Wednesday, June 08, 2022

Senators introduce bill proposing federal scheme to regulate digital assets

By Mark S. Nelson, J.D.

The presumed purpose of the Lummis-Gillibrand Responsible Financial Innovation Act, sponsored by its namesakes, Sens. Kirsten Gillibrand (D-NY) and Cynthia Lummis (R-Wyo), would be to bring unified federal oversight to bear on digital asset markets in the U.S. but without crushing the blockchain industry. At this point, many such bills have been introduced but they have tended to deal with discrete issues and discrete federal agencies. Earlier this year, a group of House lawmakers introduced a bill to grant the CFTC primary authority over digital assets and that bill will inevitably invite comparisons to the Lummis-Gillibrand bill (FAQ), which more broadly and simultaneously addresses securities, commodities, tax, and banking aspects of digital asset markets. Another, somewhat more focused bill, also introduced in the House, would target some of the same topics as the Lummis-Gillibrand bill but with a narrower scope.

Bipartisan efforts. The Lummis-Gillibrand bill is the Senate response to bipartisan House legislation introduced in late April 2022. “The United States is the global financial leader, and to ensure the next generation of Americans enjoys greater opportunity, it is critical to integrate digital assets into existing law and to harness the efficiency and transparency of this asset class while addressing risk,” said Sen. Lummis via press release.

“Digital assets, blockchain technology and cryptocurrencies have experienced tremendous growth in the past few years and offer substantial potential benefits if harnessed correctly,” said Sen. Gillibrand. “It is critical that the United States play a leading role in developing policy to regulate new financial products, while also encouraging innovation and protecting consumers.”

This article will focus on the SEC and CFTC provisions in the Lummis-Gillibrand bill, although there are also significant provisions dealing with taxation and banking. Moreover, the following provisions in the bill would address a variety of issues:
  • An interstate regulatory sandbox.
  • Annual reporting by the Federal Energy Regulatory Commission to Congress regarding, among other things, energy consumption for mining and staking of digital asset transactions.
  • Cybersecurity standards for digital asset intermediaries.
  • An SEC/CFTC study and report to Congress regarding the appropriate principles for establishing a registered digital asset self-regulatory organization.
With respect to comparisons, this article will focus on the Lummis-Gillibrand bill and the Digital Commodity Exchange Act of 2022 (H.R. 7614), sponsored by House Agriculture Committee Ranking Member Glenn “GT” Thompson (R-Pa), and co-sponsored by fellow Agriculture Committee member Rep. Ro Khanna (D-Calif), and non-committee members Rep. Tom Emmer (R-Minn) and Rep. Darren Soto (D-Fla), which purports to offer a federal regulatory alternative to firms that would otherwise have to comply with multiple state money transmitter laws. The comparison is especially relevant regarding the CFTC. For further comparison, readers also may wish to examine the Digital Asset Market Structure and Investor Protection Act (H.R. 4741), introduced by Rep. Don Beyer (D-Va), which would address the treatment of digital assets by the SEC and CFTC, central bank digital currencies (CBDCs), and anti-money laundering regulations.

Securities provisions. The Lummis-Gillibrand bill would establish a presumption that what the bill calls an “ancillary asset” is a commodity and not a security, although the SEC would retain some enforcement authorities over ancillary assets. In order to take advantage of the presumption, an issuer of an ancillary asset would have to meet certain SEC disclosure obligations that address information related to the corporate structure and history of the ancillary asset’s issuer and the risk factors affecting the ancillary asset.

More specifically, if an issuer contemplates an offering that would involve an investment contract related to an ancillary asset and the issuer furnishes the required SEC disclosures, the ancillary asset would be presumed to be a commodity and not a security. “Ancillary asset” would be defined to mean 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.” The term, however, would not include certain equity, debt, liquidation, dividend, and profit and revenue sharing arrangements.

For comparison, the Lummis-Gillibrand bill would define “digital asset” to mean a natively electronic asset that: (i) confers economic, proprietary, or access rights or powers; and (ii) is recorded using cryptographically secured distributed ledger technology, or any similar analogue; the term would include: (i) virtual currency and ancillary assets, (ii) payment stablecoins; and (iii) other securities and commodities. The Thompson bill would define “digital commodity” to mean “any form of fungible intangible personal property that can be exclusively possessed and transferred person to person without necessary reliance on an intermediary” (the definition provides for exclusions similar to those contained in the Lummis-Gillibrand bill’ definition of “ancillary asset”).

The presumption regarding an ancillary asset, however, could be lost if a “court of the United States” (presumably only federal courts) finds that there is no substantial basis for the presumption. Elsewhere, the proposed bill would not deny the presumption solely because an issuer failed to meet its SEC disclosure obligations.

The SEC disclosure obligation itself would be subdivided into three separate obligations regarding initial disclosure, ongoing disclosure, and a transition rule for disclosures regarding ancillary assets provided before January 1, 2023. Each of the three disclosure obligations has a time-frame built into it regarding the fiscal years covered but otherwise comes into effect for an issuer of an ancillary asset based on the average daily aggregate value offered or traded on all spot markets (must be greater than $5 million) and whether the issuer (or a 10 percent owner of the issuer’s equity securities) engaged in entrepreneurial or managerial efforts that primarily determined the value of the ancillary asset.

An issuer of an ancillary asset would be able to voluntarily furnish information to the SEC about the ancillary asset if the issuer believes it is reasonably likely that it will become subject to the disclosure requirement in the future.

The SEC also would be granted authority to exempt an ancillary asset from the disclosure requirement if it determines that the public policy goals of disclosure and of consumer protection are not satisfied by requiring such disclosure. The SEC also could issue rules and guidance to implement the disclosure requirement.

The bill would provide that the disclosure requirement for an ancillary asset would end 90 days after an issuer files (and not merely furnishes, as would be the case for the disclosure obligation) a certification supported by reasonable evidence after due inquiry that the average daily aggregate value of all trading for the preceding 12 months was equal to or less than $5 million or that the issuer did not engage in that same period in any entrepreneurial or managerial efforts that primarily determined the value of the ancillary asset. The SEC could deny an issuer’s certification if the certification was not based on substantial evidence, although an issuer could try again to certify that it may end its disclosure obligation.

The remaining securities provisions in the bill concern the modernization of Exchange Act Rule 15c3-3 regarding customer protection and clarifying what is a satisfactory control location while also clarifying the role of broker-dealers in the trading of digital assets.

Commodities provisions. The commodities provisions in the Lummis-Gillibrand bill largely mirror those contained in portions of the Thompson bill regarding the treatment of digital asset exchanges, although with some minor semantic differences. In this context, the Thompson bill contains a number of CFTC provisions that do not have precise counterparts in the Lummis-Gillibrand bill. Other provisions regarding CFTC transaction fees appear only in the Lummis-Gillibrand bill.

With respect to segregation of customer digital assets, the Lummis-Gillibrand and Thompson bills both provide generally that, regarding the holding of customer assets that “[e]ach futures commission merchant [FCM] shall hold customer money, assets, and property in a manner to minimize the customer’s risk of loss of, or unreasonable delay in the access to, the money, assets, and property.” The Lummis-Gillibrand bill would require customer property to be held by a licensed, chartered, or registered entity regulated by the CFTC, the SEC, federal or state bank regulators, or an appropriate foreign bank authority. The Thompson bill would provide for an FCM to hold customer property in a qualified digital commodity custodian. The Lummis-Gillibrand and Thompson bills have nearly identical provisions regarding the related topic of the segregation of customer funds.

Both the Lummis-Gillibrand and Thompson bills provide that a registered FCM cannot act as a counterparty in any agreement, contract, or transaction involving a digital asset that has not been listed for trading on a registered digital asset exchange. That suggests the main provision in both bills regarding the registration of, as the Lummis-Gillibrand bill calls them “digital asset exchanges,” while the Thompson bill calls them “digital commodity exchanges.” Thus, both bills provide that any trading facility that offers or seeks to offer a market in digital assets may register with the CFTC as a digital asset exchange by submitting the prescribed application. Both bills also provide that a registered designated contract market (DCM) or registered swap execution facility (SEF) that meets certain requirements may elect to be considered a registered digital asset exchange/digital commodity exchange.

Both the Lummis-Gillibrand and Thompson bills further provide that a registered digital asset exchange/digital commodity exchange may make available for trading any digital asset that is not readily susceptible to manipulation. This provision would address some of the issues identified by the SEC, for example, in that agency’s earlier disapprovals of exchange-traded products. Both bills likewise provide that registration as a digital asset exchange/digital commodity exchange would not permit a trading facility to offer any contract of sale of a commodity for future delivery, option, or swap for trading without also being registered as a DCM or SEF.

A digital asset exchange/digital commodity exchange would be required to comply with a set of core principles. Moreover, both bills would define “not readily susceptible to manipulation” in nearly identical fashion. Specifically, the phrase “not readily susceptible to manipulation” would mean that a digital asset’s transaction history can be fraudulently altered or its functionality or operation can be materially altered. In making such determination, both bills provide for consideration of the following factors:
  • The purpose and use of the digital asset;
  • The creation or release process of the digital asset;
  • The consensus mechanism of the digital asset;
  • The governance structure of the digital asset;
  • The participation and distribution of the digital asset;
  • The current and proposed functionality of the digital asset;
  • The legal classification of the digital asset; and
  • Any other factor required by the CFTC.
Both the Lummis-Gillibrand bill and the Thompson bill address bankruptcy issues in the context of digital assets. The Lummis-Gillibrand bill would do this through a series of discrete statutory amendments, while the Thompson bill would do this via a provision stating that all assets held on behalf of a customer by a registered digital commodity exchange and all money of any customer received by such exchange is considered customer property for bankruptcy purposes.

The CFTC also would be authorized to collect fees to fund the agency’s regulation of digital asset cash and spot markets under the bill and to recover the costs to the federal government of the annual congressional appropriation to the agency. The CFTC, however, could not impose fees on registered entities relating to leveraged, margined, or financed transactions, including activities relating to digital assets.

The CFTC’s authorization to collect fees would be capped at $30 million absent further congressional authorization. Moreover, the CFTC’s authority to impose and collect fees would only be in effect during a period that a legislative authorization of the CFTC is in effect. That latter provision could raise questions about the CFTC’s current status because the agency has not for many years been formally reauthorized by Congress, despite attempts in recent Congresses to reauthorize the agency but which faltered over political disagreements about the scope of derivatives reforms.

Lastly, much like the SEC already does, the CFTC would have to periodically issue fee rate orders setting the amount or rate of any authorized fees. The CFTC would be able to continue to collect fees at the prior fiscal year’s rate even if there were a lapse in congressional appropriations because of a government shutdown, a scenario that has occurred several times in recent years. Presumably, to the extent the CFTC could collect fees, that part of its appropriation would be to some degree deficit neutral, as is the case for the SEC, which collects transaction fees to offset its entire congressional appropriation.