On Friday, New York Attorney General Letitia James proposed legislation that would ban cryptocurrency exchanges from trading their own tokens. The new rules would also require audits of cryptocurrency exchanges to add more regulatory scrutiny of these and add a layer of investor protection to the industry. 

James’ program bill proposes the “strongest and most comprehensive set of regulations on cryptocurrency in the nation,” according to a statement released by her office on Friday.

Under the draft bill entitled The Crypto Regulation, Protection, Transparency, and Oversight (CRPTO) Act, blockchain businesses creating coins or tokens would be barred from operating as brokers of their own digital assets.

People managing those companies would not be allowed to trade those coins either, to avoid market manipulation or embezzlement. Cryptocurrency exchanges would not be allowed to hold customer funds like a bank, while brokers would not be allowed to borrow or lend customers’ digital assets.

CRPTO’s goals

The intention here is to prevent the conflicts of interest that can often lead to customers losing their money on coins when such coins are both created and managed by exchanges and brokers. And, more specifically, it aims to protect customers from losing money when such a business secretly bets their account holdings on overly risky investments.

“Rampant fraud and dysfunction have become the hallmarks of cryptocurrency and it is time to bring law and order to the multi-billion-dollar industry,” James said. “New York investors should have the peace of mind that there are safeguards in place to protect them and their money.”

Crypto platforms would also have responsibilities to customers similar to those of banks under the federal Electronic Fund Transfer Act as the rules would require platforms to reimburse customers who are the victims of fraud.

The bill would also codify the New York State Department of Financial Services’ (NYDFS’s) regulatory authority to license digital asset brokers, marketplaces, investment advisers, and issuers prior to engaging in business in New York and allow NYDFS to oversee the digital asset licensing regime. Under NYDFS rules already in place for the crypto sector, digital asset businesses must apply for a BitLicense – a business license permitting regulated virtual currency activities – to do business in the state. The agency recently announced that it would start charging cryptocurrency firms registered in New York for the costs of annual supervision and examination. 

Conflicts of interest

The bill seeks to stop conflicts of interest within the industry specifically by:

• preventing common ownership of crypto issuers, marketplaces, brokers, and investment advisers and preventing any participant from engaging in more than one of those activities;
• preventing crypto brokers and marketplaces from trading for their own accounts;
• prohibiting marketplaces and investment advisers from keeping custody of customer funds;
• prohibiting brokers from borrowing or lending customer assets; and
• prohibiting referrals from marketplaces to investment services for compensation.

One example of a conflict of interest in the crypto sector involved Terraform Labs and its token, Luna, which Terraform Labs promised would pay 20% interest to customers who invested in the token on Anchor, its lending platform.

Reporting and investor protection

Since crypto companies are not required to make public disclosures of their financial condition, most have not done so — and some have publicly misrepresented their financial condition. (See here about crypto firm Celsius manufacturing demand by buying up its own token, Cel.)

To compel transparency, the bill requires crypto firms to:

• undergo mandatory, independent auditing and publish audited financial statements;
• provide investors with material information about issuers, including risks and conflict-of-interest disclosures;
• require marketplaces to establish and public listing standards; and
• require cryptocurrency promoters to register and report their interest in any issuer whose crypto assets they promote.

The draft bill also seeks to bolster investor protections by:

• enacting “know-your-customer” (KYC) provisions so brokers will know the essential facts about their customers, and requiring crypto brokers and marketplaces to only conduct business with firms that comply with the KYC provisions;
• banning the use of the term “stablecoin” to describe or market any digital assets unless they are backed 1:1 with US currency or high-quality liquid assets s defined in federal regulations;
• requiring platforms to reimburse customers who are the victims of unauthorized assets transfers and transfers resulting from fraud.

Penalties

The bill would grant the Attorney General jurisdiction to enforce any violation of the law, issue subpoenas, impose civil penalties of $10,000 per violation per individual or $100,000 per violation per firm, collect restitution, damages, and penalties, and shut down businesses engaging in fraud and illegality.

Safeguarding the interests of New York consumers 

New York State Comptroller Thomas DiNapoli issued a statement thanking AG James for proposing this new legal framework, saying New York needed to do so, being the financial capital of the world.

Maria Vullo, a former NYDFS Superintendent, said: “New York has been a national leader in strong financial services regulation, including through its model framework for the licensing and supervision of digital assets firms and its vigorous enforcement of the Martin Act. … It is time for New York to lead once again in the dual regulatory system with clear standards that address this evolving industry.”

New York City Comptroller Brad Ladner noted the immense harm that investors in the crypto sector have endured, particularly low-income New Yorkers and people of color, saying the attorney general is “building a legal framework to protect New Yorkers and the economy from predatory companies.”