Highlights from the CFTC and SEC’s recent “Virtual Currencies” hearing, and my take

I do not come from a legal background; however, having operated a Bitcoin exchange (BitQuick.co) in the past that complied with various regulations, I consider myself to be somewhat familiar with regulatory issues surrounding cryptocurrency. This is in no way to be considered legal advice. Just my unprofessional opinion. I figure there may be interest to hear how someone who has been in the cryptocurrency space for several years, who is a cryptocurrency holder, and a long time believer in the space interprets the hearing.

The testimony by Clayton can be read here: https://www.banking.senate.gov/public/_cache/files/a5e72ac6-4f8a-473f-9c9c-e2894573d57d/BF62433A09A9B95A269A29E1FF13D2BA.clayton-testimony-2-6-18.pdf

The actual hearing can be found here: https://www.banking.senate.gov/public/index.cfm/2018/2/virtual-currencies-the-oversight-role-of-the-u-s-securities-and-exchange-commission-and-the-u-s-commodity-futures-trading-commission

The TL;DR: The SEC is concerned about ICOs abusing form over substance to circumvent securities laws. SEC is concerned about cryptocurrency exchanges. They view crypto to crypto as an MSB activity, which we already knew. They are also concerned about idiots buying into crap ICOs, which we also already saw coming. These all sound like expected developments, and the SEC was largely aware of and open to the advantages and innovation offered by blockchain/cryptocurrency developments. Short term, increased SEC enforcement may result in reduced liquidity, and negative impact on prices. Long term, these developments were largely expected, and are in fact very positive developments for the blockchain/cryptocurrency space.

Diving a bit deeper into Clayton’s testimony:

Clayton’s testimony begins by restating the purpose of the SEC and CFTC surrounding the protection of market participants. Their goal is to establish a “regulatory environment for investors and market participants that fosters innovation, market integrity and ultimately confidence.” They also briefly describe the recent rise of the cryptocurrency and ICO markets, that have attracted new investors. Clayton also establishes the tone of the hearing is not negative:

“ To be clear, I am very optimistic that developments in financial technology will help facilitate capital formation, providing promising investment opportunities for institutional and Main Street investors alike. From a financial regulatory perspective, these developments may enable us to better monitor transactions, holdings and obligations (including credit exposures) and other activities and characteristics of our markets, thereby facilitating our regulatory mission, including, importantly, investor protection.” — Jay Clayton, Chairman SEC

Clayton then continues to address main-street investors in regards to ICOs. He establishes that 0 ICO’s have registered with the SEC to date. Security risks are also acknowledged, highlighting the recent $500M XEM hack on a Japanese exchange, and the fact that ~10% of ICO proceeds have been lost in similar attacks. They also provide several investor bulletins and messages that the SEC has already given to investors, with the purpose of educating retail investors.

The next section dives into issues surrounding the usage of cryptocurrencies to facilitate the trade of ICOs. In my opinion, they seem to be discussing exchanges like Poloniex, Bittrex, Binance and other familiar cryptocurrency exchanges. None were named specifically however. They do seem to take issue with the word exchange: “Many trading platforms are even referred to as ‘exchanges’”. The fact that most of these exchanges are regulated as MSBs is mentioned.

“ the currently applicable regulatory framework for cryptocurrency trading was not designed with trading of the type we are witnessing in mind. [..] we are open to exploring with Congress, as well as with our federal and state colleagues, whether increased federal regulation of cryptocurrency trading platforms is necessary or appropriate. We also are supportive of regulatory and policy efforts to bring clarity and fairness to this space.” — Jay Clayton, Chairman SEC

The above quote perhaps is the most concerning part of the hearing, and likely the most relevant piece of information for traders. This seems to imply that there will be focus put onto the exchanges. Enforcement actions could lead to de-listings, which leads to reduced liquidity, and ultimately negatively impacts prices. However, a positive development is they do seem to be well-aware of the fact that the current MSB framework is insufficient for crypto-exchanges. I would hope retroactive enforcement would be minimal.

Also interesting to speculators may be the statement regarding ETFs and other financial products. It seems it will still be awhile until we see cryptocurrency backed ETFs. Concerns were cited surrounding liquidity, valuation and custody of holdings.

The statement continues to discuss recent ICO’s again, and re-establishes that the SEC is weary about the trend of ICO’s clinging to arguments surrounding “form over substance”. Essentially, if an ICO is marketed in a way that makes it seem like it is a security (promising returns), then it likely is a security. They specifically call this trend disturbing.

Finally, a section on enforcement discusses recent enforcement actions that have taken place, and establish that they will continue to take such actions. Interestingly, they discuss concern around recent public companies throwing around blockchain developments or distributed ledger tech. I imagine a reference to things like the Kodak ICO and maybe even Overstock to an extent, among others:

I also have been increasingly concerned with recent instances of public companies, with no meaningful track record in pursuing distributed ledger or blockchain technology, changing their business models and names to reflect a focus on distributed ledger technology without adequate disclosure to investors about their business model changes and the risks involved. A number of these instances raise serious investor protection concerns about the adequacy of disclosure especially where an offer and sale of securities is involved. The SEC is looking closely at the disclosures of public companies that shift their business models to capitalize on the perceived promise of distributed ledger technology and whether the disclosures comply with the federal securities laws, particularly in the context of a securities offering. — Jay Clayton, Chairman SEC

Summary on the hearing itself:

The hearing seemed to very much mimic the general sentiment from the testimony prepared by Clayton. Both Clayton and Giancarlo presented themselves as knowledgeable individuals and seem to have a solid grasp of cryptocurrencies, ICO’s and distributed ledger technologies. In fact, Giancarlo even mentioned anecdotally that his daughter has become interested in investing due to the new cryptocurrency craze, and that the commission owes it to this generation to encourage innovation in this new industry. This seemed to set the tone for the remainder of the hearing as being non-hostile.

Clayton distinguished early on in the hearing that he sees three categories:

1. Distributed Ledger Technologies — Have the potential to introduce inefficiencies in the market and increase oversight
2. Cryptocurrencies — They aim to replace traditional currencies
3. ICO’s — akin to a stock offering, should be treated as stocks.

Clayton also made an interesting comment that people using “exchanges” should be well aware of the fact that they are not in fact using “exchanges”, and that these are trading platforms. There was discussion surrounding the fact that the SEC does not have jurisdiction over these trading platforms since they are not registered with the SEC. The issue of jurisdiction was brought up frequently, in regards to ICO’s and cryptocurrencies, which were largely treated as separate issues. It seems regulating cryptocurrencies will be a comprehensive multi-agency effort, while ICO regulation will fall directly under SEC jurisdiction.

Other hightlights include:

• Giancarlo responded to a question about the intrinsic value of cryptocurrencies stating that economists have acknowledged that the resources put into cryptocurrency mining are arguably a price floor
• Sennator Sherrod Brown questioned if the SEC even has the resources to pursue the cryptocurrency space when they are still busy trying to regulate the traditional markets. Clayton acknowledged that there is a hiring freeze, and that he does need more bodies.
• Clayton stated at one point that he has yet to see an ICO that was not a security. He did not elaborate on this point however, or clearly define what constitutes an ICO.
• SEC does not have jurisdiction to regulate spot prices of commodities (e.g. the trading of cryptocurrencies themselves) but they can regulate derivatives, such as the futures instrument currently trading
• Senator Warren pressed Clayton about a new law preventing companies who conduct IPOs from being sued by investors.. which seemed to be completely off topic. To be fair, she did later ask a question regarding ICO’s and allowed Clayton to give re-emphasize that the SEC is watching the space closely.
• Mr. Kennedy made an interesting philosophical point about the point of regulation. He asked Giancarlo if he read the disclosures the last time he invested in something.. and Giancarlo admitted he hadn’t, which prompted Mr. Kennedy to question how far the SEC should go to protect people from themselves
• Mr. Warner made a comment that when he invested into the cell phone industry in the 1980’s it made him rich, and he believes we might be witnessing an industry with similar disruptive potential. He also asked about retroactive enforcement, a question on many of our minds, but was unfortunately not heard it seemed.
• Unrelated to cryptocurrencies, Clayton did state that in regards to yesterdays stock market drop, he has no reason to believe it was due to fraud/manipulation/increased systemic risk at this point.
• *Giancarlo mentioned HODL.. as “hold on for dear life”. While I’m fairly certain the hodl meme evolved from a typo.. this was hilarious and awesome

Conclusion:

Overall, there was a wide array of topics discussed during the hearing, and the committee members seemed to be asking the right questions generally. No overtly hostile attitudes were shown. Clayton and Giancarlo stood out in my eyes as exceptionally knowledgeable. My takeaway from the hearing is that the government has their head in the right place. I agree that our industry requires appropriate regulation. I do not agree with those that believe we need zero regulation, and certainly do not agree with those who believe we need to ban this industry. Like most things, the optimal outcome lies in the middle.

So in my opinion, nearly everything I read was expected. Perhaps Bittrex, Polo and other US based exchanges will be required to be more up-tight regarding listings and continued KYC/AML efforts. And perhaps offshore exchanges will be encouraged to do the same, or disallow US customers (think Binance, Kucoin, etc). However, I am somewhat unsure how this will play out, as the hearing did seem to give the notion that these exchanges were outside of SEC jurisdiction.

I imagine the impact is reduced liquidity in the short term for many ICO projects, which might result in a short-term bear market. I hope we will also see examples made out of bad actors by continued enforcement actions. Similar to 2013. This has happened before in some sense as well; regulatory guidance was given to exchanges by FinCEN (see here), and it became harder to buy/sell BTC and other altcoins. We will see garbage projects wither away, like always.

I think most people in the space for the long term didn’t expect this “party” and exuberance to last long. Nevertheless, the hearing gave confirmation that the technology is real, innovative, and that of course there are still problems that need to be solved. No biggie. Go out and solve them!

P.S. See something totally off base? Do you come from a law