In their testimony before the U. S. Senate Committee on Banking, Housing and Urban Affairs (the “Committee”), Chairman Jay Clayton of the Securities and Exchange Commission (SEC) and Chairman J. Christopher Giancarlo of the Commodity Futures Trading Commission (CFTC) on February 6, 2018 discussed the role of their respective agencies with respect to regulatory oversight of virtual currencies. In opening remarks and published testimonies, Chairman Clayton and Chairman Giancarlo emphasized their desire to ensure the safety and soundness of U.S. financial markets, as well as to punish those who engage in fraudulent, manipulative and deceptive conduct in the virtual currency marketplace.[1]

Building on central themes from their recent joint op-ed published in The Wall Street Journal, Chairman Clayton and Chairman Giancarlo said that while they were confident that their agencies can achieve their regulatory mandates, they perceived potential gaps in the U.S. regulatory apparatus. For example, they said that the agencies lack authority to regulate some aspects of the virtual currency spot markets, often referred to as “exchanges.” They said that these exchanges, which are generally subject only to state money transmission laws and CFTC anti-fraud and anti-manipulation regulations,[2] require further consideration. “The currently applicable regulatory framework for virtual currency trading was not designed with trading of the type we are witnessing in mind,” Chairman Clayton testified.[3]

Chairman Giancarlo proposed a path to tighten federal oversight of virtual currency markets, including measures relating to data reporting, capital requirements, cyber security standards, fraud and price manipulation and anti-money laundering and “know your customer” protections. To that end, Chairman Clayton and Chairman Giancarlo will participate in a cross-regulator working group on virtual currencies lead by Treasury Secretary Steven Mnuchin. Committee Chairman Mike Crapo (R-ID) requested that the regulators return to the Committee with recommendations as they continue their evaluation and determine whether further clarification is needed from Congress.

Chairman Clayton and Chairman Giancarlo said that they expect more virtual currency-related enforcement actions in the coming months. Chairman Clayton expressed frustration with the recent explosion of unregistered initial coin offerings (ICOs), and those “gatekeepers” responsible for advising on such issuances—i.e., lawyers, investment bankers, accountants and consultants. He repeated his recent warnings to industry practitioners that “[t]okens and offerings that incorporate features and marketing efforts that emphasize the potential for profits based on the … efforts of others continue to contain the hallmarks of a security under U.S. law.”[4] Chairman Giancarlo said that the CFTC has on multiple occasions asserted jurisdiction over fraudulent and manipulative actors in the virtual currency space. The CFTC’s increased regulatory vigilance and scrutiny are likely to result in more nuanced enforcements in the future. In his statement, Chairman Clayton returned to a theme that he has focused on throughout his time as Chair—educating and protecting “main street” or retail investors on this new and emerging investment opportunity. He reiterated his cautions to retail investors on the significant risks and uncertainties of investing in virtual currencies and ICOs and, importantly, he also warned those seeking to target retail investors with ICOs that the SEC’s Enforcement Division will be policing these markets vigorously.

The regulators also affirmed their positions on virtual currency-based investment products within their respective purviews. Chairman Giancarlo defended the CFTC’s self-certification process in respect of bitcoin-based futures products launched by CME Group (“CME”) and Cboe Futures Exchange (“Cboe”), arguing that “blocking self-certification would not have stopped the rise of Bitcoin or other virtual currencies … [but] would have ensured that virtual currency spot markets continue to operate without effective and data-enabled federal regulatory surveillance for fraud and manipulation.”[5] He further described the results of the CFTC-administered “heightened review” process that CME and Cboe underwent, which resulted in a set of enhanced monitoring and risk management steps. Such steps include far-reaching reporting thresholds, information sharing agreements with spot market platforms, monitoring of and inquiries into anomalous events, close coordination with the CFTC, significant margin requirements and, as now required, disclosure of efforts made to gather and accommodate appropriate input from concerned parties in respect of self-certified products. The CFTC will also review the current framework for new virtual currency products and formulate recommendations for possible further action.

Chairman Clayton said that the SEC is not yet ready to approve virtual currency-based exchange-traded funds (ETFs) or other funds available for retail investors, citing concerns about liquidity, valuation and custody of the funds’ holdings and creation, redemption and arbitrage in the ETF space. While it is not opposed to approving virtual currency-focused funds in the future, the SEC must first address these significant issues. Chairman Clayton invited interested parties desiring to create a virtual currency product to engage with the SEC.

Several Senators shared concerns over regulatory arbitrage in international virtual currency markets. Chairman Clayton and Chairman Giancarlo responded that while regulatory arbitrage is an open issue, they are optimistic that increased cooperation between U.S. regulators and within international bodies such as the Financial Stability Board (FSB) and the International Organization of Securities Commissions (IOSCO) will enhance stability in the global marketplace and assist regulators in achieving their respective aims. On the related topic of sanctions evasion through use of virtual currencies, Chairman Giancarlo affirmed that the CFTC is working closely with the Federal Reserve and Treasury Department’s Financial Crimes Enforcement Network (FinCEN) to develop solutions to potential problems posed by the decentralized nature of virtual currencies.

In light of the Committee’s request for additional information and continuing discussions at the SEC and CFTC on how best to regulate virtual currencies, as well as the ever-changing nature of the virtual currency marketplace, we expect sustained regulatory and legislative activity going forward. We will continue to monitor this topic for further developments.