FSOC on Crypto Assets | Dorsey & Whitney LLP

The Supervisory Board for Financial Stability published its Report on Digital Assets Financial Stability Risks and Regulation on 3 October 2022¹. The report was prepared in accordance with Section 6 of President Biden’s Executive Order 14067 on “Ensuring the Responsible Development of Digital Assets.” It discusses financial risks associated with the assets, regulatory enforcement, regulatory gaps and future steps.

Risks: A key point in the report is risk. It notes that crypto-asset activity may pose a risk to the stability of the US financial system. This could, for example, be due to rapid growth in the area if it is not linked to appropriate regulation and enforcement.

There has been rapid growth in crypto assets, according to the report. At the same time, there is a significant connection. Participants in the crypto ecosystem have been exploring avenues of connection. In addition, trading platforms offer significant potential to link assets with traditional assets and trading platforms. Consumers have also added activities in crypto assets according to the report. All of this can help to reduce the risk.

However, it is crypto asset activities that have added to the volatility. These include:

1. Lack of risk controls to protect against runs and excessive leverage
2. Prices that are driven by speculation and often suffer rapid falls
3. Many cryptoasset firms or activities have significant connections with others who have risky business profiles and opaque positions, and
4. Operational risk can arise from the concentration of key services or other vulnerabilities related to distributed ledger technology

The vulnerabilities can be attributed, at least in part, to the choices made by market participants, issuers and platforms.

Enforcement: While crypto began with an “off the grid” focus, many operating in the space are now more interested in regulation. In fact, enforcement is key. Not infrequently, crypto-assets are marketed and sold in violation of securities laws because they are offered and sold without the benefit of registration. In other cases, marketing may focus on assuring investors of safety through claims such as regulatory support that do not actually exist. Consumers may also be confused by which regulation actually governs crypto-assets.

Space: Another key point in the report is regulatory gaps. There is no doubt that while the existing regulation covers much of the crypto-claiming world, and at times there may be overlapping regulation, there are also gaps. Three examples illustrate the point:

1. Spot markets for non-securities cryptoassets are subject to little regulation, although agencies such as the CFTC may have jurisdiction in some cases.
2. Often, crypto asset companies do not have a consistent or comprehensive regulatory framework.
3. In some cases, crypto-asset trading platforms have proposed offering retail clients direct market access by vertically integrating services with intermediaries such as brokers or FCMs.

Recommendations

The report notes that large parts of the cryptoasset ecosystem are currently subject to regulation. The lawyer recommends that the members take this into account and emphasize the importance of continued enforcement of the existing regulatory scheme.

The holes must also be taken into account. These areas can be addressed, for example, by passing legislation that includes rulemaking authority for federal financial regulators over the spot market for non-securities assets. Steps can also be taken to address regulatory arbitrage, including coordination, legislation regarding certain risks and through supervision. The council also recommends strengthening the members’ capacity related to data, analysis, monitoring, supervision and regulation.See also Gary Gensler, Statement on Financial Stability Oversight Council’s Report on Digital Asset Financial Stability Oversight Council Open Meeting, October 3, 2022².

Discussion

The report provides a good overview of problems and risks related to crypto-assets. Perhaps the most interesting thing about the report is its overall approach – it almost assumes that future legislation will be a supplement to existing regulation. Under this approach, the SEC and CFTC will continue to dominate the regulatory sphere. The SEC will likely continue to take the approach that much of the area is governed by the securities laws, which would be consistent with Chairman Gensler’s assumption that many of the assets are securities.

This regulation will be supplemented by the CFTC since the tokens are commodities and many of the trading platforms used by the tokens are governed by the agency. Tokens have long been seen as commodities. CFTC v. McDonnell, Civil Action No. 18-cv-361 (EDNY Opinion Mar. 6, 2018). Trading of tokens is regulated by the agency since these places self-certify trading, unlike the securities markets. However, the CFTC closely monitors and controls trading. CFTC: Commodity Futures Trading Commission: Digital Primer (December 2020)³. Thus, regulation in the area will probably still be governed to a large extent by a combination of the securities laws and the goods statutes. These regulations will of course be supplemented by other regulators such as FinCEN regarding money laundering and others as needed.