After President Biden’s E.O. on Digital Assets, Top Regulators Hit the Road, Painting a Picture of the Digital Asset Regulatory Landscape To Come
April 13, 2022
On the heels of President Biden’s Executive Order about digital assets (which we covered in a previous client alert), top federal regulators—in prepared remarks last week—offered a bit more insight into the government’s thinking as it formulates a digital-asset policy. The regulators focused on four points: tech-neutral regulation, responsible innovation, platforms, and dollar dominance.
On April 4, 2022, in remarks before the Penn Law Capital Markets Association, SEC Chairman Gary Gensler stated, “[t]here’s no reason to treat the crypto market differently just because different technology is used. We should be technology-neutral.” This approach is not unlike the one the agency took recently in extending proposed rules on dealers and security-based-swaps to digital assets. Gensler commented that Congress and the Supreme Court had provided the top “cop on the beat: the SEC” with all the tools necessary to regulate the digital asset ecosystem.
Of course, the Commodity Futures Trading Commission (CFTC) may consider itself the “top cop” in policing digital assets, but Gensler’s comments suggest that the SEC is more open to cooperating with the CFTC than he had publicly expressed before. Gensler, however, did not deviate from his previous contention that many digital assets are, in fact, securities, even alluding to a time when the SEC found offerings of other atypical products—“chinchillas, whiskey warehouse receipts, oyster beds, and live silver foxes”—to be securities offerings to be regulated by the SEC.
With no new legislation or regulation specific to digital assets, Gensler maintains that the same protections afforded to other markets apply to crypto markets. His concluding words: “Let’s not risk undermining 90 years of securities laws and create some regulatory arbitrage or loopholes.”
Three days later after Gensler’s remarks in Philadelphia, Treasury Secretary Janet L. Yellen spoke to American University’s Kogod School of Business Center for Innovation. She echoed Gensler’s remarks: “Wherever possible, regulation should be ‘tech neutral.’” She added that “tech neutrality is also applicable to concerns related to tax evasion, illicit finance, and national security.”
The government’s preference for tech-neutral regulation raises some fundamental questions: Can current legal authority like the Howey Test (a four-prong test devised by the Supreme Court in 1946 to determine whether an investment contract is, in fact, a security) apply to digital assets, or is it an attempt to fit a square peg in a round hole? Are the questions presented by digital assets and services the same as those that legislators and regulators answered in enacting the current regulatory regime? And, does a “tech-neutral” approach really work when the asset and the “tech” are inseparable? You can’t formulate a policy of net neutrality, for example, without understanding the web, content, platforms, apps, equipment, source and destination addresses, and means of communication, among other things. To come up with meaningful regulation of digital assets, legislators and regulators will need to understand the “tech.”
A pillar of President Biden’s E.O. on digital assets was his call for “responsible innovation.” The E.O.—although generally welcomed by the industry for its thoughtful approach and call for an integrated policy that would promote innovation and US leadership in the field—expressed concerns about risks associated with digital assets. Wrapping up the regulators’ road show, on April 8, Acting Comptroller of the Currency Michael J. Hsu delivered an address on stablecoins at the Institute of International Economic Law at Georgetown University Law Center. Hsu stressed the need to protect crypto consumers—which, in the US, he noted, “are disproportionately young, diverse, and underbanked.” He stated that “70 percent of crypto owners were born after 1980 and 56 percent earn under $50,000,” and that “37 percent of the underbanked compared to 10 percent of the fully banked claim to own crypto.” Hsu’s point is presumably that the digital asset customer does not need less protection than the traditional bank customer. After noting that crypto may offer new ways to invest and trade, Gensler said, “we still need investor and market protection.”
As in the E.O., Gensler, Yellen, and Hsu all acknowledged the growth and promise of digital assets. Yellen cited the market cap of the digital-asset ecosystem expanding from $14 billion to $3 trillion in the last five years, and even offered the hope that blockchain services could one day act as a remedy for the inefficiencies in the current financial system. And Hsu highlighted the “significant advantage” that stablecoins have over fiat currencies in functioning as money in blockchain-based ecosystems.
There is no longer any question that the Biden administration and its top regulators are taking digital assets seriously, and that encouraging innovation is a priority. Both Yellen and Hsu invoked the E.O.’s call for cross-government collaboration to ensure “responsible innovation.” The trick for the administration will be striking a balance between that innovation and protecting consumers. But the key is collaboration—both among agencies and the industry.
The regulators did signal their desire for heightened scrutiny in one sector of the industry: platforms. First, Gensler’s comment that “the probability is quite remote that any given platform has zero securities” suggests that the SEC plans to closely examine all platforms. The SEC will consider whether platforms should register and be regulated as exchanges, and assess “whether and how the protections that are afforded to other investors on exchanges with which retail investors interact should apply to crypto platforms.” The SEC would also consider whether alternative trading system (ATS) exemptions apply to platforms.
As encouraged in the E.O., the SEC and the CFTC would work together to address how platforms can trade non-securities, commodities, and tokens deemed securities on the same platform. And Gensler noted that the SEC will also determine whether “it would be appropriate to segregate out custody” functions from platforms.
Regulators and legislators could decide to decouple platforms from affiliated corporate entities that offer stablecoins. In his remarks, Hsu mentioned the need for separability between stablecoins and their issuing entity. He described the liquidity risks for a bank engaging in blockchain-based payments—which are 24/7, irreversible, and settle in real-time. He expressed concern that a bank’s liquid reserves could be stripped over a weekend, and that a bank’s intraday controls and risk-management systems, which are based on traditional Fedwire payments, may not meet the liquidity needs. Hsu said that this risk can be mitigated by mandating that “blockchain-based activities, such as stablecoin issuance, be conducted in a standalone bank-chartered entity, separate from any other insured depository institution subsidiary and other regulated affiliates.”
Yellen also discussed platforms. First, she said that “consumers, investors, and businesses should be protected from fraud and misleading statements regardless of whether assets are stored on a balance sheet or distributed ledger.” Second, she stated that “firms that hold customer assets should be required to ensure those assets are not lost, stolen, or used without the customer’s permission.” And finally, she called for taxpayers to “receive the same type of tax reporting on digital asset transactions that they receive for transactions in stocks and bonds, so that they have the information they need to report their income to the IRS.”
Each regulator devoted portions of their remarks to stablecoins, but Hsu spoke only about stablecoins. All three raised concerns about the very stability of stablecoins, and stressed the paramount importance of maintaining the dominance of the US dollar. As Yellen noted, “90 [percent] of one leg in foreign exchange transactions[,] over half of trading invoices,” and 40 percent of outstanding international debt are denominated in US dollars. She stated that “we are now working with Congress to advance legislation to help ensure stablecoins are resilient to risks that could endanger consumers or the broader financial system.”
Hsu laid out three architectural policy considerations for a sound stablecoin: stability, interoperability, and separability, and maintained that the most effective way to regulate stablecoins under existing law was through bank regulation and supervision.
If, as some claim, stablecoins are an alternative to the US dollar, they present a threat to dollar dominance. Hsu warned that policy errors could “impede the potential for the dollar to serve as the base currency in a future digital economy.”
Hsu compared the current stablecoin ecosystem with pre–Civil War banking, when each bank printed its own note, purporting to represent a dollar. Currently, stablecoins can only exist on their own blockchain and are not fungible across other blockchains. While there are “bridges” that allow assets from one blockchain to transfer to another blockchain, Hsu pointed out that there have been many calamitous hacks of bridges, including the $320M Wormhole hack and the $600M Axie Infinity Ronin hack. Hsu stated that a lack of stablecoin interoperability would risk “digital ecosystems being fragmented and exclusive,” and that “interoperability between stablecoins and with the dollar…would help ensure openness and inclusion,” while ensuring broader use of the US dollar.
Some Concluding Thoughts
Until the government issues detailed guidance, addressing every scenario involving all digital assets (and of course assets fly through the cryptoverse so quickly that this can never happen), we will have to extrapolate from regulators’ public statements to predict the digital asset regulation to come. Know this: Platforms should be aware that the SEC is pursuing increased scrutiny over their activities; stablecoin projects should consider Hsu’s three principles of stability, interoperability, and separability; and the government’s approach to regulation aspires to be “tech-neutral” and to emphasize consumer protection, responsible innovation, and inter-agency collaboration.
In this rapidly evolving area of law, we will do our best to keep you informed. In the meantime, you will probably have questions. Contact professionals at O’Melveny for answers.
This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. William K. Pao, an O’Melveny partner licensed to practice law in California, Scott Sugino, an O’Melveny partner licensed to practice law in California and Illinois, and Damilola G. Arowolaju, an O’Melveny associate licensed to practice law in the District of Columbia, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.
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