As Coinbase Global Inc., the largest U.S. cryptocurrency exchange, prepares to go public, some investors will conclude crypto trading has now matured sufficiently to be “safe.” Coinbase’s market capitalization could approach $100 billion, and its settlement of an enforcement action last month with the Commodity Futures Trading Commission suggests there is good regulatory oversight. After all, one expects the occasional fine in a regulated industry, and this one was quite modest at $6.5 million, compared with 2020 revenues exceeding $1 billion.
But that would be precisely the wrong takeaway. This case shows how the regulatory framework is woefully inadequate, as even one CFTC commissioner noted.
The CTFC action concerned alleged wash trading that occurred between 2015 and 2018, behavior that should be punished. (Wash trading is a form of market manipulation where an investor simultaneously buys and sells the same financial instrument in order to inflate volume, distort pricing or otherwise feed false information to the market.)
But the CFTC does not regulate Coinbase or any other crypto exchange. That’s because Coinbase is not a derivatives exchange that is required to register with the CFTC or to comply with the extensive investor protection standards applicable to those exchanges. Coinbase operates in the cash market for cryptocurrencies.
During my tenure as chairman of the CFTC, the agency deemed cryptocurrencies to be commodities. We did so because market participants were proposing to trade crypto-derivatives, such as bitcoin swaps, and that meant the assets could be considered commodities under the law. Our action meant the agency could also bring enforcement cases concerning manipulation and fraud in the cash market, because activities in a cash commodity market can corrupt the related derivatives market.
But the agency has no power to set standards for that cash market — in crypto or any other commodity — or for the exchanges that operate in it. Nor does any other U.S. regulator have that power. The Securities and Exchange Commission only has jurisdiction if a crypto asset is deemed a security, which is not the case for Bitcoin and the other most popular crypto-assets.
That’s why this recent enforcement action may benefit Coinbase more than investors, because it creates an illusion of regulation. And nowhere is that better expressed than in the thoughtful and unusual concurrence by one CFTC commissioner, Dawn Stump. Stump agrees the wash trading was wrong, but she explains why the whole case is problematic: Because Coinbase “is not regulated by the CFTC,” the case “misleadingly suggests that the CFTC is a full-time ‘cop on the beat’ for all manipulation, false reporting, and fraud involving [crypto] exchanges.” Moreover, the case plus other statements on the agency’s website about its jurisdiction “are likely to create unrealistic public expectations” that the agency can police the crypto cash market.
Stump also argues that the investigation was a poor allocation of agency resources. The activity did not even affect listed crypto derivative contracts because there were none at the time, and the agency has many other priorities for its limited resources. The fact that the trading was several years old is also a reminder that enforcement cases, which take a long time to bring, are no substitute for immediate oversight of an exchange by a regulator.
The Coinbase case reveals the inadequacy of crypto regulation in another way as well. Wash trading is prohibited on stock and derivatives exchanges, and their surveillance systems are designed to detect and punish it. But this was not a failure of Coinbase to detect wash trading by its customers. The problem was wash trading by Coinbase itself.
The CFTC’s order holds that Coinbase operated two proprietary trading programs on its exchange and reported trades between them as real trades. (The agency also found that an employee of Coinbase engaged in wash trading through these Coinbase programs.)
The absence of a regulatory framework means that crypto exchanges can engage in activities not permitted for registered securities and derivatives exchanges that may create conflicts of interest, even if they don’t give rise to fraud or manipulation. That includes proprietary trading (imagine if the New York Stock Exchange had its own trading operation) or having an economic interest in a listed asset (Coinbase is a co-sponsor of USD Coin, a stablecoin traded on its platform).
Of course, a crypto-exchange can disclose activities like these to put its investors on notice, and it can implement investor protection standards on its own. Coinbase is better in both respects than many of its competitors. And surely being a public company will be a plus for transparency. But that is not enough.
U.S. securities and derivatives laws have been one of the principal reasons why America has had the strongest and deepest securities and derivatives markets in the world for decades. We need to create a modern regulatory framework for crypto. Right now, the U.S. is relying on old constructs that do not fully fit the current situation — such as the SEC’s Howey test on whether something is a security, which is based on a 1946 Supreme Court case about orange groves in Florida. It’s a well-reasoned test that has lived a good life; but as a basis for regulating cryptocurrency, it’s like trying to put a round peg through a square hole.
While there is good reason to be skeptical of some crypto use cases, as well as much of what goes on in the industry, cryptocurrency is here to stay. There is a huge amount of talent pouring into the sector, and it is difficult to predict where the technology will lead.
Hardly anyone was talking about central bank digital currencies two years ago; now China is rolling one out, and other countries are feeling pressure to keep up. Europe has recently announced a comprehensive package of digital laws; and other jurisdictions are taking similar steps. It’s time the U.S. did the same.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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Tobin Harshaw at email@example.com