SBC Hearing on Virtual Currencies with the CFTC and SEC

Senate Banking Committee

“Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission”

Tuesday, February 6, 2018

Key Topics & Takeaways

  • Regulatory Task Force: Sen. Richard Shelby (R-Ala.) asked if the agencies can put together a task force on cryptocurrencies on their own or if they need legislative assistance, to which Clayton replied that Treasury Secretary Steven Mnuchin has brought the SEC, CFTC, Fed, and Treasury together in a virtual currency working group. Giancarlo added that Mnuchin has been on the front line with this topic, and that they have had preliminary conversations and workstreams. Clayton stated that the agencies may come back to Congress with Treasury and the Fed to ask for expanded authority in the future.
  • Understanding Cryptocurrencies: Sen. Jack Reed (D-R.I.) asked if either agency has technologists or computer experts that understand how the cryptocurrencies work and where they may go in the future. Clayton replied that the SEC’s crypto cyber working group has done an “exceptional” job at getting up to speed on the issue, but that they could always use more “horsepower.” Giancarlo stated that the CFTC hired its first Chief Innovation Officer last year and created LabCFTC in New York City, where much of the innovation occurs. He continued that the CFTC has also formed a virtual currency enforcement task force to bring actions against fraudsters and manipulators, with more actions to come. Giancarlo then stressed the need for additional budget resources for FinTech, cybersecurity and cryptocurrencies.
  • Blockchain: Sen. Tom Cotton (R-Ark.) asked about the potential value of blockchain, and Giancarlo replied that there would be no Bitcoin without blockchain. He continued that distributed ledger technology is being used for manywithout access to banking services, and gave an example of American soy beans being sold to China through blockchain technology. Giancarlo added that if regulators had access to distributed ledger technology in 2008, they would have been able to make “more precise decisions” quickly.

Witnesses

Opening Statements

Chairman Michael Crapo (R-Idaho), Senate Banking Committee

In his opening statement, Crapo said that Americans are more interested in virtual currencies after their “meteoric” rise and valuation, citing the almost $20,000 peak of Bitcoin in December, as well as its current value of around $7,000. He noted that due to the change in market capitalization of virtual currencies, regulators have noticed the interest and given input on the products, and tried to educate investors and ensure the financial markets they oversee “work appropriately.” Crapo described the multiple statements the Securities and Exchange Commission (SEC) has released, as well as investor bulletins on initial coin offerings (ICOs), and enforcement actions against fraudsters. He then noted the Commodity Futures Trading Commission’s (CFTC’s) virtual currency website, and their own enforcement actions against scammers, adding that the CFTC has held multiple hearings and meetings on the topic.

Ranking Member Sherrod Brown (D-Ohio), Senate Banking Committee

In his opening statement, Brown also noted the attention investors have given to Bitcoin and other virtual currencies, explaining that it is “remarkable” they have spread so fast, and stressed the “critical” need for regulators to understand the technology and innovation so markets evolve, and investors continue to be protected. He noted that while the CFTC and SEC have both made public statements on threats to investor protection, neither agency has enough authority to “police all aspects of virtual currencies.” Brown also stated that while the U.S. and Financial Crimes Enforcement Network (FinCEN) are leaders on the topic, they “need to do more” by looking at gaps in regulations to “get ahead of the curve.”

Testimony

The Honorable Jay Clayton, Chairman, Securities and Exchange Commission (SEC)

In his testimony, Clayton briefly discussed the “promising new technology” known as blockchain, explaining that it can bring “great efficiencies” to the economy, including capital markets. He then discussed cryptocurrencies and ICOs, noting that cryptocurrencies have been introduced as substitutes for traditional currencies, such as the dollar and euro, and that it has been said cryptocurrencies will make it easier and cheaper to buy and sell goods across borders, reducing transaction fees and costs. Regarding ICOs, Clayton argued that many are securities offerings, stating that while they are called coins, “if it functions like a security, it is a security.” He then discussed the problems with how cryptocurrencies and ICOs operate, to include how ICO markets have “substantially less oversight” than traditional securities markets, and that investors should not take comfort in that cryptocurrencies are traded on what looks like a stock exchange platform. Clayton stated that many ICOs are conducted illegally, with promoters not following securities laws, but that the SEC believes ICOs are securities and will continue to work with the Department of Justice (DOJ) and other regulators to enforce laws.

The Honorable J. Christopher Giancarlo, Chairman, Commodity Futures Trading Commission In his testimony, Giancarlo spoke about his college-aged children’s interest in cryptocurrencies, and argued that regulators should not dismiss the new technology, but instead “respect” the interest in the technology and “crack down hard” on those committing fraudulent and manipulative activity to protect investors and reduce risk for consumers. He listed several ways for the CFTC to respond to virtual currencies, to include: 1) Learn everything possible, such as through LabCFTC which engages with innovators to educate the rest of the agency on financial technology (FinTech); 2) Put things in perspective; 3) Educate consumers and talk to the public by setting the record straight despite the negative “noise,” through podcasts, webinars, education sessions at local libraries, and briefing seniors; 4) Regulatory coordination to ensure the SEC, CFTC, Internal Revenue Service (IRS), Federal Reserve, FinCEN, and state banking officials are working together; 5) Exercise their legal authority over derivatives on virtual currencies; and 6) Have tough enforcement.

Question & Answer

Agency Jurisdiction and Coordination
Crapo asked if either agency has sufficient jurisdiction over virtual currencies or if Congress should refine current law so either one agency or multiple agencies have complete jurisdiction. Clayton stated that federal banking regulators should come together and have a coordinated plan for the virtual currency market, but that regulators may need additional legislative authority. Giancarlo added that regulators know where the gaps are, and that there is a “patchwork” of state regulation in the U.S., with some states being more assertive than others. He added that FinCEN is active in anti-money laundering (AML) and know your customer requirements, but that the patchwork is “not a comprehensive structure.”

Crapo then noted that much of the virtual currency activity is cross border and asked about FinCEN’s role. Clayton replied that the international market is why the state patchwork is “probably not sufficient.” He added that FinCEN has stepped up when it comes to virtual currencies being used for illicit activities. Giancarlo added that there are regulatory challenges in the global markets and dealing with international regulators when it comes to carrying out derivatives regulations in the Dodd-Frank Act, and that “this area requires a lot of new thinking.”

Brown asked if there has been any coordination with the Consumer Financial Protection Bureau (CFPB), to which Clayton replied that their conversations have been conducted through Financial Stability Oversight Council (FSOC) meetings.

Sen. Richard Shelby (R-Ala.) also asked if the agencies can put together a task force on cryptocurrencies on their own or if they need legislative assistance, to which Clayton replied that Treasury Secretary Steven Mnuchin has brought the SEC, CFTC, Fed, and Treasury together in a virtual currency working group. Giancarlo added that Mnuchin has been on the front line with this topic, and that they have had preliminary conversations and workstreams. He also stated that he has had solo conversations with Mnuchin on virtual currencies. Regarding legislation, Clayton stated that the agencies may come back to Congress with Treasury and the Fed to ask for new authority.

Sen. Mark Warner (D-Va.) commended Mnuchin for creating the agency working group, and asked if virtual currencies should be elevated to an FSOC-level of analysis. Clayton and Giancarlo replied that the issue has been discussed at FSOC meetings, and also with the Financial Stability Board (FSB) and the International Organization of Securities Commissions (IOSCO).

Oversight Hindrance
Brown asked how the agencies will continue to fight traditional misconduct while staying on top of virtual currencies. Clayton replied that the SEC has a personnel challenge due to their hiring freeze, and that they could use more people in their enforcement and trading and markets units.

Understanding Cryptocurrencies
Sen. Jack Reed (D-R.I.) asked if either agency has technologists or computer experts that understand how the cryptocurrencies work and where they may go in the future. Clayton replied that the SEC’s crypto cyber working group has done an “exceptional” job at getting up to speed on the issue, but that they could always use more “horsepower.” Giancarlo stated that the CFTC hired its first Chief Innovation Officer last year and created LabCFTC in New York City where much of the innovation occurs. He continued that the CFTC has also formed a virtual currency enforcement task force to bring actions against fraudsters and manipulators, with more actions to come. Giancarlo then stressed the need for additional budget resources for FinTech, cybersecurity and cryptocurrencies.

Reed then asked if someone is tracking cryptocurrencies daily and what the long-term systemic effects could be. Giancarlo replied that while there are many virtual currencies, only a handful have “significant traction,” and that they “have to watch [them] carefully.” Clayton added that while the SEC does not have direct jurisdiction, they watch because they are integrated with markets they do oversee.

Shelby asked about how cryptocurrencies are given value, to which Clayton replied that it is what investors are willing to pay.

Sen. Mike Rounds (R-S.D.) asked if Bitcoin is a commodity or security, to which Giancarlo replied that it has characteristics of “multiple different things.” Giancarlo continued that Bitcoin is a medium of exchange, stores value, and a means of accounts, all of which have different implications. He added that he has seen many means of exchanges closed to Bitcoin, but that from the CFTC’s perspective, if it as used as a store of value, it is like an asset or commodity.

Sen. David Perdue (R-Ga.) noted the “pump and dump” efforts in the virtual currency and ICO space, to which Giancarlo replied that the CFTC’s virtual currency enforcement task force is “digging deep” into the issue.

Sen. Tom Cotton (R-Ark.) asked what makes the price of Bitcoin so volatile, to which Clayton replied that he “doesn’t know,” but that it is not correlated with sovereign currencies.

Blockchain
Cotton asked about the potential value of blockchain, and Giancarlo replied that there would be no Bitcoin without blockchain. He continued that distributed ledger technology is being used for many people without access to banking services, and gave an example of American soy beans being sold to China through Blockchain technology. Giancarlo added that if regulators had access to distributed ledger technology in 2008, they would have been able to make “more precise decisions” quickly.

Sen. Catherine Cortez Masto (D-Nev.) noted her concern that companies will utilize blockchain to pump up stock prices, to which Clayton replied that the SEC has released warnings in this space to securities lawyers, and Giancarlo added that the big task is bringing forward enforcement cases.

Fiduciary Rule
Sen. Elizabeth Warren (D-Mass.) asked Clayton to comment on whether the SEC will weaken existing protections for retirement savers with their fiduciary rule. Clayton replied that the relationship between a client and their investment advisor or broker dealer is regulated by “no less than 5 people,” all with different standards, and that the SEC wants to bring clarity to those regulations without impacting investor protection.

Regulatory Arbitrage
Perdue asked if there could be jurisdictional arbitrage with cryptocurrencies and ICOs. Clayton replied that it is seen in the market, such as with tax loss due to a lack of recordkeeping and transactions being hard to trace, adding that it has been a largely unregulated space internationally, but that countries are beginning to take their own actions. Giancarlo added that the CFTC is also seeing price arbitrage and gave an example of a Bitcoin premium in South Korea due to the amount of interest in the country, causing the prices to increase. Regarding ICOs, Giancarlo stated that agencies are using their full authority to enforce regulations, as well as in other counties, such as Japan.

Investor Protection
Sen. Joe Donnelly (D-Ind.) asked how other agencies can protect investors from fraud and manipulation, to which Giancarlo described the CFTC’s partnership with the CFPB to educate consumers on Bitcoin. He continued that they are also educating local librarians on the topic because consumers tend to research the topic at libraries across the country, as well as creating podcasts on the subject, noting that the CFTC has “never done outreach like this” on a subject. Clayton added that the SEC’s office of investor education has done a “terrific” job getting the word out, and that there are financial intermediaries that also educate the public.

Cortez Masto asked how investors can get their money back when virtual currencies are stolen. Clayton replied that when consumers make investments online with offshore entities, there is very low chance regulators can get the money back, and that the SEC warns about this risk in the education documents they produced. Giancarlo added that for markets they do not regulate, they do not have the authority to require specific cyber safeguards.

Terrorist Organizations and Sanctions
Donnelly asked how agencies can help enforcement authorities to ensure virtual currencies are not used by terrorist organizations, to which Giancarlo described the CFTC’s secondment program with the Federal Bureau of Investigation (FBI) so agents can get a better understanding of the issue, and that agencies like FinCEN also coordinate with law enforcement agencies. Clayton added that the SEC has a dark web working group that identifies issues in the terrorist funding space.

Sen. Robert Menendez (D-N.J.) stated that Russia and Venezuela are using virtual currencies to evade U.S. sanctions, and asked if either agency has a role to play in reducing this practice. Giancarlo replied that the CFTC’s role is “very limited,” but that if the Commission thought virtual currencies were being used for fraud or manipulation, the CFTC would not hesitate to bring enforcement. He added that this area is one of the greatest jurisdictional lapses for the SEC and CFTC.
Disclosures
Sen. John Kennedy (R-La.) questioned the need for additional disclosures, arguing that investors do not read the disclosures they currently receive on stock exchange traded funds, mutual funds, or bonds. Giancarlo stated that disclosures are a principle of securities law, but that many investors only study the prospectus to see if they can sue should something go wrong, Clayton added that disclosures can be improved to ensure they make sense and help investors.

Exchange-Traded Funds

Warner stated that the allowance to trade futures on Bitcoin may have been done “too fast,” noting that the SEC has not allowed exchange-traded funds. Giancarlo replied that it is important for agencies to coordinate in this area, and added that Bitcoin futures and Bitcoin are “totally different,” as futures are regulated.

Sens. Jerry Moran (R-Kan.) and Menendez asked why the SEC is unwilling to approve an ETF proposal, arguing that ETFs reduce volatility, increase price discovery and reduce risk. Clayton replied that the SEC does not want to approve ETF products with cryptocurrency underliers until the Commission is comfortable, but that they will move forward when they are ready.

Cybersecurity
Moran stressed the need for the federal government to modernize their information technology (IT) systems, and described a new fund in the defense budget for federal agencies to “rid themselves of legacy technology,” giving them access to additional funds to replace their old technology and move into cloud-based technology. He continued that the federal government has to have better, safer technology, adding that both the SEC and CFTC have much risk in the data they hold.

For more information on this hearing, please click here.