Congress needs to prioritise customer protections in crypto

Congress needs to prioritise customer protections in crypto

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By Gary DeWaal and Daniel J. Davis of Katten Muchin Rosenman

It made for good dramatic theater on December 1 when the Senate held its hearing about FTX. But, the real job before Congress right now is to act quickly to adopt meaningful and comprehensive crypto legislation in the weeks ahead. The collapse of FTX under Sam Bankman-Fried (known as SBF) has only heightened this need, not eliminated it.

Firms handling crypto assets are currently regulated by a hodge-podge of laws in the United States, if they experience oversight at all. Responsible entities in this porous structure include the Financial Crimes Enforcement Network of the US Department of Treasury, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC).

Fortunately, three comprehensive bills - all co-sponsored on a bi-partisan basis - that propose to rationalise the regulation of crypto intermediaries and transactions in the US were already pending prior to FTX’s recent collapse.

Each of these bills potentially grants the CFTC exclusive jurisdiction to regulate intermediaries and transactions involving spot virtual currencies; requires the segregation of customer assets at such entities; and imposes customer protection requirements on such firms equivalent to the types of obligations imposed routinely on intermediaries in the regulated derivatives and securities industries today.

However, in light of recent events, whatever bill emerges from Congress should also expressly instruct the CFTC to adopt for crypto intermediaries the same type of enhanced customer protection rules that were adopted by the agency following the collapse of MF Global Inc. and Peregrine Financial Group, Inc. - two perceived stalwarts of the futures industry - during 2011 and 2012, respectively.

These enhancements mirrored regulatory upgrades the SEC implemented in 2008. Those followed the discovery that another industry leader - Bernard Madoff - had through his investment firm, Bernard L. Madoff Investment Securities LLC, since the 1990s been paying returns to existing customers from the new investments of other customers, leading to customer losses in excess of $50 billion (£41bn).

Sadly, FTX was not the first firm to fail for lack of adequate corporate controls. In 2011, after John Corzine — a former New Jersey governor and US senator and chief executive officer (CEO) of Goldman Sachs - was appointed CEO of MF Global, a CFTC-registered futures broker (known as an FCM), he attempted to increase the earnings of the firm by expanding the firm’s proprietary trading, engaging in increasingly riskier and larger trades without augmenting the firm’s systems and controls. According to the CFTC in charges filed in 2016, Mr. Corzine ultimately used customer funds to satisfy margin calls associated with the firm’s proprietary transactions, initially rendering the firm unable to pay back all amounts owed customers.

Russell Wassendorf, Sr., the CEO of Peregrine, another CFTC-registered FCM, was alleged to have embezzled more than $215 million of customer funds from the early 1990s through July 2012. He accomplished this by, among other means, filing false financial statements with and providing forged bank statements to regulators.

 Like Wassendorf, Madoff also orchestrated a Ponzi scheme, doing so from a sequestered office away from his firm’s principal business operations. He provided fake account statements to customers showing aggregate profits in excess of $50 billion and apparently was never asked for basic records by regulators to support his operations.

Similarly to SBF, each of Corzine, Wassendorf and Madoff were highly reputable industry leaders often interacting with regulators prior to discovery of their alleged misdeeds. Both Wassendorf and Madoff served on boards of self-regulatory organisations.

In response to the Madoff debacle, the SEC adopted enhanced safeguards for customer assets handled by investment advisers by encouraging such entities to maintain client assets in the custody of an independent firm. In response to the Peregrine and MF Global episodes, the CFTC also adopted enhanced customer protection rules, requiring, among other thing, all FCMs to grant regulators ongoing read only access to bank and other custody-type accounts holding customer funds (for example money and derivatives’ positions). The CFTC additionally required FCMs to provide their customers more information regarding risks posed by affiliated entities.

It is not possible or realistic for any government agency to prevent unscrupulous CEOs from cooking their books. However, adoption of any of the pending crypto bills buttressed by requiring the CFTC to enact enhanced customer protection provisions similar to those implemented after the Peregrine and MF Global collapses, would go a long way to ensuring that at least one regulator is principally in charge of overseeing a requirement that crypto industry registrants implement and maintain strong internal controls and processes designed to protect customer assets.

The urgent passage of a crypto bill is critical. But, it should be equally clear that customer protection should be at the core of any new regulatory regime.

Gary DeWaal is Special Counsel at Katten and previously served as a senior trial attorney with the Division of Enforcement at the CFTC.

Daniel J. Davis is a partner at Katten and previously served as General Counsel at the CFTC.

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