SEC Cracking Down on Crypto Startups

SEC Cracking Down on Crypto Startups

 Published: May 17th, 2023

Securities and Exchange Commission (SEC) chairman Gary Gensler rejected criticism on Monday that the agency isn't giving crypto companies the guidance they need to comply with federal finance law.

America’s primary financial watchdog has faced ongoing criticism from the cryptocurrency industry, both recently and in previous years, for not having clear-cut rules and for failing to recognise the unique nature of digital assets.

According to Bloomberg, Gensler told the 27th annual Financial Markets Conference in Atlanta, Georgia, that the rules for crypto companies ‘have already been published,’ adding that he doesn’t think the SEC is behind the times.

A wave of enforcement actions is underway that encompasses 140 cases, he said, many of them pre-dating the FTX meltdown. This proves that the SEC is up to the job, he said, and told event attendees that too many cryptocurrency companies have developed business models that amount to fraud.

In many cases, calling these businesses decentralised ‘is a false narrative,’ Gensler said. ‘Many have centralised aspects with most business and development activity focused in these areas.’ He went on to say that it’s common for crypto business models to rely on ‘taking customer funds and commingling them,’ something FTX executives have been accused of.

When asked about the crypto industry’s longstanding call for clearer regulations, Gensler said there was nothing about blockchain’s status as a new technology gives crypto firms a pass from having to abide by established rules.

Picking up on a theme he has used before, most recently when speaking to a senate committee on finance reform, Gensler called financial intermediaries in traditional money markets 'rent-collecting-nodes.’ The message for crypto companies was clear, he said. If a firm is holding what the SEC considers securities on a tech platform, then the rules around custody and trading must be followed to the letter.

If that’s too difficult a concept to grasp, Gensler said, the SEC is ‘ready to help bring them into compliance.’

Turning up the regulatory heat

American crypto firms operating in the country’s top financial jurisdiction were warned in February 2023 that they need to manage their customers' digital assets with greater care.

In the wake of the FTX scandal, the New York Department of Financial Services (NYDFS) published an open letter to the industry outlining how investor assets should be kept separate from company funds. The letter also included guidelines for custodians, and explained the necessary disclosures that firms need to make when keeping custody of digital assets for clients is part of their business model.

NYDFS took the action as federal prosecutors were applying more scrutiny to collapsed crypto trading exchange FTX and its controversial founder Sam Bankman-Fried. Bankman-Fried, or ‘SBF’ as he is known colloquially, is accused of misusing billions of dollars in customer assets and funneling them from the exchange to fund dodgy trades at his recently shuttered hedge fund.

‘As stewards of customer assets, crypto companies that act as custodians need to have rigorous processes in place that follow those relied on by traditional financial services firms,’ the NYDFS letter said.

The role of asset custodians in finance is to ‘hold on’ to customer assets for safe keeping. They could be funds, bonds, equities, or cryptocurrencies. In all cases custody has to be executed in a secure and transparent manner.

The new NYDFS guidelines are even more specific and provide detailed guidance on how digital assets should be handled.

Crucially, the agency said custodians must keep customers’ digital assets completely separate from any assets that belong to the custodian itself. In crypto terms this could mean recording the assets both on-chain and on the custodian’s own books, but maintaining appropriate records to avoid double counting.

The agency also said that assets under a custodian’s control should only be held for the purpose of safekeeping. Specifically, there should not be a debtor-creditor relationship between custodian and customer when possession of a digital asset is transferred.

Custodians in New York are also required to give customers written disclosures that clarify what the custodial arrangement means and how the custodian operates. Disclosures should explain how the custodian ‘segregates and accounts for and digital currency held in custody,’ and clarify the customer's ‘retained property interest in it.’

Taming the wild west

In July 2022, the Financial Stability Board (FSB), a G20 entity charged with monitoring financial activity in the world’s top-20 economies, announced a coming proposal that will lay out new 'robust regulation and supervision’ for cryptocurrencies.

An FSB press release said that digital currencies are evolving rapidly in a tumultuous environment marked by extreme volatility. 'Despite these worries, cryptocurrencies are becoming increasingly integrated into the traditional financial system, exposing investors to new risks.’

The agency is worried about the potential for one market failure to negatively impact participants in the wider crypto ecosystem. ‘Investors can suffer huge losses while risks are transmitted to other parts of the system and market confidence is damaged.’

Crypto market watchers saw this as a veiled reference to Terra’s dramatic failure in early May of 2022. The collapse of the Terra ecosystem triggered a liquidity crisis and sent several well-known crypto finance firms and hedge funds into bankruptcy.

Though the organization monitors the financial services industry closely, the October crypto proposal will mark a new chapter for the FSB. Up until now it has played a background advisory role, and any recommendations to G20 ministers and bankers have been made outside the public sphere.

In September 2022, SEC Chair Gary Gensler told the US Senate Banking Committee that the transition could re-define the blockchain in the government's eyes as something more akin to a security than a technology platform. Gensler’s view is that staking assets to a crypto network in exchange for passive rewards could be seen as proof under the so-called Howey Test that an asset qualifies as a security.

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