The U.S. Senate Committee on Banking, Housing and Community Affairs held a hearing on the state of cryptocurrency and blockchain. The two invited witnesses were Coin Center Director of Research Peter Van Valkenburgh and NYU Professor of Economics Nouriel Roubini.
Mr. Van Valkenburgh lauded the benefits of decentralized computing (i.e., blockchain) but criticized the surrounding “hype.” According to Mr. Van Valkenburgh, the terminology used to describe blockchain is often “vague and undefined,” leading to an overall lack of public understanding. In particular, he criticized the public perception that blockchain is the “solution to any number of social, economic, organizational, or cybersecurity problems.” However, Mr. Van Valkenburgh advocated for the continued exploration of decentralized computing, and advised regulators to take a “light-touch approach” in order to allow the technology to develop “unfettered.”
Conversely, Dr. Roubini criticized cryptocurrencies as the “mother of all bubbles,” and called the underlying blockchain technology the “most over-hyped – and least useful – technology in human history . . . nothing more than a glorified spreadsheet or database.”
In a statement given at the hearing, Senator Sherrod Brown (D-OH) expressed concern about the potential for fraudulent activity in cryptocurrencies and said that the malign effects of blockchain on our society are currently more prominent than the benefits. Senator Mike Crapo (R-ID) said that the “regulatory and oversight questions still remain,” but added that he wanted to better understand the opportunities and challenges regarding blockchain in order to regulate more effectively.
SEC Commissioner Hester Peirce asserted that commissioners should not substitute their judgment for decisions made by investors, particularly with regard to (i) the decision to invest in a company that requires its shareholders to arbitrate any shareholder claims against the company (rather than go to litigation) and (ii) investments in bitcoin or other digital assets.
In remarks at the University of Michigan Law School, Ms. Peirce stated that (i) the SEC is no better than an investor at evaluating the investor’s best interest. She pointed to the SEC’s decision not to approve the public offering of the Winklevoss Bitcoin Trust. Ms. Peirce said that regulators should have allowed investors to decide whether a new investment is worthwhile.
Likewise, she said that the SEC should reject calls for it to become a “more activist regulator” and should not attempt to stretch SEC authority to limit mandatory arbitration between a public company and its shareholders. In this regard, Ms. Peirce questioned whether prior actions of the SEC, in discouraging corporations that were going public from requiring shareholders to arbitrate disputes, were actually within the scope of the SEC’s authority. Ms. Peirce observed that the SEC is required by the Federal Arbitration Act to “respect private contracts that favor arbitration.”
Lofchie Comment: Commissioner Peirce has become the voice of “liberalism” (in the very, very old-fashioned sense of the word): belief in limited government, government respecting the rights and abilities of individuals to make decisions, and government agencies not stretching the bounds of their authority to accomplish what officials decide is “good policy.” Note Commissioner Peirce’s views (and wit) in Motherhood and Humble Pie: Remarks before the Cato Institute’s FinTech Unbound Conference (summarized here). At a time when so many call for the government to expand its authority over private persons, Commissioner Peirce’s defense of the individual (including the individual’s right to screw up) is welcome.
In testimony before the U.S. House Committee on Financial Services, SEC Division of Investment Management (the “Division”) Director Dalia Blass outlined the following underlying aims of the Division: (i) improve the retail investor experience; (ii) modernize the regulatory framework and engagement; and (iii) utilize resources efficiently. The Division is working on the following rule proposals or potential rulemaking areas:
- propose Regulation Best Interest;
- modernize fund disclosure both by reviewing the content of disclosures and by allowing funds to provide shareholder reports online;
- improve disclosure as to variable annuities;
- finalize a rule for the issuance of exchange-traded funds (“ETFs”), so that the SEC exemptive process can more efficiently process exemptive relief requests for ETFs not within the scope of the rule;
- reduce obstacles to publishing research on investment funds in compliance with the Fair Access to Investment Research Act of 2017;
- harmonize and improve registration and reporting requirements for business development companies and closed-end registered investment companies (“RICs”);
- regulate the use of derivatives by RICs;
- publish guidance regarding valuation procedures;
- update investment adviser marketing rules;
- improve investment company liquidity disclosures;
- support fund innovation as to cryptocurrency-related holdings; and
- review the proxy process.
Lofchie Comment: While the SEC talks the talk as to facilitating innovation, walking the walk is far more difficult. ETFs, for example, have become a significant product in the financial markets, and yet the SEC is only now considering a rule to routinize their issuance. As to cryptocurrency funds, one really has to question whether the SEC wants them to go forward, or is hoping that interest in the product is a bubble that will pop before the SEC is pushed to act. Compare SEC Rejects Another Nine Proposed Bitcoin ETFs with SEC Commissioner Peirce Calls on SEC to Embrace Innovation and Allow Cryptocurrency Risk-Taking.
The U.S. District Court for the District of Massachusetts ruled that cryptocurrencies fall within the definition of a “commodity” under the Commodity Exchange Act.
In a Motion to Dismiss, defendants argued that an allegedly fraudulent cryptocurrency, My Big Coin, is not a “commodity” since it does not deal in “contracts for future delivery” and thus is not within the CFTC’s jurisdiction over commodities. The plaintiff responded that there is future trading in cryptocurrencies and, as a result, My Big Coin falls under CFTC jurisdiction.
The Court denied the Motion to Dismiss and held that Congress defines a commodity by focusing on categories (e.g., cryptocurrency), not specific items (e.g., My Big Coin).
The SEC Division of Trading and Markets and Division of Corporation Finance (the “Divisions”) commented on the SEC’s September 9th Order temporarily suspending trading of certain bitcoin and ether tracking certificates. The Divisions asserted that the lack of accurate and consistent information pertaining to Bitcoin Tracker One and Ether Tracker One (together, the “certificates”) led to confusion amongst market participants. The Divisions cautioned market participants that seek to quote, trade, or facilitate transactions in the certificates to examine the legal and regulatory implications of doing so. The SEC staff is currently working with the CFTC staff in connection with the regulatory considerations relevant to the certificates under the Commodity Exchange Act.
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.
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.
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.
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.
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.