Lawmakers, Finra increase scrutiny of cryptocurrency

Washington is looking more closely at cryptocurrency and potential investor harm in the wake of the recent collapse of the FTX cryptocurrency exchange.

The House Financial Services Committee announced Wednesday that it will hold a bipartisan hearing next month to delve into the details of the FTX bankruptcy, which has shaken the cryptocurrency market.

Meanwhile, Finra earlier this week launched a targeted examination of how its member brokerages communicate with customers about crypto assets.

The Financial Industry Regulatory Authority Inc. said the timing of its sweep was unrelated to the implosion of FTX, which was the second-largest crypto marketplace. Nonetheless, Finra’s concerns about cryptocurrency are shared by other regulators, who are likely to boost oversight of digital assets.

Finra said investor harm could increase as the cryptocurrency market and investor demand grow. The regulator is worried about the potential for misrepresentations or exaggerated claims when brokers pitch crypto investments to retail customers, said Finra spokesperson Ray Pellecchia.

“This risk is not hypothetical,” Pellecchia wrote in an email. “The limited number of crypto asset related communications filed with Finra by broker-dealer firms fail to comply with applicable standards at a significantly higher rate than communications for other products. In order to develop a better understanding of industry practices in this area, Finra decided to conduct a sweep and assess a set of firms’ crypto asset-related communications made during the third quarter of this year.”

Firms involved in the sweep must report to Finra all of their or their affiliates’ crypto communications with retail investors between July 1 and Sept. 30. The regulator is probing whether each was filed with Finra’s advertising department and received approval from a firm principal. It's also reviewing written supervisory procedures related to developing and disseminating the crypto recommendations.

“Given the amount of U.S. retail investor interest and investment in various types of cryptocurrency, the U.S. regulators, including Finra, have to pay really close attention to how that asset class is being distributed,” said Holly Smith, a partner at Eversheds Sutherland.

The Finra advertising rule requires brokerages to be fair and balanced and avoid misleading customers when touting products. That’s where brokers might stumble if they view cryptocurrency as a token rather than a security, said Bao Nguyen, risk advisory principal at Kaufman Rossin.

“Some of these brokers who promote crypto assets may not consider them a security,” Nguyen said. “Sometimes they are, and, if they are, [brokers] must fully disclose the risks associated with investments in these types of securities. You can’t talk about all the benefits and rewards without talking about the [related] risk.”

The sweep could turn up violations. Finra might crack down, send a warning to firms or do a little of each.

“I would expect both enforcement actions and further guidance from Finra,” Smith said.

The legislative side of cryptocurrency oversight is still developing. House Financial Services Committee Chair Maxine Waters, D-Calif., and ranking member Patrick McHenry, R-Texas, haven’t agreed on a digital assets bill.

But they both expressed anger about the FTX collapse and said they would question the exchanges founder and former chief executive, Samuel Bankman-Fried, among others at the December hearing.

“The fall of FTX has posed tremendous harm to over one million users, many of whom were everyday people who invested their hard-earned savings into the FTX cryptocurrency exchange, only to watch it all disappear within a matter of seconds,” Waters said in a statement. “Unfortunately, this event is just one out of many examples of cryptocurrency platforms that have collapsed just this past year.”

McHenry added: “It’s essential that we hold bad actors accountable so responsible players can harness technology to build a more inclusive financial system.”