Digital assets rules for the road: One step forward, two steps back

It has been nearly 15 years since Satoshi Nakamoto published the white paper that led to the creation of bitcoin. In the intervening years, the digital asset space has exploded, with more than 20,000 cryptocurrencies being traded 24 hours a day on a global network of crypto platforms – more than double the number of stocks that are listed on US securities exchanges. But guess how many laws Congress has passed, and how many rules financial services regulators have adopted, to protect investors in the digital asset marketplace?

Remarkably, the answer is zero. Even in the wake of last year’s massive fraud at FTX that cost retail investors billions of dollars, lawmakers and policymakers in Washington still seem very far away from agreeing on a legislative or regulatory framework to govern the digital asset ecosystem.

To be fair, there are substantial efforts underway in Congress to pass legislation that would chart a regulatory path forward in the crypto space, but it seems that with every step forward, something happens that moves the effort two steps back. For their part, the financial services regulators have made the process even more complicated as they try to carve out their own jurisdiction without a legislative mandate, and a number of recent (and soon-to-be-decided) court opinions threaten to upend any progress that has been made to date.

In this edition of the Washington Commentary, we’ll explore the flurry of activity in the digital asset space over the past few months at the regulators, in Congress, and in the courts. And we’ll consider the prospects for whether the second half of the year portends another step forward or yet more steps back.

At the regulatory agencies

The SEC pursues high-profile enforcement actions

The focal point of regulatory activity has continued to be the Securities and Exchange Commission (SEC), where Chair Gary Gensler has doubled down on his “regulation by enforcement” approach, bringing high-profile enforcement actions against Coinbase and Binance on consecutive days in early June. The cases allege that the crypto-asset platforms operated illegally in the United States because they failed to register with the SEC and facilitated the trading of unregistered digital asset securities. The lawsuits against Binance and Coinbase are consistent with the mantra that Gensler has consistently advanced – “of the nearly 10,000 tokens in the crypto market, I believe the vast majority are securities. Offers and sales of these thousands of crypto security tokens are covered under the securities laws.”

However, Gensler’s hard-line view that all tokens are securities – and his regulation by enforcement approach – suffered a setback in early July when a federal judge in the Southern District of New York issued a long-awaited opinion in SEC v. Ripple Labs, a lawsuit that is expected to have a significant impact on the SEC’s claims about what is a security and what is not. In the opinion, the judge found that Ripple’s token, XRP, was a security when offered and sold to a targeted group of sophisticated investors. However, the court found that it was not a security when it was sold in secondary transactions on an exchange.

The decision undercuts Gensler’s claims that most crypto tokens are securities under the Howey test, and is likely to be marshaled by crypto exchanges – including Coinbase – for the proposition that crypto exchanges are not required to be registered with the SEC because secondary transactions of tokens are not securities. While it remains to be seen how impactful the ruling actually will be, one thing that is clear is that the SEC’s path in bringing crypto-enforcement cases just got a lot steeper.

Could the SEC finally approve a spot bitcoin ETF?

In other news out of the SEC, BlackRock generated a lot of headlines when it filed an application for a spot bitcoin exchange-traded fund (ETF) in mid-June. The digital asset community viewed the filing as a signal of institutional support by the traditional finance community, sending the price of bitcoin up as much as 20% and prompting similar applications by several other large asset managers (including Invesco). Despite the optimism generated by the BlackRock filing, the fact remains that the SEC has rejected every one of the dozens of applications that have been submitted to date, rendering the prospects for approval of a spot bitcoin ETF uncertain.

But there is a wildcard yet to be played that could dramatically change the prospects for SEC approval of a spot bitcoin ETF. After its application was denied last year, Grayscale Bitcoin Trust sued the SEC, alleging that the agency’s rejection was arbitrary and capricious because bitcoin futures exchange-traded products (ETPs) that the SEC had already approved are exposed to exactly the same fraud and manipulation risks as spot bitcoin ETFs. A ruling is expected soon in that case, and a victory for Grayscale could force the SEC’s hand, leading to approval of one or more of the pending ETF applications.

The SEC is criticized over its Prometheum decision

Finally, the SEC generated yet more headlines (some of which were unwelcome) when it approved an application by crypto-exchange Prometheum to become the first ever “special purpose broker-dealer” (SPBD) for digital assets under guidance issued by the SEC in 2020. The approval attracted sharp scrutiny from many in the digital asset industry – in part because it is not clear that Prometheum has a viable path to operating as a business with actual customers and revenue, and in part because of Prometheum’s ownership ties to the Chinese Communist Party. The firm’s CEO was grilled about those ties by Republican members of the House Financial Services Committee at a hearing in June. Despite the criticism directed at Gensler over the approval, some are spinning the decision in a positive light because it suggests that there could be a path for other firms to qualify as SPBDs in the future.

CFTC decision reinforces its crypto-friendly reputation

Developments at the SEC’s sister agency, the Commodity Futures Trading Commission (CFTC), have been less controversial. In June, the CFTC announced that it had approved an application from Cboe Digital to expand its product offering to include margined futures contracts, including physically settled bitcoin and ether contracts. The approval is significant because Cboe Digital will be the first US-regulated crypto native exchange and clearinghouse combination platform to offer leveraged derivatives products. The crypto community embraced the announcement from the CFTC, which has been viewed as being more forward-leaning than other regulators in pursuing a path that will enable the digital asset ecosystem to operate under a regulated framework.

Despite its crypto-friendly reputation, the CFTC still has concerns about the risks associated with digital assets, as reflected in a recently issued staff advisory on the risks associated with the expansion of Derivatives Clearing Organization (DCO) clearing of digital assets. Specifically, the release “reminds registrants and applicants that when expanding lines of business, changing business models, or offering new and novel products, [the CFTC Division of Clearing Risk] DCR will remain focused on the potentially heightened risks that may be associated with certain of those clearing activities. DCR expects DCOs and applicants to actively identify new, evolving, or unique risks and implement risk mitigation measures tailored to the risks that these products or clearing-structure changes may present.” 

Banking regulators issue guidance on digital assets

Not to be left on the sidelines, the banking regulators recently issued their own interagency guidance on the risks associated with third-party relationships in the fintech and digital asset space. Among other items, the guidance details risk management strategies for banks to follow at various stages of third-party relationships, such as planning, due diligence, contract negotiation, ongoing monitoring, and termination. The guidance notes that third-party risk management will continue to be a heightened area of focus and scrutiny. 

Second-half outlook: Lack of regulatory coordination could motivate Congressional action

As we enter the second half of 2023, look for the political jockeying among the financial services regulators for jurisdiction over the digital asset community to continue. While it remains to be seen how the pie will be divided among the various regulators, the lack of a coordinated regulatory path forward could be the spark that is needed to motivate Congress to step in and actually agree to legislation in the digital asset space.

On Capitol Hill

The House makes substantial progress on legislation

On that topic, legislative efforts to bring needed clarity to the regulation of digital assets are best characterized as a Tale of Two Houses. While the Republican-controlled House of Representatives has made substantial progress on legislative proposals, including advancing a comprehensive market structure bill and stablecoin bill out of committee, the Democrat-controlled Senate seems largely content to let the traditional financial services regulators use their existing authorities to oversee the digital asset ecosystem.

In the House, House Financial Services Committee (HFSC) Chairman Patrick McHenry (R-NC) and House Agriculture Committee Chairman G.T. Thompson (R-PA) have led the way. There have been nine hearings on digital assets between the two committees, which culminated in both committees favorably reporting the Financial Innovation and Technology for the 21st Century Act. The bill would create a comprehensive digital asset market structure framework aimed at clarifying when digital assets are commodities vs. securities, as well as establish a regulatory regime at the SEC and CFTC to oversee digital asset trading platforms.

While both committees advanced the bill with bipartisan support, both HFSC Ranking Member Maxine Waters (D-CA) and Agriculture Committee Ranking Member David Scott (D-GA) are opposed to the bill in its current form, which will make getting a large bipartisan vote on the House floor difficult. However, Republicans are likely to continue to push forward with the legislation and the narrative that the status quo is clearly not working, which is a message that Democratic supporters of the bill echoed during the recent markups.

In addition to his work on digital asset market structure legislation, McHenry has also focused on legislation that would establish a regulatory regime for payment stablecoins. For more than a year, McHenry and Waters have tried but come up short in reaching a consensus on legislation to regulate payment stablecoins. Despite failing to reach an agreement – with the main point of contention being whether there should be a path for state-regulated stablecoins – McHenry was able to advance stablecoin legislation out of committee with bipartisan support (with five Democratic members supporting the legislation in committee despite vocal opposition from Waters). 

The Senate shows little progress in digital assets legislation

Progress on the other side of the Capitol has been much slower. Senate Banking Committee Chairman Sherrod Brown (D-OH) has shown little to no interest in legislating in this space as he, along with other prominent Democratic Senators such as Elizabeth Warren (D-MA), seems content to let the regulators use their existing authorities to oversee the digital asset ecosystem.

In contrast, Senate Agriculture Committee Chairwoman Debbie Stabenow (D-MI) and Ranking Member John Boozman (R-AR) both support legislation to give the CFTC additional authority over the digital asset commodity spot markets, but the committee has yet to mark up their legislation. While Senators Cynthia Lummis (R-WY) and Kristen Gillibrand (D-NY) have continued to work on comprehensive legislation, their bill is yet to be the subject of a hearing and seems unlikely to gain traction. In fact, the legislation getting the most traction in the Senate is related to illicit finance, which was added to the must-pass National Defense Authorization Act.

Second-half outlook: Stablecoin bill has a clearer path forward

This all leads to the question of what’s next? Despite Waters’s vocal opposition to the payment stablecoin bill in its current form, its prospects remain better than a comprehensive digital asset market structure bill. Given that the Biden administration agrees that stablecoin legislation is necessary, if McHenry and Waters can ultimately reach an agreement, the bill is likely to receive significant bipartisan support in the House, which could force the Senate to take it up.

The path forward on a comprehensive digital asset market structure bill is much steeper. While there is broad agreement on the need to give the CFTC additional authority over digital asset spot markets, Brown and Warren are likely to block any efforts that are seen as taking away authority from the SEC. The two wild cards that could change this dynamic: the SEC suffering another significant loss in court or even less likely, the Biden administration pushing Senate Democrats to act.

So, while much progress has been made on legislative efforts during the first half of 2023, legislation that would provide clarity to the digital asset ecosystem likely remains a long way off. 

One step forward? Or two steps back?

Nobody ever said the sausage making in Washington happens quickly and efficiently. But it has been 15 long years since the creation of the first cryptocurrency and we still don’t have a single law or regulation on the books specifically tailored to this rapidly growing industry. As we enter the second half of 2023, it seems that while policymakers and lawmakers have taken a few valiant steps forward to bring order to the digital asset space, they’ve taken even more steps back. We’re not meaningfully closer to a regulatory or legislative framework than we were at the beginning of the year.

With an SEC Chair who seems content with his agency’s existing authorities under the securities laws, a bitterly divided House with competing priorities and approaches to digital asset legislation, a disinterested Senate, and a number of pending court actions that could dramatically upset the apple cart, any meaningful progress on digital asset regulation over the coming months still seems painfully out of reach.

With contributions from Blue Ridge Law & Policy