March 14, 2018
House Financial Services Subcommittee on Capital Markets, Securities, and Investment “Examining the Cryptocurrencies and ICO Markets”
Key Topics & Takeaways
- Commodities or Securities: Coin Center’s Van Valkenburgh noted the Howey test is helpful in going after schemes that are pretending to not be securities, but that it is not a global tool., adding that Europe has a black letter law approach rather than a test. Wilson Sonsini Goodrich & Rosati’s Rosenblum argued that trying to make a distinction between the two could lead to market distraction, and that it is difficult to draw a line between, creating a climate of second guessing. Rather than creating regulations that try to decipher between the two, he argued that there should be one system that can be applied to both securities and commodities.
- Agency Harmonization: Rep. David Scott (D-Ga.) asked if Congress should include a rule on agency harmonization in any legislation they create, to which Van Valkenburgh replied “yes, harmonization is critical.” He continued that the harmonization is not only needed between federal agencies, but also between federal agencies and state regulators, as current state-by-state money transmission licensing is redundant, costly, and the “biggest impediment” to the technology. He also argued that federal preemption of state money transmission licensing law should be discussed and include investor protections.
- Cybersecurity: The security of Blockchain technology and cryptocurrency markets was a frequent topic of discussion. Van Valkenburgh discussed protections surrounding Blockchain, explaining that every participant’s computer would have to be hacked for the technology to be compromised, allowing for well-protected records. Coinbase’s Lempres added that their protocols are “state of the art” with a team that solely handles cybersecurity.
- Mike Lempres, Chief Legal and Risk Officer, Coinbase
- Dr. Chris Brummer, Professor of Law, Georgetown University Law Center
- Robert Rosenblum, Partner, Wilson Sonsini Goodrich & Rosati
- Peter Van Valkenburgh, Director of Research, Coin Center
Subcommittee Chairman Bill Huizenga (R-Mich.)
In his opening statement, Huizenga discussed the rapid growth in the cryptocurrency and initial coin offering (ICO) market over the past year, and even more so in the past few months. He went on to explain and how ICOs are used by companies and startups to raise capital for their businesses, noting that they are different than initial public offerings (IPOs). He continued that while investors are paying attention to this new technology, regulators are also picking up on it due to the fraudulent activity and scams conducted through ICOs. Huizenga stated that the hearing is to review applicable laws and regulations for cryptocurrencies and ICOs, as well as the approach regulators are using when it comes to overseeing and monitoring the new technology.
Subcommittee Vice Chairman Randy Hultgren (R-Ill.)
Hultgren stressed the need for Congress to protect investors from fraud, scams, and bad actors, adding that the Securities and Exchange Commission (SEC) has come forward saying many online trading platforms have claimed they are registered with the Commission when, in reality, they are not.
Rep. Brad Sherman (D-Calif.)
Sherman referred to cryptocurrencies as a “crock” and questioned what social benefit they provide aside from assisting terrorists and criminals with moving money, adding that ICOs “mirror the image” of an IPO and “deliberately name themselves to lie to the public.”
Mike Lempres, Chief Legal and Risk Officer, Coinbase
In his testimony, Lempres noted that “responsible” regulation is needed for cryptocurrencies and ICOs to fulfil their potential, while cautioning that the new technology could be “stifled” by such regulations. He introduced Coinbase and described what his company does, including helping to train law enforcement on the subject, stating that they are the “most trusted company in this space” with the highest levels of compliance in the industry. Lempres discussed his company’s model and how they only buy and sell forward digital currencies, not delving into margin or derivatives trading. He then discussed ICOs, stating that they are “full of enormous potential,” allowing entrepreneurs to access capital, but cautioned that responsible regulation is needed to protect investors without “shutting out” new technology and good actors. Lempres noted that the SEC, Commodity Futures Trading Commission (CFTC), Financial Crimes Enforcement Network (FinCEN), and Federal Trade Commission (FTC) all have the authority to oversee parts of this technology, as well as state regulators. He concluded that regulators must be able to understand the difference in tokens, as they are not all the same, explaining that while some are commodities, others are securities, and should be regulated as such.
Dr. Chris Brummer, Professor of Law, Georgetown University Law Center
In his testimony, Brummer focused on what should be included in disclosures for buyers of ICO tokens to be well-informed, to include: 1) Promoter’s location and contact information; 2) Problem and proposed technology solution; 3) Description of the token; 4) Blockchain governance; 5) Qualifications of the technical team; and 6) Industry risk factors. He stressed that just like other types of investments, investors should be able to see where the promoter is located to better understand what state rules and regulations are provided for the investor. Brummer continued that there is “no information more important than an issuer’s financial statements,” describing the reforms he sees that would include requiring “plain English” descriptions of a problem and solution, and that disclosures for Blockchain should also be provided.
Robert Rosenblum, Partner, Wilson Sonsini Goodrich & Rosati
In his testimony, Rosenblum made suggestions to Congress for the short- and long-term. He stated that Congress could help ICOs in the short-term by helping to guard investors from fraud by allowing the SEC and other appropriate federal regulators to modify or amend their existing rules to assist ICO issuers in meeting securities law requirements. Rosenblum specifically noted that current registration requirements do not work well because they are not targeted at ICOs, calling on the SEC to amend or modify those rules. In the long-term, he suggested that Congress have a unified disclosure approach, registration approach, and legislative approach when it comes to how ICOs and tokens are dealt with in the U.S. but cautioned that it is too early in the process to craft such legislation, as the industry changes too quickly.
Peter Van Valkenburgh, Director of Research, Coin Center
In his testimony, Van Valkenburgh explained digital scarcity and how it is the fundamental innovation of Bitcoin, as well as what Blockchain is. He stated that Blockchain relies on an open network of participants who are independently verified, and that records are always available as long as a participant is online and considering the thousands or millions of participants there are, the records will likely always be available. Van Valkenburgh also discussed the protections surrounding Blockchain, explaining that every participant’s computer would have to be hacked for the technology to be compromised, allowing for well-protected records. He then discussed the need for differentiating between tokens used for payment (commodities) and promises of future tokens (securities), stating that both types of tokens have investor protections risks, but that they must be approached differently by their regulators, the SEC for securities and CFTC for commodities.
Question & Answer
Multiple Members of Congress asked what current protections and hazards there are for investors, especially those who are not as familiar with the technology. Brummer replied that the SEC is working to operationalize part of its authority, but that not all tokens are subject to the SEC’s oversight. He continued that the instruments can be “very dangerous,” as it is not clear in disclosures what risks there are, and investors could end up losing all their money. Brummer called for “much more fulsome information for those interested in participating.”
Huizenga noted that SEC Chairman Jay Clayton and CFTC Chairman J. Christopher Giancarlo both stated that they may come to Congress in the future asking for help with drafting legislation to oversee this new market and asked what Congress could do in the meantime to help. Rosenblum stressed that the immediate legislation needed would authorize the SEC and other regulators to amend their existing rules and give further protections to cover the new technology but cautioned that it is hard to develop such legislation due to how quickly the industry moves.
Securities or Commodities
A common question throughout the hearing was how to differentiate whether a token is a security or a commodity. Lempres stressed that there is an important distinction between the two, as they perform different functions, and therefore must be treated differently. Van Valkenburgh noted the Howey test for what a security is, but that it is not a global tool. He explained that Europe has a black letter law approach rather than a test, but that the Howey test is helpful in going after schemes that are pretending to not be securities. Rosenblum argued that trying to make a distinction between the two could lead to market distraction, and that it is difficult to draw a line between, creating a climate of second guessing. Rather than creating regulations that try to decipher between the two, he argued that there should be one system that can be applied to both securities and commodities.
Regulatory Coordination and Guidance
Rep. David Scott (D-Ga.) noted that there seems to be a regulatory “shortfall” with the technology between federal and state regulators, to which Lempres argued that there are sufficient authorities in place. Scott then asked what federal regulators could do differently when it comes to enforcement or formal guidance. Rosenblum argued that clear guidelines are needed from the regulators, for example when it comes to SEC registration rules and exchange rules, cautioning that the rules cannot be done through “regulation by enforcement.”
Hultgren noted that Coinbase only supports four types of assets and asked how they established regulatory certainty for them. Lempres replied that they received some guidance from the CFTC listing three of the assets as cryptocurrencies, and the fourth is a derivative of Bitcoin and therefore also covered, as well as court cases that have referred to the assets as cryptocurrencies.
Ellison asked what other countries are doing when it comes to regulating the cryptocurrency and ICO markets, to which Brummer replied that information sharing and coordination between regulators could help in exporting the best values and approaches found abroad.
Rep. Steve Stivers (R-Ohio) asked whether FinCEN’s 2013 guidance on the appropriate levels of anti-money laundering (AML) and Know Your Customer safeguards are appropriate in this space. Van Valkenburgh replied that it is a “sensible piece of guidance,” but that it was written early on. He continued that all of the U.S. exchanges are collecting information on their customers and filing suspicious activities reports, which keep the system transparent.
Rep. Ann Wagner (R-Mo.) asked about the New York State bit license requirements and whether it is appropriate for the industry. Lempres replied that New York State has only issued four licenses out of the hundreds or thousands of companies in this business, and that consumers and investors do trust Coinbase more than their unlicensed competition.
Wagner then asked how including Blockchain analytics in Coinbase’s suspicious activity report (SAR) filings helps FinCEN to get a better understanding of what is going on. Lempres replied that the Blockchain analytics allow for the most accurate and complete picture of the filing, including information that many federal agencies do not have access to. Lempres also discussed the law enforcement training program his company offers, reaching hundreds of state and local agencies to teach how Blockchain technology and cryptocurrencies work so they have a better understanding.
Scott asked if Congress should include a rule on agency harmonization in any legislation they create, to which Van Valkenburgh replied “yes, harmonization is critical.” He continued that the harmonization is not only needed between federal agencies such as the SEC and CFTC, but also between federal agencies and state regulators, as current state-by-state money transmission licensing is redundant, costly, and the “biggest impediment” to the technology. Van Valkenburgh argued that federal preemption of state money transmission licensing law should be discussed and include investor protections. He noted Giancarlo’s recent hearing before the Senate Agriculture Committee where he commented that such standards should include data reporting, capital requirements, cybersecurity standards, measures to prevent fraud, price manipulation and AML, and know your customer protections.
Hultgren asked what cybersecurity standards Coinbase has, to which Lempres replied that their protocols are “state of the art” with a team that solely handles cybersecurity. He continued that with Coinbase, approximately 99 percent of the assets are held in an offline “cold storage,” meaning they are almost immune to hackers, and that they also have a “hot wallet” process much like a teller window, and that the amount is fully insured to protect consumers and investors.
Hultgren then asked what federal cybersecurity laws or regulations they are required to follow. Lempres replied that the standard they most adhere to is the New York State standard through their bit license, but that they are currently working with many accounting firms to develop their own cybersecurity standards.
Ranking Member Carolyn Maloney (D-N.Y.) asked if subjecting virtual currency exchanges to minimum cybersecurity standards is necessary, to which Brummer replied that it would be “extremely helpful,” as cybersecurity is the top challenge for the financial markets.
Anti-Money Laundering and Terrorist Financing
Distributive Ledger Technology
Rep. Bill Foster (D-Ill.) noted the “enormous” advantages to distributive ledger technology, to include reducing transaction costs, increasing transparency, and providing immediate settlements, but asked if there will be a way to “bust” trades for questionable transactions, whether something like the Consolidated Audit Trail (CAT) will be needed, and whether participants can be authenticated. Lempres replied that there are technological challenges to busting trades, but that if someone is trading on their platform, Coinbase has information on them, to include their bank account, location, source of funds, etc. Rosenblum replied that it depends on whether the items being traded are pure currencies, and whether they are being traded on platforms or exchanges. He continued that if trading on exchanges registered with the SEC, the three elements Foster asked about will be included, but that if it moves to something like Bitcoin, “that genie is already way out of the bottle” and it will be more difficult to make any changes to the existing foundation.
For more information on this hearing, please click here.