The blockchain industry has attracted more than its fair share of scammers and fraudsters. The past two years have been especially painful as the collapses of Luna, Three Arrows Capital and FTX have brought the industry to its knees.
Thankfully those of us with a long-term vision finally have a market structure bill from Congress to look forward to. However, this progress is being threatened by the U.S. Securities and Exchange Commission (SEC), which is running a covert demolition job on the industry to protect its turf and advance the political aspirations of the current chairman.
Matt Walsh is a founding partner of Castle Island Ventures, a venture capital firm that invests in blockchain technology companies. Prior to founding Castle Island Ventures he worked at Fidelity Investments, where he led a number of the firm’s blockchain projects.
The SEC’s three-part mandate is to 1) protect investors, 2) maintain fair, orderly, and efficient markets and 3) facilitate capital formation. The SEC is supposed to be a disclosure-based regulator that is technology neutral, meaning they establish a framework for issuers to divulge pertinent information to investors, but do not unilaterally take a stance on which technologies ought to make it to market.
However, under this administration it is behaving like a merit-based regulator that sees itself as the arbiter of which technologies should exist in the United States. And it is doing this covertly by manipulating esoteric but consequential rules.
I have worked in the digital asset industry for over a decade and have been investing in blockchain startups for over six years. At Castle Island Ventures we have invested in over 50 startups, many that operate at the intersection of traditional finance and public blockchains.
Based on our vantage point, it’s clear that the policies of the SEC are putting more U.S. investors in harm’s way by preventing trusted institutions from offering services, markets less orderly by forcing innovation offshore and impeding capital formation by throwing up unnecessary roadblocks for U.S. companies. In other words: the agency’s actions are negating precisely what it was founded to do.
Every day I speak with startups that are moving offshore and established firms delaying hiring plans due to regulatory uncertainty.
To be clear, the SEC has an important enforcement role to play in this market and should continue to root out the bad actors. Unfortunately, instead it has embarked on a plan to regulate via enforcement and rulemaking in lieu of working with Congress to enact market structure reforms. The result of the SEC’s so-called “guidance” and aggressive stance would be to create an environment where even the most trusted financial institutions are not able to operate digital asset businesses in the United States.
With recent proposed updates to the longstanding “custody rule” and new qualifications affecting broker-dealers, the SEC is covertly sidestepping Congress and seeking to regulate digital assets out of existence. This is backdoor rulemaking par excellence. Specifically, the SEC is doing the following:
Obscure accounting rules locking out custody banks
In the first quarter of 2022, the SEC published Staff Accounting Bulletin 121 (SAB 121), which sought to update how institutions maintain customer records. The guidance states any bank that files financial information with the SEC must record customer funds as assets on the bank’s own balance sheet—running counter to the way banks are required to record every other asset.
Although the policy has wide reaching effects, it raises particular concerns for the crypto industry. To this point the Bank of New York Mellon stated in an SEC comment letter: “banks cannot practically serve as qualified custodians for digital assets in any sufficient scale if they are still subject to the threshold limitations of SAB 121.”
It is a punitive policy to the point of rendering any digital asset business unprofitable, in part because of the corresponding capital charge related to holding the customer assets on balance sheet.
As a result of SAB 121, the SEC has created a dynamic where the most trusted U.S. custodians are not able to offer their customers digital asset custody services. This is the opposite of investor protection. We need more Bank of New York Mellons and fewer FTXs.
Targeting Coinbase by pressuring state trust custodians
In the first quarter of 2023, the SEC proposed changes to the “custody rule” section of the Investment Advisers Act of 1940. In the proposed rule, the SEC asks whether the definition of qualified custodians should be narrowed to only include banks or savings associations that are subject to Federal regulation. A change of this nature would prevent institutions like Fidelity and Coinbase, which operate under New York’s trust framework and have acted as qualified custodians for years, from holding assets for registered investment advisors.
Given that the Office of the Comptroller of the Currency (OCC) has only approved one company as a digital asset custodian, the federal path does not appear to be a workable option. This rule change would artificially and unnecessarily shrink the custody market in the U.S. and force a shutdown of some of the most trusted companies in the industry.
Hostility toward open-source software and financial transparency
In the second quarter of this year, the SEC re-opened the comment period on a controversial update it had tried to force through. Last year, the SEC rewrote the definition of “exchange” under the Exchange Act of 1934 with the effect that decentralized finance (DeFi) protocols could have been regulated as exchanges. Given that these protocols are operated by open-source software, the rule change would be a de facto ban on DeFi in the United States because few founding teams could comply with the onerous requirements.
This rule would be like banning commercial web browsers in the early days of the internet, in favor of front ends that were run by telephone companies. In addition to being questionably unconstitutional, this would firmly ensure that the next big blockchain-based technology platforms are built outside of the United States.
The path forward
If the SEC is ultimately successful in its regulation via enforcement and rule-making campaign, we will live in a country where the most secure banks cannot touch crypto, where state trusts like Fidelity Digital Assets are no longer deemed to be qualified custodians and where financial open-source software is closed off.
The United States blocking the emergence of the digital asset industry does not mean that the industry will not exist. It just means that it will flourish elsewhere. The E.U., U.K., Singapore and Australia have already passed regulatory frameworks for digital assets. The Hong Kong Monetary Authority has gone so far as to publicly tell banks to support licensed crypto exchanges.
Members of Congress from both sides of the aisle have seen the geopolitical importance and promise of blockchain technology and have promised legislation to protect it from our nation’s regulators. Among the most promising are bills focused on market structure and stablecoin issuance, which if passed will provide clarity on the key issues preventing banks and broker-dealers from participating in the digital asset market today.
These are public policy issues that should be addressed via legislation by our elected officials in Congress, not regulated in an opaque manner by the SEC.
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