A new bill introduced in the House would clarify that a digital asset that is sold as part of an “investment contract” does not necessarily become a security. If passed, the Securities Clarity Act would help settle one of the most debated legal questions in the crypto space and make it more difficult for the U.S. Securities and Exchange Commission (SEC) to argue that many existing tokens are unregistered securities.
In 2018, Bill Hinman, then director of the SEC’s Division of Corporation Finance, the agency’s unit that handles securities registration and disclosure, gave his now-infamous speech on how the securities laws apply to digital assets. He suggested that if the network on which a particular token functions was “sufficiently decentralized” to the point where “purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts,” then the “digital asset transaction may no longer represent a security offering.”
Tuongvy Le is a partner and head of regulatory at Bain Capital Crypto. Khurram Dara is a regulatory and policy principal at Bain Capital Crypto.
Since then, the question of “sufficient decentralization” and whether a digital asset could “transform” from a security to a non-security has been the subject of much debate. SEC Chair Gary Gensler has repeatedly expressed skepticism over projects’ claims about decentralization and has pointedly refused to confirm that the reason he believes bitcoin is not a security is because it is “sufficiently decentralized.”
Meanwhile, in its still-ongoing litigation against Ripple Labs and two of its executives over the XRP token, the SEC has sought to distance itself from Hinman’s 2018 remarks, claiming that they were not official agency guidance.
Even so, a number of the SEC’s recent enforcement actions have considered whether a token project’s claims of decentralization would place it outside the definition of an “investment contract” – a type of security defined by a set of standards known as the Howey Test. In essence, the agency is implying it would be possible for a truly decentralized token to fall outside of its ambit, based on the “facts and circumstances” of each crypto project.
But on the question of whether a security can “transform” into something else, Gensler has previously stated that there is no precedent in the federal securities law for the concept.
If the recently introduced Securities Clarity Act becomes law, however, the answer to that question may no longer matter.
What would the Securities Clarity Act change?
The bipartisan bill, which Representatives Tom Emmer (R-MN) and Darren Soto (D-FL) announced in May, would clarify and codify that an asset sold or transferred pursuant to a fundraising transaction deemed an “investment contract” – and that is not otherwise a security – does not become a security just because it was sold or transferred as part of a securities offering. A version of the bill was first introduced in 2021.
The bill essentially distinguishes between an investment contract transaction, which is a securities offering, and the underlying investment contract asset, which is often not a security (like the orange groves in Howey). This means that a token offered as part of an investment contract would not need to “transform” into a non-security – it would not be a security in the first place.
The distinction is important because today, unlike the initial coin offerings (ICOs) of the past, many development teams that are interested in launching a token in the U.S. raise funds in SEC-compliant securities offerings using Regulation D (Reg D) offerings, an exemption from SEC registration typically associated with a public offering. In these private offerings, rather than sell to the public, issuers sell to “accredited investors” who acquire future token interests through purchase agreements (e.g. SAFEs or SAFTs) that call for token delivery upon certain conditions being met, such as network or protocol launch.
The key question for these projects is not whether a security can “transform” into a non-security, it is whether a token can be packaged in a multi-stage agreement involving a securities offering, without itself becoming a security.
This distinction between an investment contract transaction and an underlying asset had been “well-settled” according to the bill’s text, but has been “unnecessarily conflated in the context of digital assets.” Lewis Cohen of DLx Law argued the distinction is consistent with how federal courts have historically viewed “investment contracts.” In this sense, the bill does not break new ground as much as it provides certainty.
The bill is also good policy. Gensler frequently says existing token projects should “come in and register” their assets with the SEC. But conflating an investment contract transaction with the underlying token in order to shoehorn digital assets into the securities laws would not result in better investor protection. In fact, it might have the opposite effect.
As our friends at Paradigm have thoroughly detailed, the current SEC disclosure framework is unfit for crypto assets, as it “fails to provide crypto-asset users and investors with the information they need, while also denying crypto entrepreneurs a viable path to compliance.”
By providing certainty over the distinction between an investment transaction and the underlying assets, the Securities Clarity Act provides a path to compliance in the U.S.
Moreover, given most crypto purchases take place in secondary market transactions that are independent of the issuer, by separating the investment contract from the underlying asset, the bill helps provide some comfort for trading platforms that currently struggle with evaluating whether a token that may have initially been offered in a securities transaction can subsequently be listed or made available for trading.
Finally, a world in which a digital asset can transform from a security to a non-security (and potentially back again?) presents real practical challenges in terms of supervision and enforcement.
Emmer’s bill does have an important qualification that the asset underlying the investment contract is “not otherwise a security.” Without this qualification, the bill would essentially create a loophole allowing issuers to evade securities laws. Unfortunately, this qualification also means that the SEC can still ultimately determine that an asset underlying an investment contract is a security – discretion that could be abused by a more aggressive regulator.
Still, the bill would provide much-needed clarity and could not have come at a better time. For instance, a day before the bill was introduced, Grayscale revealed in a press release that the SEC had informed the firm of its view that filecoin (FIL) is a security, in connection with Grayscale filing a registration statement for a filecoin trust product.
But Protocol Labs, the team that developed the Filecoin protocol, raised funds from accredited investors in a compliant securities offering that was exempt from registration. Given that Protocol Labs did not sell tokens to the public to raise funds for the development of Filecoin, the SEC’s argument that FIL is a security likely hinges on conflating the distinction between the investment contract and the underlying asset, which is used to help secure and purchase storage space on a decentralized file storage network.
Filecoin has been used to collect, verify and preserve everything from evidence of war crimes in Ukraine to important scientific information, representing one of the most compelling non-financial use cases in all of crypto.
Even though the proposed legislation would not preclude the SEC from determining that investment contract assets are otherwise securities, it would significantly reduce uncertainty for investors and issuers alike. At just five pages in length, it is a short but effective bill that would provide clarity with a simple amendment to the definition of a “security” in the federal securities laws.
While any potential legislation faces an uphill battle in the Senate, the bill is another step in the right direction from the House Financial Services Committee, which appears poised to pass a bill on payment stablecoins and is also rumored to be working on a market structure bill.
Edited by Jeanhee Kim and Daniel Kuhn.
There is a quietly emerging consensus among key stakeholders regarding one area of crypto regulatory policy – payment stablecoins. On Thursday, the House Financial Services Committee’s Subcommittee on Digital Assets, Financial Technology and Inclusion, will hold another hearing on stablecoins – the second on the subject in the last four weeks. Ahead of the hearing, two more drafts of bills were posted on the Committee’s website from Chair Rep. Patrick McHenry and from Ranking Member Rep. Maxine Waters – both variations of their joint draft that was under consideration by the committee last year. The latest hearing and newly circulated drafts signal the House’s commitment to introducing and passing a bill in this area.
While there are certainly differences of opinion among members of the Subcommittee on crypto, many appear to be aligned on a few key themes with respect to regulation of payment stablecoins. It may have been easy to miss during the cross-talk at last month’s hearing, but there was broad agreement among the testifying witnesses and many members of the Subcommittee that:
Congressional action is urgently needed on payment stablecoins;
Payment stablecoins backed 1:1 by cash or cash equivalents are distinct and separate from other types of non-payment stablecoins (which may use different mechanisms to maintain a “soft-peg” to the U.S. dollar or some other currency);
Payment stablecoin issuers should be subject to a prudential framework – similar to payments or banking regulation – with safeguards such as reserve and redemption requirements, segregation of assets, prohibitions on rehypothecation, restrictions on commingling of assets, and AML/KYC obligations; and
Maintaining U.S. dollar dominance and financial inclusion are critical public policy objectives that can be advanced with proper regulation and oversight of payment stablecoins.
What Congress has not done is propose regulating payment stablecoins through, say, a securities framework. Yet, one financial regulator, the SEC, appears poised to do just that. Given the legislative activity on stablecoins to date, financial regulators should not “front-run” Congress with regulation-by-enforcement.
Tuongvy Le is a Partner and the Head of Regulatory and Policy, and Khurram Dara is a Regulatory and Policy Principal, at Bain Capital Crypto, Bain Capital’s crypto-dedicated venture capital fund.
What is a payment stablecoin?
A “payment stablecoin” is the representation of a unit of fiat currency on a blockchain. Payment stablecoins are usually backed 1:1 by cash or cash equivalents and are intended for payments, as they are easily redeemable or exchangeable for fiat currency. While the term “stablecoin” is often used as an umbrella term, payment stablecoins are not as novel or exotic as their crypto origins may suggest. As one witness at last month’s hearing stated, these “look a lot like pretty basic cash instruments.”
Fiat-backed stablecoins differ from stablecoins that are algorithmically stabilized with a non-stable companion asset or those that are collateralized by crypto assets, like DAI. These non-payment stablecoins are said to be only “soft-pegged” to a unit of currency, as their value may fluctuate, and they may not be redeemable or exchangeable on a 1:1 basis for fiat.
The focus of the recent hearings and draft bills is primarily regulation of payment stablecoins, like USDC or Tether, which are estimated to account for ~90% of the overall stablecoin market and play an important role in the crypto ecosystem.
What is the point of payment stablecoins?
U.S. dollars are the preferred denomination of settlement for many crypto transactions. But without stablecoins, making payments in U.S. dollars or any other currency in exchange for crypto requires a third-party, such as a payments processor or a bank. Stablecoins are a useful innovation in that they represent a unit of fiat currency within an interoperable standard on a blockchain, allowing for transactions to occur and settle in U.S. dollars using “smart contracts” – self-executing code stored on a blockchain – rather than relying on a third-party intermediary.
Imagine an Apple Pay balance that was interoperable with any other cash balances you had on your phone, like those in your Venmo, Zelle or Amazon accounts. That’s essentially what payment stablecoins are. But with the added benefit of real-time, 24/7 settlement. In this sense, payment stablecoins are a bridge between crypto and traditional finance.
Of course, the value and usability of payment stablecoins are only as good as the cash and cash equivalents behind them. The good news is, since we’ve had cash-like instruments for some time, we know how to regulate them effectively.
Proposed legislation on stablecoins
The anticipated McHenry-Waters stablecoin bill is the latest in a long list of bills introduced over the last few years seeking to regulate stablecoins, such as the proposed Stablecoin Transparency Act, the Stablecoin TRUST Act and the Responsible Financial Innovation Act, among others. While these bills vary in their scope and approach, they evidence a strong bipartisan consensus to regulate payment stablecoins as cash instruments – not as securities.
The latest versions of the draft bill would create a prudential framework for regulating payment stablecoins with important safeguards and limitations, such as:
capital and reserve requirements (1:1 backing)
redemption timeframe requirements
segregation of assets
limitations or prohibitions on commingling, re-hypothecation (like lending or investing the funds)
treating payment stablecoin issuers as financial institutions, subject to the Bank Secrecy Act and its AML/KYC requirements.
Indeed, of the various stablecoin bills proposed so far in Congress, only one – from 2019 – would potentially give the SEC authority to regulate payment stablecoins. Another bill from 2020 would give the SEC authority over “synthetic” stablecoins (e.g. uncollateralized, algorithmically-stabilized), but excludes reserve-backed (e.g. fiat-backed) stablecoins – instead establishing the Treasury Department (FinCEN) as the primary regulator. Nearly every stablecoin bill since then has taken a banking or prudential approach for regulation of payment stablecoins.
Payment stablecoins are not securities
While the SEC has not proposed a rule, issued guidance, or brought an enforcement action with respect to payment stablecoins, SEC Chair Gary Gensler has repeatedly stated that he believes that these “so-called stablecoins” may be securities, describing them as “poker chips at the casino,” or, when used within crypto exchange platforms, possibly security-based swaps.
He has also said that some payment stablecoins resemble money market mutual funds. And in February, Paxos, a blockchain infrastructure platform that issues BUSD, a stablecoin regulated by New York State’s financial regulator, announced that the SEC was considering an enforcement action against it on the grounds that BUSD is an unregistered security.
It is clear the SEC views at least some payment stablecoins as securities, and that it could soon take enforcement action against them. While some stablecoin arrangements arguably meet the definition of an enumerated category of a security such as an “investment contract” under the Howey test or a “note” under the Reves test, payment stablecoins do not. Put simply, holders of payment stablecoins are not motivated by an expectation of profit, a necessary requirement under Howey, and a key factor of a multi-part balancing test under Reves. Payment stablecoins typically do not pay interest and are used like cash. Similarly, being fully-backed and used for non-investment purposes rebuts the presumption that payment stablecoins are notes under the Reves test.
As for their resemblance to money market mutual funds, most payment stablecoins are not marketed as dividend or income producing alternatives to bank deposits – instead, they are offered and used like digital cash. Most payment stablecoin issuers are not pooling and re-investing funds; they’re simply creating digital representations of fiat currency backed by cash or short-term treasury bills.
Although payment stablecoins must rely on an issuer or administrator to arrange for custody of the underlying cash or cash equivalents backing the stablecoin’s value, this type of financial activity and relationship is typically regulated using a prudential framework that focuses on safety, soundness and supervision. Such an approach is consistent with the recommendations of the Presidential Working Group on Financial Market in its joint late-2021 “Report on Stablecoins” issued in collaboration with the FDIC and the OCC, and most stablecoin bills introduced by Congress so far.
Meanwhile, the CFTC has asserted in multiple enforcement actions that certain stablecoins – including USDT, USDC, BUSD and DAI – are commodities. CFTC Chair Benham has also stated that USDC and other stablecoins similar to it would be commodities unless Congress says otherwise. The varied and sometimes conflicting positions taken by different financial regulators only underscores the need for Congressional action to get everyone on the same page.
Now that Congress is actively working towards a bipartisan, prudential regulatory framework to regulate payment stablecoins, the financial regulators, including the SEC and CFTC, should allow that process to play out. While the timing of any stablecoin legislation is unpredictable, stablecoin bills are clearly a high priority for both parties in Congress, which has spent more time on stablecoin legislation than any other crypto related policy area.
Comprehensive stablecoin legislation is good policy
Nearly all the witnesses at last month’s hearing agreed that the U.S. has a strong public policy interest in providing regulatory clarity, maintaining the dominance of the U.S. dollar, and promoting financial inclusion. Sensible, comprehensive legislation on payment stablecoins will help to accomplish all three.
Some have speculated that stablecoins may pose risks to the broader financial system, citing the fact that Circle, which issues and manages USDC, held large deposits at the recently-shuttered Silicon Valley Bank. Chair Gensler himself attempted to make a connection between Silvergate and Signature Bank’s activities in crypto and their ultimate demise. However, at last month’s hearing, Adrienne Harris, Superintendent of New York state’s financial regulator, which regulated Signature Bank, definitively stated that its failure was not crypto related and called the claim a “misnomer.”
Others have criticized proposals for stablecoin regulation that would call for a dual state and federal approach similar to banking regulation. But this framework allows for better, more tailored regulation.
“It does not make sense for the OCC or the Federal Reserve to be spending significant amounts of time on a $2 million market cap stablecoin run out of Alabama,” said Austin Campbell, one of the witnesses at last month’s hearing, “but nor does it make sense for Alabama to be the sole overseer for a $500 billion market cap stablecoin.” Superintendent Harris also endorsed this approach, arguing that “states can act more nimbly,” and noting that FTX, Voyager, Celsius and Terra/Luna had been barred from doing business in the state.
While finding areas of agreement between crypto advocates and U.S. regulators has become increasingly difficult in the wake of recent events, the growing consensus on the need for comprehensive legislation on payment stablecoins provides Congress with an opportunity to enact sensible regulation over an important segment of the crypto market. The financial regulators should not front-run the democratic process.
Let’s allow Congress to do its job.
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Tuongvy Le is a Partner and the Head of Regulatory and Policy at Bain Capital Crypto, Bain Capital’s crypto-dedicated venture capital fund.
Khurram Dara is a Regulatory and Policy Principal at Bain Capital Crypto, Bain Capital’s crypto-dedicated venture capital fund.