White House Report provides a number of areas of consideration for Congress and the financial regulators in shaping a digital asset regulatory framework.
We noted last week in connection with our initial post regarding the Presidential Working Group Report on Digital Assets (the "PWG Report" or the "Report") that we would be engaged in further analysis of that Report and offer additional, more detailed observations. Those observations are below. From an overall perspective, the PWG Report will be another game-changer for digital assets in the United States, and because it sets forth a "blueprint" for future action, it will be a point of reference going forward. It sets forth goals and objectives which regulators will be heavily engaged in fulfilling and which have a sense of urgency to them. It was no coincidence that within days of the publication of the report that the SEC Chair announced the launch of "Project Crypto" and the CFTC announced their own "Crypto Sprint" in coordination with the SEC.
Our broad view is that the legislative process regarding digital asset market structure may be more time consuming and difficult than currently anticipated. However, in the interim, the Report gives direction (and encouragement) to the regulators to immediately make every accommodation available with respect to digital assets and blockchain that they can do in the absence of legislation. Hence, we are now entering an unusual time period with respect to the contours of financial institution oversight. At the same time as Congress will be crafting language regarding market structure, a variety of financial services regulators will be engaged in drafting rule proposals on those same topics while attempting to accommodate innovation through the use of their exemptive powers. Coordinating those efforts will be challenging. With that in mind, we set forth below what we think are a dozen different topics that will attract special attention as this process moves forward.
1. Institutional Investment. The Report notes that institutional investors will be attracted to crypto because of changes in the regulatory framework. This continues to be a key concept. Institutional investors are not naive nor are they in the habit of investing their funds or the funds of their clients in projects that will lose money. Thus, their involvement lends both credibility and further liquidity to the digital asset ecosystem, which likely will result in a significant change in broadening the adoption of cryptocurrency throughout. Moreover, institutional investors are demanding. They want the projects in which they invest to be better, faster, and cheaper – continually. This leads to an obvious "loop of competition" in which competitors attempt to attract those same institutional investors by offering newer and better features that the current favorites do not or cannot offer.
2. DeFi. The Report treats decentralized finance ("DeFi") extensively. Unlike the prior Administration's approach, the Report recognizes that DeFi will be a significant part of the digital asset framework and further analysis of the connectivity between banking and DeFi is discussed in the Report. The Report's emphasis on DeFi is critical because it is one of the features that is the least understood by regulators. The current regulatory world depends on centralized intermediaries that can be regulated; for example: banks, brokers, exchanges, clearing and settlement agents, custodians, etc. Bringing the world of DeFi into a new regulatory perimeter will require extensive and careful thinking, something that has been recognized by SEC Commissioner Hester Peirce in her remarks and statements. The Report also notes that the integration of DeFi into mainstream finance has the potential to unlock new economic opportunities. However, whether non-controlling blockchain developers, DeFi service providers or DeFi apps can, or should be required to, comply with obligations under the Bank Secrecy Act (BSA), either as money services businesses, broker dealers, futures commission merchants, or some other category of financial institution under the BSA should be discussed and debated, in part because many DeFi protocols do not have the functional ability to register as these types of traditional finance entities.
3. Bringing Crypto Back Home. The Report makes a strong point that the Administration's overall goal is a reversal of the movement of blockchain projects and innovations outside the United States. Not surprisingly, in his "Project Crypto" speech the very next day after the Report was made public, SEC Chair Atkins declared that the SEC will "on shore" crypto projects, noting: "The SEC will not stand idly by and watch innovations develop overseas while our capital markets remain stagnant ... Project Crypto will ensure that the United States remains the best place in the world to start a business, develop cutting edge technologies, and participate in capital markets ... [and] we will work to bring crypto asset distributions back to America." The U.S. may have an advantage in building systems that are less complex and more customer friendly than the current global regulatory frameworks. The attraction to the depth and liquidity of the U.S. capital markets should be a magnet for many blockchain-centric and tokenization projects. The PWG Report does make clear that while there is an evolving global regulatory landscape, this evolution "creates an opportunity for the United States to support a less fragmented digital asset ecosystem …."
4. The States. The Report also notes that not all are in favor of a strong crypto presence in the U.S. It mentions the California Digital Financial Assets law. Regulations are being adopted under that law which are likely to be far more stringent then federal law. That will raise interesting issues of both Federalism and convenience which will determine whether California residents will have their digital asset services restrained and limited because its differences with federal law.
5. Definitions and Clarity. The Report spent time establishing a digital asset taxonomy with definitions of commodity, tokens network, tokens, collectible tokens, redeemable tokens, and utility tokens. This will make compliance with new standards easier and clearer.
6. Regulatory Coordination. The Report strongly encourages the SEC and the CFTC to coordinate and develop workable rules. This coordination was reflected almost immediately with the Project Crypto speech of the SEC and the Crypto Sprint announced by the CFTC. One can expect the SEC and CFTC to work together closely but the larger question may be how those market regulators will coordinate with the safety and soundness, consumer protection, and monetary policy regulators at the OCC, the FDIC, the CFPB, and the FRB. More and more, crypto and banking are reaching a confluence. Coordinating the efforts of six major federal regulators into a comprehensive, cohesive and smoothly operating regulatory framework will be an organizational challenge that will require all involved to think far outside their traditional perimeters and historic frameworks. Over time, this may require additional legislative efforts given the fact that legislation from 1863-1866 (the National Bank Acts), 1933 and 1934 (the Securities Act and the Securities Exchange Act), 1956 (the Bank Holding Company Act) and 1999 (the Gramm-Leach-Bliley Act) is not likely to be fully up to the task of accommodating new and rapidly evolving systems and frameworks for conducting financial affairs on personal, institutional, national and global levels.
7. "Super-Apps." The Report also focused on long-term considerations allowing registrants to offer multiple services within a single user interface and under one license. The very next day after the Report was released, SEC Chair Paul Atkins in his Project Crypto speech referenced the development of a "Super-App," which indicated the SEC would work to approve and "make this 'super-app' vision a reality." In the same vein, a major global cryptocurrency exchange recently announced that it will build an "everything exchange," which will incorporate not only core digital asset activities like trading and staking, but will also offer derivatives, prediction markets, early-stage token sales, and more. This follows the development of its rebranded app touted as bringing together "social, apps, chat, payments, and trading to create a new kind of open social network." This, of course, is very much in line with Elon Musk's desire to build X into an "everything app." And all of this development will be powered by AI. The larger point is that technology is being developed to combine many, if not all, financial services into a single application, driving further challenges for regulatory examination and supervision.
8. Interim Activity. The Report also indicated that there was, and will be, an effort to move forward with some pace, even while Congress continues its deliberations. The Report notes that as market structure deliberations continue, regulators "can work to provide appropriate accommodation for digital asset, trading and innovation." This is a hopeful and optimistic sign that the market regulators will be accommodating as the legislative process goes forward. However, one should keep in mind that very little officially sanctioned substance will be effective this year. In fact, stablecoin enactment is not likely to be official until sometime next year. This may mean more delays than the industry has hoped for regarding the actual roll outs of stablecoin products by banks and other "permitted payment stablecoin issuers." However, the SEC and the CFTC may be in a position to adopt rules and guidance using certain exemptive authorities or through related sandboxes and the like.
9. Role of Banks. With respect to banks, there is an issue of ensuring that banks can continue to provide core products and services. The Report sends a clear message that there will be no more debanking. And, if that were not enough, the White House has issued an Executive Order on debanking and the House has issued its version of the Financial Integrity and Regulation Management Act (aiming to eliminate reputation risk as a component of federal supervision of depository institutions) as a companion to the Senate version introduced earlier this year by Senator Tim Scott (R-SC). Importantly, the Report states that it is expected that banks will be facilitating customer access to digital markets through custody, trade execution, and settlement. There also is a recognition of the advent of tokenized deposits. Moreover, the Report gives an expectation that banks will provide services to clients through connectivity to DeFi financial market infrastructure (FMI) platforms, using decentralized applications (dApps), along with an expectation that banks will be facilitating digital asset trading as well as crypto lending. All of this will profoundly change banks, the talent they will need to recruit and the technology with which they will need to connect, while at the same time managing their own core technology on which traditional banking services depend. This will be a complex and difficult ballet.
10. Capital Simplification. Finally, there is a recognition that there needs to be significant simplification of capital and liquidity frameworks particularly as compared to the Basel Committee on Banking Supervision framework. Although there is a belief that there should be coordination among capital requirements, there also is an opportunity to further on-shore crypto projects by making capital and liquidity simpler and easier.
11. Countering Illicit Finance. The Report is cognizant of the need for robust money laundering and anti-terrorist financing protections. It recognizes that the vast majority of digital asset activity is legitimate, with less than 1% of all on-chain digital asset volumes in 2023 being illicit. There is full recognition of the role of failures to comply with AML/CFT/OFAC obligations as well as the use of anonymity enhancing technologies. Part of success in this area can be achieved through statutory changes to better tailor and clarify those frameworks for digital asset actors. This includes stablecoin issuers and should address higher risk activities in the secondary stablecoin ecosystem without unduly burdening the issuer. And, the Report encourages Treasury to consider next steps regarding its proposed rulemaking concerning central bank digital currency mixing. The Report also recognizes that there is a need for reform in connection with AML reporting and that there should be a Request For Information to understand ongoing developments, innovations, and gaps in existing OFAC guidance, as well as to identify opportunities for enhanced private sector collaboration. Finally, the Report notes the benefits of advancing privacy through digital identity and related tools. It notes that digital identity tools can be used in support of onboarding or by DeFi services' smart contracts to automatically check for a credential before executing a user's transaction. It also notes the increased use of Zero Knowledge Proofs, which can enable users to confirm that their identity has been verified or subject to screening by a third party without revealing underlying personal information. To reach these goals, the Report encourages public and private sector participation in real time information sharing through the Illicit Virtual Asset Notification (IVAN) program.
12. Privacy. As noted above, the Report expresses support for advancing privacy through the adoption of digital identities which it suggests would benefit from the NIST digital identity guidelines as well as from lessons learned from the National Cybersecurity Center of Excellence. However, the Report also has prompted other immediate reactions as noted above by the SEC's publication of "Project Crypto" and the CFTC's notice of its "Crypto Sprint." Other thoughts on privacy have appeared in SEC Commissioner Peirce's August 4 speech to the "Science of Blockchain Conference" in which she noted the paradox of banks using encryption to protect private customer data from theft or public disclosure, but the customer nonetheless having no expectation of privacy in the encrypted data because it has turned that data over to a third party. We should consider "with fresh eyes" whether such security measures are proportionate to the threats and whether they diminish "the liberties that make the United states a beacon for the rest of the world." The Commissioner references the PWG Report while concluding that regulators "should take concrete steps to protect people's ability not only to communicate privately, but to transfer value privately as they could have done with physical coins in the days in which the Fourth Amendment was crafted." That debate will not be resolved by implementing the recommendations in the PWG report nor by remarks from SEC Commissioners. We can expect that the discussion of privacy will be contentious and ongoing. "Restoring Americans' privacy in their financial transactions will be an uphill battle."
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