Identifying the Regulatory Gaps in Digital Asset Market Structure – House Financial Services Committee
House Committee on Financial Services
Subcommittee on Digital Assets, Financial Technology and Inclusion
The Future of Digital Assets: Identifying the Regulatory Gaps in Digital Asset Market Structure
Thursday, April 27, 2023
Topline
- Subcommittee Chair Hill said the House Financial Services Committee and House Agriculture Committee will hold a joint hearing in May to discuss digital assets.
- Republicans called on Congress to pass digital asset legislation and cited the confusion stemming from competing enforcement actions issued by the SEC and CFTC.
- Democrats warned of the risks presented by digital assets and encrypted tokenization and called on digital asset firms to comply with existing securities laws.
Witnesses
- Marta Belcher, President and Chair, Filecoin Foundation
- Daniel Gorfine, Founder & CEO, Gattaca Horizons, LLC; Adjunct Professor of Law, Georgetown University; former Chief Innovation Officer, Commodity Futures Trading Commission (CFTC)
- Joshua Rivera, General Counsel, Blockchain Capital
- Zachary Zweihorn, Partner, Davis Polk
- Hillary Allen, Professor of Law, American University Washington College of Law
Opening Statements
Chairman French Hill (R-Ark.)
In his opening statement, Hill noted the subcommittee will hold a joint hearing next month with the House Agriculture Committee to explore these issues together. He added that digital assets legislation is needed because the Securities and Exchange Commission (SEC) and CFTC have created an impossible situation where the same firms are subject to competing enforcement actions. Hill said that without legislation, the regulators will push entrepreneurs and developers offshore. He also said regulation by enforcement does nothing to fill the consumer and investor protection gaps and that the problem is more complicated than non-compliance. Hill concluded that the SEC and CFTC need direction from Congress, adding the current disclosure regime does not produce relevant information.
Ranking Member Stephen Lynch (D-Mass.)
In his opening statement, Lynch discussed his concern that the hearing would feed into a narrative shaped by the digital assets industry, which turns to attacks on the regulatory structure and regulators.
He explained that digital asset companies claim their technology is incompatible with existing laws and regulations; although it is really their business models that are incompatible. Lynch noted the U.S. has a comprehensive and longstanding framework of securities laws and rules to protect investors, promote market integrity, and facilitate capital formation. He said he agreed with SEC Chair Gensler’s assertation that most crypto assets are securities and should be regulated as such, concluding that it seems unnecessary to reinvent the rules when we already have an effective regulatory regime.
Full Committee Chairman Patrick McHenry (R-N.C.)
In his opening statement, McHenry stressed that digital assets are here to stay, noting that if Congress does not act, the rest of the world will. McHenry said the U.S. market lacks clarity, adding that Congress has a duty to create a regulatory environment that allows responsible innovation and responsible consumer protection to sit side by side.
Full Committee Ranking Member Maxine Waters (D-Calif.)
In her opening statement, Waters said Congress does not need to create an entirely new and special framework for crypto and called on crypto firms, like other tech companies before them, to recognize that they are not exceptional and need to comply with the laws of the land. She added that Congress should focus on existing limitations instead of creating more complexity.
Testimony
Marta Belcher, President and Chair, Filecoin Foundation
In her testimony, Belcher emphasized that cryptocurrency is about more than finance, and discussed how crypto is creating an alternative to Big Tech by putting people in control of their own data. She explained that today’s internet is centralized, with the vast majority of data stored by three companies: Amazon, Microsoft, and Google, creating single points of failure. Belcher said cryptocurrency provides an alternative and creates the ability to program money. She noted regulating cryptocurrencies like financial services can undermine valuable use cases and called for any cryptocurrency regulation to protect users’ ability to transact directly with each other.
Daniel Gorfine, Founder & CEO, Gattaca Horizons, LLC; Adjunct Professor of Law, Georgetown University; former Chief Innovation Officer, Commodity Futures Trading Commission
In his testimony, Gorfine explained the CFTC’s jurisdiction related to digital assets was established in 2015 when the Commission determined that certain “virtual currencies,” such as Bitcoin, met the definition of “commodity” under the Commodity Exchange Act (CEA). He added the definition of commodity under the CEA is very broad and noted the CFTC has indicated that other cryptocurrencies beyond Bitcoin, including Ether and Litecoin, are commodities. Gorfine noted the CFTC’s determination that certain digital assets fall under the CEA’s commodity jurisdiction has subsequently been upheld by a number of federal courts. He acknowledged that under the CEA the CFTC’s jurisdiction over activity involving spot or cash trading in a commodity is relatively limited. Gorfine said the SEC’s jurisdiction is implicated when an asset is deemed to be a security, and noted the SEC has broadly asserted its enforcement authority and suggested that many cryptocurrencies are securities. He concluded by discussing the implications surrounding the lack of clarity in determining when an asset is a security.
Mr. Joshua Rivera, General Counsel, Blockchain Capital
In his testimony, Rivera said the digital asset industry wants to work with Congress and regulators to develop an appropriate market structure regulation. He noted the current financial system is overly reliant on centralized intermediaries, citing the U.S. consumer credit rating system and social media companies like Facebook as examples. Rivera discussed how blockchain technology creates alternative solutions to the services and infrastructure controlled by these intermediaries, classifying the fundamental innovation afforded by blockchain networks, to allow anyone, anywhere to participate in commerce or other systems of value, without an intermediary, as a novel and fundamental shift from the traditional way in which financial markets are organized and regulated.
Rivera explained there is a false perception that participants, investors and founders in the digital assets industry do not want to be regulated. He criticized previous rulemaking efforts for their lack of meaningful industry engagement. Rivera noted the share of venture capital funding for blockchain startups in the EU surpassed the allocation for U.S. firms for the first time in the first quarter of this year. He explained this is a devastating policy outcome, and one that the United States may not be able to recover from. Rivera pledged that industry stands ready to work with Congress on a balanced approach to ensure that the U.S. remains a leader in all vanguard fields of innovation, especially the blockchain industry.
Zachary Zweihorn, Partner, Davis Polk
In his testimony, Zweiborn said Congress needs to clarify how and where to draw the lines around when a digital asset is or is not a security. He explained the current securities market structure regulatory scheme does not work for digital assets, noting the existing securities market structure and its regulation were designed for traditional debt and equity securities. Zweiborn said that because digital assets are held, traded, custodied, and settled differently from traditional securities, applying the existing regulatory regime raises many legal issues of first impression. He explained that there are many ways in which compliance with existing secondary market regulations for trading in digital asset securities is challenging, or virtually impossible. Zweiborn also noted digital asset trading platforms have developed in a direct-to-user manner that typically involves a single service provider, which is very different from the more diffuse provider model in which traditional securities markets operate. He concluded by calling on Congress to establish a framework for a market structure for digital assets separate from the traditional securities market structure.
Hillary Allen, Professor of Law, American University Washington College of Law
In her testimony, Allen urged Congress to be wary of rolling back laws designed to protect the public from harm. She cited the example of the $50 billion of new securities which were floated in the United States in the 1920s, half of which proved to be worthless. Allen said the flotation of this mass of essentially fraudulent securities was made possible because of the complete abandonment by many underwriters and dealers in securities of those standards of fair, honest, and prudent dealing that should be basic to the encouragement of investment in any enterprise. She said Americans who invested using centralized crypto platforms like Celsius and FTX, and using DeFi platforms like Terra/Luna, could relate to this historical example of people using their life savings after investing in worthless assets supplied by unscrupulous dealers who did not provide any meaningful disclosure.
Allen said the emergence of blockchain technology has not meaningfully altered the economic incentives of the people using that technology to provide financial services, explaining that people still have incentives to centralize economic control, and once centralized, they have the same incentives that providers of financial services have always had to exploit and profit from that control. She noted there is nothing economically decentralized about the crypto markets, adding that the enforcement of existing law is not incompatible with blockchain technology. Allen said that while members of the crypto industry often claim that existing regulation is incompatible with their technology, existing regulation is just incompatible with the economics of their business model, especially if their business model depends on doing things that we have learned, over the years, tend to harm people. She concluded that laws make markets, and affirmed existing financial law and regulations are well-suited to dealing with many of the harms associated with crypto business models.
Question & Answer
Jurisdiction and Classification of Digital Assets
Hill asked if Gorfine agreed that there is a third bucket of digital assets that need oversight and clarity which don’t fall under the jurisdiction of the CFTC or SEC. Gorfine agreed, noting the term digital asset is incredibly broad. He said we would need more than three buckets, because you can tokenize any asset.
Rep. William Timmons (R-S.C.) asked Zweihorn what suggestions he would have if Congress were to create a test from scratch to classify digital assets. Zweihorn said the question was challenging because a lot of digital assets are dual purpose. He said a test would need a threshold for utility.
Rep. Brad Sherman (D-Calif.) asked if people in the cryptocurrency business are engaged in the financial services business or the agriculture business. Sherman said they are involved in the financial services business, but want the agriculture regulator to oversee them because they know the CFTC would provide less regulation than the SEC.
Blockchain Technologies
Rep. Ritchie Torres (D-N.Y.) asked how Congress can best tailor registration to accommodate blockchain technologies without compromising investor protection. Zweihorn said nobody believes blockchain should be unregulated and called for tailored regulations.
Timmons asked if there were any risks of getting in the way of blockchain innovation. Belcher said yes, and explained that blockchain is enabling businesses and small businesses to thrive. She added blockchain is revolutionizing the way small businesses work.
Timmons asked if blockchain technology could deliver on the digital asset industry’s promise of efficiency, decentralization, and financial inclusion. Belcher said yes and cited the example of cryptocurrency being sent to Ukraine.
Rep. Sean Casten (D-Ill.) said he agrees that there is enormous value in blockchain technology.
Securities & Exchange Commission
Rep. John Rose (R-Tenn.) noted that SEC Commissioner Peirce said there has been a reluctance on the part of the SEC to provide additional guidance about how to determine whether a token is being sold as part of a securities offering or which tokens are securities. He asked if additional guidance from the SEC on this issue would be helpful Rivera said yes, adding that the industry has been asking for this for a long time.
Torres asked how Congress can ensure the SEC is a merit neutral regulator and prevent the use of the registration process to punish or sabotage an industry that has fallen out of political favor. Zweihorn said the SEC is subject to securities laws, and suggested Congress could mandate the SEC adopt something functional and possible for the market to comply with.
Houchin asked about the effects of the SEC’s failure to provide guidance on classification. Zweihorn said the lack of guidance is challenging for members of the industry, because they are left wondering if and when they will face an enforcement action.
Rep. Wiley Nickel (R-N.C.) asked if Rivera was concerned that a decline in the number of U.S. traded venues could produce new risks for American consumers. Rivera said he did, and noted this was an unfortunate policy outcome from the SEC’s enforcement actions.
Commodity Futures Trading Commission
Rose asked if there is a path towards compliance at the CFTC, specifically for exchanges. Gorfine noted the CFTC oversees a number of exchanges that offer Bitcoin or Ether, adding there is a robust, well-regulated marketplace regulated by the CFTC where registrants have been able to come in and offer those types of products.
Rep. Byron Donalds (R-Fla.) asked if the CFTC is currently equipped to serve as a market regulator for digital assets. Gorfine said the CFTC has a very good understanding of commodities, markets, and underlying assets, but noted they currently lack the authority to regulate the spot market.
Donalds asked if the CFTC has the expertise and knowledge to be an adequate regulator. Gorfine said yes, but explained that they would need additional resources.
Custody
Rep. Warren Davidson (R-Ohio) asked how important custody is to the concept of market structure. Rivera said custody is extremely important, and that it’s important to understand the differences between traditional, ledger-based custody, and digital assets custody, which relies on a decentralized blockchain to identify who has what.
Davidson asked if more than one person could have custody of something at the same time. Rivera said no, but explained that someone can gain access to funds, the same way someone can steal funds in a bank.
Rep. Mike Flood (R-Nebr.) asked about the challenges associated with proposed rulemaking from the SEC regarding qualified custodians. Rivera said his firm has a very limited number of digital asset custodians and said the rulemaking would reduce that number to zero. He added that it seems like the intent of the rule is to make it extremely difficult to comply. Rivera said the rule could result in his firm being completely disenfranchised from investing in the ecosystem.
Illicit Finance & Risks
Rep. Stephen Lynch (D-Mass.) asked if there was a system for crypto where traditional financial rules did not apply, without any compliance requirements for disclosure or the comingling of funds, what the impact would be on the traditional financial system. Allen said this would be a massive regulatory loophole for all financial services, adding that all traditional finance would be put on the blockchain and taken advantage of.
Rep. Bill Foster (D-Ill.) said the majority of all Bitcoin transactions are fakes, and asked how there could be a well-regulated market for Bitcoin futures when the majority of transactions involving the underlying assets are fraudulent. Gorfine noted this is the existing gap in the underlying spot market.
Foster called for a regulator who sees the true identity of both participants and can identify wash trades.
Sherman cited Republican concerns about other countries getting ahead of us on digital assets. He said that Peru is ahead of us in cocaine cultivation, China is ahead of us in organ harvesting, and the Cayman Islands are ahead of us in financial crime – we don’t always need to catch up.
Casten said encrypted tokenization has tremendous value for people trying to break the law.
Casten asked if anyone within the crypto space is tracking enough information about buyers and sellers to be in compliance with KYC laws. Allen said no, noting avoiding anti-money laundering regulation is a feature, not a bug, of their business model.
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