Summary
Congress should put retail investors before crypto programmers. New GOP proposals do the opposite -- and there is no way to salvage the draft bill from its flawed premise.
New draft legislation introduced by Republicans on the House Financial Services Committee represents a move in the wrong direction on regulating digital assets. If the ideas in the discussion draft were enacted, they could reinforce the problems that plague crypto trading rather than curb them.
Three issues come to mind immediately. The draft does little to challenge poor existing standards for crypto disclosures. It enables too many digital asset issuers to avoid the full scrutiny of the Securities and Exchange Commission (SEC). And it invites other financial sectors to integrate distributed ledgers to evade traditional supervision.
Getting it right in all three of these areas is only possible if policymakers begin with the right goal. They should put a priority on protecting investors. This draft package instead centers industry interests – and thus misses the mark by so wide a margin that lawmakers should start over rather than attempt to fix this unsalvageable package.
Retail investors need better information to help them evaluate an investment
Investors need the government to compel digital asset issuers to explain the value of their products. Trustworthy information of this kind could transform the information asymmetries between issuers and buyers of digital assets.
The Republican draft measure does the opposite, creating a generous loophole that would allow digital asset issuers to skirt some of the existing disclosure rules for publicly-offered investment contracts. Under a newly-created Section 4(a)(8), the loophole would let issuers out of core transparency requirements for any general solicitation of less than $75 million. Currently, businesses who use a crowdfunding platform as an intermediary to raise less than $5 million have lighter SEC reporting obligations. Those in-place rules satisfy investor needs for information without over-burdening small firms. But this draft doesn’t aim for balance. Instead, it greenlights crypto projects to raise capital from a poorly-informed public.
Exempting sellers of an investment product from telling customers basic things like “here’s how what you’re buying might change after you buy it” and “here’s a legally binding promise made to the SEC about what exactly you are buying” would be a dramatic departure from historical norms. Even exemptions for crowdfunded capital raises, which can only be for less than $5 million, have higher reporting requirements.
The exemption will probably ensure that white papers remain the primary source of information for most digital asset offerings. While these white papers make sense to sophisticated programmers, most retail investors will be incapable of understanding them. To read a crypto white paper (such as those for Uniswap and Bitcoin) is to understand what happens when a writing assignment is given to a computer programmer. Outside of individuals with sophisticated training in programming, few people will grasp the meaning of terms like “quorum slices,” “byzantine fault tolerances,” and “price oracle.”
By contrast, the S-1 registration statements prepared by securities issuers have mandatory sections that answer questions an investor needs to evaluate a business. They plainly state what products or services the business will offer, who will manage it, what regulatory matters have a bearing on its governance, the competition it faces, and other risks. S-1 forms have a uniform structure with terms like “discussion and analysis,” “use of proceeds,” and “risk factors.”
Getting rules in place to require meaningful explanations of digital assets matters because it will prevent people from being harmed. While crypto programmers will say that their tokens are not designed for speculation and also that they are not suitable for regulation, too many Main Street investors see them as a get-rich-quick opportunity. Indeed, programmers should acknowledge that the status quo permits bad actors to stage predatory coin offerings. “Rug pull” crypto scams are digital versions of old-fashioned pump-and-dump trickery, and such scams flourish when markets don’t have clear information. Regardless of what crypto’s advocates say, regulators must intervene. The contrast between S-1s and crypto white papers underscores how the SEC’s registration rules serve retail investors in ways that voluntarily submitted white papers do not.
Getting it wrong in this key area is a fatal flaw in the GOP draft and should be enough to disqualify the measure from consideration. But the mistakes don’t stop there.
The crypto industry should not get to pick its regulator
For some time, the more regulatory-friendly voices in the crypto community have said they would like Congress to create a new regulator dedicated solely to crypto or to place it under the watch of the Commodities and Futures Trading Commission (CFTC). But the crypto community may prefer the CFTC to the SEC simply because it wants a weaker enemy: The SEC has six times the staff and five times the funding of the CFTC.
The discussion draft gives primary authority to the CFTC and establishes procedural challenges that will undermine the SEC’s ability to protect investors. Alleged mega-fraudster Sam Bankman-Fried and other crypto industry leaders spent millions lobbying Congress to empower the CFTC. Observers have speculated that the crypto community prefers the CFTC because the SEC, with six times more staff and five times more funding, has more resources.
The discussion draft outlines a pathway for regulatory relief for digital assets when their organizers plan to take a “road to decentralization.” Decentralized systems have no people at the helm, and thus cannot be subject to traditional enforcement tools such as fines or imprisonment. That is why it is important to ensure rules are followed at the start, when a project is first introduced to the public.
However, crypto projects begin because of human initiative, even if their managers have plans to relinquish control by moving them to a decentralized model. Yet the draft says that unless the SEC can prove otherwise, projects claiming to become decentralized can shed regulatory scrutiny. That is a mistake. Crypto project authors should be required to explain their tokens comprehensibly to retail investors. US investors deserve explanations. Instead, the draft permits digital asset developers of to-be decentralized projects to raise funds and build their projects through a newly created registration exemption.
Policymakers must see through the technical language and recognize the draft for what it is: long-lasting regulatory relief for the crypto industry. The GOP draft would let crypto project organizers apply for an exemption and receive regulatory relief for three years. A project would then have a runway to become decentralized, subject to CFTC authority, and with a barrier between itself and the reach of the SEC.
The SEC will have to work very hard to protect investors if this draft becomes law. True, the draft does outline how the SEC can rebut a claim. But the draft deliberately undermines the SEC’s ability to rebut a claim of decentralization. It gives the agency just 30 days to review the application, take comments from the public and build a case that can survive judicial review. How many can the SEC review in 30 days?
The tug-of-war between the CFTC and the SEC seen in this draft is one moment in a larger battle between two agencies with strongly differing views about what should be done to fix these markets. The agencies have different ways to apply the famed Howey Test to determine when a digital asset is a security. Howey says an investment contract concerns the investment of money in a common enterprise with the expectation of profit to be derived from the work of others. Under the 1933 Securities Act, an investment contract is a security and, with certain exceptions, subject to the authority of the SEC.
On that standing, the SEC has staked its claim that the Howey Test gives it authority over most digital assets. In a speech last year, SEC Chairman Gary Gensler held that “of the nearly 10,000 tokens in the crypto market, I believe the vast majority are securities.” On the other hand, CFTC Commissioner Hester Pierce believes fully decentralized assets, including Bitcoin and Ethereum, are examples of commodities to be regulated by the CFTC.
There is a great deal riding on which of the two views Congress endorses. A determination of how digital assets fit with Howey answers the first-order question upon which all subsequent policy decisions will be based. It is safe to say that if a digital asset is defined as a security, it will be under more regulatory scrutiny.
The discussion draft invites traditional financial institutions to duck existing regulations
The draft’s definition of a digital asset opens up new regulatory gaps. It defines a digital asset as any “fungible digital representation of value” that can be possessed and transferred without an intermediary and whose ownership is “recorded on a cryptographically-secured public distributed ledger.”
But many types of contractual agreements can be executed via distributed ledger systems. Some of the core elements of financial services can run on distributed ledgers.
Some startups already apply the technology to perform established financial services. For example, Figure Technologies has created the Provenance blockchain to enable mortgage companies to bundle home equity lines of credit (HELOCs) and platform loans into securities. Currently, Figure provides audited filings for its securitizations to the SEC, but another securitizer of HELOCs could integrate distributed ledger technology to escape SEC’s purview under the proposed regulatory playing field.
The draft would open a yawning regulatory gap in the broader market. A traditional financial institution might choose a lighter regulatory regime by shifting how it records contracts to a distributed ledger.
Align crypto governance with needs of retail investors
Both parties in Congress want to address problems with crypto regulation. That’s a good thing. But it also creates a classic policymaking risk: Bipartisan urgency can often be exploited by lobbyists and cynics to lock in bad ideas favored by industry insiders, exacerbating problems in the guise of solving them. We know the Wild West nature of crypto must change, but if the opportunity presented by bipartisan interest is missed, Congress could lock in a dangerous new world.
The crypto industry has shown that it cannot police itself. It has become dangerous not just to invest in crypto but even in a company that trades crypto. Exchanges have ignored bedrock principles for sound governance, such as prohibitions against co-mingling of company and consumer assets, and put the interests of exchange owners ahead of their customers. Already, three major crypto trading platforms have filed for bankruptcy in the last 18 months. It would be surprising if they were the last ones.
Instead of following the industry’s preferences, Congress should align crypto governance with the decision-making framework of retail investors. Crypto assets are incredibly complicated, but only some investors have the mathematical understanding necessary to evaluate their worth, leading to an opaque market. We should not be surprised to read reports that most crypto investors have lost money. Too many small-dollar investors, tempted by stories of fast riches, have lost money on crypto. Some have fallen victim to scams. Rather than facilitate a way to fast-track the interests of industry, Congress must act to protect investors.
Adam Rust is a Senior Policy Advisor at NRC.
Photo by Maxim Hopman on Unsplash
