US Regulatory Crackdown Draws Criticism And Dissent

Our biweekly survey of developments in the future of money

February 21, 2023
Securities and Exchange Commission, SEC, Building in Washington DC.  The SEC regulates stocks and bonds and related financial activities.

Compiled by the Oliver Wyman Forum

A number of regulatory proposals and enforcement actions by the US Securities and Exchange Commission stirred industry opposition and one dissent from within the agency, while the Financial Stability Board warned about the stability risks posed by decentralized finance. These were among the notable recent developments in the future of money.

Policy Front

SEC Proposes Tighter Custody Requirements On Crypto

The US Securities and Exchange Commission (SEC) on Feb. 15, 2023, proposed extending federal custody requirements to cryptoassets and requiring companies to gain or maintain registration in order to serve as custodians.

The proposed rule would require investment advisers such as asset managers and hedge funds to use qualified custodians that undergo annual evaluations by accountants. Those custodians would have to properly segregate client assets and enter into written agreements with customers to provide account statements and other information.

SEC Chair Gary Gensler said the proposed rule would apply to all cryptoassets, whether or not they are considered funds and securities. Some crypto exchanges and lending platforms that claim to custody customers’ crypto are not qualified custodians, he added, and investors have seen their assets commingled and tied up in bankruptcy court following some recent failures. “Based upon how crypto platforms generally operate, investment advisers cannot rely on them as qualified custodians,” Gensler said in a statement.

The proposal was adopted by a 4-1 vote, with Commissioner Hester Peirce dissenting. She said the commission was overstepping its bounds by seeking to impose requirements on custodians, which it does not regulate. She also said the requirements would likely shrink the ranks of qualified custodians and could leave investors worse off.

Jake Chervinsky, head of policy at the Washington-based Blockchain Association, said the proposal was an overreaction by authorities to the failure of FTX and other firms, and that it would hurt primarily US firms seeking a path to regulatory compliance.

Regulator Orders Halt To Minting Of Binance Stablecoin

The New York State Department of Financial Services on Feb. 13, 2023, ordered Paxos Trust Company to stop minting Binance USD (BUSD), one of the leading dollar-based stablecoins, citing “unresolved issues” in Paxos’ oversight of its relationship with Binance.

Paxos also said that the US Securities and Exchange Commission (SEC) had informed it that it was considering acting against the company for not registering BUSD as a security.

BUSD is the third-largest stablecoin behind Tether and USD Coin. Its market capitalization declined by $3 billion, to a little over $13 billion, in the week after the order by New York authorities, according to CoinMarketCap.

SEC Orders Kraken To Stop Offering Staking Services In US

On Feb. 9, 2023, the US Securities and Exchange Commission (SEC) ordered service provider Kraken to stop offering staking services in the United States and pay $30 million in penalties.

Under the staking services, investors lock up their crypto tokens with a blockchain validator with the aim of being rewarded with new tokens. The SEC’s complaint contends that such programs should be registered as securities offerings because investors lose control of their tokens and take on risks with little protection. Intermediaries offering crypto staking or lending services “need to provide the proper disclosures and safeguards required by our securities laws,” SEC Chair Gary Gensler said.  

Commissioner Hester Peirce disagreed with the decision and dissented, contending that staking services have been operating for a long time and the agency should have provided guidance to the industry rather than using enforcement actions to regulate.

Fed Cautions State Banks On Cryptoasset Activities

The US Federal Reserve Board has published interpretative guidance explaining that it would limit state member banks to engage as principal in only those activities that are permissible for national banks, and subject to the same conditions and limitations as national banks, unless the activities are permitted by federal statute or Federal Deposit Insurance Corp. rules. 

In a Feb. 7, 2023, statement, the board said it wanted to clarify its stance because it had received inquiries and proposals from state banks regarding potential engagement in novel activities, including those involving cryptoassets. The board said legal permissibility is a necessary but not sufficient condition to engage in certain activities. It also said that in the case of cryptoassets, banks needed to have in place appropriate systems to monitor and control risks and comply with Bank Secrecy Act requirements and federal sanctions.

The statement said the board would presumptively prohibit state member banks from holding most cryptoassets, including Bitcoin and Ether, as principal. It also said the board reserves the right to treat any asset issued using distributed ledger technology as a cryptoasset, and subject to the same restrictions as other cryptoassets.

FSB Warns On DeFi Stability Risks

Decentralized finance (DeFi), which seeks to replicate some of the functions of the traditional financial system by replacing intermediaries with software protocols, inherits and may amplify the vulnerabilities of the existing system, the Financial Stability Board said in a report published on Feb. 16, 2023.

Vulnerabilities include operational fragilities such as opaque governance, liquidity and maturity mismatches, the outsized impact of leverage, the complexity of interconnectedness, and the concentration of activity in a small number of protocols, the report said.

The FSB should analyze vulnerabilities of the DeFi ecosystem as part of its regular monitoring of cryptoasset markets, work with regulatory authorities to measure and monitor interconnectedness between DeFi and traditional finance, and consider either extending the regulatory perimeter to include DeFi or setting regulatory requirements on traditional financial institutions’ exposure to DeFi, the paper said.

Hong Kong Proposes Licensing Regime For Trading Platforms

The Hong Kong Securities and Futures Commission on Feb. 20, 2023, launched a consultation on proposed rules for virtual asset trading platforms under a new licensing regime, including whether to allow them to serve retail customers.

The proposal would require platforms to assess clients’ risk profiles and set limits to ensure their exposure is “reasonable.” Operators also would have to do due diligence on tokens and provide a compensation arrangement to cover risks.

The licensing regime, which will take effect on June 1, reflects a “clear consensus among regulators globally for regulation in the virtual asset space to ensure investors are adequately protected and key risks are effectively managed,” commission Chief Executive Julie Leung said.

Market Developments

Banks Back Away From Crypto Amid Regulatory Crackdown

US banks are re-evaluating their exposure to the cryptocurrency sector in the wake of recent regulatory moves by the Securities and Exchange Commission in the sector and a January warning by federal banking regulators, the Wall Street Journal reported on Feb. 16, 2023. It cited New York’s Metropolitan Commercial Bank’s announced closure of its crypto business and a decision by Signature Bank to cut ties with the international arm of exchange group Binance.

Hedge Fund Shuts Down Over FTX Exposure

Galois Capital, a hedge fund that had half of its assets trapped on the FTX exchange when it collapsed in November, has decided to close and return remaining funds to investors, the Financial Times reported on Feb. 20, 2023. The crypto-focused quantitative fund had been managing around $200 million last year.

The fund sold its claim on FTX for approximately 16 cents on the dollar rather than pursuing it through the lengthy bankruptcy process, the newspaper reported. In a Twitter thread, Galois said it had lost almost half its assets and sold its claim “for cents on the dollar.”

Siemens Issues Digital Bond On Public Blockchain

Germany’s Siemens issued a 60 million euro ($64 million) digital bond on the Polygon public blockchain, the company announced on Feb. 14, 2023. The one-year bond is one of the first by a major corporation and follows recent issues by entities such as the European Investment Bank and Societe Generale.

Legal Beat

SEC Charges Terraform And CEO Do Kwon With Fraud

The US Securities and Exchange Commission on Feb. 16, 2023, charged Singapore-based Terraform Labs and Chief Executive Do Kwon with orchestrating a multi-billion-dollar securities fraud by misleading investors about the stability of its algorithmic stablecoin Terra USD (UST), among other things.

The defendants misled investors by claiming that Korean mobile payment app Chai was using the Terraform blockchain to settle transactions, which was not the case, and that UST was a triumph of decentralization even as its price was being propped up in 2021 by a secret arrangement with a third party, the complaint said.

UST and its algorithmic counterpart, LUNA, collapsed in May 2022, wiping out more than $40 billion in value. Since then, the complaint alleges that Terraform and Kwon transferred more than 10,000 bitcoin from Terraform and its associated Luna Foundation Guard to an unhosted wallet, and subsequently used a Swiss bank to convert some of that into fiat currency and withdraw more than $100 million. 

Hermes Wins Landmark Lawsuit Against NFT Artist

Hermes won a lawsuit against artist Mason Rothschild that could extend intellectual property rights (IPR) to digital assets.

The French fashion company claimed Rothschild had infringed on its intellectual property by selling non-fungible tokens (NFTs) featuring digital representations of Hermes’ Birkin handbags. On Feb. 8, 2023, the jury in the New York trial awarded Hermes $110,000 for IPR infringement and $23,000 for using a website domain name confusingly similar to that of the fashion company.

Lawyers for Rothschild, who in 2021 took in 200 Ether (then worth nearly $800,000) from the sale of NFTs he dubbed MetaBirkins, had argued that he was exercising his right to artistic expression under the US Constitution’s First Amendment.