Investors at risk in absence of adequate US crypto regulatory regime

The writer is an emeritus professor at Harvard Law School and director of the Committee on Capital Markets Regulation

The failure of the FTX exchange has triggered a sharp regulatory crackdown on the crypto world. The Securities and Exchange Commission brought civil charges against the largest crypto exchanges in the world — Binance and Coinbase — for allegedly failing to register with the regulator as securities exchanges.

But US crypto investors remain at risk in the absence of an adequate regulatory framework for crypto, particularly in the case of Binance, which has been accused by the SEC of commingling billions of dollars of customer funds. The reality is that SEC chair Gary Gensler had the opportunity to establish one but he failed to act.

As recently as May 2021, Gensler admitted in Congressional testimony, that the problem was that there was “no regulatory framework” for crypto exchanges to register at the SEC. But in December 2022, immediately after FTX failed, Gensler reversed course, instead claiming that crypto exchanges should “come in and register” with the SEC.

But can crypto exchanges actually register as securities exchanges? The answer is no. The SEC’s very own regulations have made it impossible to do so, according to a report by the Committee on Capital Markets Regulation (CCMR), a non-profit organisation.

Most importantly, if a crypto exchange were to register as a securities exchange, then it would have nothing to trade. That is because registered securities exchanges can only list and trade crypto assets that have been registered with the SEC as securities.

And only five out of the 23,000 digital assets in existence are actually registered with the SEC. These five digital assets constitute 0 per cent of the $230bn in daily crypto trading volume. They would not be able to trade digital assets such as bitcoin and ether, which are not registered securities and constitute the majority of the trading of digital assets. The SEC could easily solve this problem by using its exemptive authority to allow both securities and non-securities to be traded side by side on a registered exchange.

 Also, the SEC has failed to tailor its disclosure requirements to crypto. Issuers of registered equity and debt securities are sensibly required to provide ongoing disclosures of operations but this would not make sense for digital assets such as bitcoin and ether that have no operations and have a value that is based solely on supply and demand. Other jurisdictions, including the EU and Japan, have adopted disclosure regimes for registering crypto assets that address these issues.

Trading on registered securities exchanges is also limited by law to registered broker-dealers, but none of these are registered to trade crypto assets. Again, the SEC has made it impossible for a broker-dealer to register to trade crypto assets because its rules prohibit such parties from trading other assets such as stocks or bonds. There is no way that established broker-dealers could operate a business exclusively trading crypto assets. On the contrary, all other major jurisdictions allow registered broker-dealers to trade crypto assets along with other financial assets.

One option left for exchanges is to exclusively trade digital assets that are not securities so they do not have to register as securities exchanges. Indeed, a new crypto exchange—EDX Markets, backed by Citadel Securities and Fidelity, appears to have done just that. This solution, however, does not allow crypto exchanges to trade registered securities and non-securities side-by-side. And it does not result in providing regulatory investor protection standards of securities exchanges to crypto exchanges.

The SEC’s unnecessary failure to create a registration regime for crypto exchanges has not gone completely unnoticed. The House Financial Services Committee and House Agriculture Committee have proposed legislation to create a workable registration regime for crypto exchanges, but it is in the very early stages.

It is possible that the SEC’s strategy is to ban crypto entirely by forcing exchanges to do the impossible and then sue them for not doing so. But it is not the SEC’s role to determine whether crypto assets, or any other financial assets for that matter, are worthwhile investments.

Instead, it is the SEC’s responsibility to establish investor protections that allow investors to safely make that determination for themselves, as regulators in all other major jurisdictions have done for crypto. And, at that core mission, the SEC and Gensler have clearly failed, with the result very likely being mounting investor losses in the future.

John Gulliver, research director of the CCMR, contributed to this article