Regulating the New Crypto Ecosystem: SEC Commissioner Hon. Hester M. Peirce

Cryptocurrency. Decentralized finance. Nonfungible tokens. Once only experts on the cutting edge of financial services were familiar with these terms. Now, with the emergence of digital assets within the global financial system, crypto, DeFi, and NFTs are becoming part of the mainstream financial services lexicon.

The rapidly emerging crypto ecosystem faces uncertainty within a regulatory regime designed for very different institutions and securities. In response, on March 9, 2022, President Biden issued an executive order, “Ensuring Responsible Development of Digital Assets,” which ordered agencies to submit policy recommendations based upon multiple principles such as: providing consumer protection, ensuring U.S. financial system stability, mitigating systemic financial risk, responsibly developing digital assets, and examining the creation of a U.S. Central Bank Digital Currency (CBDC). Supporters of increased financial regulation over cryptocurrency see this as a necessity to provide security essential to ensuring financial stability and consumer protection within the digital asset space. Others view these federal regulatory efforts as a threat to future opportunities for economic innovation.

At a live Regulatory Transparency Project event, SEC Commissioner Hester M. Peirce addressed current and future efforts at regulation of cryptocurrency and its implications for innovation, financial stability, and consumer protection. An expert panel including Jerry Brito, Ryan Selkis, Todd Phillips, and moderator by J.W. Verret then followed the Commissioner’s remarks with a lively panel discussion.

Transcript

Although this transcript is largely accurate, in some cases it could be incomplete or inaccurate due to inaudible passages or transcription errors.

[Music]

 

Introduction: On June 14, 2022, The Federalist Society’s Regulatory Transparency Project hosted an in-person event on regulating the new crypto ecosystem. The event featured remarks from SEC Commissioner Hester M. Peirce. The following are those remarks. Please enjoy.

 

Host:  We are happy that you have joined us for today’s event, “The New Crypto Ecosystem: Necessary Regulation or Crippling Future Innovation?” We look forward to remarks today from SEC Commissioner Hester M. Peirce, and the panel to follow. Check out future events and content at RegProject.org, that’s RegProject.org. First, I would like to introduce today’s moderator, J.W. Verret, who is the Chair of the Regulatory Transparency Project’s Financial Services and Corporate Governance working group.

 

J.W. is an expert in banking, securities, and corporate law. He teaches on those topics at the Antonin Scalia Law School at George Mason University. He is a graduate of Louisiana State University, Harvard Law School, and the Kennedy School of Government. I encourage you to read more about all of J.W.’s many contributions and accomplishments online at Fed.Soc.org. J.W., I will now turn it over to you.

 

Prof. J.W. Verret:  Thank you, appreciate that. As I introduce today’s discussion, I want to ask a question, open with a quick question: Why do we care about crypto, cryptocurrency? Why do we care? Do we care because it’s the next big thing? Do we care because of the celebrity endorsements, Super Bowl ads? No. Do we care because it’s the next thing to speculate on, and we like when number goes up? All little bit, yes, absolutely. But let me submit that the reason why, at least; I care, and why I think we should care, is because of the central tenet of this new burgeoning industry, which seems to me to be that decentralized computing power can translate to decentralized economic and political power.

 

If economic transactions or communications can take place in a peer-to-peer way — of course peer-to-peer predated crypto, but now watching applications can really make it sing. If economic transactions can take place in a way that is computed across decentralized computers, thousands of them across the globe, then there is no central party that can stop that transaction from taking place, that can censor economic transactions between willing parties, or that can charge economic rents for the privilege of doing so. 

 

And when that decentralized computing power translates to decentralized economic and political power, it empowers the individual. And, in that way, I think FedSoc has a lot in common with crypto, actually. First of all, FedSoc operates in a decentralized way. We’re a decentralized group. The practice groups create the programming. Gene and Dean are here to help facilitate, as they’ll probably tell you. And they do a great job. And, by the way, thanks to all of our FedSoc team here for helping set this up. That’s how they operate. But, even more importantly, let’s remember the book we all revere, that FedSoc’s named after. The Federalist Papers is a book about decentralized power, isn’t it?

 

It’s a book about decentralized power at the federal level, separation of powers, keeping all three branches in check, and, more importantly, it’s a book about the decentralization of power through recognizing the states as sovereign in the constitutional structure; the states, as laboratories of democracy, laboratories of economic invention. I think the founders, today, would have loved crypto if they were alive. 

 

No question but that Ben Franklin would have a crypto project he’d be hawking in the tavern in Pennsylvania. No question, but that Thomas Jefferson would have some crypto application for agricultural processes or for trade. Alexander Hamilton would have been all over it. He would have had a crypto exchange, and a crypto bank. 

 

So I think all of these things are fascinating. Now, what’s the threat to crypto right now? That not all projects lived up to that ideal. Some of them are very centralized. Some of them are very centralized scams. Some of them are centralized earnest attempts that have horrible operational security, and a lot of hacks. Believe me, I know about all of these, because I’ve been a prolific investor in many of them. On the other hand, so what’s to do about that? On the other hand, I teach the ’33 Act, the Securities Act of 1933. It’s the one thing I know a lot about.

 

Simple cookie cutter application of the ’33 Act to crypto, brings on some incredibly ridiculous consequences. We laugh about it in securities class. My students laugh about it. Treating a kid running a miner in their basement, or a validator in their basement is treated like an underwriter, for the purposes of securities laws. The same regulatory regime for J.P. Morgan will apply to that kid in their basement — utterly ridiculous. So, what’s to be done about this? How to balance investor protection with investor innovation and investor freedom, to help to facilitate this movement that’s all about decentralization of power. 

 

I know of no one in the world who’s spent more time thinking about balancing that balance with more technical skill, with more commitment to both investor protection, and investor freedom and opportunity than Commissioner Peirce. That’s why it’s my great privilege to introduce her today, to today’s discussion. We’ll have a discussion panel that follows. Those in the audience, get ready. The Commissioner loves to take a few questions. Our panel will love to get a few questions as well. 

 

Commissioner Peirce needs no introduction. She’s been around FedSoc events for a while. But I’ll just offer. Before, she served on the Commission for a number of years, and has been a thought leader on cryptocurrency regulation through dissents and speeches, and in a number of venues. She served as a scholar at the Mercatus Center. She’s been Counsel to the Senate Banking Committee during the Dodd-Frank Act. She’s been Counsel to Commissioner Atkins, and Counsel in the SEC for over a decade. 

 

Let me stop talking here, because you know who we’re here to listen to. Please join me in welcoming Commissioner Hester Peirce.

 

Hon. Hester Peirce:  Thanks J.W. I think it’s nice to have that kind of broad overview. I’m going to be talking about a much more specific issue today, and so I think it’s good to bear in mind that broader, more conceptual framework. And I want to thank The Federalist Society, the Regulatory Transparency Project, for the chance to be with you all today. The topic of today’s event is regulating the new crypto ecosystem. And that’s certainly a very hot topic of conversation in Washington these days. 

 

And it reminds me of this book that’s a children’s book, but it’s a book called Are You My Mother? And it’s about a little bird who is — the bird hatches. His mother’s run out, or flown out, to go pick up a worm for him. And, so, when he hatches, he’s there all by himself, no mom. And so, he hops down from the tree. He doesn’t know how to fly yet, so he’s walking around and checking in with different potential mothers. 

 

And so first goes up to a cat, and the cat says, “I’m a cat. I’m not your mother.” Goes to a dog and a hen and a cow and even a front-end loader. No mom. The front-end loader does him the service of putting him back in the nest. So, when the mom comes back, baby bird and his actual mother are reunited, and he knows right away that’s his mom.

 

So the crypto industry is on a similar journey. It doesn’t seem to be in need of a mother, but it is out looking for a regulator. And I feel like it’s a similar search, keeps going up to different regulators and asking, “Are you my regulator?” But there’s a bureaucratic twist on it. It’s Washington, right? So, of course, every regulator says, “Oh, yeah, I’m your regulator.” So everyone is claiming to be the regulator of crypto. 

 

And so crypto is looking to Congress to kind of sort these things out, figure out who is actually the regulator. And there is a bipartisan bill that got a lot of attention last week, was introduced. And it attempts to answer that question. Some people in the crypto industry are celebrating, because they like the allocation of power in that bill. Certain authorities are at the SEC, but certain other authorities are at the Commodity Futures Trading Commission. 

 

And a lot of people are happy that more of the authorities didn’t end up at the SEC, because they’ve been really disappointed at how my agency, the SEC, has interacted with the crypto industry and has regulated crypto. And I understand and share that disappointment. But I’m hopeful that we can change course and use our existing authorities better. And any authorities Congress might give to us through new legislation, I hope that we’ll use that authority better, as well. 

 

Watching the SEC refuse — over the past four years, which is how long I’ve been there — to engage productively with crypto users and developers, has prompted feelings of disbelief at the SEC’s puzzling, and, I think, out of character approach to regulation. The Commission, of course, has occasionally explained its actions or its inactions. But those explanations have often been confusing, inconsistent, and unhelpful. I’ve communicated my discomfort with the Commission’s behavior to my colleagues, to the public. And the results, to date, seem to be about the same as they’ve been over the past four years, which is poor.

 

We continue to brush off the crypto products and services, without a consideration for the consequences of what we’re doing. And so I want to talk about one concrete example today. And that’s the Commission’s persistent refusal to approve a spot Bitcoin exchange-traded product. But, of course, I’ve got to give you my disclaimers before going any further. 

 

And so the first is the standard disclaimer that I always give, which is that my views are my own views, not necessarily those of the SEC or my fellow Commissioners. But I want to give you some other disclaimers too. This speech is not an endorsement of Bitcoin, Bitcoin exchange-traded products, or any other crypto-related asset. People exercising skepticism great enough to quell the dangerously seductive fear of missing out — J.W., that’s for you — should choose what to put in their portfolios when, and in what quantities.

 

Whether assisted by a financial professional or flying solo, investors should invest based on factors such as their own present and anticipated future circumstances, informed risk assessments of the assets they’re considering buying, and the portfolio in which those assets will sit, and a candid assessment of their stomach for market volatility and financial loss. They should be aware, as recent events have reminded us, that past performance is no guarantee of future performance. And people shouldn’t look to regulators to make decisions for them, and regulators should not seek to play that role themselves.

 

My third disclaimer is that, although many of the early Bitcoin exchange-traded product denials were issued by the staff, under authority delegated from the Commission, my criticism about these denials, and about other policy decisions, are leveled at the Commission, and not at the staff. The staff is appropriately following the lead that it’s getting from the Commission, but the Commission has not been leading well. 

 

The Commission’s resistance to a spot Bitcoin ETP is becoming almost legendary. “When is the Commission going to approve a Bitcoin ETP?” is the most common question that I’ve gotten in my entire tenure at the SEC. It continues to be the most frequent question. And my answer has tended to be a disappointed, “I have no idea.” Bitcoin is a relatively new asset, but the concept of affording access to commodities through an exchange-traded product is not new. 

 

The Commission long has allowed investors to gain exposure to a number of non-securities instruments through pooled investment vehicles. And that’s been a boon to investors, as their shares trade continually on national stock exchanges at market prices, much as a regular stock would trade. Through a process of creating and redeeming shares of the fund, institutional traders, called “authorized participants” play an important role in keeping the price of these shares in line with the price of assets in the investment pool. 

 

The Commission has added crypto-specific hurdles to what used to be fairly straightforward processes for approving these pooled investment vehicles. Whether exchange-traded funds under the Investment Company Act, or exchange-traded products under the Securities Act, indeed, although in the past eight months both ETFs and ETPs based on Bitcoin futures have made it through, the Commission has continued to disapprove ETPs, based on the spot Bitcoin market. 

 

The reasons for this resistance to a spot product are difficult to understand, apart from a recognition that the Commission has determined to subject anything related to Bitcoin, and, presumably, other digital assets, to a more exacting standard than it applies to other products. 

 

In a 2018 letter, for example, the staff in the Division of Investment Management expressed a willingness to engage with fund sponsors interested in incorporating crypto assets into their funds, but it outlined “significant outstanding questions concerning how funds holding substantial amounts of cryptocurrencies and related products would satisfy the requirement of the 1940 Act and its rules, those questions related to custody, valuation, liquidity, the arbitrage mechanism for ETFs, and manipulation and other risks.” 

 

Asking these questions isn’t inherently problematic, and might even be characterized as positive, because it sparks thinking about really important questions. But the Commission gave very few explicit external indications of progress on grappling with these issues, let alone resolving them. Retail funds that tried to incorporate exposure to Bitcoin into their portfolios encountered a series of challenges. 

 

The disclosure review process plays an important investor protection role, but the Commission has many polite ways of exercising merit regulation, often without a clear legal basis for doing so. Certain funds looked for ways to get exposure to Bitcoin for their investors, such as holding over-the-counter products, companies with crypto exposure, or putting small sleeves of Bitcoin futures into their portfolios. 

 

Closed-end funds, which don’t provide daily redemption, were the first to be able to incorporate Bitcoin futures. But, even as late as May 2021, the staff reminded closed-end funds seeking to invest in the Bitcoin futures market to consult with the staff prior to filing a registration statement about the fund’s proposed investment, anticipated compliance with the Investment Company Act and its rules, and how the fund would provide for appropriate investor protection. Now, this is unusual, because there’s no requirement that you seek approval before you make a filing. 

 

And, with respect to open-end funds, the statement warned that the staff would monitor the quality of the underlying Bitcoin futures market and funds ongoing compliance with the Investment Company Act and the rules thereunder, and the other federal securities laws. Again, this is very unusual, because, you’ve got to remember, when you file something, what the SEC is looking for is they’re looking to make sure that your disclosures match what you’re actually doing. 

 

But, here, the Commission was taking a step beyond that, and it’s saying it’s watching what’s happening in the markets. Again, not a problem that it’s watching what happens in the markets. But my issue with what was going on, it was an attempt to step into the shoes of the marketplace to assess whether a product would work. Then we’ve gone too far. That’s up to the market to decide. We just have to make sure the disclosures are right, and then let the market figure it out. 

 

Although a number of funds manage to hold Bitcoin futures, many sponsors wanted to provide exposure to Bitcoin in an exchange-traded form. The Commission continued to signal to would-be sponsors of such products, “Don’t file.” In October 2021, however, everything changed. The SEC finally allowed futures-based Bitcoin ETFs to start trading. And what made that change? Well, Chair Gensler gave a speech, in which he gave a signal saying, “I think a product under the Investment Company Act, with Bitcoin futures in it, would be okay.” 

 

And he cited the fact that the CFTC oversees the futures market and that this Investment Company Act — these Investment Company Act protections, that come with an ETF, would make him comfortable. And, so, some of these funds started trading. They proved popular, but demand for a spot-based product continued to be out there, because futures products are more expensive and difficult to manage, and they don’t necessarily track as closely the spot price. 

 

So, until this year, all of these products, the futures exchange-traded products, were under the Investment Company Act, which is the one that has these protections for investors. And, in April, there was a new development, which was that the Commission approved the first ETP holding Bitcoin futures, under the Securities Act. And so that implicitly acknowledged that the protections afforded by the Investment Company Act are not relevant to the question of whether approval under the Exchange Act is appropriate. 

 

The protections the Investment Company Act affords are, as industry commenters have highlighted, designed and intended to protect investors against self-interested managers. It really has nothing to do with how the product trades. In other words, as another commenter described, the 1940 Act’s protections do not address, and thus are not relevant to, the concern the Commission has repeatedly invoked when it’s denying spot-based Bitcoin exchange-traded products.

 

And those concerns are market manipulation and fraud in the underlying Bitcoin market. Some observers found this development a notable development, because spot-based products would be also under the Securities Act, rather than the Investment Company Act. But the Commission still has not approved any ETP based on the spot bitcoin market. Despite the success of futures-based ETP applicants over the past eight months, using the same tired reasoning, the Commission keeps denying spot Bitcoin ETPs. 

 

The Commission requires an applicant, which is the exchange on which the ETP is going to trade, that that applicant has to come in and show that its proposal is consistent with the requirements of Exchange Act Section 6(b)(5), and, in particular, with the requirement that the rules of the National Securities Exchange be designed to prevent fraudulent and manipulative acts and practices, and to protect investors in the public interest.

 

In demonstrating consistency with Section 6(b)(5), the exchange applying to list the ETP has a choice. It can either show a surveillance agreement, or a unique resistance to manipulation. The first option is for the exchange to show that it has a comprehensive surveillance-sharing agreement with a regulated market, or a group of markets of significant size. An acceptable surveillance-sharing agreement would provide for the unimpeded sharing of information about market-trading activity, clearing activity, and customer identity. 

 

Significant market size is determined, for example, by showing a reasonable likelihood that a person attempting to manipulate the ETP would have to trade on that market to successfully manipulate the ETP. Only then would a surveillance-sharing agreement assist in detecting and deterring misconduct. 

 

One way that a market could count as being of significant size is if it’s reasonably likely that a person seeking to manipulate the ETP would also have to trade on that market to succeed in doing so, and if trading in the ETP would be unlikely to be the predominant influence on prices in the market. So this is all very technical, but this is the kind of procedures that people have to get through. 

 

So, another option would be the exchange seeking to list the ETP could show that the underlying Bitcoin markets are uniquely resistant to fraud and manipulation. The standard requires a level of resistance higher than what exists in traditional commodity markets or equity markets. According to a majority of the Commission, no exchange successfully has made the case under either approach. An ETP disapproval order issued last month embodies the now-standard rationale. The exchange here opted for alternative two, showing that the Bitcoin markets are uniquely resistant to fraud and manipulation. 

 

And the Commission said, “As with the previous proposals, the Commission here concludes that the exchange’s assertions about the general liquidity, growth, and acceptance of the Bitcoin market do not constitute other means to prevent fraud and manipulation sufficient to justify dispensing with the requisite surveillance-sharing agreement. While the exchange states that the significant liquidity in the spot market and resultant minimal impact of market orders on the overall price of Bitcoin mitigates the risks associated with potential manipulation, such assertion is general and conclusory.” End of story.

 

The reasoning, though, underlying the Commission’s denials of spot Bitcoin ETPs is, in my view, general and conclusory, which makes it difficult to know how approval could ever be achieved. The Commission doesn’t really grapple with the important characteristics of these products in the underlying spot markets, including the widely distributed nature of trading in Bitcoin, and the methods used by these ETPs to calculate the net asset value. It doesn’t take into account the evidence from other jurisdictions where regulators have approved similar products.

 

Absent a wholesale rejection of the standard analysis, how does the Commission put itself in a position where it could approve these products? With each new disapproval, the SEC doubles down on its reasoning. The continuing refusal of the SEC to approve a spot Bitcoin ETP is puzzling, not only to me, but to many agency observers. The Bitcoin market has grown, matured, become more liquid, and attracted more and more sophisticated in the TradFi — traditional financial market sense of the word — participants.

 

At 13 years old — as of about an hour or so ago, which may have changed — Bitcoin has a market cap of approximately 430 billion and is trading at around $22,500. Bitcoin investors comprise natural persons and institutions, including regulated market participants. Many insurance companies, asset managers, university endowments, pension funds, large banks and public companies have invested in Bitcoin, or are considering doing so. Increasingly sophisticated infrastructure has built up around Bitcoin, and crypto markets, more generally. 

 

Like the traditional financial market landscape, the crypto terrain is dotted with trading platforms, trading firms, venture capital firms, hedge funds, law firms, and accounting firms. 

In contrast to 2018, when the division of investment management noted there was an absence of custodians in the space, custodians now compete to offer their services. A cornerstone of institutional participation, the Bitcoin futures market has been up and running since 2017, and that’s a vibrant market now, with open interest hovering around $1.7 billion. 

 

Spot ETPs have launched in other countries without incident, but with great investor interest. In Canada, for example, the first spot Bitcoin ETP reached a billion Canadian dollars within a month of its launch. Spot crypto ETPs are also popular in Europe, where there are more than 70 crypto ETPs, with an estimated total of 7 billion in assets. ETPs in these other jurisdictions have functioned, even in volatile market conditions. 

 

So why is the SEC a holdout? At what point, if any, does the increasing maturity of the Bitcoin markets and the success of similar products elsewhere tip the scale in favor of approval? Of course, the facts and circumstances of each application matter, but will I ever stop hearing that question that I keep hearing, “When a spot ETP?”

 

The approval of futures-based products — first, under the Investment Company Act, and, more recently of a similar Securities Act product for listing and trading under the Exchange Act — might appear to open a door to changing the approach that we’ve taken. But the language of these orders provides precious little basis for optimism that the Commission will approve a spot Bitcoin product. And, again, I don’t have any insight, I’m just saying, I’m reading the same orders everyone else is reading. 

 

The futures-based approvals turn on the regulated nature of the futures market, the CME, which is where assets held by the ETPs, themselves, trade. The Commission explained, somewhat tautologically, that the CME can reasonably be relied on to capture the effects on the CME Bitcoin futures market caused by a person attempting to manipulate the proposed futures ETP, by manipulating the price of CME Bitcoin futures contracts. A little hard to follow, but that’s kind of standard fare for these ETP approvals or denials.

 

The reasoning obviously doesn’t apply to spot-based products. And it’s difficult to see how it’s even relevant for an instrument that trades on hundreds of exchanges worldwide. It’s true that, in these approvals, the Commission reiterated its position that its concerns about the lack of a surveillance-sharing agreement in filings seeking to list and trade spot-based ETPs could be addressed by demonstrating that there is a reasonable likelihood that a person attempting to manipulate the spot Bitcoin ETP would also have to trade on CME, which is the futures exchange.

 

But the Commission also went out of its way to state that the evidence doesn’t demonstrate that this type of connection between the two markets exists, an observation that wasn’t necessary. It was kind of dicta to the Commission’s approval of the futures-based ETPs. Perhaps the Commission could be persuaded that the similarity of pricing mechanisms for the futures-based product and the spot-based product undermines its rationale for treating them differently. 

 

The Commission’s willingness to be persuaded, though, turns on whether the Commission’s primary concern is legal and logical coherence with our approvals of Bitcoin futures products, and other commodity-based products, and not, say, using the prospect of a spot Bitcoin ETP approval as an inducement to get exchanges to come in and register with us. Why does this matter? Investors might prefer a spot Bitcoin ETP to other options, and we ought to care about what investors want. 

 

This kind of product, depending on how it’s designed, could enable retail investors to gain exposure to Bitcoin through a securities product that, because of the effective arbitrage mechanisms that go with this kind of exchange-traded product, likely would track the price of spot Bitcoin more closely. It likely would be inexpensive to manage such a fund, so fees would likely be low. It would sit conveniently in investor’s brokerage accounts, alongside other securities that would allow investors to buy and sell their Bitcoin exposure, the same way they buy and sell other exchange-listed products.

 

Investment advisors also would find it easier to assist clients. And more and more investment advisors are hearing from clients’ questions and interest in Bitcoin. So it would help them assist clients as well, who are seeking to get exposure. And it would do so through a product that they’re familiar with. Some people might object to retail exposure to Bitcoin, and, thus, might oppose a product that makes it easier for retail investors to get exposure to Bitcoin. Making it harder to access Bitcoin, however, does not mean investors will not find other ways of doing so. 

 

Some do, and, of course, can hold Bitcoin directly. For the reasons I mentioned above, however, many investors want to get exposure to Bitcoin through the same way they get exposure in other areas of their securities portfolio. They have several options for doing so, but the methods can be a less direct and more expensive way to get exposure to Bitcoin. So they can hold shares of a fund that has a small chunk of Bitcoin futures exposure. They can buy over-the-counter products that lack arbitrage mechanisms to keep the prices in line with underlying spot prices. 

 

They can buy a foreign spot-based ETP, which are generally unavailable or difficult for retail investors to obtain. They can buy a futures-based ETP, which, again, is likely to have some tracking difficulties, and could be more expensive. So, are we really serving investors by keeping them from a product that not only gives them the exposure they’re trying to get, but does it in a way that is more convenient, and, perhaps, less expensive? The Commission thinks those arguments are irrelevant. 

 

So, other people might object to a spot ETP on the ground that its advocates stand to gain a tremendous amount when a spot ETP launches. And that is certainly true, that many advocates of a spot ETP are Bitcoin investors who would like to see the number go up. And ETP certainly could influence the price of Bitcoin. But Bitcoin markets do not always perform as people anticipate. A spot-based ETP, because of the ease with which it can be bought and sold, would be a way for many more voices to weigh in on the value of Bitcoin. 

 

Other types of ETPs have helped markets more efficiently incorporate information. Critics, therefore, can take comfort in the contribution that liquid efficient markets play in working out the real value of assets, whether they are shares of a company, gold, or Bitcoin. Some Bitcoin HODLers might, themselves, object to the introduction of a Bitcoin ETP. One feature of a non-sovereign censorship-resistant mechanism for storing and transferring value is its ability to function outside of the traditional financial system. 

 

Why drag it inside TradFi, and thus expose it to the meddling of incumbent financial firms, and the regulators that inevitably go with those firms? To these people I say, the concern for liberty and personal autonomy that drives you to prefer “we ought,” to “fiat,” ought also cause you to reject a government arbitrarily limiting people’s investment options.

 

The Commission’s reluctance to approve a spot-Bitcoin ETP is of a piece with its more general approach to building a regulatory framework for crypto, using standard regulatory processes. Instead, the Commission has tried to cobble together a regulatory framework through enforcement actions. Enforcement is the appropriate tool to address the rampant fraud in the crypto space. But one-off enforcement actions that represent the first time the Commission has addressed a particular issue publicly are not the right way to build a regulatory framework. 

 

For that, Congress gave us other tools, including authority to craft tailored exemptions and notice-and-comment rulemaking. Enforcement actions shortcut the regulatory process. So, take an example, the recent $100 million BlockFi settlement. That was a settlement that the Commission and a number of state regulators brought. The Commission’s piece was 100 million. The Commission, in its settlement, set out a path, pursuant to which BlockFi could register under the Securities Act, and obtain an exemption from the Investment Company Act.

 

The specific path laid out in that settlement agreement crafted between BlockFi, one company, and the SEC — and keep in mind where the leverage was in that negotiation — if successful, that’s likely to become the standard for regulation of crypto-lending. Other crypto lenders, users of those services, consumer advocates, and other interested parties were not part of those negotiations. But the results will likely affect them. 

 

A preferable approach would have been, once we identified crypto lending as implicating the securities laws, to commence a rulemaking or invite crypto lenders to come in and discuss the appropriate path forward, through careful use of our exemptive authority. We might similarly consider, rather than a reactive enforcement approach, a proactive regulatory approach with respect to nonfungible tokens, decentralized autonomous organizations, and decentralized exchanges. People doing things in crypto need to consider whether the laws, including securities laws, apply to what they do. 

 

For this to happen, though, in a more efficient and comprehensive way, the Commission needs to provide a level of clarity that has heretofore been absent. The SEC could think through issues with people in the crypto community with an eye toward achieving our regulatory objectives in a pragmatic but effective way. By doing so, we could both facilitate good actors’ compliance, and, importantly, inhibit bad actors much more effectively than we do through the resource-intensive, often-delayed enforcement approach that we’ve taken so far. 

 

We have a number of suggestions and examples of how to proceed that we can draw from. My colleague, Commissioner Crenshaw set up a special mailbox through which she solicited commentary about decentralized finance issues. Why not make that a Commission-wide request for input? J.W. Verret, in a recent petition to the Commission, recommended a starting point: open a comment file so that people could discuss open questions about how to reconcile our securities laws with today’s technologies. A small step, but a potentially important one.

 

The Financial Accounting Standards Board, having heard a lot of concern about the current accounting standards for digital assets, recently opened a project to improve financial reporting for digital assets, including recognition, measurement, presentation, and disclosure. Another great example of the way to move forward in this area. A group of crypto lawyers has put together a number of concrete proposals, an iteration on a safe harbor proposal that I made, and also an exempt offering framework for digital assets that could be starting points for the Commission to engage with not only industry, but investors, advocates for investors, anyone else who’s interested. We could have this open conversation.

 

Recently, CFTC Commissioner Pham and I called for joint roundtables with the CFTC and the SEC. The two agencies have worked well together — sometimes not well, but sometimes we do have examples of working well together in the past, where our jurisdictions bump up against each other. This is another opportunity for us to do that. Congress is doing its thing, but, we, as regulatory agencies can be working together to give them a basis on which to consider how to move forward. I think this would be an extremely productive exercise, and one that would certainly capitalize on people’s willingness to work with us. And I think that came through in a recent rule proposal in the comments, in response to a recent rule proposal we put forth.

 

That was a rule proposal where people looked at it and they were concerned that maybe this isn’t sort of an indirect way to regulate certain aspects of DeFi and crypto. And, so, people came in and they talked to us, and they — by letter — they told us they’re willing to work with us to figure out what the right approach is. But the right approach is not to adopt a rule without having the conversation that you need to have. People stand ready to work through myriad questions and regulatory concerns around crypto. Now all we have to do is extend them a hand. 

 

So I’ll conclude with just saying, although I’ve been quite critical of the SEC’s approach, I’m optimistic that we can change course. The agency just celebrated its 88th birthday last week. There’s no better age than 88 to start grappling with difficult, interesting regulatory questions around crypto to keep our mind sharp. Regardless of what one thinks of crypto, it’s in both investors’ and the SEC’s interest to take a more productive approach. Using tools that Congress has given us, and drawing on public input, we can provide regulatory clarity, facilitate iterative experimentation. And that’s an important part of it, because things are going to fail in this space. We all know that. 

 

But you’ve got to let people try to iterate on what others have done and move forward that way. And together we can also pursue bad actors in the crypto space. Again, having a regulatory framework in place is really important, because lawyers out there have nothing to point at but enforcement actions. They can’t point to something to say, “This is the way you need to do something.”

 

So I’m looking forward to the upcoming panel. I think we’ve got a great set of people on that panel who is going to be able to help us think through some productive steps forward, and I look forward to learning from what you all have to say. Thank you.

 

Prof. J.W. Verret:  Does anybody have any questions?  Got a mic right here. Hey, Berlau, why don’t you come. . . 

 

John Berlau:  Yes.

 

Prof. J.W. Verret:  John Berlau, a FedSoc member. He’s written a book on George Washington recently, that you should all read. It talks about how George Washington used private money.

 

John Berlau:  A recent column, too, on George Washington and crypto, and how he used cryptography with the Secret Six. So he would also be fascinated about it, I think. Commissioner Peirce, it’s always a pleasure to hear your lively and informative writings and speeches, because I am with the Competitive Enterprise Institute. Two questions, one is technical. My colleagues and I were just talking about just the definition of ETPs and ETFs. And, in this space, so far, are all of the ETPs also ETFs, exchange created funds? Because I don’t believe the notes are there. 

 

And, also, given recently what’s happened with Binance and Celsius, and freezing redemptions on some the exchanges where you buy the cryptocurrencies raw. What would be — I wanted to drill down a little about what would some of the investor protection benefits would have on having an ETP or ETF as an option. Are there guarantees of custody that they actually have to hold the crypto or whatever asset there is, required by law? Not that it would guarantee against going down in price or anything. But it would have to be there, belonging to the investors in the ETP or ETF.

 

Hon. Hester M. Peirce:  So, to answer your first question — and this is complicated — people often say, “When is there going to be a spot Bitcoin, or Bitcoin ETF?” is kind of the question. And what they’re really asking is, “When is there going to be a spot-based exchange-traded product?” So, an ETF, an exchange-traded fund, is something — it’s a type of investment company under the Investment Company Act of 1940, which comes with a whole suite of investor protections. 

 

That’s something that — I actually like to point to that as an example of how long — I mean, I’ve said that our behavior, with respect to crypto is uncharacteristic of the SEC. But there is a broader problem at the SEC in facilitating or setting the groundwork for innovation, with respect to securities products. So, exchange-traded funds were this huge innovation, because it’s like a mutual fund, but it trades on an exchange. So you can buy and sell anytime you want, and it’s a really effective way of keeping the price of the fund in line with what’s in the underlying basket. 

 

That took us twenty-five years to get a rule for ETFs on the books. There are a lot of other things that happened in the interim, but I think that’s an example of how long some of these things can take. Anyway, so the funds that have been approved, the futures-based funds, some of them, most of them, have been under the Investment Company Act, so they’ve been ETFs. Recently, there have been a couple that have gotten approved that are ETPs. These are funds that are under the Securities Act. And they do not have that suite of investor protections around them that an ETF would have. If there’s going to be an approval of a spot, a Bitcoin product, it will likely be in the form of a 33 Act exchange-traded product.

 

So, to your question of what kind of investor protections does that afford, I mean, these are products that we have lots of experience with. And so, there are disclosures around what the product is, and how it operates. And so, it’s a tried-and-true animal. It’s something that people are comfortable with. So that’s why I think there’s a lot of comfort. I’m, of course, not going to talk about any particular companies or projects and what’s going on there.

 

John Berlau:  Would there be — not like any kind of guarantee of the value, but, like, the promises, as far as keeping custody, as far as —

 

Hon. Hester M. Peirce:  Yeah, I mean these are much more — there are institutional protections built around them that give the retail investor a lot of comfort, to answer you. So, thanks John.

 

John Berlau:  Okay. Thank you, thank you so much again.

 

Hon. Hester M. Peirce:  Thanks John.

 

Bert Ely:  Madame Commissioner, thank you very much for being here. Crypto currencies have really taken off in a very low-interest-rate environment. We’re now in a situation where interest rates are starting to rise. Every indication is that they’re going to continue to go much higher, which raises this question: what are the regulatory challenges that would be posed in regulating Bitcoin and the other cryptocurrencies in a high-interest rate environment, where, for investors, there is a relatively high opportunity cost of holding a non-interest-bearing cryptocurrency, which, in my opinion, might lead some innovators to try and figure out some way of paying interest, or something equivalent to interest, on a cryptocurrency, in order to retain investor interest in it? To what extent have you and others at the SEC started to think about how you will regulate cryptocurrencies in a high-interest-rate environment?

 

Hon. Hester M. Peirce:  Yeah, I mean, it’s an interesting question. I think the thing I will come back to is to say that our job is not to tell you whether it’s something that you should invest in or not invest in, although, we certainly put out lots of warnings about the risks and volatility and so forth. But I think where it would come in is the question of how are you making disclosures around a product that has Bitcoin in it? What are the risks that you’re laying out? 

 

And, obviously, there’s a lot of thinking going around how you can make a crypto product that’s interest-bearing. There are existing products that are doing that now. But I think that that’s the answer, is it would be through disclosure of risks, rather than telling people they can’t participate in products that have Bitcoin or other crypto in them.

 

Prof. J.W. Verret:  All right. We have time for one more question.

 

Questioner 3:  Hi, Commissioner. You have — well, thank you for your talk today. You have also, in addition to being critical of the SEC about exchange-traded products, you have also been critical about ESG issues. And I was wondering if you saw any confluence of these two issues coming together. For instance, I could imagine the SEC putting out a rule about diversity requirements for exchanges, or for tokens, or even sort of environmental disclosures related to proof of work for Bitcoin, to sort of take that out of the marketplace and make everything proof of stakes. So, I was wondering if you saw any confluence between ESG issues and the crypto market in general.

 

Hon. Hester M. Peirce:  Well, I think the ESG term, “Environmental Social Governance,” or everything that sounds good, can encompass so many different things. And so, what I think you’re putting your finger on is that, as in this area where — one of the things that I have tried to push back against in my role as a Commissioner is merit regulation, because we’re not a merit regulator. Some other securities regulators are merit regulators. We are not. That’s not what Congress told us to do.

 

And there has been, — over my time there at the SEC, there have been numerous instances in which we’ve tried to use our authority, that’s designed as disclosure authority, to be merit-based regulation, substantive regulation. And so, I can see that we could use our disclosure authority in ways that would be designed to get a focus on particular areas in crypto. The energy one is a common one that people talk about now. People think that energy shouldn’t be used on Bitcoin mining, for example. And so you could use a disclosure rule to try to highlight it, but to actually try to stop people from using — from doing Bitcoin mining. 

 

And so, certainly, we’re seeing that on the climate side, where we put out a proposal that is a disclosure proposal, but is certainly, at least, appears to me, I should say — and again, we’re in a comment period, so I welcome anyone’s comments — tell me I’m wrong about this, but when we put in the rule, and we say, “Well, we realize it’s going to be really hard to measure your Scope 3 greenhouse gas emissions. One solution would be for you to make a different product.” What? The SEC, a disclosure regulator, is suggesting to people that they make a different product so they don’t have to make a particular disclosure to us? 

 

That’s a remarkable statement. And I think it’s an area that people really need to be focused on. The misuse of a very effective disclosure framework to affect people’s behavior substantively, that’s just not our role. And if it does start to become our role, we’re going to become a hyper-politicized regulator. And that breaks my heart. Because the SEC has a really important role to play in keeping capital markets functioning effectively. The capital markets in the United States are the best in the world. And there’s a reason that they’re the best in the world. And injecting politics into everything that we do is a terrible idea. 

 

And I hope that we’re able to resist the urge, whether it’s in the crypto area, or in green finance, or any other area. Markets are wonderful at solving problems. We just have to let them disclose what they’re doing, and then let them figure it out. They can solve problems in ways that we’re, as regulators, and even — any one person in this room wouldn’t be able to solve problems. It’s when you put people together in the capital markets that you get the brilliant combination of the money and the innovative ideas. They come together and they produce things none of us could, on our own, imagine. So, I will end with that note. 

 

Prof. J.W. Verret:  I think it’s fair to say that crypto has a formidable Tiger Mom. So, thank you, Commissioner for that great discussion, appreciate it.

 

[Music]

Hester M. Peirce

Commissioner

United States Securities and Exchange Commission


J. W. Verret

Associate Professor of Law

Antonin Scalia Law School


Financial Services & Corporate Governance

The Federalist Society and Regulatory Transparency Project take no position on particular legal or public policy matters. All expressions of opinion are those of the speaker(s). To join the debate, please email us at [email protected].