Crypto Regulatory System In The U.S. Is ‘Untenable’

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In the aftermath of today’s hearing in the House of Representatives entitled: The Future of Digital Assets: Measuring the Regulatory Gaps in the Digital Asset Markets, I had the chance to speak with Marco Santori, one of the witnesses who appeared in front of members of House Agriculture and Financial Services subcommittees.

Marco is currently Kraken’s chief legal officer, and we used to work together at the exchange. In fact, he and I appeared on a panel together about crypto regulation all the way back in 2014 in Chicago. Through a career that has spanned partnerships at prominent law firms as well as serving as CLO at before leaving to join Kraken, Marco has been front and center through all of crypto’s legal battles.

His testimony came at a very interesting time for the exchange, as it recently entered a no-judgment $30 million settlement with the Securities and Exchange Commission (SEC) where it agreed to shut down its US staking business.

For all of these reasons, I was very interested to get his thoughts on the hearing and whether he saw any progress and a way forward.

Here are some key takeaways from the discussion:

  • When asked about points of agreement among the committee members, he felt that there was widespread belief that the “situation in the U.S. is untenable” for digital assets and that something needs to get done. Pressed for some specific points of commonality among the legislators, he pointed to the desire for consumer protection and ensuring that innovation continues to happen in the U.S. Left unspoken was that prominent U.S. exchanges such as Coinbase are already setting up shop in offshore jurisdictions like Bermuda.
  • In his opinion, the biggest challenge is settling the jurisdictional battle between the SEC and Commodity Futures Trading Commission (CFTC). As I’ve written many times, the SEC is trying to assert control by claiming that many of the hundreds of crypto tokens listed by exchanges in the U.S. are securities. What’s more, the SEC is using this line of argument to request that crypto exchanges register with it.
  • Santori told me that he prefers that the CFTC gain regulatory primacy over this sector because, as he said in the hearing, “Kraken does not list securities.” Of course this is open to interpretation, but Kraken (like every other regulated exchange in the U.S.) conducts an analysis of any token that it considers listing to assess its utility, security, technical sophistication, and of course whether or not seems to be a security. Although the exact methodology differs among exchanges, a big portion of concern about the last point is ensuring that the projects are sufficiently decentralized.
  • He also pushed back against the SEC’s contention that it is easy to come in and register with the agency. Specifically he said that “its baffling that the regulator thinks its that simple.” In our conversation he pointed out that a traditional S-1 (the document that a company files with the SEC as part of its application to go public), can cost millions of dollars to complete and typically does not cover relevant information when it comes to assessing the security status of a token. He noted that when it comes to crypto, appropriate data would include the number and distribution of nodes as well as items such as the amount of developers and Github commits.
  • One final point that I wanted to ask Marco about was whether or not the hearing provided any clarity on whether Kraken would need to break up in the into separate parts. For instance, another witness, the New York Stock Exchange Chief Operating Officer Michael Blaugrund pointed out how individual retail investors do not directly trade on the exchange, nor does it take custody of the securities. In crypto, exchanges are typically all-in-one shops that serve as brokers, dealers, custodians, exchanges and sometimes even banks. Obviously if the rules of the traditional financial world are transposed on crypto, it could force firms like Kraken, Coinbase, Gemini and Binance.US, to become less vertically integrated. While this may be good from a consumer-protection point of view, it could also lead to disruption of exchange business models. For his part, Santori was not concerned about this happening and was pretty resolute that the traditional financial model may not work in crypto. That it was not an apple-to-apple comparison. In some ways I see what he means—for instance he pointed out how blockchains replace transfer agents in the traditional financial world—but at the same time the faulty accounting and alleged fraud at FTX would at minimum necessitate a separation of custody from an exchange.

So where do we go from here? Today’s hearing was noteworthy because of the fact that it brought two subcommittees that will need to agree on legislation for it to go forward and have a chance of passing the Senate before ultimately going to President Joe Biden. In opening remarks the full financial service committee chairman Patrick McHenry (R-NC) noted his desire for working on a bipartisan nature for a solution.

What will that look like? That’s really the hard part and something that I will discuss tomorrow in my subscriber-only webinar about the current status of crypto regulation.

ZoomWelcome! You are invited to join a webinar: Crypto Comes Face To Face With Regulators: What You Need To Know. After registering, you will receive a confirmation email about joining the webinar.

At some point the rubber will need to hit the road, and legislators will have to make hard decisions such as choosing regulatory primacy, determining how much power states should have vis-a-vis regulators, whether it is possible to regulate against offshore companies targeting U.S. customers and how much regulatory leeway should be given to new projects trying to get off the ground. Join me tomorrow to discuss.

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