Crypto companies need to stop poking regulators in the eye with a stick

The financial industry in the US is one of the most regulated industries in the world. There is a complex and overlapping mix of regulators at both the state and federal levels, and banks and other financial entities bear a significant burden to constantly stay up-to-date and in compliance with the rules. Not everyone follows the rule books.

Despite the many rules and regulatory guidance, some in the cryptocurrency industry decry a lack of regulatory clarity. Generally speaking, that sentence, albeit succinctly, does not accurately represent the situation. Far more often, the reality is that the answers are clear, but the guidance is not what they want to hear. Disliking the answer is not the same as lack of clarity.

When cryptocurrency industry participants receive a regulatory response that does not align with their goals, the response is often combative. Coinbase and Custodia Bank have taken that approach.

The main responsibilities of the various financial supervisory authorities may vary, but as a group they work to ensure the safety and stability of what is [SP1] the leading global financial services environment. Regulators see themselves as guardians of market participants, particularly consumers, and collectively react poorly to companies that seek to degrade the environment under their watch.

One such example of a provocative action is outlined in the 2022 Coinbase Global Annual Report. Coinbase offers “a reliable and user-friendly platform to access the broader crypto-economy,” so they barely mention that they are in conflict with a key US regulatory agency – the SEC.

Coinbase does not have the proper licenses and permits to list security products, and in its annual report there are several pages of discussion about the risks associated with the potential classification of crypto-assets as securities. In the course of these disclosures, they mention that in a July 2022 lawsuit, the Securities and Exchange Commission (SEC) determined that seven cryptoassets listed on their platform were unregistered securities (AMP, RLY, DDX, XYO, RGT, LCX, POWR).

Despite the clear and unequivocal position from the SEC (the agency that Coinbase admits is “the primary federal securities law regulator in the United States”), Coinbase has decided to disregard the SEC analysis and official position. Instead, Coinbase continues to trade these unregistered securities while it awaits a decision from a federal court.

In a completely different set of circumstances, the crypto bank Custodia filed a lawsuit against the Federal Reserve in 2022. A special purpose depository institution chartered by the state of Wyoming, Custodia sought membership in the Federal Reserve System and access to the Federal Reserve Payment System. The application, and the subsequent appeal, was formally refused.

The Custodia business plan had a number of new elements, and the Federal Reserve required significantly longer than usual to review the application. In the end, the application practically failed when the three major banking regulators issued a joint statement on the risks of cryptoassets to banking organizations. The Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC) listed a number of key risks and reasoned that “risks that cannot be mitigated or controlled” must be limited so that they “do not migrate into the banking system .”

Perhaps the most important part of the release, at least for Custodia Bank, was the statement that “the issuance or holding of crypto-assets that are issued, stored or transferred on an open, public and/or decentralized network or similar system is highly likely to be inconsistent with safe and sound banking practices.”

This effectively prohibits banks from holding cryptocurrencies on their balance sheet or issuing a stablecoin. This policy appeared to be a rejection of the Custodia Bank business model, and the Federal Reserve rejection noted that “the firm’s new business model and proposed focus on cryptoassets posed significant security and soundness risks.”

Mature financial services companies seek to cooperate with the regulatory agencies. It is far easier to change the system by working from the inside than by making noise on the outside. Those who choose to directly challenge regulatory authorities can secure the occasional victory, but at what cost? The benefits from digital assets will only be realized once they are accepted, and for that to happen, cryptocurrency market players must work within the system.

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