It's Time to Corral Finance's Wild West
SEC Chairman Gary Gensler has come under fire recently for the pace and breadth of his aggressive regulatory agenda. But based on recent and recurring issues, regulation of crypto assets is one area where financial regulators, in the U.S. and elsewhere, aren't moving nearly fast enough.
This is a critical investor trust and confidence issue that affects a broad base of participants in financial markets – particularly the 12% of Americans estimated by the U.S. Treasury Department to own crypto assets.
For one thing, outright criminality – fraud, theft, market manipulation and scams of all flavors – is rampant in the sector. While debates rage in the regulated part of the market over arcane points like whether a "fiduciary standard" or a "best interests standard" should apply to financial advisors, in the crypto world there are no standards. It truly is the finance equivalent of "the Wild West."
According to a recent whitepaper published by the U.S. Treasury Department, criminals stole $7.8 billion from crypto investors in 2021. Collectively, the FBI, Consumer Financial Protection Bureau (CFPB) and Federal Trade Commission (FTC) received over 80,000 crypto-asset related complaints or fraud reports in 2021 and the first quarter of 2022. There are few protections available if a digital platform runs into trouble, which happens with alarming frequency. Only recently, Binance, one of the larger and more established platforms in digital finance, lost more than $100 million to hackers who infiltrated its Smart Chain blockchain network. Last May, a so-called "stablecoin," TerraUSD which purported to peg its value to the U.S. dollar using an algorithmic "game theory based economic system," imploded and lost nearly 100% of its value. Unlike bank deposits, TerraUSA and less dicey dollar-value products are not insured against loss. Investors there are not likely to recoup their money. Cred, Voyager, Three Arrows, Celsius – these are names of crypto enterprises that have declared bankruptcy in the past two years.
Flawed design and misrepresentation of product features are common in the crypto space. Commenting on platforms that lend against crypto assets, the U.S. Treasury Department warns that some "may attract users by promising to pay returns that are far greater than those offered by traditional banks... and inappropriately use bank-like terms like 'savings account,' 'deposit' or 'annual percentage yield' and other promotional tactics that can obscure the associated risks."
Unregulated crypto activities are also a growing source of systemic risk to the financial system, particularly as crypto platforms grew at one point to almost $3 trillion in value and as the number of points at which they intersect with the traditional financial institutions have increased.
The Financial Stability Oversight Council (FSOC), a consortium of U.S. regulators created after the last financial crisis to scan for, spot and make recommendations about how to mitigate systemic risk, earlier in October stated, "The financial stability risks of crypto would be substantial if... the scale of crypto-asset activities and interconnectedness with the traditional financial system were to grow rapidly." As they have, even with the recent meltdown in crypto assets.
U.S. Treasury Secretary Janet Yellen recently warned, "As we have painfully learned from history, innovation without adequate regulation can result in significant disruption and harm to the financial system."
Lack of regulatory clarity and certainty ultimately makes it hard for investors, particularly retail investors, to access crypto assets, which is something that must occur if they are ever to evolve into an asset class whose properties can be quantified for the purpose of including them in portfolios in ways that improve investor outcomes. There are few products that track the price of crypto cleanly, and custodying crypto assets is onerous for traditional financial institutions (though not impossible, as firms including BNY Mellon, NASDAQ and Blackrock are endeavoring to prove).
It is high time for what SEC Chairman Gensler calls "one rule book" – "a market integrity rule book" for crypto assets.
"The public deserves the same protection they get with other issues of securities," Gensler has said. "There's no reason to treat the crypto markets differently just because different technology is used."
There has been no shortage of pronouncements about the need for a coordinated approach to crypto regulation. For example, an Executive Order of Ensuring Responsible Development of Digital Assets issued by President Biden in March. Reports by the FSOC, the international Financial Stability Board and by the U.S. Treasury Department, which cites "the need for urgent action" to address "the extensive risks associated with engagement in crypto-asset markets." But so far there has been very little tangible, concrete action on the part of regulators. (Although, to its credit, the SEC did put an end to abusive initial coin offerings and threatened to sue digital exchange Coinbase for lending against digital assets.)
One of the challenges is that crypto refers to a broad range of products falling under the purview of multiple regulators in the U.S. – among them the SEC, Commodity Futures and Exchange Commission (CFTC) and banking regulators – which is setting the stage for a turf war over what types of products, all under whose jurisdiction.
Principal among these is a tug of war between the SEC and the CFTC, which turns on the question of whether, and if so which, digital assets are securities and which are not.
Congressional legislation providing role clarity and addressing gaps would be helpful, but probably isn't coming anytime soon. "Getting any piece of legislation through both houses of Congress is going to be a monumental task," opined one spokesperson for the Chamber of Digital Commerce trade group.
What we don't need from Congress are new regulations or a new crypto regulator. Coordination and cooperation among existing regulators who apply existing regulations will do the trick. But it needs to happen sooner rather than later, before more investors suffer irreversible harm.
For those interested in learning more about this topic, I recommend the comprehensive and surprisingly readable U.S. Treasury Department white paper, Crypto-Assets: Implications for Consumers, Investors and Businesses. Among the nuggets contained in the report:
"Financial markets, products and services that use native crypto-assets... are generally speculative in nature."
"To date, competing technologies, applications and paradigms... have produced a patchwork quilt of systems that have yet to deliver, separately or collectively, on many of the promised benefits for consumers, investors and businesses..."
Data from the Federal Reserve Board finds 29% of people who hold crypto-assets for investment purposes had an annual income of less than $50,000 and "available evidence suggests that... crypto-asset products may present increased risks to populations" vulnerable to disparate impacts, specifically, low income, BIPOC and elderly populations.
Baird does not currently recommend the purchase of or custody cryptocurrencies.