In Depth: Regulation and Enforcement of the Digital Assets Markets, Part One | Cadwalader, Wickersham & Taft LLP
As more market participants, from consumers to major financial institutions and central banks of various countries, become active in the digital asset space, the U.S. regulators are ramping up their oversight activity related to digital assets. In the absence of a consistent and comprehensive legislative framework for digital assets, federal and state regulators, operating within their mandates, attempt to fill that void by asserting their jurisdiction over digital assets through public policy statements, enforcement actions and investigations. A major part of the current regulatory actions by various government agencies is conducted through prosecution of unlawful activity. As a result, there is a lack of clear guidance on how transactions in digital assets can be conducted lawfully. Meanwhile, the question of which federal regulator will be primarily responsible for overseeing digital asset activities remains open.
In the first of our two-part “In Depth” article, we will examine jurisdiction of federal and state regulators in the digital asset space and congressional initiatives aimed at creating a federal-level framework for their regulation.
The Commodities and Futures Trading Commission (the “CFTC”) has an exclusive regulatory authority over the U.S. derivatives markets (including futures, swaps, and certain types of options). Section 2(c)(2)(D) of the Commodity Exchange Act (the “CEA”) also makes commodity transactions entered into with, or offered to, a person that is not an eligible contract participant or eligible commercial entity on a leveraged, margined or financed basis (referred to in the statute as “retail commodity transactions”) subject to enumerated provisions of the CEA, including on-exchange trading and broker registration requirements applicable to futures contracts. However, contracts of sale that result in “actual delivery” within 28 days from the date of the transaction or that create an enforceable obligation to deliver between a seller and a buyer that have the ability to deliver and accept delivery in connection with their respective lines of business are excepted from this requirement. The CFTC also has enforcement authority for fraud and market manipulation in the commodity spot market that underlies the derivatives market it regulates. However, in the absence of leverage, margining or financing, spot commodity trades are otherwise outside of the CFTC’s jurisdiction. In a September 17, 2015 settlement order, the CFTC expressed its view that bitcoin and other virtual currencies are commodities under the CEA, and, therefore, are subject to the CFTC’s enforcement authority for fraud and market manipulation. That position was upheld in 2018 by a decision of the U.S. District Court for the Eastern District of New York in Commodity Futures Trading Commission v. McDonnell. However, in that decision, the court also pointed out that federal agencies may have concurrent or overlapping jurisdiction over a particular issue or area, such as virtual currencies. Nevertheless, the CFTC continues its push for a full regulatory authority over the spot market for digital assets. On May 11, 2022, in his keynote address at the International Swaps and Derivatives Association’s annual meeting in Madrid, CFTC chairman Rostin Behnam stated, “I will continue advocating for and supporting legislative authority for the CFTC to develop a regulatory framework for the cash digital asset commodity market.”
The Securities and Exchange Commission (the “SEC”) has an exclusive jurisdiction over U.S. public securities markets and financial reporting of public companies. In his remarks before the International Swaps and Derivatives Association annual meeting in Madrid on May 11, 2022, SEC chairman Gary Gensler confirmed the SEC’s position that only some digital tokens might be commodities, while most of them involve a group of entrepreneurs raising money from the public in anticipation of profits, and, therefore, meet the definition of an investment contract under the Supreme Court’s Howey Test and fall under the SEC’s jurisdiction. Further, if a swap references a digital asset that is a security, it is a security-based swap that is subject to the SEC regulation. Thus, the SEC intends to register and regulate all platforms, whether in the decentralized or centralized finance space, which offer digital assets that the SEC considers to be securities as well as security-based swaps referencing those assets. In addition, an offering of digital asset securities to retail market participants must be registered under the Securities Act of 1933.
Prudential regulators, like other financial services regulators, recognize that the growing links between traditional financial institutions and the digital asset market may present a threat to global financial stability. Unlike the CFTC and the SEC, however, prudential regulators are still working on appropriate regulatory supervision of banking organizations’ activities relating to digital assets. In November 2021, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation (“FDIC”) and the Office of the Comptroller of the Currency issued their “Joint Statement on Crypto-Asset Policy Sprint Initiative and Next Steps” where they described their plans as follows:
“Throughout 2022, the agencies plan to provide greater clarity on whether certain activities related to crypto-assets conducted by banking organizations are legally permissible, and expectations for safety and soundness, consumer protection, and compliance with existing laws and regulations related to:
- Crypto-asset safekeeping and traditional custody services.
- Ancillary custody services.
- Facilitation of customer purchases and sales of crypto-assets.
- Loans collateralized by crypto-assets.
- Issuance and distribution of stablecoins.
- Activities involving the holding of crypto-assets on balance sheet.
The agencies also will evaluate the application of bank capital and liquidity standards to crypto-assets for activities involving U.S. banking organizations and will continue to engage with the Basel Committee on Banking Supervision on its consultative process in this area.”
In furtherance of the goals outlined in the statement, on April 7, 2022, FDIC issued a letter that requires all FDIC-supervised banking organizations that are engaged or intend to engage in activities involving or relating to digital assets to notify FDIC and provide required information.
One of the central concerns of prudential regulators is addressing the risks relating to stablecoins. The recent implosion of the Luna and Terra stablecoins underscores the importance of enacting appropriate regulation of stablecoin issuers. Michael Hsu, the Acting Comptroller of the Currency, recently presented his “Thoughts on the Architecture of Stablecoins” before the Institute of International Economic Law at Georgetown University Law Center where he argued for a single banking-style regulation of blockchain-based activities, including stablecoin issuance and stablecoin-based payments. In his view, this approach would provide better safeguards against implosion of risky issuers that may cause a chain reaction across their peers in the digital asset market.
The growing interest in digital assets and a lack of a federal-level framework for their regulation prompted a number of state legislative and executive branches of government to take regulatory and enforcement actions.
Many states require businesses that engage in transmission of virtual currencies to obtain money transmission licenses. In addition to or instead of requiring money transmission licenses, some states have enacted separate laws to require licensing of virtual currency business activity in the state. For example, in New York, engaging in any virtual currency business activity, in addition to a money transmission license, generally requires obtaining a “BitLicense” from the New York’s Department of Financial Services, which has proved to be a very lengthy, time-consuming and expensive process.
Some states used a different approach. For example, in Wyoming, “[b]uying, selling, issuing, or taking custody of payment instruments in the form of virtual currency or receiving virtual currency for transmission to a location within or outside the United States by any means” is exempt from licensing as money transmission. On April 21, 2021, the State of Wyoming enacted the Wyoming Decentralized Autonomous Organization Supplement to the Wyoming Limited Liability Company Act, which provides a legal framework for formation and existence of decentralized autonomous organizations (“DAOs”) in the state, and makes it clear that members of a DAO are not personally liable for its debts and liabilities and requires DAOs to continuously maintain a registered agent in the state.
Generally, DAOs are intended to be entities that handle digital assets and implement certain actions through the use of blockchain technology and smart contracts. The articles of organization of a DAO may define it as either member managed or algorithmically managed. Accordingly, management of a DAO may be vested in its members, if member managed, or a smart contract, if algorithmically managed, unless otherwise provided in its articles of organization or operating agreement. Formation of algorithmically managed DAOs is allowed if the underlying smart contracts are able to be updated, modified or otherwise upgraded. DAOs do not have obligations to furnish any information concerning their financial condition or other circumstances to the extent the information is available on an open blockchain.
California Governor Gavin Newsom also used a different approach. On May 4, 2022, he signed Executive Order N-9-22 (EO) intended to bolster responsible development of digital asset technology and protect consumers in California by engaging with stakeholders and encouraging regulatory clarity.
Recognition of the importance of digital assets for the financial system and risks they present led to a number of recent legislative initiatives in the U.S. Congress and Senate intended to address certain aspects of the issuance and use of digital assets or to provide a more comprehensive regulatory framework for blockchain-based digital asset activities.
On April 6, 2022, Senator Pat Toomey released a draft of the “Stablecoin Transparency of Reserves and Uniform Safe Transactions Act.” The proposed bill introduces a definition of “payment stablecoin” that must be redeemable for fiat currency and requires issuers of payment stablecoins to operate in one of the three separate licensing regimes: (i) as a state-licensed stablecoin issuer; (ii) as a national limited payment stablecoin issuer (a new licensing regime introduced by the bill); or (iii) as an insured depository institution within the meaning of the Federal Deposit Insurance Act.
On May 26, 2022, Senators Tom Cotton, Mike Braun, and Marco Rubio introduced the “Defending Americans from Authoritarian Digital Currencies Act” that would prohibit persons that own or control app stores in the United States from supporting or enabling transactions in digital yuan or carrying or supporting any apps that support or enable transactions in China’s digital yuan, a digital currency payment system operated by the Government of the People’s Republic of China. The bill is intended to address concerns that the use of digital yuan would enable China to infiltrate the U.S. financial system and potentially facilitate illicit money flows.
On June 7, 2022, Wyoming Senator Cynthia Lummis and New York Senator Kirsten Gillibrand introduced the “Responsible Financial Innovation Act,” which is intended to provide a complete regulatory framework for digital assets. The bill creates a set of definitions for digital assets and a standard for determining which types of digital assets are commodities and which types are securities. It assigns regulatory authority over spot markets for digital assets to the CFTC, defines requirements for stablecoins, imposes disclosure requirements on digital asset service providers, creates a taxation structure for digital assets and addresses the need for additional studies of various issues relating to the use and regulation of digital assets.
From a jurisdiction perspective, we observe a movement to establish a federal-level regulatory framework for the digital assets market, which will provide guidance to the market participants on how transactions in digital assets can be conducted lawfully. Next week, we will take a closer look at recent enforcement actions undertaken by federal and state regulators in the digital asset space.