Regulatory Clarity? Financial Watchdogs Could Not Be More Clear
Gareth Rhodes, a managing director at Pacific Street, formerly served as deputy superintendent and special counsel at the New York State Department of Financial Services.
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In settling a lawsuit in January with the U.S. Securities and Exchange Commission (SEC), the co-founder of crypto platform Nexo stated that he is “confident that a clearer regulatory landscape will emerge soon, and companies like Nexo will be able to offer value-creating products in the United States in a compliant manner.”
Nexo’s desire for “regulatory clarity” is far from unique: Over the past year, the executives of Binance, Coinbase and Circle have issued similar statements and “regulatory clarity” has been the buzz phrase at crypto panel discussions and happy hours.
Gareth Rhodesa managing director at Pacific Streetformerly served as deputy superintendent and special counsel at the New York State Department of Financial Services. This article is part of CoinDesk’s Policy Week.
Implicit in these statements is the assumption that “regulatory clarity” is currently absent, and a suggestion that resolving this is critical for the future of the industry. However, the recent flurry of regulatory actions – including the U.S. Department of Justice’s (DOJ) case against former FTX CEO Sam Bankman-Fried, SEC lawsuits against crypto lender Genesis and the Gemini crypto exchange, the U.S. Treasury Department’s sanctions against mixer Tornado Cash and state-level actions against Celsius Network – indicate that those in charge of enforcing the laws believe the current regulatory framework is sufficient for their purposes.
What is meant by regulatory clarity? The U.S. Congress has the power to draft and pass laws that direct government agencies such as the SEC and DOJ to issue rules, supervise entities and conduct enforcement. With the assistance of court decisions and the rulemaking process, as well as agency guidance and precedent from enforcement actions, a picture comes into view of how those charged with enforcing the law and regulating the industry may act.
Such examples include whether the Commodity Futures Trading Commission (CFTC) may approve an application, or whether facts uncovered in an investigation may lead a prosecutor to pursue criminal charges. Nexo’s and the other calls for “regulatory clarity,” in its most basic form, translates to a desire for more transparency into how regulatory and law enforcement agencies will act in regards to crypto-related products and services.
Without weighing in on the underlying merits of the recent enforcement actions and other regulatory decisions (there are compendiums of persuasive writings on the extent to which crypto should be evaluated under the existing regulatory structure, which is a topic beyond the scope of this column), there is ample evidence that in the eyes of those who approve applications and enforce the law, there is little need for further regulatory clarity. It exists right now.
What does this mean and what are the implications of this for 2023 and beyond? A few possibilities:
1. Regulators have shown they are comfortable applying existing laws to crypto, and crypto entities will likely have to adjust strategy
When asked in November about applying existing laws to crypto, SEC Chair Gary Gensler stated “[i]t’s just straightforward … [t]he rules are on the books already.”
It may seem strange that laws written pre-bitcoin are applied to crypto. However, this is standard practice across industries. Despite repeated calls from lawmakers of both parties, consumer advocates and the companies themselvesCongress has failed for decades to pass any large-scale, substantive legislation focusing on Big Tech and regulators rely on laws enacted before the internet even existed.
Likewise, the SEC regulates modern-day securities offerings based on a law passed in 1933 and the U.S. Supreme Court’s 1946 Howey ruling. Allegations of mail fraudenacted in 1872 to combat counterfeit money, have been used repeatedly by prosecutors against a wide range of crimes, from prosecuting Charles Ponzi in 1920 to the recent college admissions scandal.
In short, regulators and prosecutors are practiced in applying Gilded Age-era laws to 2023 technologies, and their recent moves make it clear that they intend to follow the same practice in relation to crypto.
Of course there are strong arguments for why a bespoke set of rules is preferred for crypto (as well as Big Tech, social media and other industries). But rather than wait for new legislation that is unlikely to come based on the current political landscape, many crypto entities now face a decision whether to figure out how to comply based on the government’s interpretation of existing rules, or proceed knowing the risks of noncompliance.
2. Any additional “clarity” will most likely to come from the courts
To the extent additional “clarity” may come in 2023, the most likely source will not be Congress or a regulatory agency but the courts. In SEC v. Ripple Labsa federal court may soon issue a more definitive ruling on the application of securities laws to crypto tokens. A similar question may be addressed in SEC v. wherefocusing on alleged insider trading by a former Coinbase employee. CFTC v. Eisenberg is expected to raise questions regarding how market manipulation rules apply to decentralized exchanges.
Then there’s the lawsuit filed by crypto lobbying group Coin Center against Treasury Secretary Janet Yellenfollowing the criminalization of Tornado Cash, which may give a court the opportunity to review the application of various illicit finance laws to decentralized protocols running on open-source software. And while there are other key issues in the several cases versus Sam Bankman-Fried, a federal court may examine at what point sloppy risk management and poorly designed collateralized lending practices become criminal violations.
Each of these cases has the potential to solidify the government’s current approach to crypto, or provide new legal frameworks that may be preferred by industry participants.
3. Expect more offshore, less US-focused crypto activity
Recognizing that regulators intend to apply existing laws to crypto (often based on interpretations with which industry participants understandably disagree) it is likely that new and existing crypto entities will restrict services offered in the United States, finding the cost and complexity of compliance may outweigh the market benefit of serving American customers.
A recent statement issued by federal banking regulators expressing their view that crypto-related banking activities are “highly likely to be inconsistent with safe and sound banking practices” will also create more challenges for crypto entities seeking to serve U.S. users.
Driving crypto activity to offshore exchanges can carry its own consequences. Remember that the recently imploded FTX was such an offshore exchange, based in the Bahamas and restricted to non-U.S. users.
Absent tighter supervision abroad, the industry may proliferate in jurisdictions with little to no regulatory infrastructure. Such an outcome would also reflect practical realities: Crypto’s adoption abroad is driven in part by real-use cases that have less application in the U.S., including serving as a financial alternative where authoritarian regimes can seize bank accounts, providing off-ramps from economies with runaway inflation and wherever foreign-exchange restrictions limit access to the U.S. dollar.
4. Incumbents that choose to build in the US
The upside for entities that successfully run the U.S. regulatory gauntlet is they will likely capture substantial market share and have a seal of compliance to attract investors and customers. In the unlikely scenario Congress does enact substantive crypto-focused legislation, this is likely to further entrench these incumbents because additional rules and complexity can serve as an effective barrier to entry for new, smaller competitors.
Unfortunately, even safeguards created by the existing regulatory framework do not insulate consumers from noncrypto financial risks (just ask this Iowa farmer who lost $900,000 investing in Texas medical facilities). Some policymakers may decide the legitimizing effects of a new crypto law outweigh the benefits that come from strengthened regulatory supervision, and opt to wait until the industry is more developed.
Clarity, or changes?
Nexo may wish for a “clearer regulatory landscape” but the regulators have made clear exactly how they view Nexo’s products and services. It appears what Nexo is seeking is not regulatory clarity but regulatory changes.
Indeed, in the press release announcing it has settled with the SEC, Nexo – after comparing itself to Uber and Airbnb – stated that because “innovators do not quite fit into existing provisions, constructive dialogue for the enhancement of the prevailing regulatory frameworks is of paramount importance.”
Constructive dialogue and improving laws and regulation are certainly worthy objectives. However, regulatory and law enforcement agencies have made clear with words and actions that they believe crypto innovators do indeed “fit into existing provisions,” with Nexo serving as a prime example of how the government will continue to interpret and enforce laws in regards to crypto.
The regulatory “enhancements” or changes sought by Nexo and others are unlikely to occur absent new court decisions or legislation. Until then, it is up to crypto entities to decide whether they want to operate in the U.S. under the current framework, with the possibility of long-term benefits for those who take the plunge. (Nexo decided it did notpaid a $45 million fine and closed its U.S. business).
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