Bates Research  |  02-04-22

Crypto Regulation: Speed and Size of Evolving Market Creates Urgent Need for Framework

Crypto Regulation: Speed and Size of Evolving Market Creates Urgent Need for Framework
Image © [Vitalii Vodolazskyi] /Adobe Stock

Whether crypto regulation is just around the corner or merely at the beginning of a long deliberative process remains an open question, but regulators and legislators recognize that the market for products and services tied to blockchain technology is increasingly complex and not waiting on them to propose a path forward. In 2021, the market for cryptocurrencies nearly tripled to more than $2 trillion.

In previous posts, Bates touched on broad warnings regarding current gaps in regulating crypto that could impact national security, anti-money laundering, cybersecurity (specifically as to ransomware), and investor protection. We have also described some of the legal challenges that prevent current regulators from simply absorbing some of these developing products and services into their existing authorities and SEC efforts to overcome those challenges.

Recent movement toward some framework over cryptocurrency seeks to balance the twin goals of supporting (or at least not stifling) innovation while reducing (or at least mitigating) risk. The speed and size of the complex and evolving market is creating urgency. States are also competing to see who can be the most crypto-friendly. It is now clear that all the players across the executive and legislative landscape are engaged. Here’s a brief update on the latest developments.

The White House

Recent reports suggest that the President will issue an Executive Order this month detailing a strategy that would (i) require agencies to formally assess the risks that cryptocurrencies present (with accompanying National Security Council memorandum); (ii) coordinate on overlapping regulatory issues among agencies; and (iii) address national security, competitiveness, money laundering (and other illicit use of virtual currency) concerns. (Notably, the Federal Trade Commission just published a “Consumer Protection Data Spotlight” alerting the public to a significant increase in “crypto-currency investment scams” that use social media.) The Executive Order is expected to build upon a report by the President’s Working Group (“PWG”) on stablecoins published in November, 2021. (For more on the PWG, see previous Bates article here.)

Congress

Legislators have been active as well, but seem to still be at the information-gathering stage. In December 2021, both the House Financial Services Committee and the Senate Banking Committee heard from experts on approaches to regulating cryptocurrencies in general and stablecoins in particular. At the House hearing, fundamental concerns on risk, regulatory clarity, fraud, money laundering, and competitiveness were raised. Witnesses acknowledged the importance of bringing crypto activities inside the regulated financial system but had divergent views on a host of issues, from whether to create one primary regulator to oversee digital assets and digital products, to the need to create a clear set of standards to enhance risk management and supervision. Witnesses were dubious of any immediate legislative faction, but emphasized the importance of legislative response, in part, due to concerns over issues of regulatory clarity raised repeatedly by SEC Chair Gary Gensler.

The Senate Committee hearing focused on the risks related to market integrity and investor protection from stablecoins, issues raised in the PWG report. Witnesses differed on the legislative recommendations in that report on how to guard against stablecoin runs and how to address concerns about payment system risks and concentration of economic power. The PWG had recommended that the Financial Stability Oversight Council (FSOC) take action to address these risks if Congress failed to enact legislation that would treat stablecoin issuers as insured depository institutions under the supervision of the Treasury.

This week, House Financial Services Committee Chair Maxine Waters (D-CA) announced that the Committee will hold a hearing on February 8, 2022, devoted to the PWG’s recommendations and titled “Digital Assets and the Future of Finance: The President’s Working Group on Financial Markets’ Report on Stablecoins.” The Senate Banking Committee also calendared a follow-up hearing scheduled for February 15, 2022, titled “Examining the President’s Working Group on Financial Markets Report on Stablecoins.”

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The Federal Reserve and Stablecoins

On January 31, 2022, the Federal Reserve weighed in with new research on stablecoins. The researchers examined the impact of the adoption of stablecoins on traditional banking and credit intermediation. The report found that the banking system can support both stablecoin issuance and maintain traditional forms of credit creation, and that dollar-pegged stablecoins, in particular, “can serve as a safe haven relative to other crypto-assets during times of market distress if they are perceived to be sufficiently collateralized.”

The report concludes that a wider stablecoin issuance, beyond that advocated by the PWG, which would limit stablecoin issuance to insured depository institutions, is preferable. The report warns that “the overall structure of the narrow bank approach to stablecoin reserves is potentially destabilizing for the banking system," and that “the narrow bank approach could lead to an expansion of the central bank’s balance sheet in order to accommodate the demand for reserve balances from stablecoin issuers." Further, the researchers argue that potential credit disruptions “could be mitigated by limits on stablecoin holdings and differential reserve interest rates.” Coming at this time, the Federal Reserve research should have a significant influence on the debate of legislating and regulating cryptocurrency.

States

By the end of 2021, at least 33 states had pending legislation covering some aspect of regulating virtual currency business activity within the state. In the most recent move gaining attention, newly proposed state legislation on virtual currency and operations in Wyoming and Arizona (see here and here) would allow those states to accept digital currency tax payments. Currently, only U.S. currency is acceptable for this purpose. The Arizona bill would permit payment in Bitcoin, and the Wyoming bill would accept additional cryptocurrencies, but only applicable to sales and use taxes. The proposed state legislation would be a direct challenge to central bank regulation over U.S. currency. In the context of creating a federal regulatory framework for cryptocurrencies, the use of these alternative currencies for official government purposes is a development that cannot be ignored.

Conclusion

The market is now watching to see how these developments play out—whether the President’s Executive Order will ultimately offer the kind of direction that can move federal agencies and legislators toward some kind of consensus—whether the new framework extends the position of the PWG toward tight limitations on stablecoins, or incorporates a more expansive approach suggested by the Federal Reserve research—whether state acceptance of Bitcoin for the payment of taxes and other official purposes opens a pandora’s box by leapfrogging federal legislative action—whether the lack of, or piecemeal, federal legislative action empowers the SEC to assert greater regulatory authority and enforcement power—and, on an even more fundamental level, whether any legislative solution to protect investors and stablecoin users and deter money laundering will encourage, accelerate or stifle the momentum toward the use of cryptocurrencies. Bates will continue to keep you apprised of these fast-moving developments.

About Bates MSB, Fintech and Cryptocurrency Services

Bates Group’s MSB, Fintech and Cryptocurrency practice advises financial institutions and other companies working in the unpredictable and fast-growing sector of crypto and virtual currency. We work with crypto traders, trading platforms, ATM operators, hedge funds, exchanges, crypto and cannabis companies, and others. Our compliance specialists seek to make it as simple as possible to design and implement AML-compliant policies that are up-to-date regarding cryptocurrency requirements, helping you understand these policies and how to identify noncompliance issues and risk.

Our MSB and AML Teams also implement, manage, and maintain Money Transmitter Licensing processes and engage clients with BSA/AML/OFAC Program Development, Risk Management, Training, Advisory Services, and Independent Reviews. We provide practical guidance for obtaining and maintaining money transmitter licenses, identifying state requirements, coordinating with state regulators, submitting state reports, identifying risk, detecting suspicious or unusual activity, and preventing exposure associated with money laundering and terrorist financing.

For more information about Bates Group’s MSB, Fintech and Cryptocurrency AML and Compliance Services, please contact:

Rob Ayers, Consulting Expert

rayers@batesgroup.com or 303-478-2962

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