Libby Hall: Thank you for joining us for the third podcast in our series around cryptocurrencies and digital assets. I'm Libby Hall, Director of Communications for Oyster Consulting. In our previous podcast, Oyster’s Ed Wegener and Steve Gannon, a partner at the law firm of Davis Wright Tremaine, talked about the regulatory actions that are occurring around digital assets. In today's podcast, Ed and Steve continue their discussion on the crypto landscape, the regulatory fallout around the determination of what constitutes a security and the SEC's actions. Let's pick up where we left off.
Ed Wegener: You touched on this before, so I think maybe just briefly, the results of these determinations in terms of whether certain assets or securities not only has an impact on those assets, but on that entire ecosystem that we talked about earlier. So maybe if you could just touch on the fallout with respect to the determinations on the other players within that infrastructure.
Steve Gannon: Well, we talked a little bit about exchanges, and they'll certainly have to. If there's a determination that a majority of courts, for example, are coming down and saying, yeah, these are securities, there's a natural flow that comes from that. They're going to have to be registered as securities, which is going to be the responsibility of the project sponsors. Those, however, who are operating digital asset exchanges are going to have to make a determination. What's the security, what's not a security? And those that are securities, they believe but aren't registered, they're going to have to delist them, and they will probably have to register as exchanges or alternative trading systems themselves, which means being subject to SEC oversight. It will slow things down for sure. It will slow innovation down for sure. It will probably drive some groups of intermediaries offshore. Perhaps there is a potential that what would happen is the digital asset world will sort of split into two incumbents that are robust and that have the ability to stand up at a risk management systems that could hire the people that could do the appropriate disclosures under the SEC rules.
They might stick around. They did in fact start with a few guys sitting around a dorm room eating pizzas. And some folks will have to go overseas. Because if they get exposure to regulation, they simply won't be able to manage it. They won't be able to afford it in the first instance. Sso if you really want to see the fruits of your in innovation and you believe in the long-term value of your project, you won't be able to do very much in this regulatory community because you won't be able to afford the everything that comes along with regulation. So you could view it as almost, this is a program that is in favor of the concentration of this particular asset class in larger entities and is not very friendly to innovation.
It's friendly to innovation if you can innovate within a large institution. But that's a bit of an oxymoron. So <laugh>, it'll be interesting to see how that goes in terms of proposed rulemaking out there that would change and narrow the definition of a qualified custodian under the SEC rules. And that's something worth watching very closely because only institutional investment advisors, I should say, institutional investors, can basically have money held at places that are qualified custodians. And a lot of Coinbase today is qualified custodian. Custodial Bank, which I've mentioned in the past, is a qualified custodian. This would probably make it very difficult for those holding crypto assets to be qualified custodians, which would mean, of course, a cutting off of liquidity because you're cutting off institutional money. So, that's going to be something very, very much worth watching.
Ed Wegener: Well, we talked about the s SEC's efforts here, and as you talk about the custodial space, maybe that's a good segue into the banking regulations and what's been developing there. So can you talk a little bit about banking, and how that's been developing within that regulatory construct?
Steve Gannon: Those who follow this closely, and I would include myself among those, are experiencing a little bit of whiplash. So toward the end of the prior administration, when Brian Bark Brooks was the, acting comptroller of the currency, there were some interpretations adopted that appeared to be relatively friendly to digital assets. And for those who wanted to use digital assets in particular to perform payment functions, that was welcomed by the industry. However, the new acting comptroller of the currency, Michael Sue, who has been at the Fed for quite some time and is very much of a traditionalist and an institutionalist, sent out in November of 21, an interpretive letter IL1179 that basically said, and obviously they didn't use these words, but hey, not so fast.
Uh, and if you as a bank are a nationally regulated bank under the SEC's jurisdiction, if you are to engage in dig digital assets, you have got to meet some very high standards. And he articulated what those who are, and they are very akin to the heightened standards that the SEC published in the wake of the financial crisis. But, it is essentially, you've got to have from the top of the house, a risk strategy that is consistent with your holding or servicing digital assets. You've got to do risk assessments, you've got to have a risk framework. You've got to have controls in place, you've got to have monitoring in place, and you have to have reporting in place. And of course, you have to have the people, processes and technology that can manage all of those.
If you have those, maybe it's okay. So all I'm saying is if you have those kinds of things in place, from a banking perspective, yes, you can go forward. But the banks, and I'm now talking end of 21, early 22, the banks were going to be still very, very rigorous. That being said, a number of banks went forward with projects to, uh, become more active in the digital asset space. I don't believe any of them have come to fruition. There are a number of places, a number of digital asset companies like Prote and Paxos that had provisional bank charters granted, but that's not the same thing as having a bank charter. So, those are still very much in limbo. But the things changed very, very quickly. I don't know if it was related exactly to Tara Luna, but the pronouncements of the regulators, and by the regulators on the banking side, I mean the Federal Reserve Board, the OCC offs, the comptroller, the currency, and the Federal Deposit Insurance Corporation, FDIC, became a lot more strict.
And their concerns were, are there going to be runs on the banks? Are these assets too volatile? What's be the impact on capital? What's going to be the impact on liquidity? And in January of this year, they issued a joint agency statement that basically said it was highly unlikely that the holding of digital assets could be consistent with the safety and soundness of a particular bank. And when you are a banker and you have a regulator using the magic words safety and soundness around your bank charter, you really sit up and take notice, because you don't want there to be any doubt that your bank is a safe and sound bank. No question about it. Now, there is still the possibility they haven't banned digital assets from banks, but it is clearly constricting liquidity and the failure of the Fed to approve custodian's application to get access to the Federal Reserve systems, including the payment systems, including the ability to send wires, and then the almost immediate subsequent rejection of their membership application for Fed membership is an example of a desire to further cut off liquidity.
By the way, that matter is still in litigation in Wyoming. So, TBD, whether the fed's actions are successful and look with Silver Gate closing down surrogate and signature with the two main banks on which the industry relied to hold their deposits, send their wires, provide other related services. And with Silver Gate gone, it's essentially down to signature. And banks are needed for crypto companies to have on and off ramps to fiat. That's going to be whether or not something somebody else or some other bank or some other related entity comes in and starts providing liquidity into the industry remains to be seen. But right now it's a relatively tight place that the banking regulators have put the industry because they've made it very plain. They don't like crypto and they don't want banks to be involved in crypto.
Ed Wegener: So you mentioned TBD, and that seems to be sort of where I think all of this is, right? Yes. And it's to be determined. And as you mentioned, there's a number of projects that are ongoing and developing and, it makes it really difficult when you're in an environment where a lot of this has to be determined. So where does that leave the industry in terms of what industry members should be thinking about where they are now and as they plan for the future?
Steve Gannon: So I would say three or four different things. One is you have to take the long view. I think the old view of I'm going to be a Bitcoin billionaire in six months and I can retire at 25, that actually it has happened, but I think those days are long gone. The other phrase that was popular at the time was move fast and break things. That's not too particularly popular with regulators these days. Breaking things is not considered to be a good characteristic of a responsible member of the financial services industry. So that is going to go away. I think what's going to happen is those who are the pure technologists are going to realize, it's like any industry consolidation, and it's just going to be incumbent and really mandatory on folks.
They're going to have to build their risk systems. They're going to have to and, quite frankly, consult with folks like you. It's not going to be like, we're the developers and we're all the real smart, brilliant people from all the best schools with physics degrees, and the regulators are over here and we don't like one another. There's going to have to be bridges built between them so that the communications can be better, and they can understand more. And I think both sides are going to have to change. I think the technologists are going to have to become familiar with and adopt sound regulatory and practical regulatory steps. And real concrete things that are going to help them understand and then comply with the regulations that are going to comply with them so that there's confidence that they're managing their risk and they're disclosing their risk, and that they can monitor and get ahead of the risk.
That's where folks, by the way, like Oyster come in because you can understand those systems and you can help them implement them in a way that makes sense for their business. I think a lot of folks who are still caught up in the excitement of blockchain and digital assets which, by the way, they should be excited about it, there's a lot of incredibly positive things about that in industry, but they're going to have to realize, they can't go it alone anymore. They're going to need help and they're going to need regulatory help, and they're going to need people who can translate between those two worlds and who can figure out how to build the bridge and walk across it in both directions.
Ed Wegener: Well, we're at an inflection point, right? And inflection points are messy. And, you know, I think to your point, that's where you need people to help bridge that gap and help firms navigate areas like regulation and what they can expect and controls and those types of things. And this has been a fascinating discussion and really appreciate you joining us today. We’re going to be continuing this discussion and future podcasts as these issues develop. We're in early March right now and a number of the cases that you were talking about, you had mentioned were developing March 8th, March 9th so just days before we recorded this podcast. Things are developing very quickly and really appreciate you joining us and hope you can join us again.
Steve Gannon: Okay. I'd be delighted to Ed, I enjoyed it as well. Thanks so much.
Ed Wegener: Thanks Steve.
Libby Hall: Thanks everyone for listening. If you'd like to learn more about our experts and how Oyster can help your firm, visit our website @oysterllc.com. And if you like what you heard today, follow us on whatever platform you listen to and give us a review. Reviews make it easier for people to find us. Have a great day.