While most of the world’s regulators are still putting pen to paper, the early glimpse into the United States of America (US)’s possible crypto-regulatory future has given us much to digest. The US often leads global financial regulation on a leash. In an area as contentious and topical as crypto regulation, will Australia follow suit?
The US Responsible Financial Innovation Bill (the Bill) follows a bipartisan effort to regulate ‘Digital Assets’. While this Bill is only known in preliminary draft form, it is likely that it significantly reflects its final form. Central to this leaked Bill is the ‘Howey Test’, a Supreme Court doctrine from the 1940s that explains when an asset is a security or not. When applied to crypto, the implication seems to be that crypto securities should be regulated differently to crypto commodities.
At first instance, the leaked Bill is directed towards providing structure, clarity, and boundaries for the regulation of cryptocurrency. This broad sweep seeks to cover relevant definitions, differentiation between securities and commodities, tax considerations, consumer protections, and registration of certain entities.
The Bill is centred around the term ‘Digital Asset’ and complemented by existing definitions for ‘securities’ and ‘commodities’. Digital Assets have been defined by two key features: their rights and their form. Critically, the Bill does not define whether Digital Assets are property, data, or information. Rather, Digital Assets in the leaked Bill are:
This is a broad definition that encompasses crypto securities and crypto commodities as well as certain types of ancillary assets.
The leaked Bill adopts the definition for security under the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)) through the lens of the Howey Test. Under the Howey Test, crypto currency is a security when profits are derived from the ‘efforts of others’. For example, if backers of a particular Digital Asset develop and maintain the network, act in managerial roles, or otherwise put effort in for the asset to continue; that Digital Asset is a security. Likewise, cryptocurrency will be a security if backers actively manipulate the price of the cryptocurrency through strategies such as coin burning. In essence, cryptocurrency is a security if it is affected at a contained level.
Conversely, cryptocurrency will be a commodity in accordance with Commodity Exchange Act (7 U.S.C. 1a) where the asset isn’t a security and has a value that is universally affected by the concepts of supply and demand.
Ancillary Assets are defined under the leaked Bill as:
The impact: cryptocurrencies in their infancy are likely securities while fully decentralised, mature cryptocurrencies are likely commodities. Ancillary Assets look to capture the rest of the crypto-market.
Under this Bill, in the US, if cryptocurrency is a commodity, it will be regulated by the Commodities and Futures Trading Commission (CFTC). If it is a security, it will be regulated either by the CFTC and the Securities Exchange Commission (SEC).
The Bill proposes amendments to the Commodity Exchange Act for the regulation of Digital Assets as a whole. Surprisingly, the CFTC will be given an almost unencumbered regulation of digit asset transactions, in accordance with section 403. The only exception to this being where a Digital Asset isn’t fungible (e.g. digital collectables and unique Digital Assets (NFTs)).
For the most part, the Bill looks to align the regulation of Digital Assets with existing commodities. What is of more interest to global regulators is the US’s proposed regulation of crypto exchanges: a ‘Digital Asset Exchange’ (DAE) will be required to register if it is a trading facility that lists for trading at least one Digital Asset (cryptocurrency).
Under Title III of the Bill, specifical periodic reporting requirements under the SEC are imposed for entities behind crypto projects that hold more than 10% of their coin and the average daily trading volume exceeds $5 million per day.
The SEC is also required to conduct a review of the proposed rules as well as conduct data gathering exercises within the first 18 months of the enactment of the Bill, including factors such as how much investors need to be educated and how regulatory burdens for companies behind crypto projects can be reduced. This clear focus on the future is promising for crypto regulation, indicating that the regulators and legislatures are cognisant that these laws may need to change faster than ordinarily anticipated.
The impact: any exchange that operates with a regulated cryptocurrency commodity will be required to register with the Secretary of the Treasury as a money services business.
These DAEs will also be prevented from trading any Digital Asset that is readily susceptible to manipulation. In the world of cryptocurrency – defining what is readily susceptible to manipulation is almost an insurmountable feat.
The impact: exchanges that are likely to be regulated by this leaked Bill will need to review their offering and may need to shift their focus.
These regulations allow the CFTC to have oversight of all Digital Assets, leaving room for the SEC to streamline their focus on securities to ensure the risky, ever evolving innovations are given due regard.
Unsurprisingly, the regulation of tax for cryptocurrencies will be dealt with by the Internal Review Service (IRS). A policy goal of the Bill has been to lower taxes to encourage innovation in the area.
For the general public, cryptocurrencies will be taxed under capital gains and not as personal income, meaning that tax will only be applied on any gains made rather than on the initial amount you’ve invested. Some key inclusions are:
For Brokers, being ‘any person who (for consideration) stands ready in the ordinary course of a trade or business to effect sales of Digital Assets at the direction of their customers’, will be required to make yearly reports to the Secretary.
Interestingly, the Secretary of the Treasury will need to adopt guidance or clarifications on long-standing issues in the Digital Asset industry within one year. Guidance will include topics such as the taxation of subsidiary proceeds (airdrops, forks, etc.), treatment of Digital Asset mining and staking, and the allowance of charitable contributions of Digital Assets to name a few.
The impact: the US seems tentative to tax crypto taking a ‘lax on tax’ approach.
The US is clearly seeking to protect consumers from the risks of crypto, acting to ensure Digital Assets stay consistently safer for consumers to use. Title V of the Bill focuses on the transparency of cryptocurrency such that a person or entity that provides Digital Assets services must ensure the scope of permissible transactions that may be undertaken with a customer’s Digital Assets is disclosed clearly in a customer agreement. Furthermore, a person who provides a Digital Asset service must provide prior notice for events such as updates or changes to the source code, segregation of customer assets, effect of bankruptcy on customers assets, applicable fees and more.
Potential additional requirements for exchanges include: terms of service, accrual to the customer, withdrawal requirements, agreements, lending agreements and rehypothecation which will require affirmative consent from the original person putting up the collateral before the counter party can use it as collateral.
The impact: consumers are the focus. Those offering Digital Assets will be required to cater to increased disclosure obligations and consumer protections.
The Bill also offers a new method to regulating stablecoins, which has been topical since the recent crypto-market crash in May 2022. If Lummis-Gillibrand becomes law, all stablecoin tokens in circulation (in the US) must be 100% backed by US dollars, US government debt or other assets that fall in the same category. Most significantly, stablecoin issuers will have to meet capital adequacy requirements while also ensuring that stablecoin holders can always exchange their coins for an equivalent cash amount. This keeps the door open for banks and other financial institutions to produce and use stablecoins for payments.
The impact: stablecoins are topical and a focus of the Bill. The timing of the drafting reflects the present state of this quickly evolving market.
Firstly, the Bill must be commemorated for amending the vague definition of a cryptocurrency broker that came from the Infrastructure Investment and Jobs Act passed last November. The Bill would narrow the definition to focus on persons who affect sales of Digital Assets for customers. The intent of this is to remove any possibility for miners and stakers to fall into the definition and therefore be forced into further regulation that they themselves would not normally have to follow.
It should be noted the lack of reference to Decentralised Finance (DeFi). Section 805 of the Bill confers an obligation on the Secretary of the Treasury, in consultation with the CFTC, SEC and experts in the area, to analyse DeFi’s within a year after the enactment of the Bill. Most importantly is the need to ensure the accuracy of information in the smart contracts that DeFi’s are built on.
Senator’s Gillibrand and Lummis have held up the white flag on DeFi’s for the time being, clearly wanting to know more about the implementation of this new innovation before deciding whether to let it live a free life or strap it in red tape.
Similar to the Australian Government’s consultation paper on regulating Crypto Asset Secondary Service Providers (CASSPrs), the leaked Bill is focused on implementing the regulation of Digital Assets within and around constructs that already exist in our legal systems. It appears that regulators across the global are looking to existing first principles in an attempt to grapple with this new technology. At first instance it appears that regulators are looking to confine and define crypto assets and services providers. Only then will they turn their attention to how they should tackle key issues or hurdles.
To the credit of the Bill’s drafters, this leaked Bill clearly contemplates that this method of regulating will need updating and development. Is this how the world’s governments should be regulating cryptocurrency? Or is this a means to end till Digital Assets outgrow their new cage?
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Liam Hennessey, Partner
Taylor Green, Associate