Large parts of the digital asset market may be operating outside of the federal securities laws, SEC Commissioner Jaime Lizárraga said in remarks at Brooklyn Law School. Lizárraga stressed that not every issued digital token necessarily represents a securities offering, and not every digital asset intermediary is necessarily operating as an unregistered market participant. But he agrees with SEC Chair Gary Gensler that most of the nearly 10,000 digital asset tokens in the market are likely offered as securities, and he is concerned that intermediaries that sell, trade or advise on digital assets that are securities may be operating as unregistered market participants.
“My view is that there is likely a considerable number of digital asset issuers and intermediaries illegally operating outside of the federal securities laws,” said Lizárraga.
Lizárraga said his heart goes out to retail investors who are suffering an impact from the “troubling digital asset market events of this past week,” likely referring to the collapse of the FTX crypto empire and related market effects. Erosion of value or significant losses can have a devastating impact on a working family’s or a working person’s financial security, he said.
He highlighted major risks in the digital assets market such as increasing levels of fraud, concentration of wealth and control, highly centralized intermediaries, a lack of transparency, and high volatility.
Lizárraga emphasized that the SEC has provided “an abundance of guidance” to the industry and that the SEC has an obligation to protect investors and enforce rules and regulations.
Wild growth of crypto. Lizárraga noted that the digital assets industry arose in the aftermath of the 2008 financial crisis, which exposed weaknesses in the traditional financial system, including the need to trust intermediaries, unavoidable levels of fraud, and high transaction costs.
The digital asset industry has grown phenomenally. According to Lizárraga, there are nearly ten thousand tokens and hundreds of digital asset platforms. By some estimates, one in five adult Americans has purchased digital assets. The asset class has particularly taken off in low-income and underserved communities, where an increasing number of persons are investing in digital assets. A greater share of unbanked and underbanked individuals may own digital assets than those who are fully banked.
But as to whether the digital asset market has truly developed into a viable alternative to traditional finance, Lizárraga said in his opinion, the answer is no. Nor does it offer genuine financial inclusivity and robust protections for digital asset purchasers and investors, in his view.
Significant risks. The explosive, unregulated growth of digital assets has brought risks along with it. In March, President Biden issued an executive order directing federal agencies and financial regulators to examine issues in digital asset markets. Reports have outlined several risks.
- Increasing fraud. The U.S. Treasury Department cited one estimate of $14 billion-worth of digital asset-based crime globally in 2021—nearly double the estimate for 2020. The number of scams in 2021 rose by over 60 percent year-over-year, and the value of stolen digital assets rose by over 80 percent in 2021. Treasury noted that digital asset crimes are based on self-reporting, so it is likely these numbers don’t show a full picture.
- Concentrated wealth and control. The top 1,000 market participants owned roughly one-sixth of Bitcoin in circulation at the end of 2020, according to one study. The same study found that the top 10,000 participants owned roughly one-third of it. When “whales” (large position holders) liquidate a position or experience losses, their counterparties can face extreme financial pressure. Further, many digital asset governance tokens are held by the top 1 percent of holders of a given token, which can lead to governance problems if voting rights holders are anonymous or not subject to robust oversight.
- Highly centralized intermediaries. Belying the original vision of a decentralized trustless financial system as laid out in the Satoshi Nakamoto white paper, many digital asset platforms have an integrated, centralized structure, causing conflicts of interest. Platforms also commingle their own assets with customer assets, exposing customers to the risk of platform insolvency.
- Significant lack of transparency. According to FSOC, disclosures by digital asset promoters and issuers lack uniformity and vary widely in the amount of information provided to the public, particularly for stablecoins. There is also a lack of transparency about technological vulnerabilities, which is problematic despite the many malicious cyberattacks on platforms.
- High volatility. Lizárraga cited “recent events” and the 2022 crypto winter as evidence of how volatile the digital asset market can be. Price vacillations in digital assets are outside the norm relative to traditional markets’ routine fluctuations.
“Frankly, the problems in the digital asset market are worse than those in the traditional finance system, because they occur in a largely unregulated space,” said Lizárraga.
SEC guidance. According to Lizárraga, the SEC has provided an “abundance of guidance” including the DAO Report, the SEC FinHub Framework for “Investment Contract” Analysis of Digital Assets, and multiple no-action letters issued by the staff of the Division of Corporation Finance. Decades of legal precedent on what constitutes an “investment contract” or “note” under the securities laws also provide ample guidance to the industry and the sophisticated securities law bar, he said.
“It’s not a matter of a lack of guidance but more that the existing guidance may not be what many market participants want to hear,” said Lizárraga.
Lizárraga also pushed back on the narrative that the SEC is engaged in “regulation by enforcement.” In his view, the laws are well-established, and the cases brought to date have clear applications.
“This is not regulation by enforcement, but enforcement of our securities laws as Congress intended,” said Lizárraga.
Attorney gatekeepers play an important role in advising the digital asset industry, he said. They have an obligation to be clear with their clients about the application of the securities laws to their client’s businesses—even if it is not advice their clients want to receive.
According to Lizárraga, innovative blockchain technology can exist side-by-side and be compatible with the existing federal securities law framework—but it requires a good-faith, honest and conscious choice to comply with the law and to put the interests of investors first.
“[W]hile I believe that the SEC should work with those who come to us with good faith plans and concrete timelines to meet the requirements of the federal securities laws, the SEC has an obligation to protect investors and to enforce our rules and regulations,” said Lizárraga. “Those who do violate our federal securities laws and harm investors and markets must face the consequences, pure and simple.”