Profit & Loss’s latest OnTheBlock series featured a one-one-one discussion with former CFTC staffer Justin Slaughter, now a partner at Mercury Strategies, in which he provided an insider’s perspective on how cryptoassets are being viewed by regulators in Washington, DC.

P&L OnTheBlock: An SEC official recently said that the agency does not  view ether[eum] as a security. Does this mean that the issue is settled and the SEC definitely won’t try and regulate it as a security now? 

Justin Slaughter: What we are basically hearing is that there isn’t an explicit, major problem with ether as a security. They are not yet saying it’s totally, absolutely, not a security. They’re not yet saying crypto in general is not going to be regulated, but compared to the relative opposition the SEC has had to just about everything crypto, this is a very good signal. One hopes they will now proceed to do some kind of rule-making or act that says, ‘here is what we visualise as a security; here are the ones we visualise as not securities, and other regulators can deal with’. But knowing the tempo for how things move in DC, especially right now, you’re probably looking at 18 months or so before that happens.

P&L OTB: Eighteen months?

JS: Eighteen months. Because it takes a long time to do regulation from the ground up. We have yet to have – at least in the States…or anywhere actually – to do a comprehensive regulation or even anything resembling regulation of crypto. The most we have right now is literally an open comment period at the CFTC. That’s the most rulemakings we’ve seen so far officially, so that’s our first baby step. This is a good signal – hopefully it means that people can now pursue this and move forward with the expectation that the SEC will not deliberately try to throw sand in the gears, but we have a way to go before this is fully blessed.

P&L OTB: If you’re the kind of firm that wants to get in and trade ether and products on the Ethereum network, the fact that they’ve now got a yellow light to do so, should they really invest time, resources and manpower towards trading these products if at some later point that yellow turns back to red, or they decide it’s a security after all?

JS: The yellow light is also an invitation now for people to come in and tell the SEC what they want. Now that they’ve said we think ether is not a security, it makes sense to go together to regulators and to the SEC and start saying, ‘Here’s how we visualise our product and here’s the rubric by which we think it works’. There are two reasons to do that. One is just to see what the staff says about your individual product and whether they say, ‘yeah, this seems okay versus not okay’, and two, you want to start to help set the playing rules for this new field in America, which is harder than elsewhere because we have so many regulators.

P&L OTB: Which agencies should people be focussed on?

JS: There’s a hierarchy. The first two are the CFTC and the SEC, depending on whether you think yours is more of a future or more of a security, but they’re going to be together on this no matter what. It’s difficult – I’m hard pressed to find many products that clearly are in one camp and not the other, because of course maybe there are derivatives of your product and security. Maybe yours is a future that then wants to become a security. Being in both of those is important, and then depending on the size of your market, the size of your company and whether or not there is someone else speaking for you at the other places, you can hopefully reduce your involvement with the other areas. With that said, for an entity like a Coinbase, they need to be playing everywhere. When you reach the point where your CEO is a billionaire, it’s usually time to start really engaging with just about everybody.

P&L OTB: At the Profit & Loss conference we hosted in New York recently, we had Mike Gill from the CFTC onstage talking about crypto regulation and I asked about this seeming regulatory land grab that we had, where CFTC sees a commodity, SEC sees a security. Everybody sees, funnily enough, the exact product that they regulate – and he suggested that it was going to divide up into different types of cryptos being related to different things. But then to my mind, there’s a question of something like Ethereum, where you have the Ethereum network versus, the native currency, right?

JS: I have no doubt that when we look down the road in 10 years, that is how things will be set up. But getting there is not going to be a straight and easy path. Federal agencies fight the most over jurisdiction – over the most tiny, minuscule matters. I could go into detail about actual, multi-year court fights that got as far up as the Supreme Court over things that were just not that important, because the agencies fight to defend their jurisdiction religiously. You hope that what’ll happen is that there will be an agreement, maybe brokered by the Treasury via the Financial Stability Oversight Council, that lays out, ‘here’s what everybody has’. But it’s probably more likely going to be a chunky engagement where one agency will act, the other agency will complain, they will tussle about it, and in the meantime, those companies that have overlapping issues at various agencies will face some pain potentially. So I hope that they move fast on that, but so far, we’ve been talking about this subject now of who has what in DC for over a year.

P&L OTB: So let’s talk about the CFTC then, because they seem to have this reputation for being very crypto friendly, especially Chairman Giancarlo (aka, “Cryptodaddy”). Is this reputation for being so crypto friendly really warranted when you look at what they’ve said versus what they’ve done?

JS: Certainly comparatively to other parts of the federal government, there is no question – this has been a very welcoming agency. Giancarlo has tried to find ways to support the industry, whether that’s LabCFTC, his engagement with the industry and his touting of it. In an objective sense, has he been as supportive perhaps as Singapore? Probably not, but it’s harder, right? Singapore can talk with one voice. He can’t, he’s bound by what the SEC does. He’s definitely earned the reputation of being the most favourable regulator to crypto. I do think there’s more that could be done in terms of creating additional glide paths, but it’s difficult. Regulation always moves slower than technology or business in general. It moves much, much slower for emerging technologies, which is what we have here with crypto and fintech in general.

P&L OTB: Part of what led to the buzz and excitement around crypto space last year was all these ICOs. How much is the hammer about to come down on the whole ICO model and market?

JS: This is where the SEC is most relevant. They certainly say these are all securities, but they haven’t done much yet. I think what’s going to happen is, there’s going to be some kind of enforcement action in the pretty near future, and enforcement actions against small startups can move pretty quickly. What makes investigations take a long time in the financial space in general is the number of people affected and the number of documents. A lot of these ICOs are small and haven’t been around a long time. You could theoretically see an action at some of these small, especially egregious ones pretty quickly.

P&L OTB: Do you think the SEC represents a kind of an existential threat to the ICO model itself?

JS: Domestically, potentially. Internationally, no, I think there is no way. Even if the US acted in a very maximal sense via the SEC that said, ‘these are all clearly securities’, and set out very serious ground rules on them, I assume that most ICOs that are viable will simply move overseas. I think they are loathe at this point to provide that kind of hammer. More likely, we’re going to see some targeted enforcement actions that will operate in a – call it a boom and bust cycle – where there’ll be a big one. When that happens, people will panic. The price probably drops substantially. There’ll be a lull. People think maybe it was just a one-off. They’ll keep doing that in intervals.

P&L OTB: How much does what regulators are doing in different countries feature into the conversations in Washington around crypto?

JS: Less than you would think. I’ve actually been surprised how the conversation on crypto has not been made more international so far. For whatever reason, this has yet to really penetrate as a top issue, so it’s not getting to the level you would expect. There is interest in what certain countries have done – such as the sandbox in England. There’s been interest in what people are doing in Singapore, but so far, and I think this is a testament to how regulators are still getting their heads around this, we haven’t seen a real conversation over how we should deal with this either on a domestic or international level.

P&L OTB: Do you think that’s partially because a lot of crypto trading so far seems to have been quite regionalised?

JS: That’s part of it. There is certainly an issue with the generation gap on this in general though. For every person – like a cryptodad in Giancarlo – you have five people at these agencies who have never heard more than a few words about crypto beyond bitcoin itself.

P&L OTB: Talking about enforcement actions for a minute, we’ve heard reports of investigations into cryptofirms Tether and Bitfinex.

JS: You’ve heard criminal reports in fact, which is even more significant.

P&L OTB: What does that mean for the broader space? Does that raise questions amongst other regulators?

JS: First off, it’s worth noting that all the various financial regulators – in the United States at least – only have what’s known as civil enforcement authority, which means they can only fine you or put you out of business with a trading ban. For all criminal matters, that is operated through the Department of Justice. The way it usually operates is that when the financial regulators find a case that has potential criminal implications, they will refer that to DoJ and will work together on that matter to see whether there should be a case. When DoJ is actually looking at something, that means they are actively pursuing an investigation. That is a very significant signal that they might do something. It is also more likely that you’re going to see – once DOJ is involved – other cooperation across different civil regulators, especially for things like this that cross multiple jurisdictional lines.

P&L OTB: If they do find some kind of criminal misconduct, how much does that then open up a Pandora’s box in terms of regulators piling in?

JS: The biggest danger to crypto right now is that there is a large criminal case that then causes a piling on – and not just in the regulatory body. Criminal action often precedes congressional action. If there’s a major case by DoJ that says many retail investors were defrauded or treated improperly, that could spark congressional interest to do something, which would be very complicated and probably a negative price signal for cryptos in general. Congress, after all, operates with a very broad brush, much broader than the regulators.

P&L OTB: Have cryptoassets permeated discussions at the political level or has there just been so much going on that it hasn’t?

JS: It has not. I’ve had conversations with Hill offices about offering some kind of bill to create a council to talk about cryptos, but it has been moving very slowly because there’s 5,000 other things going on that are way beyond this issue. That said, if there’s a major criminal case, that could break through the noise, which I think the industry would not like at this time. Best case scenarios are when industries have time to grow and can engage with their regulators, who know it better than most. Once you start involving congress in an issue, things can get out of control very quickly.

P&L OTB: Do you think we’ll see a push for a Self-Regulatory Organisation (SRO) in the crypto space?

JS: The short answer is not really. There was a big discussion about the potential for them at the CFTC back in March, but there’s two problems. Number one is that there is a debate over who would be in charge of said SRO. Number two, there’s a lot of desire from some of the current SROs to have jurisdiction over this. Certainly, the NFA has some interest in being seen as a crypto regulator, but there’s also some interest by FINRA. There’s a third issue too. In the past, it almost takes an Act of Congress to create an SRO. There was a big legal debate inside the CFTC when I was there over whether the commission could order the creation of an SRO or whether it has to be done by an Act of Congress. The most recent analysis I’ve seen said that you need an Act of Congress – so that’s a very big logistical hurdle. As much as I think the industry would benefit from having its own SRO, I don’t think there’s a lot of appetite because of these various issues and because I think the regulators want to first figure out what they do with it before they turn it over to an SRO.

P&L OTB: Do you think Swap Execution Facilities (SEFs) may look to offer cryptos?

JS: I’m certain they’re going to look to do it. The SEF model has proven very vexing, because when they were first proffered about eight years ago when Dodd-Frank was passed, the vision was that these were going to be new, revolutionary exchanges that we’re going to change the way we dealt with derivatives – but they have had a troubled existence to say the least. The CFTC has been working on a proposal to change the regulations around SEFs, and that was supposed to happen next month, but I’m hearing that will probably be in the fall and maybe later because of exogenous circumstances. I wouldn’t be surprised if any kind of restriction to SEFs offering crypto will be removed by that, because the CFTC does want to create additional opportunities for SEFs to thrive. But given that they have volume issues, among other things, it’s not clear how much traction they’d actually get. It’s hard to compete with CME and Cboe in the established markets and other entities such as Gemini or various ICOs in terms of new products, so I think they’re definitely going to try, but whether they’ll succeed seems tougher.

P&L OTB: Who is really under regulators’ glare here – is it the trading venues? Is it the funds that are trading on these platforms? Is it the people offering services, whether it’s wallets, etc, around the trading?

JS: The people who are being most looked at are two kinds. One is the very established giant players – the ones that are basically the linchpins of the system – your Coinbases, Ethereum is another one, Bitfinex – the very large exchanges where a lot of people are progressing and processing trades. Those will be very significant partly because sometimes enforcement interests can follow news articles, honestly. The other is anything that has a significant engagement with or use of retail customers. Regulators are always extremely cognisant of how products are affecting the retail market – more so than the institutional market – the logic being that retail is potentially more at risk of malefactors or people taking advantage of bad decision making. That’s partly why you’ve seen so much comment around these very small ICOs, because a lot of them don’t involve large money but involve small retail. So those are the two types under the spotlight right now and I think that’s going to continue.