Bipartisan Responsible Innovation Act Limits Howey Test; Suggests Noncustodial Institutions Can Issue Payout Stablecoins | Troutman pepper


On June 6, Senators Kirsten Gillibrand (D-NY), member of the Senate Agriculture Committee, and Senator Cynthia Lummis (R-WY), member of the Senate Banking Committee, introduced a bipartisan bill , the Responsible Innovation Act (Act). , which is the first attempt by Congress to build a comprehensive regulatory framework for digital assets. The scope of the law is far-reaching, and it addresses many of the issues that have plagued digital asset markets in recent years. Importantly, the law addresses (1) the lack of clarity regarding the regulatory authority of the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) and (2) the lack of simplified legal definitions and uniforms of various products integral to the digital asset market infrastructure.

Clarification of regulatory jurisdiction

In the digital asset market, the lack of regulatory clarity has had two main consequences: it has created great uncertainty and stifled the ability of incumbents in the sector to innovate and has also apparently confused the SEC (which regulates securities) and the CFTC (which regulates commodity trading) because, in recent years, federal agencies have clashed over the scope of their respective roles in regulating digital assets.

The law seeks to address this dilemma by granting the CFTC exclusive jurisdiction over “digital assets,” which is a term that includes the practice of “spot trading.” Spot trading is the process of buying a financial instrument at the current market rate for immediate settlement. Currently, the CFTC’s regulatory authority does not extend to spot trading, but if enacted, the law would allow the CFTC to regulate US-based cryptocurrency exchanges that conduct spot trading. cash. In turn, U.S.-based cryptocurrency exchanges (or “digital asset exchanges,” which are also “financial institutions” as referred to in the law) would be subject to the law changing the law on the exchange of goods, whichamong others, would require the implementation of reasonable security standards to minimize the risk of loss or delay of access to a consumer’s digital assets. The law contains various disclosure and record-keeping requirements focused on consumer protection, which may be in addition to the current compliance requirements of these exchanges to register as money services businesses with the Financial Crimes Enforcement Network (FinCEN) of US Treasury and state level regulators and adherence to anti-money laundering and “countering the financing of terrorism” (AML/CFT) guidelines.

The law contains a significant constraint on the CFTC’s jurisdiction over a digital asset class that has been gaining traction: non-fungible tokens (NFTs). The law specifically states that the CFTC “exercises jurisdiction only over…a fungible digital asset, which does not include digital collectibles and other unique assets.” We have discussed NFTs and fungibility here.

Conversely, the law indirectly incorporates the Howey test by granting the SEC authority over which securities constitute an “investment contract”. The law attempts to delineate the limits of the SEC’s use of the Howey analytical framework test of investment contracts by creating a term called “ancillary asset”. An “ancillary asset” is defined as “a fungible intangible asset that is offered, sold or otherwise provided to a person in connection with the purchase and sale of a security through an agreement or scheme which constitutes an investment contract”. As noted above, the law empowers the CFTC to regulate “digital assets,” a term that includes “ancillary assets.” It is important to note that the definition of an “ancillary asset” excludes assets that possess the distinctive characteristics of a security par excellence offered by a company: (1) debt or equity; (2) liquidation rights; (3) the right to interest or dividend payments; or (4) the share of profits or revenues derived solely from the management or entrepreneurial efforts of others. Accordingly, firms that engage in investment contract transactions would be subject to the disclosure requirements of securities laws, as would firms that provide their counterparties with assets possessing any of the four characteristics listed above. -above. It is unclear whether assets such as Decentralized Autonomous Organization (DAO) governance tokens, which can provide token holders with a nominal percentage of revenue from the DAO’s treasury, would be encompassed by the definition of “assets”. accessories” and would be regulated by the CFTC, or whether these products would be considered “securities” and regulated by the SEC.

Finally, the law makes interdepartmental coordination possible. Within 18 months of the law’s enactment, the CFTC and SEC (together with FinCEN) must publish final guides and exam manuals that cover certain topics: (1) AML; (2) custody; (3) fiduciary and capital markets activities; (4) information technology standards; (5) payment system risk; and (6) consumer protection. Additionally, in consultation with digital asset intermediaries and industry stakeholders, the law requires the CFTC and SEC to conduct research and issue a proposal discussing the principles underlying the need for a self-regulatory body in the field of digital assets. The principles analyzed should cover, among others: (1) setting standards, corporate transparency requirements and developing rules relating to conduct in the digital asset market; (2) regular consultation with the CFTC and the SEC; (3) the investigative and disciplinary powers of digital asset exchanges; (4) authority of digital asset intermediaries to conduct business related to traditional assets; and (5) consumer education and financial literacy.

SEC Modernization of the Guard in the 21st Century

Brokers or entities that buy and sell securities (including digital assets that constitute “investment contracts” under the Act) for their own account and/or on behalf of their clients, are regulated by the DRY. Specifically, under Rule 15c3-3 of the Exchange Act, known as the “Client Protection Rule”, these entities are required to have “physical possession or control” of their clients’ securities. .

As discussed here, custody and its relationship to digital assets built on the blockchain is exclusively determined by public-key (or asymmetric) cryptography. Public-key cryptography offers a consumer – so long as they secure and maintain the private key associated with a particular public wallet address – unopposed access to digital assets tied to the private key. What happens when the hypothetical consumer engages a third party to both execute digital asset transactions and retain custody of the digital assets underlying the transactions on the third party’s platform? In practice, although the consumer can digitally see or perceive the value of their assets on the third-party platform, in this scenario the consumer has diminished their ability to exercise control over and dictate the action of the digital assets purchased. . Unaware of the private key associated with the third party’s public wallet address, the consumer is now at the mercy of the third party, and in times of extreme market volatility, the lack of true custody can be catastrophic.

The statute appears to contemplate the possibility of this issue, as it would require the SEC, within 180 days of the date of enactment, to modernize its customer protection rule by adopting final rules addressing, among others“the use of collaborative custody arrangements or multiple signatures, including the distribution of private key material and the obligations thereunder.”

Definition of payment stablecoins

After the demise of Terra Labs’ algorithmic stablecoin, TerraUSD (UST), which resulted in the loss of an estimated $42 billion in investor value, stablecoin regulation has been at the forefront of consumer, stakeholder and consumer concerns. and policy makers. Due to the lack of collateralization of algorithmic stablecoins, UST investors have been left with little to no remedial recourse. With this in mind, the law defines a “stablecoin payment” as a digital asset which is “redeemable, on demand, on an individual basis for instruments denominated in US dollars and defined as legal tender [under 31 U.S.C. 5103] …or for instruments defined as legal tender under the laws of a foreign country….” Notably, the law excludes from the definition of “stablecoin payment” algorithmic stablecoins and stablecoins backed by digital assets, both of which are encompassed by the definition of “virtual currency” in the law. Specifically, the law requires issuers of algorithmic stablecoins (or “digital assets…based solely on a smart contract”) to provide statements that “a denominated or indexed value will be maintained and will be available upon redemption from the transmitter…”.

The law allows “depository institutions,” a term that includes banks, credit unions, and FDIC-insured thrift associations, to issue payment stablecoins provided those entities cater to the state or federal bank branch at least six months before the stablecoin payment is issued. Surprisingly, the law does not prohibit non-custodial institutions from issuing payment stablecoins. Therefore, in practice, the law would sanction the continued issuance of private stablecoins by Circle (USDC), Tether (USDT), Binance (BUSD) and many others. Nevertheless, custodial institutions and non-custodial institutions would be required to maintain asset reserves containing “high quality liquid assets” on an individual basis with the entity’s exceptional payment stablecoin supply and must provide to consumers and appropriate federal or state agency, within 10 business days of the end of each month, a summary description of the assets backing the entity’s payout stablecoin.

Since the law generally defines “payment stablecoins” and “virtual currencies” as “digital assets,” both products would constitute commodities under the law and fall under the jurisdiction of the CFTC.

Our catch. The Responsible Innovation Act is a valiant effort that circumscribes the power of authority between the key federal regulators (seemingly) of digital asset markets. The law gives a stronger regulatory role to the CFTC, but depending on how the courts interpret the Howey test, the SEC could see its regulatory authority over digital assets strengthened and legitimized long before the law (or any derivative thereof) is signed into law. Finally, the law clearly defines “digital asset exchanges” as “financial institutions”. Although the law primarily deals with the CFTC, it seems clear that US-based cryptocurrency exchanges could be subject to the jurisdiction of other agencies created by the Dodd-Frank Act, in particular the Consumer Financial Protection Bureau. .


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