Plodding Mediocrity (Part III)

These series are from April 2018

Key takeaways from recent senate and house hearings

So far I’ve explained the reasons why a fund manager based out of developing economy can be willing to watch happenings in the United States regulatory environment. This leads me to point out my views on recent Senate and House hearings. I’ve covered Senate hearing in more detail before but this time I’m going to dryly cover what was said, during both of those hearings. I will place the remarks and comments that will have a recurring importance in the remainder of this work in italic. This part risks to look dry but it will serve me as the foundation for the issues I’ll try to address and that are going to be more specific, going beyond “how to create ICO-friendly regulatory environment”.

Once again this is a perspective of an outsider view on the insider rule-making, I did not grow up with my family discussing their 401ks, nor I was raised with any understanding of brokerage because there was none around. This all is an acquired perspective on the issues that (if passed) will not influence my behavior as a citizen, but as an actor in crypto economy and its decentralized promise they will influence the market we all want to participate in, thus my input.

Senate Hearing

It was a well anticipated hearing (by crypto enthusiasts) in Senate committee of banking, housing and urban affairs with testimonies from Jay Clayton (chair of SEC) and Chris Giancarlo (chair of CFTC). To a wider public and mostly non US natives, the role of this hearing must be well explained not to cause overreactions, although I am not interested, nor well-versed in explaining the process of how US legislative body works.

When hearing concluded the general consensus in the community was that it was a positive hearing, with no regulatory body saying that any form of blockchain based digital asset needed to be outright banned. Clayton and Giancarlo would acknowledge their understanding of the matter, giving these digital assets more credibility. It is important to understand both chairmen, the complexity of their works, mandates and agendas in between all the work that their agencies provide to one of the most complex financial markets, they arrive to foster the innovation and be supportive of it, it forces us to grow substantial respect for both of the chairmen.

Tones of both SEC and CFTC chairs differed. Giancarlo showing a bit more “love” for crypto, even praising bitcoin by saying “If there were no bitcoin, there would be no distributed ledger technology”. Clayton on the other hand being more blunt in these regards and pointing to the fact that so far all of the ICOs that he has seen were securities and that he’s eager to work with DOJ and other agencies in terms of the enforcement. On the question about the issues with oversight Clayton remarked about lack of human resources to provide enforcement as well.

I would like to point that it was under Giancarlo’s chairmanship that CFTC deemed bitcoin as a commodity. Giancarlo, a republican who was sworn as chairman of CFTC in 2014, has created within CFTC a dedicated group - LabCFTC. Meanwhile, SEC in July 2017 published its report into the DAO Hacking (that took place in 2016) and concluded that DAO tokens were securities and had to be registered within SEC in first place. Clayton assumed office in May 2017 and it can be considered that the investigation was initiated prior to him becoming head of SEC (no proof for this assumption though). This should not indicate that one chairman is more inclined into cryptocurrency than the other but it at least can indicate the longevity of one’s exposure to the digital assets over the other. More broadly speaking senators and regulators were both knowledgeable about the topic, but it seemed that probably Senators’ overall interest was to get answers to their questions and not to craft a general vision for a bill.

Ironically, hearing started with Senator Brown’s remark on the “big banks” it was later echoed by Sen. Warren pushing that SEC ignored class action lawsuits, protecting banks and not investors, she later brought an ICO question concluding that most of the ICOs were unregistered securities and prompting from Clayton that none were registered as of the date of the hearing. Senator Brown throughout the hearing kept going back to the question if SEC was doing enough to tame wall street banks’ greed. This is an interesting take, although it does have broader political implication from Senators providing comments to agencies and policies they disagree with, but again seeing this taking place during cryptocurrency topic hearing resonates well with the genesis block comment that Satoshi included. After all those years proper banking regulation is still up to a debate. What probably neutralized this (if it ever needed to be neutralized) were few senators who shared their stories of how their family dinners included cryptocurrency discussions, with Giancarlo making the first remark on that.

SEC looks at the Securities Act of 1933 as a landmark legal piece of work and it surely is, but having a more open attitude towards it would benefit the discussion. It could be seen later on that there are some gaps where regulators do not know how to act and lack oversight (this was well referenced as “regulatory vacuum” in the House hearing). Although Howey test is a good rule of thumb for any ICO raising entity to see if it is offering a security or not, I would be glad to hear more from SEC about what monitoring mechanisms of securities or blockchain tokens would be. As Marco Santori opined last year on Token Summit “securities, especially investment contracts, they can be investment contracts at one point in their life cycle and not be investment contracts at a different point in their life cycle and so on and so forth.” This seems like something not yet addressed from SEC’s part and this will be challenged in House hearing by Robert Rosenblum, but this is an important input on the debate of regulation. During the hearing PPM was hailed as the right way of raising funds, all while abstaining from doing Public Offerings unless registered. Regulation D provides companies with exemption from registration and SAFT is the example contract between issuers and investors so far (yet to be tested in court and recently under the rumored SEC review through subpoenas). At the end of the day, as of now, it all boils down to you making an offering to accredited investors.

Peter Van Valkenburgh later supported the idea that not all ICO tokens are securities and bases this assumption on Howey test, which is very healthy approach, but unfortunately it didn’t come out loud and clear directly from Jay Clayton. It would be helpful, otherwise actors in the field should be more worried at this stage. After all this confusion only feeds the thought that at some point there will be a sweeping enforcement coming from the SEC.

Another very interesting issue was raised as one of the Senators said “what’s the point of over disclosure if no one is reading it?” and prompting CFTC chair to reply “I didn’t read cover to cover the prospectus of the Index Fund that I‘ve invested last time”. This leads us to the point where we must admit that we need a better disclosure systems that function to the non-lawyer folks, mundane topics and lingo must be easily accessible to the regular investors. I would be even bolder saying that this movement will lead us eventually to the democratization of legal documents and it doesn’t involve blockchain, it involves consumer attitude and linguistics, but its for another discussion. Take a note that disclosure issue will be brought in the House hearing.

Clayton emphasized that there was a need for clearer jurisdictional lines. Even though there was a lot of discussion about the cooperation between the agencies such as CFTC, SEC, Fed, the patchwork approach was brought up multiple times and that the current cooperation model was not enough to bring oversight and enforcement to the market, this is why federal level control of the market can become relevant in the upcoming hearings. But deploying federal level jurisdiction will be hard on those cryptocurrency exchange businesses that during the recent years suffered from expensive compliance of the state licensing. Unfortunately not much was said about state level legislation and MSB.

Neither SEC nor CFTC have jurisdiction over the spot markets for true cryptocurrencies. U.S. based cryptocurrency platforms have decided to be regulated for this cause as money-transmission services, which are state-regulated and not overseen directly by federal agencies. It must be brought up once again that there is a distinction between exchanges regulated by SEC or CFTC and all those user-friendly interfaces that crypto exchanges might be offering, the latter tremendously lacks oversight from federal agencies, they do not face any compliance mechanism that CMEX or NASDAQ are subject to have.

Bitcoin and similar cryptocurrencies that were deemed commodities had strong reasoning behind them, which were not questioned. As other commodities, bitcoin exists independently from any company or organization and is the result of the work that anybody can do to create it, much like oil and gold. But because bitcoin’s market is not as big, as regulated and as interconnected as oil and gold, it easily attracts market manipulators and fraudsters. And this creates market supervision gap over spot transactions. CFTC that oversees commodity futures market has a limited hand of authority in the spot markets, all it can do is to investigate post-factum breaches, frauds and custody management as per Dodd-Frank Act. This leaves crypto exchanges out of the oversight and this is where Senators and regulators mostly seem to agree to fill the gap. SEC can oversee the exchanges that trade securities, CFTC oversees the exchanges that trade commodity futures - this is very basic. State licenses that some crypto exchanges have got do not perform the job of the market oversight that federal agencies require, hence the need to do something will become urgent as the market cap for cryptocurrencies will rise. State licenses are transitory regulations that exchanges can have till something more robust and controlling is in place. Peter Van Valkenburgh has mentioned multiple times against the complicated and insufficient mechanisms that these licenses provide, they are burdens to the promise of global movement of the digital assets as Peter has mentioned.

During the hearing other agencies were frequently mentioned in conversation, signaling that this was mostly the warm-up, with bigger hearing and larger testimony panel in sight. We might expect at some point Consumer Financial Protection Bureau (CFPB) coming and bringing to the table number of consumer dispute claims towards crypto businesses.

After the hearing Brian Quintenz (CFTC commissioner) noted that in order to fill in gaps identified by federal agencies, the industry can resort to the formation of self-regulatory organization. Passing any bill will take a long time and industry can provide a necessary oversight over the spot market exchanges.

Regarding ETF rejections not much was said but Clayton mentioned that they could be coming when the agency is comfortable to do so but first it needs to tackle the custody issues, SEC looking into how hedge funds do custody might be indication for that. As for the CFTC’s recent developments Giancarlo said that his agency got its hands on the cryptocurrency data through Bitcoin Futures market, which has volatility but “not as large as other assets classes like VIX. We have seen extreme volatility in bitcoin but in our world of commodities we are used to volatility in asset classes” Giancarlo mentioned.

The debate here was about the fundamentals that these regulators look at, and so far, they are supporting the innovation and are being cautious about possible frauds. They show their understanding that crypto per se is nothing of a fraud, much the contrary, but its underlying technology makes it easier for scammers to scam people.

House Hearing

House’s financial services committee held a hearing with panel consisting of participants in crypto markets such as Peter Van Valkenburgh - director of research at Coin Center; Robert Rosenblum - partner at Wilson Sonsini Goodrich & Rosati; Dr. Chris Brummer - professor of law at Georgetown University Law Center and Mike Lempres - chief legal and risk officer at Coinbase. This time panel had a hands on knowledge of legal topics around cryptocurrencies. Room at the hearing didn’t seem to be packed with Representatives coming in and leaving the room as usual. This time again hearing started with a sound-bites towards the banks, but it did not echo in the remainder of the hearing as it did during the Senate hearing.

Lempres testimony focused on how fragmented the guidelines from authorities are and also outlined Coinbase activity on the market, emphasizing that they do not offer tokens to their customers that risk to be considered securities. Dr. Brummer put an accent on the importance of disclosure mechanism, mentioning the importance of S-1 filing with SEC, he included some basic disclosures such as location, problem and proposed technology solution, technology audit and publishing on the public domain as possible disclosure items. Rosenblum testimony recommended SEC to modify and amend their rules to conduct proper enforcement in the short term and for the long-term consideration he proposed a unified disclosure and registration, saying that now it is early for the full fledged legislation, it is better to take a look at market movements and act accordingly. Valkenburgh proceeded with explaining cryptocurrencies and bitcoin in a most understandable and eloquent manner saying “the fundamental achievement of Bitcoin and follow-on cryptocurrencies is digital scarcity” while pointing to the different types of crypto assets that exist today.

All testimonies differed in what they wanted to say and that was good. Lempres brought in use-cases from one of the largest cryptocurrency companies, Dr. Brummer talked about a really obvious and simple requirements, Rosenblum provided his vision for how to tackle the legislation in the coming time and Van Valkenburgh put a good description for each type of a token and their regulatory burdens.

Compared to the Senate hearing it was interesting to see two Representatives, Maloney and Budd, to raise questions of prospective bills that they are working on. Representative Maloney emphasized that she is working on the bill to regulate virtual currencies as investments, she implied that there will be a disclosure requirement that SEC will be able to enforce later on, but Dr. Brummer noted to her that not all virtual currencies are securities and SEC will not be able to enforce these disclosures on all the virtual currencies. In order for SEC to do so it will require to widen its authority. Howey test shows that some virtual currencies will fail it (will not be considered investment contracts) and thus will not be considered securities. Disclosure and another regulations as well will not stifle the innovation in the sector he said, it will promote healthy information sharing. For the unsophisticated investors disclosures can help to let them know about the risks that they are taking, as is the case with all investment disclosures.

Another regulation promise was heard from Representative Budd who asked Valkenburgh that if a security was under the jurisdiction of SEC would make a non-security a commodity. Again Howey test was brought to representatives’ attention and Valkenburgh followed with saying that EU was having more flexible framework towards digital assets and that people move to EU (Germany and Switzerland) because they provide more defined guidances and that SEC must as well provide one or we might see talent outflow. This is where it got interesting between panel members providing different perspectives on the same subject. Here Dr. Brummer said that EU has very undefined terms around virtual currencies under MiFID and that EU has as much uncertainty as U.S. and zero understanding of how it will eventually play out, as far as I understand Valkenburgh had a point, but Dr. Brummer broke it down to more regulatory pieces and his explanation seemed more right. While EU might be creating sandboxes that seem appealing to some companies, the overall sentiment from the EU is very vague as well.

I’d like to bring up Representative Emmer’s very vocal comment (instead of getting answers to his questions he used his time to make more statements). What’s interesting to me is that, apart from his republican banter on “fewer regulations”, he was one of the few who questioned the classification of the crypto assets. He required for more clarity and followed by questioning “what is a commodity, what is a security but as well what is a currency?" This might sound a little bit naive but this is the question I’d like to address later in this discussion.

Another highlight came as an echo to previously mentioned Marco Santori’s quote about security being investment contract at one point and not at another point in its lifecycle. This was brought up by Valkenburgh in regards to SAFT and later countered by Robert Rosenblum. Valkenburgh explained that what they do (token issuers) is that they sell the promissory notes in capital raising. Once it is past the development stage these promissory notes become commodities likely to be used (as others called them utility tokens). Here it became interesting as Rosenblum asked representatives that he’s not yet been asked about his position whether a token must be considered a security or not and provided that he thinks regulators must abstain from drawing lines between when a token is a security and when it’s a utility, it’s open to second guessing and will be difficult to assess firmly. Thus it is better to first observe the market, provide necessary enforcement for investor protection and for longer-term provide legislation that will have simpler terms, accommodating both of the descriptions and thus avoiding any rigid movements as of now. He said that you can describe that something is or is not a security by the Howey test, but not in the line of time when it goes from security to commodity - “this test does not provide this. Better have in the long-run a simple guidance that applies to both, so we avoid lawyers, courts, litigations and SEC”. This is fresh perspective being expressed publicly and anything that challenges widespread opinion is worth discussion at this stage, for this Rosenblum’s effort must be highly appreciated.

The hearing included lot of information in the form of replies by panelists, I’m willing to highlight some that I found pertinent to our further discussion.

Dr. Brummer was often bringing back the topic of disclosure saying at one point that Commodities and Securities Acts put a different emphasizes on disclosures that the House must take into consideration. Dr. Brummer argued that bitcoin is different from Gold, because digital currency is not tangible it is harder to understand, while gold is easier, because it’s there and it’s shiny and tangible. Commodities Act provides disclosures “as buyers beware approach”, it is not thorough and imperative in its tone while Securities Act is, which makes disclosure a clear obligation with punitive implications for providing misleading information, and putting more obligations on relationship between contracting parties over securities and platforms of trade. Regulations around disclosure in the crypto tokens must take into account and harmonize these two approaches, maybe leaning towards the Securities Act tone, because bitcoin is intangible and not clear to understand for the most of the people who are there to invest.

Dr. Brummer also raised very interesting question that was the need to incorporate information sharing in the rule-making, so that they do not enclose the token economy, this is important but completely blank field now. This can play a major role of how the decentralized promise plays out at the end of the day, if we have one framework that works only in one jurisdiction and it protects investors within its confined borders then we might have an issue where the funds can not move easily and freely.

Lempres was explaining Coinbase's position, saying that they do not support ICOs, because it’s the most vague issue for them and they, at this stage, do not deal with SEC because it is not yet clear what position it will eventually hold towards tokens that are securities, compared to CFTC which provides more guidance. Lempres mentioned that the state-wide licensing is not the most optimal attitude but he does not think there is a need to institute a new federal agency that will oversee crypto assets, all tokens so far fall under existing asset classes that each agency has jurisdiction to conduct oversight and enforcement, he said.

When insurance issue was raised Lempres said that the cash deposits that Coinbase is holding are FDIC insured but apart from this nothing is compliant with any federal regulations would it be the cybersecurity or anything else like their hot wallets where they hold cryptocurrency for immediate settlement and trades.

It was interesting to hear Coinbase making its decision to offer a new token, basing on the guidance from CFTC that said of Bitcoin, Ethereum and Litecoin to be a commodities and then Coinbase including Bitcoin Cash on the basis that it is a fork of a Bitcoin, thus a derivative of an already existing commodity.

Later Representative Foster asked about consolidated audits and authentication and if there were any mechanisms for them to exist. Lempres replied that exchanges do authentications by default and by applying KYC/AML regulations, but pure p2p transactions can still happen out of the sight of the regulators and exchanges, unless sophisticated blockchain analytics tool is in place to investigate the transacting parties. Exchanges as well do consolidated audit of the network but this is up to the debate and we’ll discuss this as well later on.

Lempres said that New York BitLicense, although a very thorough and hard to get (only 4 were issued in the State of New York), have chilled businesses, but at the same time made the companies that got them more “respected”.

As per Rosenblum, regulation by enforcement in this dynamic field sets bad example, he as well emphasized that all VC funding that he has been dealing with was done through PPM and not through white papers, that would seem crazy to him and this is true.

Valkenburgh brought up analogy of dot-com bubble, saying that there is a bubble but for each overvalued pets.com there was undervalued amazon during the bubble.

Valkenburgh continued on State Licenses by saying that crypto is a global movement of wealth not a state by state one, “the 40th license that your company will get is not the more robust security but just an extra, it won’t bring you reputation or security”. These licenses are focused on the movement from A to B and not custodianship.

Representative Scott later asked whether digital wallets that hold those currencies (securities in some cases) must be registered with SEC or be licensed as broker-dealers or have cybersecurity protocol compliance to avoid hacks. These were answered by Valkenburgh but not in full extent in my opinion, he mostly kept on explaining the jurisdictions between CFTC and SEC, that should have given a general understanding to the question, but the issue is more complex.

Valkenburgh ended hearing by saying that harmonization was critical in space. It was not anarchic between agencies but between agencies and state regulators. He finished by bringing in Giancarlo’s outline that said a) KYC/AML; b) Data report; c) Capital Requirement; d) Cybersecurity standards; e) Price manipulation/fraud will do most of the trick. It is a great outline but in case we want to avoid the new agency, we must first thoroughly classify tokens and define their natures.

Goat Rodeo

Both hearings were interesting and informative, but they didn’t provide much of the clues to understand overall attitude of the Congress towards crypto regulation. It seems to be in its early stages so far, where federal agencies and market players are providing information to the members of Congress. This is not bad unless investor rights are protected, the more of the hearing and inclination from Congress we are going to see, the more appropriately the market players can plan ahead their movements (this in itself includes investor protection from a perspective of a healthy actor).

It was as well obvious that no serious legislative debate could be initiated in an environment where Senator Elizabeth Warren was inquiring if SEC catered to Wall Street banks and not investors and where senators discussed tokens at their family gatherings. This again is not bad, it’s just not moving legislature ahead.

We now have a Senate hearing with federal agency chairmen discussing current crypto regulatory environment and a House hearing (great panel, insightful representatives, apart from you Sherman) with industry lawyers providing their insights into market and regulation- it is all set to further move ahead and start working on more clear guidances, this should be coming next I guess, providing more sentiment on how Congress will approach this subject overall.

In addressing these hearings and market movements, I would note investor protection as being an immediate need. Example for this was Ethereum price drop that was considered to be related to the SEC crackdown on ICOs. While whole market bled recent weeks with Ethereum the hardest, it displayed the correlation with scammish ERC20 tokens and its prime token. As most of the ICOs would be using ERC20 token to raise funds, the crackdown on shady ICOs would fear those exact investors the most, resulting in Ethereum tanking with them. If investor protection was in place per SEC mandate it could downsize the the correlation between the prime and derived tokens.

It is better to have a transparent discussion before events pain substantial number of people over the loss of funds. This kind of course of events risk regulators regulating crypto out of a populist fear, lacking rationale that some of them have today. That is to say that broader and more knowledgeable people still need to take the realms of crypto legislation. The more alike of Dr. Brummer, Rosenblum, Valkenburgh and Lempres we have to participate in these discussions, the healthier the process will be.

I would love to emphasize the participation of Dr. Brummer in the House hearing, somebody with academic approach to the crypto regulation is definitely bringing a fresh, thoughtful and deeper perspective. I particularly enjoyed him bringing the distinction factor between bitcoin and gold, even though they do look alike providing ground for commodity classification of it, the differences in perception between these two must be bringing their own effect to the market. And for the same reason I enjoyed Representative Emmer’s remark, who seemed to be the only one to ask this same question.

Law is law and we’re far from living a reality where code is law and to this extent law can be flawed if a) bad actors draft it, b) bad actors pass it. It will result in good actors being the victims of garbage politico-judicial oppression that had at its core social appeal.

If current regulatory issues become the only part that drives the market we then risk Congress decision to come fast and come without much opinion put in it. We need more things to happen other than regulatory to drive the market, exposing more issues to regulators so they are more thoughtful in their bills.

Everyone in crypto started to have a regulatory outlook and opinion, at first having a regulatory opinion would right-away cast you as bear, now I think that bear settled in and proved itself right, it became a rational norm. This drove general public to neglect further regulatory issues that might arise, passing their responsibility and questioning to the regulators and crypto lawyers. I must admit that public is now well-versed in ICO/securities, Senate hearings, Sen Warren opinions, there's this positive outlook and self-satisfactory moment regarding regulations that “knowing Howey test seems to be enough”, this as a result creates lack of a challenging questions being asked and that is what I refer to as a status quo. And yes, of course there are still extremist thoughts that would claim that Bitcoin can not be regulated because it is protected by the first amendment, because text?

A wake up call: too much is still to happen while there's too much ambiguity.

I believe goat rodeo that happens now is due to the subdued community that found relief and proof in some simple regulatory topics, in Giancarlo. One thing I’ve learned in crypto is that DYOR (Do Your Own Research) is of the major things you can do to protect yourself and develop your own assumptions. You can not rely on anything (especially when you read things on twitter or reddit, not saying they feed us fake news, but reading without analyzing or proof-checking can lead you to dumb mistakes).

Even though if I think that current process of not rushing to regulate things is the healthiest approach and that regulators can do things step by step, respectively or the agencies’ needs, I can’t get rid of a thought in the back of my head, that asks me if in order to deliver on the decentralized promise we would not need to review all the complex regulations, tax codes and various Acts that keep market functioning as it does today. Decentralized promise changes the contractual and executory parts of the transaction and isn’t most of the law written with that in mind? In such case this is a short-term remedy, but then again maybe this is perfectionist approach to the promise that won’t ever materialize itself. After all nobody is going to dedicate in their conscious mind time to revise these laws so extensively. Note that I’m not saying we need to overhaul and create free market anarchy, I might be implying that we might even need spot market oversight on the contrary and a balance not to stifle the innovation.

With all that being said, I’m leaving this section with two things in mind - a custodianship and lobbying. Custodianship in the world of cryptocurrency that must have in place investor protection and mechanisms to conduct consolidated audit, seems hard to execute through law. I omit the question of oversight over the custody because classification question is not yet addressed, but per my understanding regulating custody for assets managed through PKI, will stumble upon realities of poor user interface and finally upon the question what’s the point of crypto asset if I do not hold it then?

As for lobbying, I see trend where most of the things coming from legislative chambers that are called “initiatives, forums, meetings, hearings” are just pure banter. The real deal is when we see and force Senators to endorse bills, everything else (serving a publicity) in the world of social media is considered a positive PR. Governors hosting hearings and meeting people is very different from them endorsing and working on bills - this is what they do when they want to take action, it is hard to distinguish their intentions or even inclination to the topic before, they need to have something at stake for it. And for this matter, I think, when we see harder lobbying from crypto community, that’s when we’ll see more positive and direct actions taking place. Again as I’ve mentioned earlier in this discussion that educating lawmakers is one of the priorities, lobbying for the right cause is unfortunate job someone has to do and I think that Coin Center, Jerry and Peter deserve a lot of credit for this.

finance, technology, lawGiorgi Gurgenidze