A clearer view of US digital asset regulation - Davies

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A clearer view of US digital asset regulation

“I never worry about action, only inaction”– Winston Churchill

Confused as to the latest state of crypto regulation? Uncertain what it means to be a “regulated” digital asset custodian across different international jurisdictions? Don’t fret! You are not alone: the regulatory environment continues to be extremely fluid, as guidance, classifications, and rulemaking amongst sovereign nations still has far to go to achieve any semblance of global harmonization. And the lack of clarity as to the definition of a digital asset has made the development, implementation, and standardization of common regulatory frameworks incredibly challenging.

  • What are the correct systems and controls to govern crypto custodians?
  • How are digital assets classified – Security? Commodity? Currency? New instrument type?
  • Are the correct investor protections employed by entrusting private keys to custodians who utilize hot wallets?
  • How does the traditional role of regulator to promote innovation in conjunction with investor protection and market stability apply to a decentralized marketplace?

Common questions like these persist with a landscape still in flux. Given the irreversibility of digital assets and the fluid, complex technology behind them, regulators are concerned if custodians can appropriately safeguard client funds. With conflicting thoughts across jurisdictions, classification remains an evolutionary process posing challenges for service providers trying to accommodate a global model. Ethical principles (standards of care, governance, licensing requirements, and risk management) vary by regime.

Regulators have found themselves significantly behind the curve, as interest and demand in crypto asset has soared. The US is no exception and has historically been called out for its lack of policy clarity. For instance, many countries classify stablecoins as a cash equivalent, while the Internal Revenue Service currently categorizes it as property. Stablecoins are of particular interest in today’s marketplace as they designed to be a volatility hedge, by being pegged to fiat or gold, and are often backed by segregated hard assets (such as USD). Stablecoin popularity has exploded, given its characteristics as a digital asset with the stability characteristics inherent in more traditional assets.

The fragmented nature of US regulators has only served to further complicate the situation. Take digital tokens – if the token ‘behaves’ like a commodity or derivative, the CFTC seems to have jurisdiction, while if it behaves like an equity, it falls under the SEC. Yet without clear definitions, the ball stays in the air.

But American policymakers are finally starting to play catch-up. In recent past, firms sought to become regulated to custody crypto assets in the US by becoming charted trust companies to get legal entity authority via a National Trust Bank Charter. In 2020, the Office of the Comptroller of the Currency (OCC) was empowered to grant national charters and regulate (in the same manner it does for all national and federally licensed foreign banks) institutions looking to provide crypto custody services for cryptocurrencies and stablecoins.

Highlighted below are just some of the more substantial regulatory progresses as of late.

Significant United States Regulator Activity 2021

  • The US Congress introduced the Digital Asset Market Structure and Investor Protection Bill aimed at addressing consumer protections, AML/KYC procedures, and crypto trade reporting & transparency requirements.
  • The Securities and Exchange Commission (SEC) appointed Gary Gensler as Chairman. Gensler, an ex-CFTC Chairman, made publicly know his concerns over lack of investor protections in the digital asset realm and his intention to enhance the SEC’s regulatory role in the space. Gensler’s SEC has started investigating how investment advisors, broker/dealers and transfer agents handle a litany of regulatory, risk and compliance functions (i.e., custody/safekeeping, portfolio management, registration requirements, and conflicts of interest).
  • The Federal Reserve Board (FRB) announced it was exploring a dollar-based Central Bank Digital Custody (CBDC).
  • The Commodities and Futures Trade Commission (CFTC) confirmed Rostin Behnam as Chairman who immediately confirmed crypto assets as a priority area with respect to which digital commodity transactions the CFTC has authority only over (i.e., futures, options, swaps) and which it does not, highlighting the struggle due to existing classification ambiguities.
  • The Office of the Comptroller of the Currency (OCC) after gaining authority in 2020 to grant and regulate digital asset bank charters and held stablecoin, issued Interpretive Letter #1170 providing further guidance on: circumstances where may offer digital asset custody services; whether banks may hold dollar deposit reserves to back stablecoin; and the manner in how banks need to act/behave in order to verify customer payments and utilize stablecoin to facilitate payment transactions on distributed ledgers.
  • The Department of Justice (DOJ) created the National Cryptocurrency Enforcement Team to combat criminal crypto asset activity (cryptocurrencies are the preferred payment medium for ransomware and dark web transactions).

And in Spring 2022 alone:

  • The Department of Labor (DOL) issued a note expressing its concerns of the appropriateness of cryptocurrencies in ERISA defined contribution plans (eg 401(k) plans). The DOL highlighted their position that it this stage it did not find digital assets to a prudent investment vehicle for fiduciaries of retirement funds.
  • In March 2022, the White House issued an Executive Order on Ensuring Responsible Development of Digital Assets which laid out a national policy framework initiative to address issues including US consumer protection, financial stability and systemic risk mitigation, prevention of illicit digital activity, and U.S. competitiveness on the world stage. It also included the exploration of a US Central Bank Digital Currency (CBDC).
  • In what was viewed as the British response to the abovementioned Executive Order, both the Exchequer (UK treasury) and the Bank of England (BOE) put out statements about the establishment of a formal English crypto regulatory regime (and see also here) to alleviate the existing ambiguous and limited guidance. An emphasis was placed on the role of stablecoins and their impact on market risk, and financial stability, and investor protections.

So – what next?

US regulators must stay cognizant of the fact that, if their policy making results in a more stringent regime than other nations, it risks a flight of its experienced talent to friendlier jurisdictions.

For the remainder of 2022, we can expect domestic and foreign regulators to continue advancing an overarching theme of addressing risks, opportunities and regulatory gaps that exist with respect to function and prudential authority.  As they say – watch this virtual space, closely.

June 15th: Join our forthcoming webinar on Crypto Fraud: how safe is your money?

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A clearer view of US digital asset regulation

Allen Lewis

Partner

Banking & Markets

I specialise in investment servicing, market infrastructure solutions, middle office and transformational operations and OTC collateral management

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