An ambitious proposal could bring digital assets into the mainstream regulatory fold.
By Yvette D. Valdez, Stephen P. Wink, Adam Bruce Fovent, Adam Zuckerman, and Deric Behar
During an eventful summer for the digital assets industry, it may have been easy to miss US Representative Don Beyer’s introduction of the Digital Asset Market Structure and Investor Protection Act (the Bill) on July 28, 2021. The Bill is perhaps the most promising effort to date by Congress to enact legislation that would address some of the legal ambiguities for digital assets and better define their place within existing financial regulatory structures.
Rep. Beyer described the current legal landscape for digital assets as “ambiguous and dangerous for investors and consumers.” Broadly, the Bill seeks to address deficiencies and/or ambiguities relating to consumer protection, trade reporting and transparency, and anti-money laundering / know your client (AML/KYC) procedures for digital assets.
The Bill also seeks to address a wide range of practical issues, from the fundamental (such as defining industry terms and categorizing cryptoassets) to the more nuanced (such as establishing standards for transaction reporting and consumer protection and advisories).
Security, Commodity, Other
The Bill would categorize digital assets as either “Digital Assets” or “Digital Asset Securities.” This categorization would then determine regulatory consequences and the allocation of agency regulatory jurisdiction.
The Bill would define a Digital Asset Security (in the Securities Exchange Act of 1934, the Securities Act of 1933, the Investment Advisers Act of 1940, the Investment Company Act of 1940, and the Securities Investor Protection Act of 1970) as a Digital Asset that provides the holder of such asset with any of the following:
- Equity or debt interest in the issuer
- The right to profits, interest, or dividend payments from the issuer
- Voting rights in the major corporate actions of the issuer (which shall not include new block creations, hard forks, or protocol changes related to the digital asset)
- Liquidation rights in the event of the issuer’s liquidation
The Digital Asset Security definition would also include any Digital Asset issued by an issuer with a service, goods, or platform that is not wholly operational at the time of issuance where such Digital Asset is transferred to the holder for payment, in order to fund the development of the proposed service, goods, or platform.
The Bill would also amend the Commodity Exchange Act (CEA) to incorporate a broad definition of a Digital Asset as an asset that, among other things, is created electronically or digitally through software code and has a transaction history that is recorded on a distributed ledger or other “digital data structure in which consensus is achieved through a mathematically verifiable process.”
Joint Rulemaking on Digital Asset Classification
The Bill would mandate that the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) issue a joint rulemaking no later than 270 days after the Bill’s enactment that categorizes each of the top 25 digital assets by market capitalization and also by daily trading volume under the bifurcated categorization discussed above.
Under the Bill, any Digital Asset that met the definition of a Digital Asset Security would be deemed to be, and regulated as, a security under the Securities Exchange Act of 1934.
The Bill would allow for a grace period before registering a Digital Asset Security with the SEC became necessary, akin to the Exchange Act’s treatment of issuers that are banks, savings and loan holding companies, and bank holding companies. An issuer of Digital Assets would be required to register a Digital Asset Security with the SEC:
- No later than 120 days after the last day of the third fiscal year on which the issuer first has total assets exceeding US$10 million and a class of equity security (other than an exempted security) held of record by 2,000 or more persons
The Bill would also allow for the “desecuritization” of a Digital Asset Security at any time after it is registered as a security with the SEC. An asset’s status as a security could be terminated at the SEC’s discretion (and thereby rendered a commodity) if:
- The issuer files a desecuritization certification with the SEC demonstrating that the issuer’s service, goods, or platform are fully operational and that the Digital Asset does not provide its holders with any of the rights that the Bill enumerates in the definition of a Digital Asset Security
This provision allowing for the desecuritization of a digital asset at a later date contrasts starkly with SEC Commissioner Hester Peirce’s Token Safe Harbor Proposal 2.0, which would provide a time-limited exemption at the outset for token-based projects that seek to raise capital to develop decentralized networks (see this Latham blog post for more information).
The Bill would amend the CEA definition of a “commodity” to expressly include ‘‘digital assets (including Bitcoin, Ether, and their hardforks),” thereby providing statutory confirmation of the current market understanding that has emerged through SEC and CFTC enforcement and informal guidance.
The Bill would extend the definitions of certain CFTC-regulated intermediary activities — namely, those of futures commission merchants and introducing brokers — to include engaging in the relevant intermediation activities with respect to “any contract of sale of a digital asset in interstate commerce, but not a digital asset security.” As these intermediary definitions currently apply only in relation to commodity interest transactions (i.e., commodity futures, options, or swaps) and retail commodity transactions regulated as futures under Section 2(c)(2)(D) of the CEA, this would subject spot digital asset market participants to CFTC registration and regulation.
With respect to retail leveraged, margined, or financed transactions in commodities, the Bill would shorten the requirements for the “actual delivery” exception to Section 2(c)(2)(D) of the CEA with respect to Digital Assets to require delivery within 24 hours after the transaction is entered into, rather than 28 days (see this Latham blog post for more information). In doing so, the Bill would identify “actual delivery” of a Digital Asset to have taken place by reference to the time the relevant transaction is (i) recorded on the public distributed ledger for the Digital Asset; or (ii) with respect to Digital Asset transactions that are not recorded on a public distributed ledger for the Digital Asset, reported to a CFTC-registered “digital asset trade repository.” The Bill would introduce digital asset trade repositories as a new category of CFTC-registered entities subject to similar regulatory requirements as are applicable to swap data repositories.
The Bill would also amend the CEA to provide for an “optional federal charter” allowing for Digital Asset trading and clearing through existing CFTC-registered entities. In this regard, the Bill would provide the CFTC with exclusive jurisdiction over any agreement, contract, or transaction involving a contract of sale of a commodity in interstate commerce (including any Digital Asset) that is listed, traded, or cleared on or through a registered entity (e.g., a designated contract market or derivatives clearing organization). The Bill would provide that such contracts shall be treated for regulatory and enforcement purposes as if they were contracts of sale of a commodity for future delivery.
The Bill would provide that, from the date of enactment, no person may issue, use, or permit to be used a Digital Asset fiat-based stablecoin that is not approved by the Secretary of the Treasury. The Secretary of the Treasury would be required within 90 days of the Bill’s enactment to establish a stablecoin application process through which the Secretary may approve or disapprove a person wishing to issue a Digital Asset fiat-based stablecoin. Importantly, the Bill would not grandfather existing stablecoins, and so would require an application for stablecoins in existence at the time of the Bill’s enactment.
Central Bank Digital Currency
To remove any uncertainty as to the Federal Reserve’s legal authority to issue a US central bank digital currency (CBDC), the Bill would authorize the Federal Reserve to issue “Digital Federal Reserve Notes” with legal tender status. Foreign fiat currencies, Digital Assets, and Digital Asset Securities would be expressly denied legal tender status, which could hamper digital asset proponents calls to move digital assets into the realm of legal tender (see this Latham blog post on the implications of El Salvador’s designation of Bitcoin as legal tender).
Bank Secrecy Act
The Bill would add Digital Assets and Digital Asset Securities to the Bank Secrecy Act’s (BSA’s) statutory definition of “monetary instruments,” thus subjecting them to the BSA’s AML and reporting requirements.
The Bill proposes to amend the BSA to define a “virtual asset service provider” (VASP) in such a manner as to exclude “any person who obtains a digital asset to purchase goods or services for themself; provides communication service or network access services used by a money transmitter; or develops, creates, or disseminates software designed to be used to issue a digital asset or facilitate financial activities associated with a digital asset.”
Financial Crimes Enforcement Network
The Bill would require the Secretary of the Treasury, acting through the Financial Crimes Enforcement Network (FinCEN), to issue rules within 180 days of the Bill’s enactment that govern Digital Asset anonymizing services, money mules, and anonymity-enhanced convertible virtual currency transactions that are used to prevent association of an individual customer with the movement of a Digital Asset or Digital Asset Security.
Under the Bill, VASPs that are engaged in services that are available in the US and to US persons would be required to register with the SEC or the CFTC, as appropriate, even if the VASP were located outside the US. With respect to Digital Asset Securities, the Bill would require VASPs to meet the customer protection and account custody rules that are applicable to SEC-registered broker-dealers for customer funds and securities. With respect to Digital Assets, the Bill would require VASPs to meet the customer account custody and segregated funds rules that are applicable to CFTC-registered futures commission merchants.
The Bill would also require a joint report by the SEC, the CFTC, the Office of the Comptroller of the Currency (OCC), and the Secretary of the Treasury, within 270 days of enactment “provid[ing] recommendations on the regulation, licensing, and auditing of digital asset custodians and digital asset security custodians.”
While the Bill does not substantively address decentralized finance (DeFi), it would require a joint report by the Federal Reserve Board (FRB), the SEC, the CFTC, the OCC, and the Secretary of the Treasury within 270 days of enactment that (i) summarizes the current state and use of DeFi in the US, (ii) discusses whether DeFi poses any financial stability risks, and (iii) “provide[s] recommendations regarding appropriate regulation and investor protection for decentralized finance in US banking, securities, and commodities, including with respect to US jurisdiction and application of US law.”
Within 90 days of enactment, the Bill would require the Federal Deposit Insurance Corporation (FDIC) and the National Credit Union Administration (NCUA) to publish on their respective websites a notice regarding the treatment of Digital Assets and Digital Asset Securities and stating that Digital Assets and Digital Asset Securities are not “deposits” or “shares” covered by federal deposit insurance (regardless of whether an insured bank, savings association, or credit union holds the Digital Asset or Digital Asset Security). The Securities Investor Protection Corporation (SIPC) would also be required to publish a notice on its website regarding the status of Digital Assets and Digital Asset Securities and stating that Digital Assets are not deposits and Digital Asset Securities are (in almost all cases) not securities, and thus neither would be covered by SIPC insurance.
The digital asset industry presents novel problems that are not easy to resolve under current US law. Rep. Beyer noted in a public statement that “[o]ur laws are behind the times, and my bill would start the long overdue process of updating them to give digital asset holders and investors basic protections.” Legislative solutions would be welcome, and would help avoid the development of a fragmented and burdensome regulatory environment. Top regulators themselves have remarked on the necessity for legislative guidance, including SEC Chair Gary Gensler, who noted in a recent speech that “we stand ready to work closely with Congress… to close some of these [regulatory] gaps.”
The Bill demonstrates an earnest effort to provide greater legal clarity to the digital asset industry. Moreover, it aims to support the opportunities that the digital asset industry presents, while still applying sufficient safeguards and regulations to promote market integrity and consumer protection.
Industry participants have largely expressed appreciation for the Bill’s comprehensive and thoughtful approach, though some differ over the ramifications of specific provisions.
Some areas that merit further attention include:
- Decentralization models need to have usable governance structures without such tokens being deemed securities. The Bill may be overly broad in stating mutually exclusive criteria that could define a digital asset security, and may capture many governance tokens as securities.
- Although the Bill would require that the SEC and the CFTC issue a joint rulemaking no later than 270 days after the Bill’s enactment that categorizes each of the top 25 digital assets by market capitalization and daily trading volume, there is no indication whether such token issuers would be required to self-determine status prior to that official categorization, or whether such official determination would be subject to appeal. It would appear that self-determination of status would be required, because of thousands of digital assets in existence, at most 50 would receive official designation (although the number is in reality far less, as market capitalization and daily trading volume are highly correlated).
- As noted above, the Bill would extend the definitions of certain CFTC-regulated intermediary activities to include engaging in the relevant intermediation activities with respect to “any contract of sale of a digital asset in interstate commerce, but not a digital asset security.” This provision would subject spot digital asset market participants to CFTC registration and regulation. While typically registration is an unwelcome development, this might be on balance a welcome approach if such federal regulation would relieve state licensing requirements under money transmission.
- The net cast for stablecoin approval is potentially overly broad, as it would capture everything from global stablecoins to in-game payment mechanisms, such as the one described in the Pocketful of Quarters no-action letter (see this Latham blog post).
- The requirement that “no person may issue, use, or permit to be used a digital asset fiat-based stablecoin that is not approved by the Secretary of the Treasury” as of the date of the Bill’s enactment would presumably lead to an immediate cessation of billions of dollars’ worth of stablecoin-related commercial activity, pending Treasury approval, which could take months or longer.
- VASPs, as newly defined in the Bill, would be subject to registration, custody, account protection, and AML/KYC requirements that they may not be currently required to comply with due to gaps in regulatory oversight.
Latham & Watkins will monitor and report on developments regarding the Bill’s progression.
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