The Catch-22 of U.S. Cryptocurrency Regulation

Author: Marcelo Prates, CoinDesk; Compiler: Deng Tong, Golden Finance

The current state of cryptocurrency regulation is a "Catch-22", which is a series of absurd and contradictory rules and requirements , cannot be followed.

In Joseph Heller's famous novel, "Catch-22" refers to the rule that pilots seeking to be excused from combat duty could petition, claiming they were insane. But there's a catch: Filing a plea means the petitioner is sane and therefore ineligible for immunity.

In the United States of 2024, the SEC’s “come in and register” is a Catch-22 in the cryptocurrency space.

SEC Chairman Gary Gensler has often said that registering with the SEC to comply with securities regulations is so simple, “it’s just a form on our website.” Despite knowing how to do it, cryptocurrencies Issuers and exchanges “just choose not to do this.” The SEC Chairman sounds like crypto companies are being unreasonably (if not illegally) stubbornly not filing required registrations despite being welcomed by the SEC. This characteristic hides a trap.

Even if we assume, as Gensler does, that all crypto tokens are securities and should be registered with the SEC (which is controversial) and that the registration process is simple (which is not the case), successful registration can cause problems . As with any registered security, registered cryptographic tokens may only be traded on registered exchanges through registered broker-dealers. But this is not possible today.

The Financial Industry Regulatory Authority (FINRA), a self-regulatory organization that regulates broker-dealers, has only approved a handful of institutions to handle crypto tokens. Of those, only one is special purpose broker-dealer Prometheum, which remains inactive nearly a year after being approved and has yet to list the token for trading.

Additionally, the SEC does not allow any currently registered exchange or broker-dealer to list, custody, or trade crypto tokens. The SEC’s view is thatany registered institution willing to use cryptographic tokens “may not engage in trading in, effect transactions in, maintain custody of, or operate an alternative trading system for traditional securities.”

Furthermore, few crypto tokens have been registered with the SEC so far. It’s a catch-22:Issuers won’t register their crypto tokens until they find registered exchanges and broker-dealers that can work with them, and registered exchanges and broker-dealers don’t register their crypto tokens until they see enough crypto Tokens will not start before crypto tokens are registered to make the business model economically viable.

The reality of financial technology is not so bright. In the absence of a specific federal licensing framework, fintech companies leveraging technology to deliver more efficient and cost-effective financial products and services — from debit cards and loans to mobile payments and money transfers — must partner with banks. This fintech-bank partnership is known as Banking as a Service or BaaS.

Even if a fintech startup is a money transmitter licensed at the state level, it must partner with a bank to make and receive payments in U.S. dollars, as only banks have direct access to the payment system. As a result, America's licensed banks end up being the gatekeepers of financial innovation, as new ideas in the financial system must be implemented through them.

The Office of the Comptroller of the Currency, the national bank regulator, has become increasingly wary of BaaS arrangements, making it more difficult and costly for banks to maintain "third-party relationships" with fintech companies. Regulators say they are concerned about how fintech partners attract customers, monitor transactions and handle sensitive information, and how banks manage these risks to ensure compliance with applicable rules and regulations.

As a result of this tough regulatory stance and the ensuing enforcement actions and fines, many banks are “mitigating risk” by reducing or outright terminating fintech partnerships. At the same time, federal regulators have been reluctant to create a licensing regime for fintech or allow non-banks to directly access the payment system by having a master account at the Federal Reserve.

There’s another catch-22: Fintech can only survive in the United States given the current regulatory environment. Aggressive collaboration with banks, but federal regulators don’t want banks to partner with fintech companies.

Only Congress can solve these problems. State legislators are active on both fronts, designing customized regulatory frameworks for cryptocurrencies, such as New York’s BitLicense or California’s Digital Financial Assets Act, and fintech, such as Wyoming’s Special Purpose Depository Institution (SPDI) charter.

But none of these state laws and systems can alleviate the troubles state compliance agencies face at the federal level. Just ask Coinbase, which holds a BitLicense but was sued by the U.S. Securities and Exchange Commission (SEC) for “operating as an unregistered securities exchange, broker and clearing house,” or Custodia, which Chartered SPDI is not allowed to hold a main account with the Federal Reserve and therefore cannot directly provide basic payment services.

Congress must act to keep financial innovation alive. Developing a tailored licensing and regulatory federal framework for cryptocurrencies and fintech is critical to keeping U.S. capital and financial markets sound, competitive, and inclusive. In Heller’s words, crypto and fintech companies should embrace the idea that they “either survive forever or die trying.”