The cryptocurrency market is in the throes of an extended crash, as the implosion of FTX rattled an entire sector already shaken by dramatic price drops and bankruptcies of major players. But before the dust settles, the list of failed crypto firms is likely to have grown substantially, along with the list of investors who have suffered serious financial loss. Calls for a robust framework to protect investors and bring some standards and stability to the marketplace are increasing.
Opinions differ as to how we got here: US Securities and Exchange Commission Chairman Gary Gensler would say it is because so many in the industry have failed to comply with securities laws. In his view, most of the tokens being traded are securities and, therefore, trading venues should abide by the robust investor protection standards that exist for securities exchanges. Many in the sector disagree and claim the tokens they trade are commodities. But while the Commodity Futures Trading Commission oversees commodity derivatives markets, it has very little authority when it comes to the spot market for crypto, which is where most of the trading occurs.
This leaves a major gap: the spot market in cryptocurrencies that are not deemed securities. The Financial Stability Oversight Council issued a report recommending that ‘Congress pass legislation that provides explicit rulemaking authority over the spot market for crypto assets that are not securities’ as well as legislation to regulate stablecoins. In addition, it recommended Congress ‘develop legislation that would create authority for regulators to have visibility into, and supervise, the activities of all of the affiliates and subsidiaries of cryptoasset entities, in cases in which regulators do not already possess such authority.’
While there are a few different proposals that purport to address this — including one proposed by Senators Cynthia Lummis and Kirsten Gillibrand and another proposed by Senators Debbie Stabenow and John Boozman — they take very different approaches. And while the FTX collapse increased the pressure to do something, there is no consensus on what that should be. The legislative process is likely to take time and there is no certainty that Congress will pass anything.
Fortunately, there may be a simpler and faster way to improve regulation of cryptocurrencies without waiting for Congress.
The SEC and the CFTC could, under current law, establish a joint self-regulatory organisation for the cryptocurrency market. Such an organisation, analogous to the Financial Industry Regulatory Authority or the National Futures Association, would develop standards on issues like protection and custody of consumer assets, governance standards, conflicts of interest, financial resources, including capital and margin, risk management procedures, fraud prevention and more. These standards would apply to trading venues and other intermediaries regardless of whether the tokens they trade are securities, commodities or something else.
Drawing up these standards would require a thorough understanding of securities and derivatives market rules, as well as a deep knowledge of crypto technology and market structures. An SRO would be an effective means of establishing a body with the collective expertise required.
It is important to note that SROs are only effective if regulators consistently use or threaten to use their authority to supervise their work and hold them accountable. Governance, membership, development and implementation of standards must all be overseen and approved by both the SEC and CFTC.
Ensuring a critical mass of industry players join such an organisation will require both carrots and sticks from authorities.
There is likely to be a market advantage to joining an effective and trusted SRO, since it may create greater investor confidence that members are adhering to more rigorous standards of investor protection than competitors outside the SRO.
Similarly, members would benefit from regulatory certainty, since the SEC and CFTC could focus their attention on actors that fail to comply with the SRO’s standards.
Through close oversight of the SRO, the SEC and CFTC can ensure that the standards it develops are sufficiently rigorous and in line with those applied to traditional securities and derivatives markets.
The costs of an SRO would also be borne by the industry, thus avoiding a drain on the budgets of either agency.
The crypto market desperately needs better regulation. The jurisdictional turf wars and wrangling over definitions is leaving gaps in regulators’ oversight, which are being exploited constantly by the industry. FTX’s collapse illustrates the high cost of the absence of effective regulation.
An SRO offers an efficient way to establish guidelines for the market without the delays involved in litigating classification questions, as it brings together the necessary expertise and the regulatory muscle required to enforce standards.
Howell Jackson is James S. Reid, Jr. Professor of Law at Harvard Law School. Timothy Massad is Research Fellow at the Kennedy School of Government at Harvard University, Adjunct Professor of Law at Georgetown University Law Center and Non-resident Scholar at the Brookings Institution.
This is an edited version of a paper by Howell Jackson and Timothy Massad. Read the full version here.