Talking DeFi; Gensler and AI Hallucinations; Blowback on FDIC Board Governance Rule
Capitol Account: Free Weekly Edition
Much of our attention this week was focused on Capitol Hill, where lawmakers held hearings on everything from crypto crime to stemming bank runs (the anniversary of the Silicon Valley Bank collapse is fast approaching). The regulator speaking circuit was also in full swing, with the Fed’s supervision vice chair talking about commercial real estate loan risk and what he worries about at night. And the SEC chair gave his first in-person speech outside of D.C. It was on AI and movies (not kidding), but also had some warnings for companies. We also took a look at an FDIC corporate governance rule that has somewhat surprisingly drawn a lot of blowback. For our Friday interview, we went deep on DeFi and illicit finance.
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Friday Q and A: Spurred by a series of high-profile cases against token trading platforms, the ransomware epidemic and Hamas’ attack on Israel, the issue of illicit finance in crypto has been thrust toward the top of the financial regulatory agenda in Washington. Just this week, two congressional hearings delved into the issue, as witnesses from both the government and the industry debated the extent of the problem and what to do about it.
That, no surprise, is something nobody seems to agree on. Nevertheless, movement on the policy front continues apace – whether it’s the Treasury Department asking lawmakers for additional enforcement and sanctions authority or Sen. Elizabeth Warren pushing her bill to subject digital wallet providers, miners, validators and others to anti-money laundering rules.
The crypto lobby, for its part, has largely been on the defensive – and in the opposition. But some executives say that it is time to play a more constructive role. We sat down recently with two of them – Rebecca Rettig, chief legal and policy officer at Polygon Labs, and Michael Mosier, a co-founder of the law firm Arktouros.
They recently issued a paper on how to bring decentralized finance into the U.S. financial integrity regime. It’s the first serious plan from the industry to solve one of the trickiest problems in the digital asset space. That’s because DeFi is a peer-to-peer system, where crypto is traded on blockchains without intermediaries. The rules and laws against money laundering and terrorist financing, however, were put in place for traditional finance — and they’re applied to the intermediaries it relies on, “financial institutions” like stock exchanges, brokers and banks.
What follows is our (lightly edited and condensed) discussion.
Capitol Account: What led you to crypto?
Rebecca Rettig: I was at a big, New York, white-shoe firm doing litigation and regulatory enforcement work, mostly in the financial services sector. A little bit in tech, as well…Then I clerked for a judge later in my career and read about Bitcoin on the train down to the [Southern District of New York] courthouse in the Wall Street Journal – at the back of the Wall Street Journal – one day. And I was just fascinated from then on.
CA: When was this?
RR: It was 2013. I remember it because I called my husband when I got off the train, and these aren’t the exact words, but I said, `There's this magic internet money.’ He's in TradFi and was at a hedge fund at the time. And I said, `I think we should buy some of this stuff.’ He [responded], `I literally made it through the mortgage-backed securities crisis, we're not touching anything weird that I don't know what it is.’ I probably would not be having this call with you or have written this paper – or be working – if he had listened to me.
CA: How about you, Mike? You were a prosecutor.
Michael Mosier: I had been briefly at a New York firm…and pretty quickly [realized], I'm not going to make it in mergers and acquisitions…So I went to the district attorney's office in Manhattan and ended up in what was then the special narcotics section. I gravitated immediately to money laundering cases…[Later] in the money laundering section at Main Justice, I helped set up their kleptocracy program.
CA: You were also at the Treasury’s Office of Foreign Assets Control, doing policy and enforcement work. How did that form your views of this technology?
MM: This was around when the Venezuelan government was creating the Petro, it was [Nicolas] Maduro's way of trying to circumvent sanctions. It was a huge issue for us at OFAC – what if crypto is the thing that circumvents sanctions? We did a lot of research on that. It turned out that this was not going to be a moneymaker for the Venezuelan government, but it definitely got policy makers very exercised about crypto's potential to be a problem.
CA: But there was a positive side?
MM: We were also seeing it as…an attractive thing if our foreign policy goal is protecting and promoting pro-democracy and human rights actors under authoritarian regimes. For the same reason it was attractive to [Maduro]...Fast forward and the U.S. Treasury authorized frozen funds from sanctions to be sent [via a stablecoin] to 60,000 healthcare workers in Venezuela. Only made possible because this was a censorship resistance technology.
CA: What was the motivation for doing your policy paper?
RR: We had seen a lot of the proposals that were coming out around crypto in general – AML, illicit finance type of legislation. DeFi kept getting swept in, but as a side thought. Not in any robust way, more like: we know this word and it should be captured too, but we're not quite sure what it is. Some of them were really meaningful attempts to understand the technology, but not all of them actually were going to be effective.
CA: Some in the government have complained that the crypto industry hasn’t been helpful in this debate.
RR: The deputy Treasury secretary had said, `You guys have to give us something. You're an industry. You’ve got to figure this out. You can't just keep saying no.’ We thought it was time to at least start a discussion on ideas that were going to be effective – and could be implemented in a meaningful way. And also were meaningful as to the tech…the way things work in the government today when it comes to software that underpins financial services.
CA: Your paper argues that `genuine DeFi’ should be classified by the government as critical infrastructure and overseen by the Treasury’s Office of Cybersecurity and Critical Infrastructure Protection. How did you decide that?
RR: That is something we really kicked around. We thought about whether we should put it under OCCIP or under where the communication sector falls. But just from a practical standpoint…having Treasury have that type of oversight was more compelling.
CA: Few people have probably heard of this office, which works closely with the financial industry to share information on cyber risks. It’s not a regulator like say, the SEC. Should it be?
MM: There's really no coercive element to it because it's so positively collaborative. When OCCIP calls you and says, `Hey, we understand that Lazarus [the North Korean hacker group] is about to attack the backbone of financial infrastructure at Goldman Sachs, the Goldman Sachs people don't stop to say, `Well, I don't know if you've got authority over me.’ They pick up the phone and they go into the Treasury and find out what's about to hit them.
CA: To some this probably sounds like avoiding regulation for entities that are clearly involved in finance. Doesn’t DeFi need a prudential overseer?
MM: That’s a good question and I think we’re going to get that as we go through this – from the government in particular. My initial knee-jerk reaction is: You're talking about a financial institution. We're talking about the infrastructure. And we've not treated the layers of infrastructure as financial institutions historically, but we've managed risk proactively in a very aligned way. All we're saying is, instead of by default treating every marble and domino in the Rube Goldberg process that makes a transaction happen as a financial institution…why don't we find the ways that we already manage risk?…(Friday)
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Companies Warned on AI: Sometimes it can be challenging (at least for the press) to suss out the main point of a Gary Gensler speech, especially when he uses lots of movie references. The somewhat meandering talk he gave Tuesday at Yale Law School is a good example. The SEC chair brought up nearly a dozen films – everything from “The Parent Trap” to “Beverly Hills Cop” to “The Matrix.” Somehow, he tied them all to artificial intelligence – the topic of the day.
While Gensler has spoken about the issue several times recently, there was a fresh takeaway from his remarks: The SEC’s enforcement division is paying a lot of attention to how firms are using AI. And he signaled that there are four general areas that the agency’s cops are looking into: market manipulation, conflicts of interest, misstatements over how AI is being used and errors by algorithms that harm investors.
The SEC chief also warned that companies can be held liable when an artificial intelligence model they deploy takes advantage of a customer after “learning and changing on its own.” Gensler noted that the same goes for “AI hallucinations,” where an algorithm makes an unsuitable investment recommendation based on false information. The onus is on firms, he emphasized, to ensure that the technology is in compliance with the rules:
“Investor protection requires the humans who deploy a model to put in place appropriate guardrails. Did those guardrails take into account current law and regulation, such as those pertaining to front-running, spoofing, fraud and providing advice or recommendations? Did they test it before deployment and how? Did they continue to test and monitor? What is their governance plan – did they update the various guardrails for changing regulations, market conditions and disclosures?”
Gensler said another emerging problem that the SEC is scrutinizing is “AI washing” – behavior akin to greenwashing (touting investments as environmentally friendly when they really aren’t). For AI, he said, examples could include a corporation being disingenuous about how it’s using an algorithm or failing to disclose its “material risks.”
Perhaps the chair’s most memorable, and funny, line was on the topic of hallucinations. “You don’t want your broker or adviser recommending investments they hallucinated while on mushrooms,” he told the students. “So, when the broker or adviser uses an AI model, they must ensure that any recommendations or advice provided by the model is not based on a hallucination.”
(This was also how he shoehorned “The Matrix” into his speech, pointing out that Keanu Reeves’ character Neo was living in an AI-induced hallucination.)
Following his prepared remarks, Gensler took questions for more than 40 minutes. He was clearly enjoying being back in the classroom – and even pointed out several times that he had been wait-listed from Yale Law School. (He’s not a lawyer.) What follows are some of the highlights…(Tuesday)
Governance Blowback: With all the focus on Basel endgame, it’s been easy to overlook the FDIC’s seemingly bland proposal to boost governance standards for bank boards. But with the comment deadline closing last week, it’s become clear that the effort has provoked a major backlash – and not just from the industry. One somewhat surprising opponent: the state regulators who share supervision of the 60 banks covered by the rule. The officials see a clear-cut case of federal overreach.
“Corporate governance models, standards and requirements are the province of state law,” the Conference of State Bank Supervisors wrote in a pretty scathing letter, calling for the proposal to be withdrawn. “Corporate formation itself is a matter of state law.” (For extra historical emphasis, the supervisors cited James Madison and the Constitutional Convention in a footnote.)
The state overseers especially objected to one of the proposed standards that calls for boards to be accountable to a wider array of stakeholders, including the public. And they faulted the FDIC for looking to assign directors many new responsibilities, including ones that normally fall on managers. That, they argued, promotes a “check-the-box” approach to oversight.
“The FDIC’s foray into redefining corporate duties and constituencies has potentially vast economic and political significance, presents a major question of public policy and cannot be done absent a clear congressional mandate,” the group wrote.
Underscoring the state opposition, some regulators wrote individually to urge the FDIC to drop the plan.
The Texas commissioner, Charles Cooper, faulted a requirement that would make a majority of directors be independent. The dictate “will undoubtedly cause disruption to existing companies and potentially reduce the existing talent pool,” he wrote, noting that directors commonly sit on the boards of both banks and their parent companies – something that would be limited under the rule.
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