TOP STORY—Gensler calls for more investor protection in crypto space - 02 December 2021

In a fireside chat with his direct predecessor at the DACOM Summit, Chair Gensler urged crypto trading and lending platforms to talk with the SEC about operating within the securities rules.

In a conversation at the Digital Asset Compliance & Market Integrity Summit, SEC Chair Gary Gensler repeatedly stressed that innovations like crypto and DeFi will not survive outside of the regulatory framework. “Outside of public policy norms, people get hurt, and trust is diminished,” he told former SEC Chairman Jay Clayton, who acted as interviewer. Whether it’s a trading platform or a token, entrepreneurs should meet with the SEC to find a path to registering and coming within the investor protection remit, Gensler said.

Public policy. Speaking of crypto, Gensler said, “We don’t have sufficient investor protection in this space,” which is a multi-trillion-dollar asset class. Without investor protection, people will be hurt, and trust will be undermined, jeopardizing the future of these new technologies. The chair said that there will be a “spill in aisle 3” and when that happens, the public will ask where the official sector was to prevent it. That spill could take the form of financial stability given the growth of lending in the crypto space, or it could come from stablecoin, or simply from the investing public either not having enough disclosure or outright being defrauded. The core of the bargain in our markets is that investors decide what risks they want to take, but those raising money need to share full and fair disclosure, Gensler emphasized.

Likewise, institutional investment in crypto will not evolve well outside of the tenets of public policy, said Gensler in response to a question from Clayton about the retail/investor divide. Institutional investing implicates not only investor protection but also anti-money-laundering, tax compliance, and guarding for financial stability. Gensler added that institutional investors want to see progress on custody, given that the private key is at the heart of crypto tech and if someone steals the key, they are stealing value. He said that there are many opportunities to make progress in these areas. The two key issues are, first, what is the value proposition? That’s for the markets for decide, but the second issue is for regulators to ensure that this happens within public policy frameworks.

CeFi to DeFi. Clayton also spoke about the transition from centralized finance to decentralized, or DeFi. “If we assume people have the best intentions, how do we regulate a system where we’re moving from CeFi to DeFi?” he asked. Gensler first pushed back on the assumption of honesty, observing that bitcoin is used for ransomware around the globe. But he added that economics drives systems toward some centrality and it is rare to have a trading or lending market without it. On a specific example of peer-to-peer lending, when it came on the scene in the mid-00’s, it took a few years and an enforcement action for the SEC to hammer out that the platforms were raising money, pooling funds, and offering a return based on their efforts, looking like a security under the traditional tests. Similarly, so-called “decentralized finance” (Gensler’s quotes) has spurred innovation, but it still maintains some centralization, offers some return, with tokens that have some governance—many aspects shared with traditional finance.

Clayton agreed, saying that first you ask what the product is and then you determine what regulation applies. Gensler added that there is an old saw that similar activities should have similar regulation. Arthur Levitt (who Gensler and Clayton agreed, on a bipartisan basis, was a “fabulous chair”) had to grapple with the application of this principle when the Internet became widely adopted in the 90s. Similarly, if there is a platform with commingled activity, a custody function, a trading function, and order routing, shouldn’t it be subject to the same regulations around custody, order routing, anti-manipulation, guarding against wash sales, and transparency, Gensler mused?

Whether they are trading or lending platforms, whether they call themselves centralized or decentralized, platforms are an important place for public policy and investor protection, Gensler said, which is why he addresses them as gatekeepers and urges them to work with the SEC to find a path forward within the regulatory remit. The SEC will work with platforms that don’t think they can register as a full exchange and help them find a way to operate within the rules. Gensler also warned that the SEC will use its enforcement powers where necessary, but said a better path is for platforms to work to get registered within the law.

ETFs. Clayton also observed that the SEC approved a futures-based bitcoin ETF and is discussing a spot ETF. While this conversation was a short one because Gensler could not comment on pending matters, he observed that bitcoin makes up 40 to 50 percent of the $2.5 trillion global crypto market, and global trading does not fall inside the U.S. regulatory register. The CFTC has some antifraud authority over bitcoin, but Gensler reiterated his call for platforms to get registered and come within the investor protection remit.

Stablecoins. In regard to stablecoins, Gensler said that the SEC is working with other federal agencies, and hopefully with Congress, to deal with this $140 billion asset class. He likened stablecoins to “the poker chip at the casinos” because they came about as a way to make moving value more efficient within the ecosystem of a given trading platform. On the flip side, though, the coins also allowed people to avert anti-money-laundering and tax rules. Stablecoins represent 80 percent of crypto trading and probably even more in the lending markets, Gensler said. The regulators are looking at whether stablecoins are truly backed 1-to-1. If they act like a bank account, they will be under the watch of the banking regulators. And regulators are assessing if they are within the AML and tax compliance perimeter.

Clayton added that regulators earned hard-fought wins in the areas of AML, terrorist finance, and tax evasion, and should not allow themselves to lose ground. “Those wins contribute to where our markets are today,” he said. Gensler added that AML and other regulations were layered over the existing banking system and that the bitcoin white paper was in part a reaction to that system, so it shouldn’t be a surprise that people are trying to undermine the worldwide consensus on AML.

Gatekeepers. Gensler closed by addressing conference attendees, speaking to the professionals on whom the SEC relies to help startups and new companies stay within legal bounds. He acknowledged that these gatekeepers feel compelled to give the best advice to clients while urging them to consider the public interest. The spirit of the laws is to protect the public against fraud and manipulation, and this is why Congress painted the definition of “security” with a broad brush. If clients step over the line, bring them back and suggest they talk to regulators and try to move forward within the law, he concluded.

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