The Securities and Exchange Commission (SEC) has fired a major new salvo in chair Gary Gensler’s war on crypto, declaring illegal two of the world’s largest digital-token trading platforms, Binance and Coinbase. It is a welcome development: In myriad ways, the two enterprises exemplify what financial intermediaries should not do. What is needed now is an actual rulebook.

The SEC complaints, filed in federal court, read like a catalogue of what’s wrong with the intermediaries through which most US investors interact with crypto. Both Binance and Coinbase sold products that had the features of securities, without registering as such.

Much like the now-defunct FTX, they combined exchange, brokerage and clearing services — traditionally separated to avoid conflicts of interest — while failing to meet basic standards for disclosure or investor protection.

Among other things, according to the SEC, firms controlled by Binance’s owners misused customer funds — putting nearly US$200 million ($270 million), for example, into an account that was used to buy a yacht — and engaged in “wash” trades that artificially inflated transaction volumes. The agency is right to crack down on such conduct.

Enforcement actions alone, though, will not be enough to civilise the crypto market. One problem is that the SEC must establish jurisdiction in each case by proving that securities are involved. This should be relatively straightforward with Binance and Coinbase, but it will not always be, and much of what is traded on these and other platforms probably would not qualify.

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The two largest cryptocurrencies, Bitcoin and Ethereum, are defined as commodities by the Commodity Futures Trading Commission — which gives the CFTC authority over their derivatives, but not much over trading in the tokens themselves. Other tokens — including, potentially, those associated with useful projects — might be neither securities nor commodities.

This definitional confusion leaves crypto at an impasse. If a token is a security and cannot meet SEC requirements, which most probably cannot, it is illegal. If it is something else, which some probably are, it has no rules to follow. This makes operating a legal trading platform nearly impossible.

New rules are thus needed, both to keep crypto in line and to allow for whatever benefits it might eventually deliver. But what rules?

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Stretching the existing definition of commodities to cover more digital tokens, as a new draft bill in the House seeks to do, is not a great solution. The legislation’s main criterion for identifying commodity tokens — whether governance is decentralised, with no controlling individual — would be extremely difficult to apply in practice. Worse, it would in effect reward issuers for having (or pretending to have) nobody in charge.

A better approach would be to create a blanket legal regime for trading in any instruments that do not fall into existing categories, as well as Bitcoin and Ether (spot trading in which remains largely unregulated). Congress could task the SEC and the CFTC with jointly creating requirements for issuers and intermediaries, including disclosure, governance, safety, soundness and protection of customer assets.

Alternatively, the agencies could delegate some or all of that responsibility to an industry-funded entity that they closely oversaw, on the model of the Financial Industry Regulatory Authority.

None of this requires regulators to make value judgments about crypto. Whether any good comes out of it, and whether people get rich as a result, is a separate matter. But with the right rules in place, the chances of a desirable outcome will at least be much improved. — Bloomberg Opinion

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