New York has enhanced its fraud prevention tools, while consumers can identify crypto scams using California’s scam tracker. A week after the US Securities and Exchange Commission (SEC) proposed amendments to cover cryptoassets under the Custody Rule applicable to investment advisers, federal banking agencies issued a statement reminding banks of their risk management obligations in connection with holding crypto companies’ deposits. The United Kingdom is considering fund tokenization, particularly as it relates to retail investors, and the Hong Kong Securities and Futures Commission is gearing up for a crypto exchange platform licensing regime while considering whether retail investors should trade on licensed crypto platforms.
New York Enhances Crypto Fraud Detection
On February 21, New York State Department of Financial Services (DFS) Superintendent Adrienne Harris announced DFS’s new insider trading and market manipulation risk monitoring tools. The tools are meant to enhance DFS’s ability to detect fraud and other illegal activity among New York State–regulated entities engaged in virtual currency activities. Entities subject to DFS oversight may want to “kick the tires” on their own surveillance and monitoring tools in light of DFS’s new tool set.
California Crypto Scam Tracker
The California Department of Financial Protection and Innovation (DFPI) recently announced its crypto scam tracker, which provides information about those companies subject to consumer-filed complaints. The tracker includes descriptions of losses incurred in transactions that complainants have alleged are part of a fraudulent or deceptive operation.
While the tracker does not verify whether actual losses have occurred, its goal is to provide the public with timely information about potential scams. Consumers can submit complaints online or through the postal service. Complaints must identify the person or business involved and include a description of the issue with the amount, date of any transactions, witness contact information, if any, and other relevant information that may assist the DFPI in resolving the complaint, along with other required information.
At the time we reviewed the tracker, it listed 36 complaints. Because the tracker is based on unverified consumer complaints regarding losses, legitimate crypto enterprises may want to ensure that they are not subject to fraudulent complaints.
Federal Banking Agencies Issue Joint Statement to Crypto Custodians
On the heels of the SEC’s proposal to amend the Custody Rule, on February 23, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency issued a statement highlighting the liquidity risks they believe banking organizations face when accepting deposits or other funding from or related to cryptoasset-related entities. The federal banking agencies were careful to state that the statement does not create new risk management principles, but instead highlights liquidity risks that banking organizations should be aware of, including crypto company deposits for the benefit of its customers and deposits that are the reserves for stablecoin, which “can be susceptible to large and rapid” inflows and outflows.
In light of these risks, the agencies recommend that banking organizations adhere to effective risk management and controls (some of which may mirror existing regulatory requirements or supervisory expectations), including the following:
- Understanding the direct and indirect drivers of potential behavior of deposits from cryptoasset-related entities and the extent to which those deposits are susceptible to unpredictable volatility.
- Assessing potential concentration or interconnectedness across deposits from cryptoasset-related entities and the associated liquidity risks.
- Incorporating the liquidity risks or funding volatility associated with cryptoasset-related deposits into contingency funding planning, including liquidity stress testing and, as appropriate, other asset-liability governance and risk management processes.
- Performing robust due diligence and ongoing monitoring of cryptoasset-related entities that establish deposit accounts, including assessing the representations made by those cryptoasset-related entities to their end customers about such deposit accounts that, if inaccurate, could lead to rapid outflows of such deposits.
The federal banking agencies also took the opportunity to remind banking organizations that certain deposits from cryptoasset-related entities may be brokered deposits and, as such, may require specific reporting by an insured depository institution on its call report.
We view the statement as another reminder from the federal banking agencies (assuming one was needed after their prior joint statement regarding cryptoasset risks and other actions, such as the FDIC advisory letter and proposed rulemaking regarding misrepresentation of FDIC deposit insurance and cryptoasset entities and the Federal Reserve’s denial (and more recent denial of reconsideration) of Custodia’s Federal Reserve membership application) that the agencies will continue to focus on the risks they perceive cryptoassets pose to banks, their affiliates, and the banking system more generally, and that they expect banking organizations to have a similar focus.
UK Financial Conduct Authority Issues Discussion Paper on Improving UK Asset Management Regime
The UK Financial Conduct Authority (FCA) published a discussion paper (DP23/2) on February 20 that sets out its high-level thinking on updating and improving the UK asset management regime. Among other things, it discusses fund tokenization, which the FCA understands to mean “the ability to issue a fund’s rights of participation (units or shares) to investors as digital tokens, usually by means of a distributed ledger.” With respect to fund tokenization, the FCA is seeking to understand the following questions:
- What benefits would tokenized units in authorized funds provide for investors?
- What regulatory changes would be needed to enable tokenized units to be issued?
- How much of a priority should we put on enabling tokenization of units?
In addition, the FCA is also seeking comment on tokenised portfolio assets. The FCA expressed that “fund tokenisation might be of interest as part of a wider programme in which existing assets could be held in the underlying portfolio of the fund and traded in a secondary market in tokenised form, with fully digitised clearing and settlement.” To this end, the FCA asks:
- Are there specific rules that could impact firms’ ability to invest in tokenised assets, where the underlying instrument is itself an eligible asset?
- How much of a priority should we put on enabling investment in tokenised assets?
Finally, the FCA stated that the government is considering whether there is a case for bringing the activity of portfolio management of cryptoassets (i.e., unregulated tokens, such as stablecoins and other forms of cryptocurrency) into the regulatory perimeter.
The FCA will consider feedback and publish a feedback statement later in 2023, possibly as part of a consultation paper on some of the discussion topics. Depending on the responses, the FCA will consider whether there are aspects of its rules that may need to be changed. Comments are requested by May 22, 2023.
Hong Kong Asks Whether Retail Investors Should Be Allowed to Trade on Virtual Asset Trading Platforms
On February 20, the Hong Kong Securities and Futures Commission (SFC) issued a consultation request on the proposed requirements for virtual asset trading platform operators. The consultation request is driven by a new licensing regime that will take effect on June 1, 2023. The regime will impose an SFC licensing requirement on all centralised virtual asset trading platforms located in Hong Kong, or those actively marketing to Hong Kong investors, subject to certain grandfathering provisions.
The SFC has stated its proposed licensing requirements are based on existing requirements comparable to those governing licensed securities brokers and automated trading venues. Of note, in the consultation, the SFC asks whether licensed platform operators should be able to serve retail investors and whether additional measures should be implemented if retail investors are permitted to be in scope. Comments are due by March 31, 2023.