Federal Regulation for Digital Assets Could Be Coming Soon

Significant regulation may be coming soon to the cryptocurrency, blockchain, and digital asset space.

On June 6, 2022, U.S. Senators Cynthia Lummis (R-WY) and Kirsten Gillibrand (D-NY) introduced the Responsible Financial Innovation Act (RFIA), which seeks to establish a comprehensive, federal regulatory system for digital assets. The proposal comes at a time of significant instability in the crypto market—including steep recent drops in value for Bitcoin and Ether and the collapse of TerraUSD (UST), an algorithmic stablecoin—which could generate additional support for regulation.

The RFIA defines “digital assets” broadly to include “(i) virtual currency and ancillary assets . . . (ii) payment stablecoins . . . and (iii) other securities and commodities that meet the digital asset definition.”

The RFIA allocates regulation of each of these “digital assets” as follows: payment stablecoins to the banking regulators; tokens that include voting, participation, and equity-like rights to the Securities and Exchange Commission (SEC); and ancillary assets, including spot or cash digital assets, as well as future and leveraged digital assets, to the Commodity Futures Trading Commission (CFTC). It is notable that the effect of the RFIA would be to assign most of the market regulation to the much smaller CFTC.

The RFIA seeks to create a basis for distinguishing digital assets as securities or commodities by analyzing the purpose of the digital asset and the rights it conveys to its owner. The RFIA creates a new section to the Securities and Exchange Act of 1934 and adds a definition of “ancillary asset.” Under the RFIA, an “ancillary asset” is defined as “an intangible, fungible asset that is offered, sold, or otherwise provided to a person in connection with the purchase and sale of a security through an arrangement or scheme that constitutes an investment contract.” If a digital asset is classified as an “ancillary asset,” then the issuer of the investment contract pursuant to which the ancillary asset was sold could incur certain limited disclosure obligations. Additionally, the RFIA would create a rebuttable presumption that an “ancillary asset” is a commodity rather than a security. Notably, the RFIA would classify Bitcoin and Ether – the two cryptocurrencies with the highest market capitalization – as commodities within the purview of the CFTC.   

On reading the RFIA, it is clear that the Senators intend to regulate digital assets in much the same way that traditional commodities futures and swaps have been regulated. Familiar concepts will include registered exchanges for trading, futures commission merchants to intermediate, and other regulated intermediaries.

Highlights of the proposed bill include: 

• Regulating digital assets as commodities (unless they are securities or bank-issued stablecoins).
• Granting the CFTC jurisdiction over non-securities and nonbank issued stablecoin digital assets, and excluding “digital collectibles.”
• Creating Digital Asset Exchanges that must act in accordance with general principles, much like existing designated contract markets or futures exchanges.
• Enabling futures commission merchants to hold digital asset customer funds separately, with a regulated custodian.
• Prohibiting comingling of digital asset customer funds with the assets of the futures commission merchant or using digital asset customer funds to secure other customers’ accounts.
• Limiting the investment of digital asset customer funds to certain highly liquid and creditworthy assets.
• Prohibiting the futures commission merchant from acting as digital asset counterparty to the digital asset customer. 
• Creating a class of “providers of digital asset services,” which includes digital asset intermediaries, financial institutions, and federal or state licensees. 
• Including a user fee for funding the CFTC’s regulation of the market.
• Setting out specific terms that must be addressed in digital asset customer agreements and notices that must be provided to digital asset customers

• Resolving the question of settlement finality with respect to digital assets.

Of particular note to clients are the obligations associated with being a provider of digital asset services. The entities subject to these obligations would include futures commission merchants, introducing brokers, commodity trading advisers, commodity pool operators, swap dealers, state or federally registered investment advisers, investment companies, bond trustees, banks or other depository institutions or subsidiaries of a bank or depository institution, trust companies, money transmitters, consumer credit providers, digital asset exchanges, and broker-dealers, among others. Once classified as a provider of digital asset services, that entity would be responsible for consumer protection, including entering into a customer agreement that contains specified business terms and notices relating to the risk of engaging in digital assets, including source code version changes.

Additionally, the RFIA includes provisions designed to enhance consumer protection for holders of stablecoins by requiring all stablecoin issuers to have a 100 percent reserve backing the stablecoin and to provide disclosure to the market regarding the composition of such reserve. The RFIA would require stablecoin issuers to ensure that stablecoin holders maintain an ability to redeem stablecoins at a 1:1 ratio in recognized legal tender. The stablecoin regulation included in the RFIA appears to prohibit the use of algorithmic stablecoins such as TerraUSD (UST), which recently collapsed after failing to maintain its $1 peg. 

The RFIA also would create certain federal tax implications by providing an exclusion from a taxpayer’s gross income of up to $200 per transaction where the taxpayer uses digital assets for payment for goods and services, subject to certain conditions. Additionally, the RFIA would clarify that digital assets obtained from “staking” do not give rise to a taxable event until the disposition of those digital assets and conversion into a fiat currency.

The RFIA will need to proceed through several Senate committees before being put to a full chamber vote, then would need House approval and President Biden’s signature. Therefore, the proposed legislation is subject to change before it becomes law. However, if passed, the RFIA would establish the most comprehensive regulatory framework to date for the digital assets industry in the United States.

This legislation would be game-changing, as individuals and companies in the digital asset space have for years confronted a lack of clarity from regulators, which in turn has made it difficult for lawyers to render legal advice on structuring products and compliance.  The SEC commissioners have, for years, warned lawyers that they should not be helping their clients evade the regulators. Having structure will be helpful, however, too much structure could stifle innovation, so finding the right balance will be critical as this legislation makes its way through the process.

Ballard Spahr attorneys have decades of experience with securities and derivatives regulatory matters, including at the Commodity Futures Trading Commission and as in-house counsel for futures commission merchants, swap dealers, and broker-dealers. The firm’s Blockchain Technology and Cryptocurrency team helps clients with the full range of issues, including development and implementation of new products and navigating the labyrinth of evolving government regulation and enforcement.

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