Financial Regulation Archives – Southern California Law Review

The Failed Promise of Treasuries in Financial Regulation

September 2024September 2024Pradeep K. Yadav* & Yesha Yadav†

U.S. government Treasury bonds (“Treasuries”) anchor financial stability. Public regulation mandates that financial firms maintain deep buffers of Treasuries that can be sold for cash in a crisis. In private lending between financial firms—running into trillions of dollars daily—Treasuries are the preferred form of collateral, designed to make debt fully resistant to default.

But this unquestioned reliance on Treasuries in public and private self-regulation has created a financial system that rests on fragile foundations. The first fundamental problem—thus far unnoticed in existing literature—lies in the system-wide tension that is present when both public and private self-regulation depend on the same scarce Treasuries/cash for survival.

This tension plays out in the common system of intermediation that supports both public and private self-regulation. Crucially, financial regulation places its trust in the competencies of twenty-four large financial firms—primary dealers—that uphold both the buying and selling of Treasuries as well as the supply of Treasuries to lending markets for use as collateral. This system of intermediation, however, is far from perfect. As we show, primary dealers confront incurable information gaps when allocating cash and Treasuries between private lending and public trading markets. Further, facing scarcity, primary dealers must choose whether to devote resources to one space over the other. Finally, as for-profit actors, primary dealers have no reason to continue intermediating if the cost-benefit trade-off turns sour. As it stands, for financial regulation to remain resilient, its mechanisms for intermediating Treasuries must also be lucrative.

The second problem lies in the fragmented system of supervision that governs an interconnected public trading and private lending market for Treasuries. Multiple regulators are in charge, but they lack coordination mechanisms, complementary regulatory approaches, and institutional mandates to facilitate cooperation. It follows that regulators have failed to spot shared risks to Treasuries intermediation and to develop mechanisms to correct them.

This Article sets out a three-part solution to better realize the promise of Treasuries for financial regulation: (1) enhancing transparency across trading and lending markets, (2) developing consolidated oversight, and (3) mandating that primary dealers maintain intermediation during crises. With Treasuries anchoring public regulation and trillions in private contracting, their fragility represents a danger that policymakers can ill afford to ignore.

INTRODUCTION

When COVID-19 shocked the financial system in March 2020, the (then) $17 trillion market for Treasuries became one of its most unexpected casualties.¹ As equity and corporate bond markets reeled, investors rushed to sell Treasuries and raise cash to remain solvent.² Their reaction was exactly as expected. Viewed as failure-proof, Treasuries provide the world with its most dependable safe haven. When other markets run into distress, Treasuries are supposed to buffer the fall by ensuring a constant supply of default-free assets and cash for those that sell them.³ Recognizing this fortress-like quality, public regulation and private industry rely systematically on Treasuries as the shield to protect financial markets against panic, collapse, and uncertainty.⁴

Public financial regulation mandates that Treasuries constitute a sizable part of the rainy day safety buffers of any number of regulated financial firms.⁵ The assumption here is that Treasuries can, by dint of quick sales, release cash in a crisis, allowing a firm to pay off its creditors and, in turn, prevent creditors from also going bust themselves.⁶ Using similar logic, the private market for lending between financial firms—running at trillions of dollars daily—also depends on Treasuries as the preferred form of collateral.⁷ By securing debt using Treasuries, lenders can be sure that they will be repaid, either by the borrower as promised, or by selling the Treasuries collateral.⁸ This unquestioned confidence in Treasuries as collateral means that parties do not even need to conduct due diligence on one another, so long as sufficient Treasuries can secure the debt.⁹ Indeed, it is taken for granted that the price of Treasuries will not fall when that of assets, like corporate bonds or equities, crashes. In other words, investors rush to safety during crises by putting capital into Treasuries and maintaining (or increasing) their price.¹⁰

March 2020, however, upended these assumptions. Rather than Treasuries providing reliable trading (or liquidity)—allowing sellers to cash out without distorting prices—investors found themselves unable to transact on reasonable terms.¹¹ Execution costs increased by 50%–500%, and market depth—or the quantity of offers (quotes) available to trade—plunged to 10%–38% of earlier values.¹² Testifying before the Senate Banking Committee in February 2021, the Chair of the Federal Reserve (“the Fed”), Jerome Powell, remarked that the Treasury market did not have “the capacity to handle” the pressure.¹³ Treasuries’ prices became chaotic and fell out of sync with those in related markets.¹⁴ As detailed by Annette Vissing-Jorgensen, this price instability had nothing to do with changes to the country’s economic fundamentals (for example, inflation).¹⁵ Instead, its cause was the rapid deterioration of trading conditions in the Treasury market with large investors rushing in to sell.¹⁶ As such, with equity markets plunging almost 3,000 points daily, the price of Treasuries also dropped precipitously, instead of increasing or staying stable as should have been the case for the world’s premier safe haven.¹⁷

Worryingly, the disruptions in March 2020 were not a one-off event. Rather, as shown by Matthias Fleckenstein and Francis A. Longstaff, market confidence in the capacity of Treasuries to steadfastly provide a safe haven has diminished significantly in recent years. Fleckenstein and Longstaff observe that Treasuries have traded much more cheaply to their fair value at key moments in modern financial history, with sizable price discounting observed during the 1997 Asian Financial Crisis, the 2000s, and frequently between 2015–2020.¹⁸ Taken together, these repeated performance failures call into question the core assumption made by public and private financial regulation in relying so fundamentally on Treasuries as safe assets: that their default-free nature means that Treasuries are also always perfectly tradable at fair prices.¹⁹ We close this gap in the literature to show that this assumption is simply wrong. Rather, while Treasuries can be regarded as risk-free, the market that trades them is not, diminishing their capacity to act as an anchor for public as well as private industry self-regulation. In this Article, we make two claims to detail: (1) the fragile system of intermediation that underpins Treasuries’ distribution, and (2) the deeply flawed model of market supervision that is ill-matched to contend with the risks created by faulty intermediation.

In our first contribution, we show that there is a fundamental, internal tension within a system in which both public and private financial regulation rely on scarce Treasuries to support economic survival. This tension and interconnection crystallize in a shared system of intermediation that must, at once, manage the buying and selling of Treasuries with the public as well as ensure the constant supply of Treasuries collateral to the private lending market.

For a start, this system of intermediation is remarkably fragile. Opacity, conflict, and complexity are pervasive. Crucially, regulation places trust in the capacity of (currently) twenty-four large banks and investment firms—known as primary dealers—to intermediate Treasuries. Primary dealers are uniquely authorized to purchase Treasuries from the government at auction and then to distribute them widely.²⁰ This role puts primary dealers center stage in the secondary market for buying and selling Treasuries with investors, in which they sell to those that want to buy and buy from those that want to sell. In this way, primary dealers help operationalize the assumption made in public financial regulation that Treasuries can always be liquidated by those needing cash or bought by firms wanting a reliable safe asset—all at fair and stable prices.

Primary dealers also act as critical intermediaries for the approximately five trillion dollars in exposure in the private market for short-term lending²¹—known as the repurchase or repo market—in which Treasuries constitute the preferred form of collateral.²² The repo market allows financial firms with cash to lend it to others that need it.²³ To eliminate default risk, lending is short-term and secured (mostly using Treasuries).²⁴ By ensuring firms can borrow cash whenever they need, the repo market provides a lifeline to financial firms to address everyday funding demands.²⁵ Within the repo market, primary dealers match borrowers with lenders.²⁶ They also act as lenders by using their own cash to serve those looking to borrow.²⁷ Finally, dealers borrow for themselves in the repo market as a way of funding their firm’s everyday operations.²⁸ In intermediating the supply of Treasuries to the repo market, primary dealers help insulate financial firms against default and systemic fallout.

Primary dealers confront steep and pervasive costs when intermediating across both the secondary market for Treasuries as well as the repo market. Information gaps are endemic. This opacity is structurally unavoidable in the repo market. Because Treasuries represent the preferred form of collateral and lending is short-term, due diligence is deemed unnecessary.²⁹ By design, primary dealers lack the tools and incentives to carefully monitor the default risk posed by parties with whom they contract.³⁰ They are also unable to fully gauge, on a market-wide basis, how this risk is building—for example, whether certain counterparties might be growing more indebted, less likely to repay, and whether to continue to lend to them, and on what terms.³¹

To be sure, using Treasuries as collateral should mean that primary dealers and the financial market have nothing to fear from default. But this view glosses over the damaging effect of opacity on intermediation. A system-wide absence of real-time information means that primary dealers are justified in being overly cautious when the prospect of default does arise and in quickly cutting off credit to counterparties across the board on account of not knowing exactly where the problem lies and how widespread it may be. Dealers might demand more Treasuries collateral to match unknown but higher levels of risk—even from borrowers that appear to be safe. In the absence of detailed information, withdrawing intermediation is rational, even advisable, to ensure that primary dealers do not keep lending to any number of defunct firms. After all, there is no rule forcing primary dealers to keep trading.³² From the standpoint of the market and its regulation, however, this kind of preventative action is harmful, chaotic, and liable to amplify distress. Financial firms can end up suddenly unable to meet their daily funding needs, or to roll over past debt, having to quickly find the cash to repay if a dealer calls in a repo loan or makes an existing one more expensive.³³

Opacity also raises doubts about whether Treasuries collateral is even capable of being enforced, that is, traced and sold by a primary dealer to recover the amount owed after default. Because the market lacks real-time reporting and due diligence, a borrower may not actually own the Treasuries collateral it offers up to secure a debt. Rather, collateral can belong to another party that has agreed to let the borrower use it for a time.³⁴ Collateral reuse is commonplace in Treasury-backed repo markets. Complex collateral chains, in which the same Treasury circulates to collateralize multiple loans, has become a feature.³⁵ For example, a Lender takes Treasuries from a Borrower as collateral. The Lender can then use these same Treasuries as collateral to borrow cash for itself. According to Manmohan Singh of the International Monetary Fund, each Treasury security collateralizes around three repo loans.³⁶ Reuse affords gains in efficiency. In good times, prized Treasuries can help release credit for numerous parties. But during crisis and with opacity endemic, doubts are raised about whether the collateral is traceable and capable of being sold.³⁷ Stated bluntly, even though a particular Treasury can be reused multiple times to release credit, it can be sold only once to cover a loss. Those believing they have a right to its proceeds may find that the Treasury no longer exists precisely when they need it the most. Opacity means that dealers and others cannot know in advance how complex their collateral chain will be, and whether their collateral is as protective as regulation readily assumes.³⁸

Primary dealers also confront opacity in the secondary market for buying and selling Treasuries with investors.³⁹ Home to over $600 billion in average daily turnover in both 2020 and 2021, this market lacks real transparency.⁴⁰ Trades are not reported publicly in real time.⁴¹ The secondary market did not have a comprehensive trade reporting regime until 2017, capable of delivering insights on a trade-by-trade level.⁴² The regime that is currently in place mandates reporting to regulators only (rather than wider dissemination). Until February 2023, trading statistics were published weekly and in aggregate, after which regulators permitted once-daily reporting to the public (also in aggregate terms). The reporting regime has also had major gaps historically (for example, it has not required hedge funds to report trades).⁴³ Limited, comprehensive real-time disclosure adds to the monitoring costs faced by primary dealers, forcing them to buy and organize trading data privately. This can add delays and inaccuracies to data processing, making it harder to determine how risks are building in real time (for example, predicting large orders, predatory traders, or price dislocations).

This opacity feeds tension within a system of intermediation that must meet the needs of both public and private financial regulation at the same time. That is, actions taken by primary dealers to protect repo market operations for private firms can come at a cost to maintaining trading in the secondary market for the wider public.

Reliance on Treasuries as collateral in repo funding markets means that the availability of these securities for trading in secondary markets can become restricted. The repo market requires trillions of dollars in Treasuries (and cash) to be set apart daily to support private lending and borrowing.⁴⁴ The free-float of Treasuries—or the amount of Treasuries that are circulating freely at a given point in time—is thus reduced by what must be earmarked to support trillions in daily repo operations.⁴⁵ In a crisis, primary dealers must rapidly shore up Treasuries collateral in repo operations to protect financial stability and ensure that sufficient collateral exists to support trillions in exposure between private firms. In cases when the repo market gets securely ring-fenced, secondary markets can become strained as primary dealers have a smaller supply of assets with which to respond to investors wanting to buy and sell Treasuries in a panic.⁴⁶

Opacity contributes to the challenge primary dealers face in ensuring steady intermediation to both repo and secondary markets. A lack of full and real-time information means that primary dealers face constant difficulties in attempting to predict the needs of the repo market—like how much cash and Treasuries are needed on any given day. These demands are hard to predict in any event. As a market for funding the daily life of financial firms, pressure on the repo market can vary wildly depending on any number of factors like seasonality (for example, making payroll), time of day (for example, reduced demand during lunchtimes), and the nature of the firm’s business (for example, banks requiring large amounts of cash).⁴⁷ In March 2020, for example, weekly collateral needs varied by more than $350 billion for positions held by primary dealers.⁴⁸ While the secondary market for Treasuries tends to be more stable, crises can trigger an unexpected spike. For example, total aggregate weekly trading in the turbulent week of March 6, 2020, was around $5.7 trillion. By late July, however, activity volumes had normalized, and the secondary market saw around $3 trillion in weekly aggregate trading volume.⁴⁹

This tension between protecting repo markets and maintaining resilience in secondary trading creates the danger that intermediaries stop performing when the costs of doing so become too high. Regulation does not require dealers to remain trading.⁵⁰ If the cost-benefit trade-off of intermediation becomes overly expensive, intermediaries withdraw. Or, they choose to protect one market over the other, depending on profitability, important client relationships, and keeping a reputational halo.⁵¹ Stated differently, for public and private financial regulation to currently remain credible, Treasuries intermediation must be lucrative business for primary dealers.

When primary dealers face such a choice, they have powerful incentives to resolve the tension in favor of the repo market. The repo market is much larger than the secondary market. For example, to take a more typical week in 2020, for example, the week of July 29, 2020, the average daily trading in the secondary market by primary dealers was $518 billion and their average daily risk exposure was $271 billion.⁵² By comparison, in the repo market, primary dealers had lent out around $1.58 trillion and borrowed $1.81 trillion of Treasuries.⁵³ Taken together, their repo activity measured about six times their average daily secondary market trading volume of Treasuries, and about twelve times their daily average exposure in the Treasuries secondary market.⁵⁴ With its size and repeat client relationships, dealers can make profitable gains by focusing resources in the repo market ahead of the secondary market.⁵⁵ But this private preference comes with a collective price, in which the secondary market can become disrupted and fails to function as a safe haven for investors at large. Taken as a whole, serious pressures on dealer balance sheets can damage Treasury market function. As shown by Darrell Duffie et al., the quality of U.S. Treasury market operations deteriorates markedly when dealers are forced to delve deep into their balance sheet to intermediate trading.⁵⁶

In our second contribution, we show that regulators are poorly placed to recognize the tension between a system of public and private financial regulation that is so deeply reliant on Treasuries to function.

That regulators have failed to account for the structural interlinkages between repo and secondary markets is not surprising. From the institutional standpoint, secondary trading and repo markets are subject to a patchwork system of fragmented oversight, governed by a rule book that has failed to adapt to changing market design.⁵⁷ The market does not have a lead regulator; oversight of the secondary market is shared by five or more agencies.⁵⁸ The repo market, by contrast, looks largely to the Federal Reserve (“the Fed”) and the Federal Reserve Bank of New York (“NY Fed”) for supervision.⁵⁹ This confusing division of authority breeds gaps and blind spots. Owing to fragmentation and an absence of coordination, regulators lack a coherent picture of the risks that run between repo and secondary markets. Rulemaking is costly given the need to overcome bureaucratic walls and divergences in institutional mandates and approaches between different regulators.⁶⁰

Importantly, each market is regulated in accordance with distinctive methodological approaches. The secondary market for Treasuries trading (broadly speaking) hews to a more capital markets–based approach that focuses on generating smooth trading, price efficiency, and trade reporting to regulators.⁶¹ By contrast, repo markets fall under a more “prudential” framing that protects the systemic soundness of firms and the market. Disclosure and pricing carry far less emphasis than ensuring that firms avoid default and do not sicken one another if one of them collapses.⁶² A prudential model prioritizes collateralization and deep capital buffers, and can come with the (implied) promise of federal protection in case firm failure sets off systemic contagion.⁶³ These differences in regulatory approach complicate rulemaking, monitoring, and coordination challenges already pervasive to the task of overseeing Treasury repo and secondary markets. Regulators cannot fill information gaps because Treasuries collateralization reduces the need to gather and disclose data in real time. Data gathering in the secondary market also remains patchy. Without full information, policymakers cannot know what tools might work best to prevent sudden loss of liquidity and price distortions. Because ex post interventions to stabilize the market are available, regulators may prefer to rely on them rather than to engage in complex, ex ante, administratively costly rulemaking. When the Treasury market failed in March 2020, the Fed stepped in immediately, making around $1.5 trillion in cash and Treasuries available to primary dealers in a bid to revive intermediation.⁶⁴

A final observation on the economic significance of the Treasury market. From the standpoint of political economy, weakness in Treasury market structure is profoundly problematic for the status of U.S. debt as the global risk-free asset that is a lynchpin for financial stability. As Anna Gelpern and Erik Gerding write, the notion of a risk-free asset is one that is legally constructed rather than being intrinsically real.⁶⁵ Default arises as a matter of contractual design.⁶⁶ It is conventionally believed that the United States will pay its debts. However, in theory, it may default.⁶⁷ The most tangible manifestation of Treasuries, their power and prestige, comes from the workings of the market—by investors buying and selling Treasuries, or by using Treasuries as collateral to release economic value. Public oversight and private industry self-regulation reinforce this real-world compact. This collective practice makes failures in Treasury market structure particularly dangerous for the long-term dominance of the United States. With the Treasury’s risk-free status ultimately ephemeral, a disrupted market undermines the most fundamental article of faith about the power of the U.S. economy and its financial system.⁶⁸

In conclusion, to repair the broken promise of Treasuries in financial regulation, this Article proposes a three-part solution for reform. As a starting point, it advocates for systematically greater transparency and reporting, particularly in more opaque repo markets. A richer understanding of how this market works can help regulators and dealers manage their risks, address conflicts, and unravel complexities between the secondary and repo markets. Secondly, the Article seeks to require dealers to maintain intermediation, rather than exit the market at will. Even with information, dealers can still stop intermediating both repo and secondary trading whenever this task becomes too difficult or expensive. As noted earlier, there are no rules keeping key dealers in the market in crisis periods, and so such intermediation can disappear at any moment. To counter this risk, we propose that regulators expressly require key dealers to affirmatively maintain trading and price stability in Treasuries, even in crisis.⁶⁹ We consider this to be necessary in light of the fundamental reliance that financial regulation places on the steadfastness of the intermediation system for Treasuries. Importantly, such a mandate is familiar. For example, trading on the New York Stock Exchange (“NYSE”) was long maintained by dealers that contracted to support trading and price stability during crises.⁷⁰ In addition to being well-worn and familiar, this mandate offers realistic assurance that the Treasury market will always provide liquidity, and, in particular, do so when such liquidity is most needed and when the chances of market failure are greatest. Finally, we support thoroughgoing reform of the regulatory structure for the repo and secondary market to harness the potential for coordination offered by the Financial Stability Oversight Council (“FSOC”).⁷¹ Created in the wake of the 2008 Financial Crisis, we believe that it is well placed to coordinate a more streamlined approach to rulemaking and supervision and to holistically view the repo and secondary market for Treasuries as interconnected.⁷²

This Article proceeds as follows. Part I provides an overview of why Treasuries are risk-free and the reliance placed on their risk-free status in public regulation. It details the centrality of primary dealers to intermediation and market function. Part II analyzes the workings of the multitrillion-dollar repo market and the anchoring role of Treasuries in private contracting. Part III develops a novel account of the interconnected risks of intermediation in both repo and secondary markets to show that it is undermined by opacity, conflict, and complexity. Part IV sets out a solution to remedy fragility in Treasury market design. Part V concludes.

I. TREASURIES AND THE FINANCIAL SYSTEM

Beyond funding the affairs of state, the Treasury market represents a foundational pillar of global financial stability. A Treasury bond is perceived to be a default-free security that is capable of being traded easily at fair prices, offering investors an asset that can serve as a safe, cash-like store of value.⁷³ These attributes ensure that Treasuries occupy a central place in regulation as an asset capable of being used by financial institutions to protect themselves and the market from sudden insolvency and systemic collapse. In public regulation, financial firms must keep Treasuries as part of their firm’s rainy day reserves. By owning Treasuries, firms hold a security that has predictable cash flows and is assumed to be rapidly tradable to generate cash when it is in trouble. Similarly, Treasuries are critical to private self-regulation in anchoring everyday lending between financial firms. They constitute the preferred form of collateral in the five-trillion-dollar repurchase market, allowing firms to borrow and lend to one other safely without undertaking prior due diligence.⁷⁴

This Part explains why Treasuries have acquired this stature as the foremost safe asset and haven for global financial stability.⁷⁵ It highlights that the usefulness of Treasuries is comprised of two main attributes: (1) they are, for all intents and purposes, default-free, meaning that the United States will pay its debts, and (2) they are supposed to be highly tradable (or liquid), capable of being bought and sold in their secondary market with ease, at a fair price, and without trades causing prices to become distorted.⁷⁶ These two attributes, while linked, are distinct from one another. This Part describes the key features of this secondary market and its regulation. Like any other active market, Treasuries trade in an environment that is operationally complex and risky. These risks are amplified by a unique framework of public oversight that is fragmented and lacking in leadership, making rulemaking and supervision subject to coordination costs and delays.⁷⁷

A. Why Treasuries Are Risk-Free

The Treasury market is critical to economic life in the United States and the health of financial markets globally.⁷⁸ Public debt has proven to be a transformative force for the country.⁷⁹ It has allowed Congress to implement major policy initiatives such as public works projects, wars, and efforts to counteract economic misfortunes.⁸⁰ The Treasury market provides policymakers with power to pursue far-reaching goals.⁸¹ Policies do not have to be constrained by present-day taxpayer contributions. Rather, the Treasury can tap into global capital markets to raise money.⁸² Crucially, the economic and political heft of the United States enables investors to have confidence that whatever they lend to the Treasury will be repaid exactly as promised.⁸³ This credibility means that the United States can borrow to fund itself much more cheaply than other countries with weaker economies and political institutions.⁸⁴

Holding a default-free asset can be uniquely advantageous. Investors can be sure that the money they lend to the U.S. government is safe. Importantly, Treasuries provide a counterpoint to a portfolio containing a mix of investments with riskier options like corporate debt or equity. Whereas other assets involve varying cash flows, uncertainties in valuation, periods where they become hard to sell, or lose their value (in case of bankruptcy), Treasuries are not supposed to face any such danger.⁸⁵ Instead, investors believe Treasuries will perform in accordance with their terms, retain value, price, and currency stability. It follows that Treasuries have long been viewed as the safe haven for domestic as well as foreign investors, including other sovereigns looking to invest their reserves.⁸⁶

The key attributes of a Treasury bond—default-free, denominated in the U.S. dollar, designed to be paid out in specific maturities and simple to value—are bolstered by its tradability (for example, its ability to be bought and sold quickly and cheaply without significantly impacting prices).⁸⁷ Official government reports into the Treasury market commonly begin by observing that it constitutes the “deepest and most liquid government securities market in the world.”⁸⁸

This liquidity represents a hallmark without which Treasuries could not attract investors as easily.⁸⁹ Those holding Treasuries would not be able to turn them into cash, while those wishing to add Treasuries to their portfolios would struggle to purchase them. If investors lack liquidity, they will charge the U.S. government more to reflect the cost of keeping a less tradable investment on their books.⁹⁰

B. Making Treasuries Tradable

Through much of its history, regulators have relied on a cohort of international banks and investment banks—designated as primary dealers—to support intermediation in Treasury markets.⁹¹ After the initial issue by the U.S. Treasury (in what is called the “primary” market), the secondary market for day-to-day trading of Treasury securities is divided into two parts: (1) the segment where primary dealers and other dealers transact externally with customers (like foreign governments, or mutual funds) to buy and sell Treasuries, and (2) the interdealer segment where dealers internally transact with one another in order to even out or otherwise manage the inventories they hold of Treasuries. If some dealers want Treasuries but do not have them, while others wish to sell, the interdealer trading market offers a space for Treasury dealers to be able to transact with one another.⁹² Historically, primary dealers have played a critical role in each of these three parts of the market.⁹³

Treasuries at Auction: Primary dealers are expected to use their deep pockets to bid for new Treasury securities when they are issued at government auctions. These bids must be at competitive prices, meaning that primary dealers cannot comply with their obligations by simply making unrealistic and unrealizable bids.⁹⁴ The government places great trust in primary dealers by relying on these firms to act as counterparties at every issue of public debt. In their 2007 study, Michael Fleming et al. show that primary dealers purchased an average of 71% of new issues.⁹⁵

Given regular and heavy demands on their balance sheets, primary dealers are chosen from among those that can demonstrate the financial capacity to purchase, hold, and trade these securities. Though the NY Fed slightly relaxed eligibility conditions in 2016, the firms that perform primary dealer functions come from the ranks of well-regulated financial institutions—mostly banks.⁹⁶ As part of their agreement, primary dealers provide the NY Fed with weekly reports into the activities of the Treasury market.⁹⁷

Secondary Market – Dealer-Client: The secondary market comprises two major segments. In the dealer-client market, investors like foreign governments or mutual funds come to buy or sell Treasuries. This segment is critical for ensuring that Treasuries are widely available and capable of performing their stabilizing, protective function. Trading volume for a recent single day—July 31, 2024—in this dealer-client segment was about $735 billion.⁹⁸

Primary dealers have a major advantage in the dealer-client market. As large and internationally active financial firms, they possess an ample base of clients with which to transact. This network provides the means by which to operationalize the protective function of Treasuries by ensuring they are widely distributable.⁹⁹ Importantly, by dint of their participation in Treasury auctions, primary dealers have sizable inventories of securities that they can transmit.¹⁰⁰ Indeed, when seeking to bid for Treasuries at auction, primary dealers usually collect indications of interest from major clients beforehand, ensuring that that they are able to capture and meet demand more precisely.¹⁰¹

The structure of the dealer-client market is based on an over-the-counter design. Clients contact primary dealers (and other dealers) using telephones or computer screens to ask for bids on what they are willing to buy and sell and at what price.¹⁰² It rewards those most capable of developing repeat relationships with leading investors like foreign governments, insurance, or pension funds. By their proximity to Treasury auctions, the ability to anticipate client appetites, and experience, primary dealers generally represent an efficient and informed disseminator of Treasuries across the world.¹⁰³

Secondary Market – Interdealer: The interdealer market represents the other main segment of the secondary market.¹⁰⁴ It helps Treasuries dealers to even out their reserves by selling what they do not need to other dealers or dipping into this market to buy when they face a shortfall. On July 31, 2024, the day chosen above to illustrate recent dealer-client trading, the volume of trading in the interdealer segment was similar in magnitude to that of dealer-client trading, at around $729 billion.¹⁰⁵

The interdealer market fulfills two key functions. One, it helps reduce the risk that primary dealers and others face gluts or scarcity in their inventory of Treasuries. It provides a mechanism whereby the availability of Treasuries can be modulated between dealers to meet their external client demands. Primary dealers can sometimes face sudden, one-sided demand. With COVID-19 triggering panic in March 2020, investors sought en masse to sell Treasuries in order to get their hands on cash.¹⁰⁶ According to Vissing-Jorgensen, sales by foreign investors, mutual funds, and the household sector (including hedge funds) came to around $287 billion, $266 billion, and $194 billion, respectively, in the first quarter of 2020 alone.¹⁰⁷

A market to regulate supply and demand ensures that the dealer-client market is not disrupted because dealers are unable to obtain Treasuries or cash. For example, confronting heavy demand to buy from a sovereign, dealers can go into the interdealer market to supplement thinning reserves. By doing so, they fulfill client demand. The ability to sell excess inventory to other dealers means that dealers face fewer costs in keeping securities on their balance sheets.

Two, the ability to meet client demand smoothly means that the market becomes less vulnerable to sudden spikes or plunges in Treasury prices. When dealers can transact with one another to manage their supply of cash and Treasuries, they can lower costs to clients. The effects of scarcity or oversupply can be managed, helping markets remain more reliable and affordable for investors.¹⁰⁸

It is worth briefly noting that, from the mid-2000s, the interdealer market has undergone a structural shift to transition from an analog space to one that is now largely automated.¹⁰⁹ Its plumbing has transformed from reliance on telephones to the use of fast, artificially intelligent algorithms to drive trading.¹¹⁰ High-frequency trading (“HFT”)—in which Treasuries are being bought and sold in milliseconds or less—dominates, driving around 50–75% of trading volume.¹¹¹ One study showed that the median time between trades in ten-year Treasury notes in 2015 was around ten milliseconds.¹¹² A decade earlier in 2006, trading speed for this note stood at around one hundred times slower, with transactions occurring around one second apart.¹¹³ To be sure, this trend is a secular one. Electronic, automated trading has become the norm in equities and derivatives markets, reflecting growth in computing power, data processing, and artificial intelligence since the mid-2000s.¹¹⁴ Its extensive embrace within the historically staid Treasury market has nevertheless come as something of a surprise.¹¹⁵

High-speed trading has given rise to sources of instability.¹¹⁶ An automated interdealer market has introduced new types of traders with a different profile to primary dealers.¹¹⁷ HFT firms tend to be smaller securities firms that specialize in computerized trading across multiple types of assets, such as equities. Leading HFT firms are not household names, despite driving heavy volumes of trading. Firms like KCG, Spirex, XR Trading, or Jump Trading—while not as well-known as J.P. Morgan or Wells Fargo—have risen to become major suppliers of liquidity in the interdealer market.¹¹⁸

C. Centrality of Treasuries in Public Regulation

Owing to their default-free status and perceived liquidity, Treasuries have become the go-to protective asset in public financial regulation.¹¹⁹ Following the 2008 Financial Crisis, with top financial firms collapsing or needing bailouts, the rapid loss of solvency raised worries about how best to avoid a repeat episode.¹²⁰ The causes of the 2008 Financial Crisis are complex.¹²¹ Reform has sought to address numerous vulnerabilities.¹²² But to bluntly mitigate the catastrophic effects of firms becoming unable to pay out on short-term debts and triggering a domino of failures, buffers of rainy-day and high-quality liquid assets (“HQLA”) now represent a mainstay of financial regulatory design.¹²³

To illustrate, banks are required to maintain a cushion of highly liquid assets that can help them to cover their short-term outflows over a stressed thirty-day period. Importantly, firms should be able to convert these assets into cash within just one day, without these assets losing value. In other words, assets must be highly liquid and their fire sale in stressed circumstances ought not to cause their prices to become distorted. Overall, banks need to keep more than 100% of their expected thirty-day liquidity needs in the form of HQLA.¹²⁴ This liquidity-coverage ratio (“LCR”) represents a post-2008 reform hallmark, designed to ensure that firms do not cause contagious failures by failing to make good on their immediate commitments.¹²⁵ By preserving sufficient reserves of cash and cash-like assets, firms can feel safe in their ability to pay, while others are reassured that they will be repaid. The comfort of reliable liquidity buffers can work to limit the chances of a destructive run, when firms might try and seize cash and other assets in the worry that their counterparties cannot pay.¹²⁶

Treasuries rank in the highest tier of liquid assets for firms seeking to build their buffers of HQLA alongside pure cash and deposits with the Fed.¹²⁷ While cash and Treasuries are not exactly equivalent (for example, one has to sell a Treasury to generate cash), regulation assumes that they fall within the bandwidth of the same ultrasafe, ultra-stable, and ultra-liquid asset-type that can meet the need for immediate redemptions.¹²⁸ Further, Treasuries are supposed to do be bought and sold quickly without causing serious price distortions. Regulation encourages banks to hold unencumbered Treasuries and does not impose any discounting on the value of the Treasuries held.¹²⁹

It is widely accepted that the LCR has had a dramatic impact on how banks fund themselves and on the kinds of business that they undertake. By being mandated to keep this thick buffer of HQLA to cover outflows over a stressed 30-day period, banks confront a constant demand to maintain (and have access to) a regular supply of Treasuries and cash. In consequence, they have dramatically increased their Treasuries holdings to reflect efforts at compliance.¹³⁰ On the other side, firms have sought to also adapt their business lines to reduce or adjust the size of the liabilities to be covered within the 30-day window. Services like offering large deposit holdings to clients have incurred a cost in the form of LCR holdings.¹³¹ As banks must develop new business lines, they need to keep one eye on the Treasuries/cash market to maintain constant compliance with LCR requirements.

Beyond banks, the significance of Treasuries as a cash-like, highly liquid buffer of value has led to financial firms raising their holdings across the board. For example, as Nellie Liang and Pat Parkinson note, open-ended mutual funds hold as much as 12% of all Treasuries outstanding, while hedge funds maintain around 9%.¹³² According to Liang and Parkinson, such deep reserves of safe-haven securities in the hands of regulated firms point to a readiness on their part to sell Treasuries en masse in order to raise cash in distress.¹³³

D. Regulating the Secondary Market

This central place for Treasuries gives multiple major regulators an interest in their workings. Perhaps reflecting this quality, the oversight framework for Treasuries divides authority between several regulators, with none having lead status, but all having a stake in supervision.¹³⁴

Rather than having one lead regulator, like the Securities and Exchange Commission (“SEC”) is for equities, oversight of Treasuries is divided between at least five major agencies: the Fed, the NY Fed, the U.S. Treasury, the SEC, the Commodity Futures Trading Commission (“CFTC”) and the Financial Industry Regulatory Authority (“FINRA”).¹³⁵ The Fed supervises the banks, the SEC and FINRA oversee the securities firms, while the Treasury and NY Fed ensure surveillance over the auction process. The NY Fed also exercises designation authority for primary dealers, but it is not an official regulator for primary dealers.¹³⁶ The CFTC regulates derivatives markets that are linked to Treasuries trading—notably, Treasury futures.¹³⁷ Overlapping authority is commonplace in U.S. administrative law. As Jody Freeman and Jim Rossi outline, regulators sharing authority bring unique expertise. But they also face impediments, such as barriers to information sharing and the need for coordination in the completion of everyday oversight.¹³⁸

Likely in view of their risk-free status, the usual bevy of rules that apply to traders in major markets either do not exist for Treasuries—or do so weakly. This latitude is born out of the broad exemptions that Treasuries enjoy under the Securities Act of 1933 and the Securities Exchange Act of 1934.¹³⁹ Regulators themselves often lack a concrete picture about which rules apply to Treasuries and how they should be implemented.¹⁴⁰ Commentators observe that out of the thousands of FINRA rules for equity broker-dealers, around forty-six apply to broker-dealers in Treasury markets.¹⁴¹

Interestingly, the most visible divergence from classic securities markets regulation (for example, equity and corporate bonds) lies in the area of reporting and information dissemination. Treasuries have historically lacked a trade-by-trade reporting regime.¹⁴² Since 2017, FINRA-regulated securities firms are required to report their trades. Banks must do so as well.¹⁴³ Despite this reform, however, the 2017 regime has long left serious gaps. Those that did not traditionally fall within the category of either a broker, dealer, or bank were not required to report to FINRA. For example, a number of HFT securities firms have typically not reported directly, and neither have hedge funds.¹⁴⁴ In February 2024, the SEC passed a series of measures requiring major liquidity providers—regardless of their institutional category—to register with the SEC and to report their trades. The functional aim of such rulemaking arguably lies in broadening the regulatory perimeter to require reporting by and cast a spotlight on those undertaking major Treasuries-related business (for example, high-speed traders and hedge funds). But, the SEC’s actions were met with heavy resistance and a court challenge to their validity.¹⁴⁵ At least until the SEC’s new regulations are implemented, data in relation to non-reporting firms must be captured indirectly—for example, when a non-reporting trader transacts with one that falls under the general 2017 mandate, or data is supplied by a trading platform.¹⁴⁶ Further, public reporting of Treasuries data is fairly light and recent. The public gained access to Treasuries secondary market trading data but only since March 2020. This data has generally presented aggregate totals for weekly trading in different kinds of Treasury securities, moving only to daily aggregate reporting beginning in February 2023.¹⁴⁷

***

In summary, the Treasury market represents a critical pillar of the U.S. economy and financial system. Treasuries are viewed as risk-free. This label, however, conflates two aspects of Treasuries: (1) the likelihood of repayment and (2) their trading in secondary markets. With respect to the former, it is widely accepted that the United States will not default. However, in relation to the latter, the system of trading for Treasuries does present real risks. It reflects a design choice that places primary dealers as centerpieces in intermediation. Crucially, Treasuries fall under a system of oversight that is fragmented and without a lead authority. With reporting data only recently becoming available, and lacking comprehensive coverage, regulators face coordination and information costs when seeking to understand the riskiness of this market and its intermediation.

II. TREASURIES AND PRIVATE INDUSTRY SELF-REGULATION

In addition to playing an anchoring role in public regulation, Treasuries have become the lynchpin for safeguarding the six-trillion-dollar market for short-term credit between financial firms. Default-free and highly liquid, Treasuries are the choicest type of collateral, capable of being sold rapidly when a borrower cannot pay. In the repurchase market, any number of financial institutions borrow and lend cash/securities to one another to meet their daily funding needs—with Treasuries being the preferred type of collateral. Particularly after the 2008 Financial Crisis, firms have come to depend on Treasuries as collateral in the repo market, with around four trillion dollars dependent on Treasuries to secure debt. Because repo debt is short-term and collateralized using Treasuries, it is “informationally insensitive,” meaning, so safe that due diligence is unnecessary.¹⁴⁸

This Part describes how Treasuries have become essential to maintaining the system of financial self-regulation that drives over four trillion dollars in daily lending between financial firms. Just as in the secondary market, primary dealers are the major intermediaries in repo operations, performing a variety of functions as lenders, borrowers, and connectors that match clients. In highlighting the centrality of primary dealer intermediation, this Part describes why this task can be challenging and costly in repo markets, with the risk that primary dealers can quickly withdraw and temporarily restrict credit when their job becomes too difficult.¹⁴⁹ These challenges are not easily addressed through the regulatory framework. Unlike the secondary market for Treasuries, the repo market is regulated under a more prudential format, focused on maintaining the safety and soundness of participating firms and transactions. With a far lower emphasis on disclosure, the repo market constitutes an opaque environment by design, obscuring an understanding of its workings and its interlinkages with the Treasuries secondary market.

A. Private Credit in Financial Markets

The repo market—offering short-term, secured credit—represents a solution to the funding needs of large financial firms. A basic repo transaction works as follows. A Lender (a firm with cash) offers to loan money to a Borrower (a firm needing cash).¹⁵⁰ As with any loan, this transaction carries the risk that the Borrower might default. To limit the risk of losses arising from default, the market (1) ensures that the loan is collateralized and (2) keeps the maturity of the loan short (usually overnight, but it can sometimes extend to a month).¹⁵¹ The repo market thus represents a market for secured loans. If the Borrower cannot pay back the cash, the Lender can simply sell the securities and recover their money. The collateral that a Borrower provides is in the form of securities, like Treasuries, corporate bonds, mortgage-backed securities, or stock.¹⁵² Treasuries, unsurprisingly, constitute the most prized form of collateral. In terms of pricing, the value of the collateral exceeds the size of the loan by an amount called the “haircut.” The riskier the collateral, the larger the haircut.¹⁵³ Treasuries usually come with a haircut of around 2% for overnight borrowing.¹⁵⁴ A Borrower looking for a $100 overnight cash loan will need to provide the Lender with $102 in Treasuries.¹⁵⁵

As noted above, the maturity of loans is short, usually overnight. But loans are routinely rolled over.¹⁵⁶ This means that the loan is refreshed as it comes due: the Borrower can keep using the cash, while the Lender keeps the collateral. The short maturity structure gives Lenders the ability to control their exposure. If the Lender senses trouble, it can ask for the loan to be paid back, or it can choose to ask for more collateral to reflect any additional risk posed by the transaction. If the Borrower cannot repay, the Lender can sell the Treasuries. Danger arises for the market if the Lender feels unable to continue lending or rolling over existing loans, forcing a number of its borrowers into distress where they must pay up or find additional securities to keep borrowed cash.¹⁵⁷

The repo market is mainly divided in two: (1) the bilateral market and (2) the tri-party repo market. Further, repo transactions come in two distinct types: (1) repo trades and (2) reverse repo trades.

In the bilateral repo market, parties transact directly with one another and privately organize their own risk management. By contrast, in the tri-party repo market, the administration and settlement of trades are handled by a third-party firm that intercedes between parties to manage the risk of ensuring the trade executes.¹⁵⁸

The classification of whether a repo transaction represents a repo or reverse repo depends on whether the dealer is borrowing or lending cash in the transaction.¹⁵⁹ In a repo, the dealer is borrowing cash (and providing collateral). In a reverse repo, the dealer is lending cash (and receiving collateral).¹⁶⁰ Figure 1.A shows the size of the bilateral repo market over the period 2013–2023.¹⁶¹ There are 2 points to note: (1) the daily size of the bilateral repo market, comprising both repo and reverse repos, has varied from $3.9 trillion to $5.1 trillion over the last ten years and (2) on average, around 75% of the collateral in the bilateral repo segment comprises Treasuries, meaning that Treasury securities valued at about $3 trillion to $4 trillion remain locked up as “passive” collateral to prevent default, thereby reducing the “float” readily available with dealers for secondary market trading.¹⁶² Figure 1.B shows the size of tri-party repo market over the past decade.¹⁶³ For example, in December 2021, the daily size of the tri-party repo market stood at around $3.7 trillion, around $2.5 trillion of which was backed by Treasuries.¹⁶⁴ Given the higher risk of direct trading, the bilateral repo market uses Treasuries as collateral in a much larger proportion of its transactions.

The feature that gives the repurchase (repo) market its name describes the legal arrangements that underlie how a typical repo works. The transaction is effectively structured as a sale and repurchase of securities even though it is, for all intents and purposes, a loan. The Borrower (seeking cash) sells its securities to the Lender (for the cash) with the promise to buy them back at a pre-agreed price the next day (or whenever the deal matures). The pre-agreed repurchase price represents the amount of the loan alongside an additional slice of compensation.¹⁶⁵ Because the Lender legally owns the securities, it can sell them if the Borrower defaults. The Bankruptcy Code specifically allows repo Lenders to sell collateralized securities even if the Borrower files for bankruptcy. Ordinarily, without such protection, Lenders would be stopped from doing so by the Code’s automatic stay on enforcement actions.¹⁶⁶

Scholars observe that repo markets tend to function as a “bank-like” system for financial firms.¹⁶⁷ Those that have cash can earn money by lending it and taking collateral. In turn, those that need cash but have securities can offer their securities as collateral in return for access to cash. Repo markets reflect the reality that financial firms are unique. They cannot park millions and billions of dollars in a bank account. Those with cash want this money to generate some return, rather than having it languish unproductively. On the other side, some firms’ asset base focuses on holding securities rather than cash (for example, if they invest heavily in securities as underwriters).¹⁶⁸ The repo market unlocks value by allowing those that need cash to borrow it on a short-term and secured basis, while permitting those with cash to be able to lend it out and make money from this transaction.¹⁶⁹

Secondly and relatedly, repo markets enable financial firms to use leverage if their business model and balance sheet can support it. For example, suppose a firm has 100 Treasuries, each valued at $100. The typical haircut for Treasuries is 2%. The firm can borrow $9,800 against this collateral. It can then use these funds to buy 98 Treasuries, following which it can again use the 98 Treasuries as collateral to borrow $9,600. It can then use these funds to buy 96 Treasuries and so on, potentially achieving up to 50 times leverage.

Equally, the same Treasuries may be used in multiple transactions. Repo markets permit dealers to take Treasuries belonging to a client and to use these as collateral for their own purposes in the repo market.¹⁷⁰ A hedge fund with 100 Treasuries can entrust a Dealer with their safekeeping. Rather than simply let these assets be unproductive in an account, the Dealer and hedge fund agree that the Dealer can use the Treasuries for the Dealer’s private credit needs. In return, the Dealer can offer the hedge fund a line of credit on cheaper terms than what might otherwise have been possible. Because the Dealer can control the Treasuries, it can use them as collateral to borrow funds from a Lender. The Lender, too, can take these same Treasuries and reuse them for more borrowing.¹⁷¹ According to Infante et al., by dint of contractual agreements, primary dealers are generally permitted to reuse the vast majority of the Treasury collateral that they hold for clients. Studies suggest that as much as 85% of all Treasuries collateral may be subject to reuse.¹⁷²

Reusing collateral has a number of important benefits for both dealers and their clients. It means that dealers can provide cheaper intermediation across the board. Rather than having to buy Treasuries and spend cash to do so, a dealer can request permission from its client to borrow their securities. In turn, the client also receives cheaper services.¹⁷³ Reuse also means that the market unlocks maximum value from a Treasury. Rather than only be used once in one trade, reuse can extract economic gains when Treasuries are used across multiple transactions.¹⁷⁴ So long as parties can repay, reuse can help lower the costs of intermediation and accessing repo credit affordably.¹⁷⁵

But reusing collateral can also be dangerous.¹⁷⁶ While profitable in good times, collateral reuse can amplify distress in crisis. It undermines the assumption that repo markets provide fully secured lending. If the Hedge Fund client demands its Treasuries back, the Dealer faces a problem—as do others along the collateral chain. The Dealer must immediately source the Treasuries to return to the Hedge Fund.¹⁷⁷ If the Dealer has used Treasuries to borrow cash, it must find cash to pay its Lender back and recover the Treasuries. Where the Dealer has failed (like Lehman Brothers), the Hedge Fund can find itself caught up in long legal proceedings to recover the assets.¹⁷⁸

The fragility of collateral chains was made clear around September 16, 2019, when rates to borrow cash in the repo market spiked, climbing to almost 10% from about 2% in the week prior.¹⁷⁹ In seeking to understand why, a number of commentators pointed to concerns about the quality of the collateralization—and whether collateral chains of reused Treasuries could be counted on as watertight. Manmohan Singh of the International Monetary Fund estimated that, in the 2018 Treasury repo market, around three separate actors believed that they were entitled to the very same Treasury security.¹⁸⁰ This imputed a reuse rate of 2.2. That is, in addition to the actual owner (for example, the Hedge Fund above), 2.2 further firms considered themselves entitled to the Treasury collateral.¹⁸¹ Owing to uncertainties about whether lending was really fully collateralized, primary dealers and others became wary of parting with cash, despite the promise of an almost 10% interest rate on offer that day.¹⁸² As this episode makes clear, even though a Treasury can be reused multiple times as collateral, it can only be sold once to cover exposure. In an informationally opaque environment, in which parties do not know if they might be the one caught without viable collateral, it makes sense for primary dealers to stop intermediation and withdraw from the market.

B. Intermediation in the Repo Market

Primary dealers are the key intermediaries in the Treasuries-backed repo market. According to Copeland et al., primary dealers appear to intermediate around 80% of the bilateral repo market.¹⁸³ In addition to serving the financing needs of clients, primary dealers also use the repo markets to secure funding for themselves.¹⁸⁴

As intermediaries, primary dealers are tasked with fulfilling a number of functions in the repo market. At the most basic level, they match borrowers with lenders. When one client has cash (for example, a mutual fund), while another needs it (for example, a bank), the primary dealer connects both parties and facilitates the repo transaction (for a price). A more engaged role involves the primary dealer acting as one side of the repo trade for a client, either as borrower or as lender. When doing so, the primary dealer deploys the power of its balance sheet to take risk directly on its books.¹⁸⁵

Primary dealers have unique advantages when it comes to intermediating the Treasuries-backed repo market. Beyond access to government auctions, they also possess positional dominance. For one, as connected nodes in financial markets, with access to networks of global clients, primary dealers represent trusted repositories for client cash and securities. In return to offering services and expertise, dealers acquire access to vast amounts of client securities and cash that can be reused for repo operations. Because the repo market enables collateral reuse, dealers can subsidize the costs of intermediation.

In addition, this central position affords primary dealers some informational advantages. They are well-placed to identify, connect, and transact with counterparties. Primary dealers are likely to have knowledge about which kinds of firms tend to hold sufficient cash (for example, mutual funds) to lend, and who has enough securities to be able to borrow. Repeat relationships can help build trust, deepen knowledge about the client’s financials, and allow the primary dealer to more precisely price the terms of repo debt. Connections with multiple clients can permit primary dealers to fulfill orders for larger volumes of Treasuries/cash in which a dealer can tap and pool assets across clients. Crucially, this ability to tap into a sprawling network of resources can strengthen the financial system because its key intermediaries are positioned to supply liquidity in an elastic way.¹⁸⁶

Finally, primary dealers are active throughout financial markets and supply liquidity in a variety of assets like equities and corporate bonds.¹⁸⁷ This broad-based participation in capital markets puts primary dealers in a strong position to use their experience and expertise to better predict demand for repo funding. For example, by being active suppliers of liquidity to the corporate bond market, primary dealers are likely to have a detailed understanding of who the key buyers of bond issues are likely to be (for example, insurance firms or mutual funds). This can provide special insight into possible future pockets of demand for Treasuries/cash collateral in which investors might need short-term cash to purchase a sizable volume of bonds.

C. Regulating the Repo Market

Despite its short-term and collateralized nature, the repo market is criticized for its structural instability and the profound risk that it poses for the financial system.¹⁸⁸ Scholars argue that the repo market suffers from a similar vulnerability to banks: the chance that it suffers a run in which lenders are frightened enough to recall their short-term debt en masse. According to Gary Gorton and Andrew Metrick, a major catalyst for the 2008 Financial Crisis came from a run in one part of the repo market, making it impossible or expensive for financial firms to continue funding themselves.¹⁸⁹ In Gordon and Metrick’s study, the collateral underlying the repo loans was largely comprised of mortgage-backed securities that plunged in value.¹⁹⁰ Even where underlying securities were not as risky, the fear that they could be and that repo borrowers would be unable to repay ramped up what lenders were charging or caused them to call in their loans.¹⁹¹

Unlike banks, the repo market lacks preventative structural safeguards, like deposit insurance, that could mitigate the risk of a run.¹⁹² Instead, after 2008, it largely relies on Treasuries collateralization to assure parties that they will be repaid.¹⁹³

This focus on collateralization reflects the prudential approach that characterizes the regulation of the repo market. Broadly, a slew of capital rules for financial institutions take account of a primary dealer’s repo participation to calculate how much capital it needs.¹⁹⁴

As detailed in Part I, banks must maintain a supply of highly liquid assets that can help them to remain solvent in the event of a sudden cash drain. The mandate that major financial institutions buffer themselves up with a thick reserve of highly liquid assets reflects the lessons learned in 2008 that underscored the potential for a liquidity crunch, as exemplified by the repo market’s failure.¹⁹⁵

However, their obvious utility and importance notwithstanding, these liquidity rules have also been blamed by some commentators for amplifying the instability in repo operations. In September 2019, when cash in the repo market seemed to run dry, no bank came forward to take advantage of what would have been a lucrative opportunity to lend (with a rate of 10% on offer). According to some commentators, post-2008 liquidity rules meant that banks did not wish to lend cash because they preferred to maintain high cash reserves and meet their compliance requirements. Importantly, the Fed pays interest on the cash reserves that it holds in its accounts for banks. If these interest payments are sufficiently high, banks might hesitate before using the cash for repo lending.¹⁹⁶ As Joshua Younger et al. observe, large banks were not short of cash in mid-September 2019.¹⁹⁷ They held around $700 billion in cash reserves—far in excess of what was required of them under law.¹⁹⁸ On paper at least, they should have been able to direct some of these funds into the repo market and ease the costs of lending. This suggests that dealers preferred to prioritize keeping a thick liquidity buffer, accruing interest in their account with the Fed and waiting out the uncertainty, rather than actively deploying their balance sheet to alleviate it.¹⁹⁹

In addition to liquidity ratios, primary dealer banks can also become subject to a “capital surcharge” over and above the basic capital buffer that banks maintain—resulting in banks seeking out ways to avoid the full force of paying this extra cost. Under post-2008 rules, the surcharge kicks in when a bank is deemed to be large and systemic.²⁰⁰ The greater the size and interconnectedness of a dealer bank, the greater the likelihood that it faces a higher charge.²⁰¹ From the standpoint of policy, this systemic surcharge serves the purpose of ensuring the financial markets are better girded against the possibility that a large bank fails because this bank should have a deeper buffer from which to cover its losses. However, as an unintended consequence, it can motivate dealer banks to suddenly reduce the depth of their repo intermediation in order to avoid becoming sufficiently large and interconnected to become subject to a higher capital charge.²⁰²

Industry analysts report that large, systemically important banks routinely seek out ways to show a reduced footprint when it comes time for regulators to assign scores for the purposes of the surcharge.²⁰³ Under this regime, banks have incentives to reduce their systemic activities to just below the threshold at which a higher charge would apply. Because activities in the repo market constitute one signal of a bank’s interconnectedness, heavily limiting the depth of its involvement can help a bank to reduce the capital surcharge it faces.²⁰⁴ Further, owing to the short-term nature of repo lending, dealers can precisely time their retraction to quickly closeout repo transactions before being rated.²⁰⁵ This kind of behavior—while perhaps rational for any single dealer—clearly poses problems for the market as a whole. Repo markets can experience a broad fall in the intensity of intermediation around times when dealers are to be assessed for a surcharge.²⁰⁶ Even if the market can predict that such an eventuality will occur, episodic illiquidity can still create periods of fragility in which firms struggle to get the repo loan they need at an acceptable price. Indeed, even the fact of anticipating such liquidity-draining milestones can constitute a self-fulfilling prophecy. Firms may be less willing to come forward with their cash and Treasuries to trade assuming likely frictions in the market. Whenever dealers decide to scale down their intermediation, even if temporarily, it can introduce a broad slowdown in the flow of credit across the financial system.

In summary, private self-regulation in financial markets looks to Treasuries to protect firms and the system against default. Private lending between firms in the repo market relies on primary dealers for intermediation. Despite being collateralized using Treasuries, however, the repo market suffers from built-in risks. It is opaque by design. Reuse of Treasuries collateral creates a source of instability in crisis. Short-term financing can dry up quickly. Dealers are free to withdraw or reduce intermediation. That being said, with around four trillion dollars in daily lending backstopped by Treasuries, the financial system is entrenched in its belief that Treasuries constitute the protective safe asset to anchor private industry self-regulation.

III. THE FALSE PROMISE OF TREASURIES

This Part argues that systematic reliance on Treasuries in public and private financial regulation is internally in tension. First, we show that the secondary market and the repo market are inextricably linked and interdependent such that loss of function in one market can affect the other. Secondly, primary dealer intermediation, underpinning both markets, is subject to a slew of costs and problems. Opacity is pervasive. This prevents primary dealers from gaining a full picture of the risks. This increases the challenge facing primary dealers to navigate the internal conflict between the repo and the secondary market operations. With trillions of dollars in Treasuries and cash collateral locked-in to support the repo market, the secondary market for trading Treasuries can face a shortfall, especially during crises. In seeking to resolve this tension, primary dealers are likely to favor intermediating in the market in which they will gain the most, economically and reputationally. Alternatively, if neither market provides lucrative gains, primary dealers will rationally have every reason to withdraw intermediation altogether.

Additionally, this Part observes that the regulatory system is ill-placed to recognize the risks of an interconnected repo and secondary market for Treasuries. The Treasury market is overseen by a panoply of agencies. Their approaches to oversight diverge. Cooperation costs are built-in to a fragmentated system of oversight.²⁰⁷ Regulatory incapacity increases the dangers of risky intermediation for Treasury market fragility and casts further doubt on the ability of Treasuries to function as safe assets in public and private financial regulation.

A. Opacity, Information Costs, and Monitoring

Opacity in the repo market and the secondary market adds systematic information costs to primary dealer intermediation. A lack of full and real-time information limits monitoring and makes it harder for primary dealers to anticipate demand on their balance sheets. If the costs of opacity become too much, primary dealers may limit or withdraw intermediation to one or both markets.²⁰⁸

Primary dealers face uncertainties from a number of sources in intermediating both Treasury secondary trading and repo markets. First, both markets are home to a diverse set of users whose needs for cash and securities can vary unexpectedly. The repo market exemplifies this vulnerability.

Taking data from the periodic reports that primary dealers provide to the NY Fed, it becomes clear that Treasuries’ exposure of primary dealers is much greater in the repo markets relative to the Treasury secondary market.²⁰⁹ Figure 2 shows the average daily primary dealer exposure to outstanding repos and reverse repos over the period from 2016 to 2023.²¹⁰ Similarly, Figures 3.A and 3.B show, respectively, the average daily primary dealer inventory exposure in the secondary market, and the average daily trading volume in the secondary market.²¹¹ The data underlying the charts show that the average daily collateral exposure of primary dealers in the Treasury-backed repo market averaged $1.91 trillion in 2020 and $1.84 trillion in 2021. In contrast, the average net primary dealer exposure to the Treasuries’ secondary market totaled only around $244 billion in 2020 and $159 billion in 2021. Even the average daily trading volume of primary dealers in the Treasury secondary market—that includes both buying and selling by primary dealers—was only around $500 billion in both 2020 and 2021.

Importantly, the repo market also exerts large unpredictable demands on dealer balance sheets. By contrast, the secondary market is steadier. The data underlying Figure 2 shows that the average daily collateral exposure of primary dealers in the Treasury-backed repo market varies wildly and unpredictably from 1 week to the next. In 2020, this week-to-week difference varied from under $1 billion to $385 billion during the year and averaged around $72 billion. The average daily collateral used by primary dealers for the Treasury-backed repo market also continued to vary substantially from one week to the next in 2021, with weekly changes exceeding $100 billion about 20% of the time. Further, these position changes in the repo market are not correlated from week-to-week, reflecting constantly shifting market-wide needs.²¹²

By contrast, the secondary market is much less dramatic. Using data underlying Figure 3.A, it saw average weekly variation in primary dealer exposures of only around $17 billion in both 2020 and 2021, with maximum weekly variation of only $46 billion. These figures reflect a consistent pattern over time. Figure 4 shows the sizable extent by which changes in primary dealer exposures to the repo market dominate changes in primary dealer exposures to the Treasury secondary market between 2016–2023.²¹³

Relatedly, primary dealers are also subject to the vagaries of how other dealers use Treasuries and cash in repo intermediation. Primary dealers do not intermediate all bilateral repo transactions. Copeland et al. estimate that around 20% of transactions are not intermediated by primary dealers.²¹⁴ While primary dealers occupy an outsize and influential position, their perch only allows them a partial view. Consequently, primary dealers confront blind spots about how these other firms use collateral and cash. This can create further difficulties for primary dealers in seeking to estimate the Treasuries and cash required to sustain repo operations as well as Treasury secondary markets.²¹⁵ For example, hedge funds have emerged as active and intriguing players in repo markets. According to one 2021 study, hedge funds have doubled their exposure to Treasuries to $2.4 trillion between 2018–2020, holding around $1.4 trillion in Treasuries in mid-2019, compared to the largest banks that held only around $524 billion at that time.²¹⁶ In addition to using the repo market to borrow to fund themselves, hedge funds have also taken over some of the trading and liquidity supplying functions traditionally performed by major dealers.²¹⁷

Opacity attaching both to the repo market and to hedge funds has precluded a clear understanding of what kinds of risks hedge funds pose for dealers. For example, hedge funds are well-known for taking on debt to pursue trading strategies.²¹⁸ Hedge fund participation raises the danger that leveraged funds become a credit risk for dealers that fund them. In addition, owing to their smaller balance sheets, hedge funds may need to sell Treasuries and also pull back quickly from providing liquidity to the rest of the market.²¹⁹ The March 2020 crisis has shone a spotlight on the potentially destabilizing role of hedge funds in Treasuries.²²⁰ It also highlights the pervasive danger for dealers from corners of the market they are less familiar with yet whose activities can nevertheless dramatically impact their own.

Second, primary dealers face difficulties from their participation as intermediaries in capital markets more broadly. Crucially, primary dealers are active liquidity suppliers to risky assets.²²¹ Figure 3.A shows that about one-third of net primary dealer exposure has been in risky non-Treasury securities. Figure 3.B shows that primary dealer trading volume in non-Treasuries is comparable to that in Treasuries, such that risks arising out of trading in non-Treasury assets are similar in volume to those arising from Treasuries.

Further, Figure 2 shows that the exposure of primary dealers to non-Treasuries collateral in repos and reverse repos is about 20% to 25%. Non-Treasury collateral generally comprises mortgage and asset-backed securities.²²² As Gary Gorton and Andrew Metrick observe, these securities pose especially high risks where parties rush to liquidate their loans in fear of the collateral losing value quickly.²²³ This non-Treasury segment can heighten the risk of a repo run and force primary dealers to limit their intermediation across the board, including in Treasuries repo and secondary markets.

Third, information costs are exacerbated by difficulties in the ability of primary dealers to understand whether the Treasuries collateral they hold is actually viable. In other words, can this collateral be traced and readily sold for cash? Lengthy collateral chains, formed by reusing Treasuries multiple times, muddy understanding of whether this collateral is available in a default. Information sources are scant. Primary dealers do not have to report data on their use of client collateral in their weekly disclosures to the NY Fed.²²⁴ This means that they do not need to tell the NY Fed about how they use collateral that clients entrust to them in safekeeping. This leaves firms (and regulators) to guesstimate exposures.²²⁵

The perceived safety of the Treasuries-backed repo—and the difficulty of mapping out collateral chains—can act as a disincentive for primary dealers and others to invest in information gathering. Even if they do go to the trouble of mapping out the risk, the constantly evolving nature of repo market exposures means that this map of underlying collateral chains can change quickly.

Information and monitoring costs in the repo and secondary market for Treasuries contribute to imperfections in intermediation.²²⁶ Higher costs in understanding and pricing risk can result in intermediation becoming more selective, expensive, and governed by private interests at a cost to the public good. In response to these costs, primary dealers may temporarily cut off credit in repo, including to one another. Without the ability to fund themselves using repo operations (for example, to borrow cash), they may also withdraw from the secondary market and stop buying and selling Treasuries to investors. Critically, incomplete transparency in repo and the secondary markets can shield primary dealers that withdraw intermediation. They may be quicker to leave the market whenever they see fit owing to the impossibility of being publicly identified as the dealer that stopped supplying liquidity.

B. Conflict Between Public and Private Regulation

Primary dealers also face a conflict when intermediating cash and Treasuries between the repo and secondary markets, particularly during crisis. Supporting the health of one market (for example, maintaining systemic stability in repo) can come at the expense of the other (providing liquidity to the secondary market).

This task of accomplishing successful intermediation across both markets is complicated by a number of factors. Primary dealers must decide how they allocate the “free float” of Treasuries available to them. They must examine the volume of Treasuries that is freely available and decide how much of this float should be allocated between the secondary and repo markets.

This calculus reveals the depth of the internal conflict at play between the secondary and repo market. Critically, the free float of Treasuries is reduced by the large amounts of cash and securities that are “locked-in” in the repo market.²²⁷ This means that large volumes of this float become passively captured as collateral in the repo market.

Specifically, during 2020, the daily average Treasuries transaction volume in the secondary market was around $603 billion. Compared to this, the dollar volume of primary dealer Treasury collateral in repos during 2020 was $1.9 trillion, and the dollar volume of such collateral in reverse repos was $1.7 trillion. Taken together, without reuse, Treasuries valued at a daily average of about $3.6 trillion were captured as passive collateral in the repo contracts of primary dealers in just the bilateral repo market. This is about twelve times the average exposure of primary dealers, and six times their daily Treasury trading volume in the secondary market. This inference is not specific to 2020. Rather as seen in Figures 2, 3.A, and 3.B, these trends are persistent. High amounts of captured Treasuries float—necessary to repo operations—drastically reduce the volume of Treasuries that are available for trades in the secondary market.²²⁸

These restrictions create difficulties for intermediation by primary dealers. Captured repo collateral imposes rigidity on primary dealers that reduces how fully they can supply liquidity to the secondary market during crisis. The secondary market can experience sudden and unexpected pressure from investors to perform. For example, total aggregate trading in the Treasury secondary market in the weeks of March 6, 2020, and March 13, 2020, came to around $5.7 and $4.9 trillion, respectively—an especially turbulent 2 weeks during which the Treasury market essentially stalled.²²⁹ By contrast, as secondary trading activity normalized, it started seeing approximately half the volume by summer 2020.²³⁰

Trillions in passive repo collateral create a source of fragility for the secondary market, generating logistical and financial difficulties for primary dealers: (1) dealers might have to constantly warehouse a reserve of Treasuries to support Treasury secondary trading during periods of high demand or (2) they can risk having to buy Treasuries during a crisis in order to meet demand. The first option creates costs because dealers have to allocate capital for buying and maintaining Treasuries supply, limiting profits from intermediation. In the second case, they run the risk that Treasuries become costlier to source, potentially resulting in reduced margins for their business. A third option always remains on the table: to reduce intermediation and avoid the need to source expensive Treasuries during difficult periods. This trade-off requires primary dealers to balance their private interests with public ones. When Treasuries’ float is limited and demand in secondary trading exceeds existing reserves, the incentives of dealers to remain committed to Treasuries trading diminishes.

The coexistence of the secondary and repo markets—both intermediated by primary dealers—thus reveals real structural tensions. The growth of repo lending, demanding higher volumes of Treasuries float, can result in a corresponding decrease in securities available to lubricate the secondary market. This trade-off creates a complex problem for policy. If repo lending represents a desirable and efficient form of funding for financial institutions, ensuring it is done safely is of paramount concern. At the same time, a growing reliance on repo operations for financial institutions results in fragilities for the secondary market and the regulation that depends on it.

Moreover, as intermediaries for both markets, primary dealers have incentives to prioritize the needs of one market over another depending on private preferences. This favoring of one market over another can be motivated by a number of reasons. For example, primary dealers may see larger profits, lower risk, and reputational gains from ensuring the continuity of repo lending than from supplying expensive liquidity to the secondary market. Repo markets are far larger and primary dealers earn fees for matching counterparties.²³¹ It is one in which primary dealers dominate and have repeat relationships with major clients. Moreover, dealers are themselves beholden to the repo market for their own financing needs. For dealers, then, there is a lot to gain from seeing a growth in the size of the repo financing market—even if this means periodic retreats from the more competitive secondary market for Treasuries in which primary dealers have lost ground to high-speed electronic traders.²³²

The consequences of how primary dealers navigate this trade-off is a critical matter for public policy. If primary dealers are motivated to step away from intermediating in secondary markets, their actions call into question the view that Treasuries trade in a market that is deeply and constantly liquid. Rather, it points to one that is chronically vulnerable to the private preferences of its key intermediaries who are unlikely to continue offering resilient tradability at a cost to themselves. More broadly, for public and private financial regulation to remain credible, its intermediation must be able to deliver continued lucrative profit to its major dealers.

C. A Unique Configuration of Unknown Unknowns

As detailed above, primary dealers navigate a tricky and costly task in intermediating across both the repo and secondary market for Treasuries. Opacity limits the ability of a dealer to build a real-time understanding of the activity in the repo market external to that dealer—most importantly, where Treasuries collateral is located, and whether it can be captured and sold in an emergency. Motivation to monitor is low. The secondary market’s limited historic reporting also reduces sight of pockets of disruptive trading—and the arrival of greater competition between primary dealers and newer high-speed automated traders lowers the attractiveness of the secondary market as a place to do vibrant business. Importantly, intermediation represents a source of conflict. Dealers are caught between preserving trillions in passive collateral in the repo market to maintain its safety and soundness—and using cash and Treasuries to supply liquidity to the secondary market. Especially if collateral reuse results in uncertainty about the quality of collateral, primary dealers have every incentive to ring-fence the Treasuries and cash they have for repo operations, even if demand in secondary markets is spiking. Critically, despite dependence on the services of primary dealers to preserve intermediation, they can withdraw from both spaces whenever costs and uncertainties become too high.²³³

This combination of risks represents an unprecedented set of problems for intermediation in the repo and secondary markets. It leaves dealers and policymakers facing many unknowns.

First, as shown in Part I, the repo market has grown its reliance on Treasuries collateral sharply following the 2008 Financial Crisis as a way to privately regulate short-term credit between firms. Whereas an earlier era looked to a variety of riskier assets like mortgage-backed securities, the last decade has observed a marked shift in the direction of Treasuries as favored collateral.²³⁴ With Treasuries now collateralizing around $4 trillion of repo debt, concerns about locking-in and ring-fencing collateral carry special salience given the potential for catastrophic damage to financial stability if this collateral reserve becomes unstable.

Second, post-Crisis regulation also puts special weight on Treasuries as a mandatory asset for capital buffers. As discussed in Part I, Treasuries are particularly important for post-Crisis public regulation, with financial institutions required to maintain deep buffers of high-quality liquid assets. This signal reliance by public regulation raises the stakes for primary dealers to ensure the secondary market is supplied with trading opportunities for those firms that need to liquidate their Treasuries in a financial crunch or to buy Treasuries when a safe asset is needed. As detailed by Vissing-Jorgensen, mutual funds sold more Treasuries in 2020 than they did after the 2008 Financial Crisis, owing to the thicker reserves of Treasuries they held coming into 2020.²³⁵

On the other side, detailed in Part II, post-Crisis reforms also impose these liquidity requirements and capital surcharges on primary dealers themselves and necessitate compliance with regulations that protect these firms from becoming too big to fail. According to some commentators and scholars, these rules can also make primary dealers more hesitant to supply liquidity to the repo and the secondary market, depleting reserves of cash and Treasuries, and falling out of compliance. Importantly, scholars also note that a stricter compliance environment following post-Crisis reforms has reduced primary dealer motivation to support intermediation—and opened the door for other firms to enter the fray. While a broader trend across debt markets, commentators note that non–primary dealers (for example, hedge funds) have stepped into the breach to supply liquidity more actively.²³⁶ If this trend continues, primary dealers could face more information gaps arising from the activities of those that are new to the market as well as greater competition that diminishes their profits from intermediation.

Third, as outlined in Part II, the secondary market for Treasuries has experienced radical shifts, as primary dealers have lost ground to high-speed traders in the interdealer segment. According to one study of the major interdealer trading platform, BrokerTec, eight out of the top ten traders on the venue came from the ranks of HFT firms, rather than primary dealers. Primary dealers have continued to dominate the dealer-client segment. But this rapid waning of their professional power shows that that the secondary market has become more crowded with new entrants, and the incentives of primary dealers to take on costs to keep trading are quickly becoming weaker in the face of competition.²³⁷

Putting these factors together, Treasuries intermediation has newly evolved into an especially complex, contradictory, and costly prospect for primary dealers, policymakers, and regulation. It is also foundational to financial markets and their stability post-2008. This coming together of regulatory need and operational complexity in managing intermediation requires that regulators be equipped to spot and address the risks at the heart of a straining Treasury market structure. As argued below, this is far from the case given the highly fragmented state of current regulatory design.

D. A Breakdown in Regulation

The regulatory framework to oversee the repo and secondary market for Treasuries is ill-equipped to respond to the vulnerabilities underlying their market structure. Supervisory approaches for repo and Treasuries markets are divided between a “securities” model on the one hand (for secondary trading) and a prudential one on the other (for repo). This leaves regulators unable to develop a consolidated approach to oversight that recognizes the interdependence between the repo financing market that relies on Treasuries collateral and secondary trading that needs Treasuries to be capable of being bought and sold to realize their value quickly, cheaply, and at fair prices.

The regulatory framework for secondary trading in Treasuries is institutionally fragmented without any overarching coordination mechanism to guide rulemaking and supervision.²³⁸ As detailed in Part I, unlike equities markets that, for example, fall primarily within the jurisdiction of a single regulator (the SEC), Treasuries lack a single lead overseer. Oversight is shared between at least five major bodies: the U.S. Treasury, NY Fed, the Fed, the SEC, and CFTC. FINRA also oversees securities broker-dealers and is instrumental in data collection from reporting firms after 2017.²³⁹

Fragmentation raises serious concerns in the context of an interconnected, internally conflicted repo and secondary trading market.²⁴⁰ First, information sharing becomes hobbled by institutional barriers and bureaucratic divergences in how information is collected and analyzed.²⁴¹ Consider the so-called “Flash Rally” in the Treasury secondary market. On October 15, 2014, the Treasury secondary market experienced around thirty minutes of aberrant, anomalous trading at the start of the trading day, characterized by prices surging to some of their highest historic levels for inexplicable reasons.²⁴² Eventually, prices reverted to normal but not without first sending capital markets into chaos and confusion.²⁴³ Regulators undertook a thoroughgoing, yearlong joint investigation into the event’s possible causes and implications.²⁴⁴ While the final report did not unearth any smoking gun, the investigation itself was illuminating. During the inquest, commentators singled out the legal and logistical difficulties experienced by different agencies in collecting and sharing information with one another.²⁴⁵ The CFTC, for example, required time to conclude an information-sharing agreement in order to forward its data to other regulators.²⁴⁶ The report further revealed that regulators lacked information to such a degree that they were shockingly unaware of major transformations underway in the Treasury market, specifically, the shift to high-speed, automated trading from a primary-dealer dominated, more analog interdealer market.²⁴⁷

In other words, fragmentation points to serious institutional challenges for regulators seeking to understand the interconnected machinations of the repo and secondary markets.²⁴⁸ Agencies may not feel comfortable or be permitted to share information on those they supervise.²⁴⁹ The 2017 trade reporting regime, instituted in the wake of the Flash Rally, requires that covered securities firms report their data to FINRA.²⁵⁰ Banks, on the other hand, have to provide reports of their trading to banking regulators, suggestive of the especially sensitive nature of bank exposures.²⁵¹ To harmonize the process, FINRA and the Fed have engaged in a yearslong dialogue on coordination of data collection, under which FINRA could acquire bank-reported data as an agent of the Fed.²⁵²

Different regulatory regimes mean that regulators each have varying amounts of information on those they supervise.²⁵³ Whereas primary dealers banks and broker-dealers are overseen by various dedicated banking and securities regulators, like the Fed, the SEC, and FINRA, other major participants like hedge funds are regulated on a much looser basis.²⁵⁴ By design, hedge funds fall under a lighter touch, more opaque regulatory regime with fewer disclosures.²⁵⁵ To be sure, post-2008 rulemaking does extend the regulatory perimeter to cover their activities more fully than before. Notably, bigger hedge funds must provide disclosures on various types of exposures in financial markets in a bid to help regulators map out their systemic footprint.²⁵⁶ But the intensity of their overall regulatory scrutiny is generally far less intense than that faced by banks, broker-dealers, or mutual funds.²⁵⁷ Importantly, within the Treasuries market, hedge funds have generally fallen outside of the reporting obligation for their secondary market trades because they do not fall under the category of broker-dealers or banks.²⁵⁸ This is expected to change, at least for the most active hedge fund Treasuries traders, as the SEC’s new registration and reporting rules take effect. Given the enormity of their exposure to Treasuries and the potential scale and impact of their activities, their historic exclusion from reporting has left regulators without a valuable and essential repository of data. In addition to hedge funds, many high-speed automated traders also do not qualify as FINRA broker-dealers—though again, this may change for more active players as the SEC rulemaking takes effect.²⁵⁹ The erstwhile regulatory regime has nevertheless allowed many such firms to avoid direct reporting of trades in the interdealer market. It is worth highlighting that even though the SEC has taken steps to bridge these gaps by passing new rules to encompass hedge funds and HFT firms within a registration and reporting regime, their chances of future success appear uncertain in view of industry resistance to reforms and potentially drawn-out court challenges.²⁶⁰ A 2019 supplement to the reporting regime requires Treasuries trading platforms to identify traders in records.²⁶¹ As such, regulators can get information on particular securities firms should they need it.²⁶² However, reporting to regulators is not direct—and they must absorb costs to get data on an ex post basis.²⁶³

Gaps in information and roadblocks to cooperation have limited the ability of regulators to share insights on the major risks to Treasury secondary and repo markets. And fragmentation in regulatory design and pockets of opacity are essentially fatal to the enterprise of constructing a picture of the vulnerabilities affecting intermediation and developing ex ante constraints to control the risks.²⁶⁴

In addition to fragmentation, Treasury repo and secondary markets also operate under systems of oversight that diverge in their methodological approaches. As detailed in Part II, the Fed and the NY Fed represent the prudential end of the regulatory spectrum. Focusing on safety and soundness, a prudential approach ensures preservation of systemic safety and soundness as its critical mission. This can mean less emphasis on disclosure and transparency, for example, and more on ensuring that markets remain insulated from the risk of sudden runs and default on credit.²⁶⁵ By contrast, the SEC and FINRA represent quintessential securities markets regulators, offering deft expertise in building efficient and transparent trading markets and protecting investors.²⁶⁶ Instead of financial stability as the core guiding mission, securities market regulators nurture trading markets, underpinned by the dissemination of information, efficient price formation, and capital allocation.²⁶⁷ To be clear, these are generalizations. The SEC, for example, also focuses on financial stability (e.g., by regulating the stability of money market funds that constitute an essential part of the repo market).²⁶⁸ The Fed regularly engages with securities markets to ensure that the infrastructure, such as exchanges, is protected against collapse.²⁶⁹ These generalizations, however, aide in understanding key differences between the purposes and approaches of regulators tasked with overseeing secondary and repo markets for Treasuries.

This divergence can explain why regulators have failed to connect the shared risks facing Treasury repo and secondary markets, and to oversee both in a more consolidated way. Neither the prudential nor the securities-based model neatly fits the secondary or the repo market. For a start, the interdealer secondary market—a fairly classic securities market with heavy and liquid daily turnover—holds enormous systemic implications for the economy. If this market stops working, like in March 2020, a swath of economic actors cannot meet critical prudential needs. Concretely, reliance by public regulation on Treasuries’ liquidity (e.g., HQLA) ties the proper functioning of the interdealer market to the prudential survival of any number of financial firms and the larger system.

Yet the regulatory methods used to oversee interdealer Treasuries trading fit neither a prudential nor a capital markets paradigm and leave risks exposed. Trade-by-trade reporting is of recent vintage (2017)—and only for regulators. Public reporting is limited—with data released only in aggregate form. This reticence to widely disclose potentially sensitive Treasuries trades recognizes the systemic quality of the market. However, other regulatory aspects undermine this focus on curbing systemic risks. Perhaps most importantly, lightly regulated actors are afforded ample latitude to trade in secondary markets without having to report their activities. Hedge funds, especially, are a case in point. But high-speed securities trading firms are another. Now firmly dominant in the interdealer market, such high-speed trading firms have not fallen within the regulatory regime for broker-dealers. Therefore, they have not been subject to reporting rules (but see above for anticipated changes in response to new regulatory measures).²⁷⁰ Crucially, they have typically also been able to skirt other measures designed to address prudential risks—notably, capital requirements on broker-dealer firms that require safekeeping of rainy-day assets.²⁷¹ This leads to a possibility that highly influential traders have been transacting with only a thin base of capital, making them sensitive to losses and liable to exit rather than continue supplying liquidity especially during crisis.²⁷²

Similarly, the regulatory strategy for overseeing repos fails to account for the complex dynamic between Treasuries repo and the secondary market. As detailed in Part II, repo markets are overseen through a decidedly prudential lens. Capital buffers help safeguard against runs and collapse.²⁷³ Collateral plays a pivotal role in reducing default risk.²⁷⁴ Because of this collateral and the fear of runs, real-time detailed disclosure is limited.²⁷⁵ Yet despite this focus on safety and soundness, the workings of the repo market fail to account for the role of the secondary market in maintaining the repo market’s smooth workings.²⁷⁶ This interconnection exists for a number of reasons: (1) if secondary markets experience illiquidity, Treasuries’ prices can become unstable and distorted, impacting the viability of Treasuries as collateral; (2) repo lenders that wish to liquidate Treasuries will find themselves unable to do so in an illiquid secondary market; and (3) if primary dealers cannot buy and sell Treasuries in secondary markets, they may lack the ability to source cash and securities to fulfill repo lending. As seen in March 2020, for example, firms selling Treasuries en masse caused secondary trading to stall and badly disrupted securities prices.²⁷⁷ With the value of Treasuries directly tied to the viability of firm liquidity buffers, a lack of attention to the securities market undermines the functioning of the prudential one.

In summary, this Part shows that public and private regulation’s reliance on Treasuries is subject to a number of failures arising from a flawed system of intermediation. We show that the Treasury-backed repo and secondary trading markets are connected by a common intermediary: the primary dealer. In entrusting maintenance of the trading and repo markets to primary dealers, public and private regulation has failed to account for a number of costs that mean liquidity in both markets becomes tenuous. Primary dealers incur information and monitoring costs, navigate conflict between the needs of the repo versus the secondary market, and attend to their own private business preferences. These challenges are particularly dangerous owing to the needs of a financial regulatory system that puts Treasuries at the center both in public oversight and private self-regulation. In its second contribution, this Part argues that the regulatory framework for the repo and secondary markets is fragmented, inadequate, and insufficiently adaptive to provide consolidated supervision of a connected set of markets. The result is a Treasury market that is relied on for its resilience, but one whose foundations are poorly understood and subject to rapid erosion.

IV. PATHWAYS TO STABILITY

This Article shows that the Treasury market suffers from fragilities in intermediation that makes it unstable and unreliable, casting doubt on the assumption used by regulation to place Treasuries at the center of financial stability. To begin remedying the structural deficiencies identified in this Article, we outline three proposals. Our focus lies in enabling public and private actors to strengthen the quality of liquidity and improve their understanding of the market’s risks ex ante.²⁷⁸ We recognize that if the Treasury market fails—like it did in March 2020 and in September 2019—it will be a near certain recipient of ex post federal emergency assistance. Indeed, in January 2022, regulators announced the creation of a permanent standing facility to lend securities and cash to repo market participants when the need arises.²⁷⁹ Our focus is on taking first steps to develop strong ex ante mechanisms to improve information flows, enhance liquidity, and ensure that primary dealers are well supervised even within a highly fragmented regulatory framework. We suggest (1) developing greater transparency and information sharing in repo and Treasuries trading markets, (2) encouraging major liquidity suppliers—both primary dealers and key HFT traders—to invest in maintaining the liquidity of the market, even in times of distress, and (3) bringing greater consolidation and coordination to the regulatory framework, and requiring regulators to link supervision of the Treasury secondary markets and the Treasuries-backed repo markets more systematically.²⁸⁰

A. Transparency and Prudential Safety

As detailed in Part III, information gaps are endemic within the repo and secondary markets for participants as well as regulators. These gaps obscure an understanding of how repo and secondary trading intersect and what risks are created by dint of this connection. Reform must begin by developing reliable mechanisms for improving transparency and information flows as a first step toward empowering regulators and market participants.

Information gaps are deeply embedded throughout the Treasury market, in both the secondary trading and repo market. Reforms in 2017 and 2019 have brought reporting to secondary markets. But it is limited by significant gaps in coverage (for example, excluding hedge funds and high-speed securities firms). Public, real-time transparency is restricted. Repo markets, opaque by nature, lack systematic, up-to-date reporting.²⁸¹ This allows private parties to avoid thorough due diligence. But it is far from obvious that it is protective in all cases. Collateral reuse creates opaque chains that instill a potentially false sense of confidence in which multiple parties all count on owning a single security. Further, opacity has costs even if transparency also comes with downsides. Market participants may overreact during crises, lacking information, and not knowing with which firms the problems lie.²⁸² Opacity also constrains how flexibly primary dealers manage inventories, respond to the behavior of a variety of clients as well as unknown dealers that are also active in supplying liquidity.

As a first matter, we propose increasing the information and scope of reporting available to regulators and its participants.²⁸³ This applies to both the repo as well as the secondary market. For the repo market, this represents a paradigm shift in approach. However, we believe that it offers a much-needed lever for those in the market to take steps to assess supply and demand of Treasuries/cash more precisely. It also lowers the cost of public surveillance. Regulators remain stymied in their ability to capture real-time data on repo exposures, particularly for bilateral exposures. As Victoria Baklanova writes, supervisors are left to the grind of painstaking and patchy data collection practices that require them to piece together information from weekly or quarterly mandatory disclosures, on-the-ground examinations, or informal reporting by financial firms.²⁸⁴ Such data collection is costly, quickly out-of-date, and imposes analytical costs on account of its lack of standardization and comprehensive coverage.²⁸⁵ To be sure, since late 2019, this situation is improving. Regulators have ramped-up data collection in cleared segments of the repo market. In May 2024, the Office of Financial Research approved a new rule to enhance reporting and data collection in the bilateral repo market.²⁸⁶ But market-wide, real-time data gathering remains elusive for now, and the outcome of future efforts remains uncertain.²⁸⁷

Reporting in this market has a number of benefits. It requires dealers to develop mechanisms to record their repo trades on a real-time, granular basis ex ante, to track the collateral that attaches to a particular repo, and to determine whether collateral attaching to it might be subject to reuse. Reporting can help create systematization in relation to capturing exposures and discipline about understanding the robustness of the collateral. In addition, it can create incentives for primary dealers to be more diligent with respect to understanding how collateral is sourced, whether it might be subject to reuse, how many times, and what the risks of such reuse might be during a period of distress. Importantly, we believe that such information ought to be shared regularly between regulators and the primary dealers (at least) as a group. Key intermediaries ought to develop mechanisms whereby they circulate insights about their repo exposures to one another on a regular basis with the goal of understanding collective exposures, the robustness of collateralization, and the potential market availability of cash and securities in case of need. This allows market participants to share emerging concerns, prepare for problems, and for regulators to also be ready to deal with the consequences of fallout.

Invariably, there will be pushback on a proposal to create transparency in prudential spaces. It goes against the grain of conventional wisdom in regulating prudential risks.²⁸⁸ But, despite attachment to the status quo, regulators have begun to soften their stance on keeping utmost secrecy in banking and prudential areas. For example, in banking, regulators are now increasingly revealing some of the results of bank stress tests.²⁸⁹ Even in the repo market, some public reporting has emerged for its cleared segments.²⁹⁰ While far from full transparency, this easing of traditional fetters against disclosure in banking can hint at potential openness to real-time reporting and information sharing. In addition, regulators and market participants might also balk at the cost of enabling Treasury market transparency given the interconnected complexities of the repo market and its daily size. There is also the ever-present concern that too much disclosure could result in triggering the exact externalities that everyone seeks to avoid—a run that results in a catastrophic drain on the market’s liquidity and forces regulators to have to step in and stop the bleed.

Nevertheless, such concerns are not insurmountable, and while downsides exist, the costs embedded in the status quo are also high. Importantly, the repo market is not hermetically sealed. It does allow for some pockets of reporting (albeit not to the public). In particular, the tri-party repo market—that relies on a formal system of clearing and settlement—allows for greater reporting, collateral tracking, and unraveling of the complexity inherent in trades.²⁹¹ Stated differently, the market is amenable to systematization if parties so choose. In addition, the costs of recording trades, and tracking and reporting collateral, should not be prohibitively daunting. Primary dealers and others already do risk management as individual firms, though not on a standardized basis.²⁹² Notably, regulators routinely look to dealers self-reporting their activities as a means of gaining insights about the market. Surveys are commonplace as part of public efforts to study the ins-and-outs of the bilateral marketplace from those that inhabit it most closely.²⁹³ Moreover, a real-time data repository for the bilateral repo market would save both market participants and regulators from having to perform expensive data collection, analysis, and extrapolation of the possible state of the market on a given day. Rather than guesstimates, parties could rely on a more standard and reliable reserve of information from which to understand an already complex market.

Perhaps most importantly, the centrality of Treasuries to stability means that opacity presents an incalculably high cost in which the market suffers on account of being poorly understood and inadequately protected. As made clear in March 2020, the dislocation in the market cast a pall of doubt among market participants about the resilience of Treasuries during a global crisis.²⁹⁴ Seen from this perspective, failure to understand the market and its dynamics carries not just financial costs, but also implies larger damage from the standpoint of political economy. Finally, to avoid the potential for sudden runs (transparency, it should be noted, may also avoid runs if dealers and others better understand their exposures), data circulation around the market may be staggered and delayed.²⁹⁵ For example, the repository would provide data to a closed loop of recipients (potentially the major dealers) and do so with a delay (perhaps circulating information at intervals during the day, or perhaps at the end of each day). In other words, while transparency and reporting may appear daunting at first glance, there are ways of structuring it that can allow for some aggregation and promote a careful, calibrated approach to information consumption, collation, and analysis.

B. Increasing Resilience in Intermediation

A lack of information can fuel a race to the exit by intermediaries, resulting in liquidity draining quickly and causing distress for investors as well as firms needing to fund themselves. More reporting can provide clarity to dealers when it comes to pricing their risks. But it leaves open the possibility that they exit the market at even small signs of trouble. To ensure dealer engagement in maintaining Treasury market resilience, we suggest exploring tools to incentivize market makers to assume an affirmatively active role during periods of crisis—especially in the secondary market. As highlighted by the events of March 2020, the secondary market can face enormous strain during crisis as investors rush in to transact in Treasuries. Resilience here—when the market does not buckle under stress—helps ensure that Treasuries can perform their regulatory role as safety buffers. For the secondary market, such a duty would cover both primary dealers as well as high-speed security firms. Both types of dealers are vulnerable to exiting the market rapidly, causing a decline in available liquidity and distortion in prices.²⁹⁶

An affirmative duty on key dealers to remain trading can help to build more certainty around liquidity provision in the Treasury market. To be sure, regulators face a trade-off in introducing such affirmative duties. Imposing higher transaction costs on traders can discourage them from entering the market or encourage them to pass the costs of liquidity onto investors that use the Treasury market. On the other hand, affirmative duties can be beneficial, especially given the importance of securing liquidity for Treasuries. If dealers can simply leave depending on their own preferences, they will be likely to exit exactly when the Treasury market is most necessary—during a crisis. Investors may come to regard the perception of its fail-safe liquidity as illusory, primed to dry up whenever danger strikes.

Historically, regulators have not required primary dealers to keep the market going in a crisis—perhaps assuming that they would do so anyway. Given their long-assumed dominance, perhaps this assumption could be justified. But it cannot hold now. As detailed in this Article, the Treasury market as a whole is facing new pressures, created by heavy dependence by public and private regulation on its services. In addition, the arrival of high-speed trading firms as well as nontraditional types of repo intermediary (for example, hedge funds) add to the pressures facing primary dealers and can contribute to how they navigate private decisions about continuing to provide liquidity.

An affirmative duty to maintain market liquidity can offer greater certainty that dealers make a real effort to stay, rather than simply exiting the market. Such a duty would require an affirmative obligation on traders to remain, particularly during crises.²⁹⁷

A duty to remain trading—applied to the most active dealers (primary dealers and high-speed securities firms alike)—can help to preserve price continuity and assure investors of resilient liquidity. Most importantly, it can motivate those charged with staying to play a role in monitoring and safeguarding operations through ex ante private oversight. Those that must trade, under a new duty, in all conditions ultimately bear the costs of any fallout from disruptive trading strategies or other traders that are creating outsize risks for others. This duty ought to prompt dealers to pay attention to the quality, sophistication, and reliability of their trading behavior. In this way, a duty to remain changes the trade-off governing the behavior of large Treasuries traders. Faced with the prospect of bearing potentially heavy losses if the market goes awry, taking risks starts to look more costly. Currently, easy exit and light-touch regulation have made taking careless or deliberate risks a low-cost option.²⁹⁸

To be clear, an affirmative duty to remain is not an unlimited one, forcing firms to comply to the point of making themselves insolvent, fighting enormous fires in Treasuries at a cost of their own existence. For example, some nontraditional dealers like HFT traders tend to be smaller and less capitalized.²⁹⁹ They cannot be expected to deplete their entire balance sheet to remain trading. Bigger bank dealers will have a more intensive obligation owing to their capacity to remain trading longer. That being said, a duty to remain is also likely to result in otherwise thinly capitalized firms to have to develop deeper capital buffers in readiness. Those subject to a duty will be the most active traders. Ensuring that they are better buffered provides assurance that those charged with maintaining Treasuries intermediation have the capacity to do so.

Practically, firms are likely to resist such a duty. If they have to pay large sums to selflessly protect the market, they will rationally demand a large ex ante price from the U.S. Treasury for their commitment. And regulators might consider how they ought to compensate traders that become subject to this duty. For example, one option might be to afford them special access to information on Treasuries trading order flow and repo operations as a way to help them to calibrate their risk. As above, this can lower the costs of monitoring and also help dealers to modulate their supplies of Treasuries and cash for secondary trading.

Importantly, this idea is not new to markets—earlier eras had once demanded that a designated group of traders withstand losses to protect markets in times of stress. Those that earned the designation also enjoyed certain privileges and status as a result.³⁰⁰ While such a duty may not be critical in other markets in which liquidity provision is voluntary, introducing it for Treasuries is more than justified given the crucial importance of ensuring trading continuity in Treasuries in crises. During a crisis, affirmative liquidity provisions would clearly provide greater assurance of resilience. It also forces dealers to more fully confront the responsibility that comes with the fact of transacting in securities whose workings possess near existential significance for the global economy, further helping to strengthen market integrity.

C. Fixing the Breaks in Regulation

Developing better information flows and ensuring the market’s resilience must also be accompanied by reform at the level of public oversight.³⁰¹ This Article points to the need to develop a coordinated and hybrid approach to oversight for the Treasury market that is capable of overcoming tension between different regulatory philosophies (prudential versus market based). Remedying the ill effects of institutional fragmentation is necessary as a condition precedent to more fully understanding how the market works, identifying the risks and producing a set of rules that can mitigate structural vulnerabilities at the intersection of the repo and secondary markets.

As argued in this Article, the need for coordination between regulators takes on urgency in light of the interlinkages connecting Treasury repo and secondary markets. With a common set of intermediaries—the primary dealers—Treasuries-backed repo and the secondary markets depend on one another for each to be able to fulfill its respective mission. A patchwork system of oversight makes little sense within an ecosystem in which the trading of high-speed securities firms impacts the liquidity of collateral propping up the four-trillion-dollar Treasuries-backed repo market; or where the enormous collateral and cash needs of the repo market put the resiliency of the Treasury trading markets in jeopardy. Rules to simply govern one or the other market by itself are not enough. Rather, this Article makes clear that the Treasury market exists as a whole, underpinned by the trading and funding mechanisms working together to deliver what is universally recognized as the lynchpin of the world’s financial order.

A near-term fix to the problem of regulatory fragmentation and ad hocism lies in making FSOC expressly into a coordinating supervisory agency for Treasury and repo markets.³⁰² Created by post-2008 rulemaking, the FSOC is designed to create a layer of consolidation over the patchwork of U.S. financial regulators. With the 2008 Financial Crisis showcasing systemic interconnections in financial markets, the FSOC’s creation offers an administrative response to the risks of agencies working just on single parts of an otherwise entangled system.³⁰³ By requiring the FSOC to bring multiple regulators together, it provides a way to ensure that regulators share information, develop a plan for reform, scrutinize and debate their own supervisory methodologies, and arrive at a mode of overseeing Treasuries that recognizes the linkages between trading and repo markets. As shown in this Article, this means developing a more hybrid regulatory strategy that is capable of moving beyond blunt prudential versus securities market approaches.

Introduction of the FSOC as a coordinating regulator for Treasuries is only a first step toward creating a governance model for public oversight. Even with the FSOC, agencies may struggle to work together. They may fail to share data or coordinate. Opacity may hamper attempts to understand how risks move between repo and Treasuries trading. In the absence of a strong system of supervision, the Treasury market may well just be left to depend on the Fed’s ex post interventions in a crisis. But disruptions to U.S. Treasury secondary and Treasury-backed repo markets (for example, in March 2020) show that the current fragmentation and disorganization between regulators is untenable and harmful. Coordination through FSOC begins a process of deeper institutional reform.³⁰⁴ Further, systematized transparency (for example, through disclosure and reporting) offers a way to help bridge the difficulties faced in developing a hybrid approach to overseeing the interlinkages between Treasuries-backed repo and Treasuries trading markets. With all regulators able to share in data from both repo markets and Treasuries, understanding interdependencies should become practicable. Information—in addition to saving collection costs and bridging institutional hurdles to communication—can foster collective focus on a connected marketplace. This approach of co-opting banking and securities regulators and ensuring greater coordination through the FSOC offers a way out of the bifurcated approaches that treat repo and trading markets as basically distinct and subject to separate modes of scrutiny.

This Part proposes a three-part solution to place Treasury markets on a stronger footing to better withstand the weight this market carries for the financial system and the economy. It proposes first developing stronger information flows to increase reporting and transparency, affording primary dealers greater ease in monitoring exposures as well as giving regulators a clearer idea about the market’s structural weaknesses in real time. In addition, an affirmative obligation on major dealers to remain trading creates confidence in the resiliency of liquidity across the marketplace, especially during crises. Finally, we advocate for regulatory oversight that can bridge fragmentation and offer a more consolidated, coordinated system of supervision. The FSOC provides a convening authority. But, looking forward, fixing the fractures in regulation would help to ensure that the Treasury market’s overseers are well positioned to match the realities of its critical importance to financial market stability.

CONCLUSION

Financial stability rests on a central idea that Treasuries represent a bulwark against distress, representing the foremost risk-free asset anywhere on the globe. Free of default risk and trading in a market with supposed plentiful liquidity, public and private regulation are anchored to Treasuries for their function and assume that Treasuries will protect firms and markets from collapse. In this Article, we show why this assumption is incorrect. While Treasuries themselves are viewed as risk-free, the market that distributes them is not. It is pervasively subject to flawed intermediation. Importantly, the demands of public and private industry regulation are internally in conflict, crystallizing the harms of faulty intermediation. Despite their importance, these risks in the secondary and repo markets remain undertheorized and poorly understood, leaving Treasuries perpetually at risk of failing to perform their protective role. Without real reform, the first steps to which we outline here, we worry that Treasuries cannot live up to their reputation, undermining their promise for regulation as the anchor in financial system stability.

APPENDIX: FIGURES

Figure 1.A. Bilateral Repo Market Collateral Outstanding ($ Trillions)

Sources: SIFMA Rsch., supra note 26 (providing figures for the bilateral repo and reverse repo markets through 2021); Sec. Indus. & Fin. Mkts. Assoc., supra note 21 (providing data through July 2024).

Figure 1.B. Tri-Party Repo Market Collateral Outstanding ($ Billions)

Source: Fed. Rsrv. Bank of N.Y., supra note 26 (select “Total” and “US Treasuries excluding Strips”).

Figure 2. Primary Dealer Repos and Reverse Repos Outstanding ($ Billions)

Source: Fed. Rsrv. Bank of N.Y., supra note 209 (providing raw data on trades and positions of primary dealers).

Figure 3.A. Secondary Market Trading of Primary Dealers: Daily Inventory Risk Exposure ($ Billions)

Source: Fed. Rsrv. Bank of N.Y., supra note 209 (providing raw data on trades and positions of primary dealers).

Figure 3.B. Secondary Market Trading of Primary Dealers: Daily Trading Volume ($ Billions)

Source: Fed. Rsrv. Bank of N.Y., supra note 209 (providing raw data on trades and positions of primary dealers).

Figure 4. Daily Changes in Primary Dealer Treasury Holdings: Repo Market vs. Treasury Secondary Market ($ Billions)

Source: Fed. Rsrv. Bank of N.Y., supra note 209 (providing raw data on trades and positions of primary dealers).

97 S. Cal. L. Rev. 1349

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Pradeep K. Yadav*

* W. Ross Johnston Chair and Professor of Finance, University of Oklahoma.

Yesha Yadav†

† Professor of Law and Milton R. Underwood Chair, Associate Dean & Robert Belton Director of Diversity, Equity and Community, Vanderbilt Law School. We are deeply grateful for thoughtful comments, insights, and conversations. We thank Dan Awrey, Jonathan Brogaard, Peter Conti-Brown, Chris Brummer, Nakita Cuttino, Anna Gelpern, Evan Gerhard, Patricia McCoy, Mitu Gulati, Rory van Loo, Michael Kang, Lev Menand, Robert Rasmussen, Morgan Ricks, Paolo Saguato, Nadav Shoked, Danny Sokol, Kumar Venkataraman, Jialan Wang, Mark Weidemeier and participants at the Wharton School of Business Conference on Financial Regulation, the Vanderbilt Law School Annual Conference on Central Banking and Financial Regulation and faculty workshops at the University of Illinois Business School, Northwestern Law School, and USC Gould School of Law. Runzu Wang and Doris Zhou at the University of Oklahoma provided excellent research assistance.

Auditor Independence: Moving Toward Harmonization or Simplification?

June 2024June 2024Nikita Patel*

INTRODUCTION

Auditor independence has been a priority for the Securities and Exchange Commission (“SEC”) under the leadership of both the Trump Administration and the Biden Administration. In 2020, former SEC Chair, Jay Clayton, pointed out that in the United States “auditor independence rules are far-reaching and restrictive,” which could have “unintended, negative consequences.”¹ Shortly thereafter, the SEC issued new regulation that lowered auditor independence requirements and brought the SEC’s independence rules closer to the rules set forth by the Public Company Accounting Oversight Board (“PCAOB”) and American Institute of Certified Public Accountants (“AICPA”), the other two regulatory entities responsible for auditor independence.² Meanwhile, the current chair, Gary Gensler, has signaled that auditor independence remains a “perennial problem area,” indicating that a tightening of the auditor independence requirements is soon to be seen.³

While the future of auditor independence regulations remains up in the air, the problems associated with a lack of auditor independence continue. In 2019, the SEC alleged that PricewaterhouseCoopers LLP, one of the “Big Four” accounting firms, had violated auditor independence rules in connection with nineteen service engagements for fifteen publicly traded companies by providing prohibited non-audit services that could have impaired the firm’s objectivity.⁴ Non-audit services are ancillary services, such as reviews of accounting software or tax advice, that do not assist in the goal of auditing, which is reviewing the financial statements for fraud or error. The SEC also alleged that another Big Four accounting firm, Ernst & Young LLP, had violated auditor independence standards, along with one of its partners and two of its former partners.⁵ The Chief Accounting Officer for Ernst & Young’s client on this engagement was also allegedly involved with this misconduct, indicating how far-reaching auditor independence violations can be.⁶

Auditor independence is governed by a self-regulatory model, in which the SEC, in partnership with the PCAOB, the specialized non-profit corporation created by the Sarbanes-Oxley Act of 2002,⁷ provides oversight over the AICPA, which is a private industry professional organization charged with setting substantive auditor regulation. Despite the importance of auditor independence regulation in investor protection and the existence of this self-regulatory model, the regulatory framework in this area remains entangled.

While the SEC and PCAOB provide oversight over the AICPA, they also issue their own auditor independence regulation and have enforcement practices associated with auditors.⁸ Among the SEC, PCAOB, and AICPA, each standard-setter has rules that overlap with the others in the same subject-matter and some rules that defer to the rules set by the other organizations.⁹ This leads to a waterfall effect, in which all three entities have to change their regulations any time one of the other two does, in order to ensure that the rules are not in conflict.¹⁰ This effort has been called “harmonization,” and has the goal of ensuring that all regulatory frameworks in this area are made consistent with each other, to provide more certainty to the accounting firms and other stakeholders involved in audits, including public company boards of directors.¹¹ However, an alternative solution to harmonization may be “simplification,” in which instead of expending effort to harmonize the regulation of the three entities each time one of them makes a change, the existing self-regulatory model could be streamlined so that the AICPA is the primary or sole standard setter, with the SEC and PCAOB providing government oversight.

To explore whether simplification is a compelling alternative to harmonization, this paper turns to federal judicial decisions by conducting a novel case study of all auditor independence cases decided after the passage of the Sarbanes-Oxley Act of 2002. These decisions indicate that the courts largely use AICPA standards and case law requirements in assessing auditor independence, rather than SEC or PCAOB standards. This new finding suggests that simplification of the regulatory framework by relying solely on AICPA rulemaking is a viable solution, given that the federal courts already rely on AICPA rules.¹²

This paper will proceed as follows. First, Part I provides a brief summary of the business of public company audits to preview how the structure of the audit industry gives rise to unique incentivizes and pressures that may impact auditor independence. Next, Part II includes an overview of the impact of the Sarbanes-Oxley Act of 2002 on the audit industry and highlights the debate over auditor independence, including the ways that various stakeholders have argued whether auditor independence is a worthy goal, or if auditors’ role as gatekeepers is unnecessary. Thereafter, Part III provides an overview of the self-regulatory model that governs auditor regulation, as well as regulations promulgated by the SEC, PCAOB, and AICPA in the area of auditor independence, including a summary of recent efforts to harmonize the standards set by each entity. The core of the paper’s contribution to the literature on auditor independence regulation is in Part IV, which a presents a novel case study that examines which body of regulation, between the SEC, PCAOB, and AICPA, is preferred by the federal courts when determining whether there have been auditor independence violations. This leads to the key finding that, in determining whether auditor independence violations have occurred, the federal courts rely almost exclusively on AICPA standards and case law requirements developed by the courts, rather than SEC or PCAOB standards. Accordingly, the paper then briefly examines in Part V whether this finding indicates that rule-making authority should be consolidated by giving the AICPA authority to set substantive auditor independence regulation, with the SEC and PCAOB providing oversight, given that there is already a self-regulatory model in place. Put differently, the paper concludes by considering whether the three regulatory frameworks should be simplified into that of the AICPA, the standard setter that is the most comprehensive, and the one that has been most acknowledged by the courts.

I. THE BUSINESS OF PUBLIC COMPANY AUDITS

The role of auditors in public company financial reporting is to provide third-party reasonable assurance to investors that the financial statements of their client companies “are free of material misstatement, whether caused by error or fraud,” in the form of a formally issued audit opinion, which is appended to the clients’ public company SEC filings.¹³ Audit opinions state whether the auditor believes that the financial statements included in the filings are free, in all material respects, from error or fraud.

Generally, auditors are viewed as “gatekeepers,” meaning individuals who are “reputational intermediaries who provide verification and certification services to investors.”¹⁴ As gatekeepers, auditors have incentives to signal to outsiders that they are credible because their reputation of trustworthiness is what allows them to attract future clients and remain in business by giving credibility to their audit opinions.¹⁵ The reputation of auditors is also partially what enables them to provide verification services because investors recognize that auditors have fewer incentives than their clients’ management teams to mislead investors because the management teams are corporate insiders whereas auditors are objective third parties.¹⁶ A traditional understanding of the audit profession puts forth the proposition that auditors are trustworthy because they are not incentivized to risk their reputation by assisting one client with fraud, which could lose them many additional clients and destroy their reputational capital.¹⁷

Additionally, auditors have built up years of expertise that demonstrates to third parties that their services and opinions can be trusted.¹⁸ The utility of auditors extends from the fact that they have specialized technical expertise in the area of accounting. Members of accounting firms that conduct audits are generally expected to hold state licenses as Certified Public Accountants, which give them both reputational capital and technical expertise.¹⁹ Additionally, these accounting firms are typically well staffed with local and global teams to address the audit needs of multinational companies that are listed on exchanges in the United States, despite the complexity and geographical scope of the audit procedures that may be required.²⁰

It is widely known that auditing is part of an oligopoly, in which the “Big Four” accounting firms—PricewaterhouseCoopers LLP (“PwC”), Ernst & Young Global Limited (“Ernst & Young”), Deloitte Touche Tohmatsu Limited (“Deloitte”), and KPMG International Limited (“KPMG”)—dominate the market. The Big Four were responsible for the audits of 88% of SEC large accelerated filers—which are companies with a public float of larger than $700 million that are required by the SEC to submit securities filings on a shorter timeline than other filers—and 44.7% of all public companies in 2022.²¹ There are several smaller players in the market as well, including RSM US LLP, BDO USA LLP, and Grant Thornton LLP; however, the largest of these entities produces less than a third of the revenue produced by the smallest Big Four accounting firm, leaving the market substantially dominated by the Big Four accounting firms, which have offices globally.²²

Auditors for public companies are required to examine their clients’ financial statements and notes to the financial statements, which provide supplemental information. Auditors use a variety of mechanisms, including inspecting records, confirming balances with third parties, checking compliance with internal policies, and completing detailed tests of transactions to ensure the financial statements are free from material error or fraud.²³ Auditors also often test the robustness of management’s internal controls over financial reporting. Internal controls over financial reporting are policies and procedures surrounding accounting and reporting that are designed to limit the risk of fraud and error in the financial statements. All of this testing is done with an expectation of independence—that the auditors are not personally invested in the entity they are auditing, do not have conflicts of interests, and are reviewing the information with an air of “professional skepticism.”²⁴

II. THE DEBATE OVER AUDITOR INDEPENDENCE

When discussing auditor independence, much emphasis has been placed on the fact that each of the large public accounting firms have three lines of business: audit, tax, and consulting services. In the wake of the Enron scandal, debate over whether these three lines of business lead to inherent conflicts within public accounting firms that obstruct independence. Enron was a publicly traded energy company based in Texas that went bankrupt in 2001, partially as a result of a major decline in stock price after accounting irregularities were discovered at the company.²⁵ At the time, Enron was the seventh-largest company in the United States based on market capitalization, and its bankruptcy was the largest in United States history.²⁶ The accounting irregularities alleged were largely technical in nature, involving the use of (1) mark-to-market accounting, a practice that can lead to the overstatement of the value of assets by recording them at their current market value rather than their historical cost; (2) improper recognition of liabilities within “special purpose entities” that were owned by the company, which reduced the liabilities that were attributed to Enron; as well as (3) alleged improper payments to company officers, all of which were not in accordance with Generally Accepted Accounting Principles (“GAAP”) that are set by the AICPA and required to be followed by public companies.²⁷ Arthur Andersen LLP (“Arthur Andersen”), the public accounting firm responsible for Enron’s audit, did not, however, note any of these issues with GAAP in the audit opinions it issued about the accuracy of Enron’s financial statements, which led to surprise when the company collapsed.²⁸

In the wake of the Enron scandal, many stakeholders argued that one of the main contributing factors to Enron’s collapse was that the company’s auditor, Arthur Andersen, was receiving more revenue from its consulting engagement with Enron than it was from its audit engagement, to a factor of 1.08 times.²⁹ Arthur Andersen received approximately $27 million in annual non-audit fees and $25 million in annual audit fees from Enron in 2000 and expected to grow the overall fees to approximately $100 million annually, which some alleged was why Arthur Andersen did not disclose Enron’s lack of compliance with GAAP.³⁰ Arthur Andersen was exonerated of any liability; however, the court did not reach the issue of whether the firm was conflicted and what effect that may have had on the audit.³¹

Enron was used as an example of how pressure on accounting firms to maximize revenue from consulting engagements prevents accounting firms from robustly auditing financial statements. Primarily, stakeholders worried that accounting firms would fail to report material misstatements or fraud in financial statements in order to preserve relationships with management of the companies they were auditing or to sell them consulting services; in extreme cases such as Enron’s, the concern was that this failure to report could collapse the company entirely and thus completely eliminate a revenue-generating client.³²

The furor and fallout over Enron and implications on the weaknesses of accounting firms was used as a major justification for Congress’s passage of the Sarbanes-Oxley Act of 2002, given that investors lost billions upon Enron’s collapse.³³ Specifically, the social costs of the Enron collapse were high because pension funds that supported teachers, firefighters, and government employees were endangered from the losses, leading to outcries for reform.³⁴ William Donaldson, the SEC Chair during the time of the passage of Sarbanes-Oxley, testified before Congress that Enron was a major event leading to the reforms that were implemented in Sarbanes-Oxley.³⁵

Sarbanes-Oxley included sweeping regulatory changes designed, in part, to “restor[e] public confidence” in the accounting profession, emphasizing for the first time in Congressional legislation the importance of auditor independence.³⁶ The Act created the PCAOB to inspect accounting firms and set auditing regulations, departing from the prior regulatory structure in which the accounting profession was almost entirely self-regulated by the AICPA.³⁷ Sarbanes-Oxley also created a slew of additional auditor independence rules, such as requiring audit committees to pre-approve all audit and non-audit services provided by an auditor, reducing the consulting services that could be provided by an auditor, requiring that certain auditors rotate off an audit engagement on a regular schedule, requiring that independence concerns be raised to the audit committee when auditors identified them, and requiring disclosure to investors of non-audit and audit services provided by accounting firms.³⁸ The stated purpose of these reforms was not only to “restor[e] public confidence in the independence and performance of auditors of public companies’ financial statements,” but also to “enhance the integrity of the audit process and the reliability of audit reports.”³⁹

While Sarbanes-Oxley seemed to significantly reduce the opportunity for accounting firms to provide both audit services and consulting services to their clients, there exists a gray area in which accounting firms are able to provide certain “non-audit services” to their audit clients.⁴⁰ Accounting firms have found that these non-audit services can be a profitable substitute for revenue lost from consulting services, and according to a study that reviewed audit revenue as compared to non-audit revenue disclosures in annual proxy statements—which require public companies to disclose certain matters prior to their annual shareholder meetings—non-audit revenue represented 18% of the fees paid to auditors by public companies in 2021.⁴¹ These non-audit services allow public company auditors to provide a number of ancillary services to their audit clients, such as, (1) audits over accounting and information systems, including payroll software and human resources software, (2) “carve-out” audits that evaluate portions of the business that are set to be divested, (3) tax services, (4) statutory audits, which are audits that comply with local governmental audit requirements, especially in foreign countries, and (5) employee benefit plan audits, typically meaning audits over pension plans. All of these services can be provided without impairing independence under the SEC, PCAOB or AICPA rules, and several of them are repeat, annual services, making them especially lucrative and enticing to accounting firms.⁴²

The oligopoly presented by the Big Four accounting firms also puts significant cost pressure on accounting firms to lower audit costs to attract and retain clients, while still maximizing revenue and market share.⁴³ This balance is primarily struck by the accounting firms in two ways.

First, the accounting firms can look to drive efficiencies in the audit process to lower the cost of annual audits to clients.⁴⁴ This is often accomplished by retaining clients and using institutional knowledge gained over years of repeat audits to streamline audit processes and thus reduce hours and audit costs.⁴⁵ However, this has the added effect of lowering auditor independence as auditors become entrenched in relationships with their clients over a number of years.⁴⁶ For this reason, mandatory rotation of audit firms has been adopted in a number of foreign jurisdictions, including in Europe.⁴⁷ Some have also argued that mandatory audit firm rotations should be adopted in the United States, in addition to the existing United States requirement of rotation of the individuals who lead each audit project, known as audit engagement partners and who are usually equity partners in the accounting firms.⁴⁸

Alternatively, accounting firms can look to increase revenue from ancillary, non-audit services.⁴⁹ This method of increasing revenue by cross-selling non-audit services along with public company audits is seen as a positive to many because efficiencies are driven by the institutional knowledge that auditors already have as a result of their financial statement testing, lowering the costs for both the audit and the non-audit services. For example, an accounting firm that is performing both a public-company financial statement audit and a report on internal controls for the same client can use some of the testing done for the financial statement audit to satisfy testing requirements for internal controls, thus lowering the costs for the combined services.⁵⁰

Many argue that this bundling is a positive development, and given that audit services are fungible, lower transaction costs for companies in the form of reduced fees to accounting firms increase shareholder value.⁵¹ Additionally, tracking independence over each and every ancillary service would increase transaction costs without providing shareholder value, given that some of these non-audit services can be provided without impairing auditor independence, and especially because some argue that accounting firms are already conflicted by virtue of the fact that they are paid for audit services provided.⁵² Further, proponents of bundling argue that auditors are still incentivized to provide quality audits because despite the pressure to increase non-audit service revenue, auditors would not want to risk their reputational capital, which allows them to stay in business and attract other clients.⁵³

However, others argue that fee dependence on non-audit services poses the same problems as those that existed prior to Sarbanes-Oxley, in which instead of sacrificing audit quality to retain consulting revenue, firms are now sacrificing audit quality to retain other non-audit service revenue.⁵⁴ This leads to concerns that auditor independence will be impaired in a way that increases costs to investors because material misstatements are less likely to be caught, and this outweighs the costs saved from efficiencies by the same accounting firm providing both audit and non-audit services.⁵⁵

While this paper reserves judgment on these questions of how non-audit services effect auditor independence, the primary view of auditor regulation since the accountings scandals of the early-2000s and Sarbanes-Oxley has been that auditor independence is of paramount importance to the audit industry in order to protect investors from fraud or inadvertent material errors from management.⁵⁶ In the following Part, this paper will explore the existing regulation surrounding auditor independence, including identifying the many agencies and self-regulatory organizations that promulgate such regulations, and untangle the many requirements for independence as they have appeared over time.

III. SELF-REGULATION AND THE TANGLED REGULATORY FRAMEWORK OF AUDITOR INDEPENDENCE

Modern third party audits have existed since approximately the 1920s and have varied widely in their form and requirements.⁵⁷ However, it was not until the Securities Act of 1933 that companies were required to have their financial statements certified by an independent accountant before they could register on the public markets.⁵⁸ This requirement was expanded with the passage of the Securities Exchange Act of 1934, which mandated annual and quarterly financial reporting for public companies, as well as reporting on material events, all of which were required to be certified by “independent public accountants.”⁵⁹ The Federal Trade Commission and SEC subsequently passed rulemaking that defined “independent public accountants” as those who had neither served as officers or directors of the company to be audited, nor had a “substantial financial interest” in the company, which was defined as more than one percent of the auditor’s net worth.⁶⁰

While the SEC retained statutory authority over auditor independence regulations, eventually the AICPA formed its own auditor independence requirements and in 1977 created the Public Oversight Board (“POB”) to serve as a self-regulatory organization over the accounting profession.⁶¹ The AICPA is independently funded by membership dues from members, which include individual accountants who are certified public accountants.⁶² The AICPA is governed by a council consisting of AICPA members elected by their fellow members in each state, representatives of state CPAs, and members-at-large of the AICPA, among others.⁶³ However, in the wake of the accounting scandals of the early 2000s, the SEC issued additional independence rules to move away from complete industry self-regulation by the AICPA and POB without public oversight, and these rules were then amended to coincide with the sweeping reforms passed by Congress in the Sarbanes-Oxley Act.⁶⁴ Sarbanes-Oxley required the formation of the PCAOB—a nonprofit corporation under the oversight of the SEC—but still allowed the AICPA to issue auditor independence standards.⁶⁵ The membership of the PCAOB, which consists of a five person Board, is determined by appointment from the Chair of SEC and a vote of the five SEC commissioners.⁶⁶ The PCAOB is funded by mandatory fees from public companies who are subject to audit requirements under the Exchange Act as well as fees from brokers and dealers subject to SEC regulation.⁶⁷ As a result, since 2003, when Sarbanes-Oxley took effect, the accounting profession has been governed by three primary sets of auditor independence standards, those set by the SEC, PCAOB, and the AICPA.⁶⁸ A summary of the interaction of the regulations set by the AICPA, SEC, and PCAOB is provided below and will be discussed further in the following sections:

Figure 1.

A. Self-Regulatory Models in United States Financial Regulation

The diffuse structure that contains SEC, PCAOB, and AICPA involvement in auditor independence regulation is not unheard of within United States financial services regulation. The SEC is involved in several self-regulatory models in which the SEC provides oversight to an industry organization that sets standards, and, in some cases, enforces those standards. For example, the Financial Industry Regulatory Authority (“FINRA”) sets regulation for registered broker-dealer firms and registered brokers⁶⁹ and enforces those rules.⁷⁰ The Exchange Act gives the SEC the authority to approve any rule changes made by FINRA⁷¹ as well as revoke the authority of FINRA or issue sanctions against FINRA.⁷²

The SEC is also part of self-regulatory frameworks with national securities exchanges.⁷³ The self-regulatory framework between the national securities exchanges and the SEC works much in the same way as SEC’s oversight of FINRA, in which the SEC provides oversight over and approval of the rulemaking of each securities exchange and issues sanctions for violations of the Securities Act of 1933, the Investment Advisers Act of 1940, and the Investment Company Act of 1940.⁷⁴

The SEC also has a self-regulatory model with respect to credit rating agencies.⁷⁵ Pursuant to Section 15E of the Securities and Exchange Act of 1934, each credit rating agency was required to set internal controls and policies to ensure accurate credit ratings,⁷⁶ and the SEC was required to review such policies to ensure they were robust.⁷⁷ Additionally, prior to the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”), the SEC relied on credit agencies to provide a measure of credit-worthiness in SEC rules.⁷⁸ However, Section 939A of the Dodd-Frank Act required that the SEC remove such references to the credit agencies within its rules and instead create its own independent standards.⁷⁹

Although the examples above illustrate that the self-regulatory model has been widely used, the model has also been subject to debate over its merits.⁸⁰ Supporters of the model argue it is beneficial because the knowledge of industry participants enhances the usefulness of rulemaking,⁸¹ places the costs of enforcement on industry,⁸² and is more adaptive than the state-driven model because industry entities have the experience and ability to focus on specialized regulations in a way that public entities with vast oversight responsibilities may not.⁸³ However, others believe that the self-regulatory model is not as beneficial as the European state-driven model, in which public entities are the singular or primary regulators with little or no input from industry organizations, because the self-regulatory model can result in conflicts of interest in terms of funding and regulatory capture, given that individual standard setters may be members of the group facing regulation and may seek to avoid restrictions.⁸⁴ In response, proponents of self-regulation may argue that the oversight of the public entities is sufficient to mitigate these conflicts and harness the benefits of a specialized industry standard-setter working hand-in-hand with a public oversight agency, especially when safeguards such as individual term limits for regulators, or limitations on the ability of individual regulators to participate in a “revolving door” in which they rotate between industry and regulatory entity, are put in place.⁸⁵

While the self-regulatory model is not unique to auditor regulation, what is somewhat distinctive about the auditor regulation self-regulatory model is that the SEC and PCAOB not only provide oversight over the AICPA, which is the industry organization run by accountants, but the SEC and PCAOB also have concurrent jurisdiction to set independence standards and have set their own standards for auditor independence in addition to those of the AICPA.⁸⁶ While there are additional organizations that set auditor independence standards, including state boards of accountancy, state CPA societies, federal and state agencies, and the International Ethics Standards Board, the standards set by these entities are heterogeneous and are generally superseded by the SEC, PCAOB, and AICPA rules.⁸⁷ Therefore, the regulation promulgated by these entities will not be examined in this paper. In order to assess the current landscape of auditor regulation, this paper will examine the regulations passed by the SEC, PCAOB, and AICPA in Sections III.B–D.

B. SEC Independence Rules

Under the current SEC independence rules:

The [SEC] will not recognize an accountant as independent . . . if the accountant is not, or a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the accountant is not, capable of exercising objective and impartial judgment on all issues encompassed within the accountant’s engagement. In determining whether an accountant is independent, the [SEC] will consider all relevant circumstances, including all relationships between the accountant and the audit client.⁸⁸

The SEC independence rules then set forth a non-exhaustive list of instances in which an auditor would not be independent, primarily consisting of eight categories: (1) lack of financial independence, (2) client investment in the accounting firm, (3) employment by client, (4) non-audit services, (5) contingent fees,⁸⁹ (6) improper partner rotation, (7) lack of audit committee approval,⁹⁰ and (8) improper compensation.⁹¹ Perhaps the most important of these rules are those defining financial independence because without financial independence, an auditor may have conflicts of interest that prevent them from conducting a robust audit.⁹² Accordingly, a summary of these rules is given below, along with a brief summary of the independence restrictions posed by the remainder of the SEC independence rules.

1. Financial Interests

SEC Independence Rule 2-01 states that independence is impaired when (1) the accountant has a direct financial interest or material indirect financial interest in their client;⁹³ (2) the accounting firm, a covered person in the firm, or any of the covered person’s immediate family members have a direct investment in the client, in which “covered person” includes individual accountants within a firm that provide services to a client;⁹⁴ (3) any partner or employee in the firm, including their close family, has more than 5% beneficial ownership of the client’s securities or controls the client;⁹⁵ or (4) the accounting firm, a covered person in the firm, or any of the covered person’s immediate family members have loans, savings accounts, checking accounts, broker-dealer accounts, insurance products, futures commission merchant accounts, consumer loans, or financial interests in investment companies that own the client.⁹⁶

In addition to the requirements of financial independence listed above, the SEC independence rules also prohibit the audit client from investing in the accounting firm or underwriting an accounting firm’s securities.⁹⁷ Moreover, the SEC independence rules place limits on accounting firm employees from being employed at the client both during and after the audit engagement.⁹⁸

2. Audit Conduct

The SEC independence rules also mandate certain conduct during the audit. For example, auditors are not allowed to provide non-audit services that could impair their independence, such as bookkeeping services, financial information systems design and implementation, appraisal or valuation services, actuarial services, management functions, human resources, investment advising, legal services, or expert services unrelated to the audit.⁹⁹ Much of the intent behind this regulation is to reduce the types of conflicts discussed in Part II, in which auditors are incentivized to ignore errors in the audit in order to receive revenue for these non-audit services.¹⁰⁰ Additionally, audit partners are required to rotate every five years if they are the lead partner on the engagement or every seven years otherwise, to avoid forming ties with clients that may impair independence.¹⁰¹ Auditors are also not allowed to receive contingent fees or have partners compensated for any services other than audit services.¹⁰² The audit engagement, typically including fees and non-audit services, must also be approved by the client’s audit committee to ensure independence.¹⁰³

3. Enforcement and Entanglement

The SEC’s enforcement mechanism for auditor independence violations is relatively straightforward. Under the SEC independence rules, the SEC can “censure a person or deny, temporarily or permanently, the privilege of appearing or practicing before [the SEC] in any way to any person who is found by the Commission after notice and opportunity for hearing”¹⁰⁴ to have “engaged in unethical or improper professional conduct.”¹⁰⁵ What is interesting about this mechanism is that it defers to “applicable professional standards” in determining whether there has been “unethical or improper professional conduct.”¹⁰⁶ As a result, the SEC defers the determination of the standard for violations of independence standards to the body that sets the professional standards, which has often been interpreted, both by the SEC’s Administrative Law Judges and the federal courts, to be the AICPA.¹⁰⁷ This is one instance in which the auditor independence regulations are entangled between two different standard setters—the SEC and the AICPA.

One other instance in which the auditor independence rules are entangled between regulators is that although the SEC has delegated the authority to the PCAOB to set auditor independence standards, the SEC independence rules passed in the wake of Sarbanes-Oxley in 2003 are still effective.¹⁰⁸ Aside from some minor updates to debtor-creditor relationships passed in 2019, the SEC independence rules remained largely untouched until 2020,¹⁰⁹ at which point the SEC, along with making minor updates to the independence rules, brought the PCAOB rules into harmony with the SEC rules where they conflicted, acknowledging that for several years there had been a period in which the SEC and PCAOB rules surrounding auditor independence were not consistent.¹¹⁰ This inconsistency is explored further in the sections below, including analyzing the frequency with which the courts used the SEC and PCAOB standards during this time, or the AICPA standards, which are defined in Part III.D.

C. PCAOB Standards

The PCAOB sets forth “Ethics and Independence” standards for accounting firms and their associated persons.¹¹¹

standards/ethics-independence-rules [https://perma.cc/WP6J-2LLD]. While several of these rules set forth additional requirements when compared to the SEC rules, several are similar or aligned with the SEC independence rules and AICPA standards.¹¹² First, accounting firms and their employees are required to “comply with all applicable auditing and related professional practice standards,” which implies that SEC and AICPA standards are binding.¹¹³ However, in 2003, the PCAOB released a note to PCAOB Rule 3500T, which states that the “[PCAOB’s] Interim Independence Standards do not supersede the [SEC’s] auditor independence rules” and that in situations when the SEC Rules are more or less restrictive than the PCAOB rules, the more restrictive rule is to be followed.¹¹⁴ Additionally, the PCAOB explicitly requires that accounting firms and their employees comply with AICPA Code of Professional Conduct Rules 101 and 102, including any interpretations and rulings under these rules.¹¹⁵ Further analysis of the AICPA rules will be provided in Section III.C.

The PCAOB independence rules extend beyond the SEC independence rules in three areas: (1) limiting auditors’ ability to provide audit clients with tax services,¹¹⁶ (2) requiring auditors to communicate with the client Board’s audit committee about certain independence-related matters,¹¹⁷ and (3) requiring auditors to submit a form to the PCAOB that summarizes audit hours by partner (“Form AP”).¹¹⁸

1. Tax Services

Generally, the PCAOB rules extend beyond the SEC rules by maintaining that an accounting firm is not independent of its audit client if the firm provides “marketing, planning, or opining in favor of the tax treatment of” confidential transactions or aggressive tax position transactions, or if the firm provides “tax service to a person in a financial reporting oversight role” at the client, which generally prohibits providing tax advice or preparation services to management and finance employees of the audit client.¹¹⁹

2. Audit Committee Communication

Further, the PCAOB goes beyond the SEC rules and requires accounting firms to seek audit committee pre-approval before the firms perform any permissible tax service or non-audit service related to internal controls.¹²⁰ Part of the intent of these rules is to present to the audit committee the ways that it might impair the accounting firm’s independence to provide both tax and non-audit services to the client.¹²¹ In line with this requirement, accounting firms are required to describe to the audit committees of their clients “all relationships between the registered public accounting firm . . . and the audit client or persons in financial reporting oversight roles at the potential audit client that . . . may reasonably be thought to bear on independence” both prior to beginning the audit and annually thereafter, including an annual affirmation of independence to the audit committee, which essentially requires accounting firms to disclose personal relationships that may impair independence.¹²²

3. Form AP Filing Requirements

Finally, the PCAOB requires that accounting firms file a “Form AP” with the PCAOB for each audit report it issues for a client.¹²³ The Form AP lists the lead engagement partner for the audit and notes the hours they have completed on the audit engagement, with the goal of providing users of financial statements information about the “independence of the specific individuals and firms that participate in the audit.”¹²⁴

004.pdf [https://perma.cc/U3D4-2X49] .

D. AICPA Standards

The AICPA promulgates what is the most rigorous standard of independence requirements for auditors, when compared to the SEC and PCOAB. The AICPA Code of Professional Conduct begins by setting forth a single independence rule: “A member in public practice shall be independent in the performance of professional services as required by standards promulgated by bodies designated by [the AICPA Governing] Council.”¹²⁵ Stemming from this rule, the AICPA has then set forth hundreds of interpretations,¹²⁶ which are binding on accounting firms and accountants performing “attest engagements,” which are any services to a client requiring independence from the client, including audits.¹²⁷

Given the complexity of the interpretations to the independence rule and the many scenarios effecting independence that they address, it would be impractical to describe all interpretations within this paper. However, to summarize, the interpretations to the independence rule cover a variety of situations regarding the independence of individual accountants, such as how to handle the employment of a family member at an audit client¹²⁸ and how to address whether an individual accountant’s financial investments in a client’s securities impair their independence.¹²⁹ The interpretations also cover more complex situations regarding the independence of accounting firms as a whole, such as how to maintain independence in situations in which a nonclient acquires a current client¹³⁰ or how “network firms” with multiple offices should each remain independent of each other’s clients.¹³¹

In the absence of any relevant interpretation, accounting firms and accountants are expected to apply the AICPA’s “Conceptual Framework for Independence.”¹³² The Conceptual Framework for Independence requires that accountants evaluate whether a particular “relationship or circumstance” would lead a reasonable person “to conclude that there is a threat to . . . independence . . . that is not at an acceptable level.”¹³³ The Conceptual Framework then lists potential “threats” to independence, such as holding an adverse interest from the client, advocating for the client, familiarity with the client, auditor participation in management of the client, self-interest, self-review, and undue influence by the client or a third party.¹³⁴ Following the potential threats, the Conceptual Framework identifies “safeguards” which can reduce threats to an acceptable level that will ensure independence, such as external review, competency requirements for professional licensing, analysis of an accounting firm’s revenue dependence on one client, and accounting firm policies for engagement quality control, such as external review.¹³⁵ By ensuring threats are low or nonexistent or by balancing them with safeguards, accounting firms and accountants can ensure compliance with independence standards under the Conceptual Framework in situations in which there is no authoritative interpretation set forth by the AICPA.¹³⁶

The AICPA also has a senior committee, the Auditing Standards Board, that sets forth Generally Accepted Auditing Standards (“GAAS”).¹³⁷ GAAS sets forth specific testing requirements and procedures for auditors as they undertake audit engagements for clients.¹³⁸ In addition to these audit testing requirements—which are largely technical in nature and outside of the scope of this paper—GAAS also sets for ethical requirements relating to audits of financial statements, stating that an “auditor must be independent of [a client] when performing an engagement in accordance with GAAS.”¹³⁹ GAAS then defers to the Code of Professional Conduct’s Conceptual Framework, which was discussed previously.¹⁴⁰ GAAS is often referenced more frequently than the Code of Professional Conduct, as will be discussed in Part IV, because GAAS includes not only ethical requirements for auditors, but substantive guidance for how audits are to be conducted in practice.¹⁴¹

Overall, there is significant overlap between the regulations set forth by the AICPA and the SEC and PCAOB.¹⁴² The AICPA standards set forth detailed guidance for accounting firms to ensure they comply with the broader standards set forth by the SEC and PCAOB. For example, while the SEC and PCAOB rules prevent auditors from receiving contingent fees from their clients, the AICPA rules state that same proposition and provide guidance that states contingent fees include finder’s fees, fees based on cost-savings achieved by the client, and exclude fees based on the results of judicial proceedings in tax matters.¹⁴³ This level of detailed guidance means that practitioners often consult the AICPA standards, as they set forth a more restrictive set of guidelines and also a more informative set of interpretations that can be applied to specific circumstances. This delegation of substantive regulation to the private industry organization—AICPA—is also consistent with other self-regulatory models.

E. Harmonization Efforts

In October 2020, the SEC issued updates to the auditor independence rules set forth in SEC Independence Rule 2-01.¹⁴⁴ These updates covered a variety of miscellaneous matters in the SEC independence rules, including refining the definition of affiliates of audit clients, amending the definition of an “audit and professional engagement period,” excluding some student loans from causing independence violations, and addressing inadvertent violations of the independence rules due to mergers and acquisitions, among other matters.¹⁴⁵

As a result, stakeholders raised concerns that the PCAOB rules, particularly those related to affiliates of audit clients, such as subsidiaries, were no longer consistent with the SEC independence rules.¹⁴⁶ In response, and to “provide greater regulatory certainty,” the PCAOB amended its rules to align with the SEC independence rule changes.¹⁴⁷ Additionally, several of the PCAOB rules that needed realignment with the new SEC rules were those that the PCAOB adopted directly from the AICPA or had interpreted based on the AICPA rules.¹⁴⁸ As a result, the AICPA issued a temporary policy statement as a stop-gap measure that stated to accounting firms and accountants that they would be considered in compliance with the AICPA Code of Professional Conduct if they complied with the updated SEC independence rules.¹⁴⁹ Soon thereafter, the AICPA put forth a proposal to change its rules and definitions to align with the SEC and PCAOB changes.¹⁵⁰ This proposal has not been adopted as of the time of this paper, but it seems likely that the AICPA will bring its standards into alignment with the current SEC and PCAOB independence rules.

Overall, this amendment waterfall that began with the SEC proposing changes in October 2020 that were then adopted by the PCAOB, and which still have not been adopted by the AICPA two years later, shows that the regulatory framework for auditor independence remains entangled. This entanglement may be occurring because the Sarbanes-Oxley Act created the PCAOB, which is allowed to pass audit regulations subject to the oversight of the SEC; and the Sarbanes-Oxley Act also allowed the SEC to become more involved in rule-setting for auditors, which had previously been handled entirely by the AICPA.¹⁵¹ While some argue that harmonization between these three entities is a worthy goal to disentangle regulations that are not consistent between the three entities,¹⁵² one might also consider whether harmonization is the answer, or rather whether simplification is a better goal, to avoid having to involve three regulatory agencies in rule changes, in order to ensure clear standards for accounting firms, clients, and stakeholders in the market. The following section of the paper will explore whether one regulatory entity is dominant over the others, and whether this agency should be favored for simplification that centers around focusing auditor independence on this agency and its rules exclusively, rather than the standards set across all three entities.

IV. CASE STUDY

As discussed, the following case study will assess published federal court opinions in which auditor independence was at issue in a civil litigation to determine whether SEC, PCAOB, or AICPA standards were used in the courts’ reasoning.¹⁵³ While a study of administrative law decisions from the SEC was considered, federal court decisions were deemed to be a more relevant indicator of which body of regulation is used in deciding civil matters because SEC administrative law decisions rely almost exclusively on a single, broad rule, SEC Rule 102(e)(1)(ii), which “censure[s] a person . . . after finding that a person engaged in improper professional conduct.”¹⁵⁴

There were fifteen cases decided by federal courts in which auditor independence was at issue in civil litigation, and which were used to comprise the population for this case study.¹⁵⁵ The population of cases includes only cases in which auditors were performing financial statement audits, and therefore excludes government and internal audit services, as these non-financial statement audits are typically not part of the debate over auditor independence because they involve different monetary incentives, risks for auditors and investors, and different auditing standards. Additionally, cases were only observed after May 6, 2003, which was the effective date of the Sarbanes-Oxley legislation, given that Sarbanes Oxley completely changed the landscape of auditor independence, giving the SEC broad authority to issue rulemaking in this area and effectively creating the PCAOB.¹⁵⁶ Finally, cases that relied on state regulations over auditor licensing and independence were excluded, as they do not address the relevant issue of federal regulatory structure.¹⁵⁷

This case study aims to examine which body of regulatory law federal courts rely on in making determinations over whether auditors have breached their independence obligations. Each of the AICPA, SEC, and PCAOB have their own enforcement mechanisms to sanction auditors who do not adhere to independence requirements, and each enforcement division uses their own regulation as well as occasionally relies on the regulation of the other entities to sanction auditors.¹⁵⁸ However, the civil courts do not have a requirement to adhere to the regulations of any particular standard-setter under the requirements of Sarbanes-Oxley or the Securities and Exchange Act of 1934. Given this lack of constraints, the standard used by the federal courts in determining independence violations has not been examined and is ripe for analysis to determine whether one set of standards (that is, those of the AICPA, SEC, or PCAOB) is preferred over the others. Therefore, this study will examine all fifteen federal court decisions to determine what standards have been used by the courts in the area of auditor independence as well as whether the result was in favor of the auditor or against the auditor in each scenario.

There are three major areas in which auditor independence has been examined by the federal courts. First, individuals who have been sanctioned by the SEC for violations of auditor independence standards can appeal to the federal courts for a review of the SEC’s decisions under a broad “abuse of discretion” standard to argue that the agency acted arbitrarily and capriciously in a way that requires the SEC’s decision to be overturned under 5 U.S.C. 706(2)(A).¹⁵⁹

Next, auditor independence is frequently at issue in Securities and Exchange Act Section 10(b) and SEC Rule 10b-5 claims, which are often brought as class-actions.¹⁶⁰ To prevail on these claims, plaintiffs must prove scienter, meaning that the defendant employed a “device, scheme, or artifice to defraud,” in addition to proving the elements of a material misstatement or omission, on which the plaintiff relied, and was the proximate cause of the plaintiff’s loss.¹⁶¹ Plaintiffs often allege that auditors’ violations of independence rules are evidence of scienter for purposes of satisfying this element to bring a successful 10(b) or 10b-5 claim.¹⁶² However, this practice has been complicated by the heightened pleading requirements for Section 10(b) and Rule 10b-5 claims established in the Private Securities Litigation Reform Act of 1995 (“PSLRA”), which was passed in part to reduce the number of non-meritorious securities class action claims raised by plaintiffs and requires that plaintiffs “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.”¹⁶³ The PSLRA has resulted in different pleading standards for scienter among and within circuits, however, many courts find “scienter [is] plead with particularity by facts supporting a ‘motive or opportunity’ to commit fraud.” ¹⁶⁴ As will be discussed in Section IV.B, this heightened pleading standard has reduced the circumstances in which courts have viewed violations of auditor independence rules to be sufficient to show scienter.

Finally, plaintiffs also bring state law claims—including negligent misrepresentation, professional negligence, and fraud suits—against auditors who have violated auditor independence standards, using the alleged violations of these standards as de facto evidence of a breach of duty.¹⁶⁵ In one instance, a plaintiff also attempted to bring a state law breach of fiduciary duty claim against an auditor who allegedly did not comply with auditor independence standards.¹⁶⁶

Given the heterogeneity of the claims within these cases, this paper examines the cases within these three groups—reviews of SEC administrative decisions, federal securities law claims, and state law tort claims—to identify developments in the case law regarding auditor independence and to examine when courts apply SEC, PCAOB, or AICPA standards in determining whether there has been an independence violation sufficient to warrant a judgment against auditors.

A. Appeals of SEC Administrative Decisions

In Ponce v. SEC, the Ninth Circuit reviewed an appeal from a decision that the SEC made to bar a plaintiff accountant from practice, and the court acknowledged that as part of the SEC’s decision, the accountant had been held in violation of SEC Independence Rule 102(e)(1)(ii), which means he engaged in “improper professional conduct.”¹⁶⁷ In order to determine whether there was truly “improper professional conduct,” the court turned to AICPA standards and ruled that the auditor failed to maintain his independence because he allowed his clients to run up a substantial balance of unpaid fees, which under AICPA guidance, resulted in a presumed lack of independence because the AICPA standards set forth that “independence is considered to be impaired if fees for all professional services rendered for prior years are not collected before the issuance of the member’s report for the current year.”¹⁶⁸

Similarly, in Dearlove v. SEC, the Court of Appeals for the District of Columbia Circuit used the same approach as Ponce, albeit six years after the decision¹⁶⁹ and six years after the implementation of Sarbanes-Oxley, including its resulting reform of SEC independence rules and the formation of the PCAOB. In Dearlove, the court concluded that “the appropriate standard of care . . . is supplied by . . . GAAS” when reviewing whether the SEC had abused its discretion in determining that an accountant violated SEC Independence Rule 102(e)(1)(ii) by failing to maintain independence from their audit client.¹⁷⁰

Ponce and Dearlove are indicators of how the federal courts have given credibility to the AICPA standards, including GAAS, in determining whether there has been a violation of auditor independence. The court’s opinion in Dearlove references SEC Independence Rule 102(e)(1)(ii), but it does so only to note that the SEC rule states “improper professional conduct” will warrant sanctions, before deferring to the AICPA GAAS standards to assess what improper conduct is.¹⁷¹ The court also stated that “the SEC need not establish a standard of care separate from the GAAS in order to give meaning to” what SEC Independence Rule 102(e)(1)(iv)(B)(2) describes as “unreasonable conduct,” showing further deference to AICPA standards.¹⁷² The fact that this decision came more than six years after the implementation of Sarbanes-Oxley, when the court had the ability to reference the updated SEC independence rules or PCAOB rules, but chose not to, shows even more significant reliance on the standards set by the AICPA.

B. Determinations of Scienter in Securities Claims

Similarly, in In re WorldCom, Inc. Securities Litigation, defendants moved for summary judgment on the matter of whether Arthur Andersen, the auditors at the helm of both the Enron, and in this case, WorldCom accounting scandals, had the requisite scienter to be in violation of Section 10(b) of the Securities and Exchange Act and SEC Rule 10b-5 because they allegedly recklessly issued false audit opinions.¹⁷³ The plaintiff alleged that violations of the AICPA’s GAAS were sufficient to prove scienter, even under the heightened pleading standards required by the PSLRA, which required the plaintiffs to plead recklessness in order to avoid their claim being dismissed.¹⁷⁴ The court recognized the importance of violations of GAAS in proving scienter, but ultimately denied summary judgment due to conflicting expert reports on whether GAAS was violated.¹⁷⁵ Although the claim survived the motion for summary judgment due to unresolved questions of fact, this case was another high profile example of the federal courts giving credence to AICPA standards in determining whether there was auditor wrongdoing.¹⁷⁶

In re WorldCom, Inc. Securities Litigation also included a Securities Act claim, in which the plaintiffs alleged that Arthur Andersen was in violation of Section 11 of the Securities Act, which states that a “preparing or certifying accountant . . . may be liable ‘if any part of the registration statement . . . contained an untrue statement of a material fact.’ ”¹⁷⁷ Arthur Andersen attempted to assert a due diligence defense, in which it claimed that it “had, after reasonable investigation, reasonable ground to believe and did believe, at the time . . . the registration statement became effective, that the statements therein were true,” and then moved for summary judgment.¹⁷⁸ In deciding whether summary judgment was appropriate on this issue, the court issued an even stronger affirmance of the relevance of AICPA standards, concluding that a “reasonable investigation” that would support a due diligence defense, like that raised by Arthur Andersen, must be a “GAAS-compliant audit.”¹⁷⁹ Because the plaintiff presented sufficient evidence to rebut the argument that the audit was “GAAS-compliant,” Arthur Andersen’s motion for summary judgment was denied. While this second issue is not directly related to auditor independence rules, it shows the courts’ general deference to the AICPA’s GAAS.

However, not all courts have agreed with the Southern District of New York’s decision in WorldCom, which may be in part due to differing interpretations of the heightened pleading requirements of the PSLRA. In In re Cardinal Health, Inc. Securities Litigations, the Southern District Court of Ohio ruled that Ernst & Young’s failure to adhere to the AICPA’s GAAS requirements for auditor independence did not establish the requisite scienter for a plaintiff’s claim to survive Ernst & Young’s motion to dismiss on a Rule 10b-5 claim.¹⁸⁰ The Court reasoned that while recklessness is generally sufficient to meet the pleading standard under the PSLRA, claims brought against auditors were subject to the even more heightened pleading standard of “a mental state ‘so culpable that it approximate[s] an actual intent to aid in the fraud being perpetrated by the audited company,’ ” which was not met in this case based merely on the alleged failure of Ernst & Young to adhere to AICPA GAAS requirements.¹⁸¹

Further, the court opined that an auditor’s past sanctions in SEC administrative proceedings were insufficient to prove scienter.¹⁸² In this case, the court also noted that SEC administrative decisions were not dispositive in determining scienter for Rule 10b-5 claims, perhaps suggesting that judicial interpretation of independence violations supersedes determinations by regulatory bodies.¹⁸³ This is in line with existing administrative law doctrines that do not require federal courts to defer to the SEC’s interpretations of the Exchange Act.¹⁸⁴

Similarly, in In re Royal Ahold N.V. Securities and ERISA Litigation, the United States District Court for the District of Maryland ruled that alleged violations of AICPA’s GAAS standards on independence—in which the only allegations from the plaintiff were that auditor independence was impaired due to the auditor providing audit and non-audit services—were not sufficient to establish scienter for a Rule 10b-5 claim against an auditor.¹⁸⁵ However, the court did note that violations of AICPA’s GAAS can be sufficient to plead scienter when they are coupled with allegations that show that “the nature of the violations of those violations was such that scienter is properly inferred.”¹⁸⁶ Likewise, in New Jersey v. Sprint Corp., a group of class action plaintiffs brought Rule 10b-5 claims against Sprint Corporation and Ernst & Young for filing false and misleading registration statements, prospectus supplements, and proxy statements that did not disclose that the company had considered dismissing their auditor, Ernst & Young, and that there were conflicts between executives at the company and the auditor, which resulted in auditor independence violations under AICPA’s GAAS.¹⁸⁷ The court relied on the AICPA’s GAAS to assess independence, noting that the plaintiffs did not plead sufficient facts to show that Ernst & Young lacked the independence in “mental attitude” required by GAAS, and even if sufficient facts were pled to show that Ernst & Young violated GAAS, this would not be sufficient under the PSLRA to establish scienter because the standard for scienter is recklessness, that is “so obvious that the defendant must have been aware of it” which goes beyond a mere violation of GAAS. ¹⁸⁸ Therefore, the motion to dismiss was granted in favor of Ernst & Young.¹⁸⁹

While the varied interpretations in different jurisdictions over whether violations of the AICPA’s GAAS standards is sufficient to plead scienter persists, some courts have ruled that merely “articulating violations of GAAS and GAAP alone is insufficient” to satisfy the element of scienter under the PSLRA’s heightened pleading requirements and instead imposed additional requirements to plead scienter through case law.¹⁹⁰ For example, the court in Grand Lodge of Pennsylvania v. Peters determined that in order to prove scienter, violations of GAAS must be accompanied by “red flags” that would put a reasonable auditor on notice that their client was committing fraud.¹⁹¹ Therefore, the plaintiff’s allegations in this case that the auditor was conflicted by providing consulting services to the client in violation of GAAS were insufficient to establish scienter for a Rule 10b-5 claim.¹⁹² Additionally, the court in In re Williams Securities Litigation ruled that “GAAS violations must be coupled with evidence that the violations were the result of the auditor’s fraudulent intent to mislead investors,” in order to have a sufficient pleading of scienter.¹⁹³ This supports the idea that some courts grant credibility to the AICPA standards, however, they impose additional burdens on plaintiffs that are developed through case law.

This case law has developed in the years since the passage of the PSLRA. The Ninth Circuit Court of Appeals summarized the development of the additional requirements to prove scienter, other than GAAS violations, in New Mexico State Investment Council v. Ernst & Young LLP.¹⁹⁴ The court ruled that failing to “maintain independence in mental attitude during an audit,” in violation of GAAS and PCAOB standards, is not sufficient to prove scienter.¹⁹⁵ Rather, there should be “red flags” that a reasonable auditor would have investigated as well as a showing that there were violations that amount to more than “alleging a poor audit.”¹⁹⁶ New Mexico State Investment Council indicates how the courts’ reliance solely on AICPA standards has lessened slightly over the years, as the burden to meet additional case law requirements for scienter has increased due to the passage of the PSLRA and its heighted pleading requirements, which require that plaintiffs “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.”¹⁹⁷

While the discussion above indicates that courts have largely relied on violations of AICPA’s GAAS and case law requirements in determining whether auditor independence violations are sufficient to show scienter, other courts have discussed Sarbanes-Oxley in determining whether an auditor independence violation is sufficient to show scienter as an element of a Rule 10b-5 violation.¹⁹⁸ In Brody v. Stone Webster, Inc., the First Circuit Court of Appeals examined whether scienter could be presumed on the part of PwC in connection with a 10b-5 claim because PwC allegedly turned a blind eye toward accounting irregularities to protect its accounting and consulting revenue from a client.¹⁹⁹ The court determined that “turn[ing] a bind [sic] eye” to misleading accounting for a “profit motive” may have been a rationale for the passage of Sarbanes Oxley, but it is not enough in itself to prove scienter sufficient for a valid Rule 10b-5 claim under the PSLRA without specific allegations that the auditor ignored “red-flags” that were signs of fraud.²⁰⁰

Courts have also been reluctant to find that scienter has been sufficiently pled in accordance with the PSLRA when plaintiffs allege auditor independence violations on the basis of general policy arguments against auditors depending on fees from clients.²⁰¹ In In re ArthoCare Corporation Securities Litigation, plaintiffs alleged that PwC was not independent in its audit because the firm had a longstanding relationship with its client and was dependent on the client’s audit fees.²⁰² The United States District Court for the Western District of Texas found that general allegations based on a perceived lack of independence or violations of GAAS due to fee dependence or long-standing relationships, which are allegedly against public policy, are not sufficient to establish scienter on the part of auditors under the PSLRA.²⁰³ Similarly, in Ley v. Visteon Corporation, the Sixth Circuit determined that an allegation that Ernst & Young was not independent during an audit because it sought to preserve revenue from a client by not pointing out the client’s alleged accounting irregularities was not sufficient to plead scienter on the part of the auditors under the PSLRA’s requirements because it was merely an allegation of a “motive.”²⁰⁴

On the whole, these cases show a broad trend of the courts giving credibility to the AICPA’s standards, as compared to SEC or PCAOB standards. As the case law has developed, violation of AICPA standards has been shown as one of the avenues plaintiffs can use to establish scienter for Securities and Exchange Act Section 10(b) and SEC Rule 10b-5 claims, when additional case law requirements are met. Notably, neither violations of the PCAOB independence rules nor the SEC independence rules have been used by the federal courts to assess whether there has been scienter for the purposes of a Section 10(b) or Rule 10b-5 claim that has been sufficiently pled in accordance with the PSLRA. Instead, the courts have relied on the AICPA rules as one factor for establishing scienter, and then have developed additional case law standards, such as finding “red flags” and alleging more than a poor audit, in order for plaintiffs to prevail on Section 10(b) and Rule 10b-5 claims against auditors. This focus on the AICPA rules is aligned with the deference given by the courts to AICPA standards in appeals of SEC enforcement decisions, discussed in Section IV.A.

C. Fraud, Negligence, and Other State Law Causes of Action

In state law actions for fraud, courts have required a heightened standard for liability that extends beyond a violation of the AICPA’s GAAS independence standards in order to hold auditors liable. For example, in In re Parmalat Securities Litigation, plaintiffs pled that Deloitte aided an audit client with common law fraud.²⁰⁵ Given that this was a state law cause of action, the court applied the New York common law requirements for fraud, requiring the plaintiff to prove “that the defendant (1) made a material, false statement; (2) knowing that the representation was false; (3) acting with intent to defraud; and that plaintiff (4) reasonably relied on the false representation; and (5) suffered damage proximately caused by the defendant’s actions.”²⁰⁶ The court focused primarily on the intent to defraud and ruled that an auditor’s violation of GAAS does not by itself show intent, however “an auditor’s decision to take on non-audit work that threatens to compromise its duty of independence gives rise to a strong inference of . . . [fraudulent] intent . . . when . . . the auditor has a ‘direct stake’ in the alleged fraud.”²⁰⁷ This heightened standard to show the intent element for common law fraud in New York, which includes not only a GAAS violation but also an auditor’s direct stake in the fraud, is in some ways analogous to the heightened standard to prove scienter on the part of auditors, as discussed in Section IV.B, because in both instances the courts have recognized a violation of the AICPA’s GAAS standards as helpful in showing intent, in addition to adding case law requirements to plead a valid claim.

However, some courts have not found it necessary to analyze auditor independence regulation when determining whether auditors were negligent in their review of their clients’ financial statements. In a consolidated action, insurance companies brought state law claims against Enron, Enron management, and Enron’s auditors, Arthur Andersen, in the wake of the Enron accounting scandal and resulting collapse.²⁰⁸ The plaintiffs specifically alleged that Arthur Andersen made negligent misrepresentations to investors and committed common law fraud in violation of Texas law.²⁰⁹ In connection with the negligent misrepresentation claim, the plaintiffs were required to show (1) the defendant provided information (2) that was false, (3) the defendant did not exercise reasonable care or competence in obtaining or communicating the information, (4) the plaintiff justifiably relied on the information, and (5) the plaintiff suffered loss by justifiably relying on the information.²¹⁰ In connection with the common law fraud claim under Texas law, the plaintiffs were required to show “(1) a material representation was made; (2) the representation was false; (3) when the representation was made, the speaker knew it was false or made it recklessly . . . (4) the representation was made with the intention that it be acted upon by the other party; (5) the party actually and justifiably acted in reliance upon the representation; and (6) the party suffered injury.”²¹¹ While the plaintiffs alleged that Arthur Andersen’s violations of AICPA’s GAAS standards showed the firm lacked independence, which they claimed was sufficient to show that Arthur Andersen did not meet the standard of care and competence as required by the negligent misrepresentation claim,²¹² and that the violation of GAAS showed that Arthur Andersen made false representations about its independence sufficient for a common law fraud claim,²¹³ the court did not reach these issues, instead dismissing both claims because the plaintiffs could not show they relied on Arthur Andersen’s representations.²¹⁴

Another area in which courts have assessed whether auditor independence gives rise to liability is in the area of state law claims for breach of fiduciary duties. In In re SmarTalk Teleservices, Inc. Securities Litigation, a trustee argued that PwC exceeded its normal role as an independent auditor, as defined by the AICPA’s GAAS, and therefore PwC owed a trustee fiduciary duties that the firm then breached by providing inadequate accounting and audit services.²¹⁵ While the court did not reach the issue of whether there was a valid cause of action for breach of fiduciary duty, the court determined that whether PwC violated GAAS standards for independence was a genuine issue of material fact and denied the auditor’s motion for summary judgment on the breach of fiduciary duty claim, providing yet another example of the federal courts giving credence to the AICPA standards in determining auditor liability.²¹⁶

V. IMPLICATIONS OF STUDY ON HARMONIZATION OR SIMPLIFICATION OBJECTIVES

In all three areas of the law covered by the case study, including appeals of SEC enforcement decisions, federal securities claims, and state law claims, the federal courts have preferred to use the AICPA standards, including GAAS, in their decision-making over auditor independence. In many instances when AICPA standards were used in federal securities actions, case law requirements were also supplied to determine whether there was sufficient evidence presented to plead scienter. But, notably, there were no cases found that apply PCAOB or SEC auditor independence rules.

On the whole, this paper does not aim to provide a normative proposal for auditor independence regulation. However, the case study presented in Part IV can shed light on the process of harmonization, which, as discussed in Section III.E, involves the SEC, PCAOB, and AICPA each having to change their rules regarding auditor independence each time one of the other entities changes their independence rules, in order to ensure that the rules are not in conflict. Given that the case study indicates that AICPA standards are preferred by the federal courts, along with case law, in determining whether auditor independence has been violated, there is an argument to be made that the power to regulate auditor independence should be simplified into one regulatory framework run by a single entity—the AICPA. Under this proposal of “simplification,” the regulations set by each entity would not need to be harmonized each time one entity makes a change in auditor independence rules. Rather, given that the federal courts rely on AICPA standards, the substantive rule-making authority would be given to the AICPA alone. This is because the current framework has two entities, the SEC and PCAOB, whose frameworks are rarely applied in the federal courts or outside of internal enforcement actions and investigations.

As discussed in Part III, the AICPA, PCAOB, and SEC are involved in a self-regulatory model, in which the SEC provides oversight over the PCAOB, and the SEC and PCAOB have concurrent jurisdiction to set auditor independence standards as a federal regulatory agency and as a non-profit corporation subject to the oversight of the SEC, respectively. In this self-regulatory model, the SEC also provides oversight over the AICPA, which is a private industry organization run by accountants and which sets substantive auditor independence regulation. This self-regulatory model could be simplified to reflect other self-regulatory structures in United States financial services regulation so that rule-making authority is deferred entirely to the AICPA, with oversight by the SEC, in order to simplify the regulatory framework and reduce conflicts between the independence rules set by the AICPA, SEC, and PCAOB. This would be similar to the model between the SEC and FINRA, in which the SEC allows FINRA to set rules for national securities exchanges and provides oversight over that rulemaking, rather than having the SEC set its own detailed regulation over exchanges. Given that the AICPA sets forth the most comprehensive rulemaking and interpretations of auditor independence standards, and the federal courts rely on these standards, simplifying the regulatory framework for auditor independence by deferring to the AICPA seems like a possible solution.

Overall, the relative costs and benefits of self-regulation and the outsourcing of rulemaking to private industry are beyond the scope of this paper; however, the following arguments are meant to provide a brief summary of why simplification of rule-making authority regarding auditor independence regulations by giving authority to the AICPA and oversight to the SEC may or may not be beneficial.

There are valid reasons to argue against simplification that comes in the form of allowing the AICPA to be the only standard-setter in the area of auditor independence. Several critics have pointed out that self-regulation was one of the issues at the forefront of the Enron collapse and resulting scandal, and that the accounting profession needs an external regulator.²¹⁷ However, others have argued that it was not self-regulation, but market failures and misaligned incentives over reputational costs that caused the accounting scandals during the early 2000s.²¹⁸ Further, self-regulatory organizations, such as FINRA, have successfully provided guidance to their respective stakeholders, with some oversight from the SEC, indicating that self-regulatory organizations with some administrative oversight can be successful.²¹⁹

Additionally, critics may argue that the AICPA relies on the SEC and PCAOB enforcement practices in addition to running its own enforcement program,²²⁰ and to split up the enforcement and regulation practices could pose problems. However, given that the current system splits the enforcement burden between the SEC, PCAOB, and AICPA, and each uses violations of the other’s regulations to bring sanctions, consolidating the regulations into one body would not have to change this framework.

CONCLUSION

This paper reserves judgment on the relative merits of self-regulation and instead notes that the current regulatory harmonization effort is not the only solution to disentangle the regulatory framework for auditor independence. Instead, this paper poses a new potential solution—simplification—to the problem of unwinding the tangled regulatory framework of auditor independence to promote efficiency in rulemaking and clarity for stakeholder accounting firms, regulators, and clients.

Given that the courts frequently defer to AICPA auditor independence standards—along with case law requirements for pleading federal securities law violations—rather than SEC and PCAOB standards, and having three regulatory frameworks that need to be continuously updated to align with each other is complex and costly, simplification is a worthy goal. However, it is just one solution of many. As the SEC, PCAOB, and AICPA continue to pursue harmonization,²²¹ it is worth considering whether other alternative approaches to auditor independence regulation, such as simplification, exist.

APPENDIX

Appendix
	Case Name and Citation	Procedural Posture	Body of Law Applied	Result in Favor of Auditor?
1	Ponce v. SEC, 345 F.3d 722 (9th Cir. 2003).	Appeal of Administrative Decision	AICPA and SEC	No
2	Dearlove v. SEC, 573 F.3d 801 (D.C. Cir. 2009).	Appeal of Administrative Decision	AICPA and SEC	No
3	New Jersey v. Sprint Corp., 314 F. Supp. 2d 1119 (D. Kan. 2004).	Motion to Dismiss	AICPA	Yes
4	Newby v. Enron Corp. (In re Enron Corp. Secs., Derivative & ERISA Litig.), 762 F. Supp. 2d 942 (S.D. Tex. 2010).	Motion to Dismiss	AICPA^a	Yes
5	In re WorldCom, Inc. Sec. Litig., 352 F. Supp. 2d 472 (S.D.N.Y. 2005).	Motion for Summary Judgment	AICPA and SEC	No, on Securities Act Claim. Yes, on SEC Rule 10b-5 claim.
6	In re Cardinal Health, Inc. Sec. Litigs., 426 F. Supp. 2d 688 (S.D. Ohio 2006).	Motion to Dismiss	AICPA	Yes
7	In re Royal Ahold N.V. Sec. & ERISA Litig., 351 F. Supp. 2d 334 (D. Md. 2004).	Motion to Dismiss	AICPA	Yes
8	Brody v. Stone & Webster, Inc. (In re Stone & Webster, Inc., Sec. Litig.), 414 F.3d 187 (1st Cir. 2005).	Motion to Dismiss	Sarbanes-Oxley	Yes
9	Ley v. Visteon Corp., 543 F.3d 801 (6th Cir. 2008).	Motion to Dismiss	AICPA	Yes
10	Grand Lodge of PA v. Peters, 550 F. Supp. 2d 1363 (M.D. Fla. 2008).	Motion to Dismiss	AICPA	Yes
11	In re Williams Sec. Litig., 496 F. Supp. 2d 1195 (N.D. Okla. 2007).	Motion for Summary Judgment	AICPA	Yes
12	N.M. State Inv. Council v. Ernst & Young LLP, 641 F.3d 1089 (9th Cir. 2011).	Motion for Summary Judgment	AICPA	Yes
13	In re Parmalat Sec. Litig., 501 F. Supp. 2d 560 (S.D.N.Y. 2007).	Motion to Dismiss	AICPA	Yes
14	In re ArthroCare Corp. Secs. Litig., 726 F. Supp. 2d 696 (W.D. Tex. 2010).	Motion to Dismiss	AICPA	Yes
15	In re SmarTalk Teleservices, Inc. Secs. Litig., 487 F. Supp. 2d 928 (S.D. Ohio 2007).	Motion for Summary Judgment	AICPA	No
Note: The plaintiffs pled a violation of AICPA standards, but the court did not reach the issue in this case before making its final determination.

97 S. Cal. L. Rev. 495

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Nikita Patel*

* Executive Articles Editor, Southern California Law Review, Volume 97; J.D. Candidate, University of Southern California Gould School of Law, 2024; B.S., B.A., Boston College, 2017. Many thanks to Professor Jonathan Barnett for his feedback and guidance, as well as to the editors of the Southern California Law Review for their thoughtful suggestions. All mistakes are my own.

Secondary Trading Crypto Fraud and the Propriety of Securities Class Actions

April 2024April 2024Menesh S. Patel*

Traders participating in secondary crypto asset markets risk significant loss. Some trading loss will arise simply because of market dynamics, including inherently volatile crypto asset prices. But secondary crypto asset traders also risk considerable monetary injury resulting from fraudulent statements or acts by crypto asset sponsors or others occurring in connection with their secondary transactions. If subjected to such fraud, the affected crypto asset traders may turn to a Rule 10b-5 class action for redress.

Crypto asset traders’ reliance on Rule 10b-5 class actions implicates important doctrinal and public policy questions. This Article analyzes two of these questions—one doctrinal and another in the domain of public policy. In its doctrinal analysis, the Article evaluates issues pertinent to the threshold definitional question of when an exchange-traded crypto asset will constitute an investment contract and therefore fall within the definitional perimeter of a security. The Article proposes a slight generalization of the horizontal commonality test that renders the test suitable for use in both primary transaction and secondary transaction cases, and also addresses aspects of Howey’s efforts of others prong that are relevant to Howey’s application in the crypto asset context.

With respect to the public policy question, the Article evaluates whether the public policy justification for crypto asset-based Rule 10b-5 class actions is significantly weaker than for stock-based Rule 10b-5 class actions. The Article’s public policy determinations break in different directions and in some respects are to be considered preliminary, but the analysis does not justify limiting the availability of crypto asset-based Rule 10b-5 class actions any more than stock-based Rule 10b-5 class actions.

INTRODUCTION

Asset digitization through distributed ledger technology has transformed trading markets. Traders in the United States now routinely trade hundreds of crypto assets on various crypto exchanges, and the pool of tradable assets is growing.¹ Through these secondary transactions, crypto asset traders have seen both financial gain and financial loss, which at times have been substantial.

Recent events have amplified the prospect of secondary crypto asset traders incurring significant monetary loss through incidents of fraud. Misconduct was commonplace in the 2017 to 2019 time period, when a high frequency of crypto asset initial offerings were riddled with fraud, causing investors to lose substantial amounts.² Now, traders transacting in secondary crypto asset markets risk being subject to fraud by crypto asset sponsors or others occurring in connection with their secondary transactions, which the Article refers to as secondary trading crypto asset fraud.³ The injurious effects of secondary trading crypto asset fraud extend beyond the defrauded traders. Such fraud, in combination with other types of misconduct, has the potential to fully undermine the legitimacy of the entire crypto asset ecosphere, including causing collateral damage to the reputation of economically scrupulous actors, and to strengthen the calls by some that the sector be subject to intense regulatory scrutiny.

To take an example that mirrors allegations from a recent fraud suit, suppose that a crypto asset sponsor develops a novel blockchain protocol and an accompanying crypto asset that serves as the blockchain’s native token.⁴ Suppose that the crypto asset goes on to trade on one or more crypto exchanges after its initial offering. At some later point, the crypto asset sponsor falsely represents that a payment provider has adopted the developed blockchain to process payments. Because the fraudulent statement is understood to evidence a new and potentially monetizable use value for both the blockchain and the associated crypto asset, secondary traders update their valuation of the crypto asset, which causes additional trading activity resulting in the crypto asset’s price appreciating on the secondary markets in which it trades. Traders who purchase the crypto asset at the resulting higher price will suffer financial harm once the market becomes aware of the falsity of the sponsor’s fraudulent statement and the crypto asset’s price falls in response. Depending on the magnitude and nature of the fraud, traders’ losses may be substantial.⁵

Additional regulation of the crypto asset space may diminish the prospect of fraud ex ante, but defrauded crypto asset traders may seek ex post relief in the form of private litigation. Traders sustaining losses in connection with secondary transactions of stock and other more conventional assets routinely seek class-wide relief under Rule 10b-5,⁶ which serves as the workhorse of federal securities laws’ antifraud prohibitions. Given the prominence of Rule 10b-5 class actions in modern securities litigation, defrauded crypto asset traders likewise may turn to Rule 10b-5 class relief to recover their secondary trading losses.

These observations raise an important question: Should defrauded crypto asset traders be able to rely on Rule 10b-5 class actions to recover their secondary trading losses, both as a doctrinal matter and as a matter of public policy? A host of considerations bear on this question, and this Article focuses on two leading considerations, one doctrinal and one public policy related.

A primary consideration pertinent to the doctrinal propriety of secondary crypto asset traders relying on Rule 10b-5 class actions is the fundamental question: under what conditions will an exchange-traded crypto asset be within the definitional scope of a security because it is an investment contract under the multipronged test enunciated by the Supreme Court in Howey?⁷ Scholars have dedicated considerable attention to this definitional inquiry but not with a specific focus on exchange-traded crypto assets.⁸

The Article evaluates the investment contract issue as it relates to exchange-traded crypto assets with an emphasis on Howey’s “common enterprise” and “efforts of others” prongs. The contours of these and Howey’s other prongs have been shaped by courts in primary transaction cases, that is, cases in which investors directly or indirectly transacted with the enterprise’s promoter. In a secondary transaction case—such as a case involving an exchange-traded crypto asset—investors will have transacted with their trading counterparties, perhaps with the involvement of one or more intermediaries, and those counterparties ordinarily will not have been the enterprise’s promoter. Unlike crypto assets, earlier occurring investment contract cases arising in connection with primary transactions did not involve instruments that readily lent themselves to secondary trading, so courts have not had much occasion to consider the operation of Howey in the secondary transaction context.

In many instances, the investment contract rules that courts have developed in primary transaction cases have been articulated in a manner that allows them to be sensibly applied to secondary transaction cases. That is not the case for the horizontal commonality test, one of the three tests that courts use to assess Howey’s common enterprise prong. As the Article explains, because of its pooling requirement, that test is ill-suited for use in secondary transaction cases and thus requires reorientation.

The Article proposes a slight generalization of the horizontal commonality test that renders the test suitable for use in both secondary transaction and primary transaction cases. The generalized test recognizes that pooling is but one method by which investors’ financial interests in the underlying enterprise can become intertwined in the manner that horizontal commonality requires. Under the generalized test, horizontal commonality will be present if there is some mechanism, pooling or otherwise, that ties investors’ fortunes to one another and dependent on the enterprise in which they are invested.

The generalized test reasonably broadens the scope of instruments for which horizontal commonality would be found. As relevant to the Article’s question of interest, even if there were no pooling of a secondary crypto asset investors’ purchase amounts, the generalized horizontal commonality test may still be satisfied because the asset’s trading price can serve as a non-pooling mechanism that causes the pecuniary interests of the crypto asset’s traders to be linked and dependent on the success of the crypto asset and any of its associated applications. For the crypto asset’s price to actually have served that non-pooling role for purposes of the generalized horizontal commonality test, the crypto asset’s price must generally respond to material, public information in a directionally appropriate way. As part of its analysis, the Article also explains why certain facts that are present in the investment contract cases that courts have analyzed to date—such as the presence of a contract among the investment contract’s promoter and the investors—simply represent common factual features shared by the decided cases, rather than elements of the pertinent legal rule.

The Article also addresses two aspects of Howey’s efforts of others prong relevant to application of Howey to exchange-traded crypto assets. First, the Article explains that Howey’s efforts of others prong should not be understood as requiring the presence of a centralized body that exerts the requisite entrepreneurial or managerial efforts. Instead, Howey’s efforts of others prong is better understood as requiring investors to have reasonably believed that their profits were significantly determined by the entrepreneurial or managerial efforts of those other than the investors themselves, whether or not those “others” constituted a centralized group.

Second, as the Article explains, investors’ expectations concerning the use of their sales proceeds is doctrinally irrelevant to Howey’s efforts of others analysis, which instead focuses on investors’ expectations concerning whose entrepreneurial or managerial efforts significantly determined their expected profits. Thus, the fact that investors’ sales proceeds in a secondary crypto asset transaction case may not have flowed to the crypto asset’s sponsors would not itself prevent Howey’s efforts of others prong from being met. This and the Article’s other Howey-related conclusions are not limited to the specific context of a Rule 10b-5 class action and instead also are applicable to other securities claims involving secondary crypto asset transactions.

The Article’s public policy analysis is prompted by the observation that stock-based Rule 10b-5 class actions have been the subject of academic criticism, intense at times. Supported by two longstanding primary critiques known as the circularity critique and the diversification critique, prominent voices have argued that stock-based Rule 10b-5 class actions fail to properly advance their intended public policy objectives of deterrence and compensation. Other scholars have disputed the relevance of the circularity and the diversification critiques and also have identified theories that provide alternate public policy justifications for stock-based Rule 10b-5 class actions, with the leading example being a corporate governance justification for stock-based Rule 10b-5 class actions.

A normative inquiry into whether defrauded crypto asset traders should be able to rely on Rule 10b-5 class actions implicates a range of subsidiary questions. One constituent question is whether the public policy justification for crypto asset-based Rule 10b-5 class actions is significantly weaker than for stock-based Rule 10b-5 class actions. If so, then that would support legal change that limits the availability of crypto asset-based Rule 10b-5 class actions, relative to stock-based Rule 10b-5 class actions, such as the adoption of prophylactic steps in the form of legislative action or doctrinal modification that would curb crypto asset-based Rule 10b-5 class actions before they become commonplace as stock-based Rule 10b-5 class actions have become. The Article evaluates that specific public policy question in terms of the circularity and diversification critiques and the corporate governance justification.

While its public policy determinations are mixed and in part preliminary, the Article’s analysis does not lend support to the notion that the public policy justification for crypto asset-based Rule 10b-5 class actions is significantly weaker than the public policy justification for stock-based Rule 10b-5 class actions. As reflected in the discussion below, the circularity critique has significantly less relevance in the crypto asset context than in the stock context. While the diversification critique may be more or less relevant in the crypto asset context than the stock context, nothing in the analysis indicates that it is significantly more relevant in the crypto asset context than the stock context. An offsetting consideration is that the corporate governance justification loses its relevancy in the crypto asset context.

The Article is organized as follows. Part I provides a high-level summary of three key features of crypto assets that are pertinent to the Article’s substantive analysis. Part II addresses the investment contract question, while Part III provides the public policy analysis.

I. FEATURES OF EXCHANGE-TRADED CRYPTO ASSETS

While exchange-traded crypto assets vary in their characteristics and features, they share key points of commonality relevant to an inquiry into the propriety of defrauded secondary crypto asset traders relying on Rule 10b-5 class actions as a means of redress. Three points of commonality are discussed below: operational decentralization, the absence of cash flow, and significant price volatility.

A. Operational Decentralization

As a rough approximation, a crypto asset’s lifecycle will have three stages. The first stage is the period preceding the asset’s initial offering, during which the crypto asset’s sponsors develop the asset and any associated applications.⁹ The second stage of a crypto asset’s lifecycle is the asset’s offering period. During this stage, the asset’s sponsors first offer and sell the crypto asset, or rights to the future delivery of the crypto asset, to the public and others.¹⁰ Historically, crypto asset offerings have been unregistered offerings, with very limited exceptions.¹¹

com/articles/1186166 [https://perma.cc/QSQ8-ZDJJ] (describing an offering pursuant to Regulation A). There appears to be just one instance of a registered crypto asset offering. See INX Ltd., Registration Statement Under the Securities Act of 1933 (Form F-1) (Aug. 19, 2019), https://
http://www.sec.gov/Archives/edgar/data/1725882/000121390019016285/ff12019_inxlimited.htm [http://web.
archive.org/web/20230324012325/https://www.sec.gov/Archives/edgar/data/1725882/000121390019016285/ff12019_inxlimited.htm] (showing INX Ltd.’s registered offering of its INX crypto asset). The third and final stage is the period following the crypto asset’s offering, or the period after the crypto asset is delivered to those who previously purchased rights to its delivery, during which the asset trades on one or more crypto exchanges.¹² In some instances, a crypto asset may have a fourth stage when it is delisted from the crypto exchanges on which it trades and then ceases all secondary trading.¹³

At some point in this lifecycle, the development, operation, management, and promotion of a crypto asset and any associated applications may move from a small group of sponsors to a significantly larger group of stakeholders. This latter process can be referred to as operational decentralization, and the resulting set of designated decision‑makers ordinarily will include the crypto asset’s holders. The modifier “operational” reflects the fact that other aspects of a crypto asset or its application may be decentralized, but in ways not directly relevant to the securities law definitional question discussed in Part II below.¹⁴

As an example of these observations, consider the application Filecoin, which is an innovative blockchain-based data storage network that enables those needing computing storage to remotely use others’ idle computing storage.¹⁵ So, for instance, a large data center or an individual maintaining unused computing storage space can have that dormant storage incorporated in Filecoin’s storage network, thereby allowing other Filecoin users to access its idle storage in exchange for payment.¹⁶ Filecoin generates economic benefit by facilitating mutually beneficial transactions, allowing unused computing storage space to be put to productive use.

The crypto asset “FIL” is associated with and facilitates Filecoin’s storage network. Transactions on the Filecoin network are conducted in FIL, in that users of Filecoin’s storage network pay storage providers in FIL rather than fiat currency.¹⁷ Filecoin’s users who want to acquire or sell their FIL holdings can do so on various crypto exchanges.¹⁸ As reflected in publicly available information, FIL’s holders do not buy and sell the crypto asset purely for its use value on the Filecoin network, but also, or perhaps primarily, trade the asset for investment purposes, seeking financial gain from appreciations in the crypto asset’s price.¹⁹ FIL presently has a market capitalization near $2.9 billion and its 24-hour transaction volume ordinarily exceeds $200 million.²⁰

Protocol Labs, an innovative research and development company founded in 2014, developed both Filecoin and FIL.²¹ In 2017, Protocol Labs conducted two Reg D offerings through which it sold accredited investors the rights to the future delivery of FIL²² and raised over $200 million.²³ In 2020, Filecoin became fully operational, and Protocol Labs distributed FIL to the accredited investors who had purchased the future delivery rights to FIL in the two 2017 Reg D offerings.²⁴ The crypto asset thereafter began trading on a number of crypto exchanges.²⁵

FIL and its associated application Filecoin exhibit features of the operational decentralization discussed above. In the years following FIL’s initial offering in 2017, Protocol Labs continued to develop Filecoin and FIL but continuously expanded the ability of other stakeholders, including the general public, to contribute to Filecoin and FIL’s development. In the immediate period following FIL’s initial offering, the public’s role in facilitating Filecoin and FIL’s development was limited to referring potential employees and early users to Protocol Labs and suggesting improvements to the underlying protocol.²⁶ Subsequently, but before Filecoin became fully operational and FIL started trading in secondary markets, Protocol Labs made several key aspects of Filecoin and FIL’s software code available to the public for review and comment.²⁷ This important milestone provided the public with an indirect way to guide Filecoin and FIL’s development but ultimate authority remained vested in Protocol Labs.

Protocol Labs’ current decision-making authority over Filecoin and FIL is much more attenuated than before. Now, while Protocol Labs remains actively involved in Filecoin and FIL’s development²⁸ and potentially may still maintain significant holdings of FIL,²⁹ Protocol Labs does not have sole decision-making authority over the crypto asset or its associated application. First, another centralized body, Filecoin Foundation, facilitates governance of the Filecoin network.³⁰ Moreover, any person can influence Filecoin’s governance by submitting a Filecoin Improvement Proposal.³¹ Filecoin’s many stakeholders, including FIL holders and Filecoin’s developers, determine whether to adopt the proposal.³² Modifications and improvements to Filecoin’s technical features are undertaken through a similarly decentralized process, with any individual able to propose a technical change and then Filecoin’s many stakeholders deciding whether to adopt the technical modification.³³

B. Absence of Cash Flow

A specific crypto asset may provide its holders with a range of benefits. In addition to investment gain, some crypto assets also may be used as methods of payment for conventional goods and services, while others may enable their holders to use an associated application or exercise governance rights with respect to the crypto asset or an associated application.³⁴

Despite these benefits, a crypto asset ordinarily will not provide its holders with dividends or cash flow in any form, realized or expected. Even if there exists a centralized body with some involvement in the crypto asset’s development and operation, the crypto asset’s holders usually will not be entitled to any income from the profits of that centralized body. In contrast, a public company’s common shareholders will receive cash flow at the board’s discretion in the form of dividends paid from the company’s net income.

More generally, a crypto asset’s holders usually will not be entitled to income from any entity or individual involved in the development and operation of the crypto asset and any associated applications. Holders of some crypto assets may earn income through staking, which is the process through which a crypto asset holder agrees to lock up their assets to facilitate the validation of transactions on a blockchain that uses a proof-of-stake consensus mechanism.³⁵ But staking is an optional process that requires the holder to forgo transacting the staked assets.³⁶ While it is theoretically possible for a crypto asset to entitle its holders to cash flow, very few crypto assets with this feature have actually been implemented to date.³⁷

C. Significant Price Volatility

Crypto assets exhibit significant price volatility. Crypto asset prices can change markedly, even in relatively short periods of time. Take for instance, “SOL,” the crypto asset associated with the Solana blockchain. On July 1, 2022, SOL traded at $32.80, according to CoinMarketCap’s calculated average price on a group of crypto exchanges.³⁸

solana/historical-data [http://web.archive.org/web/20230627040245/https://coinmarketcap.com/
currencies/solana/historical-data]. On August 1, 2022, and September 1, 2022, SOL traded at $41.79 and $31.59, respectively, according to CoinMarketCap’s calculated average price.³⁹ So, within one month, the price of SOL appreciated by more than 27%, but then dropped by more than 24% the next month. Crypto asset prices can swing dramatically even over shorter durations, such as weeks or days.

Statistical analysis shows that crypto asset prices can be much more volatile than stock prices. For instance, Liu and Tsyvinski examined the returns of over 1,700 crypto assets between January 1, 2011 and December 31, 2018.⁴⁰ The authors created an index of the crypto assets in their sample and found that over the sample period, the standard deviation of daily returns of the index was 5.46%, which was five times higher than the standard deviation of daily stock returns over the sample period.⁴¹ The authors also found that crypto asset returns over the sample period yielded extreme losses and gains with high probability.⁴² According to their findings, a trader who held the constructed index over the sample period would have experienced an extreme 20% negative return to daily returns with a probability of 0.48% and an extreme gain of 20% positive return to daily returns with a probability of 0.89%.⁴³

Though crypto asset prices may be more volatile than stocks, some crypto assets may exhibit significantly less price volatility than others.⁴⁴ The volatility of some crypto assets may be closer to that of stock. Additionally, there is some empirical evidence showing that crypto asset volatility decreases over time. For instance, returning to the study discussed above, the authors found that the standard deviation of the index’s returns diminished over the sample period.⁴⁵

II. THE DOCTRINAL PROPRIETY OF CRYPTO ASSET-BASED RULE 10B-5 CLASS ACTIONS

The propriety of crypto asset traders using Rule 10b-5 class actions as a means of recovering losses caused by secondary crypto asset fraud implicates a set of important doctrinal and public policy considerations. In the discussion below, the Article focuses on the leading doctrinal question of when secondary trading crypto asset fraud constitutes securities fraud and so is properly within the scope of Rule 10b-5. The pertinent issue is whether the exchange-traded crypto asset on which the Rule 10b-5 claim is predicated is definitionally a security because it is an investment contract.⁴⁶ To better frame the issue, it is helpful to first provide some observations on the nature of secondary trading crypto asset fraud and Rule 10b-5 relief.

A. The Nature of Secondary Trading Crypto Asset Fraud and Rule 10b-5 Relief

Secondary trading crypto asset fraud can inflict trader harm by altering the prices at which traders transact. The motivating hypothetical from the Article’s Introduction involved the sponsor of an exchange-traded crypto asset making misrepresentations about a new and potentially monetizable use value for the crypto asset. Defrauded crypto asset traders who purchased at the resulting inflated prices may seek relief though a Rule 10b-5 class action. Their ability to viably do so requires, among other things, that (1) the at-issue crypto asset satisfies Howey’s four-part test for an investment contract—the focus of the discussion in the next Section; (2) the substantive elements of Rule 10b-5 are met; and (3) the pertinent elements of Rule 23 are met.

Different variants of the Introduction’s hypothetical may cause the case to turn more heavily on one of the necessary legal determinations. For instance, suppose that the false or misleading statement instead was made by a person of notoriety that the crypto asset sponsor had monetarily incentivized to provide promotional services, but all other facts of the hypothetical were unchanged. In this case, if the plaintiffs asserted their Rule 10b-5 claim against the influencer, greater focus may be on the materiality of the statement than if it were made directly by the crypto asset sponsor as in the baseline hypothetical. Depending on the circumstances, such as the identity of the influencer and other background considerations, a reasonable person may not consider the misrepresentation important to their trading decision, in which case it would not be material,⁴⁷ while they may consider it important to their trading decision if it had instead been made by the crypto asset’s sponsor.⁴⁸ Or consider a statement by an influencer opining about a crypto asset’s expected future price. In addition to the statement potentially being immaterial, it may be a nonactionable opinion statement under the rule in Omnicare.⁴⁹

Some crypto assets may be more amenable to secondary crypto asset fraud than others. In the hypothetical from the Introduction, the associated crypto asset had potential use value, in that its associated blockchain could be used to facilitate economically meaningful activity. That is not the case for all crypto assets. Consider meme coins, which are crypto assets that are based on an Internet meme or joke. These assets often have no use value, though they vigorously trade on crypto exchanges and can have significant market capitalization. The body of statements that investors may consider important to their trading decisions may be circumscribed. For instance, if a meme coin has no intended use value, and traders understand that fact, then they may not consider a statement about a potential use value for the crypto asset to be relevant to their trading decision.⁵⁰

The alleged fraud in each of these examples is an instance of statement-based fraud. Secondary trading crypto asset fraud can also be in the form of deceptive schemes. In the hypothetical in the Introduction, suppose that the crypto asset’s sponsor and the payment provider instead had devised a clandestine scheme that caused the crypto asset’s traders to believe that the payment provider would begin using the crypto asset’s blockchain to process payments. Traders who purchased the crypto asset at the resulting higher prices would suffer financial injury, just as in the baseline hypothetical in which the fraud was in the form of a false statement by the crypto asset’s sponsor.

Finally, crypto asset traders’ ability to rely on Rule 10b-5 class actions to recover losses sustained in connection with secondary crypto asset transactions raises doctrinal issues beyond the definitional one addressed below. For instance, putting Affiliated Ute to the side,⁵¹ secondary market crypto asset traders will only be able to litigate their Rule 10b-5 claims as a class if they are able to avail themselves of fraud on the market.⁵² The question thus arises whether fraud on the market properly extends to the crypto asset context. Or, to take another example, a private plaintiff Rule 10b-5 claim only reaches transactions that are within the extraterritorial reach of the securities laws as defined by Morrison.⁵³ But suppose the crypto exchange on which the at-issue transactions occurred is not a registered exchange and maintains no trading operations in the United States.⁵⁴ This scenario raises the doctrinal question of whether those secondary crypto asset transactions cannot be the subject of a private Rule 10b-5 suit because they do not satisfy Morrison’s requirements.⁵⁵ While some academic focus has been directed at these non-definitional doctrinal questions, additional research is necessary.⁵⁶

B. Is Secondary Trading Crypto Asset Fraud Securities Fraud?

If secondary crypto asset traders incur trading loss because of fraud, they will be able to pursue Rule 10b-5 relief based on those secondary transactions only if the exchange-traded crypto asset at issue is an investment contract under Howey’s multipronged test.⁵⁷ Many issues pertinent to that definitional inquiry will be the same as those relevant to an assessment of whether a crypto asset at its offering stage satisfies Howey’s definition of an investment contract.⁵⁸ For instance, if an exchange-traded crypto asset is promoted for its use value because it enables its holders to use an associated application, and if the asset’s holders in fact hold the asset primarily for that purpose rather than its investment value, then Howey’s “expectation of profit” prong would not be met under Forman’s investment/consumption distinction.⁵⁹ This very issue has been litigated in cases in which a crypto asset was alleged to have been an investment contract at its offering stage.⁶⁰

But there are issues pertinent to the application of Howey in the context of exchange-traded crypto assets that are not present, or are much less salient, in the context of crypto assets at their offering stage. This Section explores a set of such issues relating to Howey’s common enterprise and efforts of others prongs.

1. Exchange-Traded Crypto Assets and Common Enterprise

Doctrinal development of Howey’s common enterprise prong, as with all other parts of Howey’s test, has occurred through investment contract cases involving a primary transaction, that is, a transaction in which investors purchased the instrument when it was first offered for sale directly or indirectly from the enterprise’s promoter.⁶¹ That was the case in Howey, for instance. The other investment contract cases to date have similarly involved primary transactions and include such varied examples as sale-and-leasebacks,⁶² annuities,⁶³ and crypto assets.⁶⁴ There are virtually no investment contract cases concerning secondary transactions, in which investors purchased the putative investment contract from other investors.⁶⁵

The factual orientation of the body of investment contract cases naturally has resulted in courts shaping investment contract doctrine around primary transactions. But a Rule 10b-5 case involving an exchange-traded crypto asset will involve secondary transactions, rather than primary transactions, and the two transactions differ in important ways. As noted, in a primary transaction, investors transact directly or indirectly with the promoter. In a secondary transaction, investors transact with their trading counterparties, perhaps with the involvement of one or more intermediaries, and those counterparties ordinarily will not be the promoter.⁶⁶ Also, depending on the circumstances, it may also be that when a secondary transaction occurs, the promoter who facilitated the instrument’s initial offering no longer has any meaningful involvement in the underlying enterprise, though there may be other non-investors who facilitate the enterprise.

In many instances, the legal rules that courts have developed in primary transaction cases concerning the investment contract question are equally sensible in secondary transaction cases. Take, for instance, the rule that Howey’s “investment of money” prong does not require a cash payment and instead is satisfied when any form of consideration is provided.⁶⁷ That rule is as sensible in the secondary transaction context as the primary transaction context, as consideration in either context may involve cash or noncash payment. That is not the case for the horizontal commonality test, one of the three commonality tests that courts have developed in primary transaction cases to evaluate the presence of common enterprise.⁶⁸ As discussed below, the horizontal commonality test, as it is presently articulated, is analytically ill-suited for use in secondary transaction cases because of the test’s requirement that investors’ assets be pooled.

i. Secondary Transactions, Horizontal Commonality, and the Pooling Requirement

The horizontal commonality test evaluates relationships among the investment contract’s investors⁶⁹ and inquires whether the investors’ fortunes are intertwined and collectively dependent on the success of the enterprise in which they are invested.⁷⁰ The test usually is defined in relation to a pooling requirement, which requires investors’ assets be combined and comingled in a manner that causes investors’ fortunes associated with the enterprise to be codetermined. Specifically, in the primary market transaction cases in which the test was developed, courts usually find horizontal commonality only when there is “the tying of each individual investor’s fortunes to the fortunes of the other investors by the pooling of assets.”⁷¹

A good description of the pooling requirement comes from the court in Savino v. E.F. Hutton:⁷²

“Pooling” has been interpreted to refer to an arrangement whereby the account constitutes a single unit of a larger investment enterprise in which units are sold to different investors and the profitability of each unit depends on the profitability of the investment enterprise as a whole. Thus, an example of horizontal commonality involving brokerage accounts would be a “commodity pool,” in which investors’ funds are placed in a single account and transactions are executed on behalf of the entire account rather than being attributed to any particular subsidiary account. The profit or loss shown by the account as a whole is ultimately allocated to each investor according to the relative size of his or her contribution to the fund. Each investor’s rate of return is thus entirely a function of the rate of return shown by the entire account.⁷³

In other words, pooling can be understood as the usual mechanism in a primary transaction case that causes investors’ fortunes in the enterprise to be interconnected and dependent on the enterprise’s success. Consider, for instance, the Seventh Circuit’s decision in Milnarik v. M-S Commodities.⁷⁴ There, the plaintiff opened a discretionary trading account in commodities futures with a broker.⁷⁵ Many other investors also had opened their own discretionary trading accounts with the same broker.⁷⁶ The plaintiff’s account sustained losses, and the plaintiff sued for violation of Section 5’s registration requirement, on the theory that the discretionary trading account contract was an investment contract.⁷⁷ The Seventh Circuit rejected that claim because it found no pooling and thus no investment contract under Howey.⁷⁸

The absence of the pooling of investors’ funds unsurprisingly led to the court’s conclusion in Milnarik that the investors’ fortunes were not intertwined and mutually dependent on the success of their collective trading accounts.⁷⁹ Because investors’ accounts were separately maintained and their funds not combined, the value of any given investor’s trading account was independent of the value of any other investor’s trading account.⁸⁰ This would not have been the case had the arrangement instead involved the defendant combining the various investors’ funds in a single account, executing trades with respect to that single account, and then distributing any profits to the investors. If this had been the case, then every investor would have been made financially better off as the account became more profitable and financially worse off as its value dropped. In other words, the aggregation of investors’ funds would have caused the investors’ individual financial interests in the combined account to be tethered together and dependent on the underlying enterprise.

But pooling is not an analytically meaningful way of evaluating the presence of horizontal commonality in an investment contract case involving secondary transactions. In primary market transactions, like the ones in Howey and Milnarik, investors will have transacted directly or indirectly with the promoter. In such cases, the promoter may have pooled investors’ assets in a manner that caused investors’ fortunes in the enterprise to rise or fall together, as horizontal commonality requires.

On the other hand, secondary market investors will have transacted with trading counterparties. If those trading counterparties were separate persons or economic entities, then those counterparties would have no reason to aggregate the amounts they received from their sales, except in rare and idiosyncratic circumstances. If, alternatively, the trading counterparties included one or more persons or entities who sold to multiple traders, then it is possible that the counterparty aggregated the amounts it received for its sales, because it may have some business or other reason for doing so. Nonetheless, the counterparty’s aggregation of secondary investors’ assets, unlike the promoter’s aggregation of primary market investors’ assets, will usually not create a linkage between the secondary investors’ financial interests in the enterprise because the success of the underlying enterprise will not turn on whether the counterparty aggregated the sales proceeds it received or how it used any aggregated amounts. Simply put, there is no analytical justification for the horizontal commonality question in a secondary transaction case to turn on the pooling requirement.

An evaluation of horizontal commonality in a secondary transaction case using the lens of pooling can be both underinclusive and overinclusive. First, in a secondary transaction case, investors’ financial interests in the underlying endeavor may still be interdependent even if the investors’ sales proceeds were not aggregated. To see this, suppose that in Howey, each of the primary market investors had sold their interests to another, later stage investor. Those secondary investors’ purchase amounts presumably will not have been pooled. The secondary investors purchased from the primary market investors, rather than the promoters, and those primary market investors would ordinarily have no reason to aggregate their individual sales proceeds. Nonetheless, horizontal commonality would be present with respect to the secondary investors because those investors’ profits would have been intertwined and dependent on the success of the enterprise. If, for instance, there was a poor harvest because of the promoters’ neglect or malfeasance, each of the secondary investors would have seen their profits fall.

Second, just as the absence of an aggregation of investors’ assets does not demonstrate a lack of horizontal commonality, the presence of asset aggregation, by itself, may not necessarily establish horizontal commonality in a secondary transaction case. In the example in the previous paragraph, suppose that the primary market investors in fact had aggregated the proceeds from their resales because, for instance, they wanted to collectively invest in a new venture. That pooling of the secondary investors’ assets by the primary market investors itself has no bearing on whether the secondary purchasers’ profits associated with the orange orchard enterprise would have moved in tandem as required by horizontal commonality.

Imposing a pooling requirement in secondary transaction cases not only would be analytically infirm but also would prevent nearly all investment contracts that arise in connection with secondary transactions from satisfying the horizontal commonality test.⁸¹ That would effectively cause those transactions to be categorically excluded from the investment contract category in those jurisdictions in which horizontal commonality is the only recognized test for common enterprise.⁸² Such limitation finds no basis in logic or public policy and also runs roughshod over the Supreme Court’s directive that the term security be interpreted in fidelity to economic reality and not hindered by rigid formalities.⁸³

ii. Generalization of the Horizontal Commonality Test

Because it is logically inapt in secondary transaction cases, the pooling requirement renders the horizontal commonality test ill-suited for use in those cases. Hence, the test must be appropriately generalized so that it is articulated in a manner that renders it sensible both in secondary transaction cases and the primary transaction cases in which it and Howey’s other rules have been developed. As discussed below, the necessary reformulation of the horizontal commonality test requires only a slight generalization of the test from its present form.

As an initial observation, recall that pooling is neither necessary nor sufficient for investors’ profits to be intertwined and mutually dependent on the success of the underlying enterprise as doctrinally required. Instead, as discussed above, pooling is the usual way that the requisite financial linkages arise in a primary transaction case. In other words, pooling is the usual path to interrelated investor profits in a subset of investment contract cases. An appropriately generalized articulation of the horizontal commonality test must recognize pooling as just one possible mechanism that ties investors’ financial interests in the enterprise together.

So that it has a sensible analytical meaning in both primary transaction cases and secondary transaction cases, the horizontal commonality test must be framed so that the test is met whenever the pooling of investors’ assets or some other non-pooling mechanism causes investors’ fortunes to be tied to one another and dependent on the success of the enterprise in which they are invested. In other words, the horizontal commonality rule must be articulated so that it accurately reflects that pooling is but one mechanism that results in investors’ profits being intertwined, not the only mechanism. Note that the generalized test does not merely require that pooling or some other mechanism caused investors’ fortunes to be tied together but, consistent with the underlying analytical underpinning of the test, also requires their fortunes to be dependent on the underlying enterprise.⁸⁴

The generalized test is consistent with Howey, in that there is nothing in the opinion indicating that the Court sought to impose a pooling requirement, even in primary market cases. In fact, it is difficult to support a conclusion that there was a pooling of investors’ assets in Howey, and for that reason the presence of horizontal commonality under the test’s present formulation. In Howey, the promoters sold each investor their own tract of land and an individual service contract.⁸⁵ The promoter did not aggregate investors’ purchase amounts and then use that aggregated amount to sell investors’ a single tract of land serviced by the promoter in which each investor maintained a fractional interest, as the usual definition of pooling would require.⁸⁶

The proposed generalization is superior to the present articulation that implicitly assumes that pooling is the only path to investor wellbeing interdependence. First, a primary transaction case in which a court would find horizontal commonality under the present test would continue to satisfy the horizontal commonality test under the generalized test outlined above. The presence of pooling necessary for a finding of horizontal commonality under the current test would also cause the generalized test to be met.

Second, the generalized test does not excessively broaden the scope of horizontal commonality in primary transaction cases. If a primary transaction case would not satisfy the horizontal commonality test as it is presently articulated because of a lack of pooling, the generalized test would admit a finding of horizontal commonality only if there was some other mechanism that caused investors’ profits to be intertwined and dependent on the success of the underlying enterprise. For instance, returning to Milnarik, there are no facts in the opinion suggesting that there was some non-pooling mechanism that caused investors’ profits to be intertwined.⁸⁷

The generalized formulation would admit a broader array of investment contracts in primary transaction cases than under the current formulation, but these would be sensible additions. For instance, suppose in Milnarik, the broker’s policy and practice was to execute identical transactions for each of the accounts over which it had discretionary authority. In this case, while there would be no pooling of the investors’ assets,⁸⁸ there would be horizontal commonality under the generalized test, as the value of investors’ portfolios would move in unison because of the broker’s trading policy and practice. The investors in this example can be understood to be in a common enterprise with one another because the value of each of their accounts is dictated by the same trading practice, even though their funds were not pooled.

Unlike the present restrictive formulation, the generalized formulation would result in investment contracts that arise in connection with secondary transactions satisfying the horizontal commonality test even in the absence of pooling, so long as there was some non-pooling mechanism that met the doctrinal requirement that investors’ profits were interrelated and dependent on the success of the underlying enterprise. The generalized test is sufficiently circumscribed and not all investment contracts arising in connection with secondary transactions will meet it. For instance, suppose that the investors in Milnarik had sold their interests in their accounts to other investors, with all other facts the same. In addition to an absence of pooling, there would be no other mechanism connecting the profits of those later investors to one another and thus no finding of horizontal commonality as to those secondary transactions under the generalized test.

a. Application to Exchange-Traded Crypto Assets

Investors in a crypto asset offering ordinarily will have the proceeds from their purchases pooled by the crypto asset’s sponsors to facilitate the asset and any associated applications.⁸⁹ That may not be the case for secondary crypto asset traders who transact on crypto exchanges, as those transactions would have occurred with trading counterparties and those trading counterparties, in turn, may have had no reason to pool the amounts they received. Despite any lack of pooling of the secondary investors’ purchase amounts, the crypto asset may still meet the generalized horizontal commonality test through its price, which can serve as a potential non-pooling mechanism that causes the pecuniary interests of the crypto asset’s traders to be linked and dependent on the success of the underlying enterprise, that is, the crypto asset and any associated applications.

Start first with the requirement that secondary traders’ fortunes in the crypto asset are linked. A given exchange-traded crypto asset can trade on multiple exchanges,⁹⁰ which may either be centralized or decentralized. A centralized crypto exchange will involve an intermediary to facilitate transactions, while a decentralized crypto exchange will not. The two types of exchanges also may differ in their pricing mechanism. A centralized crypto exchange will use a limit order book to match buyers and sellers, and therefore the exchange’s prices will be set directly by traders’ submitted orders.⁹¹ Rather than relying on a limit order book, a decentralized exchange may facilitate transactions using an automated market maker, in which prices are set through a pricing algorithm.⁹²

Whether a crypto exchange uses a limit order book or an automated market maker, the exchange’s pricing mechanism will generate, for a given crypto asset, a single price at which any trader can transact, holding fixed other traders’ transactions. That single trading price links together the financial wellbeing of all the crypto asset’s secondary investors. Every investor holding the crypto asset is made financially better off as the crypto asset’s price on the exchange rises and each is made worse off as the price drops. The fact that a crypto asset trades on multiple exchanges does not break the linkages between the financial wellbeing of traders on different exchanges since arbitrage causes crypto asset prices across different exchanges to closely align.⁹³

A crypto asset’s trading price thus provides a mechanism that links together its secondary investors’ financial interests. It is the case that a crypto asset’s trading price will be influenced by market fluctuations, but the doctrinal relevance of that observation is better understood as concerning Howey’s efforts of others prong, which is discussed below, rather than the common enterprise prong.⁹⁴

A crypto asset’s price also may provide the doctrinally necessary linkage between the financial interests of the crypto asset’s secondary traders and success of the underlying enterprise. Empirical studies show that the prices of exchange-traded crypto assets generally respond in the directionally appropriate way to material, public information.⁹⁵ For this reason, as a general matter, the financial interests of a crypto asset’s holders will be dependent on the success of the crypto asset and any associated applications. If, for instance, the crypto asset undergoes some value-enhancing change, then once that change is publicly known, the crypto asset’s price would be expected to increase, because of the directionally appropriate responsiveness of crypto asset prices to material, public information as a general matter.

Nonetheless, it is possible that while the prices of crypto assets—as an asset class—generally respond in a directionally appropriate way to material, public information, that is not the case for any given exchange-traded crypto asset. If the specific crypto asset being evaluated as a potential investment contract lacks that requisite informational responsiveness, then the crypto asset’s price would not connect the financial interests of the crypto asset’s secondary traders with success of the underlying enterprise. For instance, if the crypto asset underwent some value-reducing change, but the asset’s price was either impervious to material, public information or moved in the directionally inappropriate way to material, public information, then the value reducing change would either have generated no change to the crypto asset’s price (and thus would have made the crypto asset’s holders no better or worse off) or increased the crypto asset’s price (and thus would have made the crypto asset’s holders better, not worse, off).

Accordingly, a crypto asset’s price can serve the role of a non-pooling mechanism that satisfies the requirements of the generalized horizontal commonality test only if the crypto asset’s price generally responds to material, public information in a directionally appropriate way. If the plaintiffs in a crypto asset case implicating the Howey question rely on the asset’s price to serve that non-pooling role, then the generalized horizontal commonality test demands that there be a showing of the necessary price responsiveness. The plaintiffs can make that showing using an event study that demonstrates that the crypto asset’s price generally responds to material, public information in a directionally appropriate way.

If the plaintiffs cannot establish the necessary price responsiveness of the crypto asset, then the asset’s price cannot serve the role of a non-pooling mechanism that satisfies the requirements of the generalized horizontal commonality test, because in that circumstance, the plaintiffs will not have established that the asset’s price connects the secondary investors’ pecuniary interests to the success of the enterprise in which they are invested. In this case, the generalized horizontal commonality test will be met with respect to the at-issue crypto asset only if there was pooling of the secondary traders’ purchase amounts or there was some non-pooling mechanism other than the crypto asset’s price that caused the pecuniary interests of the crypto asset’s traders to be linked and dependent on success of the crypto asset and any associated applications.

b. Other Reformulations of the Horizontal Commonality Test

In addition to generalizing Howey’s horizontal commonality test in the manner discussed above, there are other sensible ways to reformulate the test so that it is suitable for use in both secondary transaction and primary transaction cases. One possibility is to broaden the test so that it is also met in secondary transaction cases if (1) there was pooling of the primary market investors’ assets, and (2) the primary market investors purchased the instrument only because they reasonably expected the ability to resell their interests to secondary investors. If these two conditions are met, then the secondary investors can be understood to have effectively pooled their assets, in the sense that the reasonable expectation of eventual resales to secondary investors was a necessary condition to the primary market investors engaging in the transactions that resulted in their assets being pooled. This type of pooling by the secondary market investors can be referred to as effective pooling.

Finally, unlike the horizontal commonality test, the two vertical commonality tests do not require reformulation to be analytically workable notions in secondary transaction cases. Strict vertical commonality is met when “the fortunes of investors [are] tied to the fortunes of the promoter” and broad vertical commonality is met when the “the fortunes of the investors [are] linked . . . to the efforts of the promoter.”⁹⁶ It is worth observing that the role of the promoter in secondary transaction cases will be different than in primary transactions cases. In a primary transaction case, the promoter ordinarily will have facilitated the enterprise in part by soliciting investors. In a secondary transaction case, the promoter likely will not have engaged in any such solicitation because it usually will not have been an active participant in the secondary markets, though the promoter may have directed other efforts to facilitate the enterprise.

c. The Irrelevance of a Contractual Relationship

Finally, while a primary transaction case ordinarily will involve contracts between the promoter and the investors, that usually will not be the case in secondary transaction case, because secondary market traders will not have transacted with the promoter, except in rare circumstances.⁹⁷ Nonetheless, the absence of a contractual relationship between the promoter and investors—whether those investors were secondary market traders or purchasers in a primary market transaction—does not provide a proper basis for defeating a finding of an investment contract. In Howey, the Supreme Court did not limit the investment contract category to just formal contractual arrangements between the promoter and the investors. Instead, the Court articulated the definitional category more expansively so that, in addition to contractual arrangements, the investment contract category also encompasses “transactions” and “schemes.”⁹⁸ Though the Court did not define the term “scheme,” had it meant for scheme to simply mean a series of contractual arrangements, then it would have just used the term “contracts” rather than scheme.

Howey’s lack of a contract requirement is sensible. As a matter of public policy, the investor protection objectives of the securities laws are not weakened simply because the relevant transactions were not undertaken pursuant to a formal contract.⁹⁹ And while Howey and the other Supreme Court’s investment contract cases to date have involved contractual arrangements between the promoter and the investors, this common factual feature has not become a part of the Court’s enunciated rule.¹⁰⁰ Instead, the Supreme Court’s post-Howey investment contract cases have consistently invoked Howey’s articulation of the investment contract category as encompassing schemes.¹⁰¹

Stated differently, simply because a set of cases share a common factual predicate does not mean that the factual predicate necessarily becomes a component of the pertinent rule of law. As another example of this somewhat unremarkable observation, note that the profits that investors received in the Supreme Court’s investment contract cases arose through income generated by a business enterprise that was organized and facilitated by the promoter. But the fact that these cases share this common factual predicate does not mean that the factual predicate is part of the operative rule. As the cases recognize, investors’ “profits” for purposes of the Howey determination are not limited to proceeds from an investment in a business enterprise and instead include capital appreciation more generally.¹⁰² This observation is especially relevant to the crypto asset context because, as noted in Section I.B above, a crypto asset’s holders ordinarily do not receive and are not entitled to any income arising from development and operation of the crypto asset or any associated applications.

2. Exchange-Traded Crypto Assets and Efforts of Others

For a given instrument to be an investment contract, it must also satisfy Howey’s efforts of others prong. In the context of an exchange-traded crypto asset, that requirement will be met if investors reasonably expected the crypto asset’s value to be significantly determined by the entrepreneurial or managerial efforts of others.¹⁰³ Whether this requirement is met will depend on the at-issue crypto asset’s specific features, including the extent of its operational decentralization. This subpart explores issues pertinent to application of Howey’s efforts of others prong in the secondary trading crypto asset context.

The discussion below makes two points regarding Howey’s efforts of others prong. First, the discussion explains why operational decentralization, by itself, is not a per se bar to Howey’s efforts of others prong being met, though there may be specific factual features that result in a particular exchange-traded crypto asset not satisfying that Howey element. Second, the discussion below also explains the doctrinal irrelevancy of investors’ expectations concerning the use of their sales proceeds.

i. Why Operational Decentralization Is Not a Per Se Bar

The first issue to consider is whether a crypto asset’s operational decentralization should preclude satisfaction of Howey’s efforts of others prong. To structure the analysis, consider two possibilities. The first possibility is that the exchange-traded crypto asset has achieved some operational decentralization but a centralized third party continues to direct some entrepreneurial or managerial efforts toward the crypto asset’s success. The second possibility is that the crypto asset has achieved complete operational decentralization, in the sense that no centralized third party directs entrepreneurial or managerial efforts toward the success of the crypto asset; instead, those efforts are undertaken by a decentralized group of unaffiliated persons.¹⁰⁴

a. Continued Involvement by Sponsors or Other Centralized Third Party

If the crypto asset’s sponsors or some other centralized third party continue to exert entrepreneurial or managerial efforts such that investors reasonably expect those efforts to significantly determine the crypto asset’s value, as usually embodied by its trading price, then Howey’s efforts of others prong will be met.¹⁰⁵ This observation is reflected in courts’ determinations of the Howey question as it pertains to crypto assets at their offering stage,¹⁰⁶ which have found the efforts of others prong to have been satisfied because the crypto asset’s investors reasonably expected their profits to arise from the sponsor’s entrepreneurial or managerial efforts.¹⁰⁷

Presently, nearly all crypto assets appear to be associated with one or more centralized bodies that have at least some involvement facilitating their success, including through developing, operating, managing, and promoting the crypto assets and any associated applications.¹⁰⁸ While the importance of the efforts of such centralized bodies on a given crypto asset’s success may ebb as the crypto asset matures and becomes the subject of additional secondary trading, those efforts may remain instrumental to the crypto asset’s success. Even crypto assets like ether that have experienced significant operational decentralization have at times benefited from the focused efforts of a collective group of developers.¹⁰⁹

Whether the presence and activities of these centralized groups is sufficient to satisfy Howey’s efforts of others prong will hinge on the nature of the centralized third party’s involvement. A series of issues await judicial determination. For instance, a crypto asset or its associated applications, if any, ordinarily will have a presence on software code repositories and messaging platforms, where the crypto asset’s developers, investors, and others come together and communicate to improve the asset or its associated applications.¹¹⁰ Some of these activities may be managed by the crypto asset’s sponsors rather than investors.¹¹¹ If those managerial efforts are important to the viability of the crypto asset or any associated applications, then that would militate in favor of a finding that Howey’s efforts of others prong was met.¹¹²

The availability of pricing data opens the possibility of using empirical techniques to assess Howey’s efforts of others prong in investment contract cases involving an exchange-traded crypto asset. An assessment of whether a crypto asset’s trading price was influenced by the activities of a centralized body is relevant to the efforts of others question, which demands a determination whether reasonable investors would expect the asset’s value, as ordinarily measured by its price, to be significantly determined by the entrepreneurial or managerial efforts of the centralized body. If a crypto asset’s price was influenced by the efforts of a centralized body, then the crypto asset’s price would be expected to move in a directionally appropriate way once value-relevant activity by the centralized body became known to the market. For instance, an announced improvement in a crypto asset’s associated application by the centralized body would be expected to cause the crypto asset’s price to increase, assuming that Howey’s efforts of others prong was met.

An event study therefore could be used to assess the extent to which the at-issue crypto asset does or does not respond to potentially value-relevant activities of a centralized body.¹¹³ However, the use of event studies in that context should be undertaken with care. First, there are important methodological considerations, such as the issue of low power, which are amplified in the crypto asset context because of high crypto asset price volatility.¹¹⁴ Second, the event study may be underinclusive in that it would not capture the effects of a centralized body’s ongoing influence on a crypto asset’s price and instead would be limited to analysis of how episodic events associated with the centralized body affected the asset’s price. Finally, even if the event study showed that the crypto asset’s price responds to value-relevant activities of a centralized body, that finding would not fully resolve the pertinent question of whether investors reasonably expected the crypto asset’s price to be significantly determined by the centralized body’s entrepreneurial or managerial efforts, though it would be one important determinant in that inquiry.

b. Absence of Any Centralized Third Party

Now, suppose instead that the crypto asset is fully decentralized in that there is no centralized third party that directs entrepreneurial or managerial efforts toward the crypto asset’s success; instead, those efforts are undertaken by a decentralized group of unaffiliated persons. The prospect of full decentralization raises the question of whether Howey’s efforts of others prong requires the existence of one or more centralized third parties whose entrepreneurial or managerial efforts significantly affect the investment contract’s success. If such centralized third parties in fact are necessary, then sufficient decentralization would by itself preclude satisfaction of Howey’s efforts of other prong.

SEC staff guidance concerning the application of Howey in the crypto asset context can be reasonably interpreted to envision the presence of one or more such centralized third parties for purposes of evaluating Howey’s efforts of others prong.¹¹⁵ That guidance defines an “Active Participant” as “a promoter, sponsor, or other third party (or affiliated group of third parties)” and then goes on to explain that Howey’s efforts of others prong in the crypto asset context requires an inquiry into whether “the purchaser reasonably expect[s] to rely on the efforts of an [Active Participant]” and the nature of those efforts.¹¹⁶ In other words, the SEC staff’s definition of an Active Participant could be read to exclude the efforts of a decentralized group of unaffiliated third parties from meeting Howey’s efforts of others prong. Scholars also have proposed tests for assessing Howey’s efforts of others prong in the crypto asset context that similarly appear to hinge on the presence of one or more centralized third parties, such as the crypto asset’s sponsors.¹¹⁷

The well-publicized 2018 speech by the SEC’s then-Director of Corporate Finance, Bill Hinman, can also be interpreted as implicitly adopting the notion that Howey’s efforts of others prong requires the presence of a centralized third party. In that speech, then-Director Hinman observed that increasing operational decentralization during a crypto asset’s lifecycle could cause a crypto asset that previously satisfied Howey’s test of an investment contract to no longer satisfy that test because no centralized group is tasked with the crypto asset’s entrepreneurial or managerial functions.¹¹⁸ That proposition has been featured prominently in crypto asset litigation that implicate the Howey question¹¹⁹ and has been the subject of academic inquiry.¹²⁰

Howey should not be read as requiring the presence of one or more centralized third parties for purposes of its efforts of others prong. There is nothing in the language or reasoning of Howey suggesting that the requisite entrepreneurial or managerial efforts must be undertaken by a centralized third party.¹²¹ Howey’s efforts of others prong instead is better understood as requiring investors to have reasonably expected their profits to have been significantly determined by the entrepreneurial or managerial efforts of those other than the investors themselves, whether or not those “others” constituted a centralized group.¹²²

Compared with a formulation of Howey’s efforts of others prong that requires the presence of a value-enhancing centralized party, an advantage of a formulation that permits the prong to be satisfied even in the absence of a centralized party is that it better focuses the analysis on an essential feature of an investment: delegation of entrepreneurial or managerial efforts to those outside of the investor class. So long as investors are sufficiently passive, in the sense they ceded sufficient entrepreneurial and managerial efforts to others, the putative investment contract will bear this indicium, independent of the degree of centralization of the group to whom those efforts were delegated. The investment contract cases addressing whether investors’ managerial involvement in the enterprise defeats Howey’s efforts of others prong embody this observation. Those cases evaluate the efforts of others prong by focusing on the extent of investors’ passivity.¹²³

Because Howey’s efforts of others prong should not be understood as mandating the presence of a value-generating centralized body, the prong may be met even if a crypto asset has undergone substantial operational decentralization such that there is no centralized third party that exerts entrepreneurial or managerial efforts influencing the crypto asset’s value. The relevant inquiry is whether the crypto asset’s investors reasonably believed the asset’s value was significantly determined by the entrepreneurial or managerial efforts of individuals or entities other than the investors themselves. If the asset’s investors had those reasonable expectations, then Howey’s efforts of others prong would be met even if the pertinent efforts were undertaken by a dispersed and large number of unaffiliated individuals or entities.

Not all exchange-traded crypto assets will satisfy Howey’s efforts of others prong. First, if the putative investment contract is such that it requires no ongoing entrepreneurial or managerial efforts to succeed, then Howey’s efforts of others prong would not be met. Mining, the energy-intensive process of validating transactions on proof-of-work blockchains,¹²⁴ should be considered ministerial rather than entrepreneurial or managerial.¹²⁵ Second, if the investors were the ones who significantly directed the entrepreneurial or managerial efforts pertinent to the investment contract’s success, then Howey’s efforts of others prong also will not be met.¹²⁶ This may be the case if the crypto asset provided investors with extensive governance rights that they can readily exercise.

Additionally, Howey does not admit as investment contracts instruments whose value is driven almost entirely by market forces. In such a circumstance, it would not be reasonable for the putative investment contract’s investors to believe that its value is significantly determined by any person’s entrepreneurial or managerial efforts.¹²⁷ That is the case, for instance, for such varied tradeable items such as gold, baseball cards, and bitcoin, which are all understood to have their value driven almost entirely by market forces rather than by any person or persons’ entrepreneurial or managerial efforts. At the same time, even if the crypto asset’s price is determined in part by market forces—for instance, if its price moves in part because of price changes of another crypto asset such as bitcoin—investors may still reasonably expect the asset’s price to be significantly determined by the entrepreneurial or managerial efforts of others, in which case Howey’s efforts of others prong will be met.¹²⁸

ii. The Irrelevance of Investors’ Expectations Concerning the Use of Their Sales Proceeds

In a primary transaction case, investors’ sales proceeds ultimately will flow to the promoter, who then is expected to use the proceeds to facilitate the enterprise in which the purchasers are invested. That will not be the case in a secondary transaction case. In this circumstance, investors’ sales proceeds instead will flow to the trading counterparties, who ordinarily will not be the enterprise’s promoter and also will not direct the sales proceeds to the promoter. For instance, in a secondary crypto asset transaction, the purchasers’ proceeds usually will not flow to the crypto asset’s sponsors and instead will be retained by the trading counterparties. For this reason, while investors in a primary transaction case may have a reasonable expectation that their sales proceeds will be used by the promoter to facilitate the enterprise in which they are invested, investors in a secondary transaction case generally will not reasonably have those expectations, as their sales proceeds will directly flow to trading counterparties, who will usually not be the promoter, though investors may reasonably have those expectations in certain circumstances.¹²⁹

The fact that investors in a secondary transaction case may not reasonably believe that their sales proceeds will be used by the promoter to facilitate the enterprise is doctrinally irrelevant to Howey’s efforts of others prong. Howey’s efforts of others prong requires that investors reasonably expected their profits to have been significantly determined by others’ entrepreneurial or managerial efforts, and the operative rule makes no mention of investors’ expectations concerning the use of their sales proceeds.¹³⁰ So, for example, while investors’ sales proceeds in a secondary crypto asset transaction case may not have flowed to the crypto asset’s sponsors, Howey’s efforts of others prong will still have been met so long as traders reasonably expected the crypto asset’s value to have been significantly determined by the entrepreneurial or managerial efforts of others, such as the sponsor.¹³¹ In other words, the appropriate focus of Howey’s efforts of others prong is on investors’ beliefs about whose entrepreneurial or managerial efforts significantly determined their expected profits, not investors’ beliefs about how their sales proceeds specifically would be put to use.¹³²

There is no public policy justification for limiting the investment contract category to only those circumstances in which investors reasonably expected the promoter to use their funds to facilitate the enterprise in which they are invested. First, the adoption of that limiting rule would permit instruments that otherwise would be investment contracts to permissibly be the subject of an unregistered public offering if the offering were structured in a manner that investors could not readily discern whether their proceeds would flow to the sponsor.¹³³ For example, if a promoter simultaneously undertook multiple investment projects, the promoter could pool all investors’ funds, which may result in investors of any given project not knowing whether the promoter specifically used their funds to finance their project, even though there was no question that the investors’ profits would be significantly determined by the promoter’s entrepreneurial or managerial efforts.

Second, limiting the investment contract category so that it only encompasses circumstances in which investors reasonably expected the promoter to use their funds to facilitate the enterprise would exclude an expansive swath of secondary transaction investment contract cases from the scope of federal securities law. This near wholesale carveout of an entire transaction class from the reach of the securities laws would serve no public policy goal and instead would undermine the investor protection objectives that the securities laws seek to promote.

C. The Value of Additional Definitional Clarity

Crypto asset sponsors and crypto exchanges sometimes criticize Howey’s investment contract analysis when applied to the crypto asset context as unreasonably uncertain.¹³⁴

20231119200747/https://www.sec.gov/files/rules/petitions/2022/petn4-789.pdf] (“Applying the Howey test[] piecemeal to an entire market sector has proven itself to be an unworkable solution.”). Any offering of securities, unless exempted, must be registered, and any exchange that facilitates securities transactions must register, unless exempted. It is thus important to crypto asset sponsors and exchanges that they have clear guidance on which of the crypto assets they may offer or list are securities under federal securities law. Crypto asset sponsors and crypto exchanges contend that Howey fails to clearly inform them which crypto assets may be securities, and thus subject them to federal securities law, including its robust registration requirements.¹³⁵ The effect of Howey’s uncertainty on crypto asset sponsors and exchanges is heightened because the pertinent transactions are not one-off or episodic transactions but instead are the foundations of those market participants’ business models.

The discussion in the previous Section shows that the effects of any uncertainty in Howey’s application in the crypto asset context extends beyond crypto asset sponsors and exchanges and also encompasses crypto asset traders. Crypto asset traders who are subject to secondary crypto asset trading fraud, or other forms of misconduct prohibited by the federal securities laws such as market manipulation, may seek to recover through claims asserted under the securities laws but only to find their claims dismissed on grounds that the pertinent transactions did not involve securities.¹³⁶

As the case law grows and matures, crypto asset market participants’ uncertainty about Howey’s analysis in the crypto asset context should abate.¹³⁷ The opinions courts have authored to date in crypto asset cases concerning the investment contract question have been detailed and reasoned (even if one disagrees with their reasoning or conclusions).¹³⁸ Future opinions at that level of care should provide market participants with a clearer understanding of when crypto asset transactions are within the scope of securities law. SEC staff may also offer additional guidance on crypto assets and the definitional question.¹³⁹

The pace of such doctrinal development may be slower than market participants prefer, especially crypto asset sponsors and exchanges.¹⁴⁰ Further clarity may come in the form of legislation that seeks to articulate with more specificity the circumstances when a given crypto asset will be within the scope of securities law. Some of the introduced or contemplated bills would define a large class of crypto assets as commodities rather than securities.¹⁴¹ To the extent a crypto asset is deemed to be a commodity rather than a security, traders sustaining losses from secondary trading crypto asset fraud could seek recovery through a CFTC Rule 180.1 class action rather than a Rule 10b-5 class action.¹⁴² If the substantive claim underlying secondary trading crypto asset fraud class actions were to shift to Rule 180.1, the public policy discussion in Part III below would also apply in that context.

Finally, it is worth observing that certain aspects of the securities laws’ registration and post-offering disclosure requirements are not especially well-suited for the crypto asset context. With respect to the registration process, scholars have observed that because the disclosures required by registration were developed with an eye to offerings of more conventional securities like stocks and bonds, they do not always align well with crypto asset offerings.¹⁴³ This point about incongruity also applies to the regulatorily mandated post-offering disclosures. For instance, suppose that a crypto asset sponsor conducts a registered offering of the crypto asset. Through section 15(d) of the Securities Exchange Act,¹⁴⁴ the sponsor becomes subject to the ongoing reporting requirements of section 13(a) of the Exchange Act, such as the requirement to prepare and file an annual report.¹⁴⁵ Suppose that, at some point, the crypto asset undergoes complete operational decentralization such that the crypto asset sponsor ceases to be involved in any aspect of the crypto asset and instead the development, operation, management, and promotion of the crypto asset and any associated applications are undertaken by a decentralized group of other stakeholders.

In this case, should the sponsor, as the crypto asset’s issuer, still be obligated to make the required ongoing disclosures, on the ground that section 13(a) obligates the “issuer” to make those disclosures?¹⁴⁶ Alternatively, if the ongoing reporting obligations instead were to somehow apply to the decentralized non-issuer group, then how, as a practical matter, could such a diffused group be able to prepare the necessary periodic and current reports? There is also the question of whether the information called for by the required post-offering disclosures is meaningful and appropriate for the crypto asset context. These questions demonstrate that some regulatory effort should be directed at reformulating the post-offering disclosure requirements so that they are better suited for the crypto asset context.¹⁴⁷

III. PUBLIC POLICY CONSIDERATIONS PERTINENT TO CRYPTO ASSET-BASED RULE 10B-5 CLASS ACTIONS

In addition to the doctrinal propriety of defrauded crypto asset traders relying on Rule 10b-5 class actions, there is the normative question of whether defrauded traders should be able to rely on Rule 10b-5 class relief as a matter of public policy. That issue arises in part because of the considerable skepticism that some legal scholars have expressed about the use of Rule 10b-5 class actions in stock-based cases as effective compensation and deterrence mechanisms.

The assault on stock-based Rule 10b-5 class actions has primarily been through two longstanding critiques—the circularity and diversification critiques.¹⁴⁸ More recently, some scholars have challenged the relevancy of those critiques,¹⁴⁹ while others have articulated theories that provide alternate public policy justifications for stock-based Rule 10b-5 class actions, with the leading example being a corporate governance justification for stock-based Rule 10b-5 class actions.¹⁵⁰ Despite the lingering skepticism by some academics that stock-based Rule 10b-5 class actions fail to achieve their public policy objectives, they remain a core fixture of securities practice.

If the public policy justification for crypto asset-based Rule 10b-5 class actions is significantly weaker than stock-based Rule 10b-5 class actions, then we may want a preemptive curtailment of those litigations through legislative action or doctrinal reorientation before they become commonplace as stock-based Rule 10b-5 class actions have become. More generally, if the public policy justifications are significantly weaker for crypto asset-based Rule 10b-5 class actions than stock-based ones, that would justify different legal treatment of the two types of class actions. This Part of the Article evaluates that particular public policy question viewed through the lens of the circularity and diversification critiques and the corporate governance justification.

The public policy determinations below are mixed and preliminary in part, but do not lend support to the notion that the public policy justification for crypto asset-based Rule 10b-5 class actions is significantly weaker than the public policy justification for stock-based Rule 10b-5 class actions. First, the circularity critique—the leading critique in the stock-based Rule 10b-5 context—is significantly attenuated in the crypto asset context because the principal factors supporting the circularity critique in the stock context are substantially absent in the crypto asset context. There are countervailing reasons why the diversification critique may be more or less relevant in the crypto asset context than in the stock context, but no reason to expect that the diversification critique has significantly more force in the crypto asset context than in the stock context. On the other hand, the corporate governance justification loses relevance in the crypto asset context.

Sections A, B, and C below address the circularity critique, the diversification critique, and the corporate governance justification, respectively. Section D provides a few comments concerning the issue of frivolous litigation.

A. The Circularity Critique

The key critique against Rule 10b-5 stock-based class actions is circularity, which is the idea that when class actions settle, as nearly all do, the settlement is ultimately paid for by the company’s shareholders.¹⁵¹ This serves to undermine both the deterrence and compensatory features of the class action process. Because of its centrality to public policy analysis of securities class actions, it is valuable to work through some of the details of the circularity critique before turning to its applicability in the crypto asset context.¹⁵²

1. Circularity in the Stock Context

Circularity arises in the stock context for two reasons. The first driver of the circularity critique is that individually named directors and officers usually will not directly pay any of the settlement amount because of D&O insurance and indemnification. A study by Klausner, Hegland, and Goforth, for instance, evaluated a sample of over two hundred and fifty securities class actions that had settled and found that directors and officers did not make any payments in 98% of those cases.¹⁵³ That number is not surprising given that nearly all public companies purchase D&O insurance.¹⁵⁴ Empirical studies also indicate that directors and officers may not pay any reputational penalty when they are accused of fraud.¹⁵⁵ The lack of director and officer liability thus mitigates the deterrence effect of securities class actions on director and officer conduct.

The second driver of the circularity critique is the relationship between shareholders and the company’s net income. Because individually-named defendants ordinarily do not contribute to stock-based securities class action settlements, settlements instead are paid for by the company, either directly or through the company’s D&O insurance, or some combination of the two.¹⁵⁶ Accordingly, settlement of a Rule 10b-5 class action against an issuer and its directors and officers usually will be funded by the issuer directly or indirectly through the cost of the D&O insurance that the issuer has purchased. Because shareholders are the company’s residual claimants, these corporate expenditures associated with settlement payments are ultimately borne by shareholders in the form of diminished cash flow.

One group of shareholders bearing the cost of settlement will be the same ones who were injured by the fraud (assuming they did not sell their shares). Because these shareholders will be partially footing their own recovery, full compensation will not be achieved. The other of the firm’s current shareholders responsible for the settlement will be ones who were not class plaintiffs. These shareholders have no direct responsibility for the fraud but will be paying for the injured shareholders’ recovery, which implicates fairness considerations.

The circularity critique can be more formally illustrated through a simple model that embodies these observations. Consider a stock-based Rule 10b-5 class action in which the subject company has N shares outstanding that were trading at a pre-fraud price of P₀ per share. Assume there was a fraudulent material misrepresentation attributed to the issuer and its directors and officers that increased the stock’s price to P₁, which eventually returned to the pre-fraud level of P₀ once the market became aware of the fraudulent statement.

Suppose that the class of the company’s shareholders who purchased shares at the inflated price bring a Rule 10b-5 class action against the company and its directors and officers. For simplicity, assume these injured shareholders do not sell their shares. Of the company’s N shares outstanding, suppose that n shares are represented by the litigating class. So, if π is the fraction of the company’s outstanding shares represented by the litigating class, then π = n/N. The case settles and then pays s dollars per share to each of the n shares purchased during the class period, for a total settlement payment of s*n. Given the discussion above regarding corporate obligations for class action settlements, the company will pay a fraction α of the settlement, where α is between 0 and 1, which ultimately will be borne by the firm’s shareholders holding the N shares. In discussions of the circularity critique it is ordinarily assumed, either expressly or implicitly, that the company directly or indirectly pays the entirety of the settlement, which corresponds to the circumstance in which α = 1.

Given this setup, first consider the post-settlement welfare of the shareholders who were injured by the fraud because they paid the inflated price for the company’s stock. For expositional simplicity, consider a shareholder who is a member of the class and who purchased just a single share of the company’s stock. The value of the share that the shareholder maintains is P₀, but they purchased the share for P₁, which means that the net value of their portfolio is P₀– P₁. The shareholder receives a settlement payment of s but because shareholders ultimately bear the company’s settlement expenditure of α(s*n), each of the firm’s shareholders bears a per share settlement expense equal to α(s*n)/N, or α(s*π). Thus, a class plaintiff receives a per-share net settlement amount of s – α(s*π). Collecting terms, the per-share post-settlement welfare of a class plaintiff is:

P₀ – P₁ + s(1 – α*π) (1)

Even in the hypothetical but unrealistic world in which there are no litigation costs and no plaintiffs’ attorney fee awards,¹⁵⁷ and even if the settlement were to compensate defrauded shareholders for the full amount of their overcharge, a settlement would not make the injured shareholders whole so long as the corporation pays at least some portion of the settlement. That is evident in the model above. To see this, suppose there are no litigation costs or plaintiffs’ attorney fee awards and the settlement fully pays the overcharge—that is, s = P₁ – P₀. In this case, the post-settlement welfare of the injured shareholder discussed above who holds one share of the stock is – α*π(P₁ – P₀),¹⁵⁸ which is negative whenever the corporation pays at least some portion of the settlement, that is, whenever α is greater than 0.

In other words, while the settlement makes class shareholders whole in the first instance, they ultimately are not fully compensated because they each pay a portion of the settlement amount equal to α(s*π) per share. Each of the other firm’s shareholders also pay a per-share amount equal to α(s*π) to finance the settlement. As this example shows, the circularity critique supports the position of those who argue that stock-based Rule 10b-5 class actions fail to meet compensation and deterrence objectives and implicate fairness concerns.¹⁵⁹

2. Circularity in the Crypto Asset Context

Circularity is a significantly attenuated consideration for Rule 10b-5 crypto asset class actions because the drivers of the critique discussed above are substantially absent in the crypto asset context. To start, individual defendants in crypto asset Rule 10b-5 class actions are much less likely to be able to rely on insurance or indemnification as a shield from personal liability, relative to the stock-based context. First, because of the operational decentralization discussed in Section I.A above, an individual wrongdoer may not be associated with any entity such as a corporate body that provides indemnification rights or insurance coverage. Second, while publicly available data is lacking, D&O coverage appears very limited in the crypto asset context because of an avoidance by D&O carriers of the crypto space, as well as high premiums and unfavorable terms.¹⁶⁰

news/international/2022/12/19/699978.htm [https://perma.cc/VME7-JJG3] (“Insurers were already reluctant [prior to the collapse of the crypto exchange FTX] to underwrite asset and directors and officers (D&O) protection policies for crypto companies because of scant market regulation and the volatile prices of Bitcoin and other cryptocurrencies. Now, the collapse of FTX . . . has amplified concerns.”); Josh Liberatore, Crypto Winter Raises Host of D&O Coverage Issues, Law360 (Feb. 10, 2023, 9:38 PM), https://www.law360.com/articles/1575237 [https://perma.cc/FLC9-2XG9] (quoting a D&O lawyer for the observation that “[m]ost D&O underwriters view crypto firms as toxic in today’s environment, so the availability of D&O insurance for those firms is quite limited . . . . Even when available, the insurance is expensive and somewhat limited in scope of coverage”). So, even if an individual wrongdoer is affiliated with a centralized entity, the individual may not have the protection of D&O coverage, or only very limited protection, relative to an individual defendant in a stock-based Rule 10b-5 action. Furthermore, the apparent rarity of D&O coverage presumably would make indemnification a rarity as well, as a crypto asset entity would not be readily able to purchase Side B coverage to cover its indemnification expenses.¹⁶¹

The absence of crypto asset holders’ cash flow rights further diminishes the relevance of the circularity critique in the crypto asset context. As discussed in Section I.B above, except in very rare circumstances, a crypto asset’s holders will not be the recipients of any profit distributions resulting from their crypto asset holdings. So, if a Rule 10b-5 crypto asset class action settles, then the crypto asset’s holders may not bear any of the cost of the settlement, as would be the case in the stock context.

For instance, suppose the defendant set in a Rule 10b-5 crypto class action includes an entity involved in developing the crypto asset and the entities’ directors or officers. Suppose that the class action settles for s dollars per asset purchased during the class period. None of the settlement amount will be borne by the crypto asset’s holders (other than any defendant who may be a holder). Even if only some of the settlement is paid by the individual defendants, leaving some of the settlement to be paid by the named entity, that expenditure will not be passed down to the class plaintiffs or any other of the crypto asset’s traders because none have cash flow rights in the named entity.

With respect to the stylized model above, the named entity defendant may pay a fraction α of the settlement but because that amount is not borne by the crypto asset’s traders, the class plaintiffs’ welfare after the settlement is P₀ – P₁ + s for each share purchased during the class period. Putting aside any litigation costs or attorney fee awards, this then supports the feasibility of complete compensation if the settlement amount is set equal to the overcharge.¹⁶² One countervailing consideration is that, to the extent the defendant is actively involved in developing or supporting the crypto asset or any associated applications, a settlement payment by the defendant may impede its ability to effectively engage in those facilitating efforts. By decreasing the perceived value of the crypto asset or any associated applications, the settlement may lower the crypto asset’s price, which would adversely affect the crypto asset’s holders, including class plaintiffs.

In addition to the possibility of full compensation, because crypto asset traders outside of the class are not paying for the settlement of the class plaintiffs, the fairness concerns noted above are ameliorated in the crypto asset context. A related implication of the circularity critique in the stock-based context is that putting litigation costs to the side, litigation is zero-sum, in that shareholders’ aggregate wealth is unchanged after a settlement or judgment.¹⁶³ That is not the case in the crypto asset context. Because the cost of a settlement is not borne by the crypto asset’s traders, their aggregate welfare will increase after a settlement, putting aside the point above about a settlement potentially having adverse effects on development of the crypto asset or any associated applications. Finally, deterrence is heightened relative to the stock context because of the significantly greater likelihood that the individual defendants responsible for the fraud will incur monetary liability and thus be better incentivized to avoid that conduct in the first instance.

B. The Diversification Critique

Diversification is another leading critique lodged in the literature against stock-based Rule 10b-5 class actions. While circularity focuses on compensation and deterrence considerations in a single securities class action, the diversification critique peers with a broader lens. It inquires how a shareholder’s entire portfolio is affected by fraud and concludes that the cost of fraud can be diversified away, thereby nullifying the role of Rule 10b‑5 class actions as a remedial mechanism.¹⁶⁴

The key features of the diversification critique can be seen through a simplified model. Suppose that there are N publicly traded firms and a single investor. There are two time periods, period one and period two. In period one, the investor decides, for each one of the N firms, whether or not to purchase a single share of the firm’s common stock. So, in the first period, the investor can purchase up to N shares—one share of each of the N firms—but may invest in just a subset of the N firms. In the second period, the investor sells all of the shares that they purchased in the first period.

Suppose further that each of the N firms will be the target of fraud, the effect of which will be to artificially and temporarily inflate the firm’s stock price. Assume, for further simplicity, that all firms have the same fundamental, that is, non-fraud, share price and that the fraud will have the same price-inflating effect on each firm’s stock. For any given firm, there are two possibilities of the timing of the fraud. One possibility (which can be referred to as scenario one) is that the fraud occurred immediately before period one and is revealed to the market between period one and period two. The second possibility (which can be referred to as scenario two) is that the fraud occurred immediately after period one and is revealed to the market after period two. Firms are randomly assigned to the two scenarios with equal probability and the firms’ assignments are uncorrelated.

This setup illuminates the two key tenants of the diversification critique. First, the diversification critique postulates that, for any given issuer, every shareholder of the firm ex ante is as likely to be a victim of fraud as a beneficiary. This can be seen in the model above. For any firm in which the investor became a shareholder in period one, the investor’s likelihood of being in scenario one (in which case the investor will have purchased at the fraud-inflated price and sold at the lower, fundamental price) is the same as the likelihood of being in scenario two (in which case the investor will have purchased at the fundamental price and sold at the higher, fraud-inflated price). This means that even without a compensatory scheme in place, the expected cost of fraud to the investor for any given stock in their portfolio is zero: the likelihood that a shareholder will incur the cost of fraud is the same as the likelihood that they benefit, and the cost and gains are the same. But note that while the expected cost to the shareholder from fraud directed at any given firm in which the shareholder is invested is zero, fraud still affects the variability of the shareholder’s portfolio, since half the time the trader will be a victim of fraud and the other half the time, a beneficiary.

The second key tenant of the diversification critique is that investors can diversify away the risk that fraud injects into their portfolio. In the stylized model above, that diversification occurs through the investor taking positions in a greater number of firms. In the context of that model, while fraud will have the same, non-zero effect on the expected value of a portfolio comprised of the shares of a single firm and a portfolio comprised of the shares of many firms, fraud will result in the latter portfolio being less risky than the former portfolio. If stock traders are sufficiently diversified, then fraud will not only have zero expected cost on their portfolios but also will cause traders’ portfolios to be exposed to only limited additional risk.¹⁶⁵

As this discussion indicates, the strength of the diversification critique as a basis for concluding that fraud has no ex ante adverse effect on shareholder welfare turns primarily on two things. First, the theory’s strength depends on the extent to which shareholders are diversified. If shareholders are not well-diversified, then even though fraud will not affect the expected value of shareholders’ portfolios, it will increase their portfolios’ riskiness, which will undermine the welfare of risk averse shareholders. Second, the critique’s strength turns on the extent of shareholder risk aversion. If shareholders are strongly risk averse, then the effects of fraud on shareholder welfare through increased portfolio volatility will be more pronounced than if they were less risk averse, all else equal. The reason is that a more risk averse shareholder experiences greater disutility from an increase in portfolio risk than a less risk averse shareholder, all else equal.¹⁶⁶

These observations show that an assessment of whether the diversification critique is more or less pronounced in the crypto asset context than the stock context should focus, at least in the first instance, on comparing the extent of stock traders’ diversification and risk aversion with the extent of crypto asset traders’ diversification and risk aversion.¹⁶⁷ Empirical work is needed in order to be able to competently assess how the extent of crypto asset investors’ diversification and degree of risk aversion compares to that of stock traders.

Though strong conclusions are not possible in the absence of this empirical analysis, it is reasonable to expect that the implications of the diversification and risk aversion considerations break in different directions, but nothing suggests that those considerations are such that the diversification critique has significantly greater relevance in the crypto asset context than in the stock context. Turning first to trader diversification, it is likely that stock traders are better diversified than crypto asset traders. Through the widespread availability of index funds, index-based exchange-traded funds (“ETFs”), and managed funds, equity traders can readily and cheaply diversify their stock portfolios. The prominence of those instruments suggests that many equity traders do maintain diversified stock portfolios. That likely is not the case for crypto asset investors given that the means for crypto asset investors to easily diversify their crypto asset holdings, such as through tokenized index funds that track a broad basket of crypto assets, are not commonplace, and crypto asset investors appear to prefer purchasing and selling individual crypto assets rather than funds.

To the extent crypto asset traders are less diversified than stock traders, this would translate into the diversification critique having less relevance in the crypto asset context than in the stock context. On the other hand, it is reasonable to expect the risk aversion consideration to work in the other direction, because crypto asset traders may be less risk averse than stock traders. As discussed in Section I.C above, crypto asset prices are very volatile as a general matter and more volatile than stock prices as a relative matter. That crypto asset traders are willing to trade in the face of such volatile prices may be reflective of those traders being more willing to accommodate risk than stock traders. To the extent that is correct, then this would provide a mechanism for the diversification critique to have more, not less, relevance in the crypto asset context than in the stock context.

C. The Corporate Governance Justification

The circularity and diversification critiques have been the primary arguments asserted against stock-based Rule 10b-5 class actions. One rejoinder to those critiques is a corporate governance justification that posits that stock-based Rule 10b-5 class actions advance public policy through improvements in corporate governance.¹⁶⁸

The corporate governance justification focuses on securities law’s disclosure regime. The justification is based on the notion that more accurate disclosures by companies subject to the disclosure regime translate into improvements to legal and nonlegal channels of corporate governance. These improved corporate governance mechanisms, in turn, incentivize managers to be better focused on share value maximization, which results in economic gain. For example, the corporate governance justification posits that more accurate corporate disclosures increase the disciplinary power of a hostile takeover. The underlying reasoning is that more accurate company disclosures enable potential acquirers to more readily identify managerial deviations from share value maximization, where the threat of such takeover better incentivizes managers to maximize share value in the first instance.¹⁶⁹ The corporate governance justification concludes that securities class actions work alongside public enforcement to improve the accuracy of company disclosures, which serves to facilitate these and other forms of economic gain.¹⁷⁰

The corporate governance justification loses relevance in the crypto asset context. The primary reason is that crypto asset sponsors are not reporting companies, and thus subject to the securities law’s ongoing disclosure obligations, at least under current law and practice.¹⁷¹ Crypto asset sponsors also do not voluntarily furnish the market with information that is substantively similar to the disclosures provided by public companies.¹⁷² So, it is not meaningful to ask whether crypto asset-based Rule 10b-5 class actions generate disclosure improvements.

Second, the various channels of corporate governance that the corporate governance justification posits to be improved by stock-based Rule 10b-5 class action have no or little applicability in the crypto asset context. For example, crypto asset sponsors are not publicly traded companies and so cannot be the subject of a takeover effort. Even if a party were to acquire significant amounts of a crypto asset, that would not allow the acquirer to exercise control over the crypto asset’s sponsor or to replace its management, as may be the case with the acquisition of sufficient voting shares of a publicly traded company.

D. Price Volatility and Frivolous Litigation

The analysis above, when aggregated, does not provide a basis for concluding that the public policy justification for crypto asset-based Rule 10b-5 class actions is substantially weaker than the public policy justification for stock-based Rule 10b-5 class actions. The circularity critique is significantly less relevant in the crypto asset context than in the stock context, and the diversification critique may be more or less relevant in the crypto asset context than the stock context, but nothing indicates that it is significantly more relevant. An offsetting consideration is that the corporate governance justification ceases relevancy in the crypto asset context.

Absent from the discussion above is the issue of frivolous litigation, which can impose social cost by causing the defendants to divert resources away from value-enhancing activity to paying legal expenses and incurring settlement payments. One question pertinent to the Article’s public policy question is whether unmeritorious Rule 10b-5 class actions are more likely to be expected in the crypto asset context than in the stock context.

The prospect of frivolous lawsuits is heightened in the crypto asset context because of the significant price volatility discussed in Section I.C above. A crypto asset’s traders may lose significant amounts simply because of inherent price changes. In the face of a significant volatility-induced price drop, financially impaired crypto asset traders may seek to use Rule 10b-5 to recover their non-fraud losses, understanding that such cases often result in at least some recovery through settlement. Instead of crypto asset investors leading the charge to the courtroom in such circumstances, lawyers may be the first movers.¹⁷³ In either case, frivolous suits may deplete or deteriorate the budgets of crypto asset sponsors and others who are involved in the development of crypto assets and their applications, which would serve to diminish incentives to innovate. That prospect of dampened innovative activity is amplified given the apparent current rarity of D&O insurance.¹⁷⁴

This is an important consideration, but the same price volatility that may incentivize non-meritorious suits may also work to disincentivize them. At various points of their Rule 10b-5 class action, crypto asset traders will need to establish aspects of their case through statistical methods. For instance, the plaintiff traders will need to establish loss causation, which will necessitate use of an event study to show that the crypto asset’s price responded in a statistically significant manner to one or more corrective disclosures.¹⁷⁵ As has been documented elsewhere, event studies in Rule 10b-5 class actions may not be able to identify statistically significant price effects because of low power.¹⁷⁶ The issue of low power is heightened when there is high price volatility, as in the crypto asset context.¹⁷⁷ For this reason, whether or not a crypto asset Rule 10b-5 case is meritorious or not, the issue of low power will make it difficult for crypto asset traders to establish elements of their claim. That inability combined with an awareness that other aspects of their claim may have poor factual support may dissuade crypto asset traders from bringing frivolous Rule 10b-5 cases.¹⁷⁸ As this discussion shows, the same relatively high price volatility that could cause more frivolous crypto asset Rule 10b-5 class actions to be litigated than stock-based Rule 10b-5 class actions simultaneously provides a reason why there may be fewer frivolous suits of the former type than the latter.

CONCLUSION

Traders who participate in secondary crypto asset trading markets understand that any trading gains are accompanied by the risk of trading losses. Most traders presumably also understand that their losses at times can be significant because of the high volatility of crypto asset prices. But accompanying these market-determined losses are potentially significant trading losses caused by fraud occurring in connection with traders’ secondary transactions. In response to incidents of secondary trading crypto asset fraud, crypto asset traders may seek recovery for their trading losses through Rule 10b-5 class actions. The propriety of crypto asset traders relying on that form of relief implicates a host of doctrinal and public policy questions. This Article sought to analyze two such questions, one doctrinal and one public policy related.

In its doctrinal analysis, the Article evaluated issues pertinent to the threshold definitional question of when an exchange-traded crypto asset will constitute an investment contract and therefore fall within the definitional perimeter of a security. That analysis identified a slight generalization of the horizontal commonality test so that the test is suitable for use in both primary transaction and secondary transaction cases. The analysis also explained why Howey’s efforts of others prong should not be understood to require the presence of a centralized third party and also explained why the prong does not concern itself with investors’ expectations concerning the use of their sales proceeds. These findings, though, are legal propositions. Whether or not a particular exchange-traded crypto asset is or is not an investment contract will depend on the pertinent facts and the totality of the circumstances.

In its public policy analysis, the Article evaluated whether the public policy justification for crypto asset-based Rule 10b-5 class actions is significantly weaker than stock-based Rule 10b-5 class actions. It structured its analysis around the primary theories advanced in the literature to assess whether stock-based Rule 10b-5 class actions advance their public policy objectives. The Article’s public policy determinations break in different directions and in some respects are to be considered preliminary, but the analysis does not justify limiting the availability of crypto asset-based Rule 10b-5 class actions any more than stock-based Rule 10b-5 class actions.

96 S. Cal. L. Rev. 1571

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Menesh S. Patel*

* Professor of Law, UC Davis School of Law. This Article benefited from helpful comments by Jordan Barry and Jill Fisch, as well as participants at the University of Southern California’s Digital Transformation in Business and Law Symposium. Parts of this Article build on and draw from points in a prior work. See Menesh S. Patel, Fraud on the Crypto Market, 36 Harv. J.L. & Tech. 171 (2022). I thank Merritt Fox for his comments on that earlier work, which motivated me to address points in Part III of this Article. I also thank Madeline Goossen, Jessica Langdon, Remy Merritt, and the other journal editors for their helpful suggestions and editing assistance. Maximilian Engel, Katherine Gan, and Ada (Xia) Wu provided excellent research assistance.

The Bankruptcy Court as Crypto Market Regulator

April 2024April 2024Yesha Yadav* & Robert J. Stark†

In the second half of 2022, several large and systemically important cryptocurrency firms, such as BlockFi, Celsius, FTX, and Voyager, collapsed into bankruptcy. Their sudden implosion can be attributed, at least in part, to a scant pre-existing framework for oversight, allowing firms to engage in runaway risk-taking, exuberant opportunism, and, in some cases, outright fraud. Bankruptcy courts adjudicating these cases found themselves in a strange role: serving as a sort of proxy overseer for a maturing cryptocurrency industry, and forced into doing some of the work historically entrusted to regulatory agencies like the SEC, CFTC, and Fed. This Article explores the implications of bankruptcy courts being drafted into this kind of quasi-regulatory service. We observe that bankruptcy’s intervention comes with numerous payoffs, given that Chapter 11’s end-goals often align with traditional regulatory objectives. Indeed, by case necessity, bankruptcy courts have overseen broad and detailed reporting from some of the industry’s darkest corners, rendered decisions that likely will have lasting impact on customer protection, directed regulatory attention to particular points of public vulnerability, and afforded opportunity for regulatory agencies to advance their policy initiatives. Nevertheless, we also observe that bankruptcy courts are inadequate proxies for administrative, technocratic oversight. Focused mainly on the debtor’s fate, the Bankruptcy Code is ill-equipped to address, in a prophylactic way, system-wide risks in crypto markets. Even disclosure––a foundational regulatory tool––works idiosyncratically when delivered in the bankruptcy context, intended to inform the debtor’s stakeholders in furtherance of bankruptcy-specific imperatives, rather than to facilitate knowledgeable investing by the general public. Bankruptcy courts are, moreover, statutorily constrained in ways that lack the mission, modalities, and mechanisms to protect an industry and its participants. As we show here, even as bankruptcy courts have stepped up to do their work, their role in overseeing crypto bankruptcies firmly establishes a paramount need for comprehensive regulation tailored for the digital asset space.

INTRODUCTION

The collapse of the FTX cryptocurrency exchange in November 2022 was a pivotal moment for the digital asset industry. The company’s sudden implosion triggered billions in economic damage across the sector, as well as immeasurable personal pain for millions of everyday customers.¹

Prior to its failure, FTX had been one of crypto’s brightest stars, serving as a leading trading hub for digital assets, offering a panoply of sophisticated financial products, and boasting a (supposedly) enviable balance sheet.² Just one year after its founding in 2019, the company was hosting $385 billion in annual trading volume.³ The following year, it reported five million customers worldwide, more than $1 billion in revenue, and almost $275 million in earnings.⁴ By January 2022, FTX was valued at $32 billion.⁵ The company had also been absorbed into popular culture, helping to demystify digital assets for everyday Americans: the FTX brand was emblazoned across the Miami Heat’s basketball stadium; it was endorsed by celebrities like Tom Brady and Larry David, including a memorable advertisement aired during the 2022 Superbowl; and, Sam Bankman-Fried, FTX’s once-wunderkind CEO, became known for contributing lavishly to political campaigns and marketing himself as the legitimizing, ethical face of crypto.⁶ In fewer than four years, FTX had become big, powerful, and ubiquitous––bridging Wall Street, Main Street, and the nation’s capital to a brand new crypto marketplace––which too had become far too big, powerful, and ubiquitous to ignore.⁷

But, in November 2022, FTX was outed as a possible fraud, suspected of grossly misrepresenting its enterprise value and misusing customer deposits.⁸ Within weeks, Bankman-Fried was in handcuffs,⁹ other FTX executives were cutting plea deals,¹⁰ and the company was in bankruptcy.¹¹ The resulting Chapter 11 case is sweeping, both in scale and complexity, spanning over 130 entities worldwide, with total value estimates ranging anywhere from $10 to $50 billion.¹² The administrative fee burn has been commensurately immense, with the debtor’s bankruptcy professionals seeking over $200 million in fees for the initial six months of work.¹³

Intriguingly, the FTX story is not unique.¹⁴ The company’s meteoric rise and sudden descent tracks that of other crypto behemoths. Firms like BlockFi, Celsius Network, Core Scientific, Genesis Global, Three Arrows Capital, and Voyager Digital each found themselves intermediating billions in crypto assets only a few years after launch and, like FTX, imploding in the wake of a sharp market downturn. Several major crypto bankruptcies have also generated substantial allegations of executive wrongdoing, and those allegations overlap, reflecting somewhat repeating patterns of alleged customer deception and sloppy safeguarding of customer assets.¹⁵

None of this should be terribly surprising. The crypto market has, through its evolution, lacked a systematic regulatory framework to constrain excessive risk-taking, interconnection, and propensities for predation against customers.¹⁶ This has meant, for example, a lack of vetted, mandatory public disclosure about the business dealings of some of its most significant enterprises, as well as their corporate governance and risk management practices.¹⁷ Nor has regulation imposed comprehensive standards for protecting customer assets.¹⁸ It has thus failed to speak on how the market should ensure the overall safety and soundness of crypto firms––and, importantly, what procedures crypto businesses need to follow in order to legally insulate the value of customer assets against instances of theft, hacks, and firm bankruptcy.¹⁹ This relatively threadbare regulatory environment has afforded considerable space for firms to take excessive financial risks or institutionalize problematic practices (e.g., opaque governance), with predictably costly consequences. This has left bankruptcy courts to become, oddly, the frontline responders–– tasked with cleaning up the fallout by imposing their jurisprudence onto an otherwise lightly governed crypto marketplace.

This Article shows that, by dint of historical happenstance, bankruptcy law has been required to partially fill an administrative void and to function in an almost quasi-regulatory capacity. Several bankruptcy courts in New York, Delaware, and New Jersey have come to simultaneously oversee what is, collectively, a sort of grand public inquest into crypto market infrastructure and operations, surveying a wide spectrum of industry-specific transactions, practices, and methods of corporate decision-making. These courts have also decided issues of first impression that will likely leave a lasting impact on the maturing crypto industry (e.g., modified terms of service).²⁰ The courts have been doing their work in advance of a mainstay framework for regulating cryptocurrency markets, driven by case imperatives to perform certain functions commonly entrusted to financial supervisors like the Securities and Exchange Commission, the Commodity Futures Trading Commission, and the Federal Reserve.²¹

In forwarding this argument, this Article moves to examine the implications of bankruptcy law and its courts being drafted into quasi-regulatory service. It makes three points. First, we observe that bankruptcy has stepped into an arena where financial regulators have struggled to craft a system of rules and standards, applying its own principles and processes to the messy task of preserving and allocating economic value. In many respects, crypto represents an inherently complicated challenge for U.S. financial regulation, given the industry’s extraterritorial nature, fast-moving technology, and originating anti-government spirit.²² But, even as the likes of FTX are far from the first crypto players to fail,²³ the scale of alleged wrongdoing and magnitude of damage caused by 2022’s “crypto winter”²⁴ have laid bare the significance of sparse regulation and deepened the strains experienced by the New Deal administrative apparatus in policing the digital asset space.²⁵ This has left the bankruptcy system charged with, among other things, calculating the economic costs of regulatory failure and, where possible, developing mechanisms to safeguard and redistribute enterprise value within otherwise under-protected crypto markets.

Second, we show that bankruptcy law offers a number of advantages when its courts are, by default, performing traditional regulatory functions. By its very design, bankruptcy involves a system of rules that advance certain core regulatory objectives. For example, Chapter 11 is demanding when it comes to disclosure, a phenomenon highlighted by the production of startling revelations across various crypto Chapter 11 proceedings (e.g., FTX, Celsius, Voyager, and BlockFi).²⁶ Chapter 11’s adversary process typically divulges more as the case unfolds. And, in bankruptcies involving particularly troubling facts, the court may compel the appointment of an examiner to deliver a “tell-all” report, as it did in two crypto cases (Cred and Celsius)²⁷ and is poised to do in FTX.²⁸ This emphasis on disclosure can meaningfully promote management accountability and, in turn, help ward away bad C-Suite behavior. In the Celsius case, for instance, the 689-page examiner’s report presented a damning account of the company’s historical business practices.²⁹ The report presaged, and likely contributed to, the Celsius CEO’s eventual indictment and arrest, which occurred only a few months after the report’s publication.³⁰

Bankruptcy disputes also deliver poignant teaching moments for government overseers and the wider public. For instance, a value allocation contest in the Celsius bankruptcy––pitting depositors in interest-bearing accounts against depositors in “wallet” accounts––revealed just how fragile customer ownership rights can be when deposited crypto-value exists in digital and legally ambiguous form.³¹ Customers came to learn that, contrary to marketing promises,³² the cryptocurrency ceased being legally “theirs” upon deposit in interest-bearing accounts. That is, customers were deemed to be merely unsecured creditors in the bankruptcy case, left to fight for scraps near the bottom of the priority ladder.³³ The bankruptcy court, in so ruling, not only resolved a critical case issue, it also delivered a hard truth to crypto customers: entrusting savings to an unregulated crypto exchange or “bank” comes with serious risks, given that these companies are not well policed for fraud and that customer savings lack conventional protective mechanisms, like federal deposit insurance.³⁴ Such lessons can be unsparing, yet also clarifying about the economic and legal vulnerabilities faced by crypto customers––who, en masse, were tempted by tantalizing marketing promises but ultimately found themselves exposed to inherently complex, opaque legal and economic risks.³⁵ By highlighting the traps, bankruptcy courts direct agency attention to acute public vulnerabilities, hopefully motivating regulators to develop the kind of customer protections that have long existed in more traditional marketplaces (e.g., securities or commodities markets).³⁶

As a concluding observation on this point, we show how bankruptcy represents a forum where regulatory agencies can press specific policy objectives in advance of a new statutory framework and without facing the usual set of political/rulemaking constraints and ramifications. Regulators have some leeway to inject themselves into bankruptcy proceedings, promoting an agency’s policy priorities.³⁷ The SEC and the federal government, for example, intervened in Voyager’s Chapter 11 case to object to its proposed sale to Binance.US, the American affiliate of Binance––the world’s largest crypto exchange, by volume.³⁸ The government contended that the proposed Chapter 11 sale came with serious regulatory problems, suggesting that Binance.US may not be a fully law abiding corporate citizen and that distributions to Voyager creditors (via Binance.US) might violate securities laws.³⁹ The government’s arguments floundered in court,⁴⁰ but its highly public attack effectively terminated the transaction.⁴¹ This case study illustrates how agencies can, with efficiency, produce regulatory impact when the target of their action falls under the bankruptcy court’s stewardship.

Nevertheless, in our third contribution, we observe that reliance on bankruptcy courts to perform regulatory functions comes with serious shortcomings. Bankruptcy courts are tribunals of limited jurisdiction, and their powers are localized to the specific debtor and its stakeholders, not the public welfare more generally.⁴² They are, in turn, intended to work in tandem with functioning regulatory arms of government; they are not supposed to assume their oversight responsibilities.⁴³ These courts are particularly ill-equipped to address risks arising from an interconnected and multifaceted financial market, especially in a prophylactic way.⁴⁴ Stated differently, corporate bankruptcy is not structured to expressly entertain regulatory imperatives, like stopping financial calamity before it happens or ensuring that a firm’s distress does not trigger systemic contagion within the wider market.⁴⁵

Further, Chapter 11’s legal and normative rules––focused on maximizing each debtor’s distributable value, allocating that value among stakeholders, and where possible rehabilitating the broken business––are not friendly to outsiders, even government outsiders seeking to advance public policy aims.⁴⁶ Competition between economic and regulatory agendas can, in fact, lead to value-deteriorating outcomes, such as dooming Voyager’s sale to Binance.US, contrary to bankruptcy’s primary mission. Even concerning matters of disclosure, the objective is case-specific (e.g., maximizing and allocating estate value) and often strategic in nature (e.g., the debtor’s desire to remain in possession of estate assets), not to obviate risk in the industry generally.⁴⁷ In some cases, the court may not favor augmented public disclosure if doing so may be prohibitively costly or where greater public disclosure threatens an orderly Chapter 11 process.⁴⁸ This may explain why examiner reports were commissioned in the Cred and Celsius cases, but not in the FTX case (that is, until compelled by the Third Circuit Court of Appeals).⁴⁹ Stated simply, even as bankruptcy is (by case necessity) doing important regulatory work, it is far from its natural functionality and is an inherently inadequate substitute for administrative agencies whose mandates include establishing a set of robust, lasting, and standardized rules that protect marketplaces both in peacetime and in crisis.

This Article proceeds as follows. Part I describes the cryptocurrency ecosystem and the challenges of establishing regulatory perimeters for this emerging asset class. Even though regulators have struggled to develop rules-of-the-road for the digital asset industry, this Part highlights some key risks (e.g., systemic risk, information deficits, and user vulnerability) that are commonly cited to justify the application of traditional financial regulation. Part II explains how Chapter 11 has been drafted into quasi-regulatory service to help clean up the mess enabled by crypto’s sparse regulatory environment. This Part illustrates how bankruptcy court oversight has generated a slew of benefits, with the potential to promote insight, expertise, clarity, and good governance. Part III explores the fuller implications of bankruptcy serving quasi-regulatory functions. It shows that, despite all their good and hard work, bankruptcy judges are imperfect overseers for the crypto marketplace. Not only do they lack the statutory directive and powers to address market risks, their decision-making is further limited by the estate-specific focus of bankruptcy’s adversary process, the case-specific nature of bankruptcy disclosures, as well as general inexperience in addressing complex, esoteric, and systemic financial risks––especially risks arising outside prevailing regulatory frameworks. Relying on bankruptcy courts for quasi-regulatory assistance, instead of technocratic rulemaking, is thus profoundly problematic, as Part IV concludes.

I. CRYPTO’S MISSING REGULATORS

Despite acquiring popular appeal and developing a sophisticated array of financial services and products, the market for cryptocurrencies has come of age largely outside of a comprehensive system of regulation.⁵⁰

papers.cfm?abstract_id=4405036 [https://perma.cc/S8C4-TN4B] (discussing the legality of “regulation by enforcement” and exploring why agencies rely on this approach, alongside the trade-offs of doing so, especially in the context of using litigation to test novel/ambitious applications of law to innovation). There are many reasons to explain this historical gap in oversight. For one, the asset class is legally complex, with agencies, most notably the SEC and CFTC, publicly at odds over which of them has authority.⁵¹ In other words, jurisdictional wrangling is underway over whether some or all crypto-assets ought to be legally defined as securities (the purview of the SEC) or commodities (the purview of the CFTC)––this determination being critical to situating crypto within existing bodies of securities and commodities regulation. Additionally, digital assets are far from monolithic in their design, with different types of tokens implicating different kinds of risks and entitlements: more decentralized and volatile cryptocurrencies like Bitcoin, for example, operate distinctively from so-called stablecoins, digital assets typically attached to an identifiable issuer and designed to maintain a steady one-token-to-one-dollar correspondence.⁵² Even while navigating such definitional challenges, digital assets raise intriguing considerations for policymakers looking to calibrate their supervisory toolkit, such as: how should domestic national authorities oversee risks arising across decentralized, globally dispersed blockchains; and, do existing administrative processes suffice, or might regulators benefit from crafting tailored solutions to match novel attributes of the asset class (e.g., decentralization)?⁵³

This Part has two objectives. First, it summarizes key features of crypto markets to highlight some of its distinguishing features and risks. Second, it describes fundamental theories of financial regulation that generally explain and justify its application (e.g., to protect financial stability and enhance consumer welfare). This Part shows that crypto markets exhibit the kinds of risks that fall under usual rationales justifying the application of financial regulation. We observe, however, that the crypto market has evolved largely outside of a dedicated system of financial regulation, leaving it intrinsically vulnerable to costly externalities and failure.

A. Some Key Features of Crypto Market Structure

Broadly, the cryptocurrency market is made up of three major parts: (1) at its most fundamental, it originates within globally dispersed computer networks that work to produce a “distributed ledger” (or blockchain) recording the transactions submitted to and verified by each network; these automated networks often mint digital tokens/coins as a means of rewarding users that work to maintain the system’s integrity;⁵⁴

click&module=RelatedLinks&pgtype=Article [https://perma.cc/P7DL-YD3C]; Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System, Bitcoin.org 2–4, https://bitcoin.org/bitcoin.pdf [https://perma.cc/HFX5-DAWH]. (2) various types of more centralized firms like cryptocurrency exchanges and quasi-banks that intermediate access to cryptocurrency assets (e.g., coins) and offer related financial services and products;⁵⁵ and (3) a slate of digital applications aiming to offer financial products in a more decentralized manner, harnessing the verification capacity of blockchain networks. These applications derive their utility by running automated programs (colloquially, “smart” contracts), rather than relying on centralized firms like exchanges or banks to provide an intermediary service.⁵⁶ A detailed discussion of each of these component parts is outside the scope of this Article. However, the summary below outlines some of their defining characteristics (and risks).

1. The Building Blocks: Chains, Coins, and Ledgers

The origin story of modern-day cryptocurrencies emerges from the Bitcoin white paper, written by Satoshi Nakamoto, that sets out a vision for an entirely digital payments network capable of operating globally on a person-to-person basis.⁵⁷ Its radicalism lies in envisioning the creation of a payments system that does not look to centralized intermediaries like banks to validate flows of money, nor does it presuppose the power of the state to enforce bargains or maintain the integrity of the system. Instead, it conceptualizes an infrastructure for making payments that depends on a network of computers, running a common protocol, to verify and record transactions. In place of a bank checking key details (e.g., whether the sender has enough money in his account) or regulators monitoring transactions, these tasks are approximated by the application of computerized code. By running the Bitcoin protocol, participating networks of computers (“nodes”) apply verification rules that examine incoming transactions to check whether they conform to the protocol’s standards of accuracy and integrity. Once nodes agree, by consensus, that a transaction is valid, it can be accepted, processed, and written into the protocol’s “ledger.” Transactions are batched into blocks and presented for validation, a practice that has given rise to the nomenclature of the “blockchain.” Unlike a bank payment, which remains confidential between the parties and the bank, the ledger is public and verifiable. This transparency is supposed to provide a mechanism whereby external scrutiny constitutes a means of interrogating whether the system is running in a safe and trusted way (e.g., that the same coins are not being sent twice or double spent).⁵⁸ Once accepted and validated, transactions are generally irreversible. This aspiration for immutability provides a proxy for certainty and reliability within the system, where it is not subject to idiosyncratic changes by one or another player.⁵⁹

2021), https://medium.com/coinmonks/finality-in-bitcoin-f82890bf39b7 [https://perma.cc/ZHD7-NJLB] (noting that finality on the Bitcoin blockchain is probabilistic).

The “coins” underlying the Bitcoin blockchain speak to digital rewards given to those that work to safeguard the network. Within Bitcoin, the dispersed network of nodes is vulnerable to the risk that a node (or a group) turns malicious––seeking to disrupt its function or to use it for its own benefit (e.g., by only proposing transactions that are sent to accounts connected to operators of a malicious node).⁶⁰ To secure the network’s integrity, the blockchain looks to a system of “protectors” tasked with looking into the pool of transactions entering the system and picking those for approval that should meet the protocol’s standards.⁶¹

The network creates incentives for participants to become “protectors” by awarding “coins” to those that succeed.⁶² In the Bitcoin network, “protectors” can also collect any discretionary fees that users might attach to a transaction.⁶³ Bitcoin looks to a “proof of work” validation mechanism, where network protectors––or “miners”–– competitively deploy extensive computing power to solve a mathematical challenge. A winning miner then builds a block of transactions for the network to approve and receives new Bitcoin (and fees) for their effort.⁶⁴ The “proof of stake” validation mechanism is also common across major blockchains (e.g., Ethereum). Broadly, in a proof-of-stake blockchain, those that already have a number of coins in the system can win the chance to build the block and collect more coins (and fees) as rewards.⁶⁵

While this description is highly simplified, it serves to highlight some legal puzzles confronting regulators. Major blockchain networks, like Bitcoin or Ethereum, are global and open to anyone, anywhere, willing to download and run the relevant protocol on their computer.⁶⁶ Additionally, users do not give their real-world names in order to join, as they would when using a bank. Instead, users are known and accounted for on a blockchain by their “public keys,” a form of pseudonymous public handle, that links to a private password known to the user.⁶⁷ If a user loses her password, she cannot access her account or make and receive payments, meaning that value on the network is lost.

This globally distributed system, designed to operate outside of traditional private and public intermediation, presents unusual regulatory conundrums. How should U.S. regulators construct a system of rules capable of applying to an automated cross-border network that aims to avoid centralized governance and control altogether? What tools can regulation deploy to overcome information gaps, address potential misconduct, or costly fragilities existing within a blockchain’s operation?⁶⁸ And, what legal classification ought to apply to coins minted on blockchains: do they constitute securities or commodities under conventional stipulations of federal law, extending existing regimes to crypto assets; or, do they fall under an entirely different, more tailored legal category?

As such, while market regulation is usually equipped to accommodate innovation, crypto assets have come to pose a significant challenge.⁶⁹ For example, the definition of innovative kinds of security––as covered by the concept of an “investment contract” in the Securities Act of 1933––was elaborated by the 1946 case of SEC vs. Howey. Per Howey, a security is a claim that represents: (1) an investment of money; (2) in a common enterprise; (3) for profit; and (4) through the effort of others, where those that promote an investment exercise managerial control over any scheme.⁷⁰ A discussion of the jurisprudence born out of Howey is outside the scope of this Article. But concepts like “common enterprise” or “through the efforts of others” signal the difficulties confronting policymakers when seeking to apply conventional precepts to cryptocurrencies and their blockchains. Emphasis on miners/stakers extracting higher returns relative to other network participants, for example, sits uneasily with long-rooted notions of a horizontal common enterprise. The task of identifying promoters with managerial powers strains in the context of public blockchains that seek to structure themselves in ways that look to be deliberately diffuse from a governance standpoint and where self-help constitutes a basic rule-of-thumb.⁷¹ With these thorny definitional questions key to establishing how regulators legally assert authority in the first place, it is not surprising that debates on the issue have become contentious as between regulators themselves, each seeking to jostle for their agency to have primary jurisdiction.⁷² This administrative squabbling has arguably played an important part in delaying the production of a comprehensive system of rulemaking for digital asset markets, leaving them to evolve largely outside of everyday administrative oversight.

2. Centralized Finance in Crypto Markets

As much as decentralization is popularly perceived as the distinguishing feature of cryptocurrencies, the everyday experience of digital asset markets for many is often intermediated through “centralized finance.” Engaging with sophisticated blockchains, setting up public keys, protecting their private passwords, or learning technical specifics of the computing involved can act as a barrier to entry for the average person looking to enter the crypto market. Finding a party through which to buy and sell crypto on a blockchain might similarly be impractical for those unfamiliar or uncomfortable with searching online for brokers.

So-called “centralized finance” firms have emerged as essential conduits for mitigating these difficulties and increasing crypto’s appeal for the mainstream. Exchanges, in particular, have established themselves as organizing architecture for the crypto markets, bringing together volumes of institutional and retail users, developing a variety of financial products, and helping to popularize the asset class for everyday people.⁷³ By connecting to users through smartphone apps, advertising on prime time television slots (e.g., the Superbowl), and using top-flight celebrity endorsements, crypto exchanges like Coinbase, Binance, Kraken, and infamously, FTX have established a prominent position both within crypto as well as financial markets more broadly.⁷⁴

Exchanges deploy established market structure tools to connect cryptocurrency buyers and sellers. By creating an organized marketplace, users no longer have to worry about seeking out a counterparty privately within an ecosystem of pseudonymous users who could be located anywhere in the world. The need for self-help is also reduced. Centralized firms provide a known point of contact, capable of correcting problems (e.g., hacked accounts), as well as offering users compensation and recourse if they suffer damage.⁷⁵ Unlike public blockchains that demand that their users be capable of looking after their own interests or dealing with the consequences (e.g., irreversible transactions), exchanges offer services to facilitate uptake of cryptocurrency trading (e.g., by offering loans for trading, custody services, or educational resources). By reducing the transaction costs and building avenues for accessible participation, exchanges have introduced everyday users to cryptocurrency markets. Tellingly, leading exchanges were drawing in eye-catching trading volumes during most of 2021––the cryptocurrency market’s boom year. Binance, for example, intermediated around $7.7 trillion in trading over 2021, reportedly generating $20 billion in revenue.⁷⁶ FTX, founded in 2019, saw its valuation grow over 1000% in the course of 2021 to around $1.1 billion, soaring to $32 billion by 2022––before collapsing into insolvency in November 2022 and liqudidation in January 2024.⁷⁷ Even as trading volumes fell sharply with the onset of “crypto winter” and FTX’s failure, crypto exchanges remained financially significant for the digital asset ecosystem. In its first quarter earnings report for 2023, Coinbase reported revenues of $773 million, up 23% from the final quarter of the previous year.⁷⁸ In April 2023, Binance saw sharply reduced activity, losing almost 50% in trading volume, while still recording approximately $287 billion in trading activity for the month.⁷⁹

In addition to exchanges, centralized finance includes firms performing a variety of financial services (e.g., lenders, hedge funds, broker-dealers, and specialist traders). Cryptocurrency deposit/lending and investment firms, in particular, have assumed considerable importance. Crypto quasi-banks, for instance, took in vast sums of customer capital/crypto––offering lucrative interest rates on these deposits––and for a shot time profited handsomely by relending those deposits. Predictably, as the crypto markets suffered a sharp downturn in 2022, these entities were hit especially hard with loan defaults and collapsing collateral prices, pushing several of the more prominent quasi-banks into bankruptcy.⁸⁰

Take Celsius. Founded in 2017, Celsius billed itself as a way for everyday people to “unbank” themselves––meaning, exiting the traditional banking system and putting money into a vehicle that promised depositors tantalizing returns. At its height, Celsius marketed investments that would pay as much as 18% interest on customers’ crypto deposits. Given such dazzling promises, the firm ended up controlling assets of around $20 billion, reaching 1 million or so customers.⁸¹ Its business model relied on putting customer assets into high-yield, high-risk investments. The value of these investments eventually plummeted with the onset of “crypto winter” in May 2022. Owing approximately $4.7 billion to its customers and unable to make good, Celsius filed for Chapter 11 protection.⁸²

Genesis Global, alongside two of its lending subsidiaries, also found itself in Chapter 11 in January 2023. Genesis, too, functioned like a quasi-bank; it took in customer deposits, offering high interest rates, and redeployed those deposits as loans extended to other industry players, like hedge funds.⁸³ With a loan book totaling around $12 billion in 2021, Genesis found itself in a vulnerable position with the onset of “crypto winter”: first, it lent $2.4 billion (partially collateralized) to the defunct crypto hedge fund, Three Arrows Capital, that collapsed in Spring 2022; and, second, it lent hundreds of millions of dollars to FTX’s affiliated hedge fund, Alameda Research, which imploded a few months later.⁸⁴ The mounting losses, alongside larger struggles in the crypto market, contributed to Genesis entering into Chapter 11.⁸⁵

Centralized firms have come to exercise enormous economic influence within the cryptocurrency marketplace.⁸⁶ As exemplified by the likes of FTX, Celsius, and Genesis, centralized firms routinely hold deep pools of crypto capital and convene a crowded and diverse range of stakeholders within their institution.⁸⁷ This capacity to build scale and complexity within a purportedly decentralized marketplace is hardly accidental. As noted above, centralized firms often offer a range of services and conveniences that bypass many of the novel and technically quirky facets of crypto market structure.⁸⁸

The far-reaching pull of centralized platforms within crypto has given rise to sources of vulnerability, creating risk for everyday users and market integrity. For example, platforms routinely require customers to transmit the password to their crypto “wallets” to the venue.⁸⁹ Practically speaking, by taking custody of user passwords (or “keys”), the venue is able to move the user’s crypto into accounts (i.e., the “wallets”) that it (the platform) controls, meaning that assets can be pooled and placed by the venue into various onward investments. With the platform holding the customer’s passwords, users confront the risk that they lose control of––and, indeed, potentially even legal title to––their own assets.⁹⁰ Because crypto’s foundational design assumes that those that hold the password to an account constitute its owners, a platform’s custodianship can leave customers suddenly bereft should the platform fail or end up losing the passwords for whatever reason (e.g., a theft or fraud).⁹¹

From a broader structural standpoint, the ability of centralized firms to pool and deploy capital has resulted in the creation of fragile interconnections between various types of market participants. Described above, exchanges and firms like Celsius and Genesis have emerged as prolific investors, putting customer capital into various crypto ventures. Such investments have taken the form of loans––where funds have made their way into crypto-lending arrangements promising (sometimes) double-digit interest rates (e.g., Celsius). BlockFi, for example, found itself in Chapter 11 after making bad loans to failed hedge funds, Three Arrows and Alameda.⁹² But, they can also comprise equity investments. That is, platforms put capital into the riskiest slice of the corporate balance sheet in a bid to secure potentially unlimited upside should the venture succeed. Exchanges, for example, have emerged as active investors in start-ups. FTX, notably, collapsed holding an eclectic balance sheet comprising crypto as well as more mainstream equity investments, reportedly worth around five billion dollars at the time of its failure.⁹³ Seen as a whole, centralized finance firms have shown themselves to be economic lynchpins of the crypto ecosystem, creating close financial linkages between themselves, their customers, as well as any number of stakeholders through often opaque, complex investments. Such relationships have resulted in regulators confronting a broad tangle of interconnected exposures, where risks from one entity can be transmitted to other firms, and ultimately to everyday customers, resulting in potentially heavy economic fallout whose permutations are not understood ex ante and cannot be easily remedied ex post.

B. Rationales for Regulation in Crypto and Finance

Though crypto markets have evolved mostly outside of the regulatory perimeter, they showcase a number of features that have traditionally proven persuasive in anchoring oversight for financial markets: (1) vulnerability to systemic risks; (2) information asymmetries; and (3) customer and investor protection. While a full discussion examining theoretical grounds justifying financial regulation is outside the scope of this Article, the observations below demonstrate that the relative absence of oversight in crypto markets represents a costly gap out-of-step with established paradigms in financial market design.

1. Mitigating Systemic Risks

Traditional financial regulation is often justified by reference to the importance of reducing “systemic” risk.⁹⁴ The task of defining systemic risk, in practice, has proven to be notoriously slippery.⁹⁵

153927406281.pdf [https://perma.cc/MH65-GS8B] (noting the role of interconnectedness in the definition of systemic risks); Morgan Ricks, The Money Problem: Rethinking Financial Regulation, 52–77 (2016) (highlighting short-term run-risks within the unregulated money market sector as a key indicator of systemic risks, justifying financial regulation). Particularly in the shadow of the 2008 financial crisis, the capacious intervention of the federal government to backstop the safety of financial markets pointed to a concept whose parameters might only become clear ex post, when failure illuminates sources of previously unknown but intolerably high risks within the marketplace. Even as banking regulators invoked an emergency “systemic risk” exception to fully protect deposits at two fairly large but relatively niche banks in March 2023 (Silicon Valley Bank and Signature Bank), the ensuing debate surrounding the need and propriety of such interventions has only served to underscore the tricky boundaries of conceptualizing systemic risk and what regulators ought to do about controlling it.⁹⁶

Notwithstanding these definitional difficulties, containing systemic fallout has long been a critical objective of financial regulation. Broadly seen, it references two core scenarios. The first scenario is one in which a firm’s behavior leads it to take risks that result in it creating dangers that can spread far beyond its own four walls. In other words, a risky, failing firm lacks the resources to pay for its own behavior, forcing others to bear the losses, risking collapse themselves. The second scenario is where a shock to the market (e.g., a pandemic) causes similarly situated firms to face potential distress, resulting in crisis impacting multiple firms simultaneously.⁹⁷ Simplifying things, certain kinds of firms have traditionally been viewed as being especially susceptible to failure, with the potential to trigger a larger crisis. Specifically, firms vulnerable to sudden runs––for example, they owe money short-term and may have invested it in longer-term ventures––can face catastrophe if creditors seek to take out their money all at once. This can force a firm to sell its longer-term investments at distressed prices, plunging its balance sheet into the red, as assets end up fetching less than the money it owes. Conventionally, banks represent the quintessential purveyors of such run-risk. Their depositors constitute short-term (on-demand) creditors, while their assets typically take the form of longer-term loans. But, exemplified by the wide-ranging rescue of institutions like money market mutual funds in 2008, other types of firms and markets can become vulnerable to sudden crises, setting-off the possible specter of systemic collapse.⁹⁸

Regulation normally wields a range of tools to prevent such crises from occurring, as well as to respond to them when they do. Ex ante levers can include, for example, mandatory requirements on vulnerable firms to maintain buffers of high-quality assets that make a firm safer and less likely to end up without money.⁹⁹ Firms might be subject to regular “stress tests,” designed to interrogate how well they might withstand a sudden shock.¹⁰⁰ Federal insurance might prevent customers from panicking and rushing for the exits, where the state stands behind the promises made by a financial firm. U.S. bank accounts, notably, are protected by insurance that promises to cover up to $250,000 worth of deposits.¹⁰¹ Expert monitoring by regulators can help spot and punish the kinds of risky behaviors that might lead to a crisis and loss of customer confidence.¹⁰² In turn, ex post tools can also mitigate harm as and when they arise. Regulators might step in with emergency loans. The Federal Reserve, for instance, offers banks a “lender of last resort” facility, providing bridge lending during difficult times.¹⁰³ In extreme cases, liquidity support can take the form of federal facilities set up with the specific purpose of prioritizing systemic stability, even if such rescues protect firms that otherwise deserve to fail.¹⁰⁴ Or, if there is no prospect of a rescue, a specialist insolvency regime can step in to wind down a failing institution before its collapse can contaminate the rest of the market. In the context of banking, the Federal Deposit Insurance Corporation¹⁰⁵ operates a resolution regime for failed banks, designed to ensure that their loans and deposits can be transferred to viable firms without lengthy bankruptcy regimes that might leave depositors in limbo.¹⁰⁶

Crypto markets have shown themselves capable of inhabiting an ecosystem where systemic risks can manifest in a number of ways. First, as highlighted above, it is home to a number of centralized firms that constitute singularly important points of failure. Crucially, these firms have tended to become interconnected to a web of stakeholders, creating transmission pathways for losses to flow from one institution to another. FTX offers perhaps the most compelling example of such entanglement, where its sudden failure caused firms like BlockFi and Genesis also to seek bankruptcy protection.¹⁰⁷ Several traders failed too, as they were unable to retrieve their deposits from the FTX the platform.¹⁰⁸

Second, major centralized firms have shown themselves exposed to the costs of sudden runs, where customers seek to retrieve their funds en masse resulting in the platform suffering a cash crunch. FTX is again case in point, experiencing a wave of redemption requests from fleeing customers, eventually causing the firm to pause withdrawals.¹⁰⁹ Celsius, too, is instructive. According to a study by the Federal Reserve Bank of Chicago, 35% of all withdrawals in June 2022 (just before Celsius filed for bankruptcy protection) came from relatively wealthier depositors–– customers each with crypto worth more than $1 million in their accounts.¹¹⁰ Those holding $500,000 ended up being the fastest to retrieve their money. Put differently, larger institutional customers, likely possessing financial sophistication and reasonably roomy balance sheets, were among the most liable to trigger a panic. And, by dint of their size and resources, their private instincts to run resulted in a cost on those that could not adjust their behavior as quickly (i.e., less wealthy customers).¹¹¹

Unlike traditional markets, however, exposure to run-risk has come without the usual ex ante and ex post levers that might mitigate panic and control the costs of fallout. Even as a swath of crypto market participants––retail as well as institutional actors––faced the prospect of devastating losses, they lacked recourse to protections taken for granted in traditional financial markets (e.g., federal deposit insurance).

2. Addressing Information Gaps

A second key objective of financial regulation lies in addressing information gaps and the costs that they pose.¹¹² This involves ensuring that regulatory supervisors as well as market participants can acquire insight about the riskiness of claims and assets alongside an understanding of the institutions that operate within the perimeters of financial and capital markets. In seeking to intermediate the informational environment, policy can also seek to create ways in which thorough due diligence becomes less important, for example, where the claims being issued are presumed to be so safe that detailed investigation would be a waste of time and money.¹¹³ Broadly seen, regulation can work to provide tools and create incentives for reducing information costs, improving the accuracy by which risk is priced. It can help firms and investors protect themselves by equipping them with insight as well as offer spaces for creating informationally-insensitive claims, contracts that do not need a great deal of due diligence owing to their perceived safety, connecting parties in situations that might otherwise showcase complexity, and unknowable risks.¹¹⁴

perma.cc/2ZHA-GLDT] (highlighting varying interpretations of the notion of information insensitivity). A full discussion of this interplay between information deficits in markets and regulation is outside the scope of this Article. A few examples, however, serve to underscore how foundational this relationship is for shaping key aspects of market design.

First, regulation can help ensure that the marketplace enjoys a baseline level of insight about key claims and assets. When a company issues equity or debt in public markets, the worth of the promised cash flows emerges through an understanding of the capacity of the firm to deliver on its promises. At a very general level, whether and how it can do so constitutes a function of many aspects of its enterprise, such as its organization, governance, business model, and industry. This multiplicity of factors helps shape the kinds of results that a firm can achieve and, ultimately, what kinds of future cash flows investors and other stakeholders might expect to receive.¹¹⁵

Regulation has stepped in to overcome some of the frictions that might cause actors to withhold information about their firm. As modeled by Sanford Grossman and Oliver Hart, disclosure can be excessively costly for a firm, creating a disincentive for revelation. It also might expose a firm to outside scrutiny, give away competitive secrets, or highlight managerial failures.¹¹⁶ At the same time, where the firm constitutes the most knowledgeable repository of its own activities, the chances that single investors (or even regulators) might be able to obtain information efficiently about and from it are slim, if not outright impossible. Everyday investors will not be able to muster the resources, or obtain the access needed, to acquire key details of the risks governing their claim. Even deep-pocketed institutional investors may be loath to share the fruits of their labor, forcing others to replicate the same research and analysis that might still be incomplete.¹¹⁷

Where firms have few incentives to distribute information freely, regulation can mandate full and honest disclosure. In seeking to punish those that fail to disclose or lie, regulation modifies the incentives against putting information into the marketplace. Such broad and freely available distribution of prized information affords all investors access to this knowledge, reducing the pressure on their own pocketbooks and minimizing the risks of duplicative investigation. Rather, investors might focus on honing the quality of their analysis, making money, or deriving some other gain by bringing new interpretations of the disclosures to the fore.¹¹⁸ In this way, investors can learn about the kinds of risks that they are carrying in a relatively systematic and thorough manner. They can protect themselves by charging more for their capital, taking other precautions (e.g., putting only so much at risk as they are willing to lose), and ensuring that their prior biases and expectations are better kept in check.¹¹⁹

In addition to ensuring information about claims, regulation provides ways to increase understanding about entities within the marketplace. Regulators benefit from knowing whether entities that are active within financial markets can do so safely and have the resources to fulfill their obligations to stakeholders (including customers). This also entails supervisors knowing that firms can look after themselves, with sufficient and accessible resources to pay creditors and to reduce the systemic risks they create for others.¹²⁰ In place of enabling a free-for-all, allowing anyone to set-up shop, regulation imposes stipulations designed to procure detailed information from a firm. For example, eligibility criteria demand that those seeking to do business satisfy entry conditions concerning internal corporate governance, balance sheet capacity, and customer protection.¹²¹ Supervisors can conduct examinations on a regular basis to assure themselves that the firm conforms to expected rules and standards. Enforcement actions offer regulators and others a mechanism to learn more about an entity generating suspicion (e.g., via discovery).

Finally, regulation can control information gathering and dissemination to account for some of the costs and effects of disclosure. In particular, regulation can determine who gets data, how fully, at what speeds, and at what time intervals. Even where transparency constitutes a valuable policy goal, full openness to the inner workings of complex institutions can, in some situations, constitute a risk in itself. For example, regulators are typically careful about how much information is publicly disclosed about banks (e.g., through stress tests or supervisions).¹²² Revelations about a bank’s balance sheet might foster panic where information ends up interpreted by the public as presaging a collapse, triggering a needless run on the firm.¹²³ Relatedly, developing disclosure regimes can also look to policies in which the goal lies in ensuring that relationships do not have to require detailed disclosure between parties. For example, where money is lent on a very short-term basis and fully collateralized, lenders have less need to invest in uncovering information on a borrower. Instead, this debt becomes more informationally-insensitive, allowing for credit to flow more quickly, with fewer formalities, and still providing for risk mitigation by the terms of the debt agreement.¹²⁴

Limited comprehensive regulation for cryptocurrency markets has thus resulted in a relative paucity of tools for addressing the need to create information about the quality of claims being traded and market participants.¹²⁵ Interestingly, crypto represents a unique mix between the transparent and opaque. On the one hand, it is defined by its reliance on blockchains, which intend to provide the ultimate in transparency––by ensuring that each transaction is readily inspectable¹²⁶––as described above.

On the other hand, crypto’s larger ecosystem is opaque, with critical aspects of its workings taking place without adequate standardization and verifiability. For a start, digital assets themselves can exhibit unknown risks for which even the traditional regulatory system can be a poor match. Crypto inhabits an informationally complex environment from the point of view of its technology. As Chris Brummer, Trevor Kiviat, and Jai Massari observe, crypto combines legacy informational deficits (e.g., about a token issuer’s internal governance) with novel considerations about technological riskiness that conventional regulatory paradigms are ill-suited to match.¹²⁷ Without an applicable and properly tailored regulatory framework, token holders must take on the costs of diligence privately. Even where they can get some help (e.g., through “white papers” that typically launch new crypto ventures), a lack of regulatory vetting for these disclosures can result in limited accountability for those producing them.¹²⁸ Exchanges too might demand information from token issuers seeking to list the asset on their exchange. But, even here, the approach is ad hoc and varies by venue, creating a hodge-podge of regimes for customers to try to follow.¹²⁹

Crypto market regulation also lacks tools to acquire information about key market participants. As noted earlier, exchanges are key pillars within the crypto ecosystem. Notwithstanding this significance, considerable uncertainty exists about their inner governance, the quality of their balance sheets, or their readiness to respond in a crisis. According to a May 2023 Financial Times survey of 21 of the most prominent crypto firms, many refused to supply critical information about their governance, measures for customer protection, and balance sheets––underscoring concerns raised in the wake of “crypto winter” failures about opaque and complex governance structures that pose a risk for stakeholders.¹³⁰ In the absence of express disclosure regimes to stipulate eligibility criteria or supervisory regimes to ensure compliance, certain crypto firms appear to lean heavily on opacity as a part of their business model.¹³¹

3. Protecting Customers and Stakeholders

Perhaps the most straightforward rationale for financial regulation lies in protecting customers and stakeholders.¹³² Investors and financial consumers routinely fall prey to scams, display biases and impulsivity, and open themselves up to losses that can result in enormous personal suffering.¹³³

perma.cc/A9GZ-CNJV] (noting the especial prevalence of investment fraud); Sec. & Exch. Comm’n, Social Media and Investment Fraud––Investor Alert (Aug. 29, 2022), https://www.sec.gov/oiea/investor-alerts-and-bulletins/social-media-and-investment-fraud-investor-alert [https://perma.cc/PK5W-ZKDG] (noting the ways in which social media might lure investors in scams). Beyond safeguarding customers against predation, regulation can also step in to secure financial assets and their integrity. Predictably, where vast pools of customer money are entrusted to an agent (e.g., a fund or bank), there is the risk of misuse, misappropriation, and mismanagement. To counter such “agency costs,” regulation provides a slew of measures to safeguard customer interests and counter the negative incentives of those holding money for others.¹³⁴

Arguably the most consequential for a customer’s everyday peace-of-mind are rules designed to ensure that their assets are safely custodied and accounted for, and, where custody arrangements work, to prevent such assets from being mingled with those of the agent (e.g., a broker) in the event of an agent’s insolvency. Customer protection rules in securities and commodities regulation, for example, set out detailed procedures for ensuring that customer assets are diligently protected.¹³⁵ A variety of measures enable such assurance to be offered through regulation. For example, rules governing brokers of traditional securities and commodities provide that customer assets must be fully segregated, so that there can be no mixing between a broker’s funds and those of the customer.¹³⁶ Additionally, the broker must rigorously track how customer assets are being handled and can only entrust them to reputable custodians. To ensure compliance, firms face examination by regulators and must maintain an appropriate paper-trail.¹³⁷ Firms that fall short risk economic penalties and may suffer reputational damage.¹³⁸ Those risks can extend to supervisors, incentivizing more rigorous policing. When the failed brokerage firm, MF Global, was found to have breached applicable rules for protecting and safekeeping customer assets, its frontline regulator (the Chicago Mercantile Exchange) came under heavy scrutiny¹³⁹ and ultimately paid $130 million to the broker’s customers.¹⁴⁰

Crypto customers are subject to similar risks (e.g., being scammed and seeing their funds stolen or misappropriated) but they do not today enjoy specific protections as part of a regulatory scheme. This leaves crypto customers exposed to a slew of dangers that they have little power to mitigate, while being afforded few practical levers under law to safeguard their interests privately. The costs of this regulatory gap have come into sharp focus, as millions of everyday crypto customers fell victim to a series of high-profile firm failures during 2022’s “crypto winter,” leaving them caught in uncertain and costly bankruptcy proceedings, rather than protecting them from these processes in the first place.

II. BANKRUPTCY IN CRYPTO WINTER

Part I charted the limited federal regulatory landscape for the cryptocurrency industry. Post-pandemic, the crypto-market experienced sharp growth and, as a result, there was a period of time during which the digital asset marketplace was flush with customer money and able to operate freely in the relative shadows outside of a dedicated system of oversight. This created, predictably, room for mischievous C-Suite behavior, where billions in customer deposits could be lured with promises of outsized returns (typically adorned with marketing puffery about corporate integrity, transparency, and investment safety) but without providing customers any real capacity (e.g., through mandated disclosures) to know what was truly happening. A series of catalytic events would bring down large segments of the industry in mid-2022, starting the so-called “crypto winter.” Major Chapter 11 filings followed. But, while bankruptcy is used to cleaning up individual corporate messes, it is not the arm of government usually charged with taming unruly facets of a financial system. But, by necessity, that has become an inadvertent aspect of the work performed by bankruptcy courts in seminal crypto cases, as described in this Part below.

A. A Brief History of Crypto Winter

In May 2022, the Terra/Luna stablecoin ecosystem suffered a surprise crash, wiping out approximately $60 billion in value from digital asset markets.¹⁴¹ The hedge fund Three Arrows Capital held significant investments in Luna and, consequently, was immediately forced into liquidation in the British Virgin Islands.¹⁴² This resulted in the default of around $657 million in unsecured debt Three Arrows owed to Voyager, the crypto quasi-bank and brokerage firm.¹⁴³ As word spread, Voyager became inundated with customer withdrawal requests, prompting it to suspend trading and redemptions¹⁴⁴ A week later, Voyager filed for Chapter 11 protection.¹⁴⁵ Contagion also hit Celsius, another crypto quasi-bank. Celsius too was required to pause customer redemptions and withdrawals, ending up in bankruptcy come mid-July.¹⁴⁶ BlockFi, yet a third large quasi-bank, avoided bankruptcy by tethering itself to FTX, securing emergency financing from the then-powerful exchange.¹⁴⁷

On November 2, 2022, a leading news service dedicated to cryptocurrency, CoinDesk, reported (based on a leaked internal document) that the wealth of FTX’s hedge fund affiliate, Alameda Research, was largely comprised of FTX’s native token, called FTT.¹⁴⁸ This crypto asset was issued by the exchange itself and offered to customers, promising holders a variety of rewards like reduced trading fees, loyalty benefits, and miscellaneous customer services.¹⁴⁹ As the exchange’s popularity had grown, so too had the market value of FTT, even though the token’s intrinsic worth was controlled in key ways by FTX management (e.g., by calibrating the available float).¹⁵⁰ Thus, for purposes of determining FTX’s enterprise value, FTT may be better likened to FTX treasury stock than value independent of the corporate entity itself. ¹⁵¹

Prior to this publication, the public did not know the skewed composition of Alameda’s balance sheet. Once disclosed, the market reacted with fury. Binance, for example, promptly announced it would sell all of its FTT holdings.¹⁵² Watching its enterprise value plummet, FTX immediately offered to sell itself to Binance––which alone seemed financially positioned to catch the company in free-fall.¹⁵³ After some cursory due diligence, Binance passed on the offer,¹⁵⁴ thickening the cloud of suspicion hovering over FTX. Nine days after CoinDesk’s publication, FTX collapsed into bankruptcy.¹⁵⁵ Restructuring specialist John J. Ray III was appointed to succeed Bankman-Fried as CEO, and Ray promptly declared that, in his “40 years of legal and restructuring experience,” he had never seen “such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.”¹⁵⁶ Bankman-Fried was soon arrested.¹⁵⁷

FTX’s sensational collapse deepened 2022’s “crypto winter.” The token native to Crypto.com, another large exchange, lost $1 billion in market value virtually overnight.¹⁵⁸ BlockFi, facing another round of withdrawal demands, liquidated all of its domestic crypto portfolio and filed for Chapter 11 protection.¹⁵⁹ Core Scientific, one the largest crypto mining firms, also filed for bankruptcy.¹⁶⁰ Genesis, the brokerage firm, lasted outside of bankruptcy only until mid-January 2023,¹⁶¹ as discussed above. Smaller and ancillary crypto companies succumbed as well.¹⁶²

On January 31, 2023, the court-appointed examiner in the Celsius Chapter 11 case filed her final report.¹⁶³ Purportedly, Celsius too operated in a deceitful manner: “In every key respect—from how Celsius described its contract with its customers to the risks it took with their crypto assets—how Celsius ran it [sic] business differed significantly from what Celsius told its customers.”¹⁶⁴ On July 13, 2023, the company’s founder and CEO, Alex Mashinsky, was arrested and charged with seven criminal counts, including securities and wire fraud.¹⁶⁵

The rash of bankruptcies and revelations of customer deception––following patterns that overlap across companies––began infusing popular culture. Late night television hosts turned crypto headlines into crypto punchlines.¹⁶⁶ The FTX logo was removed from the Miami Heat’s stadium.¹⁶⁷ Consumer fraud claims were filed against not only crypto executives but also celebrities that had provided paid endorsements.¹⁶⁸ Charlie Munger, Berkshire Hathaway’s venerable chairman, declared the cryptocurrency market to be “stupid and evil” and that digital assets are only useful to “kidnappers.”¹⁶⁹ Both chambers of Congress began a series of hearings focused on, among other things, what the government should do to rein in the perceived lawlessness.¹⁷⁰ But, neither Congress nor traditional regulatory arms of government (e.g., SEC and CFTC) seized the moment, essentially deferring to bankruptcy courts to assume immediate responsibility.

Chapter 11 thus became the default legal framework, overseeing not only the affairs of each individual debtor but also, seemingly, the trajectory of the industry more generally. Millions of individual customers had entrusted tens of billions to debtors that, collectively, controlled a substantial share of the ecosystem. How could all of this have happened? What kinds of value-maximizing strategies would be available to resolve these cases and deliver real value to customers as quickly and efficiently as possible? And how could bankruptcy’s recuperative powers help an industry in tumult, with government agencies still competing for jurisdiction, and a regulatory void still in existence? This simultaneously became the charge of several bankruptcy courts, primarily in New York, Delaware, and New Jersey. But, to better understand their particular case work, it first must be contextualized through the lens of Chapter 11’s general missions and mechanisms.

B. A Primer on Chapter 11’s Missions and Mechanisms

Chapter 11’s baseline theory is that business reorganization is preferable to liquidation.¹⁷¹ Rehabilitating productive, albeit insolvent, firms can generate more distributable value.¹⁷² It insulates contagion by preserving and continuing customer/vendor relations, jobs, retiree benefits, and future tax payments.¹⁷³ Reorganization also helps solve the so-called “common pool” problem––that is, the tendency of competing creditors to destroy value by racing to take before all others––by channeling stakeholders toward a durable system that prioritizes distributable value (e.g., equity in a reorganized entity) over distributable cash.¹⁷⁴ And, it provides legal rules that are not only flexible but also sophisticated about emerging economic and market theories,¹⁷⁵ as exemplified by developments in distressed debt financing and investment techniques.¹⁷⁶

The Bankruptcy Code, for all its size and complexity, boils down to five essentials: (1) the creation of the bankruptcy estate;¹⁷⁷ (2) the statutory pause and protective blanket of the automatic stay;¹⁷⁸ (3) interim steps a debtor may take to maintain and hopefully augment enterprise value, such as entering into a new financing arrangement (“debtor-in-possession” or “DIP” financing)¹⁷⁹ and the rejection of burdensome contracts and leases;¹⁸⁰ (4) rules governing value distribution to stakeholders, typically via a confirmed plan of reorganization;¹⁸¹ and (5) the debtor’s entitlement to lead the bankruptcy,¹⁸² subject to an effective adversary process.¹⁸³ The outcome is, in theory, supposed to distribute reorganization value largely consistent with stakeholder expectations established pre-petition under contract and other non-bankruptcy law.¹⁸⁴

The Bankruptcy Code does not look much further than the interests of the debtor and its stakeholders.¹⁸⁵ It provides a list of options available for the debtor to try to solve its financial woes; and, it offers rights and empowerments enabling stakeholders to counter or even undermine the debtor’s intended reorganization strategy.¹⁸⁶ The debtor is required to continue post-petition as a law-abiding corporate citizen¹⁸⁷ and the government’s police powers are excepted from the automatic stay.¹⁸⁸ But, the “general public interest” finds little quarter in the statutory regime.¹⁸⁹ The adversary process, rather, pits the debtor on one side of the bargaining table (and courtroom) against its stakeholders––typically, bank lenders and the official committee of unsecured creditors––on the other side.

Bankruptcy court jurisdiction hews close to this scheme. Bankruptcy courts are not Article III tribunals with full judicial power over life, liberty, and property; bankruptcy courts are, rather, Article I tribunals of limited authority.¹⁹⁰ Bankruptcy judges may only decide issues that are “core” to the bankruptcy, meaning those “arising in” or “arising under” the Bankruptcy Code.¹⁹¹ That includes matters such as DIP financing, asset sales, contract assumption or rejection, and plan confirmation¹⁹² Bankruptcy courts also may adjudicate matters “related to” the bankruptcy, but only if the litigants consent;¹⁹³ otherwise, the court may only issue proposed findings of fact and conclusions of law for the overseeing district court to consider.¹⁹⁴ Bankruptcy courts cannot conduct jury trials without litigant consent;¹⁹⁵ they cannot send anyone to prison for criminal contempt;¹⁹⁶ and, they cannot render judgments on personal injury claims.¹⁹⁷ Matters beyond what directly concerns the debtor and its stakeholders are for other courts to decide.¹⁹⁸

Separately, bankruptcy’s adjudicatory process is peculiar. In most commercial litigation, the plaintiff seeks redress for a past event. An alleged wrong happens, and the trial can be scheduled any time after the complaint is filed and pre-trial procedure has run its course. Chapter 11, by contrast, litigates to a future event, again most often confirmation of a plan of reorganization. The debtor’s business rehabilitation is, in other words, a sort of “becoming” in which much of the nucleus of operative fact develops post-petition, as the reorganization takes shape.¹⁹⁹ The process is, nevertheless, often pressured and time constrained. The debtor’s exclusivity periods to file and then solicit acceptances for a plan are not limitless.²⁰⁰ And, in cases where DIP financing is required (that is, most business cases), it is customary for such loans to include “milestone” covenants or a near-term maturity––essentially a ticking timebomb for the case.²⁰¹ The debtor must move the case along quickly, all the while meeting performance and other covenants, or the DIP lender may cut off liquidity.²⁰² The adjudicatory process thus invariably melds legal principle with pragmatism and business necessity.²⁰³ The Bankruptcy Code allows for this by establishing rules that, among other things, lean heavily on judicial discretion.²⁰⁴ But, in practice, that means bankruptcy courts are often required to make interim case decisions on relatively thin evidentiary records, always trying to preserve and advance the process to some form of successful outcome. ²⁰⁵

Further, getting to a confirmable plan can be brutal work.²⁰⁶ Section 1129 of the Bankruptcy Code imposes extensive structural, voting, and evidentiary requirements for plan confirmation, especially for so-called “cram down” on non-consenting classes.²⁰⁷ Stakeholders use those rules for their benefit, threatening and jockeying for larger helpings.²⁰⁸ They may accumulate “blocking” positions in critical debt classes.²⁰⁹ They may contest ambiguities and assumptions undergirding the debtor’s business plan and proposed reorganization value.²¹⁰ They may strategize to exclude others from plan treatments²¹¹ or exploit the debtor’s desperation for DIP or exit financing.²¹² Stakeholders exploit ingenious structures to fleece others in the capital structure, sometimes even above or within the same class.²¹³

These cases can, in sum, burn hot in their own self-contained crucible until extinguished by winnowing fuel or other paramount need for resolution. The announcement of a plan, any plan, can bring about hope and a sense of relief. The costs can be astounding, both in terms of administrative expense and consumption of judicial resources.²¹⁴ This is especially true in complex, multilayered cases.

To avoid this, bankruptcy tends to nudge stakeholders toward settlement. It does this in two primary ways. First, the Bankruptcy Code compels disclosure of substantial private information. Mandatory public disclosures include the debtor’s schedules of assets and liabilities,²¹⁵ statement of financial affairs,²¹⁶ monthly operating reports,²¹⁷ and a disclosure statement to inform voting on any plan of reorganization.²¹⁸ A debtor will invariably supplement the record with additional disclosures as it seeks interim relief from the bankruptcy court over the course of its Chapter 11 case.²¹⁹ Stakeholders may demand discovery in connection with any case dispute.²²⁰ They also may seek extraordinary discovery from the debtor and third-parties under Bankruptcy Rule 2004, so long as such discovery may serve a useful bankruptcy purpose.²²¹ In cases involving disconcerting facts, the bankruptcy court may order the appointment of an examiner to conduct an investigation and publish a “tell-all” report of their findings.²²² In these ways, bankruptcy embraces the unremarkable proposition that knowledgeable negotiations are ultimately more efficient and efficacious. Bankruptcy courts enforce this expectation.

Second, bankruptcy courts render decisions over the course of the Chapter 11 process that narrow points of disagreement. “Contested matters,” i.e., general bankruptcy motion practice, are resolved with procedural expediency;²²³ “adversary proceedings,” i.e., mini-lawsuits within the bankruptcy, follow more traditional federal civil procedure.²²⁴ But, either way, the bankruptcy court will often bring the matter to a quick evidentiary presentation, followed by a clear ruling that guides the case towards larger resolution. A bankruptcy court might, for example, determine, well in advance of a plan, whether a creditor does or does not have a perceived value entitlement; by resolving the dispute (one way or the other), the court clears a path to more effective plan negotiations.²²⁵ Same is true for corporate decision-making: if the case generates substantial allegations of corporate wrongdoing and such allegations start to inhibit negotiations, the court may prompt management changes.²²⁶

Respecting financial firms (e.g., a bank holding company or brokerage firm), bankruptcy relies on and works in tandem with regulatory authorities.²²⁷ By the time of filing, a financial debtor typically has been policed by government regulators (e.g., the SEC, CFTC, or the Fed) for quite some time. The company’s books, records, public disclosures, and manner of business have long been based on rules and expectations established by those administrative supervisors.²²⁸ The regulatory interplay is supposed to continue post-petition, with bankruptcy focusing primarily on a reworked balance sheet and regulatory authorities keeping an eye on operational developments.²²⁹ This affords regulatory agencies some leeway to intervene in the bankruptcy, asserting non-economic imperatives. As Jared Ellias, George Triantis, and Robert Rasmussen have observed, the interplay between bankruptcy and regulatory regimes can generate considerable case frictions.²³⁰ But, if all goes well, the company leaves bankruptcy in a stronger financial position, without objections voiced by regulatory supervisors.²³¹

This is the context in which bankruptcy courts have been engaged to oversee the factual development and consider the legal implications of 2022’s “crypto winter.” The crypto bankruptcies have, to date, shed disinfecting light on some of the industry’s darkest corners, revealing what may have occurred there and who may bear responsibility for the staggering losses. Bankruptcy courts have also rendered rulings that not only propel their cases forward, but also instruct the crypto community––and market regulators––more generally. Bankruptcy has, furthermore, provided a unique forum for regulatory involvement and, it seems, an occasional clash of economic and agency agendas. Below, we set out two case studies that exemplify the ways in which the bankruptcy court has emerged as a sort of default regulatory forum for crypto markets.

C. Crypto in Chapter 11: The Celsius and Voyager Cases

1. Celsius

Celsius, founded in 2017 and led by Alex Mashinsky, grew over a few years to be one the largest crypto finance platforms in the world. It presented itself as a sort of virtual bank. Individual customers could electronically, via computer or cellphone, deposit their crypto assets in a Celsius “Earn” account (akin to a traditional savings account) and accrue a relatively high rate of interest, payable in kind or in the Celsius native token, called the “CEL.”²³² Customers could borrow fiat money from Celsius (e.g., to pay household expenses with fewer tax consequences)²³³ collateralized by their deposited crypto in the Earn account.²³⁴ Celsius would, in turn, lend deposited crypto to third-parties, pocketing what it made in interest/fee income over what it owed to the account holders.²³⁵

Earn accounts, though functioning economically like general savings accounts, were not insured by the FDIC.²³⁶ Not to worry, said Celsius. The company’s management emphasized “safety,” touting that “our top priority is keeping your assets secure.”²³⁷ Celsius would not lend capital to third-parties without first conducting extensive diligence, and would use deposited capital only in “a very conservative” way, “such as only allowing very small or overcollateralized positions.”²³⁸ Even though Celsius was not a public reporting company, customers were promised even better disclosure: Celsius committed to “publish to a blockchain all our transactions which will provide users transparency as to how many coins we have and what they are used for.”²³⁹ Any Earn account holder that did not like how the business was operating had the ability to pull his money out at a moment’s notice.²⁴⁰

The company’s marketing strategy also sought to play into crypto’s anti-establishment ethos. As discussed above, Celsius was a home for those wanting to “unbank” themselves and thereby enjoy a newfound “financial freedom.”²⁴¹ Here, an everyday customer could “dream big” and help pursue “economic opportunity and income equality to everyone in the world,”²⁴² just as the people were freed from quarantine and the so-called “Great Resignation” became a mass phenomenon.²⁴³ Mashinsky presented himself as the leader of this “financial freedom” movement.²⁴⁴

The marketing strategy worked. By December 2020, Celsius had more than $3.3 billion under management²⁴⁵ and, by January 2021, that figure had grown to $4.5 billion.²⁴⁶ In October 2021, the business was valued at $3 billion.²⁴⁷ Management expedited plans to grow internationally, including the acquisition of an Israeli cybersecurity firm in October 2021.²⁴⁸ Come May 2022, Celsius had almost $12 billion under management and more than $8 billion in loans outstanding to third- parties.²⁴⁹ It boasted 1.7 million registered users by July 2022.²⁵⁰ Then it all came to an abrupt end: Luna’s collapse segued into a run-on-the-bank scenario for Celsius, leading to a brief suspension of withdrawals, and the company’s emergency Chapter 11 filing on July 13, 2022.²⁵¹

The bankruptcy was, from its inception, surrounded by controversy. In his “first day” declaration, Mashinsky asserted that Celsius was a sound, well-run company victimized by extraneous forces and rumor mongering.²⁵² He attributed the company’s financial troubles to the “macroeconomic” crypto environment and world economy, with only passing reference to certain “poor asset deployment decisions.”²⁵³ Purportedly, the bank-run was due to “unsupported and misleading” news reports.²⁵⁴

For many, the narrative did not add up. How could Celsius find itself in this position if it deployed capital in only “very conservative” ways? Indeed, Mashinsky’s own declaration admitted a “shortfall” in its balance sheet of at least $1.2 billion and about one-third of its loan book was comprised of “bad” debt.²⁵⁵ Moreover, news outlets started reporting that, while Celsius was touting CEL, Mashinsky was liquidating tens of millions of the native token from his personal account.²⁵⁶ Former employees began leaking stories of excessive risk-taking, disorganization, and perhaps even market manipulation.²⁵⁷

On September 14, 2022, the bankruptcy court entered an order directing the appointment of an examiner to conduct a broad-ranging investigation into the facts undergirding the case.²⁵⁸ Two weeks later, Mashinsky resigned as CEO.²⁵⁹ On September 29, 2022, the bankruptcy court approved the appointment of former federal prosecutor, Shoba Pillay, as examiner.²⁶⁰

On January 30, 2023, Pillay published her “tell-all” final report, a scathing 689-page description of the company and its historical practices. The report explained: (1) how the cryptocurrency ecosystem operates;²⁶¹ (2) Celsius’ important role in that ecosystem as a sort of virtual thrift bank for millions of individual customers;²⁶² (3) how the business operated day-to-day, including granular investment choices;²⁶³ and (4) how those operations and business decisions differed materially from what was represented to customers.²⁶⁴ Despite customer promises of disclosure and transparency, Celsius “frequently” made statements “that were inaccurate and misleading.”²⁶⁵ According to the report, Celsius ultimately could not generate earnings over what it owed customers, driving it into ever riskier investments that ultimately caused its undoing.²⁶⁶ The report includes an internal email describing certain corporate strategies as “very ponzi like.”²⁶⁷ It also revealed that, despite mounting corporate losses, Mashinsky pocketed nearly $70 million by selling his personal holdings in CEL, while the company was hawking CEL’s (supposed) intrinsic value to the market.²⁶⁸ The final report is a detailed account that, again, likely contributed to Mashinsky’s indictment and arrest seven months later.

Disclosure aside, Celsius came to bankruptcy with billions in assets, including fiat cash, crypto assets, a loan book, mining interests, and other hard and inchoate assets,²⁶⁹ which needed allocation among and distribution to the company’s creditors (predominantly customers). Prior to bankruptcy, management repeatedly communicated to the customer-base that crypto deposits remain “your” crypto,²⁷⁰ giving the customers the clear impression that Earn accounts liken better to safe deposit boxes than traditional savings accounts. With Celsius in bankruptcy, 600,000 Earn account holders, who had collectively deposited $4.2 billion, wanted “their” crypto traced, excepted from the automatic stay, and immediately released to their rightful owners.²⁷¹ This was, after all, what Mashinsky had promised all along.²⁷²

Celsius’ advertising puffery did not, however, match up with what was written in the customer agreements. Earn customers may not have realized, when they signed their Celsius contracts, that deep within the legalese was a transfer of ownership of all digital assets deposited into an Earn account.²⁷³ Earn depositors could redeem such assets at will, requiring Celsius to go into the market to cover any demanded crypto it did not then have in treasury. But, after deposit and prior to redemption, the crypto belonged to Celsius and could be exploited as management saw fit for the company’s own profit-making purposes.²⁷⁴ The contract relationship was, contrary to Mashinsky’s “unbank” representations, very much like that of traditional depository institutions.²⁷⁵

This entitlement issue was, as described by the bankruptcy court, “a gating issue at the center of many disputes in this case.”²⁷⁶ On January 4, 2023, following an evidentiary hearing, the bankruptcy court issued its opinion resolving the matter. The court concluded that, despite the marketing representations and client expectations, the language of the customer agreements control.²⁷⁷ Earn customers were merely unsecured creditors in the Celsius Chapter 11 cases, entitled to recover the remainderman’s interest after payment of ever-ballooning administrative expenses.²⁷⁸ Deposits were not, in sum, “your” crypto after all²⁷⁹ and, making matters worse, the deposits were not FDIC insured. The ruling delivered a painful lesson not only to the 600,000 Celsius Earn customers, but also hundreds of thousands of BlockFi customers who deposited their crypto in comparable accounts and came to learn that the Celsius ruling would be followed in BlockFi’s bankruptcy as well.²⁸⁰

2. Voyager

Voyager was founded a year after Celsius (in 2018) and, like Celsius, also focused its marketing strategy on individual crypto enthusiasts. But, Voyager was a hybrid brokerage and quasi-banking firm. Customers could trade, after depositing digital assets, using an interface accessible via the Voyager app.²⁸¹ They just needed to sign a customer agreement, download the app, and then select which of over one hundred asset types they wanted to buy or sell.²⁸² Voyager made money by pocketing the spread between the buy and sell prices of traded crypto assets and by relending customer deposits, akin to Celsius and BlockFi.²⁸³

Like Celsius, Voyager too experienced explosive growth.²⁸⁴ In 2020, Voyager counted only 120,000 users on its platform.²⁸⁵ A year later, Voyager’s app was among the top 10 in the world.²⁸⁶ At year-end 2021, Voyager had nearly $5.9 billion in assets under management.²⁸⁷ By springtime 2022, it counted over 3.5 million users.²⁸⁸ Then came the Luna collapse and Three Arrows defaulting on its $657 million Voyager loan. Mass customer redemptions followed.²⁸⁹ Voyager filed for bankruptcy protection on July 5, 2022.²⁹⁰

Given Voyager’s abrupt failure, the board of directors created a special committee to investigate underlying facts.²⁹¹ The special committee retained independent counsel to conduct this investigation.²⁹² The investigative report was made public (in redacted form) on February 14, 2023.²⁹³ The report focused on the decision-making process driving the Three Arrows loan, which was put in place only a few months before Luna’s collapse.²⁹⁴ As detailed, management conducted negligible diligence before agreeing to lend Three Arrows up to $1 billion. Prior to committing capital, Voyager: (i) received merely a single-line statement in lieu of detailed financials, to wit, “We confirm the following for Three Arrows Capital Ltd as at 1-January-2022 in millions of USD. NAV 3,729”;²⁹⁵ and (ii) conducted a single due diligence call with two executives from Three Arrows, where no mention was made of the fund’s Luna exposure.²⁹⁶ None of the loans were collateralized.²⁹⁷ At the time of Voyager’s bankruptcy filing, the Three Arrows debt represented nearly 58% of its loan book.²⁹⁸

Blame aside, Voyager’s bankruptcy––like all bankruptcies–– required an exit strategy. At case inception, Voyager proposed a plan of reorganization.²⁹⁹ This was, however, merely an aspirational statement, given the tumultuous state of the industry in July 2022.³⁰⁰ The plan, nevertheless, functioned as a kind of “stalking-horse” for alternative exit strategies, particularly a sale transaction.³⁰¹ On August 5, 2022, the bankruptcy court approved bid procedures, initiating an M&A process designed to find a buyer for Voyager.³⁰² That process concluded in September, with FTX advancing a $1.422 billion offer to buy the company.³⁰³ That transaction had not yet closed when, in November, CoinDesk published its article outing FTX as a possible fraud, and the company imploded.³⁰⁴

This was devastating news for Voyager and its stakeholders.³⁰⁵ By then, Voyager had incurred millions in professional fees chasing the FTX deal.³⁰⁶ Fortunately, Voyager found another potential suiter: Binance.US,³⁰⁷ the American affiliate of Binance, the behemoth cryptocurrency exchange.³⁰⁸ In December, Binance.US agreed to acquire Voyager for approximately $1.022 billion, and the transaction would be consummated as part of Voyager’s pre-existing plan of reorganization.³⁰⁹ Under the plan, Voyager customers would transition to the Binance.US platform, subject to various vetting procedures.³¹⁰ Ineligible customers would have their crypto liquidated and receive the cash proceeds.³¹¹ Same for customers located in jurisdictions where Binance.US was not licensed to provide digital currency services.³¹²

But, there was a problem. The federal government, as well as the SEC, United States Trustee, and several state regulatory agencies expressed concerns over Binance.US as purchaser.³¹³ Binance.US, it seems, was an entity of concern for federal and state regulators, evoking government suspicion that it was not a suitable buyer for Voyager’s expansive role in the U.S. market.³¹⁴ The SEC, in particular, contended that the Binance.US transaction and its distribution of digital assets to creditors might end up violating federal securities law,³¹⁵ with the federal government furthering that, as a matter of principle, the plan should not have any preclusive effect on regulatory authorities (federal or state) if the transaction or such distributions are subsequently found to be wrongful.³¹⁶ That meant, among other things, that Voyager and Binance.US executives, as well as bankruptcy professionals advising the debtors and the official committee of unsecured creditors, could face post-consummation regulatory scrutiny––perhaps even liability––for supporting and helping consummate the plan.³¹⁷

The bankruptcy court was unmoved by these arguments. The court accepted Voyager’s contention that the proposed transaction was the most value-maximizing path forward, with approximately $100 million in value over liquidation.³¹⁸ The court disagreed, as a matter of fundamental bankruptcy principle, that parties should remain liable under securities laws for helping the plan close and, in turn, fulfilling their statutory mandates under the Bankruptcy Code, especially as the government equivocated on whether the Binance.US transaction would or would not actually violate securities laws.³¹⁹ The court further chastised the government objectors for interposing objections rooted in speculation, not evidence.³²⁰ The court ultimately overruled the objections, and the plan was confirmed.³²¹ Voyager was thus authorized to move forward with the sale to Binance.US.³²²

The government appealed, focusing its argument on the plan’s exculpation provision, contending that it infringed on its regulatory authority to prosecute enforcement actions against, among others, those working to close the deal.³²³ A motion for stay pending appeal followed shortly thereafter.³²⁴ The appeal did not go far, however. In the face of these developments, Binance.US exercised its right to terminate the transaction, decrying the “hostile and uncertain regulatory climate in the United States.”³²⁵ On April 25, 2023, Voyager announced that it had pivoted to liquidation.³²⁶

The Voyager case story is, from the perspective of bankruptcy law, rather strange: the most value-accretive case solution was scuttled based on unproven contentions. But, considering the government’s larger regulatory ambitions, it is instructive. Management remained in possession throughout the case. The case background factswere not buried. The public ultimately received exacting, candid, and stark disclosures of how the C-Suite took excessive risks with customer deposits (i.e., the Three Arrows loan). These disclosures, when married with comparable revelations from the BlockFi, Celsius, Cred, and FTX cases, reflect patterns of governance failures that can be targeted by administrative agencies as well as the consuming public. Moreover, with respect to the failed Binance.US transaction, the case illustrates––in about as clear and impactful way as possible––how bankruptcy can provide an oddly effective forum for public regulators to advance their administrative agendas, prior to comprehensive regulatory reform, with relative ease and crisp effectiveness. That is so, even if the bankruptcy court is left almost entirely in the dark about what is motivating aggressive agency response.

These observations point to a number of gains for overseers arising out of the bankruptcy court’s role as accidental quasi-regulator. Just as traditional financial regulation seeks out ways to protect the marketplace, produce information on its risks, and safeguard user interests, the court’s unique legal toolkit can achieve outcomes aligned with these regulatory objectives. Indeed, there is an argument that the court’s intervention comes with specific advantages. The capacity of bankruptcy judges to exercise wide discretion in applying statutory measures, combined with powers to compel delivery of detailed disclosures, can allow for a flexible, solutions-orientated approach that may be especially well-suited to address the novel, evolving nature of the crypto industry. An objective examiner’s report (e.g., Cred and Celsius),³²⁷ for example, can reveal insights about a firm and its industry that may not be easily discernible through regular, standardized disclosures, where a company might present its affairs in an overly curated, sanitized light. Approaches to address thorny problems like valuation of crypto assets (e.g., Voyager) can reflect efforts on the part of any number of experts enlisted by the court, including regulatory agencies. This can better equip judges to develop resolution strategies that stand the best chance of success in addressing risks and distress within a novel, understudied asset class like crypto. Further, the public nature of the bankruptcy process means that the court’s efforts are afforded general scrutiny (including on social media). There is signaling of regulatory priorities (e.g., customer protection). And, the court’s judgments and analysis create opportunities for wider learning about the legal complexities (e.g., custody) and industry characteristics of crypto markets.

Yet, even as bankruptcy courts have risen to meet the legal and economic challenges posed by “crypto winter,” the consequences of their engagement reveal the high costs of relying on these courts to function as proxy financial regulators. As we discuss in Part III, bankruptcy courts are highly specialized actors that are poorly suited to act as general overseers and rule-makers for any financial industry.

III. THE BANKRUPTCY COURT AS (IMPERFECT) CRYPTO MARKET REGULATOR

Part II showed how bankruptcy is, functionally, administering the clean-up of large segments of the crypto ecosystem. It observes that some of bankruptcy’s work is serving non-bankruptcy regulatory objectives, including broad and exacting public disclosures, management accountability, loss allocation in ways that are instructive to regulators and crypto investors, even opportunity for traditional government supervisors to advance policy objectives before enactment of corrective regulation. This contention might, however, be troubling, perhaps even to the bankruptcy judges overseeing the crypto cases. As explained in Section II.B, bankruptcy’s purpose and intentions look no further than the estate and its stakeholders. Any larger-scale administrative objectives served by bankruptcy are, therefore, more or less incidental to––rather than and by virtue of––the Bankruptcy Code’s underlying design.

There lies the trouble with relying on bankruptcy courts to serve as default quasi-regulators. This Part surveys the implications. We observe that there are difficult tensions between core bankruptcy policies and those of more traditional financial regulation. Particularly on matters of systemic risk or customer protection, bankruptcy’s usual focus––looking to safeguard, augment, and ultimately distribute estate value––can result in destabilizing and costly externalities for actors like customers or creditors. Though knock-on hardships are commonplace and expected in insolvencies, bankruptcy courts cannot deploy the kind of tools available to financial regulators (e.g., to backstop customer money claims or provide emergency bridge financing for struggling counterparties) to shore up a hurting market or ensure its go-forward integrity.

Even disclosure, a foundational regulatory device, furthers a different imperative in bankruptcy. The timing, extent, and even reliability of bankruptcy disclosure encapsulates the point-counterpoint nature of bankruptcy’s adversary process. It is sharply focused on its intended audience––Chapter 11 stakeholders––not the markets more generally. Such disclosures can only instruct and, hopefully, positively affect crypto market development by presenting cautionary tales. Bankruptcy courts can do little more for the wider audience.

Finally, the frictions exemplified by BlockFi, Celsius, FTX, Genesis, Three Arrows, and Voyager illustrate the costs to financial market design where policy looks to the bankruptcy court as a frontline regulator––rather than as but one critical part of an otherwise larger, dedicated architecture for oversight and resolution. Requiring bankruptcy courts to step into a leadership role, rather than to adjudicate within an existing framework for oversight (where oversight is largely entrusted to other facets of government), imposes on these courts a responsibility far outside of their usual functions and capabilities, creating enormous inefficiency and, in the end, grave concerns over effectiveness.

A. Systemic Risk and The Bankruptcy Code

The interventions of bankruptcy courts in the context of crypto have exemplified the tensions between the Bankruptcy Code and financial regulatory approaches designed to address systemic risks. As noted in Part I, crypto markets showcase the potential for externalities––where institutions like exchanges (e.g., FTX, Genesis, and Voyager), quasi-banks (e.g., BlockFi and Celsius), and hedge funds (Alameda and Three Arrows) pose dangers to others, resulting in the creation of pathways for risk to move from one firm to others rapidly and unpredictably.

But, despite these risks, fundamental aspects of the Bankruptcy Code stand in tension with regulation’s emphasis on preserving market stability and assuring the safety and soundness of large, deeply networked financial firms. For one, the typical mission of bankruptcy courts looks to address the debtor’s insolvency, protecting and enhancing the value of the estate, and overseeing the development of a plan to distribute value to creditors. How bankruptcy courts achieve this has long elicited debate and prompted recourse to competing judicial philosophies to guide how the pie is best divided among stakeholders. Scholars have tussled, for example, over the workability of divergent economic approaches when deciding how much leeway to afford managers struggling to return a distressed business to profitability: whether only creditors’ rights ought to be recognized; or, if community interests should also be afforded some voice in a bankruptcy process; or even whether certain creditors (e.g., DIP lenders) ought to be permitted especially close control over the firm’s workings and managerial discretion.³²⁸ While not underplaying their importance, nor diminishing the attention bankruptcy courts often pay to non-economic stakeholders (like local communities and public policy imperatives), these variations generally operate with an overarching focus on the debtor and the financial distress that it is experiencing.³²⁹ Indeed, bankruptcy law expects third-parties to absorb loss, uncertainty, and distress of their own in order to afford the debtor an opportunity to reorganize.³³⁰ In other words, the focus of the Bankruptcy Code is almost exclusively on the debtor––rather than preventing the spread of distress to third-parties and the industry sector more generally.

Perhaps the most visible tension between the Bankruptcy Code and its effect on systemic risks can be seen in the broad application of the automatic stay. Designed to freeze attempts to collect debts against the debtor’s estate, it precludes any number of creditors from accessing and retrieving their funds.³³¹ In the context of crypto insolvencies, such as Celsius and BlockFi, this has meant precluding the firms’ customers from accessing assets and withdrawing them from the debtor platform, leaving billions of dollars trapped without clarity as to when they might be returned––if they might be returned at all.³³² Importantly, limited financial regulation has meant that the automatic stay is applied bluntly to crypto assets, without any calibration to reflect the common sense (but not, in the end, legal) notion that these assets constitute customer property.³³³ By contrast, in regulated securities and commodities markets, rulemaking mandates that assets be protected to clearly recognize investor ownership rights, with custody arrangements eliminating the risk of these assets becoming scooped up in a custodian’s bankruptcy.³³⁴

This tension has played out repeatedly across the major crypto insolvencies. Bankruptcy courts do not have discretion and must strictly enforce the automatic stay, without regard for potentially systemic consequences within the crypto-ecosystem and the economic damage inflicted on otherwise blameless retail creditors. For one, platform clients not been able to withdraw their assets, causing damaging knock-on effects, if they lack the cash to pay out on their own obligations.³³⁵ In the case of FTX, for instance, this included institutional creditors, such as BlockFi, that ended up pushed into their own insolvency.³³⁶ It also compromised millions of vulnerable retail interests, everyday savers with limited or negligible economic slack to absorb the shock.³³⁷ Indeed, in seeking to navigate the damage, retail creditors have been forced to reckon with sophisticated parties in crowded and confusing legal proceedings. This has required administrative investment in filing claims as well as in carefully following the trajectory of their legal entitlements.³³⁸ With these cases (and the automatic stay) stretching on for many months, the complex nature of crypto bankruptcies invariably threaten all customers, retail and institutional, with lengthy and legally burdensome separation from whatever value is ultimately left for them – no matter the resulting knock-on shocks.³³⁹

As an added source of risk, crypto holders confront reckoning with the shifting valuation of a highly volatile asset. As Anthony Casey, Brook Gotberg, and Joshua Macey write, the changing valuation of crypto assets can create incentives for a debtor to use these assets to fund itself at low cost.³⁴⁰ With crypto assets likely to have a depressed valuation on the filing date of a large bankruptcy, an exchange can gain by holding onto a base of assets with appreciating price, and to eventually reap winnings from the difference between a low-dollar customer claim and a higher valuation further into the insolvency process.³⁴¹

These risks are not new for insolvencies where the debtor’s failure might result in costly externalities for financial markets. Crucially, however, regulated markets have developed sophisticated conventions to recognize and privilege systemic risk considerations over the interests of the debtor. As noted above, custody arrangements in securities and commodities markets look to keep customer assets outside of the bankruptcy.³⁴² But, other provisions, too, are worth highlighting. For example, under the Bankruptcy Code, certain kinds of risky and short-term financial contracts are expressly exempted from the stay.³⁴³ For certain kinds of derivatives and short-term credit arrangements, a debtor’s counterparty is permitted to close-out the contract and set-off liabilities to secure what is owed to them.³⁴⁴ This process is designed to happen automatically, preventing these specific financial creditors from becoming locked in lengthy proceedings and facing the prospect of cash-shortages themselves.³⁴⁵ Of further note is the fact that certain kinds of financially systemic firms are saved from becoming subject to long and uncertain corporate bankruptcies. This is most clearly exemplified by the regime for addressing bank failures, where the process is managed by a particular government agency––the FDIC––rather than the courts. This design is supposed to offer a highly technocratic, fast, and minimally disruptive process, where customer deposits and outstanding bank loans are transferred (ideally) seamlessly to another bank, preventing worries about the larger solvency of the banking system and helping to prevent a run by frightened depositors.³⁴⁶

In other words, regulatory policy recognizes the tension between the Bankruptcy Code and the costs of system-wide fragility. Whereas rulemaking in securities markets, commodities, and banking regulation has looked to navigate this tension through well-established, Congressionally-approved, crafted tools, crypto markets have been left exposed to the vulnerability of systemic risks but with only the discretion and generalized case oversight of bankruptcy court for recourse. With courts equipped only with traditional tools (e.g., the automatic stay), bankruptcy law is ill-equipped to protect short-term creditors and vulnerable customers in crypto markets.

B. Bankruptcy Disclosure vs. Market Disclosure

The close nexus between financial regulation and disclosure finds its originating, and perhaps best, articulation in Justice Brandeis’ famous statement: “Sunshine is said to be the best of disinfectants; electric light the most efficient policeman.”³⁴⁷ And, so, while scholars have long debated the efficacy of disclosure as a regulatory tool, and contested even further how best it should be implemented to achieve its intended purpose, compelling businesses to periodically divulge core performance and governance data remains a vital component in the administration of financial systems.³⁴⁸ The general idea is that, if the law mandates regular and sufficient disclosure, the consuming public and markets more generally will do much of the policing on their own.³⁴⁹ The SEC and other regulatory agencies have, in turn, issued extensive guidelines and disclosure standards have evolved to aspire for clarity, consistency, and comparability in public communications.³⁵⁰

voxeu/columns/bank-transparency-regulation-and-stress-tests-what-works-and-what-does-not [https://
perma.cc/54KC-NXH8]. Broadly viewed, capital markets, as well as the general consuming public, have come to expect high-quality, reliable disclosures (as compelled by law and enforced by federal and state administrative agencies), assuring greater confidence in the efficient and safe workings of regulated markets.³⁵¹

That is not the nature of bankruptcy disclosure, however. Debtors do not have to broadly divulge information in their bankruptcy cases to accommodate a regulatory scheme intended to properly inform a market.³⁵² Come Chapter 11, the typical debtor’s securities are already delisted, ³⁵³ and disclosure imperatives arising under non-bankruptcy law shift to what is expected in bankruptcy. Thereafter, and as a normative attribute of Chapter 11, debtors tend to publicly disclose only what is necessary and only when they desire particular relief from the bankruptcy court.³⁵⁴ As explained in Section II.B, a debtor’s reorganization is a sort of “becoming” that often takes shape after the bankruptcy has started.³⁵⁵ Bankruptcy law does not compel the debtor to issue much in the nature of progress reports along the way. And, at least during the formative stages of the bankruptcy, a shroud of secrecy is generally acceptable, allowing key constituents, such as the official creditors committee, to do their work.³⁵⁶ Unlike the public more generally, key constituents receive sensitive information early on because they are the counter-balance in bankruptcy’s adversary process and they are the ones the debtor needs to eventually negotiate a plan.³⁵⁷ It is true, as mentioned above, that the Bankruptcy Code and Bankruptcy Rules compel granular public disclosures about the assets comprising and the debts burdening the estate, as well as public release of monthly operating reports.³⁵⁸ But, these disclosures are far from fulsome, they are not completely standardized, and they are neither designed nor intended to offer everyday market participants confidence, clarity, and comparability about firms and their workings.³⁵⁹ For example, monthly operating reports, untethered to a disclosed bankruptcy strategy or turnaround business plan, do little to elucidate where the case is going at any particular moment.³⁶⁰ It is not until the publication of a detailed disclosure statement that the “case story” comes together for the public more generally. But, by then, the story may be almost over.

Debtors do make interim disclosures in the bankruptcy––including, especially, the debtor’s so-called “first day” declaration (an explanatory, often lengthy, statement filed with the Chapter 11 petition)––and those disclosures often present a detailed case narrative: why and how the debtor finds itself in need in bankruptcy relief; what it hopes to achieve while in bankruptcy; how and when it expects to exit bankruptcy.³⁶¹ But, unlike disclosure requirements under non-bankruptcy law,³⁶² there are few repercussions for a debtor whose interim disclosures are ultimately found to be insufficient, incomplete, or even inaccurate.³⁶³ Bankruptcy anticipates that the debtor’s case narrative, including the “first day” declaration, may be inculcated with advocacy; it relies on the debtor’s case adversaries (e.g., the official creditors committee) to exploit discovery and other tools of bankruptcy to ferret out and eventually present the counter-narrative.³⁶⁴ Celsius, for example, initially presented its case narrative in the “first day” declaration of its CEO, Alex Mashinsky. This narrative was largely debunked in the examiner’s final report,³⁶⁵ and Mashinsky was arrested a short time later. But, tellingly, that did not lead to the appointment of a Chapter 11 trustee, conversion to a Chapter 7 liquidation, dismissal of the case, or even curtailment of the debtor’s exclusivity to file its own bankruptcy plan.³⁶⁶ Bankruptcy wants the parties to negotiate and, so, bankruptcy courts are loath to impose interim process changes over factual disputes, even where the debtor’s factual narrative is so blatantly wrong.³⁶⁷ Stated differently, bankruptcy rarely prioritizes factual accuracy in interim (prior to dissemination of a disclosure statement) public disclosure over an orderly Chapter 11 process.³⁶⁸

It is perhaps for this reason that examiner appointments have been rare occurrences in Chapter 11, historically reserved for only the most extreme cases.³⁶⁹ Examiners seize part of the adversary role occupied by creditor representatives, who are otherwise entrusted not only to learn the case facts but also to exploit them at bargaining table.³⁷⁰ Examiner appointments can, in other words, enervate the official creditors committee (among others) and that may not help the parties reach consensus on a plan.³⁷¹ Examiner reports also can be costly, eating into eventual recoveries, and they take time to prepare, resulting in case delay.³⁷² Moreover, examiners are required to make their investigative findings public––even the findings that may be best reserved for quiet negotiation––and this can further chill dealmaking.³⁷³ These dynamics may help explain why even in a case as extreme as FTX the bankruptcy the bankruptcy court was reluctant to order the appointment.³⁷⁴

Finally, and most specific to crypto, bankruptcy disclosure does not have permanence. Data delivered in cases such as BlockFi, FTX, and Voyager explain the root causes of failure, and thus can offer cautionary tales for regulatory authorities and the industry more generally to observe and consider.³⁷⁵ But, it can do little more. A “bad” Chapter 11 debtor will change its ways through the reorganization process; a liquidating debtor has no future; and, other industry participants have no obligation to study or heed any cautionary tale. Bankruptcy disclosure, therefore, offers little protection unless the lessons learned are formalized into some kind of mandatory rulemaking.³⁷⁶

C. An Imperfect Policymaker

Facing information deficits and without a mandate to address systemic risks and market stability, bankruptcy courts are a sort of “make-do” but ultimately highly imperfect proxy-regulator for the crypto-market. Yet, their decision-making is likely to have lasting effects that shape future rulemaking and constrain the room to maneuver available to policymakers looking to craft a framework for crypto oversight.

Perhaps the clearest illustration of the courts’ impact as imperfect policymaker is reflected in the ownership determinations respecting customer crypto assets deposited with bankrupt custodians. As detailed in Part I, cryptocurrencies reflect a relatively novel kind of asset class, where ownership rests with those holding the private keys (the passwords) to a crypto accounts. This design speaks to the fundamental self-help orientation of underlying blockchains that have emerged from a philosophical rejection of third parties like banks, brokers, or state regulators.³⁷⁷ However, as centralized actors have come to assume a critical role, attracting waves of customers, they have also become vast repositories of user assets, holding onto passwords and able to access accounts, the value of which they carry.³⁷⁸ As Adam Levitin notes, this leaves customer assets vulnerable, caught up in a legal gray zone where the fact of a custodian having de facto control and the capacity to access assets at will can leave customers holding a simple contractual––rather than a property-based––claim.³⁷⁹ It has also left the courts facing a complex policy conundrum, whether to (1) recognize customer property rights in crypto assets and, in turn, to permit those assets to remain outside of the custodian’s estate or (2) deem the assets property of the estate, repositioning customers as general unsecured creditors.³⁸⁰ Arguably, financial regulatory policy would favor recognizing and protecting customer’s property rights–and by extension their savings. As evidenced by the safeguards afforded to customer assets in securities and commodities markets, the emphasis placed by traditional financial regulation on investor protection is well-established and uncontroversial. Even where comingling of assets or failure to secure them has meant that customers have not been able to fully enforce their property rights, regulation has stepped in (e.g., MF Global) to ensure compensation and redress for those whose entitlements were abridged.³⁸¹

By contrast, the absence of a focused regulatory policy and a relative lack of prior rulemaking in crypto markets, has led the bankruptcy courts––the Celsius court in particular––to assert bankruptcy norms, thus reducing customer claims to a contractual (rather than proprietary) nature. As such, around $4.2 billion in customer assets deposited with Celsius were found to belong to the bankruptcy estate, and a broad swath of depositors entitled only to the remainderman’s interest after a long and torturous bankruptcy case.³⁸²

As detailed above, while this ruling might reflect bankruptcy’s interpretative norms, it nevertheless raises broader policy concerns surrounding fairness and market integrity. For one, the impact of this ruling can result in some customers faring better than others during a crisis. Specifically, the effect of the ruling means that those that leave assets with an intermediary face the risk that these assets can end up subsumed within a custodian’s estate. It follows that those able to hold their assets off-platform, hosted on their own private wallets face far better odds in maintaining their property rights. While straightforward, this scenario creates the risk of a two-tier market, where those possessing the technical savvy to protect themselves out-maneuver the risk, but those that are perhaps less knowledgeable or otherwise unable to take such steps lose their entitlements. Such a state of affairs appears especially problematic given that those most likely to see their assets tapped on a platform are likely to include the most vulnerable, with less knowledge and sophistication about using crypto technologies. In other words, rather than protect all customers equally, the decision leaves crypto investors to fend for themselves. Those that cannot––in other words, customers that are in the most precarious situation––end up unprotected and liable to be harmed.

The Celsius court’s ruling ended up being especially powerful in the absence of wider regulatory action to protect customers and support market integrity. This has meant that decisions of the bankruptcy court – formed within a particular system of constraints – have given rise to structural effects on the marketplace (e.g., interpretations of terms of service, review of custodianship norms). Unlike administrative rulemaking, however, this impact has taken effect without the benefit of precision market understanding, cost-benefit analysis, stakeholder consultation, or deliberation. While bankruptcy courts have done what they can within their mandate, bringing some order to the prevailing chaos, their intervention can hardly be considered as optimally engineered to provide a lasting and reliable set of guardrails for the crypto-marketplace, designed to operate both in peacetime and in crisis.

CONCLUSION

This Article has sought to offer a new account of cryptocurrency regulation to highlight bankruptcy’s role, by default, as a force in financial markets oversight. With the industry lacking a real framework to govern its integrity, customer protection, and relationship with regulators, bankruptcy courts have been required to step in, addressing gray areas and thorny problems surrounding cryptocurrency’s legal and economic underpinnings. In applying its expertise and authority, these courts have shown themselves to be deft and creative, bringing clarity to important questions impacting customer entitlements and the risk management practices adopted by crypto firms (e.g., in relation to crypto custody). But the courts’ role remains an imperfect and incomplete one. The focus of bankruptcy remains on the debtor. Bankruptcy courts cannot perform policy to address larger concerns––such as the immediate welfare of customers or the overall health of the market. Even as bankruptcy’s influence in this space has grown, its deficits have also become apparent, underscoring the larger costs of regulatory inertia and inaction for establishing standards of governance and safety within innovating industries. Ultimately, the bankruptcy court’s emergence as an accidental financial regulator raises deeper questions about how best to push administrative mobilization to rise to the challenge of complex innovation. As financial regulators endeavor to create new standards for crypto oversight, they face an even more complex task ahead, forced to maneuver in the shadow of the bankruptcy’s authority as a first mover in this arena.

96 S. Cal. L. Rev. 1479

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Yesha Yadav*

* Yesha Yadav is the Milton R. Underwood Chair, Associate Dean, and Professor of Law at Vanderbilt Law School.

Robert J. Stark†

† Robert J. Stark is Chair of the Bankruptcy and Restructuring Practice Group at Brown Rudnick LLP. We are deeply grateful to Kenneth Aulet, Jordan Barry, Preston Byrne, Cathrine Castaldi, Jill Fisch, Pamela Foohey, Andrew Hayashi, Elizabeth Pollman, Danny Sokol, Robert Rasmussen, Andrew Rizkalla, and Samuel Weinstein, as well as participants at the USC Digital Transformation in Business and Law Symposium, the Cardozo Law School Corporate Governance Symposium, and the BYU Winter Deals Conference for all of their valuable insights, comments, and perspectives. We also thank Matthew Fisher, Samuel Khan, and Roshni Parikh for excellent research assistance. In the interest of full disclosure, Robert J. Stark and/or his firm were involved in several of the cases discussed in this Article: he served as the examiner in the Cred Chapter 11 case; he represented the official creditors committees in the BlockFi and Prime Trust Chapter 11 cases, as well as the winning bidder (Fahrenheit LLC) in the Celsius Chapter 11 case; his firm represented an ad hoc claimants committee in the Genesis Global Chapter 11 case, the Bahamas Government in connection with the FTX collapse, and parties in other restructurings in the digital asset and mining spaces. This Article represents the views of the authors only. Errors are our own.

Fintech and Financial Inclusion: A Review of the Empirical Literature

April 2023April 2023Carter Faust, Anthony Dukes & D. Daniel Sokol

The financial technology industry, or “fintech,” has experienced rapid growth within recent years. Between 2015 and 2019, global fintech adoption among consumers rose from 16% to 64%.¹ Adoption of fintech services has continued to rise and further accelerated during the COVID-19 pandemic.²

An emerging field of research highlights the important role that fintech can play in promoting financial inclusion—the availability and equality of opportunities to access financial services. The 2017 Global Findex Database noted that 1.7 billion adults worldwide are unbanked, meaning they lack an account with a financial institution or mobile money provider; nearly all unbanked adults live in the developing world.³

Access to financial services is a key enabler for financial inclusion and, on a broader scale, reducing worldwide poverty. Financial accounts encourage personal savings and investment, provide insurance against risks and shocks, and promote economic mobility.⁴ Thus, the importance of bringing financial services to the unbanked has captured the attention of many researchers.

Online platforms have an important role to play in financial inclusion. Numerous studies have demonstrated that fintech services, such as mobile money, digital payment solutions, and digital lending platforms, have the potential to enable account ownership among the unbanked.⁵ Further research has shown that countrywide fintech adoption can decrease income inequality by up to 23%.⁶ Overall, research points to the fact that fintech can have a positive impact on financial inclusion, yet the magnitude of its effects are dependent on relevant infrastructure and policies.⁷

Recently, governments and global organizations have begun to recognize the need for harnessing the power of fintech to promote financial inclusion. For example, the Group of Twenty (“G20”) High-Level Principles for Digital Financial Inclusion emphasize the importance of utilizing fintech to achieve financial inclusion and reduce global income inequality.⁸ Additionally, the United Nations (“U.N.”) 2030 Agenda for Sustainable Development calls for innovation and development of fintech to spur economic growth among emerging and developing countries.⁹

This research commentary surveys key research related to fintech and its implications for global financial inclusion. Specifically, it provides an overview of studies regarding digital lending, digital payment, and mobile money platforms and how these services can bridge the financial gap for traditionally unbanked and underserved communities. In terms of the legal role through public and private law, it also identifies common concerns and challenges associated with the adoption of fintech, as well as relevant policies to mitigate these concerns and foster financial inclusion.

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Dynamic Regulation by Natasha Sarin

February 2022March 2022Southern California Law Review Admin

Article | Financial Regulation
Dynamic Regulation
by Natasha Sarin*

From Vol. 94, No. 5 (2021)
94 S. Cal. L. Rev. 1005 (2021)

Keywords: Financial Regulation, Great Recession, Bank Capital

The average American family lost one-third of its net worth during the Great Recession. One in ten families lost their homes. One in ten workers lost their jobs.[1] The consequences of the crisis still reverberate today, reflected in distrust of large financial institutions,[2] dissatisfaction with politics as usual,[3] and concern that capitalism is no longer working for the American people.[4]

It is possible to draw a line from the crisis to the election of Donald J. Trump as the 45th President of the United States. Further, in the most recent presidential election cycle, much of Senator Elizabeth Warren’s case for her electability was tied to her work in the Recession—arguing that she, unlike Republicans (and many Obama Administration officials), was focused on putting consumers first after the worst downturn since the Great Depression.[5]

While much has been written on the ways in which financial regulation has been overhauled since the crisis,[6] little research has been done on whether this overhaul was sufficient, or whether the system is still at risk. This Article steps in to fill this void. I argue that, despite regulators’ statements to the contrary, the vulnerabilities that led to the Recession remain in our financial sector. Without a course correction, the next time will be the same, and the consequences for ordinary Americans likely even more dire.

This Article differs substantially in tone from the calm espoused by those in the financial regulatory community of late. For example, in a speech in July 2019, Federal Reserve Vice Chair Randal Quarles announced that “banks have now built enough capital to withstand a severe recession.”[7] He further stated that it was now appropriate to deregulate large financial institutions because, since the crisis, large banks have addressed the “substantial deficiencies in their ability to measure, monitor, and manage their risks”—deficiencies that led to the Great Recession.[8]

Vice Chair Quarles is not alone in his optimism. Federal Reserve officials have claimed repeatedly in recent years that financial crises are behind us due to substantial reforms enacted in the aftermath of the Recession.[9] These reforms include decreasing banks’ ability to make risky bets and designing a plan for how to unwind large financial institutions with minimal harm to consumers. Perhaps most importantly, banks are now subject to annual stress tests that are intended to measure their ability to cope with a crisis-like event. For the last several years, all large financial institutions have cleared the stress tests with flying colors, suggesting that the system today is well equipped to weather the next storm.

At the same time, the market has not been so sanguine. In fact, in August 2019, only weeks after passing the stress tests, all large banks lost ten percent of their market value. Their probability of defaulting on borrowers, assessed from the cost of buying insurance that pays out if the firm defaults, skyrocketed. Analysts attributed this steep decline in value to an increase in bank risk: The business of banking involves borrowing short term and lending long term. In 2019, revenues from lending (long-term interest rates) fell below the costs of borrowing (short-term interest rates). This threatened the business model of large financial institutions and also prompted fears that a recession was imminent.[10] Concerned credit analysts downgraded financial firms,[11] and large financial institutions themselves advised their clients to begin to prepare for a recession.[12]

While industry participants, observers, and market signals were sounding alarms, regulatory measures of bank health were static. It is plausible that the market overreacted in August (in fact, it experienced a partial recovery in subsequent weeks), but it is unlikely that the risks in the financial sector were unchanged during this period as regulatory measures of bank capital suggested. Market measures provide a more dynamic assessment of the evolution of financial stability during this period. Regulators can, and should, monitor this information. Yet they do not.

Since the 1980s, capital regulation has been the primary form of bank regulation. Banks fail when the total amount of money they owe (their liabilities) exceeds the total value of the assets they have. The difference between a bank’s assets and liabilities is known as equity capital. Capital helps banks absorb losses that decrease the value of their assets and is measured by regulators as the difference between book values of bank assets and liabilities, known as book or “regulatory” capital.

However, this information is reported only quarterly and is prone to manipulation by sophisticated firms.[13] Because regulators rely solely on backward-looking, static, and manipulatable measures of capital, their assessments paint an inaccurate picture of bank health. I show this empirically in two ways.

First, I subject large banks in the United States to a hypothetical “market-based” stress test based on the value financial markets assign a bank’s business. These measures are dynamic and forward-looking, unlike the book-capital measures regulators have relied on historically. The results of a market-based stress test demonstrate that large financial institutions would experience cataclysmic losses in the event of a crisis like the Recession. Despite policymakers’ statements to the contrary, it is unlikely that these banks would be able to continue to intermediate as usual in the absence of substantial government assistance (that is, bailouts) during the next crisis.

Second, I document the failure of regulatory capital measures during the Great Recession and show that these measures were lagging indicators of bank health. Only days before some of the largest banks in the country failed, capital ratios indicated that all was well. In the case of Bear Stearns, Securities and Exchange Commission (“SEC”) Chairman Christopher Cox even testified before Congress after the firm had failed that it was healthy and well capitalized based on regulatory measures.[14] In contrast, market measures of bank health signaled cause for concern an entire year before the bankruptcy of investment banking giant Lehman Brothers sent the economy into free fall. In addition to being slow moving, regulatory capital measures also proved inaccurate: it was impossible to distinguish between healthy and doomed banks based on their reported capital levels. In contrast, there was significant divergence in the market’s perception of risk at these institutions, and its prediction of bank failures proved prophetic.

Our very recent experience illustrates the consequences of misplaced reliance on book capital as a measure of bank health, yet the post-crisis overhaul of financial regulation did not include a rethinking of the role this information plays in our assessments of large financial institutions. There has been no move toward incorporating more accurate market information into the regulatory regime.

This is an unforced error with significant repercussions. Large banks remain vulnerable to a crisis, and these risks are unacknowledged by the regulatory community. The singular focus on regulatory capital has also fueled a misunderstanding of the causes of the Great Recession and the tools policymakers had at their disposal to address them at their onset.

Policymakers typically offer two responses when asked about their failure to act more aggressively in the early stages of the crisis—that is, before Lehman’s bankruptcy—to forestall the catastrophe that ensued. The first is that the crisis could not be foreseen; illustrated, for example, by former Treasury Secretary Henry Paulson’s 2018 statement that his “strong belief is that these crises are unpredictable in terms of cause or timing or the severity when they hit.”[15] The second is that regulators lacked the legal authority to bolster struggling institutions. For example, as former Treasury Secretary Timothy Geithner stated in 2014: “The Fed didn’t have the legal authority to force Bear Stearns, Lehman Brothers, or other investment banks to raise more capital. We couldn’t even generate stress scenarios bleak enough to force the banks we regulated to raise more capital.”[16] Neither of these explanations, however, is accurate.

As to the unpredictability of financial crises, as this Article will show conclusively, substantial time existed between the first tremors in financial markets in the summer of 2007 and their eventual collapse in the fall of 2008. I assemble data on a variety of market-risk measures (including stock-price volatility, credit default swap (“CDS”) spreads, and market-based capital measures) and compare these with regulatory capital indicators. Market-based risk measures for large financial firms raised red flags for an entire year before the system collapsed. However, regulatory measures are slow to update—thus, failing banks were well above regulatory requirements for minimum capital ratios, not because they were healthy, but because these measures are flawed.

As to the lack of legal authority to intervene with financial institutions, this Article reviews the substantial legal authority at the disposal of financial regulators and demonstrates that lack of authority was not the binding constraint to action. Some pieces of evidence from this novel analysis are especially dispositive: First, regulators in fact did rely on their substantial legal authority to strengthen small financial institutions once risks emerged in the financial sector in the fall of 2007 and early 2008. This same authority could have simultaneously been wielded to bolster large, systemically important financial firms. Second, once the crisis was underway, regulators found ways to intervene and prevent even worse damage. By 2009, they forced banks to stop paying dividends and to raise new capital, which prevented additional failures. No new legal authority emerged between 2007 and 2009, which proves that lack of authority cannot explain the failure to respond more aggressively to the crisis at its onset.

In fairness to regulators, hindsight is twenty-twenty. It was impossible to predict with certainty in the summer of 2007 that a Lehman-size catastrophe was a year away. However, in the months leading up to Lehman, and especially after the collapse of Bear Stearns in the spring of 2008, the probability of a systemic collapse increased dramatically. In February 2008, academics presenting to Federal Reserve officials estimated that the losses that followed the collapse of the housing market would total about $500 billion, with half being borne by large and heavily leveraged financial institutions. This, they estimated, would imply a $2.3 trillion contraction in bank balance sheets—a substantial decrease in lending to households and businesses that would have immediate real consequences.[17] The way to prevent this contraction was to increase banks’ capital levels so they would not fail or to stop lending to households and businesses when imminent losses began to accumulate.

Yet instead of hoarding and raising capital to buffer against imminent asset losses, more than $100 billion of bank capital left the financial system in the form of dividend payouts to bank shareholders in the year before Lehman’s catastrophic bankruptcy. In fact, Lehman increased its dividend by thirteen percent in January 2008—six months before it collapsed and months after industry observers were aware of significant problems at the firm.[18] This is akin to deflating an airbag exactly when the risks of a crash are rising. The same occurred in the lead-up to the COVID-19 crisis—regulators allowed capital to be paid out to shareholders in the form of dividends and share buybacks at the same time monetary and fiscal authorities were contemplating economic interventions of unparalleled scope.

If not wanting for time or authority, what caused regulators to underreact to the initial stages of the crisis? This Article attributes this failure to reliance on regulatory capital, which painted (and continues to paint) an overly optimistic picture of financial stability.

Specifically, regulators failed to act in the early stages of the crisis because the default rule was inaction until book-capital levels signaled distress. Many looked at banks’ high regulatory capital ratios and concluded that there were few risks in the system: in the month before Lehman’s collapse, one Federal Reserve official guessed “that the level of systemic risk has dropped dramatically and possibly to zero.”[19] Others believed that, although it would be helpful for banks to have more capital, they were unlikely to do so while well above regulatory capital minimums, pointing to banks’ assertions that “now is not a good time” for equity-raising. Still others believed that acting aggressively—for example, by restricting banks’ dividend payments—would fuel a panic rather than prevent one.[20]

It is inaccurate and unfair to equate today’s regulatory regime to that in place in the summer of 2007. Capital requirements are higher, so banks have more of a cushion in place to bolster themselves when their assets begin to lose value. But the exercise of stress testing highlights the vulnerabilities that remain—that is, should a situation arise in which losses are so large that banks need to recapitalize, regulators will be slow to force them to do so because our tools of measuring banks’ risk, despite their known unreliability, have yet to be overhauled.

This Article provides a way forward, arguing that supplementing our understanding of financial stability with market information will paint a fuller picture. It also makes a case for automating regulatory action when banks appear undercapitalized—either based on regulatory or market measures. If in place during the crisis, such a regime would have forced banks to hoard and raise new capital in the year leading up to Lehman Brothers’ collapse, decreasing the need for costly government bailouts. The regulatory innovations advanced in this Article will prevent the next recession from becoming a “Great” Recession.

I propose different approaches to incorporating market information into the financial regulatory regime. The most extreme form would automate an aggressive response to market indicia that distress is imminent. This approach, which I label “dynamic capital regulation,” would quickly recapitalize banks the market deems to be on the brink. This recapitalization could be accomplished through: (1) a market-based stress test whereby failure requires new capital-raising; (2) the requirement that banks purchase capital insurance; (3) the conversion of some proportion of bank debt to equity, which eliminates the risk that creditors will be able to withdraw funds and push the bank to failure; or (4) a market trigger that forestalls capital leaving the financial system when bank equities experience drastic moves.

These market-based approaches will increase the dynamism and the transparency of financial regulation. However, dynamic capital regulation will also highlight concern about death spirals—that is, that market speculators will short financial firms when dilution appears imminent. Properly designed regulation can address these concerns, as I describe.

Still, dynamic capital regulation is not a panacea. The result will be fewer Great Recessions but also more false positives, which create unnecessary pain for the financial sector and its shareholders. For example, banks may be disallowed from paying dividends in periods when distress is not actually imminent, despite market signals to the contrary. However, concerns about false positives may be overblown: the analysis in this Article demonstrates that the simplest market-based indicator (bank stock performance) correctly identifies the two financial crises that have occurred since 1990 and results in no false positives. Deciding on the type of errors we prefer—false positives that are unfairly harsh to banks and their shareholders versus false negatives that result in costly losses to the government and taxpayers—is a tradeoff that requires thoughtful deliberation.

This Article favors dynamic capital regulation based on a premise that our regulatory regime should favor the protection of ordinary citizens over the protection of bank shareholders. Incidentally, given the more extreme alternatives, this approach is also likely to be favored by large financial institutions; it will allow them to intermediate efficiently with low levels of capital in normal times and only require them to bolster themselves in extraordinary moments when distress appears likely. In contrast, approaches like a thirty percent capital requirement proposed by Professors Anat Admati and Martin Hellwig,[21] or even more extreme discontinuation of financial intermediation full stop, as proposed by Professor Adam Levitin, are less efficient and more punitive.[22]

The right approach to bank capital is ultimately a question of policy, which regulators must decide. The main objective of this Article is to force a debate that is currently missing in the financial regulatory community due to misplaced confidence in regulatory measures of bank health. Given the known failure of these measures to provide useful and timely indicia of distress during the Great Recession, our continued sole reliance on them is puzzling. Market data are plentiful and informative; ignoring them would be extremely ill-advised for our regulatory regime.

This Article proceeds as follows. Part I begins by demonstrating the importance of bank capital to the financial system and describes how financial crises begin. Part II tells the story of the Great Recession, arguing that the severity of the crisis could have been mitigated by more aggressive regulatory action in 2007 and 2008. Although authority for intervention existed, inaction was the consequence of a regulatory regime that fails to respond until regulatory measures of bank health—which are static and often inaccurate—signal cause for concern. Part III calls for overhauling the regulatory default to make action, rather than complacency, the automatic response to the early stages of a downturn. This approach would have forced banks to stop paying dividends and required raising new capital at the beginning of the financial crisis. This approach will prevent the next downturn from being “Great.” Part IV concludes.

* Assistant Professor of Law, the University of Pennsylvania Carey Law School, and Assistant Professor of Finance, the Wharton School of the University of Pennsylvania, nsarin@law.upenn.edu. I am indebted to Howell Jackson, for first recommending that I write this Article and for providing feedback on various drafts. For helpful conversations, I thank Kathryn Judge, Dorothy Shapiro Lund, Timothy Geithner, David Hoffman, Andrei Shleifer, Jeremy Stein, Lawrence Summers, Daniel Tarullo, and Mark Van Der Weide.

[1]. E.g., Fabian T. Pfeffer, Sheldon Danziger & Robert F. Schoeni, Wealth Levels, Wealth Inequality, and the Great Recession 1–2 (2014), https://inequality.stanford.edu/sites/
default/files/media/_media/working_papers/pfeffer-danziger-schoeni_wealth-levels.pdf [https://perma.cc/J6H4-NYY7]; Pew Rsch. Ctr., A Balance Sheet at 30 Months: How the Great Recession Has Changed Life in America 57 (2010).

[2]. Jordan Smith, Millennials and Big Banks Have Trust Issues – Here Are Three Ways Financial Institutions Are Trying to Fix That, CNBC (Jan. 16, 2019, 5:52 PM), https://www.cnbc.com/2019/01/16/
banks-millennials-trust-jp-morgan-chase-goldman-bank-of-america.html [https://perma.cc/YJF6-D6D
Y].

[3]. Matt Taibbi, Turns Out That Trillion-Dollar Bailout Was, in Fact, Real, Rolling Stone (Mar. 18, 2019, 5:11 PM), https://www.rollingstone.com/politics/politics-features/2008-financial-bailout-8097
31 [https://perma.cc/E5AB-YF53].

[4]. David Leonhardt, Opinion, American Capitalism Isn’t Working., N.Y. Times (Dec. 2, 2018), https://www.nytimes.com/2018/12/02/opinion/elizabeth-warren-2020-accountable-capitalism.html [https://perma.cc/5PJQ-MTT4].

[5]. Gretchen Morgenson, Elizabeth Warren on Big Banks and Their (Cozy Bedmate) Regulators, N.Y. Times (Apr. 21, 2017), https://www.nytimes.com/2017/04/21/business/23gretchen-morgenson-wells-fargo-elizabeth-warren.html [https://perma.cc/Z383-4FXP].

[6]. See, e.g., Viral V. Acharya, Thomas F. Cooley, Matthew Richardson & Ingo Walter, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance (2011); Samuel G. Hanson, Anil K Kashyap & Jeremy C. Stein, A Macroprudential Approach to Financial Regulation, 25 J. Econ. Persps. 3 (2011); Ben S. Bernanke, Chairman, Bd. of Governors of the Fed. Rsrv. Sys., Speech at the Federal Reserve Bank of Kansas City’s Annual Economic Symposium: Reflections on a Year of Crisis (Aug. 21, 2009), https://www.federalreserve.gov/news
events/speech/bernanke20090821a.htm [https://perma.cc/T7KU-9SSM].

[7]. Randal K. Quarles, Vice Chair for Supervision, Bd. of Governors of the Fed. Rsrv. Sys., Speech at a Research Conference Sponsored by the Federal Reserve Bank of Boston: Stress Testing: A Decade of Continuity and Change (July 9, 2019), https://www.federalreserve.gov/newsevents/
speech/quarles20190709a.htm [https://perma.cc/2UQE-UHNP].

[8]. Id.

[9]. See Fed’s Yellen Expects No New Financial Crisis in ‘Our Lifetimes,’ Reuters (June 27, 2017, 10:49 AM), https://www.reuters.com/article/us-usa-fed-yellen/feds-yellen-expects-no-new-financial-crisis-in-our-lifetimes-idUSKBN19I2I5 [https://perma.cc/HP2C-EPKN] (noting Federal Reserve Chair Janet Yellen’s suggestion in 2017 that she “does not believe that there will be another financial crisis for at least as long as she lives”); Press Release, Bd. of Governors of the Fed. Rsrv. Sys., Federal Reserve Board Releases Results of Supervisory Bank Stress Tests (June 22, 2017, 4:30 PM), https://www.federalreserve.gov/newsevents/pressreleases/bcreg20170622a.htm [https://perma.cc/W732-U58X] (reporting Governor Jerome H. Powell’s statement that the 2017 stress-test results “show that, even during a severe recession, our large banks would remain well capitalized, . . . allow[ing] them to lend throughout the economic cycle, and support households and businesses when times are tough”).

[10]. Yield-curve inversion has preceded every recession since 1955. See Jonnelle Marte, Recession Watch: What Is an ‘Inverted Yield Curve’ and Why Does It Matter?, Wash. Post (Aug. 14, 2019, 12:51 PM), https://www.washingtonpost.com/business/2019/08/14/recession-watch-what-is-an-inverted-yield-curve-why-does-it-matter [https://perma.cc/H4Z9-RLLT].

[11]. Thomas Franck, Bank of America Is Downgraded – Inverted Yield Curve, Fed Rate Cuts Will Hurt Income, Analyst Says, CNBC (Aug. 29, 2019, 10:27 AM), https://www.cnbc.com/2019/08/29/bank-of-america-downgraded-amid-yield-curve-inversion-likely-fed-cuts.html [https://perma.cc/JD77-7LY
D].

[12]. Scott Barlow, ‘We Advise Investors to Prepare for Recession’ – Citi, Globe & Mail (Mar. 29, 2019), https://www.theglobeandmail.com/investing/markets/inside-the-market/article-we-advise-invest
ors-to-prepare-for-recession-citi [https://perma.cc/J88V-L2HU].

[13]. See Andreas Fuster & James Vickery, What Happens When Regulatory Capital Is Marked to Market?, Fed. Rsrv. Bank N.Y.: Liberty St. Econ. (Oct. 11, 2018), https://libertystreeteconomics.
newyorkfed.org/2018/10/what-happens-when-regulatory-capital-is-marked-to-market.html [https://per
ma.cc/7M54-WYE9]; Jeremy Bulow, How Stress Tests Fail, VoxEU (May 9, 2019), https://voxeu.org/article/how-stress-tests-fail [https://perma.cc/E64H-VZ8J] (noting that the regulatory regime uses “regulatory rather than market measures for both the value and riskiness of bank assets—measures that failed badly during the financial crisis”).

[14]. Christopher Cox, Chairman, U.S. Sec. & Exch. Comm’n, Testimony Before the U.S. Senate Committee on Banking, Housing and Urban Affairs: Testimony Concerning Recent Events in the Credit Markets (Apr. 3, 2008), https://www.sec.gov/news/testimony/2008/ts040308cc.htm [https://perma.cc/4
MY4-GE4X].

[15]. Interview by Andrew Ross Sorkin with Ben Bernanke, Former Chair, Fed. Rsrv., Tim Geithner, Former Sec’y, U.S. Dep’t of the Treasury & Hank Paulson, Former Sec’y, U.S. Dep’t of the Treasury, in Washington, D.C. (Sept. 12, 2018) (transcript at 9, available at the Brookings Institution), https://www.brookings.edu/wpcontent/uploads/2018/09/es_20180912_financial_crisis_day2_transcript.pdf?mod=article_inline [https://perma.cc/C62S-NKZN].

[16]. Timothy F. Geithner, Stress Test: Reflections on Financial Crises 98 (2014).

[17]. David Greenlaw, Jan Hatzius, Anil K Kashyap & Hyun Song Shin, U.S. Monetary Pol’y F., Leveraged Losses: Lessons from the Mortgage Market Meltdown 11 (2008).

[18]. Viral Acharya, Hyun Song Shin & Irvind Gujral, Bank Dividends in the Crisis: A Failure of Governance, VoxEU (Mar. 31, 2009), https://voxeu.org/article/amidst-crisis-banks-are-still-paying-dividends [https://perma.cc/XKV3-RDLU].

[19]. Bd. of Governors of the Fed. Rsrv. Sys., Meeting of the Federal Open Market Committee on August 5, 2008, at 51 (2008) [hereinafter August 5, 2008, Meeting], https://www.federalreserve.gov/monetarypolicy/files/FOMC20080805meeting.pdf [https://perma.cc/XB
56-D8VP].

[20]. Geithner, supra note 16, at 138 (“We considered forcing banks as a group to stop paying dividends in order to conserve capital, but we were concerned, perhaps mistakenly, that doing so might do more harm than good.”).

[21]. See, e.g., Anat Admati & Martin Hellwig, The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It 179 (2013).

[22]. See Adam J. Levitin, Safe Banking: Finance and Democracy, 83 U. Chi. L. Rev. 357, 454 (2016).

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The New Data of Student Debt – Article by Christopher K. Odinet

September 2019December 2019Southern California Law Review Admin

Article | Regulations
The New Data of Student Debt
by Christopher K. Odinet*

From Vol. 92, No. 6 (September 2019)
92 S. Cal. L. Rev. 1617 (2019)

Keywords: Student Loan, Education-Based Data Lending, Financial Technology (Fintech)

Abstract

Where you go to college and what you choose to study has always been important, but, with the help of data science, it may now determine whether you get a student loan. Silicon Valley is increasingly setting its sights on student lending. Financial technology (“fintech”) firms such as SoFi, CommonBond, and Upstart are ever-expanding their online lending activities to help students finance or refinance educational expenses. These online companies are using a wide array of alternative, education-based data points—ranging from applicants’ chosen majors, assessment scores, the college or university they attend, job history, and cohort default rates—to determine creditworthiness. Fintech firms argue that through their low overhead and innovative approaches to lending they are able to widen access to credit for underserved Americans. Indeed, there is much to recommend regarding the use of different kinds of information about young consumers in order assess their financial ability. Student borrowers are notoriously disadvantaged by the extant scoring system that heavily favors having a past credit history. Yet there are also downsides to the use of education-based, alternative data by private lenders. This Article critiques the use of this education-based information, arguing that while it can have a positive effect in promoting social mobility, it could also have significant downsides. Chief among these are reifying existing credit barriers along lines of wealth and class and further contributing to discriminatory lending practices that harm women, black and Latino Americans, and other minority groups. The discrimination issue is particularly salient because of the novel and opaque underwriting algorithms that facilitate these online loans. This Article concludes by proposing three-pillared regulatory guidance for private student lenders to use in designing, implementing, and monitoring their education-based data lending programs.

*. Associate Professor of Law and Affiliate Associate Professor in Entrepreneurship, University of Oklahoma, Norman, OK. The Author thanks Aryn Bussey, Seth Frotman, Michael Pierce, Tianna Gibbs, Avlana Eisenberg, Richard C. Chen, Kaiponanea Matsumara, Sarah Dadush, Jeremy McClane, Emily Berman, Donald Kochan, Erin Sheley, Melissa Mortazavi, Roger Michalski, Kit Johnson, Eric Johnson, Sarah Burstein, Brian Larson, John P. Ropiequet, the participants and the editorial board of the Loyola Consumer Law Review Symposium on the “Future of the CFPB,” the participants of the Central States Law Schools Association Conference, the faculty at the University of Iowa College of Law, and Kate Sablosky Elengold for their helpful comments and critiques on earlier drafts, either in writing or in conversation. This Article is the second in a series of works under the auspices of the Fintech Finance Project, which looks to study the development of law and innovation in lending. As always, the Author thanks the University of Oklahoma College of Law’s library staff for their skillful research support. All errors and views are the Author’s alone.

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Regulating Entities and Activities: Complementary Approaches to Nonbank Systemic Risk – Article by Jeremy C. Kress, Patricia A. McCoy & Daniel Schwarcz

September 2019December 2019Southern California Law Review Admin

Article | Financial Regulation
Regulating Entities and Activities: Complementary Approaches to Nonbank Systemic Risk
by Jeremy C. Kress*, Patricia A. McCoy† & Daniel Schwarcz‡

From Vol. 92, No. 6 (September 2019)
92 S. Cal. L. Rev. 1455 (2019)

Abstract

The recent financial crisis demonstrated that, contrary to longstanding regulatory assumptions, nonbank financial firms—such as investment banks and insurance companies—can propagate systemic risk throughout the financial system. After the crisis, policymakers in the United States and abroad developed two different strategies for dealing with nonbank systemic risk. The first strategy seeks to regulate individual nonbank entities that officials designate as being potentially systemically important. The second approach targets financial activities that could create systemic risk, irrespective of the types of firms that engage in those transactions. In the last several years, domestic and international policymakers have come to view these two strategies as substitutes, largely abandoning entity-based designations in favor of activities-based approaches. This Article argues that this trend is deeply misguided because entity- and activities-based approaches are complementary tools that are each essential for effectively regulating nonbank systemic risk. Eliminating an entity-based approach to nonbank systemic risk—either formally or through onerous procedural requirements—would expose the financial system to the same risks that it experienced in 2008 as a result of distress at nonbanks like AIG, Bear Stearns, and Lehman Brothers. This conclusion is especially salient in the United States, where jurisdictional fragmentation undermines the capacity of financial regulators to implement an effective activities-based approach. Significant reforms to the U.S. regulatory framework are necessary, therefore, before an activities-based approach can meaningfully complement domestic entity-based systemic risk regulation.

*. Assistant Professor of Business Law, University of Michigan Ross School of Business. Kress was previously an attorney in the Federal Reserve Board’s Legal Division.

†. Liberty Mutual Insurance Professor, Boston College Law School. McCoy founded the Mortgage Markets group at the Consumer Financial Protection Bureau in 2011 and was responsible for mortgage policymaking at the Bureau.

‡. Fredrikson & Byron Professor of Law, University of Minnesota Law School. Schwarcz has testified before Congress on issues relating to entity-based nonbank designations on six different occasions, and he was one of four academic participants in the Presidential Memorandum Engagement Process for the 2017 United States Department of Treasury Report to the President on Financial Stability Oversight Council Designations. For helpful comments and suggestions, we thank Anat Admati, Hilary Allen, Michael Barr, Christopher Bruner, Gregg Gelzinis, Erik Gerding, Claire Hill, Michael Malloy, Heidi Mandanis Schooner, Steven Schwarcz, Art Wilmarth, David Zaring, and the audiences at presentations at The Wharton School, Tulane Law School, Center for International Governance Innovation, National Business Law Scholars Conference, Academy of Legal Studies in Business Annual Conference, Office of Financial Research—University of Michigan Annual Conference, and Villanova Workshop on Insurance and Contract Law. Thanks to Alexander Tibor for research assistance.

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