FTX Train Wreck Demonstrates Need for Modernized Regulatory Guardrails

FTX Train Wreck Demonstrates Need for Modernized Regulatory Guardrails

Few can deny that the misuse of customer funds, extreme leverage, and the subsequent collapse of FTX was catastrophic for retail investors that trusted disgraced crypto wunderkind, Sam Bankman-Fried. Politicians, companies, and celebrities that had lucrative partnerships with the company will certainly need to come to terms with the baggage and potential lawsuits that may arise.

The political fallout has already been immense, with SEC Commissioner Gary Gensler, and Senator Elizabeth Warren (D-MA), among many others, already calling for aggressive legislative and executive branch scrutiny of the crypto industry.

Despite this well-deserved backlash against an extremely bad actor, it’s crucial that Congress and the executive branch don’t crush the potential out of this industry with a new wave of stiflingly strict red tape. Similar to the internet revolution of the 1990s, cryptocurrencies and blockchain more broadly can unleash productivity and prosperity with the help of tailored legislation that creates guardrails for innovators to rely on.

Over the past decade, Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) both have issued substantial guidance on their respective treatments of cryptocurrencies. Unfortunately, there has not yet been clarity on the division of crypto regulatory authority between the CFTC and the SEC. Even some of the largest crypto company CEOs have been quoted recently asking for regulatory clarity. For a nascent industry with tough growing pains, it’s of the utmost importance to get the definitional language correct.  It’s far past time to bring the crypto industry out of the regulatory shadows and into a workable legal framework where it belongs.

From the last Congress, one of the potential solutions for a new and more stable regulatory regime that defines “digital commodity” was the bipartisan Digital Commodities Consumer Protection Act (S. 4760) from Sens. Debbie Stabenow (D-MI) and John Boozman (R-AR). Similar legislation titled the Digital Commodity Exchange Act (H.R. 7614) from the House Agriculture Committee includes a nearly identical definition of digital commodity. In addition to establishing this definition, the bill would place similar regulations on digital commodity brokers and marketplaces as with physical commodity brokers and marketplaces.

Industry feedback on this bill has been mixed, even though it is generally accepted that many within the industry would prefer to be regulated by the CFTC. One of the major reasons for this pushback is the discontent with the definition of digital commodity in the legislation.

Currently, the legislation’s definition reads as follows:

“The term ‘digital commodity’ means a fungible digital form of personal property that can be possessed and transferred person-to-person. through the use of distributed ledger technology or a similar means.”

This definition is overbroad, and further problems would arise from the fact that it provides little guidance for future and current innovators. Although some in the crypto community would prefer a broadly encompassing definition of digital commodity under total CFTC control, given recent events, I don’t believe that will be possible in the existing legislative environment.

To address this concern, I propose the following edits to the draft definition:

“The term ‘digital commodity’ means a fungible nonphysical form of personal property that can be possessed and transferred person-to-person through the use of distributed ledger technology or a similar means, and is used primarily as a store of financial value, and without direct and immediate managerial control over its operation, immutability, irreversibility, and scarcity exercised or held in reserve by an individual or organization, as indicated within the intrinsic nature of the property and associated distributed ledger technology.”

This definition solves many of the problems in clearly delineating the difference between crypto tokens covered by CFTC and SEC jurisdictions. Firstly, the language of “designed and is used” intends to ensure that Initial Coin Offerings and project-based tokens for DAOs  and other purposes are not covered under CFTC jurisdiction. It also encapsulates the economic realities portion of the current SEC stance on crypto in that some currently unknown token may become ubiquitous to the point that it functions as a store of value. Further, under the “reasonable expectation of profits from the efforts of others” portion of the Howey test from the SEC which determines what contracts are securities, the line including “without direct and immediate managerial control” intends to remove tokens with a significant portion of their key characteristics under the control of a single entity or entities. It is also intended to be technology-agnostic. This does still allow for regulatory discretion on the nature of “direct and immediate control” but this is still superior to an obvious alternative, which would be to fully codify the Howey test. It will also however remove from consideration software engineers, or other experts with novel solutions that could potentially help facilitate a decentralized change to the token’s protocol or fork of the blockchain. Finally, the last line will ensure that regulatory scrutiny will focus on the wallet distribution of tokens, the body of transactions, and inherent coding of the potential digital commodity when weighing whether it would fall under their jurisdiction. It is intended to exclude organizations like the Ethereum Foundation that help propose changes but do not have the authority to unilaterally implement them.

This definition is close to comprehensive and solves many of the problems in clearly delineating the difference between crypto tokens covered by CFTC and SEC jurisdictions. It also draws much clearer lines between CFTC and SEC authority while avoiding many of the past definitions’ pitfalls. It is intended to be a reasonable compromise between many of the different perspectives on this topic, from regulators, to industry, to other think tanks as well. Contrary to some maximalists’ thinking, building a consensus framework in a Congress with tight margins will be key for legislative success in shaping a new crypto future.

As lawmakers consider bringing down the proverbial hammer to squash the crypto industry, it seems obvious that the more challenging but rewarding approach would be instead hammering out intelligent and modern regulatory guardrails to ensure consumer protection. Bad actors should not ruin the opportunity for many other good companies to flourish and provide innovation and economic prosperity to the public.