Update 627 — Crypto Crash Begs Regs:
Hill Action as Euphoria Yields to Reality
As the House returns today to vote on the Inflation Reduction Act and send it to Biden’s desk, we turn towards a murkier legislative task: regulating cryptocurrencies. Following the flurry of 2022 Super Bowl ads, markets saw a crypto winter of massive sectoral bankruptcies, losses, and systemic failures that now have the attention of Congress. The digital asset market remains unpredictable, posing both broad investor protection and financial systemic risks.
But the series of bills introduced thus far in Congress seem more informed by the former euphoria and lobbying by market participants than the risks to the public and the economy. For progressives, however, there is also the important factor of political timing to consider. We explain below.
Good weekends all,
Concurrent with President Biden’s Executive Order on Ensuring Responsible Development of Digital Assets, Congress has introduced a series of bills whose sponsors say provide a clearer regulatory framework sought by those inside and outside industry. Many advocates and regulators, though, believe existing frameworks are sufficient to regulate digital assets.
The bills proposed have been bipartisan, but the odds of a Republican Congress following the midterms mean these bills could become even friendlier to the industry next year. So regulatory agencies and consumer advocates are grappling with the tension between getting some rules on the books now, before what they see as the minimal regulations in the current bills are replaced by still more permissive ones.
By way of crypto background, here are some key definitions from the New York Times and other crypto commentators:
- Cryptocurrencies: A digital asset designed to work as a medium of exchange through a decentralized computer network without reliance on any central authority. Since Bitcoin was first conceived in 2008, thousands of other cryptocurrencies have been developed. Among them are Ether, Dogecoin, and Tether; the latter of which is a stablecoin.
- Stablecoins: A type of cryptocurrency that is designed to have a stable value (which is typically pegged to an existing government-backed currency). To promise holders that every $1 they put in will remain worth $1, stablecoins promise to hold a bundle of assets in reserve, often short-term securities such as cash, government debt, or commercial paper.
- Central Bank Digital Currency: A digital form of central bank-backed currency that could complement physical currency and allow people and business to make digital transactions as if it were cash. CBDC could help move our economy fully into the digital era, but there are tensions around the Federal Reserve’s capacity to administer a CBDC, the reticence for the government to access payments data, and the decision to intermediate with commercial banks.
Comprehensive Crypto Legislation
The cryptocurrency industry has been eager to support legislation that would legitimize the industry under light-touch financial market regulations. There are two main bipartisan bills floating around right now: the Responsible Financial Innovation Act (RFIA) and the Digital Commodities Consumer Protection Act (DCCPA).
Introduced in early June, the RFIA is a bipartisan effort between Senators Cynthia Lummis and Kirsten Gillibrand to establish a comprehensive framework for the regulation of digital asset:
- Taxation: RFIA creates numerous tax loopholes including a de minimis exception for capital gains taxation for personal transactions of digital assets that do not exceed $200, a deferral period for crypto miners on assets they receive for validation, and a narrowed definition for broker qualifications. These provisions run afoul of traditional tax principles and create significant loopholes in our tax regime.
- Stablecoins: RFIA would not permit algorithmic stablecoins, largely due to the crash of the LUNA algorithmic stablecoin, but the bill does allow non-depository institutions with charters to issue stablecoins, which could heighten systemic risk concerns.
- Retirement: RFIA requires the Government Accountability Office to study how digital assets can be used for retirement investments, a dangerous expansion of the financialization of retirement due to the volatility in the digital asset market.
- Agency Jurisdiction: RFIA would expand the definition of “commodities” to include most digital assets. RFIA would take a significant amount of regulatory authority away from the SEC and place it under the CFTC, which has been eager to increase its role in digital asset oversight.
The RFIA is a dangerous legitimization of the digital asset market with light-touch regulations that facilitate tax avoidance, increase systemic risk in the financial sector, endanger the retirements of millions, and overburden the CFTC. We are skeptical that the bill will and should move forward in current form.
A slimmer bill focused almost exclusively on agency jurisdiction is being supported by the Senate Agriculture Committee.
Introduced in early August, the Digital Commodities Consumer Protection Act is co-sponsored by Senate Agriculture Committee Chairwoman Debbie Stabenow and Ranking Member John Boozman.
DCCPA grants the CFTC broader jurisdiction over cryptocurrencies by asserting Bitcoin and Ether will be under the commission’s purview, but the SEC could still provide tough oversight and enforcement over the rest of the industry. DCCPA would also establish new registration mandates for digital asset market participants and digital commodities. Some observers worry that the new regulatory requirements in the bill are still not equivalent to the level of oversight and protection for investors found in the existing securities regime.
The crypto industry met DCCPA with a warm reception, potentially a warning sign for financial regulation and consumer advocates. As such, we are skeptical of DCCPA, but also acknowledge the political realities at play. If Congress changes hands in the midterms, Republicans will likely draft legislation that is even more forgiving to the industry, a bill that President Biden would be unlikely to sign. The SEC should continue engaging in rigorous oversight of the digital asset market, and we believe it is possible to improve DCCPA if it seems destined for passage this fall.
House Financial Services Committee Chairwoman Maxine Waters and Ranking Member Patrick McHenry are negotiating a bipartisan framework that would place guardrails and other specified mandates onto stablecoins while permitting a broad range of issuers.
The draft bill, still under wraps, would give banks and non-banks the authority to issue their own stablecoins while placing non-bank issuers under the oversight of the Federal Reserve. Issuers would be required to maintain all reserves and would not be permitted to lend stablecoins out to customers. Including non-banks under this framework would present concerns about regulatory arbitrage and financial stability. Provisions designed to address money-laundering, one-to-one dollar reserve requirements, and prohibitions restricting certain commercial companies from being issuers, are expected to be included.
While HFSC had planned a July 27 markup of the bill, consideration was effectively delayed until after August recess due to concerns about consumer protections brought forth by Secretary Janet Yellen. Consumer advocates and the banking industry also provided intense pushback, citing the need for greater financial system protection and the overall need for further research into the digital asset industry. We echo such concerns and believe the legislation would ultimately do more harm than good by legitimizing a systemically risky asset with little real protection for investors and the marketplace.
Getting a CBDC Right
The Federal Reserve has routinely suggested Congress must first authorize the development of a CBDC. In the meantime, the central bank has been exploring the benefits and risks of one, particularly honing in on whether a standardized digital currency could improve our national payments system. Additionally, a US CBDC could support international trade by facilitating cross-border payments more efficiently and tighten our national security apparatus.
Congressman Jim Himes’ office recently released a white paper considering policy options for a US CBDC. Himes’ office claims a CBDC in the United States would benefit most from being intermediated by private institutions. The office proposes access points for financial inclusion via the incorporation of non-bank entities with account system functions similar to that of a bank and asserts that in using this approach, the CBDC would prioritize privacy through intermediation and prevent pushing out commercial banking.
The need for smart US CBDC policy that builds trust with the unbanked to bring them in and remains under public control is more acute than generally appreciated, for reasons of international competition. Still, the Fed stays clear of comment on most of the important questions that need answers in its paper. And while Himes’ office has gotten the ball rolling on the conversation, intermediation increases the risk of a CBDC becoming controlled by the private sector and not actually reaching the unbanked.
Is the Perfect the Enemy of the Good?
Despite having ample options on how to proceed in establishing a clearer regulatory framework for digital assets, none of the aforementioned choices have necessarily proven worthy of further time or dedication from the perspective of sound policy. While none of these proposals are particularly good in their own right, some provisions have the potential to be used as a benchmark in future discussions surrounding digital assets and to dissuade a Republican Congress from writing more industry-friendly rules. Congress and financial regulators must proceed cautiously, but diligently, to mitigate systemic risk and provide ample protections for investors in this turbulent market.