What to expect after the Senate banking hearing on crypto crash

The Senate Banking Committee met on crypto today, calling the Valentine’s Day hearing “Crypto Crash: Why Financial System Safeguards are Needed for Digital Assets.” This hearing covered the week’s hot topics, including stablecoin regulation, consumer protection, banking in the crypto industry, whether a self-regulatory organization is needed, and how the Securities and Exchange Commission (SEC) should work with the Commodity Futures Trading Commission (CFTC) to regulate digital assets .

In the testimony of Lee Reiners, director of policy at Duke University’s Financial Economics Center, the law professor proposed a sweeping new approach to regulation. Overall, the committee, chaired by Sherod Brown (D-Ohio) and Tim Scott (R.S.C.), aims to begin work on a two-pronged cryptocurrency regulatory framework. They heard testimony from Georgetown University law professor Linda Jeng, JD, who is also the Chief Global Regulatory Officer at the Crypto Council for Innovation, and law professor Yesha Yadav of Vanderbilt Law School. Regarding Reiners’ testimony, he argued that Congress should clarify that the SEC has the authority to draft rules for DeFi applications, in addition to formal crypto businesses. Jeng and Yadav argued for innovation, financial inclusion, diversity of user base and other countries taking the lead like China. Reiners argued for consumer protection, financial stability and whether this is really an asset class or just gambling. The committee was clear in pointing out Gary Gensler’s absence and said he had to appear before September – it’s just too late.

The stakes have never been higher for the crypto industry, as lawmakers grapple with how, or whether, to allow innovation to grow in established economic hubs like New York and San Francisco. The future of the dollar’s global dominance may also be affected by the decisions being debated today on Capitol Hill.

SEC vs. CFTC

Reiners argued that the SEC should have control, noting that the CFTC regulates commodity derivatives but does not regulate commodity spot markets. The practical effect of this structure is that cryptocurrency exchanges in the United States are currently not regulated at the federal level. This is precisely because lawmakers want to solidify how crypto exchanges are regulated at the federal level. This will improve clarity and reduce the likelihood of crypto companies being penalized for offerings they didn’t know how to handle, as was the case recently with Kraken and Ethereum.

According to his statement, published before the hearing, Reiners argued “the best and most feasible way forward is for Congress to separate cryptocurrency from the definition of a commodity in the Commodity Exchange Act and recognize cryptocurrencies as securities under a special definition to the securities laws.” In short, Reiners believes the SEC should be the primary regulator focused on crypto exchanges.

He went on to argue that if a crypto exchange offers custodian services for client funds – as opposed to requiring the use of a qualified custodian – that exchange could be subject to special resolution administered by the Securities Investor Protection Corporation (SIPC) so that clients were insured against losses up to $500,000 if the exchange company goes bankrupt. This may have helped protect some of the victims of the FTX bankruptcy, for example. As important as these decisions are, they may pale in comparison to how lawmakers could bet on decentralized crypto services and tools.

Regulation of DeFi

The inclusion of DeFI as a topic in today’s consultation is subtle, yet important. Reiners notes “several firms have developed online user interfaces that allow users to access DeFi protocols. These firms should be required to register as brokers.” This will affect many companies and projects such as AaveAAVE and CompoundCOMP.

Reiners added that DeFi projects that run solely on blockchain-based smart contracts, which do not rely on the efforts of others, pose less potential risk because “very few people have the technological capacity to directly access them.” Additionally, these projects are still so experimental that they have “little connection to real-world assets.” Given that the most prominent risks associated with DeFi today are code vulnerabilities that could attract illegal hackers, Reiners argued that the SEC could “start requiring independent code audits and IT security testing of DeFi protocols.” It would be a big leap for a traditional regulator like the SEC to consider code audits as part of the normalized compliance process.

Stable coins

Reiner’s proposal would also give SEC oversight of stablecoins. Elizabeth Warren and Roger Marshall probably agree with him. If lawmakers follow the law professors’ lead, regulators will impose strict requirements that all stablecoin reserves be held in cash or US Treasury securities. This was not the case, for example, with the crypto exchange Paxos, which was recently ordered to stop issuing the stablecoin BUSDBUSD.

The idea would also be to subject stablecoin issuers to routine audits and disclosures, possibly even banking regulations. Instead of deciding whether stablecoins are commodities or securities, Congress could simply direct the CFTC and SEC to engage in joint rulemaking and share enforcement authority in the case of stablecoins. There is precedent for this, as the two agencies engaged in joint rulemaking to implement Title VII in 2010, which governed the regulation of derivatives, of the Dodd-Frank Act. Instead of forcing stablecoins into the banking system, Congress could give the SEC the authority to regulate them as money market funds, with strict requirements that stablecoin reserves be held in cash and government securities.

All things considered, this hearing is different from past hearings because there is now more pressure from the Biden administration for Congress to finally take definitive action. If Congress responds to that pressure, the most likely first step lawmakers will take is to pass stablecoin regulations first. It would be the most similar action to what lawmakers have done before. Regardless of what happens next, these decisions will surely affect the country’s economic growth for decades to come. The future of digital assets in North America is decided on days like today.

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