Foundational principles for US crypto asset regulation
Christopher Giancarlo and Justin Browder of Willkie Farr & Gallagher discuss the key foundational principles for regulating cryptocurrency in the US
A new wave of the internet is upon us – an Internet of Value. Among other things, this wave is recasting financial assets and money in digitally native forms of cryptographically stored units of value based on public blockchain infrastructure. The breakthrough came in 2009, with the White Paper of Satoshi Nakamoto, Bitcoin’s pseudonymous creator, that posited drawing upon the decentralised network of the world’s unrelated computers – the internet – to reliably reach agreement with each other on the question of who owns what. You might call the idea “bookkeeping without a bookkeeper,” or, at least, without centralised bookkeepers.
The Internet of Value holds the promise that all things of value, like energy, agricultural and mineral commodities, contracts, stock certificates, land records and property titles, cultural assets like music and art and personal assets votes in an election, even personal identities can be stored, managed, transacted and moved around in a secure private way from person to person, without central bookkeepers and other opaque intermediaries.
Nowhere has this Internet of Value have a greater impact than in the area of financial services, where it has the potential to unlock scalable, disruptive innovation. Today, more than 200 million people worldwide – as many as 60 million in the US – are participating in this technological revolution, empowering creators, innovators and developers, while introducing much needed competition to the world’s ever more concentrated, financial markets.
This technology has the potential to do to banking, payments and money itself what the earlier Internet wave did to information, communications, retail shopping, travel and entertainment – that is, reduce cost and latency while increasing accessibility, inclusion and economic liberty.
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A quarter of a century ago, the first wave of the internet – an Internet of Information – was greeted in Washington in a timely, enlightened and bipartisan manner. A democratic White House and a republican Congress came together to promote the development of online commerce and sharing of information, that was unfettered by inapt federal and state law. This wise policy response adopted the Hippocratic Oath of “first, do no harm”. Only time will assess the critical role played by this official response in furthering the extraordinary societal impact of the democratisation of global access to information over the internet.
In our current era, Washington’s policy response to the Internet of Value has been largely ad hoc and uncoordinated, that may soon change. Reportedly, the Biden administration is preparing an executive order concerning cryptocurrencies. Questions remain as to what the order should say, if the policy response of the 1990s is the right policy response for today, or if it should be a different response all together.
As with all new technologies, including the first wave of the internet, there are honest concerns about the use of emerging technology in illicit activities, fraud and manipulation and schemes that trap the unwary, and such conduct continues to be actively prosecuted by the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC). There are also legitimate concerns particular to crypto innovation, such as the environmental impact of “proof of work” blockchains that rely on “mining”. There are also systemic concerns about financial runs and other disruption to the existing framework of financial intermediation, lending and payments and the manner in which they are overseen and regulated. Some critics see digital assets as a threat to the existing architecture and operation of intermediated, centralised finance.
There is also a generational divide between operators of the legacy financial system and the pioneers of the Internet of Value. There is an institutional “trust gap”. Legacy financial system defenders became comfortable with branch banking in their teens with the deposit of paychecks from summer or after school jobs. Today, most kids form institutional relationships with mobile phone providers, video game and social media platforms and online retailers well before the age of 14. Convincing younger users that Bitcoin and cryptocurrency is dangerous while traditional banking is fun and safe is unlikely to be effective. Crypto has attracted more interest and excitement than Wall Street has enjoyed in a generation. For the young, digital technology is an essential agent of social change and expression.
The question is how to craft a public policy response to the Internet of Value that brings together these two worlds: the legacy financial system with the new architecture of decentralised trust. How do we respond to the Internet of Value in a way that preserves the necessary functionality of the old system, while embracing the potential advantages of the distributed ledger architecture of the new? How do we capture its potential to reduce cost and latency while increasing accessibility and inclusion, and, how do we do so in a way that enhances political legitimacy of legacy regulatory frameworks among a generation nurtured on the internet – tomorrow’s heirs of today’s financial system.
The following are key foundational principles for US crypto regulation that will enhance political legitimacy for oversight of this new architecture of finance.
Assert Congressional Leadership: First and foremost, national crypto policy needs to emanate from Congress. In democratic systems, it is for the legislative branch to gather public opinion, sort through various and sometimes conflicting policy objectives, and arrive at overall national policy. The time has come for the US Congress to identify national public policy for crypto and conceive and formulate a comprehensive regulatory framework.
Seek Bipartisanship Input: National crypto policy must be established on a bipartisan basis, this should not be one political party’s singular accomplishment. The growing crypto community represents wide ranging political views, all of which must be brought to bear in developing national policy. To ensure that any resulting legislation enjoys wide and long-lasting political legitimacy, it must be accomplished with broad bipartisan support.
Garner Public Input: There also must be ample opportunity for substantive public input through Congressional hearings and legislative review and comment. This is especially important where the ethos of the emerging crypto industry is individualist, egalitarian and not beholden to legacy regulatory frameworks. Legislation and regulation that bespeaks a “top down” approach will not gain the respect of the internet generation. Congressional action and subsequent regulation must garner industry “skin in the game”. This is best done through active industry dialogue and engagement. Crypto regulation must require federal agencies to respect well established norms of ample public notice and comment for new rulemaking.
Be Comprehensive: Washington’s crypto policy response must be comprehensive, balanced, and tailored to the unique features of emerging technology. It cannot be a defensive programme to preserve the status quo, rather, it must recognise the national interest in fostering healthy development of crypto innovation, well ordered crypto trading markets and their contribution to the modernisation of the existing financial system to make it less exclusionary and more accessible, affordable and dynamic.
Among other elements, a comprehensive national crypto regulatory framework should encompass:
(a) Promotion of crypto innovation and national competitiveness;
(b) Fostering of economic growth, efficiency, entrepreneurship and new business formation;
(c) Ensuring consumer protections and benefits, including increased financial access and economic inclusion as well as enhanced financial privacy and citizen control of financial data;
(d) Oversight of crypto trading and market activity free of fraud and manipulation with appropriate degrees of disclosure and transparency;
(e) Assuring an “even playing field” of competition between financial service industry incumbents and new entrants; and
(f) Supporting law enforcement, including policing against money laundering, illicit trafficking and market fraud and manipulation.
It is the duty of Congress to balance these various national interests and promulgate a comprehensive crypto legislative framework with clear rules, responsibilities and regulatory jurisdiction.
Update financial instrument taxonomy: In crafting national crypto policy, Congress must also reconsider the current taxonomy of regulation that divides crypto assets into securities and commodities. The security/commodity taxonomy was crafted and its jurisprudence developed in the physical, analog world of the early twentieth century. This taxonomy struggles to be relevant in the twenty-first, where the term “crypto assets” refers to a diverse collection of utility tokens, payment tokens, stablecoins, NFTs, cryptocurrencies and a wide range of other instruments. Applying legacy securities and commodities jurisprudence to such assets results in a patchwork of very different (and sometimes conflicting) substantive laws and bodies of regulatory oversight that collectively act to impede innovation without conferring corresponding consumer protections.
The legacy taxonomy encourages legal and compliance arbitrage by market participants. In myriad cases where the definitions are inapt, innovators, often early stage and leanly-funded, face risk of regulatory enforcement action costing precious time and resources and putting a pall on national innovation aimed at financial industry modernisation. Congress must address these issues by revisiting the specific application of the securities/commodities taxonomy to crypto assets.
Seek financial Inclusion: Among the promise of crypto is the potential for greater financial inclusion than can be achieved through the current financial system. Undoubtedly, there is a federal role in ensuring consumer protection. Yet, Congress needs to reconsider the current US approach to consumer protection, which restricts ordinary investors from participating in promising new business ventures that are reserved for wealthy and sophisticated “accredited investors,” few of whom – by definition – are young. Congress must establish a national crypto policy framework that allows ordinary and non-wealthy citizens to engage in digital asset investment and risk exposure in an informed and self-directed manner.
Close crypto spot market gap: Congress must also address the US crypto spot market gap. As many know, no federal market regulator has comprehensive jurisdiction over crypto asset trading in the United States. The SEC regulates issuance and trading in both spot and derivatives market of crypto assets categorized as securities, but not commodities. The CFTC regulates trading of derivatives of crypto assets that are categorized as commodities, but not securities. Yet, the CFTC has only limited authority over spot trading of crypto assets. Thus, no federal agency has direct jurisdiction over US trading platforms for spot trading in non-security crypto assets. As a result, there are no nationally mandated investor protection measures against fraud, manipulation, and abuse in spot crypto markets of the kind that are common in US derivatives and securities markets.
Recently, CFTC Chair Rostin Behnam testified before Congress as to the agency's regulatory oversight of digital assets. He referred to "regulatory gaps presented by innovations in the financial markets" and the lack of a "viable substitute for a functional regulatory oversight regime for the cash digital asset market." Benham noted that there are distinguishing elements of the crypto commodity cash market that make it suitable for direct CFTC oversight, including: the high percentage of retail investors participating in the market; the high degree of trading leverage; and cybersecurity risks to trading platforms.
It is time for Congress to close the regulatory gap by authorizing exclusive oversight over spot crypto commodities to the world’s most experienced and successful crypto regulator, the CFTC. Support, however, for the expansion of CFTC authority over crypto commodities must come with congressional authorisation of crypto market self-regulation.
Embrace Industry Self-Regulation. The United States has a long and successful experience with self-regulatory organisations (SROs). Essentially, SROs are private or quasi-governmental organisations that have the power to set rules and standards over their members. SROs often derive their authority from a statutory basis and remain subject to the ultimate oversight of a principal regulatory agency. Participation in an SRO may be voluntary, though it is often effectively mandated by statutory or regulatory requirements.
The American futures markets have operated with self-regulation since 1859, decades before the advent of federal regulation in the 1920s. On the securities side, the Financial Industry Regulatory Authority (FINRA) oversees broker-dealers, while the New York Stock Exchange and the Nasdaq (among others) operate as self-regulated securities exchanges. It is hard to deny the significant connection between self-regulation and the stability of US futures and securities markets, the world’s largest and most dynamic and competitive.
There is broad support and momentum for formal self-regulation within the crypto asset industry. A number of voluntary crypto asset industry organizations have recommended best practices and promulgated codes of responsible crypto conduct, such as the Crypto Market Integrity Coalition.
Interest in crypto self-regulation is unsurprising given the advantages that an SRO yields over exclusive government oversight. Most notably, SROs place greater authority in the hands of industry experts who are most familiar with market practices and emerging issues. SROs promote the specialisation of knowledge, focusing on issues unique to their industry or sector, as opposed to a federal agency’s significantly broader jurisdiction. Given the early evolution of crypto assets and the complexity of their underlying technologies, substantial technical input from stakeholders is critical for the development of sound consumer protections and efficient markets.
Authorising an SRO with industry member funding would ensure that taxpayers would not bear large additional costs for crypto oversight and address reasonable concerns about ballooning federal budgets. It would also support regulatory efficiency, allowing the CFTC and other federal agencies to conserve limited resources for highest-priority concerns. Moreover, the work of an SRO could yield additional fiscal savings by reducing redundancies of overlapping state and federal regulatory initiatives.
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Finally, a crypto asset SRO would serve as a hub of resources for members and the public. SROs like the National Futures Association and FINRA promulgate and enforce industry standards, offer training, prepare market reports, educational materials and compliance guides, and provide specialised tools that allow investors to conduct diligence on member firms. A crypto asset SRO would provide the same market benefits.
The time has arrived for Washington to respect the enthusiasm for crypto asset and financial innovation with a thoughtful and balanced response. Congress should reduce regulatory risk for this dynamic new cohort of financial innovators by enacting a comprehensive framework specifically designed for the industry. At a minimum, the framework must promote continued innovation, foster economic growth and a level economic playing field, ensure appropriate consumer protections and benefits such as financial access and privacy, and support law enforcement, including against money laundering, illicit trafficking and market fraud and manipulation. This policy framework should include a key role for industry self-regulation that has well served America’s legacy financial markets. If we act now, we can harness this wave of innovation for far greater financial inclusion, capital and operational efficiency, and economic growth for generations to come.
J. Christopher Giancarlo is senior counsel and Justin Browder is a partner at Willkie Farr & Gallagher. Mr. Giancarlo is a former chairman of the US Commodity Futures Trading Commission.