States, Countries Focus on Fraud Prevention and Customer Protection in Crypto – All Things FinReg

New York has improved its fraud prevention tools, while consumers can identify crypto scams using California’s fraud tracker. A week after the US Securities and Exchange Commission (SEC) proposed changes to cover crypto assets under the depository rule applicable to investment advisers, federal banking agencies issued a statement reminding banks of their risk management obligations related to holding crypto company deposits. The UK is considering fund tokenisation, particularly as it relates to retail investors, and the Hong Kong Securities and Futures Commission is preparing for a licensing regime for crypto exchange platforms as it considers whether retail investors should trade on licensed crypto platforms.

AMERICA

New York improves detection of crypto fraud

On February 21, New York State Department of Financial Services (DFS) Superintendent Adrienne Harris announced DFS’s new insider trading and market manipulation risk monitoring tool. The tools are intended to enhance DFS’s ability to detect fraud and other illegal activity among New York State regulated entities engaged in virtual currency activities. Entities subject to DFS oversight may want to “kick the tires” on their own surveillance and monitoring tools in light of DFS’s new toolset.

California Crypto Scam Tracker

The California Department of Financial Protection and Innovation (DFPI) recently announced its crypto fraud tracker, which provides information about the companies that are subject to consumer complaints. The tracker includes descriptions of losses incurred in transactions that complainants have alleged are part of a fraudulent or deceptive operation.

Although the tracker does not verify whether actual losses have occurred, the goal is to provide the public with timely information about potential fraud. Consumers can submit complaints online or by post. Complaints must identify the person or business involved and include a description of the problem with amounts, dates of any transactions, witness contact information, if any, and other relevant information that may assist DFPI in resolving the complaint, along with other necessary information.

At the time we reviewed the tracker, it listed 36 complaints. Because the tracker is based on unverified consumer complaints regarding losses, legitimate crypto businesses may want to ensure they are not subject to fraud complaints.

Federal banking agencies issue joint statement to crypto custodians

On the heels of the SEC’s proposal to change the custody rule, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency issued a statement on February 23 highlighting liquidity risks they believe banking organizations face when accepting deposits or other financing from or related to crypto-asset-related entities. The federal banking agencies were careful to state that the statement does not create new risk management principles, but instead highlights liquidity risks that banking organizations should be aware of, including crypto company deposits for the benefit of customers and deposits that are the reserves of stablecoins, which “may be susceptible to large and fast” inflows and outflows.

In light of these risks, the agencies recommend that banking organizations follow effective risk management and controls (some of which may reflect existing regulatory requirements or supervisory expectations), including the following:

• Understand the direct and indirect drivers of the potential behavior of deposits from crypto-asset-related entities and the extent to which these deposits are subject to unpredictable volatility.
• Assess potential concentration or correlation across deposits from crypto-asset-related entities and associated liquidity risk.
• Incorporate liquidity risk or funding volatility associated with crypto-asset-related deposits into contingency funding planning, including liquidity stress testing and, as appropriate, other asset-liability management and risk management processes.
• Conduct robust due diligence and ongoing monitoring of crypto-asset-related entities that establish deposit accounts, including assessing the representations made by those crypto-asset-related entities to their end customers about such deposit accounts that, if inaccurate, could lead to rapid outflows of such deposits.

The federal banking agencies also took the opportunity to remind banking organizations that certain deposits from crypto-asset-related entities may be brokered deposits and as such may require specific reporting by an insured depository institution on its call report.

We see the statement as yet another reminder from the federal banking agencies (assuming one was needed after their previous joint statement regarding risks to cryptoassets and other actions, such as the FDIC advisory letter and proposed rulemaking regarding misrepresentation of FDIC deposit insurance and cryptoasset entities and the Federal Reserve’s denial (and more recent denial of reconsideration) of Custodia’s Federal Reserve membership application) that the agencies will continue to focus on the risks they perceive cryptoassets pose to banks, their affiliates, and the banking system more generally, and that they expect banking organizations to have a similar focus.

GREAT BRITAIN

UK Financial Conduct Authority issues discussion paper on improving UK asset management regime

The UK Financial Conduct Authority (FCA) published a discussion paper (DP23/2) on 20 February outlining its high-level thinking on updating and improving the UK asset management regime. Among other things, it discusses fund tokenization, which the FCA understands to mean “the ability to issue a fund’s participation rights (shares or shares) to investors as digital tokens, usually by means of a distributed ledger.” In relation to fund tokenisation, the FCA seeks to understand the following issues:

• What benefits will tokenized units in authorized funds bring to investors?
• What regulatory changes will be required to enable the issuance of tokenized units?
• How much of a priority should we prioritize enabling device tokenization?

In addition, the FCA is also seeking comments on tokenized portfolio assets. The FCA expressed that “fund tokenisation may be of interest as part of a wider program where existing assets can be held in the underlying portfolio of the fund and traded in a secondary market in tokenised form, with fully digitized clearing and settlement.” To this end, the FCA asks:

• Are there specific rules that may affect companies’ ability to invest in tokenized assets, where the underlying instrument is itself an eligible asset?
• How much of a priority should we prioritize enabling investments in tokenized assets?

Finally, the FCA stated that the government is considering whether there are grounds to bring the activity of portfolio management of crypto assets (ie unregulated tokens, such as stablecoins and other forms of cryptocurrency) into the regulatory perimeter.

The FCA will consider feedback and publish a response later in 2023, possibly as part of a consultation note on some of the discussion topics. Depending on the responses, the FCA will consider whether there are aspects of the rules that need to be changed. Comments are requested by 22 May 2023.

ASIA

Hong Kong is asking whether retail investors should be allowed to trade on virtual asset trading platforms

On February 20, the Hong Kong Securities and Futures Commission (SFC) issued a consultation request on the proposed requirements for virtual asset operators. The consultation request is driven by a new licensing regime that will come into force on 1 June 2023. The regime will impose an SFC licensing requirement on all centralized trading platforms for virtual assets located in Hong Kong, or those that actively market to Hong Kong investors, subject to certain grandfathering provisions .

The SFC has stated that the proposed licensing requirements are based on existing requirements comparable to those governing licensed securities brokers and automated trading venues. In the consultation, the SFC asks whether licensed platform operators should be able to serve retail investors and whether additional measures should be implemented if retail investors are allowed to be within the scope. Comments must be sent by 31 March 2023.