Last month, Wyoming Senator Cynthia Lummis and New York Senator Kirsten Gillibrand unveiled their long-anticipated bipartisan legislative proposal to build a federal regulatory framework for cryptocurrencies like Bitcoin. If the bill, called the “Responsible Financial Innovation Act,” were to become law, the U.S. could instantly leapfrog its competitors and become the world leader in crypto innovation and inclusion. Here’s why.
How regulatory clarity can enhance innovation
A common staple of public policy debates is that too much regulation will stifle innovation, by reducing the ability of entrepreneurs and businesses to come up with new ways to solve old problems. This is true. But an uncertain regulatory environment is just as bad, because it’s hard for businesses to invest huge sums of time, effort, and capital into ventures that the government later decides are illegal.
The U.S. regulatory environment for crypto has been singularly bad, driving many of the most innovative companies offshore. A big part of the problem has been that U.S. financial markets are regulated by several independent agencies whose jurisdiction overlaps: most notably, the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), the U.S. Treasury Department, and the U.S. Federal Reserve. In other countries, these regulatory functions are under a single agency, making it easier to propose consistent regulations for new asset classes.
Under both the Biden and Trump administrations, the SEC has been notable for its aggressive yet unpredictable behaviortoward crypto businesses. Last September, for example, the SEC told Coinbase to end its effort to offer interest payments to its customers, arguing that such interest payments were “securities.” Coinbase Chief Legal Officer Paul Grewal, in a lengthy blog post, expressed frustrationthat Coinbase’s efforts to preemptively share their product design with the SEC were to no avail. “The SEC still won’t explain why they see a problem,” Grewal wrote. “Rather they have now told us that if we launch [the interest payment service] they intend to sue. Yet again, we asked if the SEC would share their reasoning with us, and yet again they refused.”
The SEC’s approach to crypto regulation has been simply to say that projects must adhere to the Howey test, a vague standard based on a 1946 Supreme Court case called SEC v. W. J. Howey Co.. Because so much of crypto innovation transcends 1930s-era securities law, and because the SEC has refused to give clear guidance about their approach to cryptocurrencies, many entrepreneurs operating in good faith have no idea whether they will wake up one day to find that the SEC wants to shut them down.
The Responsible Financial Innovation Act would solve many of these problems, by creating clear legal definitions and regulatory lanes for digital assets. Let’s take a look inside the bill to see how.
A big win for the CFTC
Lummis-Gillibrand effectively divides the digital asset world into three buckets: commodities, securities, and “ancillary assets.” Effectively, the bill defines digital ancillary assets as crypto tokens that, while fluctuating in value, do not provide the holder with a “profit or revenue share” or “other financial interest” such as “debt or equity” in the company issuing the tokens. By contrast, traditional publicly traded stocks offer ownership shares in the issuing businesses.
Importantly, under Section 301 of the bill, issuers of these ancillary assets would be required to make certain disclosures to the SEC. By complying with these disclosure requirements, digital asset issues “shall be presumed to be a commodity,” and therefore under the regulation of the CFTC. Section 403 explicitly gives the CFTC “exclusive jurisdiction over any…digital asset…including ancillary assets” other than equity or debt securities.
These provisions would end the chaotic turf war between the SEC and other federal agencies. Crypto projects would know which regulations to follow, and which regulators to engage. In turn, this will open enormous financial innovation up to American consumers, who today are barred from participating in many digital asset innovations because projects don’t want to deal with the SEC’s unpredictability.
At the same time, projects that want to tap into the U.S. market will need to make meaningful disclosures about their businesses, their financial condition, and their plan for protecting consumers in the event of bankruptcy. This transparency will weed out fly-by-night crypto projects, and reward those with genuine economic utility.
Bringing the dollar into the 21st century
Lummis-Gillibrand makes a significant effort to create a regulatory structure around “stablecoins,” digital assets that are pegged in value to the U.S. dollar or another traditional, government-issued “fiat” currency. Stablecoin regulation has taken on added importance in the wake of the collapse of the algorithmic stablecoin TerraUSD, in which the sponsor of TerraUSD issued tokens that it claimed were worth $1, but were not fully backed, or collateralized, with hard cash or its equivalent.
Done the right way, stablecoins are basically the 21st-century version of money-market mutual funds, a $4.5 trillion asset class of mutual funds whose value is pegged to the U.S. dollar. Stablecoins fully backed by cash, Treasury bonds, and other cash-like instruments have proven to be highly useful in bridging between conventional and digital asset transactions.
Section 601 of the Responsible Financial Innovation Act creates a structure for regulated stablecoins, whose sponsors “shall maintain high-quality liquid assets…equal to not less than 100 percent of the face amount” of the value of the issued stablecoins, with “high-quality” defined as U.S. currency, Treasury bonds, Federal Reserve balances, and other well-established cash-like instruments.
By establishing clear rules for regulated stablecoins, Lummis-Gillibrand makes obsolete the Federal Reserve’s dangerous push for a China-style central bank digital currency. Stablecoin sponsors, like Circle and Coinbase’s USD Coin, are capable of providing all the advantages of a blockchain-based dollar while limiting the government’s access to total surveillance of Americans’ ordinary transactions.
A regulatory ‘sandbox’
One highly constructive provision of the Responsible Financial Innovation Act would enable states to establish “financial regulatory sandboxes” within which crypto projects could work, for a maximum of two years, without risk of being shut down by regulators (so long as the project honored basic consumer protections).
The “sandbox” idea was pioneered by SEC commissioner Hester Peirce, who in 2020 proposed establishing a safe harbor of three years for new crypto projects. “We have created a regulatory Catch-22,” Pierce observed. “Would-be networks cannot get their tokens out into people’s hands because their tokens are potentially subject to the securities laws. However, would-be networks cannot mature into a functional or decentralized network that is not dependent upon a single person or group to carry out the essential managerial or entrepreneurial efforts unless the tokens are distributed to and freely transferable among potential users, developers, and participants of the network. The securities laws cannot be ignored, but neither can we as securities regulators ignore the conundrum our laws create.”
Pierce’s three-year safe harbor seems more sensible than Lummis-Gillibrand’s two-year one, given the timeframe needed to build a new network. Fortunately, this is the kind of thing that is easy to fix, should the bill continue to advance in Congress.
Areas of improvement
As I recently discussed with Peter McCormack, the most important missed opportunity in the Lummis-Gillibrand bill is its failure to reduce the risk that the Federal Reserve create a central bank digital currency. As I noted above, China has enthusiastically embraced the idea of a crypto version of the yuan, because a move away from paper cash into a government-controlled digital currency will enable Beijing to monitor and censor its citizens’ financial activity.
At this time, the U.S. Federal Reserve is CBDC-curious: neither for nor against. In a January 2022 white paper, the Fed described what it sees as both the risks and the benefits of a CBDC, but asserted that its paper “is not intended to advance any specific policy outcome.” In order to protect Americans’ civil liberties, Lummis-Gillbrand should make clear that the Fed does not have the legal mandate to establish a CBDC without Congress’ explicit assent.
Will Lummis-Gillibrand ever become law?
If Lummis-Gillibrand were to pass Congress, the U.S. would instantly go from being a crypto laggard to the world leader in digital asset regulation. Today, many—if not most—innovative crypto businesses are domiciled overseas, so as to protect themselves from America’s opaque and haphazard regulatory approach. Under the bill, however, all of this would change. The Responsible Financial Innovation Act’s rules for disclosure and transparency would work as a quality control mechanism for the best projects, creating an environment in which U.S. rules could serve as the best environment for investment in innovation.
But it’s not clear when, or if, Lummis-Gillibrand will become law. Washington works best under deadlines, and from Congress’ standpoint, there is no clear urgency to clarifying digital assets regulation. Democrats in the Senate, in particular, are focused on hashing out a deal on prescription drug pricing reform and tax increases.
In developing their bill, Lummis and Gillibrand worked closely with key industry lobbies and trade associations: a common strategy in Washington. Alongside their bill, the Senators published six pages of supportive statements from entities like the Digital Chamber of Commerce, the Association for Digital Asset Markets, the Blockchain Association, the Crypto Council for Innovation, Kraken, Coinbase, FTX, Bitstamp, and Uniswap.
But precisely for that reason, those who are skeptical of the crypto industry are likely to stay on the sidelines for now. The key question is: does the dynamic change after November?