The Catch-22 of US Crypto Regulation

The current state of crypto regulation is a “Catch-22,” a series of absurd and contradictory rules and requirements that are impossible to follow.

Marcelo M. Prates is a central banking attorney and researcher.

In Joseph Heller’s famous novel, a Catch-22 refers to a provision that airmen who want to be excused from combat duty can submit a petition declaring that they are insane. With one catch: submitting the request implies that the requester is healthy and therefore ineligible to be excused.

In 2024 America, the SEC’s “come in and register” approach is a Catch-22 for crypto.

SEC Chairman Gary Gensler often says that registering with the SEC to comply with securities regulations is simple, “it’s just a form on our website.” And crypto issuers and exchanges “just choose not to do it” even though they know how to do it. The SEC chairman makes it sound like crypto firms have been unreasonably (if not unlawfully) stubborn in not filing the required registrations in the face of a welcoming SEC. This characterization hides a catch.

Even if we assume, as Gensler does, that all crypto-tokens are securities and must be registered with the SEC—which is debatable—and that the registration process is straightforward—which it is not—successful registration would lead to a dead end. Registered crypto tokens, like any registered securities, could only be traded on registered exchanges by registered broker-dealers. But that is impossible today.

The Financial Industry Regulatory Authority (FINRA), a self-regulatory organization that oversees broker-dealers, has only approved a few institutions to handle crypto tokens. Among these institutions, only one is a Special Purpose Broker-Dealer, Prometheum, which remains inactive and has yet to list a token for trading nearly one year after approval.

Additionally, the SEC has not permitted any currently registered exchange or broker-dealer to list, hold, or trade crypto tokens. The SEC’s view is that any registered institution willing to work with crypto-tokens “could not deal in, transact in, maintain custody of, or operate an alternative trading system to traditional securities.”

Furthermore, virtually no crypto tokens have been registered with the SEC so far. And that’s the Catch-22: issuers won’t register their crypto tokens until they can find registered exchanges and broker-dealers that can work with them, and registered exchanges and broker-dealers won’t start working with crypto tokens until they not enough tokens registered to make the business model economically viable.

The reality for fintech is not much better. Due to the lack of a specific federal licensing framework, fintech firms that use technology to offer more efficient and cost-effective financial products and services—from debit cards and loans to mobile payments and remittances—must partner with banks. This fintech-bank partnership is known as banking-as-a-service or BaaS.

Even when the fintech startup is a state-level licensed money transmitter, it must work with a bank to make and receive payments in dollars, as only banks have direct access to the payment system. As a result, licensed banks in the US ultimately serve as gatekeepers for financial innovation, as new ideas in the financial system must be implemented through them.

The Office of the Comptroller of the Currency, the national banking regulator, has been increasingly wary of BaaS arrangements, which make it harder and more expensive for banks to maintain “third-party relationships” with fintech firms. Regulators say they are concerned about how fintech partners onboard customers, monitor transactions and handle sensitive information, as well as how banks manage these risks to ensure compliance with applicable rules and regulations.

There we have another Catch-22: in the current regulatory environment, fintech can only survive in the US with the active cooperation of banks, but federal regulators do not want banks to cooperate with fintech companies. What can be done?

But none of these state laws and regimes relieve state-compliant institutions from facing problems at the federal level. Just ask Coinbase, which has a BitLicense but is being sued by the SEC “for operating as an unregistered securities exchange, broker and clearing agency,” or Custodia, a chartered SPDI that is not allowed to maintain a Fed master account and therefore cannot directly offer basic payment services.

Congress must act to keep financial innovation alive. Enacting tailored licensing and regulatory federal frameworks for crypto and fintech is essential to keeping the US capital and financial markets healthy, competitive and inclusive. To paraphrase Heller, crypto and fintech companies must embrace the idea that they are “forever going to live or die in the effort.”