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HFSC Crypto Hearing

House Financial Services Subcommittee on Oversight and Investigations

America on “FIRE”: Will the Crypto Frenzy Lead to Financial Independence and Early Retirement or Financial Ruin?

Wednesday, June 30, 2021

Witnesses

Opening Statements
Chairman Al Green (D-Texas)
In his opening statement, Green compared the “crypto frenzy” to former fiscal calamities: the 2008 mortgage crisis, the Allen Stanford Ponzi scheme, and the Bernie Madoff Ponzi scheme. He said in each of these cases, investors and financial institutions suffered losses and then received bailouts from the Federal Treasury, but noted a recurring theme and mindset by these individuals to “keep the government out of my life, until I lose money.” Green questioned if there will inevitably need to be a bailout for digital asset investors if their investments fail, or if certain cryptocurrencies will become so large and systemically impactful on the economy to require an amount or form of reserves to backstop digital securities. Green said the witnesses and members will discuss the need for greater federal oversight and rating agencies to evaluate the risks, assess systemic risks to the economy, and the risk of loss to investors with recent extreme volatility in unbacked crypto assets.

Ranking Member Tom Emmer (R-Minn.)
In his opening statement, Emmer said financial technology and cryptocurrencies are the future of the global financial system. He said noted that fintechs offer all consumers around the world the ability to access services at low costs and low barriers to entry. Emmer called cryptocurrency an innovative asset that has been sparking high demand from consumers because it allows transaction across borders in real time in a transparent and verifiable manner. He said blockchain and cryptocurrency unlock an incredible access to opportunity for people to study the underlying code and launch their own businesses. Emmer said there are many innovators who want to develop and launch their new blockchain ideas but refrain due to regulatory uncertainty and the fear of being classified as money transmitters. As a result, he said we lose many innovators to foreign markets where the regulatory compliance is more streamlined. Emmer concluded that the Securities and Exchange Commission (SEC) needs to streamline a process to determine and classify crypto assets as either securities, currencies, or commodities in order to prevent more high tech jobs moving overseas.

Testimony
Ms. Alexis Goldstein, Director of Financial Policy, Open Markets Institute
In her testimony, Goldstein stressed the danger of the lack of derivatives reporting to the SEC through Form 13F, highlighted by the meltdown of the family fund Archegos Capital. She highlighted a Federal Reserve financial stability report that noted the risk of the lack of transparency in hedge funds and other leveraged financial entities, and said that as these funds move into the cryptocurrency market, extreme volatility of cryptocurrencies could spread to other financial sectors. Goldstein stated that although the explosion of Archegos did not cause a massive financial meltdown, it will become more likely as hedge funds increase their positions in the cryptocurrency market. She urged lawmakers to examine the footprints of private funds in the cryptocurrency market. Goldstein also pointed out the extreme concentration of cryptocurrency assets where the top 20 largest Dogecoin addresses held half of the supply. Goldstein said that the lack of regulations and oversight in the cryptocurrency market is dangerous for consumers who have been scammed (i.e., buying a coin that is designed only to be bought and not sold). Goldstein said that the risk is especially high in decentralized finance (DeFi) spaces where users are anonymous and often suffer losses from hacks and exploits. She also emphasized that due to the lack of oversight in these DeFi platforms, new tokens can be offered to consumers without being vetted by a government agency. Goldstein pointed out that cryptocurrency exchanges are now moving into consumer financial products, such as credit cards, so lawmakers should examine if there are any concerns with these products. Goldstein concluded by suggesting lawmakers look for any regulatory gaps in the cryptocurrency market to ensure both consumer and investor protection, and exchange compliance with current regulations.

Ms. Sarah Hammer, Managing Director, Stevens Center for Innovation in Finance at the Wharton School of the University of Pennsylvania
In her testimony, Hammer defined blockchain technology as a shared, immutable ledger that facilitates the recording of transactions in a network. She said that the goal of blockchain is to eliminate the need for a central monetary authority to monitor, verify, and approve transactions by enabling a peer-to-peer network. Hammer said that the lack of an official U.S. public data source for cryptocurrency prices, market size, or volatility is a concern. Hammer stressed that there are potential benefits for blockchain and cryptocurrency, but lawmakers should also be vigilant as it can pose significant systemic risks to the financial system. Hammer warned about the lack of investor protection and cited a study showing more than 81 percent of initial coin offerings (ICOs) were scams and eleven percent failed due to operational issues. Hammer said that although the SEC was able to apply securities regulations to dozens of ICOs, it lacks the ability to regulate a number of cryptocurrencies that do not comply with SEC registration and disclosure obligations. She suggested lawmakers should establish a clear, sufficient, and appropriate regulatory framework for cryptocurrencies. Hammer said that the cryptocurrency market is estimated to exceed $2 trillion and could cause systemic risks in the financial market if left unregulated. She added that since cryptocurrency companies are granted national trust charters and nationally chartered banks are permitted to provide banking services to these businesses, any risks in the cryptocurrency market can spillover throughout the financial system. Hammer listed a few recommendations for cryptocurrency regulation: 1) the regulatory framework should be appropriate to the business model or activity; 2) there are concerns that regulation can stifle innovation, the cryptocurrency market is too big to be regulated, and that regulation can push criminal activity out of the U.S. making it harder to monitor; 3) regulatory objectives need to balance investor protection, consumer protection, financial inclusion, safety and soundness, and financial stability. Hammer also recommended lawmakers leverage the authority of the Financial Stability Oversight Council (FSOC) to coordinate federal interagency efforts, consult with state regulators, and consult with international standard setting bodies.

Ms. Christine Parker, Partner, Reed Smith LLP
In her testimony, Parker said that it is important for lawmakers to first determine whether a specific cryptocurrency is a commodity, a security, neither or both. Parker then explained the importance of creating a unitary regulatory agency for cryptocurrencies or else there will be significant uncertainty for market participants. Parker warned if Congress does not provide guidance, federal regulators will take it as a message that they should not certify, approve, or support digital asset-related products in any meaningful way, creating more uncertainty in the cryptocurrency market and resulting in harm to investors and consumers. She added that it is crucial to place the cryptocurrency market in the U.S. under an appropriate regulatory regime. Parker said that due to the lack of regulation in the U.S., investors turn to the foreign markets to access cryptocurrencies. Parker added that since neither the Commodity Futures Trading Commission (CFTC) nor the SEC have authority to impose rules such as registration, reporting, and recordkeeping, it creates significant barriers for them to observe and understand the cryptocurrency markets in real time. To address regulatory concerns in the cryptocurrency market, Parker suggested that: 1) new regulators need to be created to regulate this new market; 2) regulators must feel empowered to deploy the tools they currently have to allow market participants to offer both commercially attractive and reasonably regulated crypto products in the U.S.; and 3) minimize the overlapping state and federal regulatory regimes. Parker concluded by saying that she sees two areas of growth for the cryptocurrency market – gaming environments and the decentralized finance space.

Ms. Eva Su, Analyst in Financial Economics, Congressional Research Service
In her testimony, Su said that there is a lot of overlap in the regulatory regime with multiple federal agencies and state governments involved. She stressed the importance for regulatory oversight to balance financial innovation, market integrity, and investor protection. Su pointed out many areas in the cryptocurrency market that raise policy issues: 1) digital asset “exchanges” that lack transparency and are more susceptible to manipulation and fraud; 2) digital asset custody that faces difficulties in recoding ownership, recovering lost assets, and providing audits, among other considerations; 3) digital asset exchange-traded funds (ETFs) that are not sold on SEC-regulated national exchanges and are prone to market manipulation and fraud; 4) stablecoins in securities markets with little or no disclosure of reserve asset breakdowns to expose potential deceptive activities; and 5) ICOs which can raise regulatory oversight and investor protection concerns. Su said that the SEC has not been active in promulgating new digital-asset-specific rules because how the use of digital assets will evolve remains uncertain. Su stressed that although the SEC has worked to try to regulate the cryptocurrency market, there is still more to be done for proper regulation. Su said that digital asset exchanges often exaggerate their volume to attract more participation, so investors have no idea whether the trading volume and prices reflect real activities or market manipulation. Su urged Congress to provide more clarity regarding authority over cryptocurrency exchanges as suggested by SEC Chair Gary Gensler. In the realm of stablecoins, Su said the lack of reserve disclosures by Tether caused investor protection concerns. Su also recommended that Congress clearly define securities so ICOs can be classified as such and be subject to SEC regulations.

Mr. Peter Van Valkenburgh, Director of Research, Coin Center
In his testimony, Van Valkenburgh said that cryptocurrencies have in fact been regulated over the past decade. He said part of the regulation comes from the technology itself: the scarcity of the coins is preserved by a peer-to-peer accounting technology – a public blockchain. Van Valkenburgh also said that digital asset exchanges are registered money transmitters, chartered trusts, or banks that must meet minimum capital requirements in yearly examinations. Van Valkenburgh pointed out that cryptocurrencies are enforced by the Consumer Financial Protection Bureau (CFPB), the Federal Trade Commission (FTC), the SEC, the CFTC, and state attorneys general and the fact that in 2020 only 0.34 percent of all cryptocurrency transaction volume involved a criminal sender or recipient is proof that the current regulations work. Van Valkenburgh emphasized that there is no need for additional regulation, but rather the existing laws need to be applied sensibly. Van Valkenburgh concluded that despite the fact cryptocurrencies can foster illicit activity, they also allow people across the world to trade freely without needing access to local financial intermediaries.

Question & Answer
Potential Risks
Rep. Maxine Waters (D-Calif.) asked if there are systemic risks associated with hedge funds investing heavily in cryptocurrencies. Goldstein said she is very concerned about the presence of hedge funds in cryptocurrencies, pointing to the Archegos meltdown as a risk example that negatively affects taxpayers. She argued that if hedge funds get deeper into crypto, they do not care about their direction and “will go long, short, or use leverage,” and when combined with massive volatility in the market, it could lead to margin calls in their non-crypto assets and forced liquidation.

Rep. Alma Adams (D-N.C.) asked what the most concerning risks are facing investors in the crypto marketplace and how they can be most effectively mitigated. Su said from an investor protection perspective there are three groups of primary risk. First, she said market volatility is front and center but can be handled through disclosures and investor restrictions. Su said a second general risk relating to fraud can be handled through rulemaking, enforcement, and reporting. The third risk Su mentioned was around safekeeping functions, such as lost passwords, and said custodian services may remedy this.

Rep. Nikema Williams (D-Ga.) asked how regulators can best communicate risks associated with investing in digital assets. Hammer’s suggestion was to coordinate federal agencies with FSOC and create the data and resources to evaluate the market, noting without public data regulators and legislators are in the dark.

Current Regulation
Waters asked about the current oversight in crypto markets. Hammer said she has concerns about crypto trading by private funds since there is no official public source for data in the crypto markets. She said this harkens back to credit default swaps in which a market was traded almost exclusively over-the-counter (OTC) and highly unregulated, but noted once it became regulated and central clearing counterparties were instituted, risks were more easily identifiable.

Waters asked if there are any current reporting requirements hedge funds must comply with that would provide more transparency regarding which hedge funds are most heavily invested in cryptocurrencies. Goldstein said not to her knowledge because cryptocurrency is not currently reported on SEC Form 13F.

Rep. William Timmons (R-S.C.) asked Hammer to describe the current regulatory state of cryptocurrency in the U.S. Hammer said crypto and crypto companies receive different types of regulatory treatment throughout our system. She explained that it can be regulated as a commodity by the CFTC or as a security by the SEC, and in some cases is considered income by the IRS and taxed as such. Hammer said her key issue is the need for regulatory clarity and urged the FSOC to lead this mandate.

Emmer asked if it is regulated when people make bets on the future price of cryptocurrency or trade with leverage. Van Valkenburgh said yes, that these are commodities derivatives and the CFTC has jurisdiction over that kind of trade and these markets. Emmer asked if companies can sell and transmit cryptocurrency without identifying their customers. Van Valkenburgh said every U.S. exchange is heavily regulated, so it does not avoid Know Your Customer (KYC) as some members had suggested. Emmer asked if statements from persons and groups regarding prices of crypto like Dogecoin are regulated. Van Valkenburgh explained that Dogecoin does not qualify as a security, but as a commodity the CFTC has the jurisdiction to investigate and prosecute manipulation. Van Valkenburgh mentioned Chair Gensler’s statement that a gap exists within spot markets, which have higher volume and retail participation, and argued that it may be appropriate to extend market supervision to these entities.

Additional Regulation
Green asked for comments on his concern about managing a possible failure within the crypto markets. Hammer said it is important to be proactive rather than wait for an emergency response. She said there is an opportunity through the FSOC and Dodd-Frank Section 120 to create a proactive policy framework for cryptocurrency that consists of gathering data, coordinating agencies, and consulting with international standards setting bodies.

Williams asked if there are legislative considerations Congress should keep in mind as investments expand in these assets. Hammer said crypto has infiltrated many aspects of the financial system and believes FSOC is the proper authority to consider systemic risk. She said a specific legislative mandate should wait to be determined after substantive study by FSOC and public data sources are established.

Adams asked if the current regulation of U.S. crypto markets is sufficient to protect against potential risks. Parker said Bitcoin and Ethereum are the two tokens that have a clear regulatory framework, and at the cash level, the CFTC has generally not been active in that space mostly due to the function of commodity markets. Parker recommended drawing digital assets spot commodities and pulling them into the CFTC’s market oversight framework.

Rep. Warren Davidson (R-Ohio) asked how regulated commercial products, like Bitcoin ETF, would provide additional consumer protection elements to the cryptocurrency system. Parker said we need U.S. regulated exchanges, securities exchanges, futures exchanges, lists, and regulated products that have some form of margin and leverage available to retail investors in order to provide an alternative to the foreign exchanges most people are currently seeking.

Rep. Chuy Garcia (D-Ill.) asked what regulators can do to keep crypto from threatening the financial system. Goldstein said the U.S. regulators are behind in issuing consumer warnings, citing examples of Canada pursuing enforcement actions, as well as Japan and Germany both having warned risks with the Binance exchange. She added that it will be important to ensure private funds are disclosing their cryptocurrency positions.

Blockchain for Cybersecurity
Rep. Barry Loudermilk (R-Ga.) asked how blockchain technology can be used to enhance cybersecurity. Hammer said blockchain has many applications and explained it is a decentralized technology, meaning it has no single point of failure, so it can be used to create security profiles for user data. She further explained that blockchain incorporates public key (used to authenticate parties) and private key security, which can be combined for end-to-end security encryption of data.

Central Bank Digital Currency (CBDC)
Loudermilk asked if there are concerns with a potential CBDC. Hammer said it is important to consider that a CBDC could take many different forms whether powered by blockchain or not. She added that there are concerns relating to privacy and whether it actually achieves the objective of having a CBDC, rather than a decentralized system like cryptocurrency or blockchain. She explained that a centralized system concentrates our private information and could be a target for hackers.

Competition with China
Rep. David Kustoff (R-Tenn.) asked if there are concerns with the U.S. moving slowly to establish a CBDC if China were to accelerate. Hammer said the most important point to keep in mind is how blockchain technology and a CBDC can strengthen and modernize our financial system, and that we should take advantage of the available technologies. She added that regulatory clarity will be necessary in order for businesses to innovate.

Rep. Brad Sherman (D-Calif.) said China is close to banning cryptocurrency to protect their citizens and tax collection system, warning that if we fail to keep up with China we will fall behind.

Inflation
Kustoff asked Van Valkenburgh to expand on the idea that bitcoin could balance a portfolio against the threat of inflation. Van Valkenburgh said that diversity can create greater financial stability, and as part of a diversified portfolio, one might be interested in bitcoin to balance against the risk of inflation. He added that with the right investor education in place, he supports average retail investors engaging in cryptocurrencies.

Carbon Footprint
Rep. Rashida Tlaib (D-Mich.) asked how to better measure the energy consumption of crypto to account for its carbon footprint. Van Valkenburgh said for energy usage, the traditional financial sector uses five times more energy than bitcoin, and noted that bitcoin energy usage does not scale per transaction because the majority of costs are fixed with just setting up a system. Sherman commented on this point and stated the traditional financial system moves hundreds more in volume, arguing it is not a fair comparison.

Tlaib asked if cryptocurrency is incompatible with a carbon-neutral future. Goldstein said it depends on both the currency and system used for validation, noting that proof of work validation is the most carbon intensive and believes it is very unlikely bitcoin will move away from that validation method.

For more information on this hearing, please click here.