US President Joe Biden’s Working Group on Financial Markets (PWG), along with the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC), released a report on the risks and legislative recommendations for stablecoins, recommending that issuers be limited to insured depository institutions.
The PWG,[1] joined by the FDIC and the OCC, released a report on November 1 (the Report) on stable value coins, or so-called stablecoins, which are crypto tokens pegged or linked to the value of fiat currencies.[2] The Report identifies and makes recommendations regarding regulatory gaps associated with those stablecoins that are used as a means of payment.
The Report highlights the potential for destabilizing runs, disruptions in the payment system, and concentration of economic power in connection with the use of stablecoins, and many of the recommendations are focused on these concerns. While the Report also discusses investor protection, market integrity, and illicit finance concerns related to stablecoins, it makes no specific recommendations as to those issues.
The Report makes the following legislative recommendations for bringing stablecoins within a prudential regulatory framework:
Perhaps recognizing that any potential legislation in this area would likely take substantial time to make its way through Congress and be enacted into law, the Report makes several recommendations on how the Agencies should use their existing authorities to address these prudential risks to the extent possible, including:
In the absence of legislative action, the Report recommends that the Financial Stability Oversight Council consider steps to address the risks discussed in the Report, including designating certain activities conducted within stablecoin arrangements as, or as likely to become, systemically important payment, clearing, and settlement (PCS) activities.
Of note, this designation would permit the Federal Reserve Board, in consultation with the other federal financial regulatory authorities, to establish risk-management and other prudential standards for financial institutions that engage in designated PCS activities, including requirements in relation to the assets backing the stablecoin and requirements related to the operation of the stablecoin arrangement.
As mentioned in the Report, financial institutions that engage in designated PCS activities also would be subject to an examination and enforcement framework.
Status Quo for the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC)
Weeks of news reports suggesting that the Report would recommend that the SEC be given significant authority over stablecoins did not pan out. Indeed, the Report did not make any recommendations or establish any position regarding the status of stablecoins (or any other digital assets) under the federal securities or commodities laws.
Given the focus on the systemic risk and potential runs that stablecoins could pose, the Report’s ultimate recommendations have a certain logic, given the established prudential framework already in existence under the federal banking laws to manage these types of risks. While there are basic measures in place under the federal securities laws that could potentially be used to address the prudential issues outlined in the Report, the recent market issues related to so-called meme stocks, and the issues from more than a decade ago that resulted in money market fund reform, suggest that a reactive rather than proactive securities or commodities regulatory regime may not be fully equipped to handle the systemic risk concerns.
Moreover, if legislation is enacted and stablecoins are issued by depository institutions, it is unclear whether the SEC or CFTC would have any jurisdiction over those products. That said, and as highlighted below, the SEC has previously recharacterized certain bank products as securities and could well seek to do so again.
Jurisdictional Fight in the Interim?
The lack of definitive guidance on the status of stablecoins under federal securities and commodities laws raises the specter of another jurisdictional fight between the SEC and the CFTC much like one associated with the status of security futures products and other derivative products almost 40 years ago. Indeed, SEC Chair Gary Gensler has noted his view that stablecoins could be securities.
While the SEC has yet to bring a formal enforcement related to stablecoins as securities per se, it has sent a “Wells” notice[3] to a major stablecoin issuer stating its consideration of a possible enforcement action in connection with that issuer’s stablecoin lending program. While it is unclear whether the SEC can definitively establish that a stablecoin in itself is a security under the test articulated in SEC v. W.J. Howey Co., 328 U.S. 293 (1946), the SEC has been successful in arguing that an instrument that is clearly not a security, such as a bank-issued certificate of deposit, can become a security depending on the marketing and maintenance of trading platforms for that instrument.[4] At the same time, recent CFTC enforcement actions regarding stablecoins may put a damper on any SEC ambitions.
Banking Agency Actions
That two of the three primary federal bank supervisory agencies co-authored the Report strongly suggests that even in the absence of the Report’s recommendations being adopted, the banking agencies could bring a significantly more focused and critical view to bank and bank partner–related stablecoin, and perhaps other, digital asset activities.
Nonregulated Entities
Although the Report’s legislative recommendations include a recommendation that stablecoin issuers be insured depository institutions, nonfinancial institutions that are engaged in these market activities are not off the hook.
The Report’s recommendation that digital wallet custodians be subject to federal oversight, and have limitations on other commercial interests, may result in these providers becoming siloed, potentially with the goal of insulating the rest of the financial markets from an insolvency event while also maintaining the traditional “separation of banking and commerce” that has long been a hallmark of US financial regulation.
This siloed approach is similar to the approach that the SEC took recently with respect to broker-dealers and their ability to custody digital assets, where that framework insulates the digital asset custody business of the broker-dealer from other business lines by limiting the broker-dealer’s activities to only digital assets.[5] These themes are also echoed with the recommendation for interoperability between stablecoins, and the recommendation of oversight over, and prudential regulation of, entities that support a stablecoin arrangement.
Ripple Effect
The highly anticipated Report received comment from numerous agencies and organizations. That same day, the Treasury Department released a fact sheet on the Report, which clarified, among other things, the purpose of the Report, risks posed by stablecoins, and the agencies’ recommendations.
In a statement released by OCC acting Comptroller of the Currency Michael J. Hsu, he emphasized his support for the recommendations highlighted in the Report, pointing out that “[s]tablecoins need federal prudential supervision to grow and evolve safely.” In a statement released by CFPB Director Rohit Chopra, he noted that although the CFPB was not a member of the PWG, the Bureau “will be taking several steps related to this market,” including the CFPB’s request to several technology companies seeking information and data on their payment system business practices.
Banks, broker-dealers, investment companies, investment advisers, FinTech companies, and other companies are increasingly taking notice of stablecoins and considering what role digital assets should play in their business.
While it is too soon to tell whether Congress will act on the Report’s recommendations, let alone whether legislation will actually be enacted into law, what is clear is that the various Agencies will likely continue to explore the appropriate regulatory treatment of digital assets pending any congressional action. And the market may continue to face regulatory uncertainty in the interim. While we hope that market participants will have legal certainty regarding stablecoins specifically, and digital assets generally, it is unclear when that will happen.
Businesses that are interested in integrating stablecoins into their operations must consider a number of legal issues, including (1) the future regulatory treatment of digital assets; (2) the permissibility of the activity under applicable bank regulatory laws; (3) consumer financial services laws; (4) the applicability of securities and commodities laws; and (5) anti-money laundering, sanctions, and privacy laws.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Washington, DC
Amy Natterson Kroll
Ignacio A. Sandoval
Steven W. Stone
Laura E. Flores
Chicago
Michael M. Philipp
New York
Martin Hirschprung
[1] The PWG is chaired by the Secretary of the Treasury and includes the Chair of the Board of Governors of the Federal Reserve System, the Chair of the Securities and Exchange Commission, and the Chair of the Commodity Futures Trading Commission. Along with the OCC and FDIC, the Report refers to these institutions collectively as the “Agencies.”
[2] As discussed in the Report, stablecoins are digital assets that are designed to maintain a stable value relative to a national currency or other reference assets. Today, stablecoins are primarily used in the United States to facilitate trading, lending, or borrowing of other digital assets, predominantly on or through digital asset trading platforms. Proponents believe that stablecoins could become widely used by households and businesses as a means of payment. Proponents also believe that well-designed and appropriately regulated stablecoins could support faster, more efficient, and more inclusive payment options.
[3] A Wells notice is a letter and/or telephone call from the SEC indicating that the SEC staff intends to recommend that a civil enforcement action be taken against an individual and/or company.
[4] See, e.g., Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce Fenner & Smith, 756 F.2d 230 (2d Cir. 1985).
[5] Custody of Digital Asset Securities by Special Purpose Broker-Dealers, Release No. 90788 (Dec. 23, 2020); 86 Fed. Reg. 11,627 (Feb. 26, 2021). https://www.govinfo.gov/content/pkg/FR-2021-02-26/pdf/2020-28847.pdf