Crypto Companies Must Stop Poking The Regulators In The Eye With A Stick

The regulatory agencies work to safeguard the U.S. financial system. Gary Gensler, Chairman of the … [+]

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The financial services industry in the U.S. is one of the most highly regulated industries in the world. There is a complex and overlapping mixture of regulators at both the state and federal levels, and banks and other financial entities shoulder a considerable burden to constantly remain up to date and in compliance with the rules. Not everyone follows the rulebooks, however.

Despite the numerous rules and regulatory guidance, there are some within the cryptocurrency industry who decry a lack of regulatory clarity. In general, that phrase, albeit concise, does not accurately represent the situation. Far more often the reality is that answers are clear, but the guidance is not what they want to hear. Not liking the answer is not the same as a lack of clarity.

When cryptocurrency industry participants receive a regulatory response that does not align with their objectives, the response is often combative. Coinbase and Custodia Bank have taken that approach.

The primary responsibilities of the diverse financial service regulators may differ, but as a group, they work to ensure the safety and stability of what is [SP1] the leading global environment for financial services. The regulators view themselves as guardians of market participants, especially consumers, and collectively they do not respond well to companies who seek to weaken the environment under their watch.

One such example of a provocative act is outlined in the 2022 Coinbase Global Annual Report. Coinbase offers “a trusted and easy-to-use platform for accessing the broader cryptoeconomy,” so they barely mention that they are in conflict with a key U.S. regulatory agency – the SEC.

Coinbase does not hold the appropriate licenses and permissions to list security products, and within the annual report there are several pages of discussion on risks associated with the potential classification of crypto-assets as securities. In the course of those disclosures, they mention that in a July 2022 court filing the Securities and Exchange Commission (SEC) determined that seven crypto-assets listed on their platform were unregistered securities (AMP, RLY, DDX, XYO, RGT, LCX, POWR).

Despite the clear and unequivocal position from the SEC (the agency that Coinbase admits is “the principal federal securities law regulator in the United States”), Coinbase has decided to disregard the SEC analysis and official position. Instead, Coinbase continues to trade these unregistered securities as it awaits a determination by a federal court.

Under a very different set of circumstances, the crypto-bank Custodia filed a lawsuit against the Federal Reserve in 2022. A special purpose depository institution chartered by the state of Wyoming, Custodia was seeking membership in the Federal Reserve system and access to the Federal Reserve Payment system. The application, and the subsequent appeal, was formally denied.

The Custodia business plan had a number of novel elements, and the Federal Reserve required substantially longer than usual to consider its application. Ultimately, the application was practically consigned to failure when the big three banking regulators issued a joint statement on crypto-asset risks to banking organizations. The Federal Reserve, Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC) listed a number of key risks and reasoned that “risks that cannot be mitigated or controlled” must be restricted so they “do not migrate to the banking system.”

Perhaps to most important part of the release, at least for Custodia Bank, was the statement that “issuing or holding as principal crypto-assets that are issued, stored, or transferred on an open, public, and/or decentralized network, or similar system is highly likely to be inconsistent with safe and sound banking practices.”

This effectively prohibits banks holding cryptocurrencies on the balance sheet or issuing a stablecoin. This policy appeared to be a rejection of the Custodia Bank business model, and the Federal Reserve rejection noted “the firm’s novel business model and proposed focus on crypto-assets presented significant safety and soundness risks.”

Mature financial services companies seek to work cooperatively with the regulatory agencies. It is far easier to change the system by working from the inside than by making noise on the outside. Those that elect to directly challenge regulatory authority may secure an occasional win, but at what cost? The benefits from digital assets will only be realized when they are accepted, and for that to happen the cryptocurrency market participants need to work within the system.

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