and Congress should not limit future generations from growth and opportunity. Despite this, he said, financial innovation must be done in a safe and sound manner, which has not been the case with many actors in the digital asset space. Specifically, Scott added, Sam Bankman-Fried stole millions of customer funds instead of protecting customers’ interests and using customer funds in the manner intended. Scott argued that the American people deserve to know why no action was taken prior to FTX’s collapse. He also asked whether SEC guidance could have protected more investors from the collapses of Terra, Luna, Celsius, Voyager, and BlockFi. Finally, Scott said that while holding companies accountable is necessary, Congress should also empower consumers through financial education. He asked the Committee to proceed with a “thoughtful, bipartisan, and balanced approach that protects consumers and promotes innovation and opportunity.”

Testimony

Mr. Lee Reiners, Policy Director, Duke Financial Economics Center

In his testimony, Reiners said crypto has had fourteen years to provide its “killer use case,” but so far there has only been evidence of the harm crypto can inflict on our society. Reiners also responded to arguments in favor of innovation by noting that it is value neutral and can be used for good or bad. He continued by saying that Americans who have invested in crypto care about having the same basic safeguards they know and expect from the traditional financial system and proposed a recommendation for providing those safeguards. Specifically, Reiners said that Congress should carve out the definition of cryptocurrency from commodity in the Commodity Exchange Act and recognize cryptocurrencies as securities under a special definition to the securities laws, giving the SEC exclusive authority to regulate all aspects of the industry.

Professor Linda Jeng, Visiting Scholar on Financial Technology, Adjunct Professor of Law,

Georgetown Institute of International Economic Law

In her testimony, Jeng stated that financial sector policy should focus on empowering consumers, ensuring open markets, increasing efficiency, and lowering costs for consumers. She said that technology innovation should be harnessed to improve access, equity, and efficiency. Specifically, to facilitate the growth of a resilient digital future, Jeng argued that policymakers should focus on consumer investor protection, digital money, decentralized finance, private commercial law, bankruptcy, accounting, tax, technology standards, energy, illicit finance, and national security. She claimed that the current patchwork of state and federal requirements in the U.S. causes uncertainty for businesses and innovators, while also failing to protect investors. Finally, she noted that regulation by enforcement is not sufficient and warned that failure to enact rules that protect investors and allow digital assets to develop in the U.S. would risk offshoring innovation.

Professor Yesha Yadav, Vanderbilt University Law School

In her testimony, Yadav said that the FTX episode casts enormous doubt and reduces trust and confidence in the cryptocurrency exchanges and the entire industry. She added that it also cast doubt on the regulatory system. Her solution for the Committee and Congress is to create a self-regulating regime where cryptocurrency exchanges are tasked with oversight of the market as a whole. Yadav argued that this would bring crypto exchanges in line with traditional commodities and securities exchanges, where self-regulation has been the norm for centuries, and would task them with writing rules, monitoring the market, and exercising discipline.

Question & Answer

Regulation and Congressional Action

Brown asked if a financial product that takes in billions of dollars should have to operate with basic consumer protections. Reiners agreed and added that regulation by enforcement has become a “catchphrase” that the industry uses to deflect from the fact that they have chosen to operate outside the regulatory perimeter. Brown asked about the urgency to develop better standards for the custody of consumer assets, and Reiner replied that since the collapse of FTX, millions of crypto users have found out they are now unsecured creditors in the bankruptcy estate. Finally, Brown asked how existing disclosure principles can be used for crypto. Yadav said the disclosures are necessary for younger people and need to be readable and useable. Jeng advocated for whitepapers that clearly explain how products are designed, the risks, who holds private keys, governance and voting rights, and where the funds are held. Reiners said there is no reason why the principle of disclosures should not be applied to crypto but agreed that customized disclosures may be needed for certain decentralized products.

Scott agreed that a disclosure in plain English that the average person can understand would be helpful. He also asked Jeng what Congress should keep in mind as it considers its approach to crypto. She said that Congress should think about consumer rights, protections, and empowerment that serves as the foundation for a digital economy.

Sen. Bob Menendez (D-N.J.) asked about the importance of Congress passing legislation to provide rulemaking authority to financial regulators over the spot market for non-security digital assets. Reiners noted that while he agrees with SEC Chair Gary Gensler that most cryptocurrencies are securities, there are some commodities too. CFTC does not regulate commodity spot markets, however, so Reiners noted that there is a gap.  He reiterated his recommendation that Congress carve out cryptocurrency from the definition of commodity in the Commodity Exchange Act and include it as a new category of security so that the SEC has exclusive rulemaking authority. Yadav repeated her suggestion that private industry be made responsible and accountable, adding that exchanges are providing onramps into the crypto market for the vast swath of the population. Jeng noted in response to Reiners that digital money, such as stablecoins or CBDC, must be free from interest or title, so putting it under an SEC framework would problematic. Menendez said he will be looking for transparency and investor protection in any cryptocurrency legislation.

Sen. Thom Tillis (R-N.C.) mentioned his interest in a proof of reserves requirement and said his office is working on a bill. Reiners argued that proof of reserves are “not worth the paper they’re written on.” He did say, however, that audits are a worthwhile pursuit that Congress should look at. Yadav agreed that the ability to have robust and systemically done third party audits is important. She also added that exchanges need to have internal controls.

Sen. Bill Hagerty (R-Tenn.) said that stablecoins will help create faster and cheaper payments for Americans and will strengthen the U.S. dollar abroad. He highlighted his bill from last year to set the standard for assets backing stablecoins and require issuers to publish audited reports of their reserves.

Impacts of Overregulation

Scott highlighted fintech as another example of innovation moving in the right direction and asked how to ensure that regulation does not stifle innovation. Yadav said that innovation is moving extremely fast to improve the efficiency of the payment system and added that the question is how to make innovation work for more people. Jeng said consumer and property rights need to be taken into account and that a regulatory framework needs to clearly state the responsibilities of crypto participants.

Sen. JD Vance (R-Ohio) said the regulatory approach should protect consumers, while also not destroying the dynamic upside. Reiners reiterated that crypto is not new and said it is clear that people are just buying it with the intention of selling it at a higher price later. He did add, however, that there is a way to regulate the risk associated with crypto while still allowing traditional financial services to experiment with blockchain. Jeng argued that it is extremely important to have open, interoperable standards to prevent monopolies of the future. Yadav said that because of the uptick in crypto activity in the last three years, tools such as disclosures are needed to encourage innovation safely.

Sen. Katie Britt (R-Ala.) asked what Congress should keep in mind while developing guardrails. Jeng said that consumer and investor protection is crucial. She also said that Congress should make it clear that when consumers purchase digital assets, they have a property right that will be respected in a bankruptcy proceeding. Britt asked if overregulation results in offshoring, and Jeng said that regulatory uncertainty causes market uncertainty, but the market will go to where there is regulatory clarity. Jeng warned that if there are other countries with clearer frameworks, companies will either go there or into the shadow banking sector.

Tillis noted his concern about overreach. Hagerty added that hearing regulators discuss segregating crypto from the financial sector reminds him of Operation Choke Point.

Crypto and the Banking Industry

Sen. Chris Van Hollen (D-Md.) asked Reiners to expand on his proposed framework that “clarifies the type of crypto asset activities banks can engage in and the prudential requirements, capital, and liquidity required to engage in such activity.” Reiners said that he recommends banks do a horizontal exercise to understand all of the different ways that they are exposed to crypto and release that information to the public. He reemphasized that if crypto had been more integrated in the banking system, the fallout of FTX would have been worse. Van Hollen then asked if banking regulators are doing everything they can under current law to prevent this. Reiners said that banking agencies should be more prescriptive about what specific crypto activities can and cannot be done.

Sen. Tina Smith (D-Minn.) noted her concern about the potential for highly volatile assets to get into the banking system. Reiners said that the crypto industry has been trying to integrate into the mainstream financial system. He noted examples including Fidelity, FTX, and Grayscale and said that more investors would have lost more money if there had been a Bitcoin spot ETF on the market.

Financial Inclusion

Britt also mentioned the role of cryptocurrency in financial inclusion. When responding to a separate question by Smith, Reiners noted that there is no evidence to suggest that crypto promotes financial inclusion. He added that there is overwhelming evidence to suggest exactly opposite. He said that most people who have invested in cryptocurrency have lost money, and a plurality of those people are minorities and low-income Americans. He argued that this is an example of predatory inclusion, similar to subprime loans prior to the financial crisis.

Anti-money Laundering and Counter-terrorism Financing

Sen. Elizabeth Warren (D-Mass.) asked why criminals use crypto instead of banks or credit unions. Reiners pointed out that the pseudonymity, coupled with the fact that crypto transactions are not subject to the anti-money laundering (AML) and countering the financing of terrorism statutes of traditional transactions, makes it ideally suited for them. Warren then asked if ransomware gangs would exist without crypto, and Reiners replied that they would not because it is their exclusive payment method of choice. Warren stated that AML rules do not cover big parts of the crypto industry, and argued that companies like it that way. She added that attempts to exempt “decentralized entities” are just an effort to create a loophole for defi to launder money. Finally, Warren said that she and Sen. Roger Marshall (R-Kans.) will be reintroducing an AML bill to clamp down on crypto crime and give regulators additional tools.

For more information on this hearing, please click here.

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