Congressional Crypto Defenders accidentally triggered an SEC crackdown

Earlier this month, two top Republicans on the House Financial Services Committee wrote to Securities and Exchange Commission (SEC) Chairman Gary Gensler, accusing him of orchestrating the arrest of Sam Bankman-Fried, former CEO of collapsed crypto exchange FTX, right in front of the committee. was to hold a hearing on the company. If there is a smaller congressional letter than this, asking Gensler to explain why he arrested a criminal before Congress got in front of him, find it for me.

The letter from Reps. Patrick McHenry (R-NC), now chairman of the committee, and Bill Huizenga (R-MI), chairman of the Oversight Subcommittee, reflects a change in attitude for many House Republicans. In the immediate aftermath of FTX’s collapse, GOP members with an affinity for crypto (and a couple of Democrats) was fulminating that Gensler allowed the implosion to happen. Now they are clearly angry that Gensler is doing too hasty a job of enforcing the law.

But this backhanded move by crypto’s allies in Congress appears to have been a major tactical error. Blockchain Eight, which wrote to the SEC last year to get the agency to withdraw an investigation that included an investigation into FTX, flipped on a dime when FTX fell, arguing that Gensler and his team “failed to foresee this meltdown” , in the words of Rep. Jake Auchincloss (D-MA). That, and the real-world implications of the volatile FTX bankruptcy for investors, provided motivation for Gensler to move on to the next phase of enforcement against the crypto industry, which he has been doing with renewed vigor in recent months. If Blockchain Eight actually just wants to protect the public from crypto disasters, Gensler is obliging by rooting out the fraud from every nook and cranny of the industry.

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Key to this crackdown is Gensler’s repeated claim that most crypto firms offer unregistered securities to the public, in violation of federal law. Without registration, investors are not given information about the risk of owning the assets. Unregistered securities are also meant to be prohibited for so-called “unqualified” investors who do not have a certain net worth or annual income. Unregistered offerings are often seen as scams, and the SEC has long warned crypto firms that they will go after digital assets that are not registered.

An ongoing lawsuit with Ripple Labs over the crypto token XRP, which the SEC has deemed an unregistered security, will go a long way in determining whether the industry must comply with this registration requirement. (A judge last November appeared to side with the SEC on this point, in a case involving the blockchain platform LBRY.) But pressure in the wake of the FTX disaster for the SEC to stop crypto scams before they party, Gensler invited to move forward on this front.

– We started to get frustrated with it [Gensler’s] words were not matched with action,” said Lee Reiners, policy director at the Duke Financial Economics Center, who recently testified about crypto before the Senate Banking Committee. “But he gave the industry a chance to come in and come into compliance. The industry deliberately chose not to. This is the action part.”

In January, the SEC charged crypto-lending arm Genesis and crypto exchange Gemini Trust with selling unregistered securities, and it fined Nexo $45 million for its unregistered crypto-lending product. Gensler called the lack of registration compliance “part of the business model.”

Gensler has outmaneuvered the phalanx of crypto industry mouthpieces and supporters in Congress, using the generalized whining about an alleged lack of action before the FTX collapse to take swift action across the crypto space.

This month, the agency forced Kraken to shut down its crypto staking operation — where individuals can unlock crypto assets on a network and earn passive income — on the grounds that staking is an unregistered security. It also informed Paxos that it would soon be accused of minting Binance USD, for the same unregistered security reason. (Stablecoins are cryptoassets that are supposedly tied to the value of the dollar, and Binance USD is one of the biggest.) Paxos was later ordered to stop minting by New York regulators. The SEC’s action against Paxos in turn applies to the entire stablecoin market.

Beyond the unregistered securities push, the SEC last week sued Terraform and its CEO Do Kwon for defrauding the public with its “algorithmic” stablecoin, which was supposed to be automatically linked to the dollar through a complex set of linked assets. While the agency also highlighted that the Terra offerings were unregistered, this was more of a garden-variety scam. In another enforcement action, former NBA star Paul Pierce was fined $1.4 million for failing to disclose that he was paid to back Ethereum, a crypto asset. The settlement was seen as a warning to other celebrities who gave paid crypto endorsements.

The SEC also proposed a new rule this month that would force institutional investors such as pension or hedge funds to use qualified custodians to hold crypto assets, making it more expensive for them to do so.

This aggressiveness has spread to the rest of the government. In January, a group of banking regulators warned financial institutions against holding crypto assets, citing the risk of fraud. The banks have already started to withdraw from the industry. In addition, the Federal Reserve denied access to the payment system of a crypto bank called Custodia.

It should be said that this breach occurs without any new legislation from Congress. The SEC uses existing securities laws to restrict the industry and separate it from the rest of the financial system. Discretionary enforcement and regulatory guidance depends on the regulators, and does not have the duration or force of law. But a law from this set of legislators is unlikely to produce much value for the public. Provisions like the one proposed by Senator Elizabeth Warren (D-MA) to force crypto firms to adhere to stricter anti-money laundering laws would be welcome. But the more likely legislative outcome from a Congress full of cryptocurrency takers would be a definitive de-capture of the SEC’s efforts to enforce existing law.

While Reiners believes it is difficult to get an entire unwilling industry to comply with securities laws through litigation alone, and that there are regulatory loopholes in other offerings like bitcoin that are more like commodities, he acknowledged that the actions taken by the SEC and other regulators both protects investors and keeps the financial system stable. “Some consumers who have invested in these things will be hurt, and that’s bad,” he said. “But gambling is risky, and this is gambling.”

Gensler has outmaneuvered the phalanx of crypto industry mouthpieces and supporters in Congress, using the generalized whining about an alleged lack of action before the FTX collapse to take swift action across the crypto space. In fact, it was easier to do so after FTX, because industry insiders became more willing to give up information about fraud in their business.

Blockchain Eight wasn’t too serious about the SEC’s enforcement record, of course; they were looking for a way to pin FTX’s problems on an agency they wanted out of the picture for crypto. But this has now backfired spectacularly. “It certainly didn’t help their case,” Reiners said.

People are still going to speculate on crypto: Bitcoin prices rose briefly last week before falling. But there is a big difference between a speculative instrument or a vehicle for gambling not unlike a racetrack, and a financial asset that is connected and linked to the wider banking system. Gensler figured out how to push crypto into the first category, with some unlikely help from the industry’s biggest defenders.