Bridging the Week by Gary DeWaal: October 14 to 18, and October 21, 2019 (Stablecoins; Telegraph and TON; FINRA Examination Findings)

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Published Date: October 20, 2019

The Group of Seven Working Group on Stablecoins conceded that utilization of stablecoins might help address the lack of access to financial services by a large portion of the world’s population and inefficient cross-border retail payments. However, the intergovernmental economic organization solely identified obstacles to stablecoin rollout without suggesting any practical ways to expedite their introduction. Separately, the Financial Industry Regulatory Authority published its annual findings of not so best practices at member firms. As a result, the following matters are covered in this week’s edition of Bridging the Week:

The next scheduled edition of Bridging the Week will be November 4, 2019.

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However, the G7’s Working Group on Stablecoins – the author of the report – noted that subtle differences in structure in stablecoins could have significant differences in how such instruments are regarded. The key determinants for stablecoins that are backed by referent assets (e.g., fiat currency, government securities, commodities, cryptoassets or baskets of such instruments) are whether they are regarded as money equivalent, categorized as contractual or property rights or involve a right against an issuer or an underlying asset. Depending on the structure, in some locations a stablecoin might be regarded as a security or another financial instrument (e.g., debt instrument) or an interest in a fund or other collective investment vehicle. Each structure could result in a different outcome and the same structure could be subject to “different treatments in different jurisdictions.”

The Working Group acknowledged that stablecoins could serve as a means of payment and store of value and “potentially foster the development of global payment arrangements that are faster, cheaper and more inclusive than present arrangements.” There is a need for such arrangement, said the Working Group, because while domestic payments are well accommodated, a large portion of the world’s population do not have access to financial services and cross-border retail payments are inefficient. The report noted that while initial virtual currencies such as bitcoin endeavored to address these issues, they have to date “suffered from highly volatile prices, limits to scalability, complicated user interfaces and issues in governance and regulation, among other challenges.”

For stablecoins to be widely accepted, said the Working Group, they must overcome challenges related to governance; money laundering and all forms of illicit finance; safety, efficiency, and integrity of payment systems; cyber security and operational resilience, market integrity, data privacy and protection; consumer and investor protection; and tax compliance in addition to obtaining legal certainty. Moreover, if a stablecoin was to be widely accepted on a global scale, issues would arise regarding monetary policy, financial stability, the international monetary system and fair competition that would have to be addressed.

The Working Group recommended that public stakeholders (e.g., government bodies) support efforts to improve cross-border payments and promote financial stability generally, without referencing stablecoins, although it did acknowledge that central banks will “assess the relevance of issuing central bank digital currencies in view of the costs and benefits in their respective jurisdictions.” However, the Working Group recommended that public stakeholders continue to consider how globally used stablecoins might be categorized depending on their design features and what regulatory and oversight regimes may be relevant, including whether there are any regulatory gaps.

The Group of Seven consists of the seven large advanced world economies: Canada, France, Germany, Italy, Japan, the United Kingdom and the United States. The Working Group acknowledged the existence of algorithmic stablecoins but did not include them in its study because “their ability to maintain a stable value over the medium term is questionable.”

Last week, J. Christopher Giancarlo, former chair of the Commodity Futures Trading Commission, and Daniel Gorfine, former head of the CFTC’s LabCFTC, called for the development of a US dollar stablecoin. Under their proposal, authorized USD stablecoins would be created and maintained by an independent nongovernmental group administered by banks and other trusted third parties, and cash backing the stablecoin would be maintained in escrow accounts at the Federal Reserve. According to the authors of the proposal that appeared in The Wall Street Journal on October 15, USD stablecoins would “let individuals, companies, and states tap the potential advantages of distributed-ledger payments [with] much higher transaction speed, enhanced access and greater transparency.” (Click here to access the full article by Mr. Giancarlo and Mr. Gorfine.)

Additionally, last week the Financial Action Task Force warned that stablecoins "could potentially cause a shift in the virtual asset ecosystem and have implication for the money laundering and terrorist financing risks." As a result, FATF said that stablecoins and their service providers should be subject to FATF standards either as virtual assets and virtual assets service providers or as traditional financial assets and traditional financial assets service providers. (Click here for additional background.) FATF is an international governmental body whose objectives are to set standards and promote effective implementation of legal, regulatory and operational measures for combating money laundering, terrorist financing and other ancillary threats to the integrity of the international financial system. 

In other legal and regulatory developments regarding virtual assets:

Two weeks ago, the SEC filed a complaint and obtained a temporary restraining order against defendants precluding them from delivering and making available Grams to US persons beginning later this month as planned. The SEC filed its lawsuit in a federal court in New York City.

The SEC claimed that, beginning in January 2018, the defendants have raised US $1.7 billion, including $424.5 million from US persons, to fund the development of a proprietary blockchain – the Telegram Open Network – as well as their mobile messaging application, Telegram Messenger. The SEC claimed that the defendants’ offer and sale of Grams to US persons constituted an unregistered securities offering, and that Grams are securities because initial purchasers and subsequent investors expect to profit through Telegram’s efforts. 

The SEC also sought a preliminary injunction against defendants. (Click here for further details in the article “SEC Obtains TRO Against ICO to Support Social Media and Blockchain Platforms After Telegraphing Warnings” in the October 13, 2019 edition of Bridging the Week.)

Prior to entry into the stipulation, the defendants filed papers on October 16 opposing entry of a preliminary injunction. Defendants claimed that the SEC obtained its TRO without their involvement solely “to steamroll Telegram into consenting to a preliminary injunction when there is no need.” Telegram indicated it had voluntarily agreed to delay its distribution of Grams and enter into a stipulation, but the SEC refused unless the defendants consented to a preliminary injunction. Defendants also argued that Grams will constitute a virtual currency and not a security after launch of the TON blockchain, and they never proposed an initial coin offering involving securities.

As of late evening on October 18, the US district court filing system did not reflect that the relevant federal judge – the Hon. Kevin Castel – had executed the stipulation co-signed by the SEC and the defendants.

According to the SEC, the trust proposes solely to invest in T-bills and bitcoin, and US dollars for short periods. Bitcoin will be held by a New York chartered trust company that will be a qualified custodian under applicable law. The Trust will maintain fidelity insurance coverage for the theft of funds in hot or cold storage in excess of US $200 million. As contemplated, the balance of bitcoin and non-bitcoin will closely reflect the Bitcoin Treasury Index calculated and published by Solactive AG. The price of bitcoin used by the Trust will be based on the Chicago Mercantile Exchange’s CF Bitcoin Reference Rate. This Reference Rate is based on prices derived from five constituent platforms – Gemini, itBit, Kraken, Bitstamp and Coinbase – which the sponsor claims are inherently resistant to manipulation as evidenced by the high correlation of prices among each other and to the Reference Rate; this is because of the presence of “robust arbitrage trading and liquidity.” In any case, both NYSE Arca and CME are members of the Intermarket Surveillance Group; thus, NYSE Arca has an information-sharing agreement with a relevant market of significant size. (Click here for additional information regarding the Trust.)

Two weeks ago, the SEC disapproved rule changes proposed by NYSE Arca, Inc. to list and trade shares of the Bitwise Bitcoin ETF Trust. The Commission claimed that NYSE Arca’s proposed rules were not adequately designed “to prevent fraudulent and manipulative acts and practices.” The SEC said NYSE Arca failed to demonstrate that the spot market in bitcoin is “inherently resistant to fraud and manipulation” or alternatively that it had entered into a surveillance-sharing agreement with a regulated market of “significant size” relating to bitcoin. The SEC rejected that CME was of a sufficient size. (Click here for details in the article “New CFTC Chairman Says Ether Derivatives Likely Soon While SEC Says No to Another Bitcoin ETF” in the October 13 edition of Bridging the Week.)

My View: Despite acknowledging the inefficiency of cross-border retail payments and that a large portion of the world’s population do not have access to financial services, and recognizing that stablecoins might offer a possible solution, the G7 Working Group on Stablecoins failed to recommend any path to facilitate an expedited rollout of global stablecoins.

In a speech earlier this year, SEC Commissioner Hester Peirce pointed out the difficulty of rolling out new innovative solutions. According to Ms. Peirce: 

Entrepreneurship and innovation do not have the happiest of relationships with regulation. Regulators get used to dealing with the existing players in an industry, and those players tend to have teams of people dedicated to dealing with regulators. Entrepreneurs trying to start something new are often much more focused on that new thing than on how it fits into a regulator’s dog-eared rulebook. Regulators, for their part, tend to be skeptical of change because its consequences are difficult to foresee and figuring out how it fits into existing regulatory frameworks is difficult. 

(Click here for Ms. Peirce’s full speech.)

In the United States today, our approach to financial regulation is largely based on products and players present in the 1930s. The overlap among federal agencies and between state and federal authorities is stifling and does not accommodate today’s financial products that principally are regulated on the basis of their name, or players that within one corporate family are banks, broker-dealers, futures commission merchants and swap dealers. As the Government Accounting Office wrote in 2009, “The current U.S. regulatory system has relied on a fragmented and complex arrangement of federal and state regulators—put into place over the past 150 years—that has not kept pace with the major developments that have occurred in financial markets and products in recent decades.” (Click here for a copy of the full GAO report.)

Efforts to better coordinate have been attempted. First, in 1988, the President’s Working Group was meant to coordinate some federal financial agencies, and then in July 2010 the Financial Stability Oversight Council was authorized to coordinate even more federal and some state regulators. However, these are band-aids. The answer to more regulators is not more supervising entities, but fewer and more effective regulators.

As a result, rollouts in the US of new financial products involving new players are difficult at best and stablecoins are just the latest new financial product whose introduction has been complicated by regulatory complexity. 

Identifying societal problems and possible solutions is commendable – as the Working Group has just done. However, not impeding, let alone encouraging implementation of solutions despite legal and regulatory complexity and bureaucracy grounded in an earlier time, would be even better.

Among other things, FINRA found that some firms did not develop controls to adequately address newly adopted or amended rules, or identify such controls in their written supervisory procedures. Moreover, some firms had inadequate branch supervision and inspection programs, while others did not have reasonable processes to detect various forms of forgery in connection with the preparation of customer documentation. FINRA also claimed that some firms failed to maintain an adequate supervisory system to assess the suitability of recommendations to customers when exchanging certain products or identify red flags of unsuitable transactions. FINRA also identified that while some firms prohibited the use of certain texting and social media, they did not maintain a process to respond to red flags of violations of such policy. Also, said FINRA, some firms failed to monitor for suspicious transactions activity that related principally to securities trading. Accordingly, “some firms failed to detect red flags such as market dominance, prearranged trading or instances where groups of seemingly unrelated accounts were working in concert to manipulate stock prices,” said FINRA.

FINRA additionally found that some firms failed to include pre-trade order limits, pre-sent capital thresholds and “duplicative and erroneous order controls” for trading on alternative trading systems in potential violation of the Securities and Exchange Commission’s Market Access Rule (click here to access background). FINRA also alleged that some firms did not have adequate risk management controls that could support a chief executive officer’s required annual certification that the broker-dealer’s controls and procedures comply with Reg MAR’s requirements.

FINRA also found issues around suitability, AML and market access controls in its 2018 Examination findings published in December 2018 (click here to access).

Compliance Weeds: In my prior position as the group general counsel of an international derivatives brokerage entity, I always found examination overviews or similar documents published by regulators very helpful. This was not necessarily because I found issues spotted by regulators relevant to our situation (although very often I did), but because it caused me to reflect on our policies and compliance procedures more generally and to think about areas for possible enhancements.

It is a good discipline for all compliance and other control professionals at least annually to step back and think about processes that could be improved, and to work with supervisors to effectuate such changes.

More Briefly:

Finally, two entities – Summit Feeders LLC and XR Trading LLC – concluded disciplinary actions with CME Group exchanges for purportedly violating speculative position limits. XR Trading agreed to pay a fine of US $20,000 in connection with a one-day intraday violation, while Summit Feeders agreed to pay a sanction of US $15,000 for a violation that also occurred on one day. Summit additionally consented to disgorge profits of US $10,415.

For further information

Defendants Formally Stipulate to a Delay in Digital Asset Distribution That SEC Alleged Constituted an Unregistered Offering:

Spoofing and Speculative Positions Limits Breach Subject of CME Group Exchanges’ Disciplinary Actions:

FINRA Identifies Many Repeat Issues in 2019 Summary of Members’ Examination Findings:

Group of Seven Working Group Notes That Stable Law Environment Necessary for Stablecoins:

SEC Seeks Comments on Another Bitcoin ETF:

Eighteen Traders Charged by SEC in Alleged Stock Manipulation Scheme:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of October 19, 2019. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP may represent one or more entities mentioned in this article. Quotations attributable to speeches are from published remarks and may not reflect statements actually made. Views of the author may not necessarily reflect views of Katten Muchin or any of its partners or employees.

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Gary DeWaal

Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office focusing on financial services regulatory matters. He provides advisory services and assists with investigations and litigation.

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