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Joint Hearing on Future of Digital Assets; NY CRPTO Act; Rep. McHenry Letter to Appropriators

Joint Subcommittee Hearing on Digital Assets

What happened?

On Wednesday, a joint hearing titled The Future of Digital Assets: Measuring the Regulatory Gaps in the Digital Asset Markets was held by the House Financial Services Subcommittee on Digital Assets, Financial Technology and Inclusion (HFSCDA), and the House Agriculture Subcommittee on Commodity Markets, Digital Assets, and Rural Development (HASC).

The joint hearing focused primarily on the path forward for legislation pertaining to the digital asset space. Representatives from both parties expressed a willingness to work together to pass legislation. On the right, HASC Chairman Dusty Johnson (R-SD) emphasized the importance of bipartisan cooperation between the committees in passing legislation that will bring “certainty and sensible compliance to the digital asset space,” which lacks “rules of the road for those who want to engage with [it].” So too did HFSCDA Vice Chairman French Hill (R-AR), urging for the application of the “same risk, same regulation” principle in amending current law to “establish a functional regulatory framework.” On the left, Representative Maxine Waters (D-CA) and Representative Yadira Caraveo (D-CO) expressed similar sentiments, with Rep. Caraveo further highlighting the need for any such legislation to include a “robust enforcement regime.”

While support for new legislation was bipartisan, it was not unanimous. Representative Stephen Lynch (D-MA) was a notable dissenter, questioning the “need [for] a new regulatory structure to cover digital assets which would likely undermine well established laws and regulations.” Still, lawmakers and witnesses alike expressed concerns that the United States continues to lag behind its overseas counterparts in implementing a comprehensive regulatory framework.

As a related issue, the hearing also focused on the lack of jurisdictional clarity between the Securities and Exchange Commission (SEC) and the Commodities Future Trading Commission (CFTC). Without endorsing either regulator, Chairman Johnson lamented the ongoing turf war, noting that the “conflicting enforcement decisions create further confusion in the industry.” Rep. Caraveo went even further by ostensibly indicating her support for granting exclusive or primary jurisdiction to the CFTC as she advocated for legislation which includes “a funding mechanism for the CFTC.” As for the witnesses, Matthew Kulkin (Partner, Wilmer Hale) and Marco Santori (CLO, Kraken) also expressed their support for the CFTC. By contrast, Timothy Massad (Former Chairman, CFTC) proposed that Congress direct the SEC and CFTC to develop joint rules or create a self-regulatory organization (SRO) focused on protecting consumer assets and preventing fraud, manipulation, and conflicts of interest.

What does this mean?

Wednesday’s hearing marks the latest in a series of hearings held in recent weeks relating to the digital asset space. This can be taken as a positive sign that the push for a clear regulatory framework is gaining bipartisan momentum. Whether new legislation garners enough support remains unclear and will likely hinge upon whether the parties can agree on its substance.

Among those in agreement that new legislation is needed, a desire for consensus remains on several key issues. Chief among them is the extent to which wholly new legislation should be enacted, or whether the focus should be on amending existing legislation. Additionally, and notwithstanding the HASC’s support for the CFTC, the balance of regulatory authority between the CFTC and the SEC remains a contentious topic. Lawmakers will need to find common ground in devising a regulatory framework that clearly identifies the rules of the road without impeding innovation.

New York’s Proposed CRPTO Act Sets an Impossibly High Bar for the Crypto Industry

What happened?

Last Friday, New York Attorney General Letitia James introduced the Crypto Regulation, Protection, Transparency, and Oversight (CRPTO) Act, to the New York state legislature. AG James cites the “rampant fraud and dysfunction [that] have become the hallmarks of cryptocurrency,” as the motivation to push forward this consumer protection-oriented bill which includes a number of mandatory disclosure requirements, restrictions on exchanges also custody or lending customer funds, as well as obligations to cover consumer losses.

The stringent CRPTO Act proposal arises against the backdrop of the New York Department of Financial Services’ highly restrictive BitLicense framework in 2015, codifying pieces of it and adding additional requirements into state law. It also comes on the heels of AG James’ March 2023’s lawsuit against KuCoin for failing to register as a broker-dealer, an enforcement action that was largely scrutinized by the way it slipped in the allegation that Ethereum was a crypto-asset. This bill continues the trend of the New York Attorney General attempting to gain control over the industry.

What does this mean?

Comprehensive crypto regulation is needed to provide clarity in lieu of the current confusing landscape of regulation-by-enforcement. However, the CRPTO Act, unfortunately, does not provide the industry with that answer, instead it could act as a chilling effect for the industry due to the sheer difficulty of compliance.

First, it is unclear whether this bill applies exclusively to centralized crypto service providers or if it also includes DeFi protocols; the draft suggests that DAOs can be subject to service of process, for instance, and several of the rules broadly cover “every digital asset issuer, digital asset broker, digital asset marketplace, and digital asset investment adviser”, which suggests that DeFi could be in the purview of the CRPTO Act. Including DeFi would be problematic due to the difficulty of defining the centralized lynchpin that should be held responsible and liable for compliance with these requirements. And if DeFi is to be included, the disclosure requirements make clear why this poses a challenge; the bill requires that:

“Every digital asset issuer who issues a digital asset shall, with respect to such asset, prior to issuance: (a) publish and distribute a prospectus stating, at a minimum, all related material information about the issuer and the digital asset, including but not limited to:...(vi) the identities of all directors, executive officers (including their positions), and key employees who make or are expected to make significant contributions to the development of the digital asset…”

Second, these requirements are unduly burdensome on industry. For instance, the accounting burden to “make publicly accessible audited annual financial statements” placed on crypto companies is virtually impossible to meet in the current nascent crypto context—the bill requires “crypto companies to undergo independent auditing & publish financial statements,” in an environment where there is a dearth of accountants and auditors willing to provide these services and a lack of existing auditing standards that are compatible with crypto. Although public blockchains allow anyone in the crypto industry to be audited by anyone with access to the internet, that alone would not meet the bill’s audited accounting standards.

Moreover, as lawyer and scholar Drew Hinkes suggests, “Auditors and accountants can’t get insurance to cover their work [with regard to] crypto intermediaries. So auditors and accountants will be less likely to do this work as their risks are not appropriately covered.”

Finally, the obligation this bill places on crypto intermediaries to cover consumer losses suffers from the same problem; as Hinkes states, the insurance market for crypto is “woefully immature” and “incredibly expensive”—and “the result may be platforms that file for bankruptcy protection in case of a significant loss or hack,” in lieu of the loss coverage or indemnity that might exist for traditional financial intermediaries.

Not only does the lack of available insurance infrastructure harm the industry, but it also does nothing to protect consumers from the very concern that inspired this bill in the first place.

HFSC Chairman McHenry’s Letter to Committee on Appropriations

On Tuesday, HFSC Chairman Patrick McHenry (R-NC) sent a letter to Chairwoman of the House Committee on Appropriations Kay Granger (R-TX) and Ranking Member Rosa DeLauro (D-CT) regarding the Committee’s upcoming work on the fiscal year 2024 spending packages. Rep. McHenry’s letter offers a variety of insights to get the US economy “back on track,” including nurturing blockchain innovation in the US.

Representative McHenry’s letter expresses optimism of the technology and clarifies that it’s the responsibility of lawmakers to legislate a regulatory framework and not “unelected bureaucrats” such as the SEC. The letter suggests that the Committee prevent a budget increase for the SEC enforcement division as it is “critical that the Committee prevent the SEC from continuing its effort to regulate by enforcement—the letter notes that the SEC has already brought 130 enforcement actions against crypto assets with its existing budget.

Furthermore, Rep. McHenry suggests that the Committee prohibit funding for Staff Accounting Bulletin 121 (SAB 121)—a bulletin that “precludes banking organizations from serving clients seeking digital asset safeguarding services.” He argues that this deters market participation, and that “policy decisions made by staff circumvent the notice and comment requirements set forth in the Administrative Procedure Act (APA).

Lastly, Rep. McHenry’s letter suggests that the Committee prohibit funding for the SEC’s proposed Custody Rule—a proposal that would require Registered Investment Advisers (RIAs) to hold all assets under qualified custodians (QCs) and develops serious challenges for RIAs to “rely on crypto platforms as [QCs].”

What does this mean?

Representative McHenry correctly identifies that digital assets and blockchain technology hold promise for the future of the internet and economy. It is the responsibility of Congress to ensure that US innovation is protected—and not led offshores by the SEC’s regulation by enforcement and other efforts—by developing a regulatory framework that limits negative externalities and attacks bad actors while retaining the opportunity to innovate responsibly.

Furthermore, Rep. McHenry correctly criticizes circumvention of the APA by bulletins like SAB 121. It is critical that regulatory agencies abide by the APA to provide the opportunity for the public to comment on proposed rules and regulations as it is fundamental to a democratic society.

Lastly, the Custody Rule proposed by the SEC earlier this year aggravates standing ambiguities related to the safekeeping of blockchain-based assets such that it would make it essentially impossible for RIAs to meet the proposed obligations. Consequently, this could inhibit significant investment in the crypto space and have downstream effects on innovation. Therefore, Rep. McHenry is correct to suggest that the Committee should prohibit funding for its enforcement as the Custody Rule is discriminatory towards the digital asset class.

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