The Digital Commodities Act: The Real Deal, or a Castle on a Cloud?
By Mark Hays
The Senate Agriculture Committee is developing legislation aimed at closing the regulatory oversight gap that the cryptocurrency lobby insists is a problem. True, the crypto industry is highly volatile and riddled with scams that expose those that buy cryptocurrencies and tokens to substantial financial losses. But that’s a problem of enforcing existing rules, not regulation. The proposed bill purports to provide regulatory guardrails to this crypto Wild West, but ultimately would give a federal imprimatur to the crypto industry while only offering the patina of the necessary investor and market safeguards needed to protect vulnerable investors.
The crypto industry’s massive political spending aimed at protecting its profits from real regulatory oversight and enforcement has distorted the Committee’s priorities, as the Farm Bill and Commodities Futures Trading Commission (CFTC) reauthorization bill remain unfinished. Two years ago, the committee stood at a similar threshold. Intense industry lobbying, fronted by now disgraced FTX founder Sam Bankman-Fried, had fast-tracked an earlier version of this bill. The FTX collapse put those efforts on ice. But here we are again. Although Bankman-Fried has been jailed, the widespread crypto fraud and investor risks remain.
Sen. Debbie Stabenow’s (D-Mich.) proposed Digital Commodities Act (DCA) aspires but fails to establish the meaningful safeguards necessary to rein in the crypto industry’s widespread abuses. Federal regulators already have much of the authority they need to regulate the crypto industry. New legislation would just create a new regulatory arbitrage problem, where the industry flows to least regulated markets. To prevent this race to the bottom, any legislation must:
1) Give the Securities and Exchange Commission (SEC) the primary role in regulating the crypto sector. The behavior of most crypto asset issuers, brokers, and markets mirror traditional securities investment activity, and should be regulated that way.
2) Provide the same investor protections to retail crypto investors as they would get in the stock market, such as comparably robust rules covering investor disclosures, market manipulation and deceptive marketing.
3) Prevent regulatory arbitrage by preventing loopholes that undermine existing regulatory safeguards that could harm investors and lead to greater systemic risk and financial instability.
Stabenow’s DCA fails to meet these three essential benchmarks.
The legislation’s process all but guarantees that the SEC’s crypto oversight role will be diminished. The bill, in its current draft, gives the SEC a first look at crypto tokens to evaluate whether they should be considered commodities (governed by CFTC) or securities like stocks (governed by SEC). Crypto issuers are required to provide information justifying their consideration as commodities and the SEC can request more information for a 60-day review.
This rapid review of thousands of crypto tokens is far shorter than the complex consideration the SEC gives to new listings on regulated stock market, which can take months. The crypto industry would likely blitz the regulators with a wave of filings, overwhelming their review capacity, allowing some risky, or even fraudulent, assets to evade rigorous review. Even this paltry measure faces industry pushback: The crypto industry favors a weaker review process akin to New York City’s Department of Financial Services BitLicense regime that would essentially license crypto tokens as eligible to trade and not evaluate them from a securities markets perspective that more comprehensively prioritizes investor protection.
Second, Stabenow’s bill fails to include sufficiently rigorous protections for individual or retail investors. The CFTC lacks the statutory mandate to protect retail investors because the markets it regulates are for large, institutional investors. Retail investors don’t buy contracts for 40,000 pounds of beef or $100,000 blocks of interest rate swaps. But retail investors do buy handfuls of crypto tokens that can trade at prices as low as a few dollars.
The legislation lets the CFTC set rules for digital commodity brokers similar to those of other CFTC-regulated markets. In contrast to SEC retail investor protections, this provision would include paltry protections to protect customer assets from broker default, a few conflict-of-interest disclosures, and minimal separation between brokers and trading platforms.
The Stabenow bill also lacks comprehensive investor disclosures that help investors know what they are getting themselves into. It only requires some initial disclosures by crypto firms issuing digital commodities for trading. But the SEC requires issuers to not only provide initial disclosures, but ongoing disclosures whenever there are significant changes. Since the underlying crypto asset code can change with a few mouse clicks, without ongoing disclosure, investors could see asset values change without warning, leaving them vulnerable to steep losses.
The bill lacks strong tools to prevent market manipulation. Tackling this issue is critical, since the industry is rife with manipulation. Crypto traders artificially pump-up prices with fake trades, take advantage of insider information to jump ahead of retail investors, and use social media to tout and bash tokens while they buy or sell in the opposite direction. Yet rather than set rigorous standards here, the bill lets crypto issuers, brokers, and exchange platforms simply self-certify their crypto assets are “not readily susceptible” to market manipulation. The legislation doesn’t even define “readily susceptible.” What’s enough manipulation for investors to stomach?
This framework would only amplify investor risk because the legislation gives CFTC-approval to products that are purportedly safe from manipulation without doing much to address widespread market manipulation in the crypto space. In contrast, the SEC has robust rules to guard against manipulation that fleeces investors and destabilizes markets, which could be a formidable obstacle to crypto trading scams.
The bill also lacks meaningful protections against deceptive marketing. The SEC has long-standing comprehensive and robust rules to prevent the kind of deceptive and hype-oriented marketing that is endemic in the crypto industry. The CFTC doesn’t have comparable marketing rules. To address this, the bill lets a self-regulatory industry body help the CFTC establish brand new rules to rein in the hyperbolic advertising used to boost crypto token prices, which is no easy task. Overall, these substantial shortcomings illustrate the steep climb the CFTC would face to recreate entire oversight and compliance structures to protect investors — oversight that already exists in SEC-regulated securities markets.
Finally, the legislation sets the stage for dangerous regulatory arbitrage that allows risky crypto tokens to chase the weakest oversight. The bill can only work as long as absolutely nothing goes wrong. The bill requires the CFTC to rapidly create a host of new regulations — with little concrete or useful legislative direction — that would mean the difference between rigorous or lax oversight. Rulemakings can take a decade or more.
The SEC is still working to implement rules authorized by Dodd-Frank Act nearly 15 years ago. And, as the CFTC pursues these rules, the crypto industry will have ample time and resources to whittle down the rules through intense lobbying. The legislation dedicates $125 million for the CFTC to write, implement, and enforce the new rules — an amount that will likely be dwarfed by industry lobbying and lawsuits. For example, a single crypto firm, Ripple, has already spent over $100 million in an ongoing suit with the SEC. And, since Republicans have fought giving the CFTC more money for years, it seems doubtful they would follow through.
The bill also assumes the CFTC will prioritize retail investor protection and sound market oversight. Yet, the CFTC has a demonstrated history of being willing to bend the rules for crypto. It was on the verge of approving FTX’s petition for relaxed automatic trading rules just prior to FTX’s collapse. It approved a similar petition for the crypto firm Bitnomial only recently. Under an even more industry friendly CFTC leadership, the oversight could evaporate and be replaced with a sign reading “Ready to Fulfill Crypto Lobby Wishes.”
Although the Stabenow bill is better than the crypto giveaway offered by House Republicans, that is not saying much. The Senate bill’s failure to adequately protect retail investors and the market from the widespread scams and rampant volatility in crypto markets far outweighs its modest legislative advancements. Congress should not rush to enact crypto legislation that does not protect small investors or the market. Locking in a flawed crypto regulatory framework will make life worse, not better, for retail investors.
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