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SEC proposes new protections for crypto assets
On February 15, the SEC proposed new rules to enhance protections for customer assets, including cryptocurrency assets, managed by registered investment advisers. (See also SEC Fact Sheet here.) The proposed rules would implement measures under the Investment Advisers Act of 1940 to address how client assets are safeguarded, and would broaden the definition of “asset class” to ensure investment advisers are protecting not only their clients’ securities and funds but also “other positions held in a client’s account,” including crypto assets.
Under the proposed rules, investment advisers would be required to, among other things, segregate such crypto assets into separate accounts for safekeeping, prevent commingling of assets with the adviser’s or another related persons’ assets, and place crypto assets with a qualified custodian such as a federal or state-chartered bank or savings association, a registered broker-dealer or futures commission merchant, or certain foreign financial institutions. Foreign financial institutions would have to adhere to enhanced requirements to serve as a qualified custodian.
In a statement accompanying the release of the proposed rules, SEC Chairman Gary Gensler stated that “advisers who trade an investor’s assets cannot circumvent the custody rule and the safeguards it provides.” Gensler added that the proposal would impose several recordkeeping requirements, and require, for the first time, that advisers and qualified custodians enter into written agreements to help guarantee that customer assets are being protected.
Comments on the proposed rules are due 60 days after publication in the Federal Register.
FDIC orders entities to stop making fraudulent deposit insurance representations
On February 15, the FDIC sent letters to four entities demanding that they stop making false or misleading representations about FDIC deposit insurance. Letters were sent to a cryptocurrency exchange and to a nonbank financial services provider demanding that the entities cease and desist from making false and misleading statements about FDIC deposit insurance and take immediate corrective action to address these statements. The FDIC also sent letters to two websites ordering them to remove similar false and misleading statements claiming that the crypto exchange and the nonbank financial services provider are FDIC-insured and that FDIC insurance will protect customers’ cryptocurrency or protect customers in the event of the nonbank’s failure. Under the Federal Deposit Insurance Act, persons are prohibited “from representing or implying that an uninsured product is FDIC-insured or from knowingly misrepresenting the extent and manner of deposit insurance.”
U.S.-EU release statement on Joint Financial Regulatory Forum
On February 7-8, EU and U.S. participants, including officials from the Treasury Department, Federal Reserve Board, CFTC, FDIC, SEC, and OCC, participated in the U.S.-EU Joint Financial Regulatory Forum to continue their ongoing financial regulatory dialogue. According to a joint statement issued by the participants, the matters discussed focused on six themes: “(1) market developments and financial stability risks; (2) sustainable finance and climate-related financial risks; (3) regulatory developments in banking and insurance; (4) operational resilience and digital finance; (5) regulatory and supervisory cooperation in capital markets; and (6) anti-money laundering and countering the financing of terrorism (AML/CFT).”
The joint statement acknowledged that the Russia/Ukraine conflict, coupled with global economic uncertainty and inflationary pressures, have exposed “the financial system to downside risk both in the EU and in the U.S,” with participants stressing the importance of international coordination in monitoring vulnerabilities and building resilience against stability risks. During the forum, participants discussed recent developments related to sustainability-related financial disclosures, climate-related financial risks, cross-border bank resolution coordination, the transition away from LIBOR, digital finance operational resilience, and progress made in strengthening their respective AML/CFT frameworks.
Fed cautions banks regarding crypto risks
On February 10, Federal Reserve Board Governor Christopher J. Waller gave a speech on the cryptocurrency ecosystem and digital assets before attendees at the Global Interdependence Center Conference: Digital Money, Decentralized Finance, and the Puzzle of Crypto. Waller provided a broad overview of digital assets and digital ledger technologies and briefly discussed the use of smart contracts in peer-to-peer trading, as well as their potential to automate the execution of certain transactions in non-crypto-assets such as securities transactions. He also highlighted risks associated with another emerging technology—tokenization—which, he explained, “when combined with data vaults to securely store personal information, can be used to trade objects in a way that protects one’s identity from being exploited for profit.” Waller commented that these potential applications could also “lead to substantial productivity enhancements in other industries” beyond the crypto ecosystem.
Waller went on to express support for prudent innovation but expressed concerns about banks engaging in activities that expose them to a heightened risk of fraud, scams, and legal uncertainties. “As with any customer in any industry, a bank engaging with crypto customers would have to be very clear about the customers’ business models, risk-management systems, and corporate governance structures to ensure that the bank is not left holding the bag if there is a crypto meltdown,” Waller stated. “And banks considering engaging in crypto-asset-related activities face a critical task to meet the ‘know your customer’ and ‘anti-money laundering’ requirements, which they in no way are allowed to ignore.”
Senators exploring bank’s dealings with collapsed crypto exchange
On January 30, Senators Elizabeth Warren (D-MA), John Kennedy (R-LA), and Roger Marshall (R-KS) sent a follow-up letter to a California-based bank asking for additional responses to questions related to the bank’s relationship with several cryptocurrency firms founded by the CEO of a now-collapsed crypto exchange. As previously covered by InfoBytes, the senators pressed the CEO for an explanation for why the bank failed to monitor for and report suspicious transactions to the Financial Crimes Enforcement Network, and asked for information about how deposits it was holding on behalf of the collapsed exchange and related firm were being handled. The senators stressed that the bank has a legal responsibility under the Bank Secrecy Act to maintain an effective anti-money laundering program that may have flagged suspicious activity.
In the letter, the senators accused the bank of evading their previous questions in its December response, writing that while the bank’s answers confirm the extent of its failure to monitor and report suspicious financial activity, it failed “to provide key information needed by Congress to understand why and how these failures occurred.” The bank’s “repeated reference to ‘confidential supervisory information’” as a justification for its refusal to provide the requested information “is simply not an acceptable rationale,” the senators said. They also noted that the bank’s recent advance from the Federal Home Loan Bank of San Francisco—intended “to ‘stave off a further run on deposits’”—has introduced additional crypto market risks into the traditional banking system, especially should the bank fail. The bank was asked to explain how it plans to use the $4.3 billion it received.
The senators further commented that additional findings have revealed that neither the Federal Reserve nor the bank’s independent auditors were able to identify the “extraordinary gaps” in the bank’s due diligence process. The senators asked the bank to provide responses to questions related to its risk management policies, as well as how many safety and soundness exams were conducted, and whether any of the bank’s executives were “held accountable” for the failures related to the collapsed exchange, among other things.
Biden administration presents roadmap for mitigating crypto risks
On January 27, the Biden administration presented a roadmap for mitigating cryptocurrency risks to ensure that cryptocurrencies do not undermine financial stability, investors are protected, and bad actors are held accountable. At President Biden’s direction, the administration previously laid out a comprehensive framework for developing digital assets in a safe, responsible way that also identifies clear risks. (Covered by InfoBytes here.) The administration identified clear risks taken by some crypto entities, such as ignoring applicable financial regulations and basic risk controls, misleading consumers, having conflicts of interest, failing to provide adequate disclosures, or committing fraud. The roadmap also outlined actions taken by the federal banking agencies, including a recently issued joint interagency statement that highlighted key risks banks should consider when choosing to engage in crypto-related services and a notice of proposed rulemaking issued by the FDIC warning companies against making false or misleading claims about digital assets being insured by the agency (covered by InfoBytes here and here). The administration also noted that agencies across the government are developing public-awareness programs to help consumers understand the risks associated with digital assets.
The administration stressed, however, that further action is needed. Priorities for digital asset research and development will be unveiled in the coming months, the administration said, adding that Congress should also step up efforts in this space. This includes expanding regulators’ powers to prevent misuses of customers’ assets, “strengthen[ing] transparency and disclosure requirements for cryptocurrency companies so that investors can make more informed decisions about financial and environmental risks,” “strengthen[ing] penalties for violating illicit-finance rules and subject cryptocurrency intermediaries to bans against tipping off criminals,” and limiting crypto risks to the financial system by following steps outlined in a recent Financial Stability Oversight Council report (covered by InfoBytes here), the administration said.
Fed says limits on banking activities will apply regardless of insurance status
On January 27, the Federal Reserve Board issued a policy statement providing guidelines on how the agency evaluates requests from supervised uninsured and insured banks seeking to engage in novel activities, such as those involving crypto assets. Recognizing that in recent years the Fed has received numerous inquiries, notifications, and proposals from banks seeking to engage in new or unprecedented activities, the Fed clarified that when evaluating such inquiries, uninsured and insured banks supervised by the Fed would be subject to the same limitations that are currently imposed on OCC-supervised national banks, including crypto-asset-related activities. According to a board memo published the same day, the Fed said it “will presumptively exercise its authority to limit state member banks to engaging as principal in only those activities that are permissible for national banks—in each case, subject to the terms, conditions, and limitations placed on national banks with respect to the activity—unless those activities are permissible for state banks by federal law.” This “equal treatment” is intended to “promote a level playing field and limit regulatory arbitrage,” the Fed said.
The Fed reiterated that banks must be able to ensure that any activities they plan to engage in are permitted by law and conducted in a safe and sound manner. A bank should implement risk management processes, internal controls, and information systems that are “appropriate and adequate for the nature, scope, and risks of its activities,” the Fed noted. The Fed, however, explained that the policy statement does “not prohibit a state member bank, or prospective applicant, from providing safekeeping services, in a custodial capacity, for crypto-assets if conducted in a safe and sound manner and in compliance with consumer, anti-money laundering, and anti-terrorist financing laws.”
The policy statement was issued the same day the Fed denied a request from a Wyoming-based digital asset firm to become a member of the Federal Reserve System. The Fed explained that the firm—a special purpose depository institution chartered by the state of Wyoming that “proposed to engage in novel and untested crypto activities that include issuing a crypto asset on open, public and/or decentralized networks…“ presented significant safety and soundness risks.” Additionally, the Fed determined that the digital asset firm’s risk management framework failed to sufficiently address heighted risk concerns, including its ability to mitigate money laundering and terrorism financing risks.
DFPI announces $22.5 million multistate settlement with crypto platform
On January 26, the California Department of Financial Protection and Innovation (DFPI) announced that it entered into a $22.5 million settlement agreement with a Cayman Islands digital asset firm to resolve a securities enforcement action regarding its interest-bearing virtual currency account. As previously covered by InfoBytes, in September 2022, the New York attorney general sued the firm for allegedly offering unregistered securities and defrauding investors. A North American Securities Administrators Association working group—composed of the DFPI and state regulators from Washington, Kentucky, New York, Oklahoma, Indiana, Maryland, South Carolina, Vermont, and Wisconsin—collaborated in the investigation into the firm. The states alleged that the platform failed to register as a securities and commodities broker but told investors that it was fully in compliance. According to the New York AG’s complaint, the platform promoted and sold securities through an interest-bearing virtual currency account that promised high returns for participating investors. The New York AG said that a cease-and-desist letter was sent to the platform in October 2021, and that while the platform stated it was “working diligently to terminate all services” in the state, it continued to handle more than 5,000 accounts as of July. The complaint charges the platform with violating New York’s Martin Act and New York Executive Law § 63(12), and seeks restitution, disgorgement of profits, and a permanent injunction. The announcement also noted the SEC entered into a separate settlement with the firm for the same penalty amount, alleging that it to register the offer and sale of its retail crypto-asset lending product (covered by InfoBytes here).
Warren, Wyden urge PCAOB to crack down on crypto auditors
On January 25, Senators Elizabeth Warren (D-MA) and Ron Wyden (D-OR) sent a letter to the chair of the Public Company Accounting Oversight Board (PCAOB) urging the board to make sure it was taking sufficient measures to hold registered audit firms accountable for their work with cryptocurrency clients. The letter highlighted the recent turmoil in the crypto market following the collapse of a major crypto exchange last November, and inquired about “the role that auditors may have played in misleading the public about the financial soundness and safety of crypto companies.” Referring to reports of “scandalous accounting practices” within the industry, the senators urged the PCAOB to take action to ensure accountability. “When PCAOB-registered auditors perform sham audits—even for firms that may lay outside of the PCAOB’s jurisdiction—they tarnish the credibility of the PCAOB and undermine confidence in the PCAOB-registered auditors that investors and the public rely on when making investment decisions,” the senators wrote, adding that “misleading financial reports shake our confidence in the entire auditing industry.”
The senators asked the PCAOB to respond to several questions concerning alleged misleading auditing practices related to the exchange’s collapse, including whether the PCAOB is taking steps to mitigate risks facing retail investors, whether it was aware of any potential conflicts of interest or other concerning behavior, and whether it has “the authority to strip auditors of their PCAOB-registered status if they provide services or engage in conduct that fall short of PCAOB standards and rules, even if those actions are taken in relation to private, non-SEC registered companies.” The senators also asked the PCAOB to describe the standards that auditors must comply with “when evaluating the risk of exposure to crypto firms or validating the valuation of crypto investments.”
SEC commissioner discusses state of the crypto industry
On January 20, SEC Commissioner Hester M. Peirce spoke before the Digital Assets at Duke Conference discussing cryptocurrency lessons for the future. In her remarks, Peirce discussed the current state of cryptocurrency, stating that “the crypto world is burning.” She encouraged the audience to “not wait for regulators to fix the problems that bubbled to the surface in 2022” within the crypto industry, and instead incentivize good behavior. She also emphasized “the point of crypto,” which she considers “is not driving up crypto prices so that you can dump your tokens on someone else. Digital assets need to trade, so centralized venues or decentralized exchange protocols are necessary, but trading markets are not the ultimate point.” Among other things related to crypto, she said lessons from traditional finance are equally applicable in crypto. For example, she noted that “[h]igher returns come with higher risks.” She also suggested that the SEC should conduct some form of notice and comment process to resolve the thorniest crypto-related policy issues.
Peirce noted that “sandboxing is coming.” She then explained that SEC Chair Gary Gensler has requested “‘staff to sort through how we might best allow investors to trade crypto security tokens versus or alongside crypto non-security tokens,’[] which is an area in which experimentation through no-action letters and exemptions would be possible.” She also strongly agrees with his sentiment that “‘[g]iven the nature of crypto investments . . . it may be appropriate to be flexible in applying existing disclosure requirements.’”
She also expressed that “[r]egulation is not a silver bullet, but understanding whether, by whom, and how the company is regulated can help you calibrate your own due diligence.” Peirce said that the SEC “needs to conduct better, more precise, and more transparent legal analysis” in crypto. She noted that its continued use of the precedent from the 1946 U.S. Supreme Court case in SEC v. W.J. Howey Co. has “fleshed out the investment contract subcategory of securities, we repeat the mantra that all, or virtually all, tokens are securities,” calling the SEC’s application of the test to crypto tokens “askew.” She then noted that “an initial fundraising transaction involving a crypto token can create an investment contract, but the token itself is not necessarily the security even if it is sold on the secondary market.” Peirce also noted that the SEC often “refers to the crypto assets themselves as securities.”