Digital Asset Regulations – New Subcommittee

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Incoming Financial Services Chair Patrick McHenry (R-NC) announced that the financial services committee will create a new Subcommittee on Digital Assets, Financial Technology and Inclusion with Rep. French Hill (R-AR) as its chair. According to the announcement,

“The subcommittee’s jurisdiction will cover, among other things:

  • Providing clear rules of the road among federal regulators for the digital asset ecosystem
  • Developing policies that promote financial technology to reach underserved communities
  • Identifying best practices and policies that continue to strengthen diversity and inclusion in the digital asset ecosystem”

Clear rules, practices, and policies are needed across all entities concerning digital assets. Though, as I wrote about a few weeks ago, the talk is still reactionary. The search continues for where to put the square peg that is the general digital asset industry. And in this fragmented and divided congress, the best we may get is to split the peg in half and stick it in 2 round holes.

I am a proponent of regulation. And some very good historical laws and regulations could apply to the digital assets industry. I’ve had some good discussions with people that believe digital assets are not new and the industry has nothing new to offer. Some still call the entire industry a scam. And while I may not be able to convince everyone, I believe I am in the majority of knowledgeable people who believe the digital assets industry, from level 1 blockchains to all the technologies built up from them, are new and require a new expanded form of regulation.

This must happen as we continue to build up the digital economy around them.

To follow up on my last article, let’s review the two entities everyone talks about using to regulate different aspects of the digital asset industry. I’m not the absolute expert on either of these entities. I can only make observations based on their actions over the past several years and the statements made by their respective chairman. And I’ll put it out there: I do not think either entity currently has the tools required to regulate the digital asset industry.

Securities and Exchange Commission (SEC)

The SEC regulates the exchange of securities and the companies in the securities industry. The definition of a Security is quite broad and has been refined by case law though there is still lots of debate about its definition. There are calls for Congress to clarify this further. Which may be some of what the new sub-committee will focus on. Let’s continue to review some of the functions the SEC performs.

  1. Ensures Disclosure: Companies that issue securities must provide accurate and complete information about their stock offering, business, financial condition, and management to potential investors. This ensures that investors have the information they need to make informed decisions. This is a lofty goal with a small staff and limited resources, the SEC attempts to pursue this though it has many documented failures.
  2. Registration: Most companies that issue securities must register with the Securities and Exchange Commission (SEC) in the United States. This registration process involves filing detailed information about the company’s organizational docs, finances, and securities offerings.
  3. Insider Trading: There are rules prohibiting insider trading when company officers, directors, or other insiders use non-public information to trade the company’s securities. Asymmetrical information is not allowed in trading.
  4. Auditing Standards: Registered companies must comply with accounting and auditing standards, which are intended to ensure that financial reports are accurate and reliable.
  5. Broker-Dealer Registration: Broker-dealers, firms that buy and sell securities on behalf of their clients, must register with the SEC and meet certain net capital and other financial requirements.
  6. Anti-Money Laundering (AML) and Counter-Terrorism Financing (CTF): These rules are meant to detect and prevent money laundering, financing of terrorism, and other illegal activities through securities transactions.

There are certainly more that covers a good list of what the SEC is responsible for enforcing. The SEC has the authority to conduct investigations, bring enforcement actions, and impose penalties for violations in these areas.

Commodity Futures Trading Commission (CFTC)

The Commodity Futures Trading Commission (CFTC) regulates the derivatives markets, including futures, swaps, and some options. The CFTC’s primary role is to protect market users and the public from fraud, manipulation, and other abuses in the derivatives markets. Some key functions of the CFTC include:

  1. Market Surveillance: The CFTC conducts ongoing surveillance of the derivatives markets to detect and prevent fraud, manipulation, and other abuses.
  2. Clearinghouse Regulation: The CFTC oversees Derivatives Clearing Organizations (DCOs) that act as intermediaries between buyers and sellers of derivatives contracts to help ensure the financial integrity of these transactions.
  3. Risk Management: The CFTC sets minimum financial and operational standards for derivatives market participants to help reduce the risk of defaults and market disruptions.
  4. Position Limits: The CFTC limits the number of derivatives contracts that market participants can hold to help prevent excessive speculation and market manipulation.
  5. Reporting and Recordkeeping: The CFTC requires market participants to report certain information about their derivatives transactions and to maintain records of their activities to assist the CFTC in its market surveillance and oversight activities.
  6. Anti-Money Laundering (AML) and Counter-Terrorism Financing (CTF): The CFTC also has measures to prevent money laundering, financing of terrorism, and other illegal activities through derivatives transactions.
  7. Customer Protection: The CFTC protects customers from fraud, manipulation, and other abuses by derivatives intermediaries such as futures commission merchants and swap dealers.

As with the SEC list, there is more that could be listed though this provides a good, general review for comparisons.

SEC and CFTC

Currently, the SEC regulates securities and has the authority to regulate digital assets that it considers securities, such as shares of stock in a company or investment contracts. This means that the SEC would have jurisdiction over initial coin offerings (ICOs) or other digital assets sold as investments and provide investors with an expectation of profits.

The CFTC regulates commodity futures and options markets and has the authority to regulate digital assets considered commodities. It can be viewed that the CFTC would have jurisdiction over futures contracts, swaps, and other derivatives that are based on digital currencies.

Both agencies have issued guidance and statements on digital assets, stating that they apply the federal securities and commodities laws to digital assets on a case-by-case basis. The agencies have also cooperated in cases where companies or digital assets are believed to fall under the jurisdiction of both agencies.

Currently, the SEC and CFTC have overlapping jurisdiction regarding digital assets, with neither fully equipped to do this function adequately.

Foreign Currency Exchange and FinCEN

While we addressed the two entities above, one agency doesn’t get mentioned much. The Financial Crimes Enforcement Network (FinCEN), a bureau of the US Department of the Treasury, is responsible for administering the Bank Secrecy Act (BSA), which is designed to prevent money laundering and other financial crimes. In conjunction with the CFTC in some areas, FinCEN regulates foreign currency exchange.

FinCEN requires currency dealers, including foreign currency exchange companies, to register with the agency, report suspicious activity, and maintain certain records, among other obligations. The CFTC supplements FinCENs jurisdiction over foreign currency trading, particularly regarding futures and options contracts. The CFTC has the authority to regulate foreign currency derivatives under the Commodity Exchange Act (CEA), including futures and options contracts. Together they have effectively regulated existing “foreign currency” exchanges.

The CFTC has issued guidance on regulating foreign currency trading and its jurisdiction over these products. In addition, the Federal Reserve also has a role in regulating foreign currency exchange by ensuring the stability of the US financial system and ensuring that US banks can meet their foreign currency obligations. Add in FinCEN, and one would think we are covered though as headlines show us today, this is not the case.

While almost all foreign currency is issued as FIATFIAT Fiat (Latin for 'let it be done') is a team used in conjunction with items to make them reality. Such as Government FIAT money by the very name is money by the government. It can also be an Italian Auto company. monies by their respected sovereignSovereign The highest authority and control. Borrowed from Old French souverain, which is ultimately derived from the Latin superānus, meaning 'above'. Has evolved to additionally mean autonomous or independent. nation-states, these same nation-states are building up their digital currency and assets, which will be considered foreign currency at some point. Most will be Central Bank Digital Currencies (CBDC) though some are adopting Bitcoin or other cryptocurrencies. This is the future.

Complex layers

Regulators, such as the ones listed above, have a difficult job. They are given a set of laws and regulations with a target base of entities in which they are to ensure the regulations are followed. Even with clear guidelines and everyone agreeing on what is regulated, these regulators have a difficult job. Throw in bad actors attempting to ignore or get around the regulations, and they have full-time jobs. Add new innovations, technologies, and whole new industries, and expect the regulators to be able to adapt while remaining within their stated laws and regulations puts real strains on the regulators. Add this without adding budgets or resources, and you get where we are today: headlines and finger-pointing.

I wrote my first article when asked how regulators could do better. I explained that I saw existing agencies working on the outside layers though no agency working on the core of the digital asset industry, the technology. As much as the digital asset industry looks like existing industries, it is different. It has innovated on how assets are created, exchanged, and stored, and so must our regulatory system. We must move beyond the square and round pegs and acknowledge that this is more a quadrilateral that needs its own hole and legal definition.

As a model, I recommended we look towards the casino gaming industries and how they are regulated. Given that they include technology and technology certification is a key aspect is why I recommend this. This is a missing ingredient to all the huff and puff I’ve seen in committee meetings and the press. Let me recap some of my previous articles about a typical gaming regulator and some of its key functions.

Gaming Regulators

In a previous article, I describe the key factors of gaming regulation, I’ll briefly review them here, similar to the SEC and CFTC sections above.

  1. Licensing: Anything that looks like gaming must be legally licensed where gaming is allowed. This involves a thorough vetting process to ensure that the operator is financially stable and that their source of funds to start and operate the business was achieved legally.
  2. Certifications: A technical certification is required to review the technology, game rules, and payouts. There must be no hidden process or procedure, and what is documented and presented to the public must include all the information about the game.
  3. Advertising and Marketing: Regulators set guidelines for the advertising and marketing of products to protect consumers from false or misleading advertising.
  4. Anti-Money Laundering (AML) and Counter-Terrorism Financing (CTF): This is the same as the SEC and CFTC
  5. Age Restrictions: Many jurisdictions have a minimum age requirement for gambling, typically 18 or 21 years old. Casinos will be expected to check IDs and enforce the age restriction to prevent minors and excluded players from gambling.
  6. Problem Gambling: Regulators may also provide problem gambling education and support to prevent players from developing a gambling addiction.

Of these points, the technology certification is not part of the SEC or CFTC, along with aspects of advertising, age restriction, or problem gambling. Though there may not be a direct correspondence, all these aspects must be included.

Let’s dive a little further.

Games and Technology Regulation

The regulation of games and technology in the casino industry varies by jurisdiction, though some common practices include:

  1. Game Testing and Certification: Most jurisdictions require that casino games be tested and certified by an independent third-party testing lab before they can be offered to players. These labs will ensure that the games are fair and operate as intended and documented. This may include a full source code review under full non-disclosure between the lab and the developer. The outcome is shared only with the regulator to decide on licensing and certification approvals.
  2. Technical Standards: Regulators may also set technical standards for the equipment and software used in casinos, such as requirements for random number generators (RNGs) to ensure that the games are fair and produce random outcomes.
  3. Cybersecurity: With the increasing use of technology in the casino industry, regulators are also increasingly concerned with the security of player data and the risk of hacking or other cyber-attacks. Casinos must implement strict cybersecurity measures to protect player information and transactions and show proof from documentation and audits.
  4. Responsible Gambling: Regulators may also require casinos to implement responsible gambling features such as setting deposit limits, self-exclusion, and ID checking into the software. Especially for online gaming, which is also called interactive or remote gaming.

The casino industry’s regulation of games and technology is intended to ensure that players have a fair and secure gaming experience and that casinos operate responsibly and transparently. While these may be parts of the SEC and CFTC, they lack the technical ability, complete guidelines, and funding to do this with the digital asset industry.

Conclusion

Adding a sub-committee by the house financial services committee is to be applauded. It is a step in the right direction. The issue is that the additional details provided a gray area as to whether the committee will attempt to fit the quadrilateral, the digital assets industry, into an existing square or round hole. And while it sometimes may fit in the square hole, it is still evolving. It needs a set of forward-thinking guidelines, a new or revamped regulatory framework, and regulatory funding to allow innovation to continue. And to continue in a way that expands our society while keeping it safe and secure with a published rule of law and the protections we expect from the government.

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