SEC Jurisdiction and Perceived Crypto-Asset Regulatory Gap: An FTX Case Study
INSIGHT
SEC Jurisdiction and Perceived Crypto-Asset
Regulatory Gap: An FTX Case Study
November 29, 2022
FTX Trading, a crypto company once valued at $32 billion, filed for Chapter 11 bankruptcy proceedings
in November 2022. Some of FTX’s largest investors immediately wrote their FTX investments down to
$0. More than a million creditors (including individuals and institutions) are caught up in this FTX
insolvency. This Insight uses the FTX event as a case study to illustrate the Securities and Exchange
Commission’s (SEC’s) regulatory jurisdiction, how it applies to crypto-assets, and perceived weaknesses
in the application of the current regulatory framework.
SEC Investigation of FTX
The SEC and dozens of other federal, state, and international regulatory agencies and prosecutors have
engaged with FTX to obtain more information. The SEC generally does not publicly disclose information
regarding ongoing investigations. But multiple news sources have reported that the SEC has been
investigating FTX.US, FTX’s U.S. subsidiary, for months. While FTX is based overseas and reportedly
seeks to block U.S. customers to potentially avoid U.S. jurisdiction, FTX.US provides narrower product
offers and is tailored for the U.S. market, and it maintains several U.S. regulatory licenses.
Since the FTX crash, the SEC has reportedly expanded its investigation toward FTX and Alameda
Research, an FTX-affiliated investment management firm. At issue is whether FTX and its affiliates are
involved in certain securities-related activities, which should have been registered with the SEC (or
received an exemption) before being sold to investors. To the extent that these are securities transactions
that implicate U.S. jurisdiction, a crypto exchange may be subject to the SEC’s regulation, including the
Customer Protection Rule, which requires securities broker-dealers to segregate client assets from their
proprietary business activities. That rule may have mitigated some of the issues that reportedly led to
FTX’s bankruptcy, as the firm is alleged to have loaned client funds to Alameda Research.
More importantly, even if the SEC could prove that FTX and its affiliates violated securities regulations,
the SEC’s capability to go after FTX is limited to securities activities, which generally do not include
commodities and other non-securities instruments that make up the bulk (or even all, depending on whom
you ask) of FTX’s business. Some observers believe that the SEC may face difficulty pursuing FTX
mainly because of the firm’s offshore status and how existing regulatory frameworks are currently applied
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to crypto-assets—certain crypto-asset market segments are generally not subject to federal securities
marketplace regulation commonly seen in traditional investments.
SEC Jurisdiction
The current regulatory landscape for crypto-assets is fragmented. Multiple agencies apply different
regulatory approaches to crypto-assets at the federal and state levels. The SEC is the primary regulator
overseeing securities offers, sales, and investment activities, including those involving crypto-assets. In
general, a security is “the investment of money in a common enterprise with a reasonable expectation of
profits to be derived from the efforts of others.” When a crypto-asset meets this criterion, it is subject to
the SEC’s jurisdiction.
SEC Chair Gary Gensler has repeatedly stated that he believes the vast majority of crypto tokens are
securities (while recognizing some crypto-assets are not). Other stakeholders, including the crypto
industry, disagree with that assertion. In cases where they are not securities, crypto-assets may be
commodities under the Commodity Exchange Act (CEA). In such cases, they would be subject to the
Commodity Futures Trading Commission’s (CFTC’s) jurisdiction, which generally extends to
commodities and derivatives. For example, under this framework as currently applied, most initial coin
offerings are considered securities, but Bitcoin is considered a commodity, not a security. Securities
regulations could also apply if the crypto market intermediaries (e.g., investment advisers, trading
platforms, and custodians) are directly engaged in the security-based crypto-asset transactions.
In cases where the crypto-assets are securities, the SEC has both (1) enforcement authority that allows the
SEC to bring civil enforcement actions, such as anti-fraud and anti-manipulation actions, for securities
laws violations after the fact and (2) regulatory authority, including over digital asset securities, which
could include registration requirements, oversight, and principles-based regulation. Also, the CEA
provides the CFTC with certain enforcement and regulatory authority when it comes to digital asset
derivatives. However, the CFTC has enforcement authority, but not regulatory authority, over the spot
market of digital asset commodities.
Perceived Crypto-Asset Regulatory Gap
Because crypto-asset commodities spot market activities receive CFTC oversight that generally pertains
to enforcement (but not regulatory) authority, activities in these non-security crypto-asset markets are not
subject to the same safeguards as those established in securities markets. Examples of such safeguards
include certain rules and regulations that encourage market transparency, conflict-of-interest mitigation,
investor protection, and orderly market operations.
In the case of FTX, if FTX and its affiliates are involved in the crypto commodities spot market (e.g., the
trading of Bitcoin), neither the SEC nor the CFTC would normally regulate these activities.
Certain observers, including the Financial Stability Oversight Council (FSOC), characterize this
framework as having a regulatory gap. FSOC has encouraged Congress to provide explicit rulemaking
regulatory authority for federal financial regulators over the spot market for crypto-assets that are not
securities. FSOC states that this new rulemaking authority “should not interfere with or weaken market
regulators’ current jurisdictional remits.”
Policy Questions
Some Members of Congress have proposed to redesign SEC and CFTC jurisdiction, and Congress will
likely continue to propose changes and explore alternatives. When designing a new regulatory landscape,
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policymakers face challenging questions about how (or if) to make crypto-asset securities and
commodities regulation more alike. Financial regulators have traditionally followed the “same activity,
same risk, same regulation” principle to mitigate the potential risks of regulatory arbitrage. Related
questions include: To what extent should the design of the crypto-asset regulation framework align with
the existing securities trading and investment regulation? Should different sets of rules be based on the
regulatory jurisdiction or the nature of risk exposure and risk mitigation needs? What are the operational
costs to the platforms under different alternatives? Should Congress appoint a primary regulator for
crypto-asset markets, or should actions such as rulemaking be evenly coordinated across financial
agencies that are governing the same or similar entities?
Author Information
Eva Su
Analyst in Financial Economics
Disclaimer
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