The Case for Self-Regulation for the Digital Assets Industry

The concept of self-regulation and the use of Self-Regulatory Organizations (SROs) as a feature of legal and regulatory frameworks has been adopted to support effective and efficient capital markets development in a number of countries around the world. Most notably, the International Organization of Securities Commissions (IOSCO) set forth through its SRO Consultative Committee a “Model for Effective Self-Regulation,” the general principles for self-regulation and why self-regulation should be incorporated into regulatory frameworks. Since 2000, this has served as the outline for SRO development. Today, many countries are struggling with the question of how to regulate cryptocurrency and digital assets – including the United States. The rapid evolution, high degree of expertise and understanding needed, and decentralized, cross-border nature of digital assets presents unique challenges for regulators. In the wake of the failure of the centralized finance (CeFi) digital asset exchange FTX, our research explores whether an SRO may be suited to the nature of the digital asset industry and how it may provide a strong complement to formal U.S. government regulation. Such a complementary relationship may offer United States regulators and legislators a mechanism for providing a high degree of regulatory coverage which balances the need for consumer protection and market integrity with the need for innovation. In exploring this subject, researchers undertook desk study on the IOSCO Framework for Effective Self-regulation and explored existing and emerging national SROs in the digital asset space. Desk study was coupled with individual one-on-one interviews with global digital asset industry leadership and public roundtable fora. This research concludes that an SRO may serve to provide the U.S. legal and regulatory framework with a high-quality solution to the challenges of legislating and regulating in the ever-changing environment of digital assets.

Introduction

Cryptocurrency and digital assets are now at the forefront of investment activities. Despite this, regulatory clarity and regulating agency oversight have not kept up with the increased adoption of the new asset class and the growth of the broader crypto industry as a whole. The need for appropriate regulation has also been amplified by recent events. Throughout 2022, several cryptocurrency firms failed, and many are at risk of bankruptcy. In their wake, millions of retail customers lost their savings, adjacent businesses were left teetering, and the viability of the entire industry has been called into question. In light of the regulatory gap that exists, SROs can provide the policy guardrails and regulatory clarity the industry needs. This body of research seeks to present an outline of an initial framework of an SRO best suited for the current industry and regulatory landscape in the US.

Why does the Cryptocurrency and Digital Assets Industry Need Regulation?
As most digital asset firms, cryptocurrency exchanges and Virtual Asset Service Providers (VASPs) are money transmitter institutions, or money services businesses (MSBs), under federal regulation  and state law, they are subject to anti-money laundering (AML) and counter terrorist financing (CFT) laws and regulations, such as the Bank Secrecy Act (BSA) and the USA PATRIOT Act, enforced by the U.S. Department of Treasury, Financial Crimes Enforcement Network (FinCEN). Firms are also subject to regulations related to consumer protection, such as the Consumer Protection Act enforced by the Federal Trade Commission’s Bureau of Consumer Protection. Adherence to these laws, rules and regulations requires some combination of oversight, monitoring, examination, and testing, and enforcement of the rules via disciplinary actions -- functions typically provided by a regulatory authority. 

What is Self-Regulation?
As a first step, it is important to provide a common understanding of what is meant by self-regulation. One of the leading resources in understanding the modern philosophy and approach surrounding self-regulation is the IOSCO SRO Consultative Committee Report entitled Model for Effective Self-Regulation.  As defined by this report, self-regulation typically involves a unique combination of private interests with government oversight and provides an effective and efficient form of regulation for the complex, dynamic and ever-changing financial services industry. In its most complete form, self-regulation encompasses the authority to create, amend, implement and enforce rules of conduct with respect to the entities subject to the SRO’s jurisdiction and to resolve disputes through arbitration or other means. 

What is an SRO or Self-Regulatory Organization? 
SROs are the entities which facilitate self-regulation. As noted by the same IOSCO report, typically, this authority is derived from a statutory delegation of power to a non-governmental entity. The report goes further to highlight that at the time of its publication, there were a number of organizations on the IOSCO Consultative Committee that provided valuable industry input in terms of codes of good conduct and master agreements and performed important roles in the standardization of common practices without any formal regulatory status. In fact, historically, in several jurisdictions around the world, effective self-regulation existed before any form of statutory regulation. This is also true of emerging economies or sectors where financial sector transformation is rapid and outpaces the speed of legislation and formal government regulatory development.

In its further report on the Objectives and Principles of Securities Regulation, IOSCO has endorsed the use of SROs within statutory oversight frameworks for financial markets, as part of a broader set of thirty principles. The report recommends appropriate use of SROs with direct responsibilities in their areas of competency, to the extent appropriate to the size and complexity of the markets, to assist regulators in meeting their regulatory objectives of investor protection: fair, efficient and transparent markets and reduction of systemic risk. 

Are there Examples of SROs in Traditional Financial Markets?
Some of the best examples of SROs have developed within the securities and commodity futures industries, including all national securities and commodities exchanges.

In particular, in the case of the securities industry, the Financial Industry Regulatory Authority (FINRA), an SRO, regulates firms and individual brokers across the country. FINRA is overseen and delegated authority by the Securities and Exchange Commission (SEC) and is authorized by Congress to protect U.S. investors by making sure the broker-dealer industry operates fairly and honestly to protect investors and promote market integrity. Though an SRO, FINRA performs all the functions expected of a regulatory authority including promulgating and enforcing rules governing the activities of all registered broker-dealer firms and registered brokers in the U.S., examining firms for compliance with those rules, recovering money for harmed investors, and removing bad actors from the brokerage industry.  

Similarly, the commodities and futures industry, also known as the U.S. derivatives industry, is regulated by the National Futures Association (NFA), an SRO. Designated by the Commodities Futures Trading Commission (CFTC) as a registered futures association, NFA safeguards the integrity of the derivatives markets, protects investors, and ensures Member firms  meet their regulatory obligations. The NFA regulates firms (commodity trading advisors, futures commissions merchants, commodity pool operators, introducing brokers, etc.) and individual associates. Like FINRA, the NFA also engages in rulemaking, enforcement, market regulation, and other investor protection programs.

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This article is co-authored by Gabriella Kusz, CEO of Global Digital Assets & Cryptocurrency Association, USA.

Reprinted with permission from the Henry Stewart Publications - Journal of Financial Compliance Volume 7 Number 1. All rights reserved. Further duplication without permission is prohibited.