[House Hearing, 117 Congress]
[From the U.S. Government Publishing Office]
THE FUTURE OF DIGITAL ASSET REGULATION
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON COMMODITY EXCHANGES, ENERGY, AND CREDIT
OF THE
COMMITTEE ON AGRICULTURE
HOUSE OF REPRESENTATIVES
ONE HUNDRED SEVENTEENTH CONGRESS
SECOND SESSION
__________
JUNE 23, 2022
__________
Serial No. 117-36
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Printed for the use of the Committee on Agriculture
agriculture.house.gov
________
U.S. GOVERNMENT PUBLISHING OFFICE
49-769 WASHINGTON : 2022
COMMITTEE ON AGRICULTURE
DAVID SCOTT, Georgia, Chairman
JIM COSTA, California GLENN THOMPSON, Pennsylvania,
JAMES P. McGOVERN, Massachusetts Ranking Minority Member
ALMA S. ADAMS, North Carolina, Vice AUSTIN SCOTT, Georgia
Chair ERIC A. ``RICK'' CRAWFORD,
ABIGAIL DAVIS SPANBERGER, Virginia Arkansas
JAHANA HAYES, Connecticut SCOTT DesJARLAIS, Tennessee
SHONTEL M. BROWN, Ohio VICKY HARTZLER, Missouri
BOBBY L. RUSH, Illinois DOUG LaMALFA, California
CHELLIE PINGREE, Maine RODNEY DAVIS, Illinois
GREGORIO KILILI CAMACHO SABLAN, RICK W. ALLEN, Georgia
Northern Mariana Islands DAVID ROUZER, North Carolina
ANN M. KUSTER, New Hampshire TRENT KELLY, Mississippi
CHERI BUSTOS, Illinois DON BACON, Nebraska
SEAN PATRICK MALONEY, New York DUSTY JOHNSON, South Dakota
STACEY E. PLASKETT, Virgin Islands JAMES R. BAIRD, Indiana
TOM O'HALLERAN, Arizona CHRIS JACOBS, New York
SALUD O. CARBAJAL, California TROY BALDERSON, Ohio
RO KHANNA, California MICHAEL CLOUD, Texas
AL LAWSON, Jr., Florida TRACEY MANN, Kansas
J. LUIS CORREA, California RANDY FEENSTRA, Iowa
ANGIE CRAIG, Minnesota MARY E. MILLER, Illinois
JOSH HARDER, California BARRY MOORE, Alabama
CYNTHIA AXNE, Iowa KAT CAMMACK, Florida
KIM SCHRIER, Washington MICHELLE FISCHBACH, Minnesota
JIMMY PANETTA, California MAYRA FLORES, Texas
SANFORD D. BISHOP, Jr., Georgia ------
MARCY KAPTUR, Ohio
SHARICE DAVIDS, Kansas
______
Anne Simmons, Staff Director
Parish Braden, Minority Staff Director
______
Subcommittee on Commodity Exchanges, Energy, and Credit
SEAN PATRICK MALONEY, New York, Chairman
STACEY E. PLASKETT, Virgin Islands MICHELLE FISCHBACH, Minnesota,
RO KHANNA, California Ranking Minority Member
CYNTHIA AXNE, Iowa AUSTIN SCOTT, Georgia
BOBBY L. RUSH, Illinois DOUG LaMALFA, California
ANGIE CRAIG, Minnesota RODNEY DAVIS, Illinois
ANN M. KUSTER, New Hampshire CHRIS JACOBS, New York
CHERI BUSTOS, Illinois TROY BALDERSON, Ohio
------ MICHAEL CLOUD, Texas
------ RANDY FEENSTRA, Iowa
KAT CAMMACK, Florida
Emily German, Subcommittee Staff Director
(ii)
C O N T E N T S
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Page
Fischbach, Hon. Michelle, a Representative in Congress from
Minnesota, opening statement................................... 4
Kuster, Hon. Ann M., a Representative in Congress from New
Hampshire, prepared statement.................................. 6
Maloney, Hon. Sean Patrick, a Representative in Congress from New
York, opening statement........................................ 1
Prepared statement........................................... 3
Thompson, Hon. Glenn, a Representative in Congress from
Pennsylvania, opening statement................................ 5
Witnesses
McGonagle, J.D., Vincent ``Vince'', Director, Division of Market
Oversight, Commodity Futures Trading Commission, Washington,
D.C............................................................ 7
Prepared statement........................................... 8
Submitted questions.......................................... 127
Brummer, J.D., Ph.D., Chris, Agnes N. Williams Professor of Law,
Georgetown University Law Center, Washington, D.C.............. 12
Prepared statement........................................... 13
Levin, Jonathon, Co-Founder and Chief Strategy Officer,
Chainalysis Inc., New York, NY................................. 19
Prepared statement........................................... 20
Hoskinson, Charles, Chief Executive Officer, Input Output Global,
Inc., Singapore, SG............................................ 39
Prepared statement........................................... 41
Submitted Material
Bankman-Fried, Samuel ``Sam'', Co-Founder and Chief Executive
Officer, LedgerX LLC d/b/a FTX US Derivatives, submitted
statement...................................................... 103
THE FUTURE OF DIGITAL ASSET REGULATION
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THURSDAY, JUNE 23, 2022
House of Representatives,
Subcommittee on Commodity Exchanges, Energy, and Credit,
Committee on Agriculture,
Washington, D.C.
The Subcommittee met, pursuant to call, at 10:31 a.m., in
Room 1300 of the Longworth House Office Building, Hon. Sean
Patrick Maloney [Chairman of the Subcommittee] presiding.
Members present: Representatives Maloney, Plaskett, Khanna,
Axne, Rush, Craig, Kuster, Fischbach, Austin Scott of Georgia,
Balderson, Cloud, Feenstra, Cammack, Thompson (ex officio),
Baird, and Mann.
Staff present: Lyron Blum-Evitts, Carlton Bridgeforth,
Emily German, Josh Lobert, Brian Robinson, Paul Balzano, Caleb
Crosswhite, Kevin Webb, John Konya, and Dana Sandman.
OPENING STATEMENT OF HON. SEAN PATRICK MALONEY, A
REPRESENTATIVE IN CONGRESS FROM NEW YORK
The Chairman. Good morning, everyone. This hearing of the
Subcommittee on Commodity Exchanges, Energy, and Credit
entitled, The Future of Digital Asset Regulation, will come to
order.
Welcome, and thank you for joining us at today's hearing.
After brief opening remarks, Members will receive testimony
from our witnesses today, and then the hearing will be open to
questions. In consultation with the Ranking Member and pursuant
to Rule XI(e), I want to make Members of the Subcommittee aware
that other Members of the full Committee may join us today.
Again, thank you all for joining me. I would like to thank
our erstwhile colleague, Antonio Delgado, for chairing this
Subcommittee, and for his service to the country and to New
York. I am delighted to be stepping into this role, even if
briefly. Thank you all for joining me today in that first
hearing as Chairman of the Commodity Exchanges, Energy, and
Credit Subcommittee, and welcome to the hearing we are calling,
The Future of Digital Asset Regulation.
Today's hearing is a good opportunity to engage market
experts at the CFTC, digital asset stakeholders, and academics
in a discussion on the effectiveness of current regulation of a
continuously evolving digital assets market, and how to address
regulatory concerns in any future framework.
Since the launch of Bitcoin in 2009 and the creation of the
Ethereum blockchain in 2013, there has been, to put it mildly,
rapid and expansive growth and innovation in both the diversity
and volume of digital asset products available.
A digital asset can be a virtual currency, an investment
opportunity, or traded on an exchange, and the novel nature of
these assets, the complexity of them, and how investors and
consumers use them should say a lot and will say a lot about
how they should be regulated.
As the Committee of jurisdiction over the CFTC, of primary
importance to today's hearing is digital commodity products
available for trade in the derivatives and underlying spot
markets, a primary access point for investors to the digital
asset market. Digital assets are popular, very popular, but
volatile, very volatile. We see this reflected in the
substantial decrease in combined digital asset market
capitalization from its peak of approximately $3 trillion in
November of last year, to its current level of approximately $1
trillion: $3 trillion in November, $1 trillion today.
Polling also reveals that approximately 20 percent of
American adults have invested in, traded, or used
cryptocurrencies. Providing Congressional direction to
establish the rules of the road to ensure American retail
investors are informed and protected is as important as ever.
While the CFTC has dutifully exercised its role as a
regulator and enforcement authority in digital asset markets,
its authority is not unlimited. Indeed, its authority is
specifically limited. When you couple the recent volatility
with high retail participation in digital asset spot markets,
it is concerning that there is a gap in oversight and
regulation of these markets, and it is that gap that we are
particularly focused on.
The growth of the digital asset industry has centered on
innovation, transparency, and security, and I believe in
fostering that innovation here in the United States. In
contrast to a traditional bank or financial institution, the
most popular cryptocurrencies, Bitcoin and Ether, have entirely
public ledgers. Anyone can view them and participate in
recording and authenticating transactions on them.
As we will hear from our witnesses today, the digital asset
economy presents opportunities to support financial inclusion,
but without strong customer protections, education, and
regulatory certainty, participants in the industry may be at
increased risk of financial loss and exposure to fraud.
Digital assets are complicated, and retail participants may
be tempted by the promise of quick returns without knowing how
the digital asset functions, or without knowing who received
early access to information. Regulation regarding disclosure to
market participants may help retail investors understand the
volatility of the assets and facilitate smart digital
entrepreneurship, but how we do that matters, and it may
require new ways of thinking.
Today's hearing will help this Committee understand how
Congressional action, if done right, can give the CFTC the
tools it needs to protect investors while fostering innovation
here in the U.S. I am especially focused on whether such action
could be done in a fully bipartisan manner.
Thank you again to the Members and witnesses joining us
today as well as those who are following along online. I look
forward to a productive conversation about the future of
digital asset regulation.
[The prepared statement of Mr. Maloney follows:]
Prepared Statement of Hon. Sean Patrick Maloney, a Representative in
Congress from New York
Again--Thank you all for joining me today in my inaugural hearing
as Chairman of the Commodity Exchanges, Energy, and Credit
Subcommittee, and welcome to today's hearing, The Future of Digital
Asset Regulation.
Today's hearing is an excellent and timely opportunity to engage
market experts at the CFTC, digital asset stakeholders, and academics
in discussion on the effectiveness of current regulation of a
continuously evolving digital asset markets and how to address
regulatory concerns in any future regulatory framework.
Since the launch of Bitcoin in 2009 and the creation of the
Ethereum blockchain in 2013, there has been rapid and expansive growth
and innovation in both the diversity and volume of digital asset
products available.
A digital asset can be a virtual currency, an investment
opportunity, or traded on an exchange--and how investors and consumers
use these products will say a lot about how they should be regulated.
As the Committee of jurisdiction over the CFTC, of primary
importance to today's hearing is digital commodity products available
for trade in the derivatives and underlying spot markets--a primary
access point for investors to the digital asset market.
Digital assets are popular, but volatile. We see this reflected in
the substantial decrease in combined digital asset market
capitalization from its peak of approximately $3 trillion in November
2021, to current levels of approximately $1 trillion.
Polling also reveals that approximately 20% of American adults have
invested in, traded, or used cryptocurrencies.
Providing Congressional direction to establish the rules of the
road to ensure American retail investors are informed and protected is
as important as ever.
While the CFTC has dutifully exercised its role as a regulator and
enforcement authority in digital asset markets, its authority is
limited. When you couple the recent volatility with high retail
participation in digital asset spot markets, it is concerning that
there is a gap in oversight and regulation of these markets.
The growth of the digital asset industry has centered on
innovation, transparency, and security--and I believe in fostering that
innovation here in the United States. In contrast to a traditional bank
or financial institution, the most popular cryptocurrencies, Bitcoin
and Ether, have entirely public ledgers. Anyone can view them and
participate in recording and authenticating transactions on them.
As we will hear from our witnesses today, the digital asset economy
presents opportunities to support financial inclusion, but, without
strong customer protections and regulatory certainty, participants in
the industry may be at increased risk of financial loss and exposure to
fraud.
Digital assets are complicated, and retail participants may be
tempted by the promise of quick returns without knowing how the digital
asset functions, or without knowing who received early access to
information.
Regulation regarding disclosure to market participants may help
retail investors understand the volatility of the assets and facilitate
smart digital entrepreneurship.
Today's hearing will help this Committee understand how
Congressional action can give the CFTC the tools they need to protect
investors while fostering innovation here in the United States.
Thank you again to the Members and witnesses joining us today as
well as those who are following along online. I look forward to a
productive conversation about the future of digital asset regulation.
With that, I'd now like to welcome the distinguished Ranking
Member, Mrs. Fischbach from Minnesota, for any opening remarks she
would like to give.
The Chairman. With that, I am pleased to welcome the
distinguished Ranking Member, Mrs. Fischbach from Minnesota,
for any opening remarks she would like to give.
OPENING STATEMENT OF HON. MICHELLE FISCHBACH, A REPRESENTATIVE
IN CONGRESS FROM MINNESOTA
Mrs. Fischbach. Well, thank you, Mr. Chairman, and first of
all, congratulations, and I am looking forward to working with
you. But more immediately, thank you very much for holding this
important hearing. I appreciate your comments on bipartisan
work, so thank you so much for that.
And there is no better time than the present to discuss how
and why we regulate financial markets and consider how to best
balance the need to protect customers with the desire to
protect innovation. According to a recent survey, roughly half
of American adults today own or have owned some sort of
cryptocurrency. This brings digital assets on par with the
number of Americans that own traditional securities. Of those
Americans who own cryptocurrency, more than 74 percent bought
them for the first time within the last 2 years.
Since the creation of Bitcoin, thousands of cryptocurrency
projects have been developed. Today, there are nearly 20,000
cryptocurrencies in existence spread across numerous blockchain
platforms. Unfortunately, these tokens do not always fall
neatly into our current financial regulatory framework.
Traditionally, we protect investors through disclosure
requirements and the segregation of their assets, and we
promote market integrity through regulatory oversight and
intermediaries and enforcement actions. But what rules apply
depend on the nature of the asset and the specific types of
risk market participants face.
Regulations have struggled to provide guidance to market
participants on how and when their activities require
registration and compliance. Market participants still do not
know what rules apply and when. Real risk to market
participants exist and we have an obligation to address them.
Over the past several years, Members of this Committee have
proposed legislation that would lay down clear parameters for
the roles of both the SEC and the CFTC in digital asset
markets. In April Republican leader Thompson and Congressman
Khanna introduced the bipartisan Digital Commodity Exchange Act
of 2022 (H.R. 7614). The DCEA would give the CFTC--lots of
initials today--expanded oversight of the trading of those
digital assets which are commodities, and it would bring
certainty to market participants by doing what the regulators
cannot--providing legal clarity to market intermediaries and
participants.
I appreciate the efforts of the CFTC and the SEC that they
have made to try to fold digital assets into existing
framework, but in some cases, particularly for spot digital
commodity transactions, the existing laws simply lack the
authorities necessary.
As the popularity of digital assets continues to grow, it
is incumbent upon Congress to speak clearly about how best to
regulate. I am glad we have the opportunity to explore these
issues and the way Congress can better create an environment
where digital assets can become not only a valuable financial
product, but an important conduit of innovation in our
financial system.
Thank you to each of our witnesses for their willingness to
share their expertise with us, and I am looking forward to
hearing your perspectives on how and why we regulate in
financial markets, and where and when we might apply those
lessons to the crypto markets and to the market participants.
Thank you, Mr. Chairman, and I yield back.
The Chairman. I thank the Ranking Member, and also would
like to take this opportunity to recognize the leadership of
Chairman David Scott on these issues. I don't see him present
today, but we will be happy to yield to him for any opening
remarks should he join us. I do note the presence of the
Ranking Member of the full Committee, Mr. Thompson, and I would
invite him to share any opening comments he may wish to make.
OPENING STATEMENT OF HON. GLENN THOMPSON, A REPRESENTATIVE IN
CONGRESS FROM PENNSYLVANIA
Mr. Thompson. Well, thank you, Mr. Chairman. Let me start
by echoing the remarks of our Subcommittee Ranking Member, and
congratulate you in your new role with leading the
Subcommittee.
I look forward to working with you, and I know that digital
assets have been an area of interest for you for several years
now.
As you know, the House Agriculture Committee has a long
history of fostering technology and innovation. Leading on
digital assets is no exception. Given the Commodity Futures
Trading Commission's role in regulated markets, the Agriculture
Committee has an opportunity and responsibility to be at the
table for these discussions. I appreciate you holding this
hearing, and your commitment to continuing the Committee's
education and examination of digital asset regulations and
markets.
As some may recall, this Committee held one of the first
Congressional hearings to examine digital assets in 2018, which
led to subsequent roundtables and conversations focused on how
to regulate these novel assets. While these events provided
ample education on blockchain and cryptocurrency, we still find
ourselves debating foundational questions about how to
integrate these markets into our financial system.
Over the past month, the carnage in digital assets has
filled our newsfeeds. Prices have fallen dramatically, projects
have imploded, customer funds have been lost or frozen, and
billions of dollars in value have been lost. For those who have
lost significant sums of money, this sell-off has been a
catastrophe. And yet, the promise of cryptocurrency remains.
Despite losses, the public's interest in this technology has
not diminished. Developers and investors continue to build new
projects and refine the technology, and this is why this
hearing on the regulation of digital assets is so timely.
Clearly defined guardrails can provide more certainty to
developers, investors, and the public. To provide these
guardrails, I introduced H.R. 7614, the Digital Commodity
Exchange Act, with Congressman Khanna. The DCEA offers a
framework to bring regulatory clarity to digital asset markets.
This legislation protects market participants and builds on the
successful system of principles-based regulation already in
place at the CFTC. It establishes clear jurisdictional lines
between financial regulators, helping to reduce regulatory
complexity, and clarify existing regulatory roles. And perhaps,
most importantly, it provides a clear pathway to compliance for
those hoping to build the next great innovation with digital
assets.
The DCEA will provide regulators with tools to hold bad
actors accountable and help to protect market participants from
fraud and market manipulation. Clearly defined core principles
will also help establish a better understood and flexible
framework to support the creation of new products and meet
evolving market demands.
We don't yet know all the ways digital assets will be used,
but that should excite us, not intimidate us. America has
always been a leader in technological innovation and the spirit
of entrepreneurship, and we should continue to embrace that
spirit. Our Committee must continue to put forward innovative
ideas and sound proposals in these novel policy areas facing
Congress. I hope we can implement smart bipartisan solutions
like the Digital Commodity Exchange Act together.
Again, thank you to our panelists for being here today, and
thank you for taking the time to come and educate us. I look
forward to today's discussion.
With that, Mr. Chairman, I yield back.
The Chairman. I thank the gentleman.
The chair would request that other Members submit their
opening statements for the record so that we may proceed
directly to witness testimony.
[The prepared statement of Ms. Kuster follows:]
Prepared Statement of Hon. Ann M. Kuster, a Representative in Congress
from New Hampshire
Thank you, Mr. Chairman. And thanks to our panel for being with us.
We are in the midst of a brave new world of digital asset trading.
Our Committee has given this issue worthwhile attention this Congress
because of the role the Commodity Futures Trading Commission (CFTC) has
and will continue to play in regulating this trade.
As more and more Americans invest in these assets, it is imperative
for Congress to keep up as we regulate and oversee the digital realm
just as we do the more established marketplaces.
As we all have seen recently, Bitcoin--the most popular
cryptocurrency--has badly tumbled in the last few weeks and lost more
than \1/2\ its value in 2022 so far.
Clearly no marketplace is immune from severe vulnerability and
uncertainty, be it Bitcoin or Wall Street. But we do need to assure
digital markets are operating above-board and secure, and that
investors have access to the information they need to fully understand
the risks they are taking.
With that in mind, I'd like to focus my questions on consumer
protection as it relates to digital assets.
The Chairman. Welcome, all of you. Our first witness today
is Mr. Vincent McGonagle, the Director of the Division of
Market Oversight at the Commodity Futures Trading Commission.
Our second witness today is Dr. Christopher Brummer, Professor
of Law at the Georgetown University Law Center. Our third
witness is Mr. Jonathan Levin, the Co-Founder and Chief
Strategy Officer of Chainalysis--am I saying that correctly?
Okay, good. Let's get that right. Our fourth and--I mean, it is
my first hearing. I don't want to screw it up.
Mrs. Fischbach. You are doing a great job.
The Chairman. Is it going all right? Okay, good. A lot of
pressure up here. I have only been doing this for 10 years. I'm
starting to get the swing of it.
Our fourth and final witness is Mr. Charles Hoskinson, the
Chief Executive Officer and Founder of Input Output Global.
Thank you all for joining us today. We will now proceed to
hearing your testimony. You will have 5 minutes. The timer
should be visible to you all, so it will count down to zero, at
which point there is no time left.
Mr. McGonagle, please begin when you are ready. Thank you,
sir.
STATEMENT OF VINCENT ``VINCE'' McGONAGLE, J.D.,
DIRECTOR, DIVISION OF MARKET OVERSIGHT, COMMODITY FUTURES
TRADING COMMISSION, WASHINGTON, D.C.
Mr. McGonagle. Thank you. Good morning, Chairman Maloney,
Ranking Member Fischbach, Ranking Member Thompson, and Members
of the Subcommittee. Thank you for the opportunity to appear
before you today.
My views are mine alone, and do not reflect those of the
Division of Market Oversight or the Commission.
The CFTC is the primary regulator of the futures and
options markets, and since 2010, the swaps market as well. The
agency's mission is to promote the integrity, resilience, and
vibrancy of the U.S. derivatives markets through sound
regulation. We do that through a regulatory framework that
seeks to ensure market integrity and the protection of customer
funds, avoid systemic risk, and police derivatives markets for
abuses, while fostering innovation and fair competition.
A trading facility for market participants, including
retail customers, interested in listing and trading futures
must apply to the Commission to be designated as a contract
market. That market must then comply with 23 statutory core
principles. Those core principles require the market to ensure
the protection of customer funds, protect market participants
and the market from abusive practices, and promote fair and
equitable trading in the contract market. The contract market
must be able to detect and prevent manipulation, price
distortion, and disruption of the contracts' cash settlement or
delivery processes.
To comply with the system safeguards core principle, the
market must establish and maintain a program to identify and
minimize sources of operational risk, including cybersecurity
and disaster recovery.
Designated contract markets are also self-regulatory
organizations. That is, they must establish and maintain
effective oversight programs, including monitoring and
enforcing compliance with their rules. A market must submit to
the Commission all new product terms and conditions, which must
meet certain core principles, including the core principal that
the designated contract market only lists contracts that are
not readily susceptible to manipulation.
To ensure compliance with the core principles, CFTC staff
conduct rule enforcement reviews and system safeguards
examinations, and at any time, Commission staff may ask a
designated contract market for a detailed justification of its
continued compliance with core principles. And the CFTC also
conducts direct surveillance on trading on those markets.
Digital assets are commodities, and the CFTC has broad
regulatory oversight over any derivatives products listed by
designated contract markets. In December 2017, three designated
contract markets self-certified that they would list Bitcoin
derivatives contracts for trading. Today, five contract markets
list for trading futures and options contracts on Bitcoin,
Ether, or both of those products.
The CFTC does not have regulatory authority over cash
markets. We do have anti-fraud, false reporting, and anti-
manipulation enforcement authority over commodity cash markets
and interstate commerce. Since 2014, the CFTC has brought more
than 50 enforcement actions involving digital assets. We filed
numerous cases charging retail fraud, as well as charging
platforms with illegally offering off-exchange trading in
digital assets. In all, the CFTC has filed 25 enforcement
actions that have included digital asset-related allegations in
the past 18 months.
Through the CFTC's extensive experience overseeing the
trading of digital asset-based derivatives on CFTC regulated
exchanges, as well as our vigilant exercise of our enforcement
authority, the CFTC has developed a keen understanding of
digital assets and will continue to deliver on its commitment
to protect customers to the fullest extent of its statutory
authority.
Thank you for the opportunity to appear before the
Subcommittee. I look forward to answering any questions you may
have.
[The prepared statement of Mr. McGonagle follows:]
Prepared Statement of Vincent ``Vince'' McGonagle, J.D., Director,
Division of Market Oversight, Commodity Futures Trading Commission,
Washington, D.C.
Chairman Maloney, Ranking Member Fischbach, and Members of the
Subcommittee, thank you for the opportunity to appear before you today
to share my views on digital asset regulation as the Director of the
Division of Market Oversight at the Commodity Futures Trading
Commission (CFTC, Agency or Commission).
CFTC Mission
As you know, the CFTC is the primary regulator of the futures,
options, and swaps markets. The Agency's mission is to promote the
integrity, resilience, and vibrancy of the U.S. derivatives markets
through sound regulation.
Our governing statute, the Commodity Exchange Act (CEA or Act),
serves the public interest by mandating the establishment of a
regulatory framework that allows the Agency to ensure market integrity,
protect customer funds, avoid systemic risk, and police derivatives
markets for manipulative activity, fraud and other abuses, while
fostering innovation and fair competition.\1\ As the transactions
within our jurisdiction ``are affected with a national public interest
by providing a means for managing and assuming price risks, discovering
prices, or disseminating pricing information through trading in liquid,
fair and financially secure trading facilities,'' \2\ the CEA outlines
``a system of effective self-regulation of trading facilities, clearing
systems, market participants and market professionals under the
oversight of the Commission.'' \3\
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\1\ CEA 3(b) (7 U.S.C. 5(b)).
\2\ CEA 3(a) (7 U.S.C. 5(a)).
\3\ CEA 3(b) (7 U.S.C. 5(b)). This system provides multi-tiered
protections to market participants trading on our regulated exchanges,
including the elimination of the risk of counterparty default or
bankruptcy (because a regulated clearinghouse takes the opposite side
of customers' transactions). Further, entities that broker futures
trades (called futures commission merchants) are required to register
with the CFTC, establish safeguards to prevent conflicts of interest,
and segregate customer assets to protect the assets from the risk of
the broker's bankruptcy. See CEA 4d(a) and 4d(c) (7 U.S.C. 6d(a)
and 6d(c)).
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Designated Contract Market Registration, Compliance Obligations, and
Product Listing
Generally, in order for an entity to provide a trading facility for
market participants (including retail customers) to trade futures, the
market must apply to the Commission to be designated as a contract
market.\4\ To obtain and maintain designation, an entity must comply,
on an initial and ongoing basis, with twenty-three Core Principles set
forth in the CEA and CFTC regulations.\5\ By design, the designated
contract market Core Principles ensure customer protections, establish
guardrails that provide clarity regarding the risks and protections
involved in trading derivatives products, and enhance transparency,
without hindering the trading facilities' ability to innovate and
compete fairly. This firm but flexible approach has allowed the CFTC,
with authority from Congress, to evolve along with the derivatives
markets.
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\4\ Such designation is required absent an applicable exemption or
exclusion. Criteria, procedures, and requirements for designation as a
designated contract market are set forth in Section 5 of the CEA (7
U.S.C. 7) and Part 38 of the CFTC's regulations. Appendix A and B to
Part 38 provide specific information on these requirements and guidance
to applicants seeking to become designated contract markets. Similarly,
absent any applicable exemption or exclusion, in order for an entity to
operate a trading facility for the trading or processing of swaps by
and between eligible contract participants, the entity must seek and
obtain registration with the CFTC as a swap execution facility (SEF)
through CEA Section 5h and Part 37 of the CFTC's regulations. For a
definition of eligible contract participants, see CEA 1a(18) (7
U.S.C. 1a(18)).
\5\ See CEA 5(d) (7 U.S.C. 7(d)), with the implementing
regulations under Part 38 of the CFTC's regulations.
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The CFTC oversees designated contract markets through various
tools, including rule enforcement reviews and system safeguards
examinations to ensure compliance with the Core Principles. The CFTC
also conducts direct surveillance of trading on designated contract
markets. Designated contract markets are separately required to serve
as self-regulatory organizations,\6\ and must establish and maintain
effective oversight programs, including monitoring and enforcing
compliance with their rules. As self-regulatory organizations and
designated contract markets, they play a key role in safeguarding the
integrity of the derivatives markets by, among other things, ensuring
that their members understand and meet their regulatory
responsibilities.
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\6\ See CFTC Regulation 1.3.
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Among other things, the Core Principles require each designated
contract market to establish and enforce rules to: ensure the
protection of customer funds; \7\ protect market participants and
markets from abusive practices; and promote fair and equitable trading
on the contract market.\8\ The Core Principles also require each
designated contract market to ensure that the contracts they list are
not readily susceptible to manipulation, and require a designated
contract market to have rules and resources in place to detect and
prevent manipulation, price distortion, and disruptions of the cash-
settlement or delivery process.\9\ The Core Principle addressing system
safeguards requires each designated contract market to: establish and
maintain a program of risk analysis and oversight to identify and
minimize sources of operational risk, through the development of
appropriate controls and procedures and the development of automated
systems that are reliable, secure and have adequate scalable capacity;
establish and maintain emergency procedures, backup facilities, and a
plan for disaster recovery; and periodically conduct tests to verify
that backup resources are sufficient to ensure continued order
processing and trade matching, price reporting, market surveillance,
and maintenance of a comprehensive and accurate audit trail.\10\
---------------------------------------------------------------------------
\7\ Core Principle (CP) 11 at CEA 5(d)(11) (7 U.S.C. 7(d)(11)).
\8\ CP 12 at CEA 5(d)(12) (7 U.S.C. 7(d)(12)).
\9\ CPs 3 and 4 at CEA 5(d)(3)-(4) (7 U.S.C. 7(d)(3)-(4)).
\10\ CP 20 at CEA 5(d)(20) (7 U.S.C. 7(d)(20)).
---------------------------------------------------------------------------
Under the CEA and the Commission's contract review regulations,
prior to listing any new product for trading, a designated contract
market must submit to the Commission all new product terms and
conditions, and subsequent associated amendments.\11\ In all such
submissions and amendments, a designated contract market is legally
obligated to meet certain Core Principles--including Core Principle 3,
which requires that a designated contract market only list contracts
for trading that are not readily susceptible to manipulation.\12\ Under
the CEA, the designated contract market may file its new product
submission under a process called ``self-certification'' by certifying
that the product to be listed complies with the Act and CFTC
regulations and providing a concise explanation and analysis of the
product and its compliance.\13\
---------------------------------------------------------------------------
\11\ CEA 5c(c) (7 U.S.C. 7a-2(c)) and CFTC Regulations 40.2 and
40.3. These same processes also apply for products to be listed on
SEFs, with compliance required with the corresponding SEF regulatory
framework.
\12\ The Commission has provided Guidance to designated contract
markets and SEFs on meeting their Core Principle 3 obligations in
Appendix C to Part 38 of the Commission's regulations. See 17 CFR pt.
38, Appendix C. At any time, Commission staff may ask a designated
contract market or SEF for a detailed justification of its continuing
compliance with core principles, including information demonstrating
that any contract listed for trading on the designated contract market
or SEF meets the requirements of the Act and designated contract market
or SEF Core Principle 3, as applicable. See CFTC Regulations 38.5 and
37.5. Failure of a designated contract market or SEF to adopt and
maintain practices that adhere to these requirements may lead to the
Commission's initiation of proceedings to secure compliance.
\13\ CEA 5c(c)(1)-(3) (7 U.S.C. 7a-2(c)(1)-(3)) and CFTC
Regulation 40.2. Alternatively, the designated contract market or SEF
may voluntarily request that the CFTC review the exchange's analysis of
the product and its compliance with the CEA and CFTC regulations and
approve the new product for listing (through CEA 5c(c)(4)-(5) (7 U.S.C.
7a-2(c)(4)-(5)) and CFTC Regulation 40.3).
---------------------------------------------------------------------------
Similarly, under the CEA and the Commission's rule review
regulations, prior to implementing a new or amended rule, a designated
contract market must submit to the Commission the text of the rule and
note any substantive opposing views to the rule that were not
incorporated into the rule.\14\ In all such submissions, a designated
contract market is legally obligated to meet Core Principles. The
designated contract market may file its new or amended rule submission
through self-certification by certifying that the rule complies with
the Act and CFTC regulations and providing a concise explanation and
analysis of the operation, purpose and effect of the new or amended
rule and its compliance.\15\
---------------------------------------------------------------------------
\14\ CEA 5c(c) (7 U.S.C. 7a-2(c)) and CFTC Regulations 40.5 and
40.6. These same processes also apply for products to be listed on
SEFs, with compliance required with the corresponding SEF regulatory
framework.
\15\ CEA 5c(c)(1)-(3) (7 U.S.C. 7a-2(c)(1)-(3)) and CFTC
Regulation 40.6. Alternatively, the designated contract market or SEF
may voluntarily request that the CFTC review the exchange's analysis of
the rule and its compliance with the CEA and CFTC regulations and
approve the new rule (through CEA 5c(c)(4)-(5) (7 U.S.C. 7a-2(c)(4)-
(5)) and CFTC Regulation 40.5).
---------------------------------------------------------------------------
CFTC Regulatory Jurisdiction Involving Digital Assets
Digital assets have been broadly determined by the CFTC and Federal
courts to be commodities under the CEA.\16\ As discussed below, the
CFTC has broad regulatory oversight over any futures, options, and
swaps listed by designated contract markets.
---------------------------------------------------------------------------
\16\ The CFTC first found that Bitcoin and other virtual currencies
are commodities in 2015. See In re Coinflip, Inc., d/b/a Derivabit, and
Francisco Riordan, CFTC No. 15-29 (Sept. 17, 2015), http://
www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/
legalplead
ing/enfcoinfliprorder09172015.pdf. In 2017, the CFTC proposed guidance
regarding its jurisdiction over certain types of retail transactions
involving virtual currency. Following extensive industry engagement and
public comment, the CFTC finalized this guidance in 2020. Retail
Commodity Transactions Involving Certain Digital Assets, 85 Fed. Reg.
37734 (June 24, 2020). In 2018, Federal courts affirmed the CFTC's
jurisdiction over digital assets in two cases, CFTC v. McDonnell, 332
F. Supp. 3d 641 (E.D.N.Y. 2018) and CFTC v. My Big Coin Pay Inc., 334
F. Supp. 3d 492 (D. Mass. 2018). Certain digital assets may also be
securities to which the securities laws apply. Whether or not a given
digital asset is a security requires examination of the specific
characteristics of that asset, as set forth in SEC v. W.J. Howey Co.,
328 U.S. 293 (1946).
---------------------------------------------------------------------------
The CFTC has regulated exchange listed futures contracts on digital
assets since late 2017. By way of background, in 2017, three designated
contract markets expressed interest to the CFTC in listing digital
asset-based derivatives contracts for trading.\17\ These designated
contract markets voluntarily provided the CFTC with advance draft
contract terms and conditions for their proposed contracts.\18\ In
December 2017, the three designated contract markets self-certified
that they would list Bitcoin derivatives contracts for trading.\19\
Though the Commission did not determine to stay the certifications or
seek public comment at the time, the CFTC published two documents in
connection with these self-certification submissions to provide the
public with background information on the CFTC's oversight of, and
approach to, virtual currency futures markets.\20\
---------------------------------------------------------------------------
\17\ CFTC Backgrounder on Self-Certified Contracts for Bitcoin
Products, Dec. 1, 2017, available at https://www.cftc.gov/sites/
default/files/idc/groups/public/@newsroom/documents/file/bit
coin_factsheet120117.pdf. Two designated contract markets intended to
list futures contracts on Bitcoin and a third designated contract
market intended to list a new contract for Bitcoin binary options.
\18\ Id.
\19\ Id.
\20\ CEA 5c(c)(3) (7 U.S.C. 7a-2(c)(3)). See https://
www.cftc.gov/sites/default/files/idc/groups/public/@newsroom/documents/
file/bitcoin_factsheet120117.pdf and https://www.cftc.
gov/sites/default/files/idc/groups/public/%40customerprotection/
documents/file/background
er_virtualcurrency01.pdf.
---------------------------------------------------------------------------
A few months later in 2018, staff issued an advisory to encourage
innovation and growth of digital asset derivatives products to be
traded on designated contract markets and cleared by derivatives
clearing organizations within an appropriate oversight framework under
the Core Principles.\21\ Specifically, staff clarified their priorities
and expectations when reviewing new virtual currency derivatives to be
listed on a designated contract market or to be cleared by a
derivatives clearing organization.\22\
---------------------------------------------------------------------------
\21\ See CFTC Staff Advisory No 18-14, https://www.cftc.gov/
LawRegulation/CFTCStaffLetters/index.htm.
\22\ See Id.
---------------------------------------------------------------------------
Since then, the trading of futures contracts in digital assets has
grown notably. Today, of the sixteen designated contract markets that
the CFTC oversees, five list for trading futures and options contracts
on Bitcoin, ether, or both. Market participants are actively trading
over a dozen different futures and options contracts on digital assets
across these five designated contract markets. When market participants
trade digital asset-based futures contracts on a designated contract
market, they are afforded the same customer protections and
transparency as when they trade in futures contracts on any other asset
class--including certainty over custody of their margin and clarity
regarding bankruptcy protections.
CFTC Cash Market Enforcement Actions Involving Digital Assets
While the CFTC does not have direct statutory authority to regulate
cash markets, the CFTC maintains anti-fraud, false reporting,\23\ and
anti-manipulation enforcement authority over commodity cash markets in
interstate commerce (including digital asset cash markets). When the
CFTC becomes aware of potential fraud or manipulation in an underlying
market, we investigate and address misconduct through our enforcement
authority. In the digital asset space, since 2014, the CFTC has
aggressively exercised its enforcement authority bringing more than 50
enforcement actions.
---------------------------------------------------------------------------
\23\ In re Coinbase Inc., CFTC No. 21-03 (Mar. 19, 2021).
---------------------------------------------------------------------------
Most recently, in FY 2021, the CFTC filed numerous cases charging
retail fraud involving digital assets,\24\ and cases charging platforms
with illegally offering off-exchange trading in digital assets.\25\ In
all, the CFTC filed over 20 enforcement actions that included digital
asset-related allegations of misconduct in FY 2021.
---------------------------------------------------------------------------
\24\ Press Releases 8366-21, 8374-21, 8381-21, 8441-21, 8434-21,
8434-21, and 8452-21.
\25\ Press Releases 8374-21 and 8433-21.
---------------------------------------------------------------------------
Thus far in FY 2022, the CFTC has filed several enforcement actions
involving digital assets, including an action for making untrue or
misleading statements and omissions of material fact in connection with
the U.S. dollar tether token (USDT) stablecoin.\26\ In addition, the
Commission recently filed a complaint involving allegations for making
false or misleading statements of material facts or omitting to state
material facts to the CFTC in connection with the self-certification of
a Bitcoin futures product.\27\
---------------------------------------------------------------------------
\26\ Press Release 8450-21.
\27\ Press Release 8540-22.
---------------------------------------------------------------------------
The Derivatives Markets the CFTC Oversees Work Well
The CEA and the CFTC's regulatory framework have worked well for
our futures markets for many decades. The CFTC's focus on customer
protections, market integrity, price discovery and transparency has
proven to be effective, even in times of volatility. The strength of
our futures markets is why in 2010, Congress tasked the CFTC with
creating an oversight system for the over-the-counter swaps markets
after the 2008 financial crisis.
Following enactment of the Dodd-Frank Act, the CFTC thoughtfully
and quickly enacted regulations to register trading facilities for
swaps as swap execution facilities and to regulate the trading of swaps
on swaps execution facilities as well as customer protections for swaps
traded bilaterally. Today, the swaps markets that the CFTC oversees
exceed $300 trillion in gross notional outstanding. Of the swaps in the
credit and interest rates markets (two of the largest swap asset
classes in terms of volume and notional outstanding), a notable portion
of the swaps positions are cleared at a derivatives clearing
organization. By bringing the previously opaque over-the-counter swaps
market under the CFTC's oversight, our extensive swaps markets now
benefit from transparency, enhanced customer protections, and promoted
competition.
Conclusion
Through the CFTC's extensive experience overseeing the trading of
digital asset-based derivatives on CFTC-regulated exchanges as well as
the CFTC's vigilant exercise of jurisdiction of its enforcement
authority over commodity cash markets in interstate commerce, the CFTC
has developed a keen understanding of digital assets, and will continue
to deliver on its commitment to protect customers to the fullest extent
of its statutory authority.
Thank you for the opportunity to appear before the Subcommittee. I
look forward to answering any questions you may have.
The Chairman. I thank the gentleman.
Dr. Brummer, you may proceed when ready.
STATEMENT OF CHRIS BRUMMER, J.D., Ph.D., AGNES N.
WILLIAMS PROFESSOR OF LAW, GEORGETOWN UNIVERSITY LAW CENTER,
WASHINGTON, D.C.
Dr. Brummer. Subcommittee Chairman Delgado and Chairman
Maloney, Ranking Member Fischbach, and Members of the
Subcommittee, it is a distinct pleasure to be here with you
today. The Agriculture Committee is home to many of my favorite
Members of Congress, which is saying something for a law
professor.
If there is one thing I would like you to remember from my
remarks today, it is that the future of digital asset
regulation will require much more than just placing various
digital asset products into varying digital--excuse me--
governmental organizational charts. It will also have to
involve revisiting longstanding assumptions about market
infrastructures and adapting the regulatory system in creative
ways that reflect the best of our collective values and
experience.
As a securities law professor, I like to use disclosure as
a simple example. All too often, carelessness, inaccuracies,
and omissions of--social media posts, and blogs have plagued
the retail investor experience and welfare. Something I noted
in my testimony on ICOs with your colleagues in the House
Financial Services Committee 4 years ago, and something that
has only been highlighted in the last several weeks as
investors and consumers have, too often, been caught unaware of
the risks entailed when transacting with opaque intermediaries.
Yet, deeming a digital asset a commodity or a security will
not magically cure the problem. Commodities like gold, corn,
and oil are subject to grading and quality requirements, but
spot commodity transactions are not automatically subject to
any particular disclosure regime. Meanwhile, calling a digital
asset a security won't solve the problem either. U.S.
securities law is simultaneously under- and over-inclusive. It
asks for disclosure on things like corporate board governance
but not blockchain governance. Furthermore, securities
regulations are premised on the idea of disclosures being filed
and not read, a posture that does little to help consumers and
investors desperate for information as they navigate digital
asset markets.
So, irrespective of which regulator is in charge, that
regulator will have to have a builders' mentality. Strong and
rigorous enforcement is essential, but it is just one tool, and
by definition, involves waiting for problems to arise instead
of nipping them in the bud. You also need auditors of
blockchain source code and better delivery systems for
information and more.
Now, with that said, there is the question for this
Subcommittee as to whether the CFTC in particular is up to the
task of regulating the spot market for those digital assets
which are commodities and not securities. Fortunately, the
United States enjoys not one, but two world-class regulators,
the SEC and the CFTC, and I do believe that both regulators
could do the job. But each would bring to the table very
different comparative advantages. The CFTC has a deep well of
experience substantively regulating digital asset
infrastructures, from approving the first Bitcoin swaps and
options traded on exchanges in 2014, to overseeing the first
U.S. listed Bitcoin futures contract.
Through its work, the CFTC has gained expertise overseeing
the institutionalization of significant infrastructures
intersecting directly with the digital asset commodities spot
market, something the SEC has arguably only accomplished in
attenuated fashion through Bitcoin futures ETS. The CFTC is
also an important cop on the beat of Bitcoin spot markets.
So, in many ways, extending oversight of cash digital asset
commodity markets could be interpreted as a natural evolution
or extension of its existing oversight.
Where the CFTC is less developed than the SEC, however, is
in the domain of disclosure, and the CFTC is well behind the
SEC in terms of resources. The CFTC is but \1/4\ the size of
the SEC, and enjoys a fraction of the SEC's budget.
Where, however, I think the builders' mentality will be
most critical for either agency will be in the context of
financial inclusion. To its credit, the digital assets debate
has opened up a long overdue dialogue on how overlooked
communities, and especially minority communities, build wealth.
But critics and proponents alike tend to miss the forest for
the trees, and almost entirely on the wisdom of a particular
asset class. Is Bitcoin good or bad for Black Americans, for
example. Without tackling the larger, thornier issue head-on,
how do we ensure communities traditionally left out of our
capital markets participate in a meaningful and diversified way
over the long-term and earlier in a sector's life and economic
cycle when value and wealth is created?
Moreover, focusing on digital assets as an investment also
diverts attention from what is likely the far more relevant
question, at least from the standpoint of financial inclusion.
Namely, whether there are parts of the ecosystem's technology
stack that can be leveraged to open opportunities for the
underserved here in the United States, and in my testimony, I
list some of those potential use cases.
So, thank you very, very much for your time. I am really
looking forward to this conversation, and I am looking forward
to your questions.
[The prepared statement of Dr. Brummer follows:]
Prepared Statement of Chris Brummer, J.D., Ph.D., Agnes N. Williams
Professor of Law, Georgetown University Law Center, Washington, D.C.
Chairman Maloney, Ranking Member Fischbach, and Members of the
Subcommittee:
It is a distinct pleasure to be here with you today. The
Agriculture Committee is home to many of my favorite Members of
Congress--which is saying something for a law professor--and I've long
been impressed, and thankful for the bipartisanship this Committee has
long embraced. Today's hearing is yet another example.
With financial markets experiencing enormous volatility, and global
monetary practice reversing decades long trends in old and new markets
alike, I've been asked to talk about how best to strategically think
about the regulatory future of digital assets, and the implications of
digital asset markets for financial inclusion.
Either issue could be the subject of its own hearing, but they are
not altogether unrelated. I'll try my best to connect the dots where I
can.
The Coming Work of Regulatory Agencies
If there is one thing I would like you to remember from my remarks
today, it is that the future of digital asset regulation will require
much more than just defining agency jurisdiction and placing digital
asset products into varying governmental organizational charts. It will
also, necessarily, involve revisiting longstanding assumptions about
market infrastructures embedded in securities and derivatives law and
adapting the regulatory system in creative ways that reflect the best
of our experience and collective values.
Four years ago, near the height of the Initial Coin Offering (ICO)
boom, I advised your colleagues in the Financial Services Committee
that there would be significant work ahead for Congress and regulators
seeking to tackle digital asset regulation, regardless as to how
digital assets, ICOs or otherwise, were classified.\1\ Time has proven
those comments correct, and given the limited advances regulatorily
since then, they are as true today as ever. Irrespective of which
agency is ultimately given more authority over digital assets markets,
regulators need to undertake significant work with regards to upgrading
systems to be mission ready. The jurisdictional question is but the tip
of a much larger iceberg of issues confronting regulators and Congress
today.
---------------------------------------------------------------------------
\1\ See What Should Be Disclosed in an ICO White Paper?, Hearing
Before the Subcomm. on Cap. Mkts., Sec. and Inv of H.R. Comm. on Fin.
Servs., 115th Cong. (2018) (written testimony of Chris Brummer, Fac.
Dir., Geo. U. L. Ctr.); See also an expanded analysis by Chris Brummer,
Jai Messari & Trevor Kiviat in What Should be Disclosed in an ICO?,
Digital Assets: Legal, Regulatory and Monetary Perspectives 157-202
(2019).
---------------------------------------------------------------------------
As a securities law professor, I like to use disclosure as a simple
example. As some of you may recall, disclosure was the focus of my
testimony when I spoke on ICOs.\2\ Today, the topic of disclosure has
once again been highlighted as retail investors have been too often
caught unaware of the risks entailed when engaging in digital asset
transactions with lending firms, custodians and complex intermediaries
and protocols.
---------------------------------------------------------------------------
\2\ For an overview of shortcomings of white paper disclosures, see
Shaanan Cohney, David A. Hoffman, Jeremy Sklaroff, & David Wishnick,
Coin-Operated Capitalism, 119 Colum. L. Rev. 608 (2019). These
shortcomings have particular salience given the complexity of some
services; See also Hilary Allen, DeFi 2.0?, https://papers.ssrn.com/
sol3/papers.cfm?abstract_id=4038788 (noting how complexity inherently
makes risks harder to anticipate, and to understand, especially for
retail participants). The FTC has attempted to, at least indirectly,
quantify the extent of the problem, suggesting that losses from digital
assets scams topped $1 billion in 2021. Lesley Fair, Reported digital
assets scam losses since 2021 top $1 billion, says FTC Data Spotlight,
FTC (June 3, 2022) available at https://www.ftc.gov/business-guidance/
blog/2022/06/reported-crypto-scam-losses-2021-top-1-billion-says-ftc-
data-spotlight.
---------------------------------------------------------------------------
Yet deeming a digital asset a ``commodity'' or ``security'' will
not magically passport digital assets to regimes ready built to provide
proper or even efficient oversight or clarity. Financial futures on
``commodities'' like corn, gold, and oil may face grading and quality
requirements, but spot commodity transactions are not automatically
subject to any particular disclosure regime. Instead, the
identification of a product as a commodity subjects those that transact
on the spot market to a range of anti-fraud protections--effectively
`negative' disclosure requirements prohibiting misleading statements
and market manipulation--as opposed to any substantive, positive
disclosure demands.\3\
---------------------------------------------------------------------------
\3\ See 17 CFR 180.1.
---------------------------------------------------------------------------
Calling a digital asset a ``security'' won't solve the problem,
either. This is because the SEC's disclosure obligations largely fail
to anticipate the particularities of blockchain infrastructures.
Indeed, as I have consistently noted for lawmakers, even if one were to
make the counterfactual assumption that all digital assets were
securities, Regulation S-K, the disclosure template for Initial Public
Offerings, is simultaneously under- and over-inclusive. As such, it
fails in some instances to account for critical aspects of the digital
assets ecosystem, and in others imposes obligations with little to no
relevance, creating both a lack of clarity and inefficiency in
compliance.
Complicating things even further, the infrastructure supporting
digital assets presents novel policy and strategic questions on the
part of any regulator. Traditionally, U.S. disclosure regimes have
rested on the assumption that the issuer is in possession of nonpublic
material information that needs to be made broadly accessible to
investors. This transparency is intended to allow investors to better
understand the risks they face and to then respond to these dangers by
appropriately pricing that risk or avoiding altogether by investing
elsewhere. But in most digital asset contexts, particularly those
involving more decentralized actors operating on public blockchains,
much (although not all) information relevant to an investor or consumer
is already visible to the public on chain--but it is accessible and
understandable only to technologically sophisticated actors.
This feature takes on special importance when contemplating the
basic goals of a disclosure system for digital assets. With vast
quantities of complex information already encoded on public blockchains
for sophisticated actors, any disclosure regime for digital assets
should be geared to speak to everyday retail customers and investors.
Yet for those with even a passing familiarity with today's primary
disclosure system, which applies to public companies, it is clear that
disclosures are largely designed to be ``filed and not read.''
Submissions are voluminous and dense. They are written in legalese and
filed on the SEC's Edgar database, and often follow formats that
respond to the demands of analysts at financial institutions, not
retail investors.\4\
---------------------------------------------------------------------------
\4\ See Zohar Goshen & Gideon Parchomovsky, The Essential Role of
Securities Regulation, 55 Duke L. J. 711, 713 (2006) (``Any serious
examination of the role and function of securities regulation must
sidestep the widespread, yet misguided, belief that securities
regulation aims at protecting the common investor. Securities
regulation is not a consumer protection law.''); see also Troy Paredes,
Blinded by the Light: Information Overload and Its Consequences for
Securities Regulation 2 (St. Louis U., Faculty Working Paper Series,
Paper No. 03-02-02, 2003) available at http://ssrn.com/abstract=413180
(noting that ``[s]ecurities regulation is motivated, in large part, by
the assumption that more information is better than less,'' but that it
can create ``information overload'' for retail investors).
---------------------------------------------------------------------------
To truly protect participants in digital asset markets, another
model is likely to be better suited for the diverse interests and
backgrounds represented by retail investors. I have argued that we need
to look much more carefully at consumer protection law's focus on
targeted, retail-friendly disclosures that are meant to be engaged with
and digested by everyday participants, and not ignored because they are
too inaccessible or overwhelming.\5\ Specifically, I've suggested
building a better disclosure regime, one that could involve revamping
Regulation S-K for the risks of digital asset applications and
financial products--or a new regime that is developed from scratch
employing the shorter, crisper disclosure approaches typically
associated with consumer protection law. I've also drawn attention to
the necessity of clarity and ``Plain English'' in disclosures for not
just the business, but also the technology used to support different
protocols.\6\
---------------------------------------------------------------------------
\5\ Chris Brummer, Disclosure, Dapps and DeFi, Stan. J. of
Blockchain Law & Policy (Mar. 27, 2022 forthcoming) available at
https://papers.ssrn.com/sol3/papers.cfm?abstract_
id=4065143.
\6\ Notably, the SEC has implemented ``Plain English'' disclosure
rules designed to reduce the jargon and difficulty often associated
with reading registration statements. The most stringent requirements
in Rule 421(d) articulate definitive prohibitions against ``legal
jargon'' and ``technical terms'' in the summary, risk factors, and
cover and back pages of a prospectus. Meanwhile, under Rule 421(b), the
Commission has outlined a number of norms such as ``short sentences
whenever possible,'' ``bullet points,'' and ``descriptive headers''
while advising that prospectus drafters avoid ``legal and highly
technical business terms,'' ``legalistic, overly complex
presentations,'' ``vague boilerplate,'' ``excerpts from legal
documents,'' and ``repetition.'' As such, the Plain English rules speak
to the overly complex business narratives and communications that have
traditionally made securities offerings indecipherable for everyday
investors. Plain English disclosures apply, however, only to the front
and back pages, and summary and risk factors, of prospectuses included
in registration statements filed with the SEC. They do not relate to
the disclosures consumers may need most, like the more in-depth
descriptions of relevant tokens or supporting technologies that are
often critical to understanding a dapp as an investment thesis. Id.
---------------------------------------------------------------------------
I've also made the case that serious regulation, irrespective of
which regulator is in charge, requires courageous creativity and a
builder's mentality. Strong and rigorous enforcement is essential--
particularly where rules are reasonably clear and bad actors ignore
them or exploit ambiguities. But it's still just one tool--and by
definition involves waiting for problems to arise instead of nipping
them in the bud and preventing them before they happen.
A safer, fairer, and more efficient system requires additional
building blocks. Gatekeepers suited to the environment are an obvious
starting point. Auditors of a blockchain or protocol's code will be as
important in digital asset ecosystems as auditors of a public company's
financial statements. Purpose-built operational systems will be
critical as well. Just this month, an anonymous hacker was served with
a restraining order via an NFT delivered to the perpetrator's
wallet.\7\ In a similar guise, I've written about using NFTs for
disclosure delivery in some DeFi settings, incentivizing investors to
read disclosures (through rewards or whitelisting) in ways that improve
their disclosure experience in meaningful ways that advance consumer
protection.\8\ My point then, as now, is that a functioning system that
safeguards consumers and investors will need more than just (re)drawing
the regulatory perimeter, and punishing actors after the damage has
been done. Proactive, creative steps will also be necessary to make the
system work well for everyone--steps that acknowledge the strengths and
weaknesses of not only emerging financial technologies, but also those
of the legacy regulatory system.
---------------------------------------------------------------------------
\7\ Sam Bourgi, Anonymous hacker served with restraining order via
NFT, CoinTelegraph (June 9, 2022) available at https://
cointelegraph.com/news/anonymous-hacker-served-with-restraining-order-
via-nft.
\8\ Brummer, supra note 5 at 35-37.
---------------------------------------------------------------------------
CFTC as Crypto-Regulator
With that said, there is the obvious question for this Subcommittee
as to whether the CFTC in particular is up to the task of regulating
digital asset markets. It is in many ways a surprising question--even
with the work ahead, few doubt that the United States enjoys not one,
but two world class markets regulators. The SEC can and should regulate
digital asset securities. The question is whether the CFTC could--or
should--regulate the spot market for those digital assets which are
``commodities'' and not securities. I believe both agencies could do
the job. But each would bring to the table different comparative
advantages.
The CFTC's experience lies in effective and nimble deployment of
its own limited authority, which has enabled it to be an important cop
on the beat of Bitcoin spot markets. Although the agency does not have
the power to set standards for digital asset commodity spot markets--or
for that matter compel the registration of spot digital asset commodity
exchanges--it does have the authority to police fraudulent and
manipulative activities in digital asset commodity markets.\9\
Additionally, CFTC jurisdiction covers digital asset commodity
products, including products offered to retail investors and end-users,
that provide for margin or leverage and is offered to retail
customers.\10\ Thus to the extent that spot digital asset commodity
trading relies on margin or leverage to U.S. persons, it already falls
under the CFTC's broader and more comprehensive registration
jurisdiction--and the agency enjoys the authority to declare that those
products be traded on an exchange and/or through a registered FCM.\11\
Extending oversight of cash digital asset commodity markets, from this
perspective, could be interpreted as a natural evolution of existing
oversight.
---------------------------------------------------------------------------
\9\ Stephen M. Humenik, et. al., CFTC and SEC Perspectives on
Cryptocurrency--Vol. 1: A Jurisdictional Overview, K&L Gates (May 6,
2022) available at https://www.klgates.com/CFTC-and-SEC-Perspectives-
on-Cryptocurrency-and-Digital-Assets-Volume-I-A-Jurisdictional-
Overview-5-6-2022. Notably, in the past fiscal year, the CFTC filed 23
digital asset-related enforcement actions, nearly half the total number
of digital asset-related enforcement actions brought by the CFTC in the
2015-2021 period. James Rubin, CFTC Chair Indicates Agency Will
Increase Crypto Enforcement: Report, Coindesk (May 19. 2022) https://
www.yahoo.com/video/cftc-chair-indicates-agency-increase-
233028535.html.
\10\ See Commodity Exchange Act, 7 U.S.C. 2(c)(2)(D).
\11\ Id.
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The CFTC has also gained unique regulatory experience dealing with
the risks entailed in substantively regulating digital asset
infrastructures. As early as 2014, the CFTC granted under CFTC Chairman
Timothy Massad approval for trading the first Bitcoin denominated
swaps, options and NDFs on CFTC registered Swap Execution
Facilities.\12\ Several years later in 2017, the CFTC under CFTC
Chairman Chris Giancarlo permitted the first Bitcoin futures contract
to be listed on CBOE Futures and CME.\13\ Similar to today's
environment, critics panned the move, doubting both the asset and the
CFTC's ability to oversee the market and arguing that the oversight
would create a bubble. Subsequent studies by the San Francisco Fed
would, however, confirm the opposite, that not only were the markets
functioning properly--but that, if anything, the introduction of the
futures market helped push Bitcoin's price down, not up. Through it
all, the CFTC gained expertise in overseeing the institutionalization
of significant infrastructures intersecting directly with the digital
asset commodity spot market, something that the SEC, which has yet to
approve a spot Bitcoin or digital asset commodity ETF, has arguably
only accomplished in attenuated fashion through multiple Bitcoin
Futures ETFs.\14\
---------------------------------------------------------------------------
\12\ Joon Ian Wong, CFTC Chairman: We Have Oversight of Bitcoin
Derivatives, Coindesk (Dec. 11, 2014) https://www.coindesk.com/markets/
2014/12/11/cftc-chairman-we-have-oversight-of-bitcoin-derivatives/.
\13\ Bitcoin makes debut on futures market, AP (Dec. 10, 2017)
https://www.theguardian.com/technology/2017/dec/11/bitcoin-makes-debut-
futures-market-cboe-chicago-board-options-exchange.
\14\ Pressure on SEC to Approve First Bitcoin ETF Ratchet Up,
PYMNTS (Apr. 25, 2022), https://www.pymnts.com/blockchain/bitcoin/2022/
pressure-on-sec-to-approve-first-bitcoin-etf-ratchets-up.
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Where the CFTC's expertise is less developed than the SEC's is in
the domain of disclosure. With nearly 90 years of history, the SEC has
established itself as the nation's premier (but not sole) information
regulator, with particular expertise where transactions involve an
investment of money, in a common enterprise, with the expectation of
profits, that is dependent on the efforts of others.\15\ But where the
target of regulation is fully decentralized assets, even disclosure
principles would, as noted above, need a fundamental rethink by any
regulator, including the SEC, and a revamp of existing legal
infrastructure. And the SEC would have to pivot to doing things in ways
that speak to the challenge and the times--and to build the
infrastructure to do it properly. The SEC would have a head start in
this particular area, but given the kind of conceptual agility needed,
its already packed agenda, and the comparatively higher hurdle of
establishing its jurisdiction (e.g., the existence of a security),
perhaps not as much as one would assume.
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\15\ SEC v. W.J. Howey Co., 328 U.S. 293 (1946); Securities Act
1933 2(a)(1) Pub. L. No. 112-106, 48 Stat. 74 (codified as amended at
15 U.S.C. 77a et seq.)
---------------------------------------------------------------------------
The CFTC is also well behind the SEC in terms of resources. The
CFTC is but a quarter of the size of the SEC (700 vs. 4,000 full time
employees), and enjoys a fraction of the SEC's budget ($350 Million v.
$2.5 Billion). To build an architecture for regulating digital assets
comprehensively will require considerably more resources than are
currently available,\16\ and unlike the SEC, which is able to move
resources around the agency to meet staffing needs pertaining to
digital asset regulation, the CFTC--an agency long under resourced--
would presumably have little room to maneuver if proper resources were
not allocated.\17\
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\16\ CFTC Chairman Rostin Benham has indicated that the CFTC would
need about $100 Million in additional funding to handle regulating the
spot Digital Asset commodities market, and varying proposals, and some
Industry officials, have suggested a range of transaction taxes or fees
to meet the challenge.
\17\ What maneuverability the agency would have is hard to
estimate. There is precedent suggesting that the CFTC's ability to make
the most of the budget is considerable. Despite the staffing and
funding differentials Congress ended up giving the CFTC, not the SEC,
95% of the swaps market jurisdiction under Dodd Frank. And despite
largely missing out on commensurate increases in funding, even when
compared with the SEC, the CFTC is widely viewed as a successful
regulator of that market, despite its hamstrung resources. However,
stacking additional responsibilities on top of an already resource poor
agency, without the necessary funding, could end up not only hampering
supervision of digital asset markets, but also disrupting other
critical agency functions.
---------------------------------------------------------------------------
Financial Inclusion
Where, however, I think the builder's mentality is most critical in
the digital assets conversation is in the context of financial
inclusion. Digital assets are, like most technologies, a tool whose
benefits will depend on how the technology is used, and for whom.
Skeptics have claimed that digital assets present no benefits for
inclusion, or for that matter, anything else. Industry, meanwhile, has
all too often touted inclusion without thinking seriously about what it
means, or how to achieve it concretely.
To its enormous credit, the digital assets debate has opened up a
long overdue dialogue on just how much the legacy financial system
continues to fail many communities--and how overlooked communities, and
especially minority communities, build wealth. But critics and
proponents alike tend to miss the forest for the trees, and dwell
almost entirely on the wisdom of a particular asset class (``Is Bitcoin
a good or bad investment for Black Americans?'') without tackling the
larger, thornier issue head on: how do we ensure communities
traditionally left out of our capital markets participate in a
meaningful and diversified way, over the longer term, and earlier in
sectors' life and economic cycles, when value is created? It's a
question that digital assets prompt, but which is much larger than
``crypto.'' And when digital assets are the avatar through which the
conversation takes place, policy debates are invariably fixated on
daily or weekly price movements instead of on basic principles of
investing and on reforms needed to address a sprawling wealth gap.\18\
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\18\ Instead of focusing on whether people of color invest in any
particular digital asset, the healthy policy discussion would center on
the appropriate portfolio of low, medium and high-risk investments
investors should have in order to build their economic lives--and
ideally, overcome historic and growing wealth inequality. From this
standpoint, basic principles of investing dictate that most investors
should try to have some (modest) exposure to a diversified slice high
risk or alternative assets--whether it be digital assets, high end art,
silver, private securities, etc.--alongside a much larger swath of
medium and low risk assets, derisking the portfolio as a person nears
retirement. Policy proposals should focus on whether or not the market,
and regulatory policy, support enabling such longstanding, long proven,
and nonpartisan insights. For communities of color that have long been
under-invested in capital markets and have traditionally lacked access
to the fastest growing parts of the economy and technology, this work
is especially critical.
---------------------------------------------------------------------------
Focusing on digital assets as an investment also diverts attention
from what is likely the far more relevant question, at least from the
standpoint of financial inclusion--namely whether there are parts of
the ecosystem's technology stack that can be leveraged to open
opportunities for the underserved here in the United States.
I have been frank, at times painfully so, about the shortcomings in
the digital assets and fintech ecosystem where I see them.\19\ But for
all of the challenges, the core attributes of immutability,
programmability, transparency, and publicness are truly novel--and
position it in ways, if done well, to supplement, and positively
disrupt, a payments and financial system long tilted towards the
wealthy. And it is these features that present a unique opportunity to
experiment and think seriously about how to upgrade our financial
system in ways that can uplift non-coastal, rural and minority
populations.
---------------------------------------------------------------------------
\19\ See 99 Problems, Hearing Before the H.R. Comm. On Fin. Servs.,
(July 17, 2018) (written testimony of Chris Brummer, Prof. of Law Geo.
U. L. Ctr.); See also Chris Brummer, Fintech's Race Problem, Medium
(June 9, 2020), https://chrisbrummer.medium.com/fintechs-race-problem-
856df6351695.
---------------------------------------------------------------------------
Remittances have long been highlighted in Congressional hearings as
obvious use cases, especially for immigrant communities facing
predatory fees for cross border payments. (They also helpfully
distinguish the interest many people have in using digital assets vs.
investing in them.) But there are many other digital asset and
blockchain-related projects currently under development that target
financial inclusion and the democratization of opportunity even more
directly for the U.S. context, and with obvious relevance to working
class people and communities of color:
Opportunities like decentralized identity, which can enable
individuals to collect verifiable credentials with any
constellation of actors--like banks, schools, employers, post
offices, and more--that can be mixed and matched to prove not
only who you are for any range of governmental purposes from
voting eligibility, jury duty, ``sophistication'' for
accredited investor status, etc.).
Opportunities to build new kinds of reputation to open the
credit box through decentralized credit scoring, or leverage
decentralized credit scoring alongside decentralized IDs and
credentials (e.g., landlords and utility companies issuing
credentials relating to a solid repayment history).
Opportunities for using tokenized, real world assets as
collateral for borrowing.
Opportunities to not only reduce closing costs for home
purchases and mortgage closing costs with portable credentials
from mortgage agents, but to store title certificates as NFTs
on blockchains.
Opportunities to build a decentralized net for community
banks and minority depositary institutions to process AML/KYC
requirements associated with new bank accounts and in the
process dramatically reduce their operational costs.
Opportunities to escape predatory payments and banking fees,
and access faster and cheaper financial rails via stablecoins
(or CBDC) for quickly paying part time, remote and gig workers
living check to check.
These kinds of innovations and projects are being explored, and in
some instances built, with blockchains and digital asset technology,
and could end up being massively profitable as well as socially useful.
But in a world of sensational Twitter posts, big personalities and mega
deals, they don't get the attention they deserve, from industry or
national media. Meanwhile, regulatory agencies aren't in the business
of financial inclusion, either--indeed, the Fed, SEC and CFTC all lack
a financial inclusion mandate--and there is little incentive to take
the time to ask what reforms are possible that could help direct
energies towards positive social uses, or to ensure that the industry
reaches its espoused potential of democratizing economic opportunities
for everyone.
As I said 4 years ago, and at the outset of my remarks here today,
the future of digital asset regulation will require much more than just
defining agency jurisdiction and placing various digital assets into
governmental organizational charts. More legal and regulatory
brainpower will be needed, and lawmakers have a unique opportunity to
step into the void, especially in periods of crisis or uncertainty, to
make a real difference. But moving the dial, whether it be on consumer
and investor protection, or financial inclusion, requires understanding
the technology, its limitations, and opportunities. And having a
builder's mentality.
Thanks so much to you all for the invitation to speak to you today.
I look forward to your questions.
The Chairman. I thank the gentleman.
Mr. Levin, you may begin.
Mr. Levin. Thank you.
The Chairman. I will say, sir, you are joining us from
Australia?
Mr. Levin. I am actually now in South Korea. I am in Seoul.
The Chairman. South Korea. Well, thank you for staying up
late or getting up early. I appreciate it.
STATEMENT OF JONATHON LEVIN, CO-FOUNDER AND CHIEF STRATEGY
OFFICER, CHAINALYSIS INC., NEW YORK, NY
Mr. Levin. Thank you, Mr. Chairman. Yes, I like doing
things for the first time, since this is the first time that I
am testifying from South Korea.
So, Chairman Maloney, Ranking Member Fischbach, Ranking
Member Thompson, and distinguished Members of the Committee,
thank you for inviting me here today on this important topic. I
appreciate that this Committee is looking at how to approach
market regulation for digital assets, and as has been said
previously, this couldn't be more timely.
My name is Jonathan Levin, and I co-founded Chainalysis in
2014. I currently serve as our Chief Strategy Officer. I began
studying cryptocurrencies 10 years ago through my research as
an economist, but actually before that, my career started in
commodities studying the impact that speculators have on the
price of copper. Having visited the London Metal Exchange
several times, I appreciate how an orderly and well-functioning
market that sets reference prices of important commodities is
critical to the functioning of our global economy. I think the
stakes are as high in the regulation of digital assets.
While the internet brought citizens much closer together in
terms of global connectivity, it hasn't given everyone the same
economic opportunities that were promised. The cryptocurrency
industry provides a new way to conduct global commerce,
creating these economic opportunities for people across the
world. The entrepreneurial dynamism present in cryptocurrencies
allows for innovators and builders to create universal access
to financial products that better serve consumers and their
data. This technology has the potential to be significant in
the U.S. competitiveness in the global economy over the coming
decades.
An important point that I want to make to Members of this
Committee is that the transparency of blockchains enhances the
ability of policymakers and government agencies to detect,
disrupt, and ultimately deter illicit activity and abuse in
cryptocurrency markets. By examining a cryptocurrency payment
made by a scammer, government agencies are actually able to
look inside into the entire network that is behind this illicit
activity, and the services that have relationship to that
individual.
In contrast, in a traditional criminal financial
investigation, a similar tip linking an illicit actor to a bank
account is just the beginning of a long, extensive process of
legal requests and EMLA requests.
As with any new technology, cryptocurrency can be used by
both good and bad actors. In my written testimony, I outline
some of the evidence that we have at Chainalysis about the
scams, thefts, and types of manipulation that we have seen.
Preventing cryptocurrency from being abused in this way is
intricately connected to our ability to unlock its profound
potential for our economy. We are in a unique position to help
this industry mitigate the risks, and in turn, increase the
potential for a vibrant economy built on this new
infrastructure.
The transparency provided by cryptocurrency enables unique
insights into cryptocurrency markets, including an
understanding of market risks that enables surveillance. There
is a great deal of data and information available to government
agencies looking to understand this space, whereas blockchain
analytics companies like Chainalysis surveil and glean insights
from transactions that are settled on the blockchain, there is
also a lot of off chain data that can be used to understand
market manipulation trends and market manipulation in order
books, and allow typologies related to this type of abuse.
I make a number of recommendations in my written testimony,
but a key recommendation I would like to highlight for this
Committee is that we should aim to create a stable, regulated
market whereby the world looks to the United States for
established asset reference cryptocurrency prices just as they
do for many other types of commodities. If America wants to
lead in this sector, we must lead cryptocurrency market
regulation. The clarification of cryptocurrency market
regulator responsibilities would be a very important step for
this market and would lend a great degree of order to the
market functioning.
I appreciate your time and look forward to your questions.
[The prepared statement of Mr. Levin follows:]
Prepared Statement of Jonathon Levin, Co-Founder and Chief Strategy
Officer, Chainalysis Inc., New York, NY
Chairman Maloney, Ranking Member Fischbach, and distinguished
Members of the Committee. Thank you for inviting me to testify before
you today on this important topic. I appreciate that this Committee is
looking at how to approach market regulation of digital assets. The
topic of market regulation is important for safeguarding digital
assets, but also the financial system more generally.
My name is Jonathan Levin and I co-founded Chainalysis Inc. with
Michael Gronager, CEO of Chainalysis, in 2014. I currently serve as
Chief Strategy Officer. I began studying cryptocurrencies 10 years ago
through my research as an economist. I was interested in the way that
the internet could create accessibility to markets and impact
developing economies. While the internet brought citizens of the world
closer together in terms of global connectivity, it did not give people
the economic opportunities that were promised. The cryptocurrency
industry provides a new way to conduct global commerce, creating
economic opportunities for people across the world. The entrepreneurial
dynamism that cryptocurrencies present allows for innovators and
builders to create universal access to financial products that serve
individuals and their data. This technology has the potential to be
significant in global competition over coming decades.
An important point I want to make to the Members of this Committee,
is that the transparency of blockchains enhances the ability of
policymakers and government agencies to detect, disrupt and,
ultimately, deter illicit activity in cryptocurrency markets. By
examining a cryptocurrency payment made to a scammer, government
agencies unlock immediate insight into the network of wallet addresses
and services (e.g., exchanges, mixers, etc.) that have a relationship
with this entity. In contrast, in a traditional criminal financial
investigation, a similar tip, linking an illicit actor to a bank
account, is just the beginning of a long, extensive process to request
and subpoena records that are manually reviewed and reconciled to
generate a comparable amount of insight. Despite the success of many of
these investigations, the significant time investment that is required
may create opportunities for illicit actors to evade justice vs. the
real-time monitoring capabilities of blockchain intelligence.
As with any new technology, cryptocurrency can be used by both good
and bad actors. As such, preventing cryptocurrency from being abused
for illicit purposes is intricately connected to our ability to unlock
its profound potential for the world. We are in a unique position to
help this industry mitigate risks and, in turn, increase the potential
for a vibrant economy to be built on this new infrastructure. The
transparency provided by the blockchain enables unique insights into
cryptocurrency markets, including an understanding of market risks,
that can enable surveillance. There is a great deal of data and
information available to government agencies looking to understand this
space that is available for analysis. Whereas blockchain analytics
companies like Chainalysis survey and glean insights from transactions
settled on the blockchain, off-chain analytics companies offer trading
insights into cryptocurrency firms' order books, and alert on
typologies related to market price/volume manipulation. Off-chain
analytics and market surveillance companies that we integrate with,
provide alert capabilities to such typologies as pump and dumps,
rugpulls, flash attack loans, spoofing, circular wash-trading as well
as insider/employee trading. Where these datasets are found to be
insufficient for market oversight, regulators may look to have a more
complete understanding by combining on-chain data with off-chain data
from other sources, or requiring additional reporting.
American markets are the world's largest, most developed, and most
influential. Many of the world's most important agricultural, mineral,
and energy commodities are priced in U.S. dollars in the U.S.
derivatives markets. Dollar pricing of the world's commodities provides
a tremendous advantage to American producers in global commerce, an
advantage well-recognized by competing economies abroad. There is a key
opportunity for the United States to have the regulator that
establishes the world's prices for cryptocurrencies.
American markets are the best regulated in the world. The Commodity
Futures Trading Commission (CFTC) has provided oversight of the U.S.
exchange-traded derivatives markets for over 40 years. The CFTC is
recognized for its principles-based regulatory framework and
econometrically driven analysis. It also is recognized around the world
for its level of expertise and breadth of capability. This combination
of regulatory expertise and competency is one of the reasons why U.S.
markets continue to serve participants' needs around the globe to hedge
price and supply risk safely and efficiently. It is why well-regulated
U.S. markets continue to serve a vital national interest--U.S. dollar
pricing of important global commodities.
If America wants to lead in this sector, we must lead
cryptocurrency market regulation. The clarification of cryptocurrency
market regulator responsibilities would be a very important step for
this market and would help to lend a greater degree of order. We should
aim to create a stable, regulated market whereby the world looks to the
United States for established asset-reference cryptocurrency prices,
just as they do for many types of commodities.
I would also like to highlight that the cryptocurrency industry is
working hard to ensure that there are the right protections for
investors in this space. Two ways this is happening is through work
conducted by trade associations made of cryptocurrency industry
members, as well as initiatives like the Crypto Market Integrity
Coalition,\1\ a group of cryptocurrency industry members who have taken
a pledge to focus on cultivating a fair digital asset marketplace to
combat market abuse and manipulation and promote public and regulatory
confidence in the new asset class. The cryptocurrency industry has made
enormous strides to improve market integrity in the past few years. At
the same time, cryptocurrency businesses are keenly aware of the
concerns that still need to be addressed, and are committed to engaging
with regulators to advance solutions to cryptocurrency's unique
challenges.
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\1\ https://www.cryptomarketintegrity.com/.
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In my testimony, I provide background on Chainalysis, outline how
blockchain analysis can be leveraged by government agencies to provide
greater insight into the cryptocurrency ecosystem, and describe risks
we see to consumers, including contagion risks, scams, thefts, and
manipulation in the cryptocurrency space and how they can be identified
and mitigated using blockchain data. I also provide recommendations for
how the government agencies, like the CFTC, can address potential risks
in the market.
Background on Chainalysis
Chainalysis is the blockchain data platform. We provide data,
software, services, and research to government agencies, exchanges,
financial institutions, and insurance and cybersecurity companies.
Chainalysis has over 750 customers in 70 countries. Our data platform
powers investigations, compliance, and risk-management tools that have
been used to solve many of the world's most high-profile cyber-crime
cases and grow consumer access to cryptocurrency safely. We have worked
closely with law enforcement and regulators as they have worked to
disrupt and deter illicit uses of cryptocurrency.
Chainalysis's partnerships with law enforcement and regulators are
consistent with our corporate mission: to build trust in blockchains.
Fundamentally, we believe in the potential of open, decentralized
blockchain networks to drive new efficiencies, reduce barriers for
innovators to create new financial and commercial products, encourage
innovation, enhance financial inclusion, and unlock competitive forces
across financial services and other markets. Our goal is to contribute
our data, tools and expertise to drive illicit finance and other risks
out of the cryptocurrency ecosystem, enabling the realization of the
technology's potential.
Chainalysis's data powers both investigative and compliance tools.
Our investigative tool, Reactor, enables government agencies and
investigative teams to trace the illicit uses of cryptocurrency,
including money laundering, theft, scams, and other criminal
activities. Our compliance tool, KYT (Know Your Transaction), provides
cryptocurrency businesses and financial institutions the ability to
screen their clients transactions and ensure that they are not
attempting to interact with illicit entities. This transaction
monitoring tool provides ongoing insights for cryptocurrency businesses
so that they can protect their businesses and clients and ensure
regulatory compliance.
Another tool, Chainalysis Market Intel, provides the unique
insights needed to conduct cryptocurrency research and make investment
decisions. Chainalysis traces the funds flowing on the blockchain and
tracks the cryptocurrency activity of over 3,300 businesses. This
translates into intelligence on over 95% of the cryptocurrencies traded
on the market. As all transfers are recorded on the blockchain in real-
time, on-chain data, once mapped to real-world entities, this is a
powerful dataset. It is a complete and real-time description of how
cryptocurrency is being used and held. This means our metrics describe
tangible, real-world activity rather than technical blockchain metrics.
This offers new ways to value cryptocurrencies, and understand the
market and the broader crypto-economy, as we can see how assets move in
response, or to cause, events.
Chainalysis also leverages our data to conduct research into the
cryptocurrency ecosystem, including the illicit use of cryptocurrency.
We publish a number of reports, including our annual Crypto Crime
Report. Based on this research, we reported in our 2022 Crypto Crime
Report \2\ that cryptocurrency-based crime hit a new all-time high in
2021, with illicit addresses receiving $14 billion over the course of
the year, up from $7.8 billion in 2020. Top categories include scams,
stolen funds, darknet markets, and--pertinent to this hearing--
ransomware.
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\2\ https://go.chainalysis.com/2022-Crypto-Crime-Report.html.
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Total cryptocurrency value received by illicit addresses, 2017-2021
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Despite this large increase in illicit transaction volume, illicit
activity as a percentage of total volume has actually fallen
dramatically since 2019. In 2019, the illicit share was about 3%, in
2020 it was just over 0.5%, and in 2021 it was 0.15%. The reason for
this is that cryptocurrency usage is growing faster than ever before,
so while cryptocurrency-related crime is definitely increasing, the
legitimate use of cryptocurrency is far outpacing its use by illicit
actors. This is good news for the cryptocurrency ecosystem, but the
government and industry are still faced with putting in place and
implementing the appropriate controls to mitigate risks in the system.
How Blockchain Data Can be Leveraged to Gain Insights into the
Cryptocurrency Ecosystem
It is a common misconception that cryptocurrency is completely
anonymous and untraceable. In fact, the transparency provided by many
cryptocurrencies' public ledgers is much greater than that of other
traditional forms of value transfer. Cryptocurrencies like Bitcoin
operate on public, immutable ledgers known as blockchains. Anyone with
an internet connection can look up the entire history of transactions
on these blockchains. The ledger shows a string of numbers and letters
that transact with another string of numbers and letters. Chainalysis
maps these numbers and letters--or cryptocurrency addresses--to their
real-world entities. For example, in Chainalysis products, we are able
to see that a given transaction was between a customer at a specific
exchange, with a customer at another exchange, between a customer at an
exchange and a sanctioned entity, or any other illicit or legitimate
service using cryptocurrency. Our data set and investigative tools are
invaluable in empowering government and private sector investigators to
trace cryptocurrency transactions, identify patterns, and, crucially,
see where cryptocurrency users are exchanging cryptocurrency for fiat
currency.
Using blockchain analysis tools, law enforcement can trace
cryptocurrency addresses to identify the origination and/or cash-out
points at cryptocurrency exchanges. Law enforcement can serve subpoenas
to these cryptocurrency exchanges, which are required to register as
money services businesses (MSBs) here in the United States and collect
know-your-customer (KYC) information from their customers. In response
to a subpoena, the exchange will provide law enforcement with any
identifying information that it has related to the cryptocurrency
transaction(s) in question, such as name, address, and government
identification documentation, allowing the authorities to further their
investigation.
Blockchain analytics and market surveillance are two pillars for
effective crypto risk monitoring and compliance programs. Chainalysis
KYT addresses the need for insights across blockchain-based
transactions and anti-money laundering (AML) compliance, while market
surveillance tools detect manipulative trading behavior across order
books and venues. Combined, these capabilities give exchanges,
brokerages, regulators and other market participants a powerful view
across both the external and internal risk landscapes of crypto
trading. This takes market integrity to the next level, bringing us
closer to addressing regulatory concerns associated with consumer and
investor protections, for example.
There are many private sector tools that enable oversight of the
cryptocurrency markets and detecting market abuse and manipulation in
cryptocurrency trading. Our tools can be paired with these tools,
including those focused on analysis of orderbook data, to enable
broader insight into the ecosystem. We are working with regulatory
agencies to incorporate our on-chain data alongside off-chain data from
other sources in order to allow for better market surveillance. This
will better enable agencies to identify market manipulation and
malicious activity on the blockchain, including front and back running,
rug pulls, and initial coin offering (ICO) scams, among other things.
The amount of transparency that exists in the market enables an
understanding of the systemic risks that can be used to provide
appropriate oversight of this space. There is a great deal of data and
information that are readily available for analysis. Agencies can
identify where there may be information gaps and implement additional
reporting requirements or additional data sources to gain a more
complete picture.
Risks in the Digital Asset Space
While Chainalysis tracks the illicit use of cryptocurrency in a
number of different categories, for the purposes of this Committee and
the agencies over which they have jurisdiction, I will focus on scams,
thefts, and manipulation in this testimony. Here I will explain what we
see in each of these categories.
Contagion Risks
One risk that has been highlighted by recent cryptocurrency news is
the potential broader contagion of risks in this market. We are
currently in a bear market across financial assets, including
cryptocurrency. In fact, cryptocurrency prices are now more correlated
to tech stocks than ever before. This means, when the broader financial
markets slump, cryptocurrency prices do as well.
But there's one important difference between cryptocurrency and
traditional finance: transparency. Due to the open nature of
decentralized finance (DeFi) protocols, the market can often see where
large, well-known players placed their bets and if those positions are
facing liquidation. Furthermore, market participants can use this
transparency to assess the stability of the core protocols that power
the DeFi ecosystem. However, this transparency has not stopped large,
centralized companies from making bets on the price of various
cryptocurrencies, both using open DeFi protocols and by lending funds
to one another. This creates potential contagion risks, as various
centralized market participants are financially exposed to one another.
While the transparent DeFi protocols continue to function as designed
because they are simply code running on the blockchain, some highly
leveraged businesses have struggled to unwind complex financial
positions in a hostile macroeconomic environment.
This transparency and the fall in cryptocurrency prices is also
exposing projects with fundamental design flaws or unsustainable
economic models. Some projects that were hastily built or didn't
properly manage risk will fail, and that's a natural process for any
new technology or industry. This is an opportunity for the industry to
leverage blockchains' transparency to analyze systemic risk and build
better systems and design better rules for the next bull market.
It is important for regulators to understand both the decentralized
and centralized parts of the cryptocurrency market and how they may
impact each other. For example, centralized players investing in
decentralized finance may find themselves over-leveraged if they have
not appropriately calculated the risks, in particular in a bear market.
The decentralized projects in which centralized entities have invested
may also fall victim to code exploits or hacks and lose their value
precipitously. Being able to adequately oversee centralized players
will require understanding the entire ecosystem.
Scams
There has been an evolution of scamming activity in the
cryptocurrency space over the past few years. Several years ago, scams
mostly presented themselves as centralized platforms where you could
invest in new cryptocurrencies. OneCoin \3\ is an example of this type
of scam. As law enforcement has become better at identifying and
investigating these sorts of scams, and as consumers have become wise
to them, we are seeing a new trend in this space, where scammers will
impersonate high-profile people \4\ and make claims such as offering to
double any cryptocurrency sent to them. Others will impersonate
legitimate cryptocurrency projects on social media \5\ platforms like
Telegram, Discord, or Twitter in order to trick would-be investors into
sending the scammers their funds, rather than sending them to the real
platform. We also see an increase in romance scams, where the scammer
develops a relationship with a victim over time and convinces them to
invest in a scam website, or send them funds directly. This type of
scam is also conducted using other financial assets, but it's becoming
prevalent \6\ in the cryptocurrency space, with a focus on elderly
individuals. Another type of scam we now increasingly see are rug
pulls. As is the case with much of the emerging terminology in
cryptocurrency, the definition of ``rug pull'' isn't set in stone, but
we generally use it to refer to cases in which developers build out
what appear to be legitimate cryptocurrency projects, for example
create ``legitimate'' ERC-20 tokens or non-fungible tokens (NFTs) that
work technically on-chain. However, the real intention of the project
is to accumulate as much funds as possible and disappear abruptly.
Usually they try to drum up as much hype as possible (potentially
hiring celebrities to endorse the product) before taking investors'
money and disappearing.
---------------------------------------------------------------------------
\3\ https://www.justice.gov/usao-sdny/pr/manhattan-us-attorney-
announces-charges-against-leaders-onecoin-multibillion-dollar.
\4\ https://www.cnbc.com/2020/07/15/hackers-appear-to-target-
twitter-accounts-of-elon-musk-bill-gates-others-in-digital-currency-
scam.html.
\5\ https://coinmarketcap.com/alexandria/article/3-minute-tips-
avoiding-common-crypto-scams-on-telegram.
\6\ https://www.cftc.gov/PressRoom/PressReleases/8545-22.
---------------------------------------------------------------------------
In 2021, scams were once again the largest form of cryptocurrency-
based crime by transaction volume, with over $7.7 billion worth of
cryptocurrency taken from victims worldwide.
Total yearly cryptocurrency value received by scammers, 2017-2021
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
That represents a rise of 81% compared to 2020, a year in which
scamming activity dropped significantly compared to 2019, in large part
due to the absence of any large-scale Ponzi schemes. That changed in
2021 with Finiko, a Ponzi scheme primarily targeting Russian speakers
throughout Eastern Europe, netting more than $1.1 billion from victims.
Another change that contributed to 2021's increase in scam revenue:
the emergence of rug pulls, a relatively new scam type particularly
common in the DeFi [1] ecosystem, in which the developers of
a cryptocurrency project--typically a new token--abandon it
unexpectedly, taking users' funds with them. We'll look at both rug
pulls and the Finiko Ponzi scheme in more detail later in this
testimony.
---------------------------------------------------------------------------
\[1]\ Also known as decentralized finance, ``DeFi'' offers peer-to-
peer financial services without the need of intermediaries such as
banks, exchanges, or brokerages (who typically charge for their
services). DeFi services are built and run on a blockchain through the
use of smart contracts which defines the logic and rules for the
service being used.
---------------------------------------------------------------------------
As the largest form of cryptocurrency-based crime and one uniquely
targeted toward new users, scamming poses one of the biggest threats to
cryptocurrency's continued adoption. However, cryptocurrency businesses
are taking innovative steps to leverage blockchain data to protect
their users and nip scams in the bud before potential victims make
deposits.
Investment scams in 2021: More scams, shorter lifespans
While total scam revenue increased significantly in 2021, it stayed
flat if we remove rug pulls and limit our analysis to financial scams--
even with the emergence of Finiko. At the same time though, the number
of deposits to scam addresses fell from just under 10.7 million to 4.1
million, which we can assume means there were fewer individual scam
victims.
Total yearly cryptocurrency value received by investment scams, 2017-
2021
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
This also tells us that the average amount taken from each victim
increased.
Scammers' money laundering strategies haven't changed all that
much. As was the case in previous years, most cryptocurrency sent from
scam wallets ended up at mainstream exchanges.
Destination of funds leaving investment scam addresses by year, 2017-
2021
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Exchanges using Chainalysis KYT for transaction monitoring and
other transaction monitoring solutions can see this activity in real
time, and take action to prevent scammers from cashing out.
The number of financial scams active at any point in the year--
active meaning their addresses were receiving funds--also rose
significantly in 2021, from 2,052 in 2020 to 3,300.
Total number of unique active investment scams by year, 2017-2021
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
This goes hand in hand with another trend we've observed over the
last few years: The average lifespan of a financial scam is getting
shorter and shorter.
Lifespan of average scam by year, 2013-2021
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
The average financial scam was active for just 70 days in 2021,
down from 192 in 2020. Looking back further, the average cryptocurrency
scam was active for 2,369 days, and the figure has trended steadily
downwards since then.
One reason for this could be that investigators are getting better
at investigating and prosecuting scams. For instance, in September
2021, the CFTC filed charges \7\ against 14 investment scams touting
themselves as providing compliant cryptocurrency derivative trading
services--a common scam typology in the space--whereas in reality they
had failed to register with the CFTC as futures commission merchants.
In October 2021, the CFTC charged \8\ an El Paso resident and his firm
in ongoing $3.9 million forex and cryptocurrency fraud and
misappropriation scheme. In March 2022, the CFTC charged \9\ four
people with fraud for operating Ponzi schemes involving Bitcoin. In
April 2022, the CFTC settled a case \10\ against Florida-based
companies and their owner for fraudulently soliciting customers to
purchase a digital asset they falsely promised would allow customers to
gain access to a proprietary foreign currency (forex) trading
algorithm.
---------------------------------------------------------------------------
\7\ https://www.cftc.gov/PressRoom/PressReleases/8434-21.
\8\ https://www.cftc.gov/PressRoom/PressReleases/8452-21.
\9\ https://www.cftc.gov/PressRoom/PressReleases/8498-22.
\10\ https://www.cftc.gov/PressRoom/PressReleases/8510-22.
---------------------------------------------------------------------------
Previously, these scams may have been able to continue operating
for longer. As scammers become aware of these actions, they may feel
more pressure to close up shop before drawing the attention of
regulators and law enforcement.
Rug pulls have emerged as the go-to scam of the DeFi ecosystem,
accounting for 37% of all cryptocurrency scam revenue in 2021, versus
just 1% in 2020. All in all, rug pulls took in more than $2.8 billion
worth of cryptocurrency from victims in 2021.
Most DeFi projects entail developers creating new tokens and
promoting them to investors, who purchase the new token in order to
access the utility that the cryptocurrency network provides, or with
the hope it will rise in value. These actions also provide liquidity to
the project. In rug pulls, however, the developers eventually drain the
funds from the liquidity pool, sending the token's value to zero, and
disappear. Rug pulls are prevalent in DeFi because, with the right
technical know-how, it's cheap and easy to create new tokens on the
Ethereum blockchain or others and get them listed on decentralized
exchanges (DEXes).
The chart below shows 2021's top 15 rug pulls in order of value
stolen.
2021 top 15 rug pulls by cryptocurrency value stolen
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
It's important to remember that not all rug pulls start as DeFi
projects. In fact, the biggest rug pull of the year centered on
Thodex,\11\ a large Turkish centralized exchange whose CEO disappeared
soon after the exchange halted users' ability to withdraw funds. In
all, users lost over $2 billion worth of cryptocurrency, which
represents nearly 90% of all value stolen in rug pulls. However, all
the other rug pulls in 2021 began as DeFi projects.
---------------------------------------------------------------------------
\11\ https://decrypt.co/68894/thodex-ceo-denies-rug-pull-discloses-
cyberattacks-says-funds-are-safe.
---------------------------------------------------------------------------
Finiko: 2021's billion dollar Ponzi scheme
Finiko was a Russia-based Ponzi scheme that operated from December
2019 until July 2021, at which point it collapsed after users found
they could no longer withdraw funds from their accounts with the
company. Finiko invited users to invest with either Bitcoin or Tether,
promising monthly returns of up to 30%, and eventually launched its own
token that traded on several exchanges.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
According to the Moscow Times,\12\ Finiko was headed up by Kirill
Doronin, a popular Instagram influencer who has been associated with
other Ponzi schemes. The article notes that Finiko was able to take
advantage of difficult economic conditions in Russia exacerbated by the
[COVID] pandemic, attracting users desperate to make extra money.
Chainalysis Reactor \13\ shows us how prolific the scam was.
---------------------------------------------------------------------------
\12\ https://www.themoscowtimes.com/2021/07/30/as-incomes-fall-
russians-are-once-again-falling-for-pyramid-schemes-a74654.
\13\ https://www.chainalysis.com/chainalysis-reactor/.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
During the roughly 19 months it remained active, Finiko received
over $1.5 billion worth of Bitcoin in over 800,000 separate deposits.
While it's unclear how many individual victims were responsible for
those deposits or how much of that $1.5 billion was paid out to
investors to keep the Ponzi scheme going, it's clear that Finiko
represents a massive fraud perpetrated against Eastern European
cryptocurrency users, predominantly in Russia and Ukraine.
As is the case with most scams, Finiko primarily received funds
from victims' addresses at mainstream exchanges. However, we can also
see that Finiko received funds from what we've identified as a Russia-
based money launderer.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
This launderer received millions of dollars' worth of
cryptocurrency from addresses associated with ransomware, exchange
hacks, and other forms of cryptocurrency-based crime. While the amount
the service has sent to Finiko is quite small--under 1 Bitcoin (BTC)
total--it serves as an example of how a scam can also be used to
launder funds derived from other criminal schemes. It's also possible
that Finiko received funds from other laundering services we've yet to
identify.
Finiko sent most of its more than $1.5 billion worth of
cryptocurrency to mainstream exchanges, high-risk exchanges, a hosted
wallet service, and a peer-to-peer (P2P) exchange. However, we don't
know what share of those transfers represent payments to victims in
order to give the appearance of successful investments.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Finiko also sent $34 million to a DeFi protocol designed for cross-
chain transactions via a series of intermediary wallets, where it was
likely converted into ERC-20 tokens and sent elsewhere. It also sent
roughly $3.9 million worth of cryptocurrency to a few popular mixing
services. Most interesting of all, perhaps, is Finiko's transaction
history with Suex, an over-the-counter (OTC) broker that was sanctioned
\14\ by U.S. Department of Treasury's Office of Foreign Assets Control
(OFAC) for its role in laundering funds associated with scams,
ransomware attacks, and other forms of cryptocurrency-based crime.
---------------------------------------------------------------------------
\14\ https://blog.chainalysis.com/reports/ofac-sanction-suex-
september-2021/.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Between March and July of 2020, Finiko sent over $9 million worth
of Bitcoin to an address that now appears as an identifier on Suex's
entry into the Specially Designated Nationals (SDN) List. This
connection underlines the prolificness of Suex as a money laundering
service, as well as the crucial role of such services generally in
allowing large-scale cybercriminal operations, like Finiko, to
victimize cryptocurrency users.
Soon after Finiko's collapse in July 2021, Russian authorities
arrested Doronin,\15\ and later also nabbed Ilgiz Shakirov, one of his
key partners in running the Ponzi scheme. Both men remain in custody,
and arrest warrants have reportedly been issued for the rest of
Finiko's founding team.
---------------------------------------------------------------------------
\15\ https://news.bitcoin.com/court-extends-detention-of-finiko-
pyramid-founder-doronin-and-his-right-hand-man/.
---------------------------------------------------------------------------
How one cryptocurrency platform is saving users from scams
Mainstream cryptocurrency platforms, like exchanges, are in the
perfect position to fight back against scams and instill more trust in
cryptocurrency by warning users or even preventing them from executing
those transactions. One popular platform did just that in 2021, and the
results were extremely promising.
Luno is a leading cryptocurrency platform operating in over 40
countries, with an especially heavy presence in South Africa. In 2020,
a major scam was targeting South African cryptocurrency users,
promising outlandishly large investment returns. Knowing that its users
were at risk, Luno decided to take action, in part by leveraging
Chainalysis tools and services.
The first step was a warning and education campaign. Using in-app
messages, help center articles, emails, webinars, social media posts,
YouTube videos, and even one-on-one conversations, Luno showed users
how to spot the red flags that indicate an investment opportunity is
likely a scam, and taught them to avoid pitches that appear too good to
be true.
Luno then went a step further and began preventing users from
sending funds to addresses it knew belonged to scammers. That's where
Chainalysis came in. As the leading blockchain data platform, we have
an entire team dedicated to unearthing cryptocurrency scams and tagging
their addresses in our compliance products. With that data, Luno was
able to halt users' transfers to scams before they were processed. It
was a drastic strategy in many ways--cryptocurrency has historically
been built on an ethos of financial freedom, and some users were likely
to chafe at a perceived limitation on their ability to transact. But
thanks to Chainalysis' best in class cryptocurrency address
attributions, Luno was able to establish the trust necessary to sell
customers on the strategy.
Luno first began blocking scam payments for South African users
only in November 2020, and then rolled the feature out worldwide in
January 2021. The plan worked, and transfers from Luno wallets to scams
fell drastically over the course of 2021.
Daily value received by scams from Luno, 30 day moving average
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Orig Sheets link \16\
---------------------------------------------------------------------------
\16\ https://docs.google.com/spreadsheets/d/
16qcyOn8EBz8KLQ6aRGmE1WObaBy0tRO8v
1gMCGUBNTg/edit#gid=1289181670&range=E8.
---------------------------------------------------------------------------
The moving 30 day average daily transaction volume of transfers to
scams fell 88% from $730,000 at its peak in September 2020, to just
$90,000 by November. One customer summed up the results perfectly,
saying, ``Thank you, Luno. I was about to lose my pension and
savings.''
Scams represent a huge barrier to successful cryptocurrency
adoption, and fighting them can't be left only to law enforcement and
regulators. Cryptocurrency businesses, financial institutions, and, of
course, Chainalysis have an important role to play as well. With this
strategy, Luno took an important step towards establishing greater
trust and safety in cryptocurrency, which we hope to continue to see
grow in the industry.
Theft
Throughout 2021, $3.2 billion in cryptocurrency was stolen from
individuals and services--almost 6x the amount stolen in 2020.
Approximately $2.3 billion of those funds were stolen from DeFi
platforms in particular, and the value stolen from these protocols
catapulted 1,330%.
Total value stolen and total number of thefts, 2015-2021
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
This shift toward DeFi-centric attacks doesn't just sound
pronounced--it looks like it, too. In every year prior to 2021,
centralized exchanges lost the most cryptocurrency to theft by a large
margin. But this year, DeFi platform thefts dwarfed exchange thefts.
The biggest cryptocurrency thefts of 2021
Top ten cryptocurrency theft incidents by amount stolen, 2021-2022 Q1
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
As is the case most years, the ten largest hacks of 2021 and Q1
2022 accounted for a majority of the funds stolen at $2.2 billion.
Eight of these ten attacks targeted DeFi platforms in particular.
Code exploits are a prominent feature in 2021's cryptocurrency theft
landscape
Historically, cryptocurrency thefts have largely been the result of
security breaches in which hackers gain access to victims' private
keys--the crypto-equivalent of pickpocketing. These keys could be
acquired through phishing, keylogging, social engineering, or other
techniques. From 2019 to 2021, almost 30% of all value was stolen from
just this type of hack.
With the rise of DeFi and the extensive smart contract capabilities
that power those platforms, deeper vulnerabilities have begun to emerge
around the software underpinning these services. While these services
are decentralized, these sorts of exploits can lead to contagion in the
centralized parts of the cryptocurrency market, so it is important for
regulators to understand these exploits and their broader impacts.
In 2021, code exploits and flash loan attacks--a type of exploit
involving price manipulation--accounted for a near-majority of total
value stolen across all services, weighing in at 49.8%. And when
examining only hacks on DeFi platforms, that figure increases to 69.3%.
Annual total cryptocurrency stolen by victim type, 2019-2021
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
These exploits occur for a variety of reasons. For one, in keeping
with DeFi's faith in decentralization and transparency, open-source
development is a staple of DeFi applications. This is an important and
broadly positive trend: since many DeFi protocols move funds without
human intervention, users need to be able to audit the underlying code
in order to trust the platform. But this also stands to benefit
cybercriminals, who can analyze the scripts for vulnerabilities and
plan exploits in advance.
Another potential point of failure is DeFi platforms' reliance on
price oracles.\17\ Price oracles are tasked with maintaining accurate
asset pricing data for all cryptocurrencies on a platform, and the job
isn't easy. Secure but slow oracles are vulnerable to arbitrage; fast
but insecure oracles are vulnerable to price manipulation. The latter
type often leads to flash loan attacks, which extracted a massive $364
million from DeFi platforms in 2021. In the hack of Cream Finance, for
example, a series of flash loans exploiting a vulnerability \18\ in the
way Cream calculated yUSD's ``pricePerShare'' variable enabled
attackers to inflate yUSD price to double its true value, sell their
shares, and make off with $130 million in just one night.
---------------------------------------------------------------------------
\17\ https://cointelegraph.com/explained/defi-oracles-explained.
\18\ https://medium.com/cream-finance/post-mortem-exploit-oct-27-
507b12bb6f8e.
---------------------------------------------------------------------------
These two dangers--inaccurate oracles and exploitable code--
underscore the need for the security of both. Fortunately, there are
solutions. To ensure pricing accuracy, decentralized price oracles like
Chainlink \19\ can protect platforms against price manipulation
attacks. To ensure the security of smart contracts, code audits can
steel programs against common hacks \20\ like reentrancy, unhandled
exceptions, and transaction order dependency.
---------------------------------------------------------------------------
\19\ https://chain.link/.
\20\ https://www.usenix.org/system/files/sec21summer_perez.pdf.
---------------------------------------------------------------------------
But code audits aren't infallible. Nearly 30% of code exploits
occurred on platforms audited within the last year, as well as a
surprising 73% of flash loan attacks. This highlights two potential
shortfalls of code audits:
1. They may patch smart contract vulnerabilities in some cases, but
not all;
2. They seldom guarantee that platforms' price oracles are tamper-
proof.\21\
---------------------------------------------------------------------------
\21\ https://blog.chain.link/flash-loans-and-the-importance-of-
tamper-proof-oracles/.
So while code audits can certainly help, DeFi protocols managing
millions of users and billions of dollars must adopt a more robust
approach to platform security.
Following the money: the final destinations of stolen cryptocurrencies
In the aftermath of cryptocurrency thefts, more stolen funds flowed
to DeFi platforms (51%) and risky services (25%) this year than ever
before. Centralized exchanges, once a top destination for stolen funds,
fell out of favor in 2021, receiving less than 15% of the funds. This
is likely due to the embrace of AML and KYC \22\ procedures among major
exchanges--an existential threat to the anonymity of cybercriminals.
---------------------------------------------------------------------------
\22\ https://blog.chainalysis.com/reports/what-is-aml-and-kyc-for-
crypto/.
---------------------------------------------------------------------------
Destination of stolen funds, 2015-2021
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Note: ``Risky'' refers to services like mixers, high-risk
exchanges,[2] and services based in high-risk
jurisdictions.[3]
---------------------------------------------------------------------------
\[2]\ A high risk exchange is an exchange that meets one of the
following criteria:
No KYC: The exchange requires absolutely no customer
information before allowing any
level of deposit or withdrawal. Or they require a name, phone
number, or email address
but make no attempt to verify this information.
Criminal ties: The exchange has criminal convictions of
the corporate entity in relation
to AML/Combating the Financing of Terrorism (CFT) violations.
High risky exposure: The exchange has high amounts of
exposure to risky services such
as darknet markets, other high risk exchanges, or mixing. We
examine if the exchange's
exposure to illicit activity is an outlier compared to other
exchanges. A service with direct
high risk exposure one standard deviation away from the average
across all exchanges
identified by Chainalysis over a 12 month period is considered a
high risk exchange.
\[3]\ High-risk jurisdictions consist of jurisdictions subject to
OFAC comprehensive sanctions, which includes Iran, Cuba, Syria, North
Korea, the Crimea, Donetsk, and Luhansk regions of Ukraine, as well as
Venezuela due to broad government-based sanctions.
---------------------------------------------------------------------------
Manipulation
In 2021 and the first half of 2022, Chainalysis tracked \23\ a
minimum $83 billion worth of cryptocurrency sent to ERC-721 and ERC-
1155 contracts--the two types of Ethereum smart contracts associated
with NFT marketplaces and collections--up from just $106 million in
2020.
---------------------------------------------------------------------------
\23\ https://go.chainalysis.com/nft-market-report.html.
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Weekly total cryptocurrency value and average value per transaction
sent to NFT platforms, 2021-2022 YTD
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
However, as is the case with any new technology, NFTs offer
potential for abuse. It's important that, as our industry considers all
the ways this new asset class can change how we link the blockchain to
the physical world, we also build products that make NFT investment as
safe and secure as possible. There have been several forms of illicit
activity in NFTs: wash trading to artificially increase the value of
NFTs, money laundering through the purchase of NFTs, and insider
trading \24\ on NFT marketplaces. Here I will outline what we have seen
in relation to wash trading.
---------------------------------------------------------------------------
\24\ https://www.justice.gov/usao-sdny/pr/former-employee-nft-
marketplace-charged-first-ever-digital-asset-insider-trading-scheme.
---------------------------------------------------------------------------
Wash trading, meaning executing a transaction in which the seller
is on both sides of the trade in order to paint a misleading picture of
an asset's value and liquidity, is another area of concern for NFTs.
Wash trading has been a concern in the past with cryptocurrency
exchanges attempting to make their trading volumes appear greater than
they are. In the case of NFT wash trading, the goal would be to make
one's NFT appear more valuable than it really is by ``selling it'' to a
new wallet the original owner also controls. In theory, this would be
relatively easy with NFTs, as many NFT trading platforms allow users to
trade by simply connecting their wallet to the platform, with no need
to identify themselves.
With blockchain analysis, however, we can track NFT wash trading by
analyzing sales of NFTs to addresses that were self-financed, meaning
they were funded either by the selling address or by the address that
initially funded the selling address. Analysis of NFT sales to self-
financed addresses shows that some NFT sellers have conducted hundreds
of wash trades.
NFT sellers by number of sales to self-financed addresses, 2021
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Let's look more closely at Seller 1, the most prolific NFT wash
trader on the chart above, who has made 830 sales to addresses they've
self-financed. The Etherscan screenshot below shows a transaction in
which that seller, using the address beginning 0x828, sold an NFT to
the address beginning 0x084 for 0.4 Ethereum via an NFT marketplace.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Everything looks normal at first glance. However, the Chainalysis
Reactor graph below shows that address 0x828 sent 0.45 Ethereum to that
address 0x084 shortly before that sale.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
This activity fits a pattern for Seller 1. The Reactor graph below
shows similar relationships between Seller 1 and hundreds of other
addresses to which they've sold NFTs.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Seller 1 is the address in the middle. All other addresses on this
graph received funds from Seller 1's main address prior to buying an
NFT from that address. So far though, Seller 1 doesn't seem to have
profited from their prolific wash trading. If we calculate the amount
Seller 1 has made from NFT sales to addresses they themselves did not
fund--whom we can assume are victims unaware that the NFTs they're
buying have been wash traded--it doesn't make up for the amount they've
had to spend on gas fees during wash trading transactions.
------------------------------------------------------------------------
Revenue from
Spent on gas fees sales of wash
Address in wash trading traded NFTs to Profits
transactions victims
------------------------------------------------------------------------
0x828 ^$35,642 $27,258 ^$8,383
------------------------------------------------------------------------
While wash trading is prohibited in conventional securities,
futures, and other derivatives, wash trading involving NFTs has yet to
be the subject of an enforcement action. Wash trading in NFTs can
create an unfair marketplace for those who purchase artificially
inflated tokens, and its existence can undermine trust in the NFT
ecosystem, inhibiting future growth. Blockchain data and analysis makes
it easy to spot users who sell NFTs to addresses they've self-financed,
so marketplaces may want to consider bans or other penalties for the
worst offenders.
Recommendations
Provide regulatory clarity to market participants.
While cryptocurrency businesses have been subject to anti-money
laundering laws since at least 2013, there are other aspects of the
market that still require additional clarification, including direction
from Congress. One of these areas is the cryptocurrency spot market,
over and above fraud and manipulation. While the CFTC oversees
derivatives markets such as Bitcoin and ether futures, and the
Securities and Exchange Commission provides oversight over those tokens
that are securities, cryptocurrency spot markets are largely regulated
at the state-level. Clarifying these responsibilities at the Federal
level, likely through legislation, would bolster anti-fraud and
manipulation protections. It is also important to provide clarity about
different tokens--for example, which tokens fall under the securities
framework and which fall under the commodities framework. Having this
guidance will help to make the perimeters very clear and will also make
clear what falls outside of an agency's specific jurisdiction.
Providing market clarity will also support the goals of economic
growth and leadership in the U.S. If America wants to lead in the
cryptocurrency sector, we must lead cryptocurrency market regulation.
Clarifying roles around cryptocurrency market regulation at the Federal
level would be a very important step for this market and would help to
lend a greater degree of order. We should aim to create a market in
which the world looks to the United States for established asset-
reference cryptocurrency prices, just as they do for many types of
commodities.
Ensure adequate funding, resources, and training for government
agencies charged with investigating fraud, manipulation, and abusive
practices in this space.
As this asset class grows and is increasingly adopted, the U.S.
government must do their best to root out fraud, manipulation, and
abusive practices. Governments that have already embraced blockchain
analysis have seized millions of dollars in cryptocurrency and stopped
a number of illicit actors exploiting cryptocurrency. Many government
agencies, including the CFTC, have limited or inconsistent personnel
dedicated to investigating the illicit use of cryptocurrency because of
a lack of training resources and a lack of funding for new personnel,
tools, and training. Allocating appropriate financial and personnel
resources to these efforts would ensure that agencies can address
illicit activity in this space.
Leverage the unique and transparent nature of cryptocurrency in
market surveillance and in the development of policies and regulations.
The information that is available to government agencies due to the
transparent nature of blockchain technology provides an opportunity for
policy makers and regulators to think differently about regulatory
requirements in this space. For example, regulators can leverage this
data to gain insights into the ecosystem and inform where the greatest
risks are as they build their capacity to provide market surveillance.
This will allow them to prioritize regulatory requirements that fill in
information gaps. For example, reporting requirements may be different
in this space given the on-chain data made available to regulators
because of the transparent nature of the technology. It may not be
necessary to require the same level of reporting because of the ease of
availability of that on-chain data. Instead, regulators can focus
reporting requirements on the parts of the market where there may be
incomplete data or other gaps.
Understand and monitor systemic risks in the cryptocurrency
ecosystem.
Regulators need to understand and monitor systemic risks in the
whole cryptocurrency ecosystem--not just those market participants they
have oversight of--to better understand the contagion risks that may be
present. For example, it is important that regulators understand DeFi
and DeFi products to understand the potential contagion risks.
Understanding the broader market structures will better enable market
surveillance and inform regulatory decisions.
Prioritize public education to ensure consumers understand
cryptocurrencies and have the information they need to make educated
decisions.
As with any new asset class, there is sometimes confusion among the
general public about what cryptocurrencies are and how they work. It is
important that the U.S. government engage in educational efforts
related to cryptocurrency to better enable consumers to understand this
asset class and avoid scams and fraudulent activity in the
cryptocurrency ecosystem. The CFTC and others should consider
partnering with the private-sector in addition to conducting agency--
lead initiatives to broaden the access, breadth, and depth of public
education and ensure its impact.
Leverage public-private partnerships.
It is important that the U.S. Government work together with private
industry to address issues related to fraud, abuse, and manipulation in
the cryptocurrency ecosystem. Establishing and improving upon
coordination and collaboration mechanisms between countries can help to
streamline investigations and improve oversight of the markets. These
partnerships can provide additional insights into what is happening in
the market to better inform policy decisions and guide discussions
about how best to improve regulation.
Conclusion
Cryptocurrency has a variety of applications which contribute to
the public good. Of particular interest to this Committee these
contributions include job creation, fast cross-border payments, global
leadership opportunities, and technological innovation. The U.S. is
well-positioned to bring to bear our decades of innovation in cutting-
edge technologies to this fast growing industry and be a key player in
regulating the industry. As regulators approach this new asset class,
they can leverage its technology and transparency to glean important
insights and assess risks. Congress must do its part to ensure that the
government agencies charged with oversight of this space are equipped
to understand and address fraud, abuse, and manipulation in
cryptocurrency markets. By providing the resources necessary, the U.S.
government as a whole will be better equipped to mitigate risks and
investigate and disrupt illicit activity when it does occur in the
cryptocurrency markets. Thank you for your time, and attention to this
very important issue.
The Chairman. I thank the gentleman.
Chainalysis rolls right off the tongue. Thank you, sir.
Mr. Hoskinson, you may proceed.
STATEMENT OF CHARLES HOSKINSON, CHIEF EXECUTIVE OFFICER, INPUT
OUTPUT GLOBAL, INC., SINGAPORE, SG
Mr. Hoskinson. Hi, everybody. Chairman Maloney, Ranking
Member Fischbach, Members of the Subcommittee, and
Congressional staffers who work so hard, thank you for inviting
me to testify at this hearing. I applaud the work of this
Subcommittee, and I appreciate you all taking the time to
provide a forum for the blockchain industry.
The blockchain industry has grown over the past decade from
a small group of uncommercialized volunteer developers--and it
was very small, believe me--to a trillion dollar global economy
encapsulating sophisticated engineering, scientific research,
publicly traded companies, and millions of users.
While our remarkable growth yields significant
opportunities ranging from infrastructure security to entirely
new economies like metaverses and NFTs, it also has presented
new challenges and amplified the existing problems. Our legacy
systems cannot handle the rapid movement of value without
counterparty risk and require centralized middlemen. Our
regulatory tools, risk management systems, and oversight
processes were never designed for such speed, scale, and rapid
evolution. For example, in just 4 years, our industry has
touched concepts ranging from IPOs to intellectual property to
completely new business structures called DOWs that are
effectively leaderless and jurisdiction free.
Reflecting upon the 20th century, the dominance of the
United States has rested upon three pillars: our financial
services, our technology companies, and our manufacturing
capabilities. These industries are rapidly transforming under
the demands of globalization, increased competition, new
technologies, and our desire to define ESG rules to ensure a
sustainable, values driven global economy. At our core, our
industries technology is about creating distributive ledgers to
store information that needs to be transparent, auditable,
time-stamped, and immutable. This process enables records of
social and economic concerns to be reliable and programmable.
For example, as a rancher, I have to deal with water
rights, grazing leases, BLM land, and numerous other
agreements, contracts, and economic events. Many of these are
not digitized, nor are they shared in ways to provide emergent
value to policymakers, regulators, and researchers. The
consequences of this fragmentation and lack of digitization are
a large amount of inefficiency, replication of work, and a lack
of access for entrepreneurs and innovators who could build new
products and services that would dramatically reduce costs and
improve efficiency for all stakeholders. The power of
blockchain technology is its universality and permissionless
model for innovation. Our company, Input Output, has never had
to pay a royalty, file a patent application, or acquire a
license to pursue business in countries as diverse as Ethiopia
to Mongolia. Thus, we have to understand that categories-based
regulation that is segregated to the borders of a particular
jurisdiction and relies upon centralized actors for reporting a
disclosure is unlikely to be effective, and frankly, will
inhibit regulation.
Furthermore, the internet's governance, evolution, and
innovation are not controlled by the ITU or some other
transnational body, but rather, by thousands of interconnected
and interdependent agencies and private companies working
towards the self-emerging common goals of increased
connectivity, capacity, and utility.
If we are to discuss how to regulate our industry, protect
consumers, and align growth with the realities of modern
society, then we ought to have the humility to admit innovation
makes specifics difficult. We should focus on principles
instead.
Blockchains enable the liquidity of value, thought and
commerce at a scale and speed society has never enjoyed before.
Instead of predicting the outcome of these new capabilities, we
ought to decide on what risks we must guard against, what
fundamental rights consumers should have, and how to use new
tools for the greatest possible good. It seems prudent to focus
on concepts like measuring decentralization, information
asymmetries, accessibility of data, and access rather than
arguing about jurisdictional bodies or asset categorization.
Cryptocurrencies are financial stem cells at their core. They
can be nearly any asset and can change over time. Principles
don't change.
For example, the notion of measuring consolidation and its
risks has been an endeavor the United States has pursued and
is, frankly, good at since the Sherman Anti-trust Act of 1890.*
While none of us are personally familiar with life in the
1890s, we would certainly be comfortable with the intent and
concepts behind the Sherman Antitrust Act. Centralization of
markets and power seldom leads to good outcomes. I hope we can
engage in a fruitful and ongoing dialogue throughout the coming
months as the United States debates the regulatory future of
the American blockchain and cryptocurrency industry. Like the
prior Congresses in the 1990s discussing the regulatory
framework for the internet that led to the rise of trillion
dollar companies, I believe this Congress can achieve great
results by working with our industry at a principles-based
legislative approach, and leveraging our capabilities to
innovate and adapt.
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* Editor's note: Enacted July 2, 1890; 26 Stat. 209, Public Law No.
51-109.
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Thank you all for your time, and I look forward to your
questions.
[The prepared statement of Mr. Hoskinson follows:]
Prepared Statement of Charles Hoskinson, Chief Executive Officer, Input
Output Global, Inc., Singapore, SG
I. Introduction
Chairman Maloney, Ranking Member [Fischbach], Members of the
Subcommittee and distinguished guests, thank you for inviting me to
testify at this hearing. My name is Charles Hoskinson and I sincerely
applaud the work of this Subcommittee and appreciate you all taking the
time to provide a forum for the blockchain industry. I am pleased to
provide you with as much information as you need in order to ensure a
fully informed and robust conversation on the future of digital asset
regulation.
II. Background on Input Output Global
I am one of the founders of the Ethereum blockchain, founder of the
Cardano blockchain and CEO of Input Output Global (IOG), which is a
research and engineering company focused on the development of
blockchain and other cutting-edge technologies. IOG is an American
company that has helped to build the Cardano blockchain as well as
other products on top of the blockchain such as Atala Prism,\1\ a
blockchain-based self-sovereign identity solution that provides digital
identity to individuals and Lace light wallet,\2\ a digital portal that
provides individuals access to a variety of financial services. IOG's
research team has published more than 140 academic research papers
relating to blockchain technology and has relationships with academic
institutions such as the University of Wyoming, Carnegie Mellon
University, Stanford University and the University of Edinburgh. Beyond
the United States, the company is working across Africa (particularly
in Ethiopia, Tanzania, Kenya and Burundi) to help expand broadband
service in rural areas, increase financial inclusion through
microfinance and lending marketplaces and provide students and teachers
with digital identities and verifiable credentials--all on the Cardano
blockchain.
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\1\ https://atalaprism.io/.
\2\ https://www.lace.io/.
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III. Using Blockchain Technology to Solve Real-World Problems
Distributed ledgers (i.e., blockchains) store information that
needs to be transparent, auditable, timestamped, and immutable. This
process enables records of social and economic concerns to be reliable
and programmable.
Public blockchains, just like many commodities, are intrinsically
decentralized and permissionless. For example, I grow hay on my farm in
Colorado. I did not ask for permission to plant and harvest my hay, and
now I am a member of a global, dynamic marketplace. There are
regulations and controls in all of these markets, but we do not assume
there is a centralized hay agency to ensure somehow this market works.
Such absurdities were reserved for the Soviet central planners of old,
not modern economies. Blockchain projects operate and embody this
decentralized ethos and would fail under the weight of a heavy-handed
and outdated regulatory structure.
As a rancher, I have to deal with water rights, grazing leases,
public land authorities, and numerous other agreements, covenants, and
economic events. The management and oversight of much of these
activities are not digitized, nor are they shared in ways to provide
emergent value to policymakers, regulators, and researchers. When these
activities are conducted and managed, and the resulting information is
shared, on a blockchain they are transparent and auditable.
Looking, for example, at the beef industry, blockchain technology
can be used in many ways including creating significant value for the
industry's end-to-end supply chain and more over sustainability and
safety, such as grass-fed assurance, trade finance, consumer
engagement, consumer feedback, certification and end-to-end
traceability. With regards to traceability, BeefChain is a blockchain
startup that allows consumers to trace their beef product. BeefChain is
built on the Cardano blockchain and utilizes IOG's Atala Trace
solution. In 2019 the company achieved USDA Certification with the
Process Verified Program.\3\ This means that certain characteristics,
such as being hormone free, are treated as audited and certified in
line with U.S. food safety regulations. By enabling unique animal
identification and ensuring origin, BeefChain allows the rancher to
receive premium pricing for premium beef and provides consumers with
greater confidence in the meat they consume. Digitizing animal branding
rules and procedures, such as those in Wyoming, could save thousands of
hours waiting for inspectors, speed up livestock sales, and enable more
data collection for supply chain management scored against
environmental and conservation goals. Livestock branding takes on a new
meaning when a record of the event is immutably fixed in a blockchain.
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\3\ https://www.ledgerinsights.com/proof-of-steak-blockchain-food-
beef-traceability/.
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As for some of the work that my company is doing, IOG is working
with Ethiopia's Ministry of Education to create a blockchain-based
digital identity and verifiable academic credentials for five million
students and teachers in the country. The goal of this vital project is
to enable data-driven policy-making and simultaneously allow students
to prove their educational achievements internally and across borders
to universities and the job market by reducing the risk of fraud. IOG's
partnership with World Mobile \4\ will lay the foundations for a
totally connected Africa by utilizing the Cardano blockchain to help
empower remote and hard to reach areas across the continent so that
everyone gets an equal chance to access services and opportunities.
World Mobile's mesh network model leveraging the Cardano blockchain
enables scalable, shared infrastructure, security, transparency and
self-sovereignty, which can lower the costs and barrier for people to
access connectivity. The sharing economy gives every participant of the
network a mutual stake in its success.
---------------------------------------------------------------------------
\4\ https://worldmobile.io/.
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In Kenya and Ghana, in order to tackle the financing gap through an
ecosystem of products that remove the frictions between crypto
liquidity and real-world economic activities to offer cheaper financial
products, IOG has partnered with Pezesha Africa Limited to facilitate
loans to small and medium sized businesses looking for short term loans
for working capital. The goal is to build simple friction-free tools
that enable seamless lending.
Another use case here in America that I would like to highlight is
a loyalty program powered by blockchain technology, which is currently
being developed through a strategic collaboration between IOG and DISH
Network Corporation.\5\ The two companies are working to create a
backend token-based loyalty system supported by the Cardano blockchain.
Cardano tracks the balance of loyalty coins or BoostcoinsTM
accrued by customers, and mints or burns the loyalty tokens based on
customer rewards and reward redemptions. The loyalty token balance is
adjusted in a nightly batch operation, using a DISH-controlled digital
wallet. IOG's Atala Prism is leveraged to ensure no personally
identifiable customer information is included in the process. This
first step of the collaboration enables blockchain capabilities in
DISH's infrastructure through Atala PRISM's identity services and
Cardano's native asset features allowing DISH to better serve and
securely connect with its customers.
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\5\ https://www.dish.com/.
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These use cases and projects exemplify the kind of economic
development and growth that blockchain technology can bring to America,
especially to rural and remote regions of the country.
IV. Principles for the Blockchain Industry
If we are to discuss how to regulate digital assets, protect
consumers, and align growth with the realities of modern society, then
we ought to have the humility to admit that innovation makes specifics
difficult and thus focus on principles instead. Although the concept of
freedom of speech is ever challenged by new technology, we can
recognize that the constitutional notions of free speech remain the
same. We have a desire to express ourselves in a free society without
fear of government interference or retribution. What are the principles
that should guide thinking coming out of the blockchain industry in its
interaction with the U.S. Government?
Looking at another American creation, the internet, the governance,
evolution, and innovation of the internet are not controlled by the
International Telecommunication Union (ITU) or some other transnational
body, but rather by thousands of interconnected and interdependent
agencies and private companies working together towards the self-
emerging common goals of increased connectivity, capacity, and utility.
The United States embraced the public-private partnership that allowed
the internet to flourish and for the United States to play and maintain
a primary role in internet technology. Similarly, it will take many
different agencies working together with the private sector to ensure
the American blockchain industry flourishes and reaches its full
potential.
Like the prior Congresses in the 1990s discussing the regulatory
framework for the internet that led to the rise of trillion dollar
companies, I believe this Congress can achieve great results by working
with the blockchain industry towards a principles-based approach that
leverages our countries' remarkable capabilities to innovate and adapt.
It is of the utmost importance to acknowledge that category-based
regulation, which is segregated to the borders of a particular
jurisdiction and relies solely upon centralized actors for reporting
and disclosure, is unlikely to be effective in a blockchain-based
decentralized ecosystem and will inhibit innovation. Whereas,
principles-based regulation, which is more flexible, can adapt and
evolve alongside the nascent technology without strangling an industry
that has only started and forcing companies abroad.
V. Values in Support of American Industry
Reflecting upon the 20th century, the dominance of the United
States has rested upon three pillars: financial services, technology
companies, and manufacturing capabilities. These industries are rapidly
transforming under the demands of globalization, increased competition,
new technologies, and the desire to define environmental, social
governance (ESG) rules to ensure a sustainable, values-driven global
economy. I believe that the blockchain industry is building the
foundational technology that will enable trust, compliance, and
competitiveness for these industries throughout the 21st century,
thereby ensuring another American century.
Transparent, immutable, always objective ledgers--provided by
blockchain technology--are phenomenal tools for record-keeping,
reporting, and oversight. In other words, blockchain technology itself
provides many of the tools that can be deployed for safeguarding
consumers and protecting market integrity. The same concepts that
protect a decentralized exchange from front running or security
breaches can also be used by regtech companies like Chainalysis to
provide unprecedented information to government agencies, regulators,
economists, and financial engineers about an exchange. The collection
of this data is permissionless and royalty-free. No more dark pools. No
more centralized brokers.
The power of blockchain technology is its universality and
permissionless model for innovation. True competition exists when
everyone has equal access to markets. My company, Input Output Global,
has never had to pay a royalty, file a patent application, or acquire a
license to pursue blockchain-related business development in countries
as diverse as Ethiopia to Mongolia. The same tools that would enable a
rancher to register a brand could be reused for land deeds, a credit
score, or issuing a non-fungible token (NFT) to represent a musical
composition, assuring its artist of receiving fair compensation.
Blockchains enable the liquidity of value, thought, and commerce at
a scale and speed society has never experienced before. Instead of
predicting the outcome of these new capabilities, we ought to decide on
what consumer and market risks we need to guard against, what
fundamental rights consumers should have, and how to use these new
tools for the greatest possible good. Compliance with regulation and
legislation coming out of the United States must be a guiding value for
the blockchain industry, nation and world, as speed of development
without any control whatsoever will lead to rampant fraud, waste, and
abuse.
VI. The Importance of Appropriate & Responsible Regulation
IOG, myself and many others in the industry are in favor of and
support appropriate and responsible regulation of digital assets and
blockchain technology. However, this is a new technology and a
radically new asset class that can not readily fit within the confines
of the laws and tests created almost a century ago.
Cryptocurrencies are financial stem cells--programmable software
that can be nearly any asset and can change over time. In fact, no two
cryptocurrencies are alike and the uses, functions and features of
cryptocurrencies can vary depending on who is holding the
cryptocurrency, why and where. Cryptocurrency can be used to verify
data, transfer information or value, purchase goods, provide access to
services, serve as a reward or membership program, act as a store of
value or as an investment, all at the same time or at different times
over the life of the cryptocurrency.
The United States legislature has never tried to regulate something
that could be so many different things at the same time. Yes, some
cryptocurrencies may be securities, some may be commodities, some may
be both, but many may not be either. Regardless of how a cryptocurrency
is labeled, three things should be kept in mind: (i) the existing U.S.
regulatory regimes never contemplated such an asset, (ii) without
cryptocurrencies, most blockchain technologies simply will not function
and (iii) any regulatory goals should be to promote appropriate
consumer protections and assure market integrity. The last can be
achieved through regulatory approaches that do not necessarily require
labeling a cryptocurrency as either a security or commodity.
U.S. securities laws achieve investor and market protections based
on the assumption that there is and will always be a centralized entity
(e.g., a corporation who is identifiable and can permanently assume the
role of providing financial and other data to the holders of its
equity). Some blockchain technologies, and thus cryptocurrencies may
initially be created or backed by a somewhat centralized entity similar
to a corporation but many times that is not the case and over time,
virtually all cryptocurrencies and blockchains exist without any
centralized entity that can be identified as the party supporting such
technology. The existing laws and regulations that assume the existence
of such centralized and responsible parties simply and logically cannot
work in the case of blockchain technology and the cryptocurrencies that
drive such technologies.
Responsible regulation should start with an understanding as to the
critical role blockchain technologies can play for assuring American
competitiveness, America's security, particularly digital
infrastructure, financial inclusion for Americans and promotion of
economic development and growth.
VII. Conclusion
Cryptocurrencies and the broader blockchain industry, which relies
on cryptocurrencies to operate and function, have grown over the past
decade from a small group of uncommercialized, volunteer developers to
a trillion dollar, global ecosystem encapsulating sophisticated
engineering, scientific research, publicly traded companies and tens of
millions of people using these technologies throughout the world.
The great growth of blockchain technology rivals only the internet
and arguably yields more significant opportunities ranging from cheaper
and more efficient payment systems, cryptographically enhanced
infrastructure security, new forms of governance, self-sovereign
identity and so much more. However, this new technology has also
presented new challenges and amplified the existing problems of many
legacy systems. The instantaneous movement of information and value
without counterpart risk nor the need for centralized middlemen
combined with reducing complex business processes and structures to
open source software that can be rapidly upgraded means that commercial
activity can now proceed at the speed of thought on a global scale.
I am grateful to have the opportunity to present these real-world
use cases, my opinions on the guiding values of the industry and
thoughts regarding the promise of the blockchain industry. My knowledge
and network are always available to this Subcommittee to aid and assist
in the legislative process. In conclusion, I hope we can engage in a
fruitful and ongoing dialogue throughout the coming months as the
United States debates the regulatory future of the American Blockchain
and Cryptocurrency industry. I sincerely appreciate your time and look
forward to your questions.
Attachment 1
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Attachment 2
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
The Chairman. Thank you, Mr. Hoskinson.
At this time, Members will be recognized for questions in
order of seniority, alternating between Majority and Minority
Members. Members will be recognized for 5 minutes each in order
to allow us to get to as many questions as possible. Please
keep your microphones muted until you are recognized,
especially on the Zoom, in order to minimize background noise.
I will now recognize myself for 5 minutes.
Mr. Brummer, should CFTC have direct statutory authority to
regulate cash markets?
Dr. Brummer. Well, the CFTC, as I said, is certainly up to
the job under a certain number of circumstances.
Number one, obviously it has to be financed and resourced
properly. Second, and this is really the point of the
conversation, all the regulatory agencies have to really have a
change in their mindset. I think what you have heard from
almost all the witnesses is that the underlying infrastructure
is very different from the infrastructure upon which many of
our both securities and derivatives laws are based, and to
really adequately oversee these markets, some degree of
familiarity with those markets is going to be necessary. So,
whether or not the SEC or the CFTC, but the CFTC is certainly
up to the job. It has certain kinds of comparative advantages,
and it is those advantages that should be leveraged and to
build upon those areas like disclosure where it has not
traditionally wielded its authority.
The Chairman. Right. I am struck by the line in your
testimony where you said it will necessarily involve revisiting
longstanding assumptions about market infrastructures embedded
in securities and derivatives law and adapting the regulatory
system in creative ways that reflect the best of our experience
and collective values.
What does that mean?
Dr. Brummer. Yes, it means, for example, in the securities
law context, our entire disclosure system is based of an
assumption that issuers have non-public information that other
expert actors don't have, and so, therefore, to make sure that
that information is available to them and it kind of trickles
down to your retail investor. So, it is based--the evolution
part disclosure system, even in securities law, is for
information to be filed but not really read.
When you go and you operate on a blockchain, it is
completely different context. In part, because much of the
material, not all, but much of the material information that
you would need is already available on chain, but is only
accessible to the expert actors. It is the retail folks who
would not have the ability to read and understand the source
code. So, that gets you into a question as to what should the
disclosure system look like? It should probably have more
consumer protection principles and to think about how do you
get that information to those people in that system?
The Chairman. Yes, it is a great question, but the one
before it is the one I am most interested in, which is who is
best to do that? That brings me back to my first question,
because I listened closely to your answer. I understand it is
complicated and I understand the concerns about how it be done,
which is actually very, very important. Is CFTC up to that?
Dr. Brummer. CFTC is up to the job. It has the experience,
in some ways, more direct experience in some ways dealing with
these issues than any other agency in the government. It is up
to the job, but again, not to be too law professory, but
context matters and it has to be properly resourced to do the
job.
The Chairman. Right. Mr. McGonagle, good news. The
professor says you are up to the job. Can you shed any light on
my question, sir, because I think the thing where, at least
that I am very interested in, is it seems clear we need to
legislate in this area, and we need to understand the follow-on
consequences of that. So, help me understand if we were to give
direct statutory authority to CFTC for the cash, spot markets,
what should that look like?
Mr. McGonagle. Thank you, Mr. Chairman, I appreciate the
question.
At the CFTC, we are a market regulator. We think about how
individual market participants from all aspects of, say, the
production and user chain might access our markets in order to
hedge risk or manage risk exposure. So, interesting compared to
the professor who is definitely spending some time thinking
about, like, how the commodity could be used. The CFTC thinks
about how individuals are interested in the change and value of
that commodity or digital asset, and how that transaction and
that interest in that change in value can be regulated. That is
what our system of regulation is meant to accomplish. We look
at market participants that are interested in trading value and
they are doing that in a centralized marketplace where there is
price transparency and where they have execution certainty.
They are able to get the product, the interest that they want,
and they are able to do that in a safe and secure manner.
The Chairman. Isn't the critical wrinkle here that there is
more speculation in the spot market with digital assets than
there would be with the traditional commodity, and are you guys
better set up for that?
Mr. McGonagle. So, for sure when you see in the commodity--
in the spot market, there is significant speculative interest
also on a leveraged basis, so putting a little money down----
The Chairman. At the retail level?
Mr. McGonagle. Exactly, and trading significant funds with
significant risks. In a regulated market space, we have the
opportunity--again, talking about disclosure obligations--to
help inform those customers about this is the type of
transaction that you are getting into, and making sure to the
best that we are able to facilitate customer protection so that
they understand the risks and they are prepared to accept those
risks. We also have safeguards in place to protect those assets
to be more stable.
The Chairman. All right. Well, I thank the gentleman. If we
have time for a second round, I would be particularly
interested in the subject Dr. Brummer opened in terms of the
innovative ways we have to think about this, given the
differences between this and what we have traditionally dealt
with.
I am pleased to recognize the Ranking Member and to extend
her the same time allotment that I consumed.
Mrs. Fischbach. Thank you very much, Mr. Chairman, and I
can't not comment on Dr. Brummer saying it is hard for him not
to be too law professory. So, I was a law student. There is a
lot of law professory stuff going on. So, I appreciate it.
But----
The Chairman. I was more struck by the fact that he said we
are his favorite Members of Congress----
Mrs. Fischbach. There you go.
The Chairman. And this Committee.
Dr. Brummer. I am a kid from Arkansas.
Mrs. Fischbach. But turning back to a little bit--the chair
was asking a little bit about the CFTC, and I just wanted to
ask, Mr. McGonagle, the CFTC is often referred to as a
principle-based regulator. Could you tell us a little bit about
what that means generally in your experience with that approach
as it has been applied?
Mr. McGonagle. Yes, thank you.
The question around principle-based articulates that there
are 23 core principles for designated contract markets that
basically sets up the system of obligations that the entity has
to comply with in order to list products for trading on our
designated contract markets. And so, they will cover grounds
including system safeguard, for example. Core principles also
require that products that are listed not be readily
susceptible to manipulation, and that there be customer
protections available. Core principals also provide for the
certainty of execution, for example, of the transaction, that
you are able to have a counterparty that minimizes the risk,
and we do that through a clearing system. Each market will have
one clearing organization that will be the counterparty for all
the market's transaction.
So, we are looking at a program of responsibility that not
only is the CFTC administering the law through application
review, compliance, and surveillance. These designated contract
markets also have responsibility on the self-regulatory basis
to make sure that their market participants are complying with
the rules. And the CFTC has broad enforcement authority to make
sure that those market participants comply with the Commodity
Exchange Act and the regulations.
Mrs. Fischbach. Thank you, and maybe just, I have heard
criticism about the CFTC, that it is a permissive light touch
regulator, and would you agree with that, and if not, could you
tell us some of your personal experiences why that criticism is
unfounded?
Mr. McGonagle. Absolutely. So, at the CFTC, we strongly
value our enforcement program, and a strong enforcement program
supports market integrity and customer protection. If people
know that the rules of the road are supposed to be followed and
that there is going to be a swift and strong response, that
encourages compliance activity. So, while we have a
comprehensive regulatory framework, we also have a very strong
enforcement program.
As I mentioned in my opening remarks, we filed 50 cases on
digital assets. We brought those cases starting in 2014. We are
looking at fraud, pump and dump manipulation, illegal contracts
that are being offered to U.S. customers, not only within the
U.S., but also from entities outside of the U.S. If there is a
violation of the Act or our regulations, the CFTC is a strong
enforcement authority to deter that misconduct. If it involves
a criminal violation, we work closely with our cooperative
enforcement partners at the Department of Justice as well as
the U.S. Attorney Offices.
Mrs. Fischbach. Thank you very much. I appreciate the
information.
Mr. Hoskinson--did I say that--I am trying here.
Mr. Hoskinson. Yes.
Mrs. Fischbach. Thank you very much, and I know we just
have a few seconds left, but there is a lot of discussion about
whether we should regulate certain cryptocurrency as
commodities or securities.
What do you think are the benefits, and maybe you could
talk just a little bit about that, what are the drawbacks,
things like that?
Mr. Hoskinson. Well, with 37 seconds----
Mrs. Fischbach. I know. I am sorry. Yes.
The Chairman. The gentleman can take as much time as he
requires.
Mrs. Fischbach. Oh, thank you, Mr. Chairman. There you go.
Mr. Hoskinson. Thank you.
The Chairman. I mean, don't push it, but----
Mrs. Fischbach. It is a fine line here.
Mr. Hoskinson. You got to be careful. I am Italian.
So, when you look at cryptocurrencies in general, I have
always viewed them like financial stem cells. They are kind of
more fundamental than a particular category like a currency or
a commodity. And really, it depends on the markets they are
traded on and the use and utility that they have. But at the
end of the day, you have to ask yourself what public policy
considerations are you attempting to satisfy? Is it sanctions
compliance? Is it consumer protection? Is it market stability?
What we do as an industry is we are all about transparency. So,
it is kind of funny that we are talking and debating about
disclosure regimes. There is no other financial asset in the
world that really is as transparent as a cryptocurrency. Every
transaction from the very beginning--for Bitcoin, for example,
from January 3, 2009, is known. Every single one. The holdings
of the founder are known because all of these things are
publicly available to everybody.
So, it is more about, in my view, understandability and the
tooling required to make this work on a global basis. So, I
don't think it would be wise to say, well, is it a security or
a commodity, or fall into this temptation of who is the more
permissive regulator or what is the regulatory arbitrage, but
rather, just take a step back and say what things do we want to
guard against? And we now have 13 years of history as an
industry of six or seven collapses, a whole bunch of
interesting new things like NFTs that have always pushed the
limit, and a global marketplace with more than 100 million
people floating around that we can draw from and we can look on
a case-by-case basis, and build a framework that makes sense.
What is encouraging to me as an entrepreneur, briefly, is
that there is a lot of great legislation that has been proposed
recently, like the DCEA, the FIA, there are Executive Orders
that have come through that are trying to force clarity amongst
the Executive Branch. So, these things together create global
dialogue, and if we are clever about it, I think we can
converge to a reasonable compromise that we as an industry can
live with and continue to be competitive with.
Mrs. Fischbach. Thank you very much. I appreciate that, and
thank you, Mr. Chairman, for your indulgence.
The Chairman. I thank the gentlelady.
I would like to yield to the Ranking Member if he has any
questions, Mr. Thompson.
Mr. Thompson. Mr. Chairman, thank you so much.
Mr. McGonagle, first of all, thank you for your dedicated
service, and your experience at CFTC, it is much appreciated.
Earlier this year, as noted a number of times, I introduced
the Digital Commodity Exchange Act (H.R. 7614), DCEA, along
with Mr. Khanna, Mr. Emmer, and Mr. Soto. Among other things,
the DCEA creates a new registered entity, a digital commodity
exchange, DCE, that is subject to a registration and compliance
regime. This is similar to the existing registered futures
exchanges and swap execution facilities under the Commodity
Exchange Act.
Can you please tell us generally about the requirements
CFTC imposes on futures exchanges and the SEFs?
Mr. McGonagle. I am sorry, Ranking Member. The door opened
and I missed the last phrase. If you could just restate that
for me?
Mr. Thompson. I just noted that under the DCEA, what we
have done with DCEA and there was a similar--it was very
similar to the existing registered futures exchange and swap
execution facilities under the current Commodity Exchange Act.
And so, the question was can you tell us generally about the
requirements the CFTC imposes on future exchanges and SEFs?
Mr. McGonagle. Great, thank you, Ranking Member, and I
appreciate you indulging me with following up.
With respect to designated contract markets and swap
execution facilities, those entities are responsible to
establish and set up. They are self-regulatory organizations.
So the rules that they implement on their platforms are the
rules that they also have to ensure that there is compliance
with. So, for example, they will establish trading protocols
and they will establish prohibitions concerning market abuse.
That self-regulatory organization responsibility is to make
sure then that those market participants follow the rules of
the road.
At the same time, the self-regulatory organization has
responsibilities to the Commission and to Congress as part of
the 23 core principles. So, for example, they need to make sure
that their trading platforms are cyber resilient. That is, they
must have the ability to operate in the event that someone
attempts to breach their system, that they have capacity to
roll over, for example, to another trading platform to allow
trading to continue. It is incredibly important that our
markets be able to operate efficiently at all times for our
market participants who are trading in the markets who have
risk exposure that they need to manage.
Mr. Thompson. Thank you for that.
Dr. Brummer, as Ranking Member Fischbach alluded to, there
is some uncertainty about when and if an asset is a commodity
or a security, and some argue that the vast majority of digital
assets are just securities. Is the law clear on this?
Dr. Brummer. No, and if it was, all of my students would be
getting an A in my securities law class. I mean, by definition,
I mean, the Howie test, leads to some clarity in some
instances, but in others, obviously, there is ambiguity, in
part because each of the prongs of the Howie test, the SEC case
that sort of defines when you have a security, are very much
intended to be sort of contextually based. And, whether or not
you may know that there is an investment of money, but when are
you relying on the efforts of others? What does that actually
mean in the digital context? What does a common enterprise mean
when you are operating on a platform? Certainly, when is money,
money, which is a little bit more established under securities
law, but in financial regulation at large, it can and often is
subject to considerable debate.
But what is clear is that it is not the case that all
digital assets are securities, even under established
longstanding principles, and there have been various
declarations made by leaders of both the SEC and the CFTC that
some of those digital assets with the largest market cap are,
in fact, commodities.
Mr. Thompson. In your testimony, you noted the CFTC and SEC
have different regulatory strengths and that there are benefits
to each. In many ways, this is what Mr. Khanna and I recognized
in the DCEA. For example, we proposed the SEC would continue to
regulate capital raising activities with their associated
disclosures for investors, and the CFTC would govern the
trading of any token which is a digital commodity using
registered exchanges to fulfill the role of a gatekeeper for
market participants.
As we continue to think about how we should structure this
regulatory regime, what else should Congress consider?
Dr. Brummer. I think it is important, and some of the more
recent cases have, particularly in the last 2 weeks, have sort
of highlighted is that as this technology grows, as this
technology scales, you are going to have different kinds of
actors that can also be operating on chain. And, when we get to
these very important questions like what is decentralized and
what is a decentralized actor, what happens when you have more
centralized actors who, by definition, may have off-chain
operations that are more opaque? What does it mean when these
digital markets intersect with the larger off-chain economy?
And I think that that is going to be a critical question. There
is a disclosure aspect to it. There is a market infrastructure
question to that, and it is going to be something that
lawmakers and regulators are going to have to think through.
Mr. Thompson. Very good. Well, thank you. Thank you to all
of our witnesses, and thank you, Mr. Chairman.
The Chairman. I thank the gentleman.
The chair now recognizes the gentleman from Illinois, Mr.
Rush.
Mr. Rush. Thank you, Mr. Chairman, for today's hearing.
The timing of today's hearing is very apt. Cryptocurrency
markets have been on a roller coaster in recent months, and the
last 2 weeks have been an absolute and horrible meltdown as
Bitcoin has lost over half of its value. As such coins melted
down so horrifically to cause concern for the rest of the
industry. Frankly, Mr. Chairman, I am concerned. I am concerned
that this industry does not adequately expose its risks and
volatility as it tries to lure in a new and unsuspecting money
as it deals with multiple crypto exchanges showing ads during
this year's Super Bowl. I am concerned about the lack of
transparency for some of the cryptocurrencies, such as so-
called stable coins, some of which have been recently
collapsing and those could potentially cause harm to the rest
of the global economy. As the Chairman of the Subcommittee on
Energy within the Energy and Commerce Committee, I am concerned
with the stress that cryptocurrency mining facilities are
putting on our electric grid in the summer where there are
blackouts in south Texas, California, and some of the
Midwestern states are already receiving warnings.
Finally, Mr. Chairman, as someone who cares deeply about
this country, I am concerned about the growing political power
of cryptocurrency companies and worried about the potential for
regulatory capture by the industry and its new [inaudible] into
dark money investment into political races, including my local
race here in Chicago for my replacement in Congress.
Now, I understand that technology does not flow within the
jurisdiction of the Agriculture Committee or the CFTC, and that
certainly is not the subject of today's hearing.
Dr. Brummer, I would appreciate your testimony on financial
inclusion, ensuring that communities like mine on the south
side of Chicago that have been traditionally excluded from
generating wealth are not excluded from the potential explosion
of wealth that blockchain technologies could create. However, I
am deeply concerned about this disruption of wealth that we are
seeing in crypto markets this year. How do we prevent these
markets from preying on overlooked and vulnerable communities,
Dr. Brummer, and prevent those communities that have been
robbed of so much from having their wealth further stripped by
financial markets that illuminate overhead?
Dr. Brummer. Yes, that is an excellent question, and like
you, this is something I have shared with many of the country's
regulators, particularly with the state regulators around the
country.
One of the primary challenges with the question of
disclosure and the degree to which Black and Brown communities
are preyed upon is that the degree of complexity in any kind of
financial instrument, whether or not it be cryptocurrency or
CDAs from 2008, complexity introduces the opportunity for
vulnerability. And the question that all of our regulatory
agencies are going to have to face--and this is getting back to
this mindset question--is understanding that disclosure,
particularly where you have large numbers of retail investors,
the way in which you think about disclosure is going to have to
be rethought, both because of the complexity of the financial
instrument, and the kinds of assumptions that our regulatory
space has traditionally made.
I do think that the industry itself is going to have to
face some challenges as well, as this industry scales and it
seeks both new customers, but also new kinds of ideas, it is
going to have to have inputs from much broader sources of
society, people from between the coasts, minority communities
are all going to have to participate more. I think it is good
on a number of levels. Number one, I think to the degree to
which you have more sort of different kinds of people
participating in the product design, you are going to be able
to reach use cases that are much more applicable to a slice of
the public. I think that when you have people from different
backgrounds largely helping to think through the technology,
there is a natural dream chute that comes from the consumer
protection space. People sort of talk about what is required,
frankly, for a real democratization of finance, and if you want
to get some of the benefits that watching technology professes,
opportunities like decentralized identity or opening up the
credit box or decentralized credit scoring, closing the costs
or reducing costs on mortgages, or figuring out new kinds of
compliance systems for MDIs and minority depositary
institutions. You have to have more brainpower involved in
different kinds of perspectives.
And I think, again, when you have those people
participating in the room and in the design and in the strategy
sessions for these companies that are still figuring out how
they diversify their operations, that is going to be a critical
piece to really speaking to the very real threats and
challenges that are out there when vulnerable communities
intersect with anything that is inherently complex.
The Chairman. The gentleman's time has expired.
The chair now recognizes Mr. Balderson from Ohio.
Mr. Balderson. Thank you, Mr. Chairman, and thank you to
all the witnesses for being here today.
A common theme that I have heard when meeting with
stakeholders in this space is that they believe the CFTC is the
best position to assume oversight of spot markets for digital
assets. Chairman Maloney touched on this, but I would like for
you all to expand on it.
I will start with you, Mr. McGonagle, but if any witnesses
have thoughts, please feel free to share them. Do you agree
that the CFTC is well-suited to oversee spot markets for the
digital assets, and what authorities, if any, does the CFTC
need to assume regulatory authority over digital spot markets?
Mr. McGonagle. Thank you, Congressman. Certainly, the way
that digital assets are being traded in the cash market today
very strongly resembles how digital assets are traded as a
derivative. What I mean by that is where there is an interest
in the change in the price of a particular commodity, and so,
there is trading around that interest. That is an area that the
CFTC----
The Chairman. The gentleman will suspend.
The chair just reminds Members to mute, please, if you are
not on camera or speaking. Thank you.
The gentleman may proceed.
Mr. McGonagle. Thank you.
So, the CFTC has a comprehensive oversight with respect to
applications for contract markets, compliance by contract
markets, and surveillance of activities on those contract
markets. And I think all of those concepts, as well as the
enforcement piece that I spoke about earlier, relate to trading
that is occurring in digital asset spot markets.
With respect to the regulatory authority, I understand and
appreciate that there is a lot of thinking around possible
regulatory structures. I will point out just quickly that
following Dodd-Frank, the CFTC received statutory authority
with respect to swap execution facilities, and there was a
determination by Congress to articulate 15 core principles,
that are similar in scope and kind to the core principles that
we have for designated contract markets. The Commission then
entered into an extensive public comment period where we took
the guidance that we had from Congress with respect to
implementation of those core principles and set forth our
proposed rules concerning trading on these platforms that are
focused on market transparency, as well as clearing obligations
and some dealer responsibility. So, not intermediary oversight
like we have currently in DCM space, but that would be
something that would be important to evaluate in the digital
asset spot complex.
Mr. Balderson. Thank you for that answer. Would anybody
else like to add on to the question? Okay.
Mr. Hoskinson. I will take a bite at it.
Mr. Balderson. All right, thank you.
Mr. Hoskinson. I am not a securities lawyer or an expert on
regulation, so take it with a grain of salt.
But I don't think it is a question of, as I mentioned
before, who is more permissive or who is less restrictive. It
is more of a question of efficacy, and when you look at
commodities, commodities are intrinsically decentralized. So, I
grow hay on one of my farms, and I didn't have to ask
permission. There is no central hay agency. We are not the
Soviet Union. We do not regulate things that way. And then
suddenly when I cut it and I sell it, it enters into a global
marketplace. Now, that marketplace has rules and principles and
protections, and there is a retail component. People feed
horses, and there is certainly an industrial component.
So, if cryptocurrencies are truly decentralized and that
actually is a real thing, then it does make sense to embed that
into a framework that is designed for things that are
intrinsically this way.
You have to look out for cartels, market manipulation. You
have to look out for where global actors try to come in, like
China or others, and take over our market like they are trying
to do the lithium markets. But that is a very different type of
notion than a security in that respect.
So, in my view, the most effective thing that can be done
over the next 12, 24 months is to have a really good notion of
what is decentralization, and what are the factors that produce
that? And if it gets past a certain threshold, it makes a lot
of natural sense to regulate things like a commodity as opposed
to a security. And if they don't, well then it is very obvious
who has the disclosure requirement.
Mr. Balderson. Well done. So, thank you for your answer.
Mr. Chairman, with lack of remaining time, I will yield
back. Thank you.
The Chairman. I thank the gentleman.
The chair recognizes Ms. Craig.
Ms. Craig. Thank you so much, Mr. Chairman, and thank you
to Ranking Member Fischbach for today's hearing on digital
asset regulation. Thanks so much to the witnesses for your
expert testimony. Obviously, this is clearly a space with
complex policy considerations and a great deal of public and
private interest.
One of the things that I have been tracking today during
this hearing and over the course of the 117th Congress is how
many of these conversations about regulatory authority will
impact many of the retail investors that have moved into the
crypto space over the last few years.
With that in mind, I know we are giving you a bit of a
workout today, but Director McGonagle, I am coming to you with
my first question. Director McGonagle, can you speak about how
Federal regulation of crypto trading platforms under the
Commodity Exchange Act is related to market transparency, and
ultimately to ensuring that retail investors have access to the
information they need to properly weigh the risk involved?
Mr. McGonagle. Thank you, Congresswoman. I appreciate the
question.
In thinking about spot markets, say, in particular the
overlap of spot and derivatives markets, an issue that we are
focused on for derivatives products deals with the concept of
the prospect around leverage, and the understanding by the
individual investor, particularly where that individual
investor is a retail participant, that they know and appreciate
the risk of trading. And while there may be good upside for
putting, say, 50 down and having a dollar's worth of a
position, there is incredible downside if the market moves
against your position.
So, at the CFTC, we are focused not only on market
integrity and having centralization or a place where market
participants can come together and understand what the pricing
is, but we also look to have a system of intermediary oversight
that focuses on retail market participants, say, in particular
with a disclosure regime that informs those market participants
sort of based on who they are dealing with. So, for example, if
it is a commodity trading advisor or commodity pool operator,
the risk of that trading strategy is disclosed as well as
associated fees add--those are disclosed. That individual
market participant understands how their funds are being
protected or utilized at a futures commission merchant, for
example, that those funds are segregated, and how those funds
can also be protected, for example, in the event of a
bankruptcy.
So, we do look for execution certainty, as well as customer
protection as part of our regulatory regime, and I think that
is helpful to the dialogue here.
Ms. Craig. I don't want to take up too much more time, but
I have been listening here for quite a while, and I hear you
saying that your agency has the capacity and the expertise to
take on any additional regulatory role in this digital asset
space. Is that what I am hearing from you today?
Mr. McGonagle. So, we definitely have the intellectual
expertise, and we have ongoing responsibility now to implement
and ensure regulatory compliance by new market participants
that are currently seeking applications for designation as
contract markets, for example, as well as ensuring that those
entities continue compliance. So, we are able to take that
skillset to the extent that we are dealing with like to like,
similar types of core principles. We are able to transition
that work, and I used earlier the example with respect to
swaps. But that also involves, certainly, a resource
determination, and depending on the number of applicants, for
example, or the scope of the responsibility, from my
perspective, that is a conversation that DMO has with the
Chairman about priorities.
But at the same time, the Chairman has initiated an effort
to accurately quantify the resources that would be needed in
the event that there is some additional grant of authority.
Ms. Craig. Thank you so much.
I don't have time to ask the whole panel, but I wanted to
ask Dr. Brummer here. In the time I have remaining, can you
give me your assessment about how the principles-based approach
of the CFTC does or doesn't fit with the dynamic nature of the
digital asset space now?
Dr. Brummer. That is an extraordinarily good [inaudible].
Thank you. I am a technology expert, but I just need to press
the red button.
So, I think that is an important and critical question in
part because one of the comparative advantages, one of the
really interesting features of the derivatives regulatory
framework is precisely because of the special relationship
between the exchanges, the DCMs and the Commission whereby you
can exercise various levels of granularity in terms of
oversight, while at the same time leveraging the self-
regulatory capacity of these exchanges to keep up with the
innovation.
And so, I do think that is one interesting and important
feature, particularly in a space that is constantly evolving
and where the rulemaking is going to have to be very agile. So,
that is something that I look to as a potential comparative
advantage.
Ms. Craig. Thank you so much, Dr. Brummer, and seeing that
I have exceeded my time, I thank the Chairman and yield back.
The Chairman. I thank the gentlelady.
The gentlewoman from Florida, Mrs. Cammack.
Mrs. Cammack. Well, thank you, Mr. Chairman and Ranking
Member Fischbach. I appreciate all our witnesses for being here
today, and has been discussed, since 2014 the CFTC has been
regulating crypto derivatives, and has also been exercising its
anti-fraud and anti-manipulation enforcement authority over
digital asset sport markets. The agency clearly has extensive
experience overseeing digital assets, including futures, which
retail users have been trading through a direct access model.
Now, Dr. Brummer, isn't it the case that several exchanges
registered with the CFTC today offer retail traders the ability
to directly access exchanges without a broker, including
through ICE, ARIS, and Kalishi exchanges?
Dr. Brummer. It is true to my knowledge that yes, there are
some direct--I know [inaudible]. I am not entirely sure about
the others, but yes.
Mrs. Cammack. Okay, and this is for you again, Dr. Brummer,
and Mr. McGonagle.
I am going--I messed that up. I am so sorry. I would like
to ask each of you, do you agree that Federal regulation of
crypto trading platforms under the Commodity Exchange Act would
raise the floor rather than establish a ceiling of required
reporting and investor protections above that currently
provided by the existing state-by-state money transmitters
licensing regime?
Mr. McGonagle. Yes. Thank you, Congresswoman.
Certainly, as a market regulator, it would establish a
floor. We have a different purpose than the money exchange
state licensing, and so, I wouldn't be in a position
necessarily to compare how those state-by-state provisions may
overlap in some instances. But to the extent that we are
talking, again, about managing risk, CFTC has a system of
regulation in place.
Mrs. Cammack. Dr. Brummer?
Dr. Brummer. That is right. The purposes of the money
transmitter laws are different. They tend to be, at the state
level, somewhat less resourced, but the entire focus is a
little bit different. So, there would be some overlap, but it
is a little bit of apples to oranges.
Mrs. Cammack. I know. I know, I am pushing you to try to
get to a point here, but thank you both for your responses.
Mr. McGonagle, how does the CFTC's expertise and experience
regulating complex derivatives markets translate to crypto
markets?
Mr. McGonagle. Thank you again, Congresswoman.
The CFTC offers the opportunity for multiple market
participants to come together to execute transactions where
there is price transparency. Individuals who are trading in the
market understand the product that they are trading and they
understand the price and volume for how they are trading that
product. There are also rules in place with respect to how
those customers possibly are entering their transactions on the
market. And when I mean possibly--and you alluded to this
earlier--to the extent that they are going through an
intermediary, there are additional protections available to a
retail market participant, including the types of risk
disclosure, segregation and protection of assets.
And then ultimately, the transactions go to a clearing
facility. Centralizing that clearing facility minimizes the
risk that you may see currently for transactions on spot
platforms, for example, who do not have centralized clearing
and instead are exposed to individual counterparties' credit
risk.
Mrs. Cammack. Thank you for that. I appreciate it.
One last question, since I have about a minute left. I
understand that you all have been working closely with the SEC
on exchange regulation in this space. A day doesn't go by that
I don't catch an article about this. Regarding this
coordination and cooperation, how productive are these
discussions to coordinate going--how are they going, and do you
see any concerns or gaps in the current conversations with SEC
that still need to be addressed?
Mr. McGonagle. So, thank you, Congresswoman. I was
reflecting on----
Mrs. Cammack. Are you sure you want to say thank you?
Mr. McGonagle. I was reflecting on 25 years with the CFTC.
In my experience, we have a longstanding relationship,
particularly on enforcement, but also on regulatory matters. We
talk all the time. We need to talk and those conversations are
always productive.
Mrs. Cammack. Are there any gaps that you see?
Mr. McGonagle. As between the two agencies, we understand
where our jurisdictions come together. We discuss when they
overlap. In physical digital assets, we currently don't have
regulatory authority over those products.
Mrs. Cammack. Thank you.
The Chairman. The gentlewoman's time has expired.
Ms. Kuster--and I will remind the Members that we do have a
fourth witness who is up in the middle of the night in Asia. I
haven't forgotten about you, Mr. Levin. The perils of being on
Zoom.
Ms. Kuster?
Ms. Kuster. Thank you so much, Mr. Chairman, and thank you
for our panel being with us, especially you, Mr. Levin, joining
us from South Korea. I will have a question for you.
We are in the midst of a brave new world of digital asset
trading. Our Committee has given this issue worthwhile
attention because of the role that the Commodity Futures
Trading Commission has and will continue to play in regulating
this trade. As more and more Americans invest in these assets,
it is imperative for Congress to keep up as we regulate and
oversee the digital realm, just as we do with more established
markets.
As we have all seen recently, Bitcoin, the most popular
cryptocurrency, has badly tumbled in the last few weeks and
lost more than \1/2\ its value in 2022 so far. Clearly, no
marketplace is immune from severe vulnerability and
uncertainty, be it Bitcoin or Wall Street, but we do need to
assure digital markets are operating above board and that they
are secure, and that investors have access to the information
they need to fully understand the risks they are undertaking.
With that in mind, I am going to focus my questions on
consumer protection as it relates to digital assets, and going
to you first, Mr. Levin. Thank you for being with us from South
Korea. Could you speak to how prevalent risky cryptocurrency
exchanges are, such as those that lack know your customer
rules, may have criminal ties, or may be connected to the dark
web?
Mr. Levin. Thank you, Congresswoman, and yes, this is
exactly what Chainalysis focuses on is mapping all of the
different participants that actually facilitate transactions in
cryptocurrencies. And to your point, we have seen over the last
few years exchanges in offshore jurisdictions actually used to
facilitate the laundering of proceeds from things like
ransomware. And so, OFAC has taken action to designate certain
of these exchanges like SUEX and TRAVEX as cryptocurrency
exchanges that have facilitated that.
I think that does speak, though, to the ability for us to
focus the discussion here on how do we appropriately equip a
market regulator with overseeing the venues that we think
should form the reference prices for these commodities and
ensure the orderly functioning of markets. And also, we have
seen Treasury take necessary action to enforce rules around AML
across the board internationally as well, and that has been
very clear in sort of the actions the Treasury has taken.
Ms. Kuster. So, let's delve into that.
Director McGonagle, you mentioned in your testimony since
2014, the CFTC has brought more than 50 enforcement actions
against digital asset markets for issues like fraud,
manipulation, and false reporting. Could you speak to how the
investigation process works at CFTC, and do you feel there is
more authority or certainly financial support that you may need
from Congress to strengthen CFTC's enforcement role?
Mr. McGonagle. Thank you, Congresswoman. I appreciate the
question.
When it comes to enforcement authority, the CFTC has very
broad and strong authority. Our anti-fraud and anti-
manipulation authority, as you mentioned, extends into the
physical markets, where we have brought cases that involve all
manner of misrepresentations, including pump and dump schemes
that are manipulating prices. There was a comment about the
Bank Secrecy Act and money laundering. We brought cases where
entities have a registration obligation with the CFTC because
of the products they were offering, did not seek registration
and also violated AML provisions. We also look at fraud in the
context of illegal contracts. So, for example, if it is a
leverage contract that doesn't result in the delivery of the
actual physical currency within a period of time, that falls
within CFTC's anti-fraud authority and it is treated as if it
is a futures contract.
Ms. Kuster. Can you elaborate on how these crimes work? You
have given an example, but what you all have identified as
emerging trends in illicit activity related to digital assets
that you are on the lookout for. I know I do a lot of work in
the addiction and opioid space, but also sex trafficking. It
looks like my time is up, so we will have to see if we can beg
the Chairman's indulgence for your response.
The Chairman. The gentleman may proceed.
Mr. McGonagle. Yes, thank you.
And say, in particular, the attraction to leverage, so that
sort of get rich quick because individual investors are at 50
to 1 leverage, for example. Like that is a significant risk
concern.
We also see digital assets where they may not be the
subject of the fraud, but they are the payment mechanism in
connection with other fraud schemes, like for example, FOREX
fraud that CFTC has jurisdiction over.
Ms. Kuster. Excellent, thank you. Thank you, Mr. Chairman.
I yield back.
The Chairman. The gentlewoman's time has expired.
Mr. Feenstra--excuse me, Mr. Scott.
Mr. Austin Scott of Georgia. I----
The Chairman. Am I right, Mr. Scott? Okay.
Mr. Austin Scott of Georgia. I apologize, I had to step
out. I had a meeting in my office with constituents.
But I am going to start with you, Mr. McGonagle. This
isn't--it is not corn; it is not gold. It is certainly not
dollars, and there are a lot of questions here. One is if the
U.S. is going to regulate, then it is CFTC versus SEC. Some
have suggested even a new agency. Then there is the how if you
do that, and then there is the who do you regulate?
So, my understanding is there are 20,000 approximately
cryptocurrencies in the world worth about $3 trillion. Is that
close, give or take a trillion on a day on the values? Is it
somewhere around 20,000 currencies?
I mean, the question I have, 20,000 currencies, CFTC--how
many people work at the CFTC today?
Mr. McGonagle. Thank you, Congressman. Several hundred.
Mr. Austin Scott of Georgia. Several hundred. So, you would
be talking about--if they gave up everything that they are
currently doing, you would be talking about 100
cryptocurrencies a person?
My point is, it is not possible to regulate all of these
currencies. It is just not. And so, then the question becomes
who, and I mean, is it that we are going to have a value if the
currency reaches a certain dollar figure that all of a sudden
we are going to regulate it? I am interested in any comments
that any of you may have on of the 20,000 cryptos, how you
determine who should be regulated?
Mr. Hoskinson. Well, one of the powers of our industry is
the fact that regulation can become algorithmic. So, you don't
have to think, well, which person is going to sit down and look
at this big pile? Think of the IRS and tax returns. We could
quadruple the size of the IRS, but we still couldn't audit
every single American. It is just not possible. And so, what
you have to do is say what tools do we have at our capability,
and what is magical about cryptocurrencies is that in the
transactions themselves, they can carry metadata. They can
carry identity. Rule makers and policy makers can take a step
back and say, ``Well, these are the things that we care about
and we can make sure inside the systems that those things don't
settle and clear until those things are present.''
So, it is really more of a conversation of what do you care
about, and then what we can do as technologists is create a
self-certification system, and then what can happen is when
there are anomalies or special cases, which often would be
rare, then the CFTC or another regulatory body could look
through and say, ``Well, let's investigate that.'' That is
generally how we do law enforcement. We don't break into
everybody's house. We wait until we get a warrant and you have
to have some cause for it, so there has to be some social
infrastructure.
Mr. Austin Scott of Georgia. So, self-certification is
different than an agency regulating?
Mr. Hoskinson. Well, they are interconnected. So, you have
SROs, you have market standards, you have principles, and in
many cases, financial regulation is mostly done by SROs or
private organizations.
If you look at, for example, compliance, it is not the SEC
or the CFTC going out there and doing KYC and AML, it is banks
that are doing these types of things. So, it is a public-
private partnership, and what needs to be done is to establish
those boundaries. And then what we can do as innovators is
write software to help make that happen, and literally, that is
what Chainalysis is doing right now, and their competitors.
Mr. Austin Scott of Georgia. I think--I mean, I don't see a
way for us to regulate them all. I do think there has got--if
it is going to happen, there has to be some type of self-
certification.
What I do fear--because I don't think that crypto should be
a significant portion of the average investor's portfolio. I
don't. I mean, and I do fear that if we all of a sudden are
regulating it, then the average investor feels like there is
more security and stability in the value of it, and I think
that is a dangerous thing for the investors. And I will tell
you, I would be very concerned about the average American
citizen having more than five percent of their investments in
the crypto markets. I am not talking about guys like you who
know it inside and out, but I just--I have expressed my
concerns. I appreciate your comments on the self-certification.
I do think that is a path that we need to be considering.
And with that, Mr. Chairman, I will yield the remainder of
my time.
The Chairman. I appreciate the gentleman yielding his 3
seconds.
Mr. Feenstra is recognized.
Mr. Feenstra. Thank you so much, Chairman Maloney and
Ranking Member Fischbach. It is great that we have having this
discussion today, and it is so important. Digital asset market
regulation is critical.
Mr. McGonagle, in addition to requirements that apply to
all CFTC regulated futures and derivative exchanges, would the
CFTC require additional authority from Congress to promulgate
additional crypto specific requirements if the CFTC were to be
given primary regulatory authority over digital asset trading
platforms by Congress?
Mr. McGonagle. Yes, Congressman, we would need additional
regulatory authority.
Mr. Feenstra. And what--going down that path, what are you
looking for?
Mr. McGonagle. Currently for both designated contract
markets and for swap execution facilities, there is a system of
core principles that the agency has. More recently, with
respect to the swaps implementation, we engaged in extensive
public comment around the establishment of setting up the
operation of the facilities, trading facilities, clearing, as
well as any other regulated or registered entity like swap
dealers, for example.
Mr. Feenstra. So, do you agree that evolution or maturation
of a digital asset and its underlying network has the potential
to remove security-like characteristics over time for assets to
become fully decentralized, or----
Mr. McGonagle. Right.
Mr. Feenstra. Is there a parallel in that regard?
Mr. McGonagle. Totally appreciate that question, and that
is an interesting topic.
Digital assets are broadly defined to be commodities. If
there is a determination under current law that the SEC
determines that it is a security, then it takes it outside of
CFTC jurisdiction, and there isn't currently a framework that
would allow evolution of the product to put it back into CFTC
jurisdiction.
Mr. Feenstra. That is correct, then that would be a
problem.
So, is there a parallel there with regard to that
evolution, then, of swaps?
Mr. McGonagle. I think how we handled swaps is we divided
the market, right, and so, characteristics of certain swaps
that were more closely aligned with the SEC were at SEC. The
SEC and the CFTC maintained a dialogue and worked together on
rules that impacted both of our jurisdictions, so that is
something that is available to the agencies.
Mr. Feenstra. So, one more question.
How do you think the notion of fully decentralized should
be defined or determined, and at what point or what triggering
event should that determination be made, and through what
process? I know this is a tangled web here.
Mr. McGonagle. Right, it is a tangled web, and I guess from
the CFTC's vantage, I don't consider or look at how the thing
presents whether it is so-called decentralized as opposed to is
it something where there is a trading interest? There are many
market participants that are interested in trading and
understanding how it trades.
So, from our perspective, we probably would be encouraging
not so much a definition of what is decentralized, but whether
the underlying digital asset is something that should fall
within regulation of the CFTC, under our structure as opposed
to defining this other structure.
Mr. Feenstra. Yes. Right, and we do need more Congressional
intent to go down that rabbit hole, that path?
Mr. McGonagle. So, certainly if Congress wanted to further
clarify the extent of CFTC's jurisdiction as it applied to any
further legislation that would be appropriate. But as I
mentioned, we currently have digital assets as a defined
commodity.
Mr. Feenstra. Right. Right, okay. Thank you for your
information. This is a great area, and we have to embrace it,
and I appreciate your comments. Thank you.
The Chairman. I thank the gentleman.
Mr. Cloud?
Mr. Cloud. Thank you, Mr. Chairman, and thank you all for
being here, and thank you, Ranking Member, for hosting this.
I carry some of the concerns, I guess, about regulation
that some of the former Members have carried, just because a
lot of times the government will see mission creed. And so, one
of the great appeals of cryptocurrencies when I talk to people
who kind of dabble in it is the fact that there is not an
intermediary at this point. And so, I also had the question
about who and how and those sorts of things. How do we keep
this limited? What is the current market failure we are trying
to fix, basically, and how do we keep it--any sort of
regulation narrowed to that and in such a way that over time it
doesn't become very much invasive?
And if you can answer that, Mr. McGonagle, but I will point
out Mr. Hoskinson mentioned the banks as an example of how this
is done well. If you talk to the bankers, a lot of them will
talk about how this is not done very well in the fact that they
have to be the authoritarian arm of the Federal Government in a
lot of different ways.
So, anyway, your thoughts on that, and feel free to chime
in.
Mr. McGonagle. Yes, thank you, Congressman, for the
opportunity to address that particular issue around the
certification of products. Currently, the CFTC is in a
situation where an exchange can willy-nilly certify a product
and allow that for trading. All core principles apply, but in
particular, is the core principal that an exchange may only
certify a contract that is not readily susceptible to
manipulation. So, what we are getting at--is who is interested
in trading this product, and why, and is there sufficient
liquidity, for example, or sufficient interest by market
participants that there actually is a market value to exchange
or trade risks?
Certainly in our markets, we think about why individuals
would want to hedge. They are producers, farmers, and users,
and they have an interest in the actual underlying commodity,
but we also see interest in past-settled contracts, these
financially settled obligations. And I think that under our
current system of regulation, we have an ability to winnow out
activity or contracts that don't provide a market value.
Mr. Cloud. Any of you want to speak to that, or--I have
another question to move on to.
Mr. Hoskinson. Sure. Can I comment on the KYC AML, sir?
I don't think anyone is doing KYC AML very well, and nobody
wants to be a data broker. It is pretty crazy what is going on
right now. I am a big believer that you have to understand what
private industry has been doing over the last century or so. If
you look at Google, you look at Facebook, you look at these
companies, they are more than companies. They don't just go and
make sprockets in cars or something and they compete in a fair
market. They are ending up getting a lot of control and power
over foundational resources.
So, if we look at the prior centuries like Standard Oil, it
got control over the energy industry, and then we said, ``Boy,
that is probably not a good idea. We should do something about
it.'' Now when we look at Google, Facebook, and these other
companies, they have gained so much control over information,
thought, speech, and other foundational resources, hosting.
They actually can define an entire marketplace and decide who
gets to compete and who doesn't. It is relevant to
cryptocurrencies and the blockchain industry because at the end
of the day, it is deliberation of those resources. That is what
we are really doing here to separate the wheat from the chaff.
We are talking about a resource-based economy. The point of
decentralization is saying that maybe nobody should be in
control of our freedom of expression or commerce or
association.
So, that requires a fundamentally different way of
interfacing with those marketplaces, different way of handling
identity and compliance----
Mr. Cloud. I only have a minute, so if I can jump in here.
Mr. Hoskinson. Sure.
Mr. Cloud. The fact that you are talking about big tech I
think is very interesting in this, because you also mentioned
that one of the features of regulation is that we can use
algorithms now.
Mr. Hoskinson. That is right.
Mr. Cloud. We have seen them use algorithms to limit
people's freedom of speech and to do all of these other
nefarious things. So, if we give the government that power,
especially as the Federal Reserve is looking toward creating a
digital currency potentially and we already have banks being
thrust upon them to enforce ESG scores, and in China, we see
where there ESG scores simply become personal scores on
individuals. It is not a far step technologically and in the
way we see some of the agencies working right now to begin to
target those algorithms toward people and their personal
habits, and their spending.
So, how do we compete economically on the world stage
without threatening the privacy rights of Americans, going
forward? This is a very dangerous slope if not handled
correctly.
Mr. Hoskinson. Yes, I couldn't agree more. I am deeply
concerned by social credit, deeply concerned by some of the
proposals for CBDCs because you can have transactional
discrimination against any ethnic group you want, or any
political philosophy you want.
So, the point is the algorithms out to be built out in an
open-source process, transparent and available to all, and
people have to have the ability to opt in instead of opt out.
So, the power of our industry is we didn't have a governing
agency or some central actor say oh, here is cryptocurrency. It
was the tireless work of millions of people, many of which
never met each other, around the world coming together
voluntarily and building a new economy worth trillions of
dollars. That is the way we ought to think about it, not how do
we create some government agency or how do we create some
central bank or central algorithm that will control everything.
And then you ask yourself about the outcomes you desire.
So, it is clear that there have been some problems over the
past 13 years, and we are working our way through that, but at
the same time, we have created value for millions of people,
and we shouldn't lose sight of that.
The Chairman. The gentleman's time has expired. I thank the
gentleman.
That concludes our initial round of questions. Seeing no
other Members in the room, I am going to extend an opportunity
for a selective round of additional questions, if the Ranking
Member has anything, I am happy to yield to her.
Mrs. Fischbach. If we are prepared to, and I don't see any
others, but I just wanted to express another thank you to
everybody because this has been an incredible informational
kind of hearing that we have been able to have, and I, again,
thank the chair for bringing us together. But thank you to all
of the witnesses.
The Chairman. Well, I thank the gentlewoman. I take it that
those are your closing remarks. I appreciate that.
Thank you to all of today's witnesses. I want to be
respectful of your time.
Let me just say in closing, given this Committee's
jurisdiction over the Commodity Futures Trading Commission,
market volatility and continued growth of this industry, it is
important we remain active and engaged as a participant and
have these conversations to consider and determine appropriate
and necessary legislation and regulation in this industry.
As you know, since Bitcoin was released in 2009, the
digital asset market has experienced explosive growth and
innovation and evolution, and the testimony we have heard today
certainly highlights those market evolutions and indicate that
that will be a key characteristic of the digital asset industry
for the foreseeable future. And of course, as recent
developments have shown, we also understand the volatility of
these markets and the risks that come with that.
The potential solutions this technology can offer are
worthy of a regulatory regime that will allow for continued
innovation while also establishing and requiring platforms
adhere to a uniform set of standards and guidelines, and will
protect those who choose to participate. While there are many
more conversations to be had, I am certainly glad that our
Committee is remaining active in this discussion regarding the
future of the digital asset regulation. Also, I want to stress
the importance we all put on the United States having a
leadership role in this space.
I would like to thank the Committee Chairman, Mr. Scott,
for the opportunity to chair the Subcommittee. I am also very
proud to take this leadership role at this critical time, and I
look forward to conducting additional hearings. We are just
getting started, and of course, we will be eager to hear
additional relevant testimony here at the Commodity Exchanges,
Energy, and Credit Subcommittee. I want to thank the Ranking
Member, Mrs. Fischbach, for joining me today. I want to thank
particularly our witness in Asia for getting up late.
And with that, the Committee stands adjourned. Excuse me, I
have to do one other piece of housekeeping, I believe, which is
to tell you that under the Rules of the Committee, the record
of today's hearing will remain open for 10 calendar days to
receive additional material and supplementary written responses
from the witnesses to any questions posed by a Member.
And with that, this hearing of the Subcommittee on
Commodity Exchanges, Energy, and Credit is adjourned.
[Whereupon, at 12:18 p.m., the Subcommittee was adjourned.]
[Material submitted for inclusion in the record follows:]
Submitted Statement by Samuel ``Sam'' Bankman-Fried, Co-Founder and
Chief Executive Officer, LedgerX LLC d/b/a FTX US Derivatives
Introduction
Chairman Maloney, Ranking Member Fischbach, and other distinguished
Members of the House Agriculture Committee's Subcommittee on Commodity
Exchange, Energy, and Credit (the ``Committee''), FTX appreciates the
opportunity to provide this statement to the record for the hearing on
``The Future of Digital Asset Regulation.'' We applaud the Committee
for assembling an excellent panel of experts to discuss this topic of
critical importance for the future of the digital asset industry and
U.S. capital markets. FTX largely agrees with many of the statements
made in the hearing that the Commodity Futures Trading Commission
(CFTC) is well-situated to exercise more oversight of non-security
digital assets. In the statement below, we offer a vision for the
expanded role the CFTC could play in overseeing digital assets markets.
Going forward, FTX is pleased to provide the Committee and its Members
with as much information needed to ensure a fully informed and robust
conversation around whether and how this Committee could address key
issues involved with regulating the digital asset space.
Background on FTX
FTX was established by three American citizens, Samuel Bankman-
Fried, Gary (Zixiao) Wang and Nishad Singh, (FTX Founders) with
international operations commencing in May 2019 and the U.S. exchange
starting in 2020. The FTX Founders sought to build a digital asset
trading platform and exchange with a better user experience, customer
protection, and innovative products, and to provide a trading platform
robust enough for professional trading firms and intuitive enough for
first-time users.
Today, FTX is the parent company of several entities across the
globe, including a U.S.-based digital asset spot market exchange
(FTX.us) and a derivatives exchange and clearinghouse (FTX US
Derivatives). FTX.us is registered with the Department of Treasury (via
FinCEN, as a money services business) and holds a series of state money
transmission licenses. FTX.us is also a registered broker dealer with
the Financial Industry Regulatory Authority (FINRA). FTX US Derivatives
is licensed by the U.S. Commodity Futures Trading Commission (CFTC) as
an exchange and clearinghouse. FTX's international exchange, which is
not available to U.S. users, holds a series of marketplace licenses and
registrations in many non-U.S. jurisdictions. For additional
information regarding FTX's business operations and licensing, please
refer to the Exhibit A of this statement.
Discussion
This statement covers the following topics: (1) an overview of the
products offered by FTX; (2) the current U.S. regulatory landscape and
existing regulatory gaps; and (3) a vision for the CFTC as a digital-
assets market regulator for the U.S. Throughout this discussion we use
`digital assets' generally to refer to digital asset tokens that are
generally considered to be a commodity rather than a security.
1. FTX Products and Their Role in the Digital-Asset Economy
Core Product: Digital Asset Exchange. FTX's core products are its
digital asset exchanges, FTX.com, FTX.us and FTX US Derivatives
(https://derivs.ftx.
us/)--FTX.us and FTX US Derivatives are being integrated into one user-
experience platform and web site. While FTX.com offers both spot market
and derivatives trading, those two categories are separated in the
United States, with spot market trading on FTX.us and derivatives
trading offered through FTX US Derivatives.
On FTX.com and FTX.us, users can trade digital assets with other
users for cash, stablecoins and other digital assets. On the spot
markets, users can set a variety of different order types on a central
limit order book (CLOB). Users are able to offer orders at a specific
price (limit order) or trade on the book at the best price shown. A
robust price and time priority matching engine sits in between these
orders to connect buyers and sellers and display the best available
prices.
Futures and volatility contracts related to digital assets also are
listed on the platforms as well, with or without leverage. On FTX.com,
leverage is limited to a maximum of 20x (i.e., minimum margin of 5%),
and is much less in most cases; as of now leveraged trading is not
available to users of FTX.us (although there is facilitation of other
forms of credit to Eligible Contract Participants--see below). The
FTX.com platforms have listed quarterly-settled (as well as perpetual)
futures contracts that are cash settled. Additionally, MOVE volatility
contracts are offered on FTX.com and are similar to futures except,
instead of expiring to the price of a digital asset, they expire to the
USD amount that the price of Bitcoin (BTC) has moved in a day, week or
quarter. FTX.com also offers BTC options for trading. Finally, FTX US
Derivatives offers to U.S. users both Bitcoin (BTC) and Ethereum (ETH)
derivatives.
To cover initial and maintenance margins, derivatives and
leveraged-product users can post collateral in the form of cash,
stablecoins or other digital assets held in their account. The
exchanges also have integrated risk-management and back-office systems
to perform clearing and settlement of trades, which includes updating
records of ownership of the digital asset or digital asset futures and
options contracts traded (clearing), and transferring value between
users' accounts (settlement), using either delivery versus payment or
delivery versus delivery. Importantly, FTX's risk model avoids the
systemic warehousing of such risks over a weekend or other period of
market closure, and instead addresses at-risk positions and accounts
immediately, in real time, 24/7/365.
Off-exchange Portal for Arranging and Matching User Orders. FTX
also offers an off-exchange portal that enables users to connect with
other, large users, enabling them to request quotes for spot digital
assets and trade directly. This facility forwards requests for quotes
to large users, returning prices offered and enabling users to then
place an order. The portal is similar to other facilities found in
traditional markets where a central limit order book is not used to
match trades.
Third-Party Lending. FTX platform users can lend their digital
assets to those who seek them for spot trading. Users (including
eligible users on FTX.us) wishing to trade digital assets they do not
have may borrow them from users willing to lend them by posting
collateral in the form of cash, stablecoins or other digital assets
held in their account. The FTX platform maintains a borrow/lending book
and matches users wanting to borrow with those willing to lend.
NFT Marketplace. FTX operates a marketplace for users to mint, buy
and sell non-fungible tokens (NFTs). NFTs are tokens that are not
fungible with any other tokens. They can take a number of forms and,
for example, can be redeemed for a physical object, or an experience
(such as a movie or phone call), or can be linked to a digital image,
etc. FTX's NFT marketplace is conducted through an auction system.
Alternatively, users can purchase directly at the prevailing selling
price set by the seller. Users can choose to display their NFT
collection on the FTX NFT marketplace portal, and/or to continue to buy
or sell on the NFT marketplace.
FTX Pay. FTX Pay is a service offered to merchants to accept
payments in digital assets or fiat. Users have the option to top up
their FTX accounts with ACH or credit cards, which are then used to
make payments to enrolled merchants. For digital asset payments, the
relevant user's FTX account would be debited by an amount in the chosen
digital asset that is equivalent to the amount that is payable to the
merchant. FTX facilitates the payments to the merchant by providing the
payment infrastructure. This allows merchants to accept digital asset
payments, without having to assume any volatility risk for the assets.
Staking. FTX.com offers the ability for users to ``stake'' certain
supported digital assets on the platform. By staking such digital
assets, users can earn staking rewards; in addition, for some tokens,
users can receive and unlock certain benefits on FTX, such as reduced
trading fees, withdrawal fees, as well as other rewards. Generally,
users can ``unstake'' their digital assets at any time, subject to an
unstaking or unbonding period.
Types of Digital Assets on FTX Platforms. FTX has developed listing
standards and a framework for determining which digital assets to list
on the platforms. Part of that framework entails evaluating the assets
to assess factors such as security, compliance risk, legal risk,
technological risk and other factors. On FTX.com, which again is
unavailable to U.S. users, FTX has listed approximately 100 stablecoins
and other digital assets on its spot exchange. Digital assets include
tokens such as Bitcoin (BTC), Ether (ETH), Uniswap Protocol Token
(UNI), Chain Link token (LINK), Solana (SOL), and Aave (AAVE).
On FTX.us, the company has taken what we believe to be a
conservative approach to listing digital assets for trading.
Consequently, there are far fewer tokens listed for trading on FTX.us
due to much stricter listing standards for this platform. Care has been
taken to avoid listing assets with features viewed to be similar to
securities in the U.S. The assets and tokens listed more closely
resemble BTC and ETH, two tokens expressly addressed by the CFTC to be
commodities subject to its jurisdiction.
On FTX US Derivatives, users can trade a Bitcoin Mini Option or
Ethereum Deci Option, a Next-Day Bitcoin Mini Swap or Next-Day Ethereum
Deci Swap, and a Bitcoin Mini Future. All of these contracts are fully
collateralized. FTX is in discussions with the CFTC about expanding our
derivatives offerings to U.S. customers.
In sum, the products available now in the digital-asset economy and
on the FTX platforms are very similar to ones found in the traditional
finance space. A key differentiator from traditional finance is that
investors can get access to all of them without going through multiple
intermediaries. FTX believes the market structure for digital-asset
platforms is risk reducing compared to others because it facilitates
more effective risk management and eliminates unnecessary points of
failure. In addition, all market data is made public and free--all
users are given full knowledge of the orderbook and trades. Easy access
to financial products and solutions on one, easy-to-use platform is a
powerful feature that empowers investors, consumers and entrepreneurs.
By simplifying access to these tools, users of the products can focus
more on the core of their everyday financial goals and needs while
making more informed decisions--ultimately this is what FTX believes
will promote financial inclusion and economic security for more people.
2. Current Regulatory Landscape for Digital Assets and the Role of the
CFTC
The current U.S. landscape for the regulation of the trading of
digital assets is a patchwork of Federal market regulations and state-
level money-transmission laws. As explained above, FTX US offers
``cash'' or ``spot'' markets and FTX US Derivatives offers access to
derivatives markets,\1\ but the regulatory treatment of each type of
market is different. For cash markets in the U.S., if a digital asset
is a security as defined by the Securities Act of 1933, then the
digital asset is subject to the jurisdiction of the SEC, and the asset
as well as any platform that lists it for trading generally must be
registered with the SEC. A digital asset that does not meet the
definition of a security under U.S. law would generally still meet the
definition of a ``commodity'' under the Commodity Exchange Act
(CEA).\2\ * Historically, the CFTC generally has not exercised
jurisdiction over the operation of spot markets for commodities (with
few exceptions), but FTX believes the CFTC could assert jurisdiction
over digital-asset spot markets under certain circumstances,\3\ even
where the agency has not done so to date--more on this below.
---------------------------------------------------------------------------
\1\ Cash or spot markets are markets where the asset being
purchased is delivered immediately. Derivatives markets are ones where
contracts or agreements between two parties are traded, and the
contract's value is based upon an agreed-upon referenced asset or set
of assets, like an index.
\2\ ``The term `commodity' means . . . all . . . goods and
articles, except onions (as provided by section 13-1 of this title) and
motion picture box office receipts (or any index, measure, value, or
data related to such receipts), and all services, rights, and interests
(except motion picture box office receipts, or any index, measure,
value or data related to such receipts) in which contracts for future
delivery are presently or in the future dealt in.'' See CEA section
1a(9).
* Editor's note: footnotes annotated with are retained in
Committee file.
\3\ See Retail Commodity Transactions Involving Certain Digital
Assets (``Actual Delivery Guidance''), 85 Fed. Reg. 37734 (June 24,
2020), https://www.cftc.gov/sites/default/files/2020/06/2020-
11827a.pdf.
---------------------------------------------------------------------------
In any case, there are no U.S. platform operators of only cash
markets for digital assets supervised by the SEC or the CFTC today.
Many states have taken the view that their money-transmission laws
apply to digital-asset platforms that have customers in their states,
which requires state licensure, but these laws do not possess the
hallmarks of Federal market regulation and its market-integrity and
investor-protection principles.\4\ At the time of this writing, FTX US
and the other largest U.S. digital-asset platforms offering cash
markets have many state money-transmission licenses and continue to
pursue others. A money-transmission business also implicates the U.S.
Bank Secrecy Act and by doing so must register with the U.S. Department
of Treasury via FinCEN, unless otherwise exempted; FTX US is so
registered.
---------------------------------------------------------------------------
\4\ FinCen defines money transmission as ``the acceptance of
currency, funds, or other value that substitutes for currency from one
person and the transmission of currency, funds, or other value that
substitutes for currency to another location or person by any means.''
See 31 CFR 1010.100(ff)(5)(i)(A).
---------------------------------------------------------------------------
For derivatives markets in the U.S., if the digital asset
referenced in the contract is a commodity and not a security, the
trading of derivatives on that digital asset is subject to the
jurisdiction of the CFTC. The CFTC today oversees the trading of BTC
and ETH derivatives on multiple U.S. trading platforms, including FTX
US Derivatives, which as mentioned lists futures, swaps and options on
these digital assets. FTX believes that there are many other digital
assets that are not securities, and so derivatives on those digital
assets would fall under the CFTC's jurisdictions as well and could be
listed by appropriately registered platforms such as FTX US
Derivatives.
This patchwork of regulations increases the operational complexity
of digital-asset platform operators, decreases capital efficiencies for
customers, and hampers the ability of platform operators to optimize
their risk-management programs. It also reveals gaps in Federal market
oversight due to the interplay of the CFTC and SEC regimes:
First, the scope of the CFTC's jurisdiction does not
indisputably apply to all cash markets for (non-security)
digital assets, and consequently U.S. customers of the
operators of these markets do not have the benefit of legally
enforceable, market-integrity and investor-protection
requirements of those markets enforced by a Federal market
regulator; and
Second, not all digital assets indisputably meet the
definition of a security under U.S. law, and consequently there
are not clear, consistent and enforceable disclosure standards
to inform investors about key information to assess risk
relating to those digital assets.
As such, there is no clear market oversight for spot trading of
(non-security) digital [assets].
Additionally, along with the unclear application of the
``securities'' definition as it applies to some digital assets, these
gaps to date have discouraged participation by many in the U.S.
digital-asset markets, including entrepreneurs, institutional market
participants and other investors. In part due to these points, the vast
majority of trading volumes in digital-assets markets (which FTX
estimates to be roughly 95% of global volume) takes place on non-U.S.
trading platforms, even though much of the human and intellectual
capital driving the industry comes from U.S. persons--many of whom have
left the U.S. to build and grow their businesses.\5\ FTX believes this
current state is harmful to U.S. competitiveness and is denying our
country many of the benefits from the growing digital-asset industry,
including attracting to the U.S. more capital formation, the best of
the global workforce, intellectual property and tax revenue. In
addition, hundreds of billions of dollars of digital asset stablecoins
are currently backed by the USD dollar, a state that clear and
consistent regulatory guidelines could help maintain.
---------------------------------------------------------------------------
\5\ See https://ftx.com/volume-monitor for data on trading volume
on offshore versus U.S. platforms.
---------------------------------------------------------------------------
U.S. Retail Commodity Transactions and the CFTC's Actual Delivery
Guidance. Another piece of the U.S. regulatory patchwork for digital
assets is the CFTC's treatment of retail commodity transactions. The
CEA provides that a commodity transaction (including one involving a
digital asset) must be listed on a CFTC-registered market, and is
subject to CFTC's anti-fraud authority, if (1) it involves a retail
participant, and (2) leverage, financing or margin is offered or used,
unless the sale ``results in actual delivery within 28 days''.\6\ The
CFTC provided guidance to the public about how to interpret ``actual
delivery'' under the statute--thus, there are circumstances when a
retail, digital-asset transaction would fall under the CFTC's
jurisdiction, and others when it would not.\7\ Below we discuss FTX's
views about how bringing all retail commodity transactions involving
(non-security) digital assets under CFTC jurisdiction would be
beneficial to the public.
---------------------------------------------------------------------------
\6\ See CEA section 2(c)(2)(D).
\7\ See id. at n. 5.
---------------------------------------------------------------------------
The Regulation of Stablecoins. Another important part of the
digital-asset ecosystem globally and in the U.S. are stablecoins, which
are frequently used as a means to transfer collateral to and from
digital-asset platforms and used as collateral once on the platform.
Their regulatory treatment is also part of the overall patchwork of
regulations that apply to the digital-asset ecosystem. There are
several stablecoins used on U.S.-based digital-asset platforms that
have been issued by U.S. state-regulated trust companies, and thus have
the benefit of state-level prudential supervision.\8\ Other
stablecoins, some widely used, are not issued by a U.S. institution
licensed at the Federal or state level. The President's Working Group
on Financial Markets' recently released ``Report on Stablecoins''
(``PWG Report'') provided a number of recommendations for the
regulatory treatment of stablecoins, and FTX has shared its own
recommendations for how to ensure the safety and soundness of
stablecoins (included here as an exhibit), the core of which is a
robust auditing and registration framework overseen by a Federal
agency.\9\
---------------------------------------------------------------------------
\8\ Paxos Standard (``PAX''), issued by Paxos Trust Company, and
the Gemini Dollar (``GUSD''), issued by Gemini Trust Company, are
issued by Trust companies regulated by the New York State Department of
Financial Services (``NYDFS'').
\9\ See Exhibit B to this statement; FTX's recommendations also can
be found at https://www.ftxpolicy.com/stablecoins.
---------------------------------------------------------------------------
There are other regulatory issues affecting the digital-asset
industry in the U.S., but the foregoing are the most relevant to this
Committee. Next, we address how this Committee, the Congress and the
CFTC could rationalize the regulatory framework for digital assets and
pursue policies that would better protect investors and increase U.S.
competitiveness.
3. A Vision for the CFTC as a Digital-Asset Supervisor
The CFTC already has considerable experience and expertise in the
regulation of digital assets, and FTX believes Congress would be wise
to leverage that expertise for the benefit of the public as well as the
digital-asset industry. The CFTC authorized the first BTC-derivative-
contract listing in 2014, nearly 8 years ago,\10\ and the FTX US
Derivatives business--the first crypto-native platform approved by the
CFTC--has been licensed and supervised by the CFTC for nearly 5
years.\11\ The CFTC-licensed, more traditional exchanges with some of
the largest global volumes of derivatives-trading activity have had
digital-asset derivatives trading on their platforms for more than 4
years, all under active supervision by the exchanges themselves as
self-regulatory organizations, in addition to the oversight of the
CFTC.
---------------------------------------------------------------------------
\10\ See TeraExchange, LLC's Filing under CFTC Regulation 40.2,
Certification of BTC Swaption Contract, April 24, 2014; https://
teraexchange.com/style/images/rnd/instr/Tera%2040.2%20Filing%20-
%202014-22%20Listing%20of%20Swaption.pdf.
\11\ See CFTC Orders Granting DCO, SEF and DCM licenses to LedgerX.
---------------------------------------------------------------------------
These facts show that there has been substantial capacity building
at the CFTC over the years regarding digital assets. No other market
regulator from a mature, major global economy can make this claim of
experience and expertise about the digital-asset ecosystem, and
Congress should actively consider how the agency can build on this to
better deliver market-integrity and investor-protections goals to the
public and ensure the benefits of the industry's growth can be
maximized in the U.S. The following are recommendations for this
Committee that would achieve those goals.
Expand the CFTC's Jurisdiction over Digital-Asset Spot
Transactions. FTX recommends broadening the CFTC's jurisdiction to
include, at a minimum, all spot transactions in (non-security) digital
assets involving retail investors, regardless of whether the
transactions currently fall within CFTC's jurisdiction under CEA
section 2(c)(2)(D). This recommendation is consistent with relatively
recent steps Congress has taken to expand the CFTC's jurisdiction over
retail cash markets, including through the passage of the Dodd-Frank
Wall Street Reform and Consumer Protection Act in 2010. This could be
accomplished in several specific ways.
First, Congress should encourage the CFTC to work with industry to
permit retail commodity transaction contracts related to digital assets
to be listed on boards of trade registered with the CFTC, pursuant to
the agency's existing authority over these transactions as established
by CEA section 2(c)(2)(D) and as affirmed in the 2020 Actual Delivery
Guidance. This would clearly promote the public interest and would not
require further legislation, being consistent with the current
authority of the CFTC.
Second, Congress could eliminate the 28 day ``actual delivery''
period in the CEA as it relates to digital-asset transactions, on the
basis that doing so would clearly bring to more of these retail
transactions the full panoply of protections from the CEA, which FTX
believes also would clearly promote the public interest.\12\
---------------------------------------------------------------------------
\12\ This approach would encompass those crypto transactions that,
per the 2020 Actual Delivery Guidance, are not offset in any way, and
whose proceeds are fully withdrawn to external, customer-controlled
wallets within 28 days.
---------------------------------------------------------------------------
Third, Congress could more broadly amend the CEA so that the CFTC
has jurisdiction over all (non-security) digital-asset spot trading
activity, not just retail commodity transactions under CEA section
2(c)(2)(D), and derivatives involving (non-security) digital assets.
Such a step also should involve a consideration of the appropriate
disclosure regime for digital assets that ensures investors are
adequately informed of their risks.\13\ In the meanwhile, Congress in
general should actively encourage the CFTC to appropriately broaden its
interpretation of its authority over digital-asset spot transactions to
better rationalize and condense the patchwork of regulations governing
U.S. digital-asset activity, facilitating the offering of both market
types on one platform.
---------------------------------------------------------------------------
\13\ See `Token Issuances' at https://www.ftxpolicy.com/areas-for-
crypto-regulation for a sketch of a possible disclosure regime for
digital asset issuances.
---------------------------------------------------------------------------
In FTX's Key Principles for the Market Regulation of Crypto-Trading
Platforms (Market Regulation Key Principles), we outlined the benefits
to offering these two market types under one unified system, with one
rule book and one technology platform to manage risks related to all
trading activity in customer accounts.\14\ This approach facilitates
one collateral and risk-margin program for customer accounts holding
both cash and derivatives positions, allowing the platform to better
manage market risk, and reducing operational risk owing to a single
technology stack for the front end (the user interface) to the back end
(settling and risk managing positions). Public policy should permit
this one-rule-book model due to its risk-reducing and customer-
protection attributes.
---------------------------------------------------------------------------
\14\ See Exhibit C to this statement, and https://
www.ftxpolicy.com/.
---------------------------------------------------------------------------
Fourth, as recommended in FTX's Market Regulation Key Principles,
Congress, the CFTC and the SEC should pursue a scheme where a digital-
asset platform operator could opt into a program of joint supervision
by the CFTC and SEC when there is joint jurisdiction over digital
assets listed on the platform (e.g., when listings include non-security
digital assets as well as digital assets that are securities). Under
these circumstances, FTX recommends that one of the market regulators
serve as the primary regulator, and the other as the secondary
regulator, for market oversight. This type of paradigm is familiar to
market regulators globally and could include the accommodation of one
rule book, one matching engine and risk engine supported by one
technology stack. FTX believes this approach could largely be created
under existing CFTC and SEC authorities, but Congress should encourage
the agencies to leverage their authorities today with these goals in
mind and consider legislating such an approach when feasible.
Embrace the Direct-Membership Market Structure of Digital-Asset
Platforms. The CFTC should continue to permit and embrace a market
structure that allows investors to become direct members of the CFTC-
licensed exchanges and clearinghouses that offer digital assets,
without the need for intermediation. FTX's CFTC-regulated business has
been operating with this type of market structure for nearly 5 years,
without any loss of customer funds or significant platform outages, and
has demonstrated that such a business model can comply with the CEA and
continue to deliver on important investor protections embodied by the
CEA. U.S. policy should remain market-structure neutral and allow non-
intermediated markets for digital-asset products, so long as key
investor protections can be adequately ensured. Every major incumbent
U.S. derivatives trading venue offers a direct member clearing
solution, and certain incumbent platforms have the majority of their
users as direct members--this is not a new concept for the CFTC and its
surveillance and risk teams.
FTX also published FTX's Key Principles for Ensuring Investor
Protections on Digital-Asset Platforms (``Investor Protection Key
Principles''), where we identified the most important components of an
investor-protection regime (which the CEA and CFTC rules also reflect),
and how FTX offers those protections today with the direct-membership
model.\15\ These components include:
---------------------------------------------------------------------------
\15\ See Exhibit D to this statement, and https://
www.ftxpolicy.com/investor-protections.
maintaining adequate liquid resources to ensure the platform
---------------------------------------------------------------------------
can return the customer's assets upon request;
ensuring the environment where customer assets are
custodied, including digital wallets, are kept secure;
ensuring appropriate bookkeeping or ledgering of assets and
disclosures to protect against misuse or misallocation of
customer assets;
ensuring appropriate management of risks including market,
credit/counterparty, and operational risks; and
avoiding or managing conflicts of interest.
While the CFTC's rules reflect these important principles today, they
often contemplate an intermediary such as a ``futures commission
merchant'' (FCM) bearing the responsibility of those protections to the
investor. The CFTC wisely has allowed a direct membership market
structure so long as those investor protections are ensured and
enforced.
The Investor Protection Key Principles touch on two key points that
the CFTC has recognized. First, technology advances have enabled a non-
intermediated market structure that, combined with effective platform
operations, can provide the above-identified protections more
effectively, ultimately leading to an overall risk-reducing market
structure, for the benefit of investors. Second, to the extent that
legacy regulations or policies would assume or require an intermediary
to provide these protections, that approach often imposes unnecessary
burdens and costs (including fees and both capital and operational
inefficiency) on investors and markets and obscures market-data without
corresponding benefit. The CFTC and Congress should address and update
any such rules through continued, appropriate interpretations in the
case of the CFTC, and refinements to corresponding legislation in the
case of Congress, to ensure equitable access to financial markets.
Ensure the Safety and Soundness of Stablecoins. Stablecoins have
become a critical component of the digital-asset ecosystem, and policy
makers have raised concerns about their growing market size and whether
the lack of uniform Federal oversight presents systemic concerns. While
the PWG Report investigated bank-like supervision for all stablecoin
issuers, such an approach might not be necessary so long as the core
requirements of stablecoin oversight are met. These include:
Daily attestations of what assets (cash, bonds, etc.) are
backing a stablecoin;
Periodic audits to confirm the asset backing is as claimed;
Federal oversight and ability to inspect the assets;
Haircuts for assets with moderate risk; and
An open line for law enforcement to blacklist addresses and
persons associated with financial crimes.
The CFTC could play an important role in creating a workable framework
with these requirements.
First, the Congress could give the CFTC authority to license
stablecoin issuers and subject them to these core requirements, perhaps
by creating and authorizing a new registration scheme for stablecoin
issuers or by otherwise allowing them to seek an existing CFTC license
with new commiserate authorities, such as a DCO license. Indeed, a DCO
is well accustomed to taking custody of assets, providing relevant
reports to ensure their safekeeping, undergoing related audits (see
FTX's Investor Protection Key Principles), and managing risks through
appropriate collateral management and marking to market. The
appropriate duties and responsibilities of a stablecoin issuer are much
the same.
Second, the CFTC without any new legislation could require DCOs
providing settlement and clearing services for digital-asset platforms
to condition the acceptance of stablecoins as collateral by the DCO on
the stablecoin issuer meeting these same core requirements, and the
stablecoin issuer providing the needed attestations and audits to
verify they are being met. The CFTC could require this through review
and enforcement of DCO policies and procedures related to the DCO's
approved risk-management program. To be sure, considerable public
policy could be made through creative use of the CFTC's existing
authorities as suggested, leading to standardized practices for
stablecoin issuers that would protect the safety and soundness of the
broader financial system.
We believe there is some urgency to create a practical regulatory
solution that promotes disclosure and transparency, but that does not
inhibit the value that stablecoins provide to markets and market
participants. All aspects of digital asset regulation will be iterative
and done in phases. For stablecoins, getting a general principles-based
disclosure and transparency requirement in place now (perhaps via CFTC
guidance, as a follow-on to certain CFTC stablecoin enforcement
initiatives), while deferring a decision on the approach to some of the
broader questions (such as whether ``registration'' is required and
which agency should oversee that registration), would deliver a
substantial amount of regulatory value.
Adequately Fund the CFTC to Ensure Resources to Protect Digital-
Asset Investors. Finally, the successful implementation of most of the
foregoing recommendations would depend on the CFTC having adequate
resources to do so. FTX supports reasonable steps to provide those
resources, including by contributing its own fair share of funds for
use by the CFTC to expand its purview over digital assets. A program
for generating and conveying such resources to the CFTC could be
designed in a variety of different ways, and FTX stands ready to engage
with this Committee and the Congress more broadly to assist in
designing and contributing to such a program.
Conclusion
FTX is grateful to this Committee for the opportunity to share
information about the digital-asset industry, our business, as well as
the recommendations for how the CFTC in particular can contribute to
the industry's growth. FTX believes the CFTC and this Committee could
play an even more prominent role in the digital-asset ecosystem and
bring greater investor protections by closing some of the regulatory
gaps identified in this statement. FTX believes that such efforts would
combine the best aspects of traditional finance and digital-asset
innovations, one of our primary goals, and further empower investors
and consumers by consolidating access to the tools they seek for
economic security, all in one place, and from a singular, risk-reducing
platform.
Sincerely,
Sam Bankman-Fried,
Co-Founder and CEO of FTX.
exhibit a
The FTX group of companies (FTX Group or FTX) was established by
three American citizens, Samuel Bankman-Fried, Gary (Zixiao) Wang and
Nishad Singh, with international operations commencing in May 2019 and
the U.S. exchange starting in 2020. The business was established in
order to build a digital-asset trading platform and exchange with a
better user experience, customer protection, and innovative products,
and to provide a trading platform robust enough for professional
trading firms and intuitive enough for first-time users. In the U.S.,
the company operates a federally regulated spot exchange that is
registered with the Department of Treasury (via FinCEN, as a money
services business) and also holds a series of state money transmission
licenses. Our U.S. derivatives business is licensed by the U.S.
Commodity Futures Trading Commission (CFTC) as an exchange and
clearinghouse. FTX US also holds a FINRA broker dealer license. FTX's
international exchange, which is not available to U.S. users, holds a
series of marketplace licenses and registrations in many non-U.S.
jurisdictions.
The core founding team had unique experience to develop an exchange
given their experiences in scaling large engineering systems at premier
technology companies, combined with trading experience on Wall Street.
This brought to the effort an understanding of how to build the best
platform from scratch, as well as what that platform should look like,
unencumbered by legacy technology or market structure. FTX has aimed to
combine the best practices of the traditional financial system with the
best from the digital-asset ecosystem.
Early International Success. The international FTX.com exchange has
been extremely successful since its launch. This year around $15
billion of assets are traded daily on the platform, which now
represents approximately 10% of global volume for crypto trading. The
FTX team has grown to over 200 globally, the majority of whom are
responsible for compliance and customer support. The FTX Group's
primary international headquarters and base of operations is in the
Bahamas, where the company is registered as a digital asset business
under The Bahamas' Digital Assets and Registered Exchanges Act, 2020
(DARE).
FTX % Global Volume, 15d
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
In addition to offering competitive products, the FTX platforms
have built a reputation as being highly performant and reliable
exchanges. Even during bouts of high volatility in the overall digital-
asset markets, the FTX.com exchange has experienced negligible downtime
and technological performance issues when compared to its main
competitors. We believe the dual-track focus on customers and
reliability, plus compliance and regulation, are key reasons why FTX
has also experienced the fastest relative volume growth of all
exchanges since January 2020.
The core product consists of the FTX.com web site that provides
access to a marketplace for digital assets and tokens, and derivatives
on those assets. Platform users also can access the market through a
mobile device with an FTX app. The core product also consists of a
vertically integrated, singular technology stack that supports a
matching engine for orders, an application programming interface or
API, a custody service and wallet for users, and a settlement, clearing
and risk-engine system. In a typical transaction, the only players
involved are the buyers, sellers, and the exchange, without any other
intermediaries.
The FTX Group has operations in and licenses from dozens of
jurisdictions around the world, including here in the U.S. and in
Europe. At the time of this writing the FTX platforms have millions of
registered users, and the FTX US platform has around one million users.
For FTX.com, roughly 45 percent of users and customers come from Asia,
25 percent from the European Union (EU), with the remainder coming from
other regions (but not the U.S. or sanctioned countries, which are
blocked). In comparison to the international exchange, nearly all users
of FTX.us are from the U.S.
U.S. Operations. FTX services U.S. customers through the FTX US
businesses, which includes the spot exchange, FTX US Derivatives, the
NFT marketplace, and a soon-to-go-live FINRA broker dealer (FTX Capital
Markets). FTX US is housed under a separate corporate entity from FTX
international and is headquartered in Chicago, IL. It has a similar
governance and capital structure to the overall corporate family, and
also has its own web site, FTX.us, and mobile app. As with FTX.com, the
core product is an exchange for both a spot market for digital assets
as well as a market for derivatives on digital assets. Like other
crypto-platforms in the U.S., the spot market is primarily regulated
through state money-transmitter laws.
The U.S.-derivatives-market product is provided by FTX US
Derivatives, which was formed through the acquisition and re-branding
of LedgerX and is being integrated with the overall FTX US platform.
The product offers futures and options contracts on digital assets (or
commodities) to both U.S. and non-U.S. persons. FTX US Derivatives
operates with three primary licenses from the U.S. Commodity Futures
Trading Commission (CFTC): a Designated Contract Market (DCM) license,
a Swap Execution Facility (SEF) license, and a Designated Clearing
Organization (DCO) license. Prior to its acquisition, this business was
the first crypto-native platform issued a DCO license by the CFTC in
2017, which was a milestone for the agency and the digital-asset
industry. That license was later amended in 2019 to permit the clearing
of futures contracts on all commodity classes and not just digital
assets.
Commitment to a Diverse Workforce. We are proud of our workforce at
FTX and believe that one of our key strengths is a culture of mutual
respect and cooperation. This type of culture is borne from the
diversity of our team, which necessitates a spirit of empathy,
understanding and humility. These traits in our workforce are good for
business and are much of the reason we have been successful at
understanding our customers and their needs, and executing on products
that meet their needs. FTX has employees from all over the world with
diverse ethnic backgrounds, and 60 percent of women in our workforce
are in senior management positions. The majority of our global
leadership comes from diverse backgrounds.
Commitment to Mitigating Climate Impacts. FTX is very serious about
minimizing our impact on the global environment where we live and work,
and as a company we have taken several important steps to ensure this.
Here, I would like to share several key points to explain why FTX's
environmental impact is de minimis, but nonetheless explain the
additional steps the company has taken to reduce even further this
impact. First, FTX has no factories or physical products and therefore
does not leverage global shipment networks, a substantial source of
energy consumption. FTX has a small workforce with a small physical-
office footprint, renting only a few small offices spread out around
the world, and operates online. FTX corporate operations, therefore, do
not have direct impacts on climate change at a globally relevant scale.
Second, while digital asset deposits to and withdrawals from FTX
platforms unavoidably require some energy consumption as public
blockchains facilitate and record those transactions, on FTX over 80
percent of deposits and withdrawals use low-cost, carbon-efficient
Proof of Stake (PoS) blockchains. These PoS networks contrast with
Proof of Work (PoW) blockchains such as the Bitcoin (BTC) blockchain,
which consume significant amounts of energy to maintain the network. By
using PoS blockchains for the vast majority of FTX deposits and
withdrawals, FTX massively reduces the overall climate impact of
blockchains. To facilitate the remaining approximately 20 percent of
deposits and withdrawals, energy consumption is relatively small, but
FTX subsidizes the blockchain network fees to share in paying the costs
of that energy consumption. Separate from deposits and withdrawals,
transactions and transfers on the FTX exchanges themselves (which is
the overwhelming majority of our user activity--100% of our $15 billion
in average daily trading volume occurs on the exchange itself) do not
require public blockchain activity and require only the amount of
energy needed to run a cloud-based trading venue.
Third, FTX also has endeavored to take ownership of our portion of
the environmental costs of mining associated with public blockchains
and has purchased carbon offsets to neutralize those costs. Estimating
the costs of energy consumption and carbon output associated with
blockchain mining is difficult because mining is decentralized, and
discerning how much energy is coming from which source is elusive.
Nonetheless, FTX estimates that it costs $1 million per year to take
ownership of those costs, and has purchased a total of 100,000 tons of
carbon offsets through two providers for $1,016,000. Additionally, FTX
through its affiliated arm, FTX Climate, created a comprehensive
program to focus on the most impactful solutions to climate change
possible. In addition to achieving carbon neutrality, our initial
program funds research that we believe can have an outsized impact, as
well as supports other special projects and carbon-removal solutions.
FTX plans to spend at least $1 million per year through FTX Climate.
Those interested in learning more about these initiatives can find more
information at https://www.ftx-climate.com.
Fourth, FTX believes energy consumption by PoW blockchains and its
impacts should be assessed within the appropriate context, which we
believe should include consideration of their benefits, an
understanding of their differences with PoS networks and how each type
of network is being leveraged and growing, as well as a comparison to
other energy-consuming activities or even industries. For example, BTC
has delivered benefits to many as measured by access to financial
products, asset transmission, and wealth creation, which should be
weighed against the network's energy costs.\16\
---------------------------------------------------------------------------
\16\ See ``Everything We Want Costs Energy, Including Bitcoin,'' by
Benjamin Powers, Coindesk, Apr. 22, 2021; https://www.coindesk.com/
tech/2021/04/22/everything-we-want-costs-energy-including-bitcoin/; see
also ``The Bitcoin Mining Network: Trends, Average Creation Costs,
Electricity Consumption & Sources,'' CoinShares Research, June 2019
Update, https://coinshares.com/assets/resources/Research/bitcoin-
mining-network-june-2019-fidelity-foreword.pdf.
---------------------------------------------------------------------------
Additionally, while PoW networks attract attention for their energy
consumption, transactional activity on PoS networks is growing
substantially due to their ability to process a greater number of
transactions in a shorter period of time at a lower cost. FTX believes
these PoS networks will become increasingly important over time, which
will continue to minimize the overall climate impact of blockchains.
And finally, the energy consumption by PoW blockchains is relatively
small when compared to other industries to which the BTC network in
particular is often compared.\17\ Of assets whose futures trade on
CFTC-regulated venues, BTC actually ranks fairly low in terms of
environmental impact, relative to traditional, physically mined
commodities, oil, livestock and other environmentally impactful assets.
---------------------------------------------------------------------------
\17\ See ``On Bitcoin's Energy Consumption: A Quantitative Approach
to a Subjective Question,'' Galaxy Digital Mining, May 2021, Rachel
Rybarcyzk, Drew Armstrong, Amanda Fabiano. https://docsend.com/view/
adwmdeeyfvqwecj2.
---------------------------------------------------------------------------
Commitment to Giving Back. FTX is committed to improving the lives
not just of our customers through superior products, but also the lives
of those in the broader global community. Toward this end, FTX created
the FTX Foundation, which was founded with the goal of donating to the
world's most effective charities. FTX has pledged to donate one percent
of net revenue from fees to the foundation, and its founders have
pledged to donate the majority of what they make. FTX, its affiliates,
and its employees so far have donated over $50 million to help save
lives, prevent [suffering and] ensure a brighter future.
exhibit b
Stablecoin Regulation
Context on stablecoin regulation
As the cryptocurrency industry matures, it's vital that a robust
regulatory regime grows alongside it which takes seriously its duty to
protect consumers, ensure transparency, and prevent illicit activity,
while still allowing for innovation and growth.
Stablecoins play a crucial role in the cryptocurrency ecosystem;
the majority of all transactions in crypto are settled via stablecoins,
and they are one of the most promising payment tools for the broader
financial sector. It is also, as of now, unclear exactly what
regulatory regime stablecoins will end up being placed in.
What is a stablecoin?
Let's start with the core question: what exactly is a stablecoin?
There are a wide variety of stablecoin designs that have been
utilized in the cryptocurrency ecosystem. For illustrative purposes, in
this article we will assume a stablecoin on the U.S. Dollar, although
parallel assets do exist on EUR, GBP, and other currencies. We will
also imagine that it is 1:1; that is, 1 token represents 1 U.S. Dollar.
We will imagine that the token's ticker to be STBC.
In this construct, this imaginary stablecoin, STBC, is a
blockchain-based asset that can be exchanged for a U.S. Dollar. That
would typically be accomplished through the following mechanics and
arrangements:
Reserves: Typically, a stablecoin is backed by one or more USD
accounts or other similar assets, generally held at a bank, in an
account under the name of the stablecoin sponsor, issuer, or other
similar body. The USD value of the assets should be at least the supply
of the stablecoin.
Token: A blockchain-based token, STBC, where one token represents
$1 (as supported by the creation / redemption process, described
below). These could be issued by a private company, a central bank, or
a decentralized protocol.
Creation/Redemption: In order to create 1 STBC token, an eligible
user must send $1 to the reserve account. In return, the protocol mints
1 new STBC token and sends it to the user.
Similarly, an eligible user may send 1 STBC token back to the
protocol to redeem it for $1. The protocol destroys the token and sends
$1 back to the user.
What are the benefits of stablecoins?
We believe that stablecoins are one of the most important
innovations of the cryptocurrency industry.
Let's say you want to send $20 to a friend. What are your options?
(a) You could hope that both you and your friend use the same peer-
to-peer transfer app (e.g., Venmo), and then separately
each of you figure out how to send money to/from that app.
(b) You could send a $20 wire transfer to your friend. This would
likely take a day and cost $5+ in fees; and if it's
international, it might take a week and cost substantially
more in fees.
(c) You could send $20 via ACH, if both you and your friend use
U.S.-based USD bank accounts. Then, the transfer would not
fully settle for months, exposing both parties to
``chargeback risk''.
(d) You could go to an ATM, withdraw $23 paying a $3 fee, and hand
$20 to your friend, who would then have to find a way to
use the physical dollar bills.
(e) You could send 20 STBC to your friend's cryptocurrency wallet;
if you use an efficient blockchain (or both use the same
exchange), it will arrive in less than a minute, costing a
tiny fraction of a penny in fees.
Option (e), the stablecoin, has a compelling case here as an
efficient means of transfer.
Taking our real-world use case a step further, consider that a user
wants to build a blockchain-based application. How should the
application's users contribute and withdraw assets?
Here, the users face the same potential options and cost structures
as before; once again, stablecoins are the cheapest, safest, and
fastest way for a user to engage with that application.
What are the risks of stablecoins?
There are three major intertwined risks associated with
stablecoins.
Reserve volatility risk
If the stablecoin is backed by something other than U.S. Dollars in
a bank account, the asset might depreciate against USD. If, for
instance, you were to back a stablecoin with 1,000,000 tokens issued
with $1,000,000 of the SPY (S&P500) ETF, and stock markets decreased 5%
in price, you would be left with only $950,000 backing 1,000,000
stablecoins--meaning that the ``stable'' token had in fact fallen in
value, at least in regards to the reserves it is purported to be
redeemable for!
Unlike investment products where customers gain from appreciation
in the assets backing the product, there is generally no way for a
stablecoin to be worth more than $1, as customers can always create
more for $1 each. This means that the core philosophy behind the assets
backing a stablecoin should be to focus on assets with low volatility
which are very similar to USD. U.S. Treasury bonds may be an
appropriate asset for a stablecoin's reserves; if Bitcoin is used, it
has to be over-collateralized to an extent that there is very little
risk of loss to the stablecoin holders. Backing 100 stablecoins with
$101 of BTC is untenably risky: a mere 2% decrease in Bitcoin markets
would cause the stablecoin to be under-backed and no longer fully
redeemable for $1. Backing 100 stablecoins with $400 of BTC, on the
other hand, is substantially more defensible, as there is very little
risk of a 75% move before the reserves would have a chance to de-risk.
Any stablecoin issuer or designer must have a transparent, robust risk
model to mitigate the volatility of its reserves, including determining
which assets are appropriate for its reserves.
Redemption risk
A related worry is that a user might own 1,000 STBC, go to the
issuer to redeem their STBC, and be denied.
This might happen if the reserves had in fact run out of dollars
and so there was nothing left to redeem STBC for; this would likely
imply the reserves had not been in USD, and had fallen in value.
Alternatively, this could happen if the issuer arbitrarily decides
to block your redemption, possibly to try to keep more impressive
metrics for STBC.
Either way, the lack of ability to redeem (or a lack of
transparency related to redemption process and requirements) presents a
risk to the user.
Financial crimes
One final risk of stablecoins is that they could be used for
financial crimes, or to finance illicit activities.
Any stablecoin issuer or designer must include creation,
redemption, and use mechanics that, in harmonization with regulation,
address and avoid this use case.
What is a sensible stablecoin regulator framework?
As noted above, we believe that stablecoins have presented a
significant positive use case to the world, and they continue to hold
the potential to revolutionize the payments and remittances industry.
Stablecoins could in the future revolutionize the payments industry,
drastically reducing friction and transaction costs, delivering to many
around the world the benefits that come with having access to reliable
and usable value transmission. As such, we think it is important to
ensure that the ongoing regulatory discussions around the approach to a
framework for stablecoins be based on a practical structure that solves
equally for usability, reliability, transparency, consumer protection,
and the identification and prevention of financial crimes.
We look forward to engaging with regulators on examples of what
such a framework might look like. There are many different approaches
and we remain open and excited for feedback and engagement from
regulators and from other participants in the cryptocurrency industry.
As outlined above, there are real risks associated with
stablecoins, and any framework should work to mitigate those.
As such, while we look forward to continuing dialogue on the
details, we would be in favor of a proposal for a transparency-based
reporting and registration regime for stablecoins.
A proposed framework might look like the following:
(a) All stablecoins issued to U.S. users must be registered on an
official list of ``regulated stablecoins'' under the
oversight of one or more U.S. regulatory department(s).
(b) The registration itself would be focused on transparency and
reporting, on a notice filing basis, coupled with clear
obligations on recordkeeping, reporting, and regular
examination. The regulatory departments authorizing the
program would have the ability to decertify registered
stablecoins.
(c) The registration would involve publishing a daily Reserves List
which details what the total net value of the stablecoin's
reserves are, and breaks that down into exact quantities of
specific categories (e.g., ``100 USD in Bank XYZ; $95 of
short-term U.S. treasury bills; $50 of Tier-1 commercial
paper of U.S. companies; $30 of Tier-1+ commercial paper of
European companies; $10 of [other suitable assets as
permitted by the regulation and by that stablecoin's
registration document]'')[.]
(d) The registration would require that the issuer maintain
``sufficient'' reserves. This could be defined by a set of
haircuts on various types of reserves. E.g., perhaps a
0.10% haircut on USD in an FDIC insured bank account; a 1%
haircut on short-term U.S. treasury bills; a 10% haircut on
Tier-1+ commercial paper; a 15% discount on Tier-1
commercial paper; a 20% haircut on EUR, GBP, JPY, CHF, CAD,
AUD, SGD, HKD, etc.; and a 50% haircut on Bitcoin.
(e) The registration would require semi-annual audits by an
accounting firm to confirm that the reserves are as
represented.
(f) The registration would require stablecoins to have clear and
transparent redemption requirements (e.g., based on Know
Your Customer documentation) and a clear customer complaint
process if a redemption is denied.
(g) To address financial crimes, all registered stablecoins would
have to be on a public ledger, and the creation and
redemption process must be sufficiently structured in order
to ensure that stablecoins associated with illegal activity
(as observed via on-chain surveillance and analytics tools,
via a suite of standard blockchain surveillance software)
cannot be redeemed.
As noted above, this is a basic strawman framework for how the key
components of a potential stablecoin registration program might look.
Each of these points are designed to preserve the usability of
stablecoins while solving for regulatory considerations that need
addressing. If designed in the right way, this framework could enhance
the ultimate usability of stablecoins. We very much look forward to
engaging with policymakers, regulators, and market participants on
these concepts.
exhibit c
FTX's Key Principles for Market Regulation of Crypto-Trading Platforms
In this piece we identify a series of ten principles (and in
some instances, proposals) that should guide policy makers and
regulators as they build the regulatory framework for spot and
derivatives crypto markets. FTX does not propose specific
legislation here but rather principles and proposals that could
be reflected in policy making, whether in the form of
legislation, rulemaking, or other regulatory action. Many of
these principles are familiar to traditional securities and
derivatives markets, but some of the principles reflect market-
structure choices made by FTX and other crypto-platform
operators that we believe lead to superior outcomes for
investors and, indeed, the public. FTX therefore believes
public policy should not only permit these choices but promote
those that lead to such outcomes. Some of the discussion here
focuses on the U.S. marketplace, but the principles and
proposals are applicable in any jurisdiction globally. FTX
appreciates being able to engage in this dialogue with policy
makers and regulators, and we are always happy to pursue
follow-up discussions with interested parties. See our prior
policy blog posts at https://www.ftxpolicy.com.
1. Proposing One Primary Market Regulator with One Rule Book for Spot
and Derivatives Listings
In the U.S. regulatory ecosystem, spot markets and derivatives
markets are subject to different regulatory programs, and this can lead
to inefficient and non-optimized market structures. In this post we
propose as a solution an alternative regulatory approach that would
provide market operators the ability to opt in to a unified regulatory
regime for spot and derivatives marketplaces, through a primary
regulator model.
As many know, the CFTC is the primary regulator of commodity
derivatives marketplaces, while the SEC is the primary regulator of
cash securities marketplaces, and the two agencies share oversight
responsibility for certain aspects of security derivatives
marketplaces.
In parallel, there is a further regulatory split for spot markets
(sometimes called ``cash markets'' in the traditional commodities or
securities context), where the applicable regulatory program depends on
whether the product being traded is categorized as a security (where
the SEC regulates) or a commodity that is not a security (where the
states largely regulate, via money transmitter or money services
business licensing).
Against that backdrop, and particularly outside of the U.S., we
observe that many crypto-native trading-market operators offer for
trading both spot transactions on crypto assets as well as derivatives
on those assets, under a unified rule book, one collateral and risk-
margin program, and a single technology stack. This model is generally
not found in the U.S. given the jurisdiction's historically fragmented
approach to market regulation. Nonetheless, we believe that for traded
crypto markets, the key principles for market regulation (customer and
investor protection, market integrity, preventing financial crimes, and
system safety and soundness) generally apply equally across spot and
derivatives markets, and commodities and securities markets. That is,
the regulatory label on a given product or market need not change the
core goals of regulation, and the same rulesets should generally apply
across all markets. For that reason, we strongly support offering a
single unified regulatory program for crypto market operators.
Specifically, in jurisdictions where there is a primary
derivatives-market regulator separate and distinct from a primary cash-
markets regulator (such as in the U.S.), policy makers and regulators
should seek to permit qualified crypto markets operators to run a
single rule book, risk program, and technology stack, approved and
overseen by a primary regulator (perhaps chosen by the marketplace on
an opt-in basis and supported thereafter by inter-regulator cooperation
and information sharing, with the possibility of the primary regulator
shifting if the underlying product mix evolves in a certain way), that
governs the listing and trading of both spot cash transactions in
crypto assets as well as derivatives on crypto assets.
Much of this can be achieved today under existing statutory
authority and with creativity and cooperation by and among market
regulators. With some specific issues, however, clarity might be needed
from legislation. Under the current U.S. paradigm, for example, we
acknowledge that it is unlikely to be absolutely clear at any given
moment, absent legislation, whether all of the crypto products listed
on such a venue are definitively ``within'' or ``without'' the
jurisdiction of either of the market regulators. However, between two
possible regulatory solutions under this paradigm--which are (1) that
regulators can prohibit the marketplace altogether (via indecision,
decree, or a combination of the two), or (2) that regulators can
innovate and cooperate to ensure that key regulatory and policy goals
are met in a clear and robust way while also permitting the marketplace
to operate--we think the second approach offers a compelling option.
Said more explicitly, in jurisdictions where there are two mature
market regulators, FTX proposes the permissibility and adoption of a
reasonable and rigorous framework that would allow a crypto-markets
platform operator to elect one market regulator as its primary
regulator for a unified spot and derivatives trading book, subject to
adherence to a cooperative framework in which the other market
regulator acts a secondary regulator while maintaining appropriate
visibility into the platform's operations, but not day-to-day
supervisory responsibilities. (Indeed, a similar approach is used today
when a market regulator from one jurisdiction ``recognizes'' the
framework of a different jurisdiction where a primary, ``home''
regulator resides, and then defers to that primary regulator's
regulations and rulesets so long as they are sufficiently comparable.)
We propose a functional-based approach, where the regulation and
the trading venue rule books that comply with that regulation should be
largely modeled after existing market regulations for securities and
derivatives markets, on the basis that most jurisdictions will follow
this same approach. FTX believes that there is a unique current
opportunity for U.S. regulators to take a leadership position in the
global crypto markets regulatory discussion, and we believe that
modeling a primary regulator model on existing market regulation will
foster standardization and harmonization of regulation globally, paving
the way for international adoption and reciprocal jurisdictional
recognition.
To underscore why we are so focused on these regulatory issues--it
is because we believe that getting crypto market regulation
appropriately calibrated is critical for the continued development of
healthy, transparent, and well-functioning global crypto markets, which
we believe will deliver knock-on positive effects to the global economy
as a whole. And we think our proposed approach, in addition to solving
for regulatory uncertainty and fragmentation, would also reduce
operational complexity by allowing matching engines for both spot and
derivatives transactions to operate on the same platform with the same
user interface. This in turn would reduce operational risk to the
platform, and promote capital efficiency by allowing collateral in
support of both order books to rest on the same platform. In the rest
of this piece, we discuss in more detail various additional practical
benefits of crypto marketplace operators being subject to unified
primary regulator oversight.
2. Full-Stack Infrastructure Providers and Maintaining Market-Structure
Neutrality
Regulation should be market-structure agnostic, provided that the
core regulatory issues (identified above as customer and investor
protection, market integrity, preventing financial crimes, and system
safety and soundness) are addressed. Technology has enabled any capable
entity to perform the various functions involved with the pre-trade,
execution, and post-trade phases of the lifecycle of an asset trade or
transaction in a single regulatory stack--in fact, to split up those
functions, from a technology perspective and when building a market
from the ground up, would require a forced and artificial
deconstruction.
However, one of the things that prohibits an entity from taking on
any or all of these functions can be the specifications of a
regulation. To say it another way, much of current market structure is
a creation of regulatory artifact rather than a reflection of a
thoughtful and holistic approach to marketplace design, efficiency,
transparency, and risk management. FTX built and continues to evolve
its trading ecosystem with the latter approach in mind.
We believe that so long as the various needed functions necessary
to the lifecycle of a transaction are being met, policy makers would do
well to remain otherwise neutral on how a market is structured (so long
as appropriate customer protections also are in place, discussed
below). For one example, most market regulation today envisions an
intermediated marketplace where an intermediary such as a broker
interfaces directly with a customer (think back to calling in, or
mailing in, your order to a broker that had access to the physical
exchange floor). In contrast, crypto-asset platforms largely dispense
with this mode in favor of a direct-membership market structure, where
end investors onboard directly to the platform for trading, and not
through an intermediary or broker (although service providers such as
internet and data-center providers are involved).
A non-intermediated market allows all users to get the same access
to market data (consider that FTX's data is free, globally, versus much
of the global trading venue industry where data fees are a material
commercial component of the business), connectivity, and key features
related to functionality and risk management, regardless of the
sophistication of the user. The positive implications of this are
potentially enormous, and are only just beginning to be seen,
interestingly, around the direct-to-consumer crypto marketplace models.
The public is better served if the barrier to entry to transact
competitively with global markets is an internet connection, rather
than a $100,000 (or more) data-subscription fee and a costly fee- or
commission-based relationship with a broker that merely plugs you into
the trading venue's technology. Non-intermediated markets create a more
level playing field that's often lacking in many traditional financial
systems, whose market structures have created a number of challenges
including real and perceived conflicts of interests between
intermediaries and their customers.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Consequently, a direct membership market structure should be
expressly permitted (not required, but permitted) so long as the
relevant customer protections continue to be afforded, in this case by
the platform provider.
3. Custody of Crypto Assets--Key Functional and Disclosure Requirements
For crypto assets, the asset is safekept in a wallet, where custody
can be performed by the asset owner or by a wallet holder on the
customer's behalf. Where custody is performed on a customer's behalf by
a platform operator or intermediary, appropriate safeguards should be
disclosed in policies and procedures of the custodian. Key areas of
focus and disclosure should include: wallet architecture; whether
insurance is provided by the custodian; how private keys are kept
secure, managed and transferred; managing risks related to insider
collusion or fraud; and physical security of data centers.
Importantly, in the case of platform operators, consideration
should be given to the increasingly common practice of using third-
party providers for data centers (i.e., cloud-service providers) as
well as custodial services. In these instances, the platform operator
will not itself perform these functions but nonetheless will be held
responsible by users for them, and users should be given visibility
into how third parties will address the aforementioned issues. Market
supervisors should require regulated platform operators to perform
regular diligence on their vendors and to have sufficient business
continuity and disaster-and-recovery programs in place in connection
with their vendor suite.
4. Full-Stack Market Infrastructure Providers and the Lifecycle of a
Trade--Addressing Risk Related to Token Issuance and Asset
Servicing, Orderly Markets and Settlement of Trades, Cross
Margining and Risk Management of Positions
Again, native crypto-trading platforms integrate into a whole the
system for custody, issuing tokens, settlement of trades, and risk
managing positions with one technology stack. In creating or fine-
tuning a regulatory framework for these platforms, policy makers should
ensure that market supervisors understand this system through well
developed and clear policies and procedures disclosed by the platform
operator. The framework should address the following key issues related
to the lifecycle of a spot or derivatives trade.
Token Issuance and Asset Servicing
Token issuers who have access to the platform for purposes of
issuing a token should be governed by disclosed policies and procedures
that explain the listing standards for tokens. In some cases, existing
securities laws will apply, in which case the policies and procedures
should explain how such laws are complied with by the platform as it
relates to issuing the security tokens.
This document does not address whether existing securities laws
should be amended to account for distributed-ledger technologies and
new methods of issuing securities in tokenized form. Suffice it to say
here that some of the traditional requirements for central securities
depositories might not be appropriate for platforms that offer these
services, but others will be.
To the extent a token is not a security but has some security-like
features at some point in time, and policy makers otherwise have not
addressed whether such tokens should be treated as securities, a
platform operator in any case should be required to disclose, or
otherwise facilitate disclosure of (i.e., most material information for
a token can be easily found on the Web, and a platform could direct a
platform user to this information), key material information about the
token issuer as part of the platform's listing standards.
Likewise, in the case of all tokens, the platform operator should
develop and disclose policies and procedures for how a token issuer
will interact with the platform for purposes of facilitating asset
servicing, so that supervisors and platform users both can understand
and assess the risks to the platform posed by token-issuance
functionality. This would be especially relevant in the case of
security tokens, where dividend payments and changes in ownership, for
example, would impact the token and the owner of the token.
Market Surveillance
Good public policy would require that a crypto-platform operator
has policies and procedures concerning the practices and technology
used to perform market surveillance of the platform's trading
environments in order to curb market manipulation and promote orderly
markets. This is standard policy for traditional supervised markets and
should be carried over to supervised crypto markets as well.
Settlement
With regard to settlement, our recommended policy would require the
platform operator to have clear and transparent policies and procedures
that explain when settlement of a transaction becomes final, and the
conditions and circumstances under which the platform provider would
reverse settlement due to errors, etc. By and large, regulated venues
do this today in their terms of service, etc., and we think it is
important they continue to do so.
One of the hallmarks of the FTX trading experience is to allow
users to pair in a transaction nearly any combination of assets for
purposes of settlement--for example, a user could exchange BTC for USDC
or for SOL. Sound policy would allow the platform to settle
transactions by pairing the assets with any of the others listed on the
platform, including stablecoins or cash fiat currencies (see below for
discussion of stablecoins) but also other crypto assets, so long as the
platform otherwise made clear how and when settlement becomes final.
Another hallmark of full stack trading experiences is access to
credit to ensure and promote liquidity on the platform. Public policy
should allow platform operators to facilitate the provisioning of
credit to platform users so long as this service and function are well
documented and explained to the supervisor and market participants on
the platform. This is a clear example of where services previously
provided by intermediaries can be solved by the trading venue itself.
Because crypto platforms have led the way in exchange innovation,
public policy should anticipate that crypto firms will become more and
more integrated with traditional payment rails and similar systems.
Policy makers should consider whether and when to expressly delineate
under what circumstances these platforms could access government-
sponsored payment systems created for the settlement of securities, for
example. Other policy initiatives will address whether and under what
circumstances securities, including government-issued securities, can
be reflected in tokenized form, but if such tokenization is permitted,
an otherwise properly supervised platform operator should be allowed to
access existing payment systems to facilitate settlement of such
securities, even if interaction with that system is not on a real-time
basis. Such a policy is recommended because otherwise access to this
payment system would involve an intermediary, introducing various types
of counterparty, operational, and credit risks to the platform that
would not be in the interests of the participants on the platform
(which itself would be highly supervised under our proposed framework).
Cross Margining and Risk Management
The regulatory framework for crypto should clearly allow for the
cross-margining of both derivatives and spot positions on the platform
with any and all assets permitted in the customer wallet and account,
subject to appropriate risk weights and haircuts, as applicable. For
the settling and risk management of crypto asset transactions on a
crypto platform, the settlement and risk systems are automated and the
relevant software interacts with the wallet and account that contain
customer assets.
A well-designed regulatory framework would allow a single platform
to perform all risk functions, and require the appropriate standards on
those functions. For example, in addition to the custody requirements
mentioned above, the settlement and risk-management systems should be
appropriately explained to the market supervisor through the platform's
rule book, and the regulator should be made aware of major changes to
the system.
Sound policy also should ensure that risk-management systems used
by a platform operator are configured to prevent customer accounts from
going net negative across positions. A risk-management system that
effectively performs this function with this goal, including through
liquidations of customer positions, should not be allowed to do so in
an arbitrary manner. Instead, the rules, risk parameters and business
logic that trigger any actions taken by the customer platform as it
relates to customer assets should be clearly disclosed and
appropriately explained to the supervisor as well as the platform users
in the platform's rule book, which should be approved by the primary
market supervisor.
In permissioning the use of a risk-management system for clearance
and settlement, policy makers should take care to remain technology and
methodology neutral, so long as the platform operator can effectively
demonstrate its responsibilities can be adequately met.
5. Trading Platform Providers--Ensuring Regulatory and Market Reporting
Regulatory reporting of transactional activity should be required
in order to provide market supervisors appropriate visibility into the
trading platform, and to better allow supervisors to police for market
manipulation and other unfair trade practices.
Policy makers should consider carefully how best to provide this
data--a requirement should be considered that would mandate that
trading platforms create an API for the beneficial use of market
supervisors to directly ingest data from the platform itself, rather
than require a separate entity to undertake reporting responsibilities.
With respect to market reporting, a hallmark of the crypto-asset
industry (as previewed above) is the provisioning of market data to
users free of charge. Policy makers should carefully consider the
standards under which platforms are permitted to charge users a fee for
the provisioning or use of market data related to trading that takes
place on said platform along with the implications of that activity for
market access, transparency, and fairness policy initiatives. The right
standards could incentivize the platform operators to focus on risk
management, user experience, and product innovation for competitive
advantage rather than fees based on trading activity brought to the
platform by the user.
6. Ensuring Customer Protections
As suggested, crypto-asset platforms have ushered in an evolution
of market structure in favor of anon-intermediated model, where
entities separate from the platform are not needed in order to access
the platform and the trading environment.
In this market structure, however, key customer protections should
remain in place. From a policy perspective, one approach could be a
very general and non-prescriptive one that requires that platform
providers or intermediaries develop and disclose policies and
procedures to ensure the best interests of all customers are protected
at all times, and leave it to the entity's discretion. This would allow
investors to choose a platform provider based on the robustness of
those policies and procedures.
If a more detailed or prescriptive approach is favored, such an
approach should consider whether specific requirements related to
practices impacting platform customers such as front-running trading
activity, market manipulation, general risk disclosures related to the
assets and instruments listed for trading, appropriate and non-
misleading communications with customers, and avoidance of entering
into conflicts of interest with customers. Again, appropriate customer-
protection requirements can be borrowed from the traditional finance
space--the key is to ensure that the platform provider can provide them
rather than insisting that an intermediary perform the function. FTX
believes that marketplace operators are properly positioned (perhaps
best positioned) to deliver these types of disclosures and materials to
users in a way that can be built directly into the trading venue user
interface/user experience.
7. Ensuring Financial Responsibilities are Met
As with traditional markets, ensuring that customer assets are
protected to the maximum extent possible should be a principle for
regulating crypto-asset markets.
Again, the prominence of the wallet as a tool for storing assets is
key to the crypto-asset space, and apart from requirements to ensure
that the wallet itself is safely maintained and secured, policy makers
should ensure that customers have access to real-time information about
their account levels at all times (and redundant access paths, in the
event of disruptions on one access path), particularly if and when a
platform operator commingles customers' assets in an omnibus manner. If
a platform provider elects to provide this infrastructure, operational
complexity can be substantially reduced while customer assets are
meaningfully protected.
In the case of a platform operator or an intermediary, policy
makers should consider whether to adopt a minimum capital requirement
(or other financial wherewithal condition) to ensure there are adequate
resources to address operational and other types of risks that could
jeopardize customer assets in custody. For platform operators, this
could take the form of ensuring operational resiliency but in addition
also ensuring adequate resources to address defaults and liquidations
performed by a risk-management system (see above discussion on platform
risk management). The goal should be to ensure platform operators need
not depend on off-platform resources for settlement and risk
management.
With respect to margining customer accounts, there should be a
policy that expressly allows portfolio margining of all customer
positions in all assets on the platform. This risk-management approach
promotes capital efficiency and reduces operational risks to the
platform or intermediary managing the customer account.
8. Ensuring Stablecoins Used on Platform Meet Appropriate Standards
A platform operator that permits the use of stablecoins for
settlement of transactions should be required to explain the standards
the platform operator uses in deciding which stablecoins it permits for
such purposes. FTX has articulated and explained its policy
recommendations for stablecoin issuers (see https://blog.ftx.com/
policy/context-stablecoin-regulation/).
The reason such a policy is recommended is that stablecoins are
exposed to reserve-volatility as well as redemption risk, and platform
users should be entitled to some understanding of whether and to what
extent those risks could impact their activity on the platform,
including their impact on settlement of transactions (which might not
be direct, but nonetheless indirect).
For example, a stablecoin backed by risky and volatile assets and
not transparently backed by an adequate amount of such assets with
appropriate haircuts, could become exposed to price risk. This price
risk could interfere with settlement finality on the platform, insofar
as the value of the stablecoin delivered as payment for the crypto
assets in a transaction on the platform are suddenly not equal.
Ensuring that stablecoins allowed for use on the platform meet adequate
standards set by the platform operator (or by public policy makers if
applicable) mitigates this risk, and should better protect the users of
the platform.
9. Full-Stack Infrastructure Providers--Ensuring Appropriate
Cybersecurity Safeguards are Kept
Market regulators in recent years have developed comprehensive
cybersecurity requirements for market infrastructure providers. Policy
makers should either apply the relevant safeguards already in place for
exchanges, or otherwise require that the platform provider develop and
disclose to market participants its policies and procedures regarding
cybersecurity safeguards. In the case of platform operators already
licensed by a market regulator, system-safeguard requirements already
will be in place. In the case of platform operators not already
licensed, one consideration for policy makers is to adopt a policy that
helps facilitate standardization of these safeguards domestically as
well as globally.
10. Full-Stack Infrastructure Providers--Ensuring Anti-Money Laundering
and Know Your Customer Compliance
Platform operators must perform appropriate KYC as part of user
onboarding and must conduct regular anti-money laundering surveillance
of user activity (both on the trading venue and via the scrutiny of
related on-chain transfers in and withdrawals out). Many platforms,
including FTX, use a combination of vendors and internal compliance
personnel to assist with these functions today. However accomplished,
it is critical that crypto marketplace regulation continues to require
significant focus on the performance of KYC and AML obligations. To
ensure this, marketplace operators should be performing periodic self-
audits and should also be subject to regular review and exam by their
primary regulator on these requirements.
exhibit d
FTX's Key Principles for Ensuring Investor Protections on Digital-Asset
Platforms
Introduction
FTX strongly believes that ensuring investor protections is
critical to the successful operations of digital-asset platforms,
including our own, as well as to ensuring a positive user experience
for our customers. FTX also believes that non-intermediated ``direct
access'' markets, such as the FTX exchanges, can and do provide a level
of investor protection that meets and exceeds the policy goals and
purposes of traditional investor protection regulation (notwithstanding
the absence of an intermediary or ``broker''). Technology continues to
displace the need for an investor to rely on intermediaries and brokers
to access certain markets or asset classes, and one of the most
important innovations of the digital-asset industry is a simplified
market structure that does not need to rely on intermediaries for
access to markets. From this observation, this paper addresses the key
investor protection principles (described below) applicable to any
market and the ways in which non-intermediated ``direct access''
digital-asset platforms can and do provide these protections for their
users.
The goal of this paper is to support two critical propositions:
The investor protection principles we describe in this paper
can be provided directly by a digital-asset exchange or
platform, using a non-intermediated market model, at an
effectiveness level that exceeds relying on a series of
intermediaries to provide similar protections and that
ultimately leads to what FTX believes will be an overall risk-
reducing market structure, for the benefit of investors.
To the extent that legacy regulations or policies would
assume or require an intermediary to provide these protections,
we believe that approach often imposes unnecessary burdens and
costs (including fees and both capital and operational
inefficiency) on investors and markets without any
corresponding benefit--and any such rules should be updated and
modernized.
If market structure policy is truly to be technology neutral (which
is an important and often stated principle expressed by policy makers),
market regulators must acknowledge that intermediated market structures
are due, in many instances, to the fact that technology was less robust
when those markets were first developed. While intermediaries
previously were helpful because the cost and complexity of accessing
(1) a market for trading assets or (2) the assets themselves
(especially when securities, for example, were in material or paper
form) were substantial enough that it was economically efficient for an
investor, especially an individual investor, to rely on an intermediary
to provide such access and attendant services. However, intermediated
market access is not an a priori first principle of market structure
design, and technology has meaningfully changed what is possible.
Today, the only tools necessary to access a centralized marketplace
for assets directly are (1) a computer or mobile device; (2) relevant
``trading'' software accessible on that hardware; (3) access to
broadband services to transfer data over the internet, and (4) an
application programming interface (API) to allow the trading software
to be built and integrate with the trading platform's software. As a
result, while investors might elect to use intermediaries for various
reasons, those intermediaries are no longer indispensable for gaining
access to financial products if the investor has the aforementioned
tools.
We believe this has led to the possibility of the reduction of many
types of risks, as explained in FTX's Key Principles for Market
Regulation of Crypto-Trading Platforms (hereinafter ``Market Regulation
Key Principles''; see https://www.ftxpolicy.com/). Combined with other
best practices and enhanced risk-management techniques utilized by FTX,
this simplified market structure forms the basis for our argument that
a well-designed and operated non-intermediated ``direct access''
digital-asset platform can be risk reducing relative to traditional
market infrastructure. Building on FTX's Market Regulation Key
Principles, this paper continues the discussion about critical investor
protections and our view that platform operators should be allowed to
provide these protections, and be held accountable for them, rather
than insisting that they be fulfilled by intermediaries on the
platform.
While not the core goal of this paper, we also note that
intermediation can reduce transparency and information available to the
customer. Traditionally, most users are not given full market data;
neither are they allowed full access to exchanges, preventing equitable
access. FTX's disintermediated structure ensures that all users have
equal access to its information and markets.
Key Investor-Protection Principles
Ultimately, all policies affecting the operation of a digital-asset
market ensure the protection of the investor on the platform, and FTX's
Market Regulation Key Principles paper addresses those.\18\ Here we
focus on specific principles related to the core of protecting
customers' interests and their assets kept on a digital-asset platform.
These include (1) maintaining adequate liquid resources to ensure the
platform can return the customer's assets upon request; (2) ensuring
the environment where customer assets are custodied, including digital
wallets, is kept secure; (3) ensuring appropriate bookkeeping or
ledgering of assets and disclosures to protect against misuse or
misallocation of customer assets; (4) ensuring appropriate management
of risks including market, credit/counterparty, and operational risks;
and (5) avoiding or managing conflicts of interest. Each of these is
addressed in turn.
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\18\ See https://www.ftxpolicy.com/.
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1. Maintaining Adequate Resources to Return a Customer's Assets
A hallmark of the investor-protection regimes for markets globally
and in the U.S. are requirements to ensure that the intermediary
holding a customer's assets has adequate liquid resources available at
all times to ensure that the customer can redeem her assets when she
chooses. Often these policies are designed to ensure that there is (1)
no delay in returning customer securities upon request, or (2) no
shortfall, where an amount lesser than the value of the customer's
assets can be returned to the customer.\19\ This principle often
involves other restrictions on the custodian, including, for example, a
restriction of the use of customer assets to finance other business
expenses or initiatives.\20\ To ensure adequate liquid assets, familiar
policies require a reserve of funds or qualified securities that is at
least equal in value to the net cash owed to customers.\21\ U.S.
derivatives policy is very similar and also requires a cushion of
resources to be held by the entity managing a customer's derivatives
positions to ensure timely return of customer assets.\22\
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\19\ See, e.g., SEC Rule 15c3-1, Rule 15c3-3 Adopting Release,
Exch. Rel. No. 9775, 1972 WL 125434, at *1 (Sept. 14, 1972). See also
FINRA Rule 2150.
\20\ Id.
\21\ The amount of net cash owed to customers is computed pursuant
to a formula provided by the rule. While the formula itself is somewhat
complex, it embodies a basic concept for the responsible stewardship of
customer cash: if a broker-dealer owes more to its customers than its
customers owe to it, the broker-dealer must set aside at least an
amount equal to that difference so that it is readily available to
repay customers. See also https://www.sec.gov/divisions/enforce/
customer-protection-rule-initiative.shtml.
\22\ See, e.g., CEA Sections 4d(a)(2), 4d(f), and 30.7. The CFTC's
customer-protection rules for FCMs are very similar, and the rules
embody, inter alia, the concepts of ``segregation of customer assets''
as well as ``targeted residual interest,'' which like the SEC's
requirements require that adequate resources provided by the FCM
itself, in this case, are included in the customer's segregated account
to ensure there is efficient and adequate return of customer assets
upon request.
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FTX recommends policy makers consider a policy embodying this
principle for digital-asset platform operators: fashioning a
requirement, to be reflected in the platform's policies and procedures
or otherwise, where the platform operator is accountable for keeping
adequate liquid resources to ensure it can deliver customer assets back
to the customer upon their request. This principle is sound for all
asset types, and while the policy today tends to fall on
intermediaries, it can just as easily be applied to the platform
operator; in general, it should apply to whichever entity is custodying
customer assets. Such a policy as applied to digital-asset platform
operators would be independent of other requirements to ensure adequate
capital to cushion losses (see discussion below).
To the extent existing regulations have implemented this principle
by fashioning restrictions on intermediaries, most market supervisors--
including those in the U.S.--have other authorities that would permit
appropriate or conditional application of such a duty on a market
operator. The fact that customer assets include digital assets and
tokens in principle need not alter the basic policy of ensuring there
is the availability of liquid assets.
FTX has policies and procedures for its platforms today that
reflect this basic principle by maintaining liquid assets for customers
withdrawals, including a sufficient balance of digital assets funded by
the company for its non-U.S. platform. The resources are funded to
provide sufficient cover against user losses under certain events and
extreme scenarios in order to, among other purposes, ensure a customer
without losses can redeem its assets from the platform on demand.
2. Securing Environment Where Customer Assets Are Custodied
Another key customer-protection principle is making sure that the
environment itself, where customer assets are kept, is safe and secure.
Existing market regulation often looks to the requirements of other
financial custodians and intermediaries that also custody assets as a
proxy for safety and security. For example, U.S. policy has the concept
of requiring the use of a ``qualified custodian'' for the custody of
customer cash and securities,\23\ which in many instances is another
intermediary that is also supervised and otherwise equipped to ledger
and track a specific customer's funds.\24\ Interestingly, the CFTC
explicitly recognizes that a clearinghouse is subject to sufficiently
rigorous standards and supervision that it can be entrusted with
safekeeping customer assets.\25\ In any case, this principle mandates
that appropriate arrangements to safeguard the clients' rights in
client assets and minimize the risk of loss and misuse are in place,
which can be accomplished by ensuring that the custodian of the assets
maintains adequate levels of financial integrity, physical and cyber
security, as well as transparency to customers about the locus and
availability of their assets.\26\
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\23\ Under the SEC's framework, ``qualified custodians'' typically
include banks, broker-dealers, and futures commission merchants. See
SEC Rule 206(4)-2(c)(3).
\24\ See, e.g., Securities Exchange Act of 1934 Rule 15c3-3. The
CFTC's rules mandate that customer assets held at an FCM be segregated
and clearly identified as customer assets, and be custodied by a bank
or trust company, a registered clearing house, or another FCM. See CEA
Sections 4d(a) and 4d(b) and CFTC Regulation 1.11.
\25\ In the United States, some CFTC regulated clearinghouses
already have direct clearing relationships with traders and are
therefore holding customer funds without using intermediaries.
\26\ See IOSCO Final Report on Recommendations Regarding the
Protection of Client Assets (``IOSCO--Protection of Assets''),
Principle 3 (Jan. 2014) http://www.iosco.org/library/pubdocs/pdf/
IOSCOPD436.pdf.
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Regarding a digital-asset platform operator, the assessment of
whether the environment delivers on this principle is different from
that for traditional assets because the ecosystem often involves
traditional fiat currencies as well as digital assets and tokens
related to public blockchains. For digital assets, the digital wallet
is central to the custody arrangements. For fiat currency, FTX and
other platform operators will necessarily rely on licensed banking
institutions to custody a customer's fiat currency; for traditional,
non-tokenized securities, the custody function will follow the lines of
the traditional market structure, unless some exemption is provided to
allow some other arrangement--in the U.S., for example, existing
regulations would require that custody be performed by a licensed
intermediary legally permitted to custody such securities. (It
certainly would be interesting, however, for policy makers to consider
permissioning platform operators with the proven resources to custody
these assets as well--again, derivatives regulation allows
clearinghouses to custody assets.)
For digital assets, however, where policy is much less developed,
custody involves control of private keys to digital wallets, and
physical security involves the safekeeping of those private keys. When
digital assets are left in the custody of platform operators such as
FTX, safekeeping private keys can be performed in-house by the platform
operator, or by the platform operator contracting with a third-party
(the platform operator would remain accountable for regulatory
requirements under this arrangement). Notably, both approaches have
been permitted by market regulators and embraced by market
participants.
Multiple architectures exist for the storage of private keys, which
can be accomplished through use of a ``hot wallet,'' cold storage,
multi-signature wallet, or even by a smart-contract wallet. To be sure,
policy makers could decide if a particular approach should be allowed
or prohibited based on a particular policy emphasis--each approach has
tradeoffs related to security and efficiency--but at this time, the
best policy approach is likely allowing market participants to decide
their preferred custody approach by electing to transact with the
platform operator that offers it. This approach necessarily would
require that a platform operator adequately disclose its wallet
architecture and security practices. In any case, limiting access to
the private keys under custody through appropriate permissioning, and
ensuring adequate cyber-security protections, are critical to
discharging this principle regarding securing the environment where
assets are kept.
Some have suggested that allowing the platform operator to serve as
the digital-asset custodian might present a conflict of interest for
the platform operator, presenting more opportunities for misuse or
misallocation of customer assets. It is far from clear to FTX that
contracting with a third party for custody would in every instance
lower the risks of misuse or misallocation of a customer asset,
particularly when the platform operator would presumably remain
accountable and, indeed, liable in every case; and each additional
party added to a customer's experience adds another potential point of
failure. We believe that rather than focus on any perceived conflict,
policy makers should instead focus on the first principles described
above for asset safekeeping (i.e., regular auditing of the
cybersecurity aspects of the custody plan along with auditing the
actual assets held in custody), and perhaps consider requiring the
platform operator to disclose any remaining potential conflicts while
developing policies and procedures to address them.
FTX uses both approaches, using a third-party custodian in part for
the U.S. derivatives platform and a proprietary in-house custody
solution for the other platforms. For its in-house wallet solution and
to maximize security, FTX leverages best-practice, hot- and cold-wallet
standards whereby only a small proportion of assets held are exposed to
the internet and the rest are stored offline. FTX policies and
procedures also address and dictate other key components to the
security of private keys, including applicable multi-signature
arrangements, as well as the storage of relevant backup information.
FTX's custody solutions comply with all relevant regulations, including
those of the U.S. CFTC, and the company takes pride in the confidence
in our security measures our customers have given to us.
3. Ensuring Appropriate Ledgering and Disclosures of Assets to Protect
Against Misuse
Another key investor-protection principle is making sure there is
adequate bookkeeping (and related records) to track the customer's
assets, combined with appropriate disclosure and reporting.\27\ This is
to ensure that whoever is in control of a customer's assets is not
misallocating or misusing those assets, particularly in furtherance to
their own purposes at the expense of the customer's best interests. The
basic concept here is that there should be controls in place to ensure
the custodian has books and records that keep track of and identify
which customer owns what, and there is adequate regulatory and customer
reporting, as well as independent auditing, to verify the same.
---------------------------------------------------------------------------
\27\ See IOSCO--Protection of Assets, Principles 1 through 3.
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In keeping with this principle, FTX provides a user experience that
enables any user to easily view account balances for all assets, for
all of its platforms, in real time. By logging in to the customer's
account at FTX, the customer can immediately view the types of assets
they own held in custody by FTX. The assets are ledgered and easily
identifiable to the user (but held in an omnibus wallet in the case of
the customer's tokens in order to better promote liquidity on the
platform) pursuant to internal policies and procedures, and FTX
regularly reconciles customers' trading balances against cash and
digital assets held by FTX. Additionally, as a general principle FTX
segregates customer assets from its own assets across our platforms.
Relatedly, and previewing the risk management discussion below, FTX
ensures redundancy, resiliency, and disaster-recovery preparedness by
using multiple geographically dispersed cloud and data service vendors
and facilities to ensure industry-leading 24/7 service.
4. Conducting Adequate Risk Management to Protect Digital Assets
The next key principle is ensuring that any market participant in
possession of customer assets is performing adequate risk management to
protect those assets, regardless of their particular role in the
ecosystem. There are multiple types of relevant risks that are inherent
to any market structure, including but not limited to credit or
counterparty risk, market risk, funding liquidity risk, and operational
risk. (All of these in turn have a bearing on or contribute to systemic
risk within the overall ecosystem.)
Credit and counterparty risk refers to the risk that a counterparty
will fail to perform its obligations. Market risk is defined as the
potential for losses arising from the change in value of an asset.
Liquidity risk is the potential that a position in an asset cannot be
unwound due to a lack of depth or a disruption in the market for the
asset. Operational risk includes a risk of loss from a failure of
internal processes at an organization, which can be caused by human
error, technology-system breakdowns, or communication-network failures;
they also can include losses caused by external factors such as ``acts
of God'' or other naturally occurring events.\28\
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\28\ For source of definitions, see The Joint Forum of the Basel
Committee on Banking Supervision, the International Organization of
Securities Commissions, and the International Association of Insurance
Supervisors, Risk Management Practices and Regulatory Capital, November
2001, p. 15, at https://www.iosco.org/library/pubdocs/pdf/
IOSCOPD122.pdf.
---------------------------------------------------------------------------
Market participants in any market, including digital-asset market
operators, must address each of these risks to ensure against
substantial or catastrophic losses that could lead to existential
threats against their own firm, thereby imperiling the assets of their
customers. In general, policy makers that develop market regulation
have required that both market operators as well as intermediaries
manage risk by developing appropriate policies and procedures to
address them, which contemplate the use of quantitative methods to
measure risk, pricing products according to their risks, establishing
risk limits, active management of risks through hedging and other
techniques, and the building of cushions to absorb losses.\29\
---------------------------------------------------------------------------
\29\ See id..
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FTX is a full-stack infrastructure provider, combining the matching
engine and the clearing function on the same platform, providing a
unified user experience for the trading of assets as well as the
clearing and settlement of those assets. FTX's Market Regulation Key
Principles addressed other risk-management considerations for the
trading venue itself, but here we focus particularly on risk management
embedded in the clearing and settlement functions that relate to
investor protections.
Clearinghouses in traditional markets again are subjected to
substantial regulatory rigor and are required to develop written
policies, procedures, and controls that establish an appropriate risk-
management framework which, at a minimum, clearly identifies and
documents the range of the aforementioned risks and more to which the
DCO is exposed, addresses the monitoring and management of the entirety
of those risks, and provides a mechanism for internal audit.\30\ Public
policy typically provides clearinghouses discretion in setting,
modeling, validating, reviewing and back-testing margin requirements
that build the cushion to absorb potential losses, but must develop
such requirements nonetheless; those models are then evaluated by
appropriate regulators.\31\ Clearinghouses are required by regulation
to frequently check the adequacy of initial-margin requirements, value
initial margin assets, back test products that are experiencing
significant market volatility, and conduct stress tests with respect to
each large trader who poses significant risk.
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\30\ See, e.g., Derivatives Clearing Organization General
Provisions and Core Principles (``DCO Final Rule''), 76 Fed. Reg.
69334, 69335 (Nov. 8, 2011); see also Standards for Risk Management and
Operations of Clearing Agencies (``Clearing Agency Rule''), SEC Rule
17Ad-22, 17 CFR Part 240.
\31\ See id..
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FTX platforms improve upon these requirements today in a number of
material respects, and indeed the FTX US derivatives platform complies
with the specific requirements of U.S. policy. First, the FTX
international exchange imposes on its users a dynamic maximum leverage
limit depending on their absolute position, which is limited to maximum
leverage of 20 times the notional value of the user's account, and
substantially lower in the case of larger positions. The limit is
calculated as a function of market liquidity and volatility, along with
the positions and collateral that the user holds. Second, FTX platforms
check customer-account levels and asset amounts, including those used
to collateralize positions, multiple times per minute as opposed to
once per day, as standard policy requires today. Third, customer
positions are liquidated if the net balance of all of a customer's
positions becomes negative, or positions fall below the maintenance-
margin threshold, and the FTX risk engine performs this function
automatically. FTX uses an advanced and user-friendly liquidation
process that gradually reduces a user's position to bring it to
solvency, instead of closing the entire position. Fourth, FTX's risk-
management program requires that digital-asset collateral be placed on
the platform itself, rather than pledged but not delivered to the
platform, to ensure the platform has immediate access to the collateral
for purposes of managing market risks. And fifth, FTX's markets are
open 24 hours a day, 7 days a week, which protects against delayed
management of customer positions or market conditions, and the
consequent build-up of market risk.
FTX undertakes this risk-management program without any reliance on
intermediaries, depending only on its own systems and personnel.
Historically, in traditional market structures, intermediaries provided
a first or outer layer of risk management, as the entity typically
responsible for onboarding customers and maintaining the customer
relationship, and thereby exposing that intermediary to all of the
attendant risks from that relationship. Market operators and
clearinghouses are beneath or within that outer layer and, as explained
above, also engage in management of the risks outlined above.
Intermediated versus Non-Intermediated
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
In traditional market structure, any type of breakdown in the risk
management at the outer layer of the intermediated market structure
exposes the inner layer to consequent risks. This is so because those
intermediaries are members of the trading platform as well, and the
effects of a risk-management breakdown can be transferred to the
trading platform as well as to the other members of the trading
platform. Policy makers refer to this concept as interconnection risk.
Arguably, the existence of this outer layer created through
intermediation increases the opportunities for risk-management failure
because there are so many more points of potential lapses or failure.
Many of these can be inconsequential to the overall ecosystem, but some
or many can be consequential.
The simplified market structure native to the digital-asset
ecosystem poses fewer interconnection risks within the system because
the outer layer of participants is folded into the inner layer--
investors access the digital-asset platform directly. Likewise, without
intermediaries bringing their customers to the trading platform, the
trading platform is not exposed to risk-management failures by an
intermediary, and can focus instead on its own risk-management program.
This in turn simplifies the role of the supervisory community
overseeing such platforms, who by focusing on the risk management of
the platform operator can dispense with concerns about the platform's
members who are not intermediaries. Again, this concept is key to FTX's
view that the market structure for our platforms is risk reducing
compared to those found in traditional markets.
One corollary to this concept is that involving intermediaries in
the market structure does not by definition lead to greater investor
protections, as some have argued. Instead, greater protections would
depend entirely on the risk-management resources and capabilities
(operational and financial) of the intermediary and whether they are
delivering on other key investor protections, which in part depends on
the level of supervision of the intermediary vis a vis the level of
supervision of the platform. As a general matter, the supervision of
clearinghouses as it relates to risk management in particular is equal
to or greater than that for intermediaries, with heightened financial
integrity and reporting standards. And as explained above, FTX risk
management is designed and has been implemented to improve upon those
standards in multiple ways.
Fewer interconnections, combined with superior risk-management
practices at the platform level, while delivering on core investor
protections, leads to a superior and risk-reducing market structure
that better protects investors.
5. Avoiding Conflicts of Interest
The final principle is that in order to ensure the investor's
interests are protected, conflicts of interest between the investor and
the entity offering the products should be eliminated, mitigated and/or
managed appropriately. Once again, in traditional capital markets the
policy focus has been on intermediaries who offer access to investment
products or otherwise sell the products to their customers directly,
and today there are considerable requirements directed at
intermediaries. Although not all existing regulations related to
conflicts will apply, to the extent that policy makers wish to apply
the relevant measures to the digital-asset space, this could be
accomplished rather smoothly by shifting the burden of those measures
from intermediaries to the platform operator as needed.
Policy governing traditional markets generally takes two approaches
to addressing conflicts of interest: expressly prohibiting certain
types of conduct, and requiring policies and procedures that involve
affirmative steps to identify areas of risk for conflicts, and measures
to mitigate or eliminate those conflicts. As an example of the former,
most securities regimes, including in the U.S., expressly prohibit
misstatements or misleading omissions of material facts, and fraudulent
or manipulative acts and practices, related to the purchase or sale of
investment products.\32\
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\32\ See, e.g., Section 15(c) of the Exchange Act.
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An example of the latter approach is a ``best interest'' or
``suitability'' requirement for entities offering investment products
to their customers, again typically intermediaries in the case of
traditional markets. This type of policy seeks to discourage entities
from offering or recommending products that the investor does not
sufficiently understand or possess the resources to use properly.\33\
Other regimes are less prescriptive and generally focus on the
financial wherewithal of a customer seeking access to a trading market,
on the premise of ensuring creditworthiness and an ability to meet
financial obligations on the platform,\34\ along with risk-related
disclosures.\35\
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\33\ See, e.g., SEC Regulation Best Interest (BI), FINRA Rule 2111.
This type of policy seeks to discourage entities from offering or
recommending products that the investor does not sufficiently
understand or possess the resources to use properly. To accomplish
this, some policy regimes require the intermediary to collect relevant
information about the customer/investor in order to ascertain the
customer's investment profile, and then have policies and procedures
for assessing suitability based on that information.
\34\ See, e.g., CFTC Rule 38.602, Rule 38.604, Rule 39.12, all of
which speak to financial fitness and wherewithal.
\35\ See, e.g., CFTC Rule 1.55 and 33.7.
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FTX favors an approach that provides equal access to all investors,
and follows sufficiently robust listing standards that ensure adequate
information about the listing is provided to the customer. But if
policy makers preferred to impose a heightened standard more similar to
what is found in securities markets, for example, they would need to
impose that responsibility on the platform operator, which again could
easily be accomplished.
In any case, whether intermediaries are involved in the market or
not, conflicts inevitably arise when each actor is pursuing its
commercial or economic interests. The key point for this particular
principle is that when they do, there are familiar methods for
eliminating or mitigating those conflicts, even as they apply to
platform operators. FTX conducts its business with a goal of maximizing
our customer's interest, but supports reasonable policy measures to
eliminate or mitigate conflicts that impose those responsibilities
directly on the platform.
______
Submitted Questions
Response from Vincent ``Vince'' McGonagle, J.D., Director, Division of
Market Oversight, Commodity Futures Trading Commission
Questions Submitted by Hon. Ann M. Kuster, a Representative in Congress
from New Hampshire
Question 1. Director McGonagle, you mentioned in your testimony
that since 2014 CFTC has brought more than 50 enforcement actions
against digital asset markets for issues like fraud, manipulation, and
false reporting.
Could you speak to how the investigation process works at CFTC, and
do you feel there is more authority or support you need from Congress
to strengthen CFTC's enforcement role?
Answer. The CFTC's Division of Enforcements (``DOE'') receives
information concerning possible enforcement matters from many different
sources.\1\ As part of DOE's process of assessing potential violations
of the Commodity Exchange Act and CFTC regulations, DOE identifies: the
necessary documents and information; the means available to obtain such
documents and information (and the timing thereof); and any legal
issues, including any statute of limitations issues. Generally, sources
of information used by the CFTC to investigate include testimony and
documents the CFTC may subpoena \2\ * as well as books, records, and
other information on the commodity interest-related activities that
registrants, registered entities, and reportable traders are required
to keep and make readily available to DOE.
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\1\ These sources include customer complaints, market surveillance,
Bank Secrecy Act Information, whistleblowers, self-reports, other
Federal, state, or local government agencies, our self-regulatory
organizations, such as the National Futures Association, designated
contract markets, and swap execution facilities.
\2\ The CFTC's power to subpoena testimony and documents in
connection with its investigatory proceedings derives from Section
6(c)(5) of the CEA, 7 U.S.C. 9(5).
* Editor's note: footnotes annotated with are retained in
Committee file.
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For entities that only offer so-called ``spot'' digital commodity
transactions, the CFTC does not have similar regulatory authority to
require maintenance and production or inspection of required records.
As a result, the CFTC must rely on voluntary cooperation and use its
subpoena authority to obtain testimony, information and records
relating to ``spot'' digital commodities. Thus, in order to strengthen
the CFTC's enforcement tools with respect to enforcement against fraud
and manipulative activity involving spot digital commodity
transactions, the CFTC would need more authority and support from
Congress, which have been thoughtfully provided in many of the proposed
bills.
To that end, the CFTC continues to provide technical assistance to
Members of Congress in support of a comprehensive Federal regulatory
regime that, among other things, strengthens the CFTC's enforcement
role with respect to spot digital commodity transactions.
Question 2. Director McGonagle, you also noted a number of recent
cases involving retail fraud of digital assets and illegal off-exchange
trading.
Could you elaborate on how these crimes work and what you all have
identified as emerging trends in illicit activity related to digital
assets that you are on the lookout for?
I know there has been a lot of focus lately on fully decentralized
blockchains, where there is no central association acting as a
supervisor, and as such there is also less trust between actors within
that market.
Answer. Illicit activity in digital asset markets has become more
sophisticated. One current trend DOE has observed is for bad actors to
direct customers to transfer their own fiat currency into digital
assets and then contribute those digital assets directly to the scheme.
For example, a fraudster may ask a victim to open an account with a
well-known cryptocurrency platform, convert his or her fiat currency
into the platform to purchase digital assets, and then transfer those
digital assets directly to the fraudster's digital asset wallet.
Fraudsters then use a variety of tools and methods to move victim funds
in ways that make it very difficult to track both the flow of funds and
the identity of the responsible individuals, particularly because the
fraudster's illicit activity rarely flows through a traditional bank
account or an account hosted by a reputable platform that has a robust
customer identification program or know-your-customer program.
Another common category of fraudulent and manipulative activity
involving digital assets--known as the ``rug pull''--typically involves
enticing victims to purchase what is held out as a soon-to-be listed
digital asset token by misrepresenting its potential value and failing
to disclose the fraudsters' own interest. Then, after the digital
asset's price increases, the fraudsters sell their holdings at the
inflated price, abscond with the purchasers' funds, and disappear.
Additionally, DOE has observed the continuing trend of ``pump and
dump'' activities where promoters of certain digital assets use social
platforms to quickly and artificially ``pump up'' the value of a
digital asset they hold and then sell off their (often undisclosed)
ownership of those assets at increasingly higher prices, often with a
correlating ``dump'' of the assets once their artificially inflated
price becomes known.
Finally, traditional Ponzi schemes are common in digital asset
fraud cases, where fraudster often promise large returns to be derived
from digital asset trading activity.
Question 3. Director McGonagle, could you talk about how you see
consumer protections being enforced in decentralized environments like
that, and as a precursor, what factors you believe are most critical to
objectively determining when a digital asset or token is indeed ``fully
decentralized''?
Answer. From the CFTC's vantage point, we evaluate whether persons
are engaged in activity that falls within the jurisdiction of the
Commodity Exchange Act or CFTC regulations or are otherwise engaging in
activity that violates those provisions (including our anti-fraud and
anti-manipulation requirements).
Even under the CFTC's current limited jurisdiction over the digital
commodity markets, the CFTC has been committed to protecting customers.
For example, the Commission recently filed an enforcement action
against a decentralized autonomous organization, for illegally offering
leveraged and margined retail commodity transactions in digital assets;
engaging in activities only registered futures commission merchants
(``FCMs'') (which are subject to various customer protection
requirements) can perform; and failing to adopt a customer
identification program as part of a Bank Secrecy Act compliance
program, as required of FCMs.\3\
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\3\ CFTC Imposes $250,000 Penalty Against bZeroX, LLC and Its
Founders and Charges Successor Ooki DAO for Offering Illegal, Off-
Exchange Digital-Asset Trading, Registration Violations, and Failing to
Comply with Bank Secrecy Act, available at https://www.cftc.gov/
PressRoom/PressReleases/8590-22.
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However, to best address consumer and investor protections, digital
asset spot markets must be subject to a comprehensive Federal
regulatory regime similar to those financial markets currently
regulated by the CFTC. By way of example, in the futures markets that
are currently under CFTC jurisdiction, the Commodity Exchange Act
provides for a regulatory framework that applies to any trading
facility that lists and offers futures contracts for trading to retail
customers on commodities, including futures contracts on digital
assets. Under this framework, the trading facility must apply to the
CFTC to be designated as a contract market and then comply with 23
statutory core principles. Those core principles require the designated
contract market (``DCM'') to, among other things: ensure the protection
of customer funds; \4\ protect market participants and the markets from
abusive practices; \5\ and promote fair and equitable trading in the
DCM.\6\ Furthermore, the core principles also require that the DCM:
only list products for trading that are not readily susceptible to
manipulation; \7\ be able to detect and prevent manipulation, price
distortion, and disruption of the contract's settlement process; \8\
and establish system safeguards, which include cybersecurity
protections and disaster recovery.\9\
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\4\ 7 U.S.C. 7(d)(11).
\5\ 7 U.S.C. 7(d)(12).
\6\ Id.
\7\ U.S.C. 7(d)(3).
\8\ 7 U.S.C. 7(d)(4).
\9\ 7 U.S.C. 7(d)(20) and 17 CFR 38.1051.
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In addition, under the current regulatory regime for futures
markets, DCMs also have the responsibility, on a self-regulatory basis,
to make sure their market participants are complying with the
rules.\10\ Additionally, the CFTC has broad enforcement authority to
make sure those market participants comply with the Commodity Exchange
Act and CFTC regulations.
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\10\ 7 U.S.C. 7(d)(2).
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The Commodity Exchange Act and CFTC regulations also provide for a
system of intermediary oversight that focuses on retail market
participants, which includes a disclosure regime that ensures those
market participants are informed of the risks of trading strategies and
fees involved for their trades.\11\ These market participants are also
informed of how their funds are being segregated and protected in the
event of bankruptcy, as well as how such funds may be utilized.\12\
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\11\ E.g., 17 CFR 4.24 and 4.34.
\12\ E.g., 17 CFR 1.55.
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The CFTC would be well positioned to adopt a similar regulatory
framework for spot digital commodity markets if Congress were to direct
the CFTC to do so.
Questions Submitted by Hon. Stacey E. Plaskett, a Delegate in Congress
from Virgin Islands
Question 1. Some observers have questioned how consumer protections
will be enforced against a fully decentralized blockchain.
Do you believe adequate consumer protections could be achieved by
regulating the exchanges and platforms on which most digital assets are
bought and sold under the Commodity Exchange Act?
Answer. Yes. By way of example, in the futures markets that are
currently under CFTC jurisdiction, the Commodity Exchange Act provides
for a regulatory framework that applies to any trading facility that
lists and offers futures contracts for trading to retail customers on
commodities, including futures contracts on digital assets. Under this
framework, the trading facility must apply to the CFTC to be designated
as a contract market and then comply with 23 statutory core principles.
Those core principles require the designated contract market (``DCM'')
to, among other things: ensure the protection of customer funds; \13\
protect market participants and the markets from abusive practices;
\14\ and promote fair and equitable trading in the DCM.\15\
Furthermore, the core principles also require that the DCM: only list
products for trading that are not readily susceptible to manipulation;
\16\ be able to detect and prevent manipulation, price distortion, and
disruption of the contract's settlement process; \17\ and establish
system safeguards, which include cybersecurity protections and disaster
recovery.\18\
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\13\ 7 U.S.C. 7(d)(11).
\14\ 7 U.S.C. 7(d)(12).
\15\ Id.
\16\ 7 U.S.C. 7(d)(3).
\17\ 7 U.S.C. 7(d)(4).
\18\ 7 U.S.C. 7(d)(20) and 17 CFR 38.1051.
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In addition, under the current regulatory regime for futures
markets, DCMs also have the responsibility, on a self-regulatory basis,
to make sure their market participants are complying with the
rules.\19\ Additionally, the CFTC has broad enforcement authority to
make sure those market participants comply with the Commodity Exchange
Act and CFTC regulations.
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\19\ 7 U.S.C. 7(d)(2).
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The Commodity Exchange Act and CFTC regulations also provide for a
system of intermediary oversight that focuses on retail market
participants, which includes a disclosure regime that ensures those
market participants are informed of the risks of trading strategies and
fees involved for their trades.\20\ These market participants are also
informed of how their funds are being segregated and protected in the
event of bankruptcy, as well as how such funds may be utilized.\21\
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\20\ E.g., 17 CFR 4.24 and 4.34.
\21\ E.g., 17 CFR 1.55.
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The CFTC would be well positioned to adopt a similar regulatory
framework for spot digital commodity markets if Congress were to direct
the CFTC to do so.
Question 2. Could regulation of platforms under the Commodity
Exchange Act in this manner achieve price and volume transparency,
order flow, segregation of client assets, bankruptcy protections,
cybersecurity, and Know Your Customer and Anti-Money Laundering
requirements?
Answer. Yes. The Commodity Exchange Act grants the CFTC the
authority to address all of the topics identified in your question
through our core principles framework applicable to designated contract
markets today. For example, DCMs provide centralized marketplaces that
provide market participants with price transparency and the ability to
trade these products in a safe and secure manner, with their assets
segregated \22\ and with bankruptcy protections \23\ built into the
system. There are also cybersecurity,\24\ know-your-customer,\25\ and
anti-money laundering requirements \26\ built into this regulatory
framework. The CFTC would be well positioned to oversee spot platforms
through a similar regulatory framework and achieve similar protections
if Congress were to direct the CFTC to do so.
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\22\ E.g., 7 U.S.C. 6d(a)(2).
\23\ See 17 CFR Part 190.
\24\ 7 U.S.C. 7(d)(20) and 17 CFR 38.1051.
\25\ 17 CFR 42.2.
\26\ Id.
Question 3. What other protections could Commodity Exchange Act
``principles based'' regulation provide?
Answer. The CFTC is considered a principles-based regulator that
issues prescriptive rules, when appropriate, in implementing the
Commodity Exchange Act. For example, the Commission has issued rules
that elaborate on the core principles applicable to DCMs,\27\ as well
as rules that mandate disclosures that commodity pool operators and
commodity trading advisors must make to their retail participants and
customers, respectively, which include, among other things, information
about past performance, conflicts of interest, and risk factors.\28\
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\27\ See 17 CFR 38.150-160.
\28\ 17 CFR 4.24 and 4.34.
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Ultimately, the type of regulatory regime provided in the Commodity
Exchange Act will enable the CFTC to implement effective customer
protections, while ensuring that the digital asset markets can continue
to innovate in a responsible manner.
[all]