Comment Text:
Enacting the Financial Regulatory Body of the Future - A Proposal For An Integrated Regulatory Approach
The U.S. government will likely need to dedicate an entirely new commission or agency to solely regulate virtual currencies. Regulating an entirely new asset class cannot be done effectively or efficiently by working in six different silos. Similarly, digital assets should not be forced to fall within preexisting categories of regulatory interest. Bitcoin is not a stock. Bitcoin is not a commodity. Bitcoin is a CC. A brand new asset class that deserves its own separate regulatory consideration. The blockchain industry deserves not only the attention of regulators, but their respect. Innovators behind this emerging technology and blockchain payment systems deserve to be regulated by a jury of their peers. By this I mean, the blockchain industry should be regulated by those with education and experience that is relevant to blockchain and CC. Teaching old dogs new tricks, if not impossible, is really hard to do. If CC regulation is to be taken seriously by its market participants, the government will need to gain the assistance of those who market participants take seriously. There is already extreme cultural resentment that exists between CC enthusiasts and government. In fact, many market participants see CC as their only hope of being freed from government shackles. We need to hire the right people. The ideologies of stock brokers from the 80s are not going to be effective leaders in this space. Therefore, to be effective and avoid backlash, our government needs to adapt and keep pace with the changing ideologies of younger generations.
Blockchain enthusiasts Cameron and Tyler Winklevoss, the Co-Founders of Gemini, recently proposed that the virtual currency industry should be governed by a “self-regulatory organization.” The Winklevoss twins specifically advocate for the enactment of the Virtual Commodity Association (VCA), which would operate as an industry sponsored self-regulatory organization for the U.S. virtual currency industry. Their proposal outlines a membership-based structural framework that would be available for all U.S. based “virtual commodity platforms, over-the-counter (OTC) trading firms, and other trading facilities acting as counterparties that: Provide an all-to-all platform or venue, available to U.S. participants, for transacting in the spot virtual commodity markets; or Provide OTC or off-exchange services, for transacting in the spot virtual commodity markets.” The VCA structural framework would consist of: “(i) a non-profit, independent regulatory organization that does not operate any markets, (ii) will not be a trade association, (iii) will not provide regulatory programs for security tokens or security token platforms, and (iv) will be in compliance with global standards and best practices for SROs.” The VCA very much embodies the virtues emphasized throughout this article: current regulators are too far behind the 8-ball to be effective. However, there are several counter arguments that cut against the VCA proposal, one of which being that due to the Winklevoss twins’ direct participation in the market, they are an interested party—and thus prone to bias and a conflict of interests. There is some logic to that argument. The Winklevoss twins have certainly attained substantial riches as a direct result of their CC investments and market participation. Cameron and Tyler Winklevoss have amassed a CC fortune “worth about $1.3 billion,” according to estimates from the New York Times. However, the fact that Winklevoss twins are financially interested should not disqualify their proposal. As stated repeatedly throughout this article, in order to be more successful, regulators in this industry desperately need the assistance of “interested” parties like the Winklevoss twins. Such “interested” parties have a superior understanding of the blockchain industry’s inner-workings and underpinnings. Thus, it would be absurd to frown upon the mere existence of financial interest. This would offend basic principles of efficient capital markets. Their interest in the space adds value to their perspectives. They are highly motivated to assure the blockchain and CC markets’ overall success.
It is clear that market regulators intend not to stifle the industry, but to help it flourish safely. As cited above, regulators vowed to take a no harm approach since day one, and the Winklevoss twins have done everything the right way since day one. Gemini and the Winklevoss twins worked with the New York State Department of Financial Services (NYSDFS) to obtain a trust company license for Gemini’s exchange and custody business in 2014. Then later, in 2017, Cameron and Tyler Winklevoss were heavily involved in the development of the CBOE Bitcoin (USD) Futures Contract. They worked side by side with regulators and entered into an Information Sharing Agreement with the CBOE Futures Exchange (CFE). Their wisdom and guidance enabled CC Futures Contracts to become registered with the Commodity Futures Trading Commission (CFTC), “to allow CFE to perform cross-market surveillance of Gemini’s marketplace.” And finally, Gemini has enacted their own substantial regulatory policies within their own governing structure. Specifically, Cameron and Tyler have adopted an “internal Trading Policy with respect to material nonpublic information, as well as Marketplace Conduct Rules for all trading on [the Gemini] marketplace, in an effort to foster a rules-based marketplace.” Their assistance should be welcomed with open arms. Cameron and Tyler have meaningful credibility within the blockchain and CC space both as market participants and as regulatory collaborators.
The adoption of the VCA, or a Self-Regulatory Agency (“SRO”) generally, would also cost less and be more efficient — similar to how the SEC leverages organizations like the Financial Industry Regulatory Authority (“FINRA”) to effectively regulate broker-dealers, an SRO could perform the same function for CC exchanges, platforms, wallets, and ICOs. Many of the rules and regulatory frameworks are already in place. The enacting of the VCA would only add to the existing SEC and CFTC regulatory structure. Yes; the SEC would still have their enforcement powers regarding fraudulent ICOs. Yes; the CFTC would still otherwise regulate CCs to the extent that a particular CC is functioning as a commodity. There are still a whole lot of regulatory concerns that have yet to be adequately addressed (wholly outside the existing SEC/CFTC scope). While the regulatory concerns may be similar to other financial products already under government jurisdiction, the differences are substantial. Regulating “commodities” and “securities” that involve multifaceted amalgamations of code requires a heightened understanding of the technology. For example, there are several gaping holes: (1) due diligence procedures, (2) financial management standards, (3) conflict of interest rules, (4) surveillance protocols, (5) cyber security requirements, and (6) enforcement.
Due Diligence Procedures
Consumers deserve a commercially adequate due diligence process whereby individuals with industry-relevant knowledge perform proper diligence and legal analysis with respect to ICOs, exchanges, wallets, and existing virtual currencies. No such process currently exists. Meaning, there is no way for investors (or regulators) to verify that a particular blockchain, CC, or ICO, will perform in the manner it is purported to. Instead, investors are forced to “wait and see,” and in the event of fraud, hope that the SEC or CFTC can recover their funds after the fact. This is not an ideal regulatory framework. To encourage a transparent and honest industry, we need to have a proper due diligence process for emerging ICOs and blockchains.
Financial Management Standards
Any industry that involves finance requires transparent financial management standards. The blockchain and virtual currency industry is no different. We do not “wait and see” whether BAML or JP Morgan are engaging in fraudulent financial practices. We have mandatory continuous reporting and best practices that must be adhered to. The prevention of fraud and misappropriation of investor funds is just as important as the prosecution of such behavior. Therefore, any new regulatory organization should incorporate some form of universal fiscal management standards.
Conflicts of Interest
This is another common problem that must be addressed in any financial regulatory system. A competent regulatory organization must be tasked with assuring that the proper transparency protocols exist to avoid material conflicts of interest. The issues and concerns that conflicts of interest represent are widely known. Thus, an expansive definition is not necessary.
Cyber Security Requirements
The financial world is becoming more and more virtual—and it is becoming increasingly necessary to assure that market participants entrusted with sensitive information are taking the proper steps to prevent security breaches. Therefore, this would be additional area of importance with respect to blockchain and virtual currency regulation. The regulatory organization would be tasked with both implementing and maintaining adequate cyber security prevention systems and threat mediation.
Surveillance Protocols
Active virtual currencies, ICOs, and market participants need to be continuously surveilled to avoid negligent, reckless, or intentional wrongdoing or manipulation. This regulatory organization would have the responsibility to detect, deter, and discipline problematic behavior. This process would require enhanced supervisory guidelines and administrative requirements to be upheld by those primarily responsible for quality assurance and regulatory compliance.
Enforcement
While the SEC and CFTC have made capable efforts in this area, it must be further augmented by an additional layer of regulatory enforcement. These major U.S. regulatory bodies have wide ranging responsibilities with regard to the financial industry as a whole. Much in the same way that FINRA (Financial Industry Regulatory Authority) focuses its attention on continuous reporting, member regulation, and enforcement with regards to broker-dealers, the blockchain and virtual currency market also requires their own regulatory enforcement body and related procedures. This would enable the market to begin to self-regulate itself through the imposition of sanctions, fines, suspensions, and expulsions for violative conduct committed by market participants.
There are certainly a number of ways by which to address the above missing areas of regulatory focus. The VCA or a similar entity is certainly an option to consider, but it is not the only one. Other options may include: (1) the SEC or the CFTC could create an additional sub-commission or sub-agency solely dedicated to CCs; (2) the SEC could delegate the continuous reporting and regulatory oversight to FINRA; (3) U.S. legislators could enact a wholly separate government entity; or finally (4) the CFTC and SEC can continue to work in silos. There is arguably not a meaningful difference between options 1 through 3, but option 4 should be strongly disfavored for obvious reasons. Generally, all of these options (with exception of tapping FINRA), will require additional resources and government spending. Therefore, to the extent that government leaders favor less costly approaches, perhaps it would make the most sense to support the adoption of the VCA. In the alternative, expanding FINRA’s scope of authority may also be an effective option. FINRA has both the physical infrastructure and requisite quasi-governmental structure in place to hit the ground running in this space. In the broker-dealer space, FINRA has already proven itself as a highly effective regulatory presence in the financial industry. In fact, the SEC has already delegated some investigatory and consumer education tasks to FINRA regarding ICOs. Additionally, FINRA’s 2018 Regulatory and Examination Priorities Letter states the following regarding their role and approach to ICOs and CCs:
Initial Coin Offerings and Cryptocurrencies
Digital assets (such as cryptocurrencies) and initial coin offerings (ICOs) have received significant media, public and regulatory attention in the past year. FINRA will closely monitor developments in this area, including the role firms and registered representatives may play in effecting transactions in such assets and ICOs. Where such assets are securities or where an ICO involves the offer and sale of securities, FINRA may review the mechanisms—for example, supervisory, compliance and operational infrastructure— firms have put in place to ensure compliance with relevant federal securities laws and regulations and FINRA rules.
Perhaps FINRA’s role should be expanded to not only continuously monitor broker-dealers within the financial industry, but “broker-dealers” and exchanges within the CC industry as well. By requiring CC market participants to be FINRA members, the U.S. government could easily address the aforementioned gaping holes. As a reminder: (1) due diligence procedures, (2) financial management standards, (3) conflict of interest rules, (4) surveillance protocols, (5) cyber security requirements, and (6) enforcement. FINRA is well suited for addressing these issues, as the organization already performs market regulation functions in all of the above areas. The subject matter is different, but the behavior is the same.
Conclusion
The “wild wild west” or “regulatory sandbox” approach is simply not sustainable. While our current approach has enabled us to bridge the gap from the early stages of blockchain to today’s environment, steps must be taken to assure a safe and efficient marketplace. As previously mentioned, the Winklevoss twins have proposed that a “self-regulatory” organization which may be well suited approach for the job. However, there are various options available to decision makers and government leaders. Therefore, for the aforementioned reasons, U.S. government actors should feel compelled to either: (1) support the Winklevoss proposal; (2) expand FINRA’s scope of authority to include CCs and its market participants; or (3) enact a government agency with a similar function using the regulatory framework outlined in the above section.
