For questions on the note below, please contact Kevin Batteh or Edmund Perry at (202) 547-3035.
Today, the House Financial Services Committee Subcommittee on Digital Assets, Financial Technology, and Inclusion and the House Ag Committee Subcommittee on Commodity Markets, Digital Assets, and Rural Development held a joint hearing entitled, “The Future of Digital Assets: Measuring the Regulatory Gaps in the Digital Assets Markets.”
The witnesses in the hearing were:
- Andrew Durgee, Head of Republic Crypto, Republic
- Matthew Kulkin, Former Director of the Division of Swap Dealer and intermediary Oversight, Commodity Futures Trading Commission (CFTC)
- Marco Santori, Chief Legal Officer, Kraken Digital Asset Exchange
- Daniel Schoenburger, Chief Legal Officer, Web3 Foundation
- Timothy Massad, Former Chairman, CFTC
- Michael Blaugrund, Chief Operating Officer, New York Stock Exchange
Attached to the hearing notice was the following legislation:
H. Res._____, Resolution Expressing Support for Blockchain Technology and Digital Assets
Below is a summary of the hearing prepared by Delta Strategy Group. It includes several high-level takeaways from both panels, followed by summaries of opening statements and witness testimonies and a summary of the Q&A portion of the hearing.
Key Takeaways
The following is a summary of the main topics explored in today’s hearing. Each is discussed in further detail in the Discussion section below.
- HFSC Subcommittee Chairman French Hill (R-AR):
- This issue should not be partisan but claims by some that the cryptocurrency industry already has total regulatory clarity and that they are just refusing to comply are untrue. The Security and Exchange Commission’s (SEC’s) disclosure regime does not fit for the digital asset space.
- HFSC Subcommittee Ranking Member Stephen Lynch:
- There is perfect clarity from the SEC on these issues, but the industry remains willfully noncompliant. Enacting a new law to tailor regulations for this industry is unnecessary, supporting a noncompliant industry, and could lead other industries to try to be reclassified as digital assets to receive preferential treatment.
- House Ag Subcommittee Chairman Dusty Johnson (R-SD):
- These two Committees must work together to give the CFTC and SEC clear guidance on how they should be handling their respective jurisdiction.
- The U.S. is being passed by other G20 countries in terms of digital asset regulation, and this is leading to a flight of capital and innovation.
- House Ag Subcommittee Ranking Member Yadira Caraveo (D-CO):
- Any bill that would give additional authority to the CFTC must come with additional funding mechanisms to ensure that it has the resources it needs to regulate the space.
- HFSC Chairman Patrick McHenry (R-NC):
- There are no clear rules of the road for this industry, and the greatest impact of this is a lack of consumer protection.
- The current SEC disclosure rules do not work for digital assets, and the CFTC needs additional authority over non-security digital assets.
- This hearing is an important step towards issuing joint legislation between these two committees.
- House Ag Ranking Member David Scott (D-GA)
- I have real concerns over corporate controls and investor protection, as we saw with FTX, in the digital asset space. There are likely other companies with these failings.
SUMMARY
Opening Statements and Testimony
Financial Services Subcommittee Chairman French Hill (R-AR)
Some Members of these Committees have said that the current legal and regulatory framework for digital assets is enough, and crypto firms are just willfully avoiding compliance with the law while Republicans are working on a partisan effort to enable this behavior through legislation, but this is untrue. Democrats have been saying that they support creating legislation for this space for months, and Rep. Maxine Waters and Rep. Stephen Lynch have clearly stated in the past that we need to create legislation. If we fail to create a functional regulatory framework for digital assets, all we are doing is forcing this activity onto offshore exchanges. There is nothing partisan about this issue.
Financial Services Committee Ranking Member Stephen Lynch (D-MA)
The problem in this industry is not regulatory ambiguity but mass non-compliance with existing laws, and today we are discussing creating a new legal structure for digital assets that would likely undermine existing laws and regulations. Enacting a new law could be seen as a light-touch for the industry, and other industries will morph their products so that they can meet the definition of a digital asset and avoid more stringent regulation. The U.S. has a comprehensive securities framework, and it has sustained massive innovation for decades. The SEC structure provides vital investor protections, and we should not carve digital assets out of this framework. We should take a step back and examine the intermediaries that operate in this space.
Ag Subcommittee Chairman Dusty Johnson (R-SD)
Digital assets and blockchain represent a new way and freedom for individuals to make better business decisions, but current law and regulation provide few rules of the road for engaging with this technology. This lack of regulatory certainty does not serve investors or the marketplace. Conflicting statements and views from the SEC and CFTC create confusion and uncertainty for how market participants and intermediaries may engage in the space.
The correct solution to these issues is for our respective Committees, speaking with one voice, to appropriately direct the SEC and CFTC to each focus on what they do best. Market participants will benefit from the long-standing investor protections of securities and commodities markets, but they will also benefit from new ideas and opportunities that these technologies present. Most G20 countries are ahead of us, and we must move quickly to ensure that we can be a leader in global regulation of digital asset markets.
Ag Subcommittee Ranking Member Yadira Caraveo (D-CO)
This issue highlights the importance of cross-jurisdictional cooperation and collaboration. The Biden administration has supported this collaborative approach through Executive Orders for Federal agencies to work jointly on reports for a variety of issues in this space. While our regulators have been successful in their use of enforcement and regulatory authorities, there has been rampant and willful non-compliance by some of the largest market participants. Ultimately, providing regulatory clarity must also support a robust enforcement regime that prioritizes investor protection.
There have been concerns that the CFTC does not have the resources it needs to regulate these spot markets if given addition jurisdiction. Previous expansions of the CFTC’s authorities during Dodd-Frank were extremely successful, but we must include a new funding mechanism for the CFTC with any expansion of their authority.
Financial Services Committee Chairman Patrick McHenry (R-NC)
We must foster innovation while creating appropriate safeguards for investors. The CFTC and SEC must work together to create clarity and regulate this industry in a practical way. This hearing is an important step towards introducing joint legislation between these two Committees.
Financial Services Committee Ranking Member Maxine Waters (D-CA)
Rep. Patrick McHenry (R-NC) and I made solid progress on market structure legislation last Congress, but we did not quite get it right. We need to get these discussions back on track.
Andrew Durgee, Head of Republic Crypto, Republic
Digital assets registered as securities cannot be traded on existing crypto exchanges, none of which are registered as national securities exchanges, leaving a limited number of alternative trading system (ATS) platforms and over-the-counter (OTC) brokers as the primary means of trading. Furthermore, current regulations do not align with the decentralized and disintermediated trading technology of blockchains. Congress should instruct the SEC to adopt rules and procedures which allow intermediaries to act as brokers or exchanges with respect to digital assets which are securities and exempt parties dealing in non-securities from complying with such rules. Congress should consider whether non-securities platforms should be regulated by the CFTC. Such potential jurisdictional overlaps call out for Congress to weigh in, and the SEC must not overstep its bounds and create potentially conflicting regulatory regimes without Congressional direction.
It is an undeniable fact that the lack of registered digital asset offerings in the United States is a result of the SEC’s failure to provide actionable guidance, issue necessary rules, or engage constructively with the crypto industry to establish a feasible regulatory framework for security digital assets. The assertion that digital asset projects can easily register their digital assets with the SEC today is simply not accurate. In reality, much more is required if the SEC genuinely desires to provide adequate investor protection in the crypto asset arena.
Matthew Kulkin, former Director of the Division of Swap Dealer and Intermediary Oversight, CFTC
There is a natural delineation between digital asset securities and digital asset commodities, both in terms of the characteristics of these products and the regulatory jurisdiction over these assets. The CFTC and SEC have successfully allocated jurisdictional oversight over other products and markets before. Given these factors, Congress should create a similar approach for digital assets, laying out clear lines between digital asset commodities and securities.
Regulatory cooperation can be modeled off of the SEC and CFTC’s joint adoption of fundamental Dodd-Frank rules that established what products were swaps and security-based swaps, as well as what entities qualified as swap dealers and security-based swap dealers. These rules were jointly adopted by the SEC and CFTC in 2012, demonstrating a commitment to establishing baseline rules that both agencies, and market participants, could follow. I believe the same principles and approach that worked for OTC derivatives could apply to digital assets, and clear differentiation of what constitutes a digital asset security and a digital asset commodity would equally benefit market participants and provide greater clarity as to the regulatory requirements that will apply when engaged in digital asset market activity.
Marco Santori, Chief Legal Officer, Kraken Digital Asset Exchange
Other countries have moved ahead with creating fit-for-purpose regulatory structures that address the specific characteristics and risks of digital assets, but the U.S. seems focused on forcing digital assets into older frameworks that do not work for the industry. This has caused a string of litigation that does nothing to protect investors.
The CFTC has a successful track record of regulating the digital asset futures markets, which play an integral role in a healthy and functioning spot market. The Commodity Exchange Act (CEA) should be amended to empower the CFTC to regulate spot digital asset markets, beyond policing fraud and manipulation, and should also provide a workable registration framework for centralized digital asset markets.
The disclosure requirements and standards for traditional securities under the Securities Act of 1933 do not work well for digital assets. For example, “material” information related to a publicly traded company is very different from what is material for a decentralized, blockchain-based asset. The value of a digital asset – unlike the value of stocks and bonds – is often not dependent on the issuer’s operations or financial condition. Forcing digital assets into the existing corporate disclosure regime deprives consumers of the most valuable information while overwhelming them with the least valuable.
There is precedent for effective cooperation between these committees and between the SEC and CFTC to develop and implement tailored rules for market regulation. For example, the statutory and regulatory creation of Swap Execution Facilities (SEFs) considered the different market and liquidity dynamics, product structure, and trading protocols of the swaps markets and their trading venues relative to other securities and derivatives markets. This was possible because Congress provided a clear roadmap for inter-agency cooperation on swaps regulation through the Dodd-Frank Act.
Daniel Schoenburger, Chief Legal Officer, Web3 Foundation
Under the current U.S. regulatory approach, almost all tokens are viewed as financial assets. A token is either a payment instrument, a commodity, or a security. However, this certainly is not the case for all tokens, and all tokens should not be treated as such. Not all tokens will fit the defined classifications that exist, and there will be some tokens that may change from one classification to another over time. While tokens may change their characteristics over time, companies should not be permitted to change the way they are regulated without carrying out the necessary steps to ensure it is appropriate. Congress should establish a procedure through legislation to authorize regulators to reevaluate the status of tokens should their characteristics change over time.
Timothy Massad, Former Chairman, CFTC
To address regulatory gaps in crypto spot markets, Congress should create a baseline of investor protection by recognizing that many of the standards we need are the same regardless of whether a token falls in the securities or commodities bucket. Congress should mandate that any trading or lending platform that trades or uses bitcoin or ether must comply with a set of core principles for all tokens traded or used on that platform, unless the platform has already registered with the SEC or CFTC. The principles would include protection of customer assets, prevention of fraud and manipulation, prohibition of conflicts of interest, adequate disclosure to investors, regular reporting, pre and post trade transparency, risk management and governance standards, among others. Congress should direct the SEC and the CFTC to develop joint rules implementing these principles. Rules could also be developed by creating a new self-regulatory organization (SRO) jointly supervised by the SEC and the CFTC to enforce these rules. SROs have been critical to the regulation of our securities and derivatives markets for decades, and there is precedent for SROs registered with both the SEC and the CFTC.
In addition, I support legislation that would create a framework for stablecoin regulation based on principles followed primarily in our regulation of banks. As long as stablecoins are used as a payment mechanism, and do not pay interest or a return to their holders, I believe it is best to regulate them as payment instruments.
Michael Blaugrund, Chief Operating Officer, New York Stock Exchange
There must be a segregation of key functions within the financial market ecosystem for the digital asset space to remove conflicts of interest and increase transparency. If investors could trade crypto in an environment similar to the system for securities, many of the issues we have seen over the last year would not have occurred. Competition between commodity future and security exchanges is fierce, and there is a well-established process for launching a new registered exchange.
Congress should provide a tailored registration process for investment contract tokens; replace the temporary SEC provisions for special purpose broker dealers to custody digital assets with a more permanent solution; permit adjustment to applicable rules for national securities exchanges and clearing houses to accommodate digital assets that are not considered national market system securities; and evaluate the potential for dual registration or substituted compliance for the SEC and CFTC’s regimes.
Discussion
Hill (R-AR): How does the existing securities disclosure regime not appropriately fit for digital assets? If a token is sufficiently decentralized, how could an intermediary even get answers for many of their questions for the purposes of disclosure? Do you like SEC Commissioner Hester Peirce’s disclosure regime from her Safe Harbor proposal? Santori: Disclosure requirements would not provide the information that investors want to have before investing in a cryptocurrency. This applies to both the risks and benefits of any particular project. Commissioner Peirce’s approach to disclosures is thoughtful and well-tailored to the digital asset space; Kulkin: An intermediary can make disclosures on how they conduct their business. In a CFTC regime, an exchange would have to certify their product and show that it is not readily susceptible to fraud or manipulation and that it has strong financial integrity.
McHenry (R-NC): What does it mean that the EU and UK are ahead of us on regulatory clarity for the digital asset industry. What are the most important next steps for Congress? Schoenburger: Companies will choose to innovate in those jurisdictions instead of the U.S.; Kulkin: Congress should authorize the CFTC to have regulatory authority over digital asset commodity spot markets. This would immediately bring important customer protections to those markets; Santori: Congress should clarify CFTC oversight over digital asset commodity spot markets. There also needs to be a functional and clear standard for determining jurisdictional lines between the SEC and the CFTC.
Lynch (D-MA): Does the SEC have the resources and authority it needs in this space? Massad: The SEC certainly needs additional resources to address the issues in this space. My SRO proposal would help bring this industry under regulation with clear guidance for how the SEC and CFTC should regulate the space.
Johnson (R-SD): Why is decentralization so important to distinguishing when securities can become commodities in the digital asset space? What differentiates cryptocurrencies from other commodities such that the CFTC should have regulatory authority over just their spot markets? Kulkin: The Howie test looks at the moment of the sale of a security, but it does not necessarily consider the trading down the road. Tokens often look far more like a commodity down the road than they do at their issuance. If there are certified futures markets for a given token, that is a good indicator that the token has been commoditized. Many digital commodities have a strong retail component which differentiates them from other commodities. Other commodities also have years of spot market regulation, and digital assets do not.
Caraveo (D-CO): Does the CFTC need additional resources to regulate these markets? How can we ensure that the SEC and CFTC work cooperatively to further industry compliance? Massad: It is not possible for the CFTC to take on a large new area of jurisdiction without new resources. We did the best we could with the swaps markets, but there was more we could have done with additional resources. The SRO approach I have suggested would effectively require cooperation between the SEC and the CFTC.
Thompson (R-PA): Would a joint CFTC SEC SRO system be effective and efficient? What are your views on the NFA? Kulkin: I agree with the diagnosis that Mr. Massad has made, but creating a new SRO would take time and ultimately be an inefficient use of that time. We have an existing framework, and we simply need to extend the CFTC’s jurisdiction into these spot markets. NFA has five hundred employees, and they have built out significant registration and regulation programs. The NFA has already changed to accommodate Dodd-Frank rules in a similar way as we would be asking them to for this industry, and it proved to be an efficient system.
Waters (D-CA): Are crypto exchanges meaningfully different from traditional securities exchanges? Blaugrund: I believe crypto exchanges should be regulated in the same way as traditional exchanges.
Foster (D-IL): How can you have a well-regulated futures market for a product with a spot market rife with fraud and manipulation? Can you prevent wash trades in a regulated way without having every transaction be associated with a verifiable digital identity? Santori: We monitor our exchange for abuse or manipulation. I would be surprised if wash trades were happening regularly with most cryptocurrencies; Kulkin: If the CFTC had regulatory authority, it would have the ability to require exchanges to live up to the principles the CFTC uses for all other markets.
Casten (D-IL): Can you verify that statements made by exchanges about their protections are more accurate than what Sam Bankman-Fried said about FTX? Blaugrund: Statements made about having appropriate controls in place have no third-party verification.
Torres (D-NY): How should digital assets transition from securities regulation to commodities regulation when they become sufficiently decentralized? Kulkin: I think allowing this transition this would help investor protections. It is challenging to identify any singular point of sufficient decentralization. It depends on the facts and circumstances of individual tokens.
Nickel (D-NC): What is the current process to try to register with the SEC? Santori: It is unclear to industry participants and the SEC how this would even work. We tried to register, and these conversations stopped before we could. There is no realistic path to registration today.
Lucas (R-OK): As other jurisdictions create their own frameworks, how does it make it more difficult for the U.S. to write its own rules? How do you determine whether tokens are securities? Santori: G20 jurisdictions are moving ahead, and we are significantly behind. We do not need to go first, but I can say that companies are starting to invest in Europe, not the U.S.; Massad: There can be securities with futures contracts traded on them. We assess the business use case of tokens before we list them. It would be hugely helpful for the SEC to provide more clarity for this process.
Davidson (R-OH): How does your company comply with KYC and AML rules while allowing self-custody? Santori: These are compatible ideas. The important factor is simply who collects KYC information, which would be intermediaries like Kraken. We KYC any user on our platform.
Rose (R-TN): Should we allow the SEC to treat all tokens as securities? Kulkin: We need to be thoughtful on which tokens we consider to be commodities.
Steil (R-WI): How have other jurisdictions surpassed us in this space? Schoenburger: We have found that European regulators have created far more clarity; Durgee: MiCA is the first major framework that we have seen, but we are seeing many jurisdictions in Asia and the Middle East working toward this end as well. This is leading to significantly more investment in these jurisdictions.
Timmons (R-SC): Why is decentralization so important for digital assets? Schoenburger: Our vision is based on community consensus without centralized control. This is vital for living up to the promises of digital assets.
Timmons (R-SC): Under the current SEC framework, could an exchange list bitcoin and a digital asset security on the same platform? Santori: No, securities exchanges are limited in the assets they can list.
Salinas (D-OR): How can we make digital assets more climate-friendly? Should we penalize large energy users? Massad: Energy usage in the crypto space is a large cause of concern. This is not typically addressed through financial regulation, but it needs to be addressed.
Budzinski (D-IL): How can digital assets impact underserved communities? Massad: When crypto markets crashed, we saw many unsophisticated investors lose large sums of money quickly. This is why we need an investor protection regime; Kulkin: Many investors do not understand that current spot markets are not regulated; Durgee: Digital assets offer many investors their first ever opportunity to invest in start-ups.
Casar (D-TX): Why do you list unregistered securities? Santori: We do not list any securities on our exchange. My belief is that there is no workable framework for SEC registration at this time; Massad: I think it is clear that exchanges are listing unregistered securities. Currently every exchange is just making its own determinations on what is a security.
Molinaro (R-NY): Is the SEC actively working with industry to tailor a registration process for the different characteristics found in digital asset intermediaries? If an exchange was registered with the SEC and listed a commodity, how would it impact the CFTC’s enforcement authority? Santori: We did try to work with the SEC, but these conversations were abruptly cut off along the way. Nobody has been successful in that process so far; Kulkin: It is unclear because this has never happened before, but it would create confusion.
Nunn (R-IA): Is ether a commodity? Are you more compliant than foreign exchanges? Santori: Yes, it is a commodity. We make abundant reporting to law enforcement and regulators. We also KYC every single user.