JONES DAY TALKS®: Crypto and DeFi Regulation: It's About to Get Serious
Cryptocurrencies and decentralized finance remain under scrutiny from federal agencies and commissions. The acting Comptroller of the Currency has publicly stated that cryptocurrencies and decentralized finance may be evolving into serious threats to the financial system, much like the way certain financial derivatives prompted serious concerns and a near collapse back in 2008.
Clearly, serious regulations are under consideration. Jones Day's Josh Sterling and Dorothy Giobbe discuss what industry stakeholders need to know.
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Dave Dalton:
U.S. regulators continue to scrutinize cryptocurrencies and decentralized finance platforms, even as public and institutional interest in these innovations trends upward. The acting Comptroller of the Currency even went as far as to say that cryptocurrencies and decentralized finance may be evolving into threats to the financial system in much the same way certain derivatives instigated the 2008 global financial crisis. There's clearly a lot to talk about here. Jones Day's Josh Sterling and Dorothy Giobbe are here for what should be a very timely and insightful discussion. I'm Dave Dalton. You're listening to Jones Day Talks.
Dave Dalton:
Jones Day partner Josh Sterling is the former Director of the Market Participants Division of the U.S. Commodity Futures Trading Commission, or CFTC. He advises Jones Day clients on enforcement, advisory, and transactional matters relating to financial markets activities. And Dorothy Giobbe has more than a decade of legal experience as a trusted advisor to C-suite leadership regarding blockchain, distributed ledger technology, crypto assets, quantum computing, machine learning and artificial intelligence, biometrics and digital identity, cybersecurity, government relations, and bank regulation. Both Josh and Dorothy are based in Jones Day's New York office.
Dave Dalton:
Josh, Dorothy, thanks for being here today.
Dorothy Giobbe:
Thanks, Dave.
Josh Sterling:
Thank you.
Dave Dalton:
Dorothy, Josh is a Jones Day Talks veteran. He's done several of these programs. But this is your first excursion with us. And welcome to the firm. Welcome to Jones Day Talks. Tell us a little bit about your background prior to joining Jones Day.
Dorothy Giobbe:
Yeah. Sure, Dave. Thanks very much. And it's great to talk with you. So I've recently joined Jones Day from the emerging technology legal practice of a large global financial institution.
Dorothy Giobbe:
And my work there, from a legal perspective, centered on supporting business initiatives in the emerging tech space. So that included blockchain and crypto assets, machine learning and predictive analytics, biometrics, including facial recognition technology, and work associated with quantum computing initiatives.
Dorothy Giobbe:
The really interesting thing about these technologies is that they have applications in so many different areas potentially, and that there are use cases that span various areas or lines of business within the financial services sector.
Dorothy Giobbe:
And that was certainly my experience in-house. The exploration and use of these technologies wasn't confined to one area or one line of business. Almost by their nature, they have broad applicability potentially.
Dave Dalton:
Sure. Where will your practice focus in terms of client interests and client concerns moving forward? What do you think will happen there?
Dorothy Giobbe:
I hope in many ways it'll be a continuation and expansion of the work that I've done. I'm focused on helping clients use emerging technologies to develop and build and get to market financial services and products.
Dorothy Giobbe:
And that really includes everything from sitting with clients as they think about how or where to use these technologies and how to navigate some of the legal and regulatory and other risk issues, which may really run the gamut depending on what the product or service offering is and where it'll be offered. But my time working in-house in close partnership with business colleagues as well as compliance and risk and other partners has given me a very helpful perspective in terms of effectively partnering with clients to help get them where they'd like to go...
Dorothy Giobbe:
... particularly in this area of incredible explosion in the emerging technology space.
Dave Dalton:
Sure.
Dorothy Giobbe:
So I'm excited to be here and very much looking forward to helping clients in this absolutely fascinating area of practice.
Dave Dalton:
Absolutely. Well, I predict you're going to be very busy, and I don't think I'm going out on a limb saying that. We're living in a fascinating time from various standpoints in terms of regulations and innovation and tech and everything. It's just fascinating what's going on.
Dave Dalton:
All right. Let's get to what we're to talk about today, and we'll stay with you Dorothy to get us started. Couple weeks ago, Michael Hsu, the acting Comptroller of the Currency, said during a recent public event, I think it was a blockchain conference of some sort, in fact, he said that cryptocurrencies and decentralized finance may evolve into threats to the financial system much like the way some derivatives brought serious concerns, a near collapse back in 2008. Now, we should be noting that since he delivered those remarks, the President has nominated a professor, Omarova, a Cornell University faculty member to lead the Office of the Comptroller of the Currency. But that's the vibe out there right now in terms of their concerns. Dorothy, given your experience and your read on the situation, what's your initial reaction to all this, to Mr. Hsu's remarks and to the nomination of Professor Omarova?
Dorothy Giobbe:
Yeah, those were strong words. But I think the message is that this is certainly a time of increased scrutiny of crypto assets and the digital asset ecosystem.
Dorothy Giobbe:
And so it's no surprise really that this is coming during a period of explosive growth and innovation in that ecosystem, with the development of new product and service offerings and ventures and partnerships and...
Dorothy Giobbe:
... investment in resources directed to the space. And so it's this balance between encouraging innovation and trying to ensure that the U.S. is leading in innovation and the...
Dorothy Giobbe:
... development of new products and services. And then the very important considerations around safeguarding markets and orderly, efficient markets and ensuring investor protection. And so I think that's the balance. And I think we're seeing that play out now in a very focused way.
Dorothy Giobbe:
It's also interesting to note that as we see regulators try to gain a stronger traction in the crypto asset space, governments around the world are looking at this technology and how it could be used to drive efficiency and innovation...
Dorothy Giobbe:
... and improve their own function. So for example, Central Bank Digital Currencies, or CBDCs...
Dorothy Giobbe:
... are a focus for almost every government, including here in the U.S. And so it is, in the larger picture, a very interesting, very interesting period.
Dave Dalton:
Well, it certainly is. And you touched on something that I'd like you to talk more about. You know, there's always that tension, isn't there? Between, okay, we want innovation, we want growth, we want progress, we want these opportunities out there, and yet regulators and legislators have a responsibility in terms of protection. You said it, protect the markets, protect consumers. This is a natural part of the process, isn't it? Now how long it goes and how we get there is a different question. But we've seen this before, haven't we, Dorothy, this kind of interaction, this kind of tension?
Dorothy Giobbe:
That is a tension that exists. It's certainly not unique. It's just that in this space, we see the pace of development and we see the pace of innovation and the volatility...
Dorothy Giobbe:
... and the speed of innovation bumping up against some of the regulations that have existed over a longer period of time. And...
Dave Dalton:
Right.
Dorothy Giobbe:
... it's always a balance. And it's not a unique dynamic. It's just that it's more intense in this ecosystem.
Dave Dalton:
Yeah. It's so high profile. So high profile. I think it was almost inevitable.
Dave Dalton:
Let's go back to Josh Sterling for a second. Josh, we talked about, in our opening remarks, the acting comptroller was concerned with certain derivatives. He was referring specifically to credit default swaps in terms of being at least partially responsible for the financial crisis of 2008. What were credit default swaps, or what are they if people are still using them? Can you tell us what those were, and how those problems were brought upon the financial system?
Josh Sterling:
Thanks for that, Dave. And great to be talking with you as always.
Dave Dalton:
You too.
Josh Sterling:
And Dorothy as well. Yeah. So Mr. Hsu's speech was focused on the 2008-2009 financial crisis in which certain default swaps were thought to play a role in exacerbating some of the risks associated with insolvencies that eventuated amongst some investment banks at the time.
Josh Sterling:
And the credit default swaps were basically a way of buying or selling protection against the default on certain debt obligations. And so basically...
Dave Dalton:
Okay.
Josh Sterling:
... one party would make regular payments to another party and the party that's making the regular payments would be assured, at least under the terms of the contract, assured that they would receive a payment...
Dave Dalton:
Okay.
Josh Sterling:
... to cover any default on the referenced debt obligation. And that didn't quite go as expected. And to sort of cut to the punch, 13 years later, 12 years later, you have the CFTC as sort of the predominant regulator of the markets. Many of those kinds of trades are now centrally cleared and executed on an exchange.
Josh Sterling:
And you had a whole other division in the CFTC created to oversee all of that. So that's the short of it.
Josh Sterling:
And I just wanted to make one observation about Mr. Hsu's speech as well. First of all, the message was quite clear that they're very concerned about things happening in the crypto space, the financial technology space from the perspective of traditional finance. And as sort of macro prudential regulators, you're responsible for banks deposits, payment system, all of it. I find it somewhat interesting, though, that in order to criticize new finance, which is outside the existing financial system in many important respects, they looked at something that was at the very core of traditional finance to criticize it. So you're basically saying, well, something went really bad in traditional finance. Watch out for alternative finance. It can...
Dave Dalton:
Right.
Josh Sterling:
... collapse on itself. Biggest point's taken. I mean, this isn't a logic exercise. The gentleman's trying to make a point. And I understand that and I think he did.
Dave Dalton:
Sure. Sure. Let's go back to Dorothy for a second. Dorothy, are the comparisons between crypto and credit default swaps reasonable? Is that apples to apples at all?
Dorothy Giobbe:
Whether the comparison with credit default swaps is the right comparison or not, the larger message to take away is that clearly regulators have focused their attention on this space and that isn't going to change anytime soon. That creates opportunity for engagement and education and collaboration and cooperation with regulators. And so... One thing I would also add, that the nature of this ecosystem is that it is cross border. And so I think it'll be important for regulatory discussion and coordination to develop here in the U.S., but globally as well, to strive for global consistency and, again, the encouragement of innovation while safeguarding those very important public policy goals.
Dave Dalton:
Definitely. All right, well, you mentioned engagement a second ago. And sometimes an agency or a regulatory body will put out a guidance or a white paper or something akin to it and they will say we'd like comments. Are regulators, at least in the U.S., the Comptroller Currency, the SEC, are they reaching out to market participants saying, hey, we have some issues here, we'd like your input? Is that a formalized process, Dorothy? Or does that happen informally? Or they pick up the phone? Or how might market participants help regulators understand and make sure this works for everyone? How might that go?
Dorothy Giobbe:
There are a number of points of engagement depending on where one sits within this ecosystem. So the agencies in the U.S. have put out requests for comment...
Dorothy Giobbe:
... requests for information. Those are very sort of formalized requests for input processes. But there are also opportunities for engagement in very individualized or specific situations. And then depending on, again, where one sits in this ecosystem, there are regular and sustained contacts with a variety of different regulators.
Dave Dalton:
Sure. Let's go back to Josh. Josh, Mr. Hsu expressed concern about the risk inherent to stable coins in his remarks a couple weeks ago. Talk about that. What's the worst case scenario there in terms of, uh-oh, everything that possibly could have gone wrong, went wrong? What was he thinking there?
Josh Sterling:
Yeah. In a word, he's probably referring to some of the problems that occurred 12 years ago and even last year when I was in government with prime money market funds. So money market funds that don't just buy government securities, they buy short-term corporate debt, commercial paper and things like that. And so stable coins play an important role between traditional finance, fiat finance, and crypto finance. And so a stable coin is a way to get U.S. dollars or other fiat into the crypto system. Dollars for stable coin, stable coin for crypto, and vice versa, how to get it out.
Dave Dalton:
Okay.
Josh Sterling:
So it has sort of this currency exchange mechanism almost built into it. And the stable coins are, as the name suggests, intended to approximate a certain dollar amount or amount of fiat currency. I would say on their face, but this is all virtual, so I guess stuff doesn't have faces anymore.
Dave Dalton:
Right.
Josh Sterling:
That being the case, the question then becomes, well, what do you hold to assure yourself that you at least closely approximate a dollar per coin? Just to give a simple example.
Dave Dalton:
Okay.
Josh Sterling:
And in some recent cases it's been uncovered or found that those sponsoring, if you will, stable coins have invested in all manner of instruments, some of which are more risky than you would expect for something that plays a vital exchange mechanism.
Josh Sterling:
So here's what could happen having said all that. You can imagine a scenario in which, for any reason, the value of crypto goes down precipitously and people want to get out and they want to get out and they want to get into cash.
Josh Sterling:
And so they can do that. And when they do that, whatever the stable coins are holding, presumably they'll need to retire those holdings, and then the number of stable coins will go down. So what you could be doing in this scenario is causing downward price pressure on the instruments the stable coin holds, which can include the debt of corporate borrowers in many cases.
Dave Dalton:
Yeah.
Josh Sterling:
And then you sort of don't have those same stable coin sponsors in the market the next day to buy more short- term debt. This is what happened in 08-09 essentially.
Dave Dalton:
Okay.
Josh Sterling:
Companies would sell their commercial paper, their shortest short-term debt to prime funds. And that, commercial papers used to do things like fund payroll and make other short-term payments.
Dave Dalton:
Right.
Josh Sterling:
And you couldn't roll it over. You couldn't roll your paper. And so you had a funding crisis. And that's, we're talking about the real economy there, payrolls paying vendors, things like that.
Dave Dalton:
Yeah.
Josh Sterling:
There's a contagion issue. And so the thought is that perhaps that contagion issue exists to some degree with stable coins. And there certainly may be other risks I'm not thinking of. That one occurs to me having been in the middle of that back in '08 and then again in government...
Dave Dalton:
Yeah.
Josh Sterling:
... in 2020. So that's part of the concern.
Dave Dalton:
Right. Contagion issue. I like that. I'm going to write that one down and use it somewhere. But good explanation there because, listeners, we prepare for these podcasts, and Josh and Dorothy and I send notes back and forth and so forth. And I was wondering where he'd go with that. But that was a terrific explanation. So thanks. We're mostly caught up there. So thank you.
Dave Dalton:
Dorothy, we touched on this a second ago sort of, but maybe this is another case where innovation is just way ahead of regulations. So someone like Mr. Hsu who has concerns, what are some of the safeguards, controls that regulators might consider to address concerns of people like Mr. Hsu? What could be done potentially? I know this is, maybe we're way out in front of it, but just notionally what might someone or someone propose?
Dorothy Giobbe:
It depends, again, on where one sits or engages in this marketplace because there are different degrees and areas of engagement across the landscape. So as a general matter, there are AML considerations, reputational considerations.
Dorothy Giobbe:
Those will continue to be an important factor with respect to what level of engagement, what type of engagement, what that looks like. And various comfort levels around the degree of engagement and activities in this space. And so that answer depends on where one sits, where they're coming from, and the manner in which they engage with this ecosystem.
Dave Dalton:
Sure. But back to Josh. Crypto and DeFi are under constant scrutiny in different agencies, commissions, even somewhat at the state level, I guess. Is this a new normal? Or based on your experience, do we settle into a situation where there are reasonable regulations and standards? And if so, Josh, how do we get there? How long might it take, and what needs to happen at various levels and at different agencies?
Josh Sterling:
Great question, Dave. As always, there's definitely been a shift in tenor with the change in administration.
Dave Dalton:
Okay.
Josh Sterling:
When I was in government, the thought and theory was we want to foster responsible innovation and financial technology so that the United States can remain a world leader. And I know when I was there I had conversations with some very well-established companies getting into fintech that sort of said to us at the time, as a representative of the federal government of the United States, look, we could have done this in Singapore too. We could have done...
Dave Dalton:
Yeah.
Josh Sterling:
... this in other markets. And there is a degree of competition amongst money centers in the world, be it the forefront of financial innovation.
Dave Dalton:
Sure.
Josh Sterling:
What it seems to me now from just the things I read and talking to folks is that the tenor has shifted more towards a risk focus, sort of a risk-off focus and thinking about that in two ways. One is sort of a market and investor risk and the other one is sort of system risk.
Josh Sterling:
And the diagnoses on that are pretty strong in the direction of we really don't care for this and need to watch it.
Dave Dalton:
I see.
Josh Sterling:
I think from the market perspective, that'd be the SEC and the CFTC, let's say...
Josh Sterling:
... considerable focus on investors, customers in the crypto context or DeFi context getting fleeced, being sold at a bill of goods, a bamboozle, a hustle.
Dave Dalton:
Yeah.
Josh Sterling:
And you'll always have cases about that on really anything. In any given day, the CFTC could pursue a retail commodity or metals case or a 4X case...
Dave Dalton:
Yeah.
Josh Sterling:
... just as well as they have recently pursued retail coin cases.
Josh Sterling:
You're always going to have that, the SEC too. So these market customer protection risks, investor risks, those are, of course, valid risks. There's bad actors in every market.
Dave Dalton:
Absolutely.
Josh Sterling:
There is a way to deal with that that can allow the products to be sold and to develop, but within some guardrails. That's possible now. What is challenging, and we'll see as the Fed and others roll out petition papers and research papers and the like in the coming weeks, is on the system risk, the financial system risk, the macro prudential regulation. The cryptocurrency and the centralized finance both present some serious challenges to sort of traditional fiat finance.
Josh Sterling:
And it's not for me to say, as I sit here, who has the better argument. I mean, these are, there are really great law school or theoretical arguments you can have about it, but there's also the real world. When you go to the ATM, the money's got to come out...
Dave Dalton:
Yeah.
Josh Sterling:
... companies have to pay their debt. You want to control your money supplies, a sovereign nation. So where does crypto, which is sort of another way to think of, conceive of, and use money, where does it go? What pressure does it put on it? So that's a harder debate to sort out. And I'm just going to say it's because there's more regulators than on the market side, to be a little glib. But we'll get some pretty strong steers on that for the next couple months.
Josh Sterling:
But there's no doubt about it that macro prudential regulators, the banking regulators are looking at crypto and DeFi and thinking about perhaps how to ring-fence the core of the financial system, the core of the banking system, which our banking system, including institution where Dorothy just worked at...
Josh Sterling:
... they play a role in sort of multiplying the money supply...
Dave Dalton:
Yeah.
Josh Sterling:
... take in deposits, put out loans, simply stated. And crypto is no part of that as it stands right now. So there's some ring-fencing going on here and it's going to continue.
Dave Dalton:
Well, it's fascinating. Since I've been paying attention, these matters have crossed over from the tech section of the newspaper to the financial section, to the main section. This is main, oh, I hate the, mainstream news now. Right? Everybody kind of is wondering where this is going. And, of course, Bitcoin grabbed all the headlines for so long. But this is a very real thing now. I'm as interested anybody to see where this all shakes out, but certainly, certainly is headline-worthy. And it's going to be fascinating to watch in the months and maybe the year or two ahead.
Dave Dalton:
Dorothy, having said that, with crypto landscape changing so quickly, what are you hearing from clients? What are their questions? What are their concerns? Are they getting their heads around this?
Dorothy Giobbe:
The recent tone has caused certainly some concern. There are questions around specific use cases. Questions about sort of the broader environment, but then questions about specific use cases as well. And that's certainly true here in the U.S. But as we said, these are by nature cross-jurisdiction, cross-border...
Dorothy Giobbe:
... markets and services and products. So the lack of sort of a comprehensive treatment of these assets increases uncertainty. And so I think those questions are focused on all of these issues that we've been talking about. What's permissible? Where can I engage? And how can I engage? And what does that look like?
Dave Dalton:
Sure. The U word, uncertainty. Markets hate uncertainty more than anything, even I've figured that out. So it'll be nice to get some clarity soon.
Dave Dalton:
Hey, this has been great. Let's wrap it up with this, with Josh. Josh, recent events, Mr. Hsu's remarks, nomination of a new comptroller. What's the main takeaway today as you look at this landscape? What do you want our listeners to know and to hear?
Josh Sterling:
To state a point, which I'm sure our listeners will regard as obvious, it's about to get serious in terms of taking a hard look at crypto and fintech regulation in this country by the financial regulators. I would add to the list something that was just announced yesterday, which is there's a sitting CFTC commissioner, Dan Berkovitz, who had previously been the GC at the CFTC, he's leaving his role as a commissioner at the CFTC to go be a general counsel at the SEC. So that's some serious legal firepower going over there. All this suggests to me that as we consider what the outward bounds are...
Dave Dalton:
Right.
Josh Sterling:
... what the regulators believe are possible or prudent to do by rule, we should look farther still. There's some pretty serious thought going into this and folks should be prepared to go through the regulatory process, try to inform and influence rules. And from whatever perspective they have, if they have a desire to challenge rules, to think about ways to do that through the legal process. So I think we're in for it.
Dave Dalton:
Interesting time, like I said before. And by the way, Josh, every time we talk you always drop one gem out there. It's about to get serious. I like that. We should put that on a bumper sticker. It's about to get serious. And how true, right? So we're going to leave it right there. Although, I want to thank Dorothy and Josh for being here again. Dorothy, this was your first Jones Day podcast, right?
Dorothy Giobbe:
It was indeed, Dave. Yes.
Dave Dalton:
And was it all that you hoped it would be?
Dorothy Giobbe:
Everything and more.
Dave Dalton:
Of course.
Dorothy Giobbe:
Absolutely.
Dave Dalton:
Well, given what you two talked about over the last half hour or so, I know we're going to talk again soon because the news never ceases when we're talking about this space and this sector. So thank you both for being here. We're going to do this again real soon.
Josh Sterling:
Thank you.
Dorothy Giobbe:
Thanks, Dave.
Dave Dalton:
All right. Thank you both.
Dave Dalton:
You can find complete contact information for Josh Sterling and Dorothy Giobbe at jonesday.com. While you're there, visit our insights page. You'll find podcasts, videos, publications, newsletters, blogs, and other interesting content. And while you're at that insights page, look for our new dedicated fintech page, which has more information regarding the kind of topics we talked about today. Look for that soon. Subscribe to Jones Day Talks at Apple Podcasts and wherever else podcasts can be found. Jones Day Talks is produced by Tom Kondilas. As always, we thank you for listening. I'm Dave Dalton. We'll talk to you next time.
Speaker 4:
Thank you for listening to Jones Day Talks. Comments heard on Jones Day Talks should not be construed as legal advice regarding any specific facts or circumstances. The opinions expressed on Jones Day Talks are those of lawyers appearing on the program and do not necessarily reflect those of the firm. For more information, please visit jonesday.com.
