SEC Commissioner Peirce Calls on SEC to Embrace Innovation and Allow Cryptocurrency Risk-Taking

SEC Commissioner Hester M. Peirce urged the SEC to embrace FinTech innovation and permit more risk-taking by investors in cryptocurrencies.

In remarks before the Cato Institute’s FinTech Unbound Conference, Ms. Peirce elaborated on her dissent from the SEC’s rejection of an exchange-traded product (“ETP”) that was designed to give investors exposure to bitcoin. Ms. Peirce explained her disagreement with the SEC’s decision to deny an exchange’s bid to list shares of the Winklevoss Bitcoin Trust (see previous coverage), asserting that “it seemed to turn on the Commission’s assessment of bitcoin rather than on the exchange’s plans for trading the [ETP].” She went on to state:

“The focus on the lack of regulation of cryptocurrencies particularly troubled me. What authority do we have to require that assets underlying securities be regulated as if they were securities? Even if we had this authority, private markets can and do regulate themselves.”

Ms. Peirce urged the SEC to:

  • avoid the temptation to replace the market’s product testing with the agency’s own and allow investors to determine the value of these innovations for themselves;
  • create a space for innovation to occur in SEC-regulated markets or accept that investors will seek out innovations in less regulated markets;
  • establish an environment in which investors can openly communicate with the SEC and its staff; and
  • reaffirm the agency’s commitment to expanding investor access, including through innovative technologies.

Lofchie Comment: Ms. Peirce’s speech is witty and thoughtful.

SEC Chair Summarizes Recent Efforts to Promote Capital Formation

In a speech at the Nashville 36|86 Entrepreneurship Festival, SEC Chair Jay Clayton outlined recent agency efforts to encourage capital formation for public companies and companies that are considering going public.

Mr. Clayton highlighted three specific categories of SEC actions: (i) a scaled disclosure framework for smaller companies (including adjusting the thresholds for companies deemed to be “smaller reporting companies” and eligible to provide more limited “scaled disclosures”), (ii) disclosure modernization and simplification (i.e., revising GAAP and S-K disclosure requirements to minimize duplication) and (iii) staff guidance to facilitate the initial public offering (“IPO”) process.

Mr. Clayton suggested that the SEC undertake a review of the current framework for exempt offerings. In particular, he stated that the SEC should:

  • examine the “complexity” of the current exemption framework for issuers and investors, and decide on changes to streamline it;
  • consider whether rules regarding who can invest in certain offerings should be expanded to focus on criteria such as the sophistication of the investor and the specific amount of the investment; and
  • permit issuers to transition more readily from one exemption to another, or to a public offering.

Mr. Clayton also discussed the SEC’s approach to distributed ledger technology, digital assets and initial coin offerings. He asserted that efforts in those particular areas reflect the two abiding principles of the SEC: (i) embrace new technologies that reduce costs while also offering new investment opportunities and (ii) require that retail investors have access to necessary information to make sound investment decisions.

SEC Rejects Another Nine Proposed Bitcoin ETFs

The SEC Division of Trading and Markets rejected applications for nine exchange-traded funds (“ETFs”) tied to bitcoin futures markets from three separate companies – ProShares, Direxion, and GraniteShares – on the grounds that they lacked adequate means of preventing “fraudulent and manipulative acts and practices.” In each case, the rejections were subsequently stayed pending review by the SEC Commissioners.

The SEC affirmed its position that bitcoin futures markets necessitate stringent market manipulation and fraud prevention procedures since they are reliant upon a single exchange to determine the value of the bitcoin ETF. According to the SEC, the companies stated in their applications that they would use the Chicago Board Options Exchange (“CBOE”) and Chicago Mercantile Exchange (“CME”) futures market to establish the value of their ETFs. However, the SEC determined that the CBOE and CME bitcoin futures markets are not “markets of significant size.” Furthermore, the SEC did not agree that the companies’ existing surveillance procedures and capacity to share surveillance information with U.S. futures exchanges were sufficient to prevent market manipulation and fraud.

FinCEN Director Examines Virtual Currency Regulatory Obligations

Financial Crimes Enforcement Network (“FinCEN”) Director Kenneth A. Blanco outlined agency efforts to protect financial institutions from fraud relating to new uses of financial technology, and described “how FinCEN is approaching virtual currency.”

Mr. Blanco emphasized FinCEN’s jurisdiction over virtual currency stating: “individuals and entities engaged in the business of accepting and transmitting physical currency or convertible virtual currency from one person to another or to another location are money transmitters subject to the AML/CFT requirements of the BSA and its implementing regulations.”

In remarks delivered at the 2018 Chicago-Kent Block Tech Conference, Mr. Blanco argued that innovation in financial services is a double-edged sword: it provides customers with greater access to various services but it can create opportunities for criminals. Mr. Blanco declared that FinCEN is focused on (i) expanding its understanding in the rapidly developing technological landscape, (ii) identifying risks, (iii) closing gaps and (iv) fostering smart innovation. FinCEN is also working to establish information-sharing programs such as FinCEN Exchange, related cyber defense programs and increased suspicious activity reports (“SARs”) to help the financial services sector protect itself from threats.

Mr. Blanco recounted FinCEN’s efforts as to virtual currency and initial coin offerings, including a listing of each of the major FinCEN administrative rulings as to the treatment of such products. In particular, Mr. Blanco stated that FinCEN expects businesses involved in initial coin offerings to meet all of their obligations in regard to anti-money laundering (“AML”) and combating the financing of terrorism. Mr. Blanco noted that financial institutions have been more active in the past couple of years as demonstrated by the increase in filings of virtual currency SARs.

Lofchie Comment: Not that one more cautionary warning was needed, but here is another cautionary warning that all firms involved with virtual currency or initial coin offerings must be extremely diligent in their procedures as improper activities may result in violations of not only securities and commodities laws, but also in those regarding money laundering.

SEC Rejects Proposal to List Bitcoin-Based ETP on Regulated Exchange

By a three-to-one vote, the SEC rejected a second application by the Bats BZX Exchange (“BZX”) (now owned by Cboe Global Markets) to list a bitcoin-backed exchange-traded product (“ETP”). The proposal, which was previously rejected by the SEC Division of Trading and Markets, would have permitted the listing and trading of shares of the “Winklevoss Bitcoin Trust.” The ETP would have (i) held only bitcoins as an asset and (ii) tracked the price of bitcoin on the Gemini Exchange, a cryptocurrency exchange founded by Cameron and Tyler Winklevoss. To date, the SEC has not approved a cryptocurrency-backed ETP.

Exchange Act Section 6(b)(5) requires that the rules of a national securities exchange be designed to (i) “prevent fraudulent and manipulative acts and practices” and “protect investors and the public interest.” In its Order, the SEC asserted that the price of bitcoin can be (and has been) manipulated through activity on bitcoin trading venues. The SEC rejected the claim by BZX that it could monitor the Gemini Exchange for potential price manipulation, finding that the Gemini Exchange did not materially represent the bitcoin market. The SEC pointed to BZX’s lack of surveillance-sharing agreements with significant, regulated markets as inconsistent with SEC-approved commodity-trust ETPs. The SEC further rejected the argument that bitcoin spot markets are inherently resistant to manipulation due to the decentralized nature of blockchain technology. In sum, the SEC found that BZX failed to establish that its various surveillance proposals were sufficient to protect investors from fraud as required to comply with Exchange Act Section 6(b)(5).

Commissioner Hester Peirce dissented from the SEC order and argued that the BZX proposal met the Exchange Act Section 6(b)(5) standard. Ms. Peirce contended that her fellow Commissioners focused too heavily on the shortcomings of the underlying bitcoin spot market, and failed to give proper consideration to BZX’s surveillance and fraud detection capabilities. She asserted that many commodity-based ETPs would be in danger if the Order’s standard for bitcoin were universally applied. Further, Ms. Peirce stated that the outcome undermined investor protection and represented a missed opportunity to institutionalize and legitimize the bitcoin market.

House Subcommittee Considers Potential for Central Bank Digital Currencies

The House Financial Services Subcommittee on Monetary Policy and Trade considered testimony on the future of cryptocurrencies, including the potential development of central bank digital currencies (“CBDCs”).

The following witnesses testified at the hearing: Dr. Rodney J. Garratt, Professor of Economics at the University of California in Santa Barbara, Dr. Norbert J. Michel, Director of the Heritage Foundation Center for Data Analysis, Dr. Eswar S. Prasad, the Nandlal P. Tolani Senior Professor of Trade Policy at Cornell University, and Mr. Alex J. Pollock, Distinguished Senior Fellow at the R Street Institute.

Dr. Garratt noted the increased prevalence of electronic payment systems and resulting decline in the use of cash for payments. He suggested the possibility of developing a “widely accessible, retail-oriented [CBDC] that could be used by the public for person-to-person and retail transactions.” Dr. Garratt acknowledged the various risks associated with such an undertaking, and asserted that further research will be necessary to better understand the monety policy and financial stability issues.

Dr. Michel explained that paper-based payments have faded in popularity. He encouraged the “neutral” treatment of all forms of currency, including cryptocurrency, and asserted that capital gains taxes should not apply to cryptocurrency transactions. Dr. Michel argued against both the development of CBDCs and restrictive policies that may limit the development and growth of private cryptocurrencies, and applications of distributed ledger technology.

Mr. Pollock warned of the dangers of CBDCs. He cautioned that CBDCs could potentially result in an “increase of the monopoly power of central banks.”

Dr. Prasad also warned of the potential effects of CBDCs on traditional banking structures.

President Trump Issues Executive Order to Establish Task Force on Market Integrity and Consumer Fraud

President Donald J. Trump issued an Executive Order instructing the Attorney General (“AG”) to establish a Task Force on Market Integrity and Consumer Fraud (the “Task Force”). The goal of the Task Force is to provide guidance on financial fraud and other crimes, including cyber fraud, that target members of the public.

Specifically, the Task Force will give recommendations to the AG on fraud enforcement activities across the DOJ regarding (i) actions to improve inter-agency cooperation in investigating and prosecuting financial crimes, (ii) actions to bolster communication among Federal, State, local and tribal authorities with respect to the detection, investigation and prosecution of financial crimes, and (iii) changes in “rules, regulations, or policy, or recommendations to . . . Congress regarding legislative measures, to improve the effective investigation and prosecution” of financial crimes.

The Task Force will terminate and replace the Financial Fraud Enforcement Task Force created by Executive Order 13519 on November 17, 2009, which is now revoked.

In remarks delivered in Washington D.C., SEC Chair Jay Clayton expressed support for the establishment of the Task Force. Mr. Clayton reaffirmed the importance of inter-agency cooperation when it comes to protecting retail investors, and underscored some of the actions that the SEC recently undertook to confront retail securities fraud. In particular, Mr. Clayton highlighted retail enforcement strategies, emergency actions, and cyber and initial coin offering (“ICO”) fraud. With respect to retail enforcement strategy, Mr. Clayton discussed the Retail Strategy Task Force created by the SEC in 2017 to provide additional protection for Main Street investors by developing strategies for dealing with various types of wrongdoing that most impact retail investors. Mr. Clayton also stated that in response to bad actors utilizing new technologies to commit ICO fraud, the Enforcement Division created a Cyber Unit to deal specifically with cyber-related crimes.

Lofchie Comment: There seem to be two major differences between the newly issued order and the Executive Order that it replaced.

First, the former Task Force included membership from a complete A-Z of agencies making it unwieldy at best. The reconstituted Task Force can call upon the agency alphabet as is needed.

Second, the former Task Force was established, in large measure, to address concerns related to the financial crisis. The new Task Force is forward-looking; it now includes fraud on the government, cyberfraud, fraud against senior citizens, health care fraud, and fraud involving cryptocurrencies.

SEC Chair Says Bitcoin Are Not Securities

SEC Chair Jay Clayton asserted that bitcoin and other cryptocurrencies that are replacements for U.S. dollars or other sovereign (fiat) currencies do not constitute securities under federal securities laws (see Securities Act Section 2(a)(1); Exchange Act Section 3(a)(10)).

In an interview on CNBC, Mr. Clayton contrasted cryptocurrencies with other blockchain technologies, such as tokens, in which money is invested in a venture in exchange for a direct return on the token, or for the ability to earn a return by selling the token on a secondary market. These types of tokens are considered securities, and both their issuance via initial coin offerings (“ICOs”) and their trading on an exchange are subject to SEC registration and oversight. Mr. Clayton said that if an unregistered ICO is to be conducted via an unregistered private placement, the SEC will expect adherence to the private placement rules.

Mr. Clayton ruled out amending the statutory definition of securities to expressly address cryptocurrencies and other blockchain technologies, saying that the SEC would not “do any violence to the traditional definition of security that has worked for a long time.” He also declined to comment on whether various specific bitcoin alternatives, or “Altcoins” – such as Ethereum and Ripple – constituted securities, saying instead that the analysis of each was effectively case-specific.

When asked about the current bitcoin futures market and what criteria issuers would need to meet in order to start a bitcoin exchange-traded fund, Mr. Clayton cited guidance from the Division of Investment Management on features the SEC will look for – such as accurate pricing and asset verification – before approving any asset class.

CFTC Issues Guidance to Exchanges and Clearinghouses on Virtual Currency Derivative Product Listings

The CFTC issued staff guidance to exchanges and clearinghouses to “ensure proper surveillance and oversight of the trading and clearing of virtual currency contracts.”

The CFTC stated that virtual currencies “are unlike any commodity that the CFTC has dealt with in the past.” The CFTC cited heightened risks and a lack of transparency and susceptibility to market manipulation as causes for concern about how virtual currency derivative products may impact the commodities markets. As a result of these risks, the CFTC identified several areas that demand greater attention from designated contract markets (“DCMs”), swap execution facilities (“SEFs”) and derivatives clearing organizations (“DCOs”). As described in the advisory, the CFTC set the following expectations:

  • Enhanced Market Surveillance. The CFTC expects exchanges to enter into information-sharing agreements with spot markets for virtual currency products in order to facilitate access to trade data. The CFTC heightened its expectations for the monitoring of “relevant data feeds” from the underlying spot markets. The CFTC expects that exchange-listed virtual currency contracts should be based on spot markets that adhere to federal anti-money laundering regulations.
  • Close Coordination with the CFTC Surveillance Group. The CFTC expects exchanges to regularly coordinate with CFTC staff regarding the surveillance of virtual currency derivative contracts, provide certain trade data to CFTC staff upon request, and coordinate with staff regarding the timing of new virtual currency derivative listings.
  • Large Trader Reporting. The CFTC recommends that exchanges implement a large trader reporting threshold for virtual currency derivative contracts at “five bitcoin” or the “equivalent for other virtual currencies.” This threshold could help to better identify traders who are engaging in virtual currency-related market manipulation.
  • Outreach to Members and Market Participants. The CFTC expects exchanges to “meaningfully” engage with stakeholders in the lead-up to new virtual currency derivative product listings. This includes the expectation that exchanges will solicit comments from stakeholders not only on contract terms and vulnerability to market manipulation, but also on the impact on clearing members and futures commission merchants. The CFTC also expects exchanges to share feedback from market participants with CFTC staff.
  • DCO Risk Management. The CFTC expects a DCO to submit to CFTC staff proposed initial margin requirements and other relevant information concerning a proposed virtual currency derivative contracts. CFTC staff also expects DCOs to explain their consideration of stakeholders’ views in approving proposed contracts.

The CFTC explained that in the event that a self-certified virtual currency derivative contract raises concerns, the CFTC will provide a notice to the exchanges regarding its concerns as to compliance with the CEA and CFTC rules.

CFTC Commissioner Reviews Current Regulation of Cryptocurrencies

CFTC Commissioner Brian Quintenz described deficiencies in U.S. regulation of cryptocurrencies and identified potential developments in the “broader tokenization revolution.”

In remarks before the Eurofi High Level Seminar, Mr. Quintenz encouraged international regulators to develop different regulations for (i) cryptocurrencies that serve only as a medium of exchange or store of value and (ii) for tokens that are intended to represent physical assets.

Mr. Quintenz asserted that, in the future, a cryptocurrency’s “volatility and transferability” could compare reasonably well even against a sovereign currency. In this “broader tokenization revolution,” Mr. Quintenz outlined three motivations that may further increase the use of tokens: (i) tokenizing a company’s product as a marketing ploy; (ii) creating a token to improve efficiency of the blockchain construct for assigning and tracking ownership, coined as “the back office tokenization revolution”; and (iii) harnessing the flexibility of tokens to create a secondary market for non-tangible items.

Domestically, Mr. Quintenz called for better regulatory oversight for cryptocurrencies, particularly in the area of spot trades. He explained that the CFTC has regulatory authority only over derivatives on commodity cryptocurrencies and cannot regulate the spot transactions in such currencies, although it does retain enforcement authority over these markets to the extent that there is fraudulent conduct. According to Mr. Quintenz, this means that “the CFTC can only police fraud and manipulation in the actual trading of cryptocurrencies, but has no ability to make platforms register with the Commission or set any customer protection policies.”

To strengthen regulatory oversight, Mr. Quintenz said that the CFTC is launching an initiative to educate customers on cryptocurrency and potential fraud, “aggressively target[ing]” incidents of fraud and manipulation, and collaborating with the SEC. He argued that the “patchwork” nature of state and federal regulation will not be enough. Mr. Quintenz recommends the cryptocurrency spot platforms form an “SRO-like entity” to regulate customer protection rules and legitimize the markets. Mr. Quintenz emphasized, however, that an SRO-like entity is not a sufficient replacement for federal oversight.

Lofchie Comment: This is at least the second time that Commissioner Quintenz has pushed for cryptocurrency exchanges to establish a self-regulatory organization. This is unlikely to happen. For self-regulation to be really effective, the firms or exchanges that deem themselves to be compliant have to be able to “punish” the non-compliant firms in some way. When several firms gang up against another, that raises significant antitrust issues. Broker-dealers can do this in the securities markets because the Supreme Court recognizes that Congress has given broker-dealers a limited exemption by providing for the establishment of SROs, as has been the case under the Commodity Exchange Act. There is nothing similar for cryptomarkets. In any case, this market is far too young and fast-moving for an SRO system to develop.