How does the U.S. government regulate stablecoins? Research based on the FIT21 Act and state legislation

1. Definition of stablecoins

1.1. Theoretical definition

According to the BIS, a digital stablecoin can be defined as a crypto digital currency whose purpose is to maintain a stable value relative to a specific asset or basket of assets. Stablecoins are token-based; Its validity is verified based on the token itself, rather than the identity of the counterparty, i.e., account-based payments.

The price stability mechanism of digital stablecoins is divided into two kinds: one is based on algorithm; The other is based on collateral. Algorithm-based digital stablecoins do not have any assets as backing, but only use the algorithm to adjust the supply and demand balance according to the current price of the stablecoin, so as to keep the exchange rate of the stablecoin stable, such as the Basis of $1 to adjust supply and demand. The second is the digital stablecoin based on mortgage guarantee, with fiat currency, gold, digital assets and other assets as the stability mechanism of the mortgage, and its stability mechanism has higher certainty than the former.

1.2. U.S. Authority Definition (H.R.8827-Stablecoin Classification and Regulation Act of 2020)

(1) The term “stablecoin” means any cryptocurrency or other privately issued digital financial instrument, and

(A) Distributed directly or indirectly to investors, financial institutions or the public;

(B) Yes

(i) denominated in or pegged to the United States dollar; or

(ii) denominated in or pegged to other national or state currencies; and

(C) when issued

(i) has a fixed nominal redemption value;

(ii) is intended to create a reasonable expectation or belief in the public that the instrument will retain a stable notional redemption value so that the notional redemption value is effectively fixed; or

(iii) regardless of intent, the effect is to give the public a reasonable expectation or belief that the instrument will retain a stable redemption face value, so that the redemption face value is effectively fixed.

(2) Nominal redemption value

(A) In general with respect to a stablecoin, “nominal redemption value” means the value of a stablecoin which, at the time of issue, it can be converted into the United States dollar or the currency or functional currency equivalent of any other country or state at any time upon demand, or which is otherwise accepted to pay or satisfy a debt denominated in the United States dollar or the currency of any other country or state.

(B) Treatment of instruments linked to the United States Dollar: For the purposes of subparagraph (A), the value of a stablecoin linked to the United States dollar or its functional currency equivalent, which may be converted to the United States dollar at any time upon request at the time of issue, shall be calculated using the express or implied pegged exchange rate at the time of issue for such conversion.

(C) Treatment of instruments denominated in or linked to the currency of another State or State - for the purposes of subparagraph (A), the value of a stablecoin denominated in or linked to the currency of another State or state or its functional currency equivalent, which may be converted into United States dollars at any time upon request at the time of issue, shall be calculated using the express or implied exchange rate at the time of issue for such conversion.

(D) Definition of functional monetary equivalents.

(i) deposits as defined in section 3 of the Federal Deposit Insurance Act;

(ii) electronic money and remitter balances;

(iii) other stablecoins;

(iv) Any other financial instrument issued for the purpose of circulating as money, paying or discharging debts denominated in United States dollars or any other national or state currency.

As defined by H.R.8827, a stablecoin is any cryptocurrency or privately issued digital financial instrument that is directly or indirectly distributed to the public, pegged to or denominated in the United States dollar or other national/state currency, and is issued with a fixed nominal redemption value, or that by its design and effect leads the public to reasonably believe that its redemption value is stable.

2. Regulatory framework at the federal level

At present, there is no comprehensive national regulatory framework for stablecoins. Historically, the regulatory regime surrounding stablecoins has been characterized by uncertainty and confusion.

One of the features of U.S. regulation of stablecoins is uncertainty about which federal agencies have the authority to regulate these products. This has been an issue for the cryptocurrency market over the past few years, particularly with disagreements between the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) over whether certain technologies should be regulated as securities or commodities or both. SEC Chairman Gary Gensler has stated that crypto products are “governed by securities laws and must operate within our securities regime,” while the CFTC has declared “bitcoin and other virtual currencies” to be commodities. This turf war has extended to stablecoins, many of which Gensler said are similar to money market mutual funds and thus could fall under the jurisdiction of the U.S. SEC.

Both the SEC and CFTC believe that stablecoins need to be regulated to minimize risks to the financial system. The CFTC has gone one step further, taking enforcement action against stablecoin issuers for violations of the Commodity Exchange Act (CEA). For example, the CFTC settled with the companies that created the stablecoin Tether for allegedly misrepresenting the reserves supporting the stablecoin. The order against Tether requires them to pay a $41 million fine and cease and desist from further CEA violations. In addition, the CFTC has rejected any attempt by the SEC to assert exclusive jurisdiction, claiming BUSD is a commodity ina separate lawsuit against Binance.

A recent proposed bill in the United States: The Financial Innovation and Technology for the 21st Century Act (" FIT 21 ") provides guidance for future stablecoin regulation. The bill has already passed the House of Representatives and is headed for a vote in the Senate.

The regulatory division of the SEC and CFTC is clear: if stablecoins are centralized, they fall under the jurisdiction of the SEC; If the stablecoin is decentralized, it falls under the jurisdiction of the CFTC.

Centralized cryptocurrencies are considered “securities” because they may relate to investors’ expectations of the management and operation of a centralized organization, which is consistent with the definition of traditional securities. Under the Howey test, a transaction may be considered a security if it meets the following characteristics: a capital investment, an investment in a common enterprise, and a profit only due to the efforts of the promoter or a third party. Centralized digital assets typically involve a central organization or entity, and they may have characteristics more similar to traditional securities, such as relying on the creditworthiness of the issuer and expected profits. Therefore, the SEC, as the regulator of the securities market, is responsible for regulating these centralized digital assets.

Decentralized cryptocurrencies are considered “commodities” because they do not rely on centralized management and operations, but are based on decentralized technologies such as blockchain, which are jointly maintained by network participants. Their value is primarily based on market supply and demand, rather than on the credibility or efforts of a centralized entity. Decentralized cryptocurrencies, which typically do not rely on a single central entity, operate through distributed ledger technology (such as blockchain) and are jointly maintained by network participants. These assets are more similar to commodities in that their value is based primarily on market supply and demand rather than on the creditworthiness of an issuing entity. Therefore, the CFTC, as the regulator of the commodity markets, is responsible for regulating these decentralized digital assets.

The bill specifically defines decentralization as, among other requirements, if no one has unilateral authority to control the blockchain or its use, and no issuer or associate has 20 percent or more of the control or voting rights of the digital asset. If passed, the bill would bring greater clarity to stablecoin regulation.

2.1. Possible regulatory direction of the US SEC

On April 4, 2022, SEC Chairman Gary Gensler spoke at the annual meeting of the Capital Markets Association at the University of Pennsylvania and raised three policy issues related to stablecoins. First, Gensler noted that stablecoins raise public policy considerations regarding financial stability and monetary policy that are covered by U.S. SEC regulations regarding money market funds and other securities. These considerations include the way stablecoins are supported and the impact that losing the peg or the issuer going out of business could have on the broader crypto ecosystem. Second, Gensler noted that stablecoins raise issues related to their potential use for illegal activities. Specifically, Gensler expressed concern about whether stablecoins could facilitate those seeking to circumvent public policy objectives associated with the traditional banking and financial system, such as anti-money laundering, tax compliance, and sanctions. Third, Gensler pointed to issues related to investor protection that could benefit from increased oversight. Gensler expressed concern about potential conflicts of interest and market integrity issues arising from stablecoins owned by cryptocurrency trading and lending platforms, given the counterparty relationship between customers and platforms.

2.2. Possible regulatory direction of the CFTC

In a Senate hearing on March 8, 2023, the Chairman of the U.S. CFTC again claimed that stablecoins and ether are commodities and should fall under the jurisdiction of the U.S. CFTC.

At a Senate Agriculture hearing, CFTC Chairman Rostin Behnam was asked by Senator Kirsten Gillibrand about the different views held by the regulator and the SEC following the CFTC’s settlement with stablecoin issuer Tether in 2021. Behenen replied that “despite the regulatory framework around stablecoins, stablecoins will remain commodities in my opinion.” He added: “Our enforcement team and the commission are clear that the stablecoin Tether is a commodity.” The CFTC has asserted that certain digital assets such as ether, Bitcoin and Tether are commodities, such as in a lawsuit against FTX founder Sam Bankman-Fried in mid-December 2022.

2.3. Possible regulatory direction of the US Treasury

The U.S. Treasury Department noted in a September 2022 report that the impact of stablecoins and their payment systems could be “difficult to predict.” The unwinding of TerraUSD caught the attention of U.S. Treasury Secretary Janet Yellen, who quickly began talking about the possibility of stablecoin regulation. Yellen believes that a regulatory framework is needed to guard against stablecoin risks.

Alex McDougall, CEO of Stablecorp, said: "We have allowed an ‘experiment’ like TerraUSD to dominate at a rate that is far beyond its inherent risk. For a number of reasons, Senator Kirsten Gillibrand (D-NY) and Senator Cynthia Lummis (R-Wyoming) introduced a bipartisan bill in the U.S. Senate in June, It is called the Responsible Financial Innovation Act (RFIA). Among other things, the bill wants to regulate “payment stablecoins.” “It includes tax requirements on various digital assets, as well as imposing stricter requirements on stablecoins, which, according to Gillibrand, would not allow the use of TerraUSD coins,” Fedenia said. The bill also includes provisions on cybersecurity, as well as a possible self-regulatory organization and some disclosure requirements.

In July 2023, the Senate reintroduced an updated version of the bill. The updated bill makes it clear that stablecoins will be regulated by state and federal banking regulators, issued primarily by depository institutions, and will be neither commodities nor securities. the bill does, however, provide a path for institutions seeking only to issue stablecoins to obtain a limited charter to issue stablecoins from the Office of the Comptroller of the Currency (OCC). It is worth noting that the new bill stipulates that algorithmic stablecoins will be considered hybrid instruments and regulated by the US CFTC. In addition, under the updated bill, issuers of algorithmic stablecoins will be prohibited from referring to these products as “stablecoins.”

Stablecoin legislation is also making its way through the House of Representatives. House Republicans, led by Rep. Patrick McHenry, introduced the Clarity for Payment Stablecoins Act, which recently passed the House Financial Services Committee, It passed largely on a partisan basis. Non-bank issuers will face bank-like requirements, such as capital, liquidity and risk management requirements. The bill, which excludes digital assets created by banks to represent deposits, would also impose a two-year moratorium on the creation of new algorithmic stablecoins, known as “endogenously pledged stablecoins,” while directing the Treasury Department to conduct further research on them.

3. State level regulatory policy and legislative dynamics

Amid this federal uncertainty with the SEC and CFTC in the U.S., various regulatory frameworks for stablecoin issuers have emerged at the state level. Currently, many states regulate virtual currency activities through their money transmission laws, but few states provide specific guidance on stablecoins.

3.1. Regulatory Treatment of Virtual Currencies Under the Texas Money Services Act

The Texas bill considers stablecoins backed by sovereign currencies to be regulated under its Money Dissemination Act, which states that stablecoins “may be considered as a claim convertible into money and therefore fall within the definition of money or the value of money.”

Money transmission

A stablecoin pegged to a sovereign currency can be considered a claim that can be exchanged for money and therefore falls within the definition of money or the value of money under section 151.301(b)(3) of the Texas Finance Code. If the stablecoin is backed by a sovereign currency reserve, and the holder of the stablecoin has a right to redemption, then the holder has a claim on the sovereign currency backing the stablecoin, since the issuer is obligated to provide the sovereign currency in exchange for the stablecoin at a later date (at the holder’s request).

Policy statement

Sovereign backed stablecoins may be considered money or monetary value under the Money Services Act, so receiving stablecoins in exchange for a promise to provide stablecoins at a later time or at a different location may be money transmission. The licensing analysis will depend on whether the stablecoin provides the holder with a sovereign currency redemption right, resulting in a claim that can be converted into money or monetary value. This is true regardless of whether the right to redemption is explicitly granted or implied by the issuer.

3.2. Nebraska Revised Statute 8-3024

The Act states that digital asset custodians have the right to carry out one or more of the following digital asset business activities:

(1) Provide custodial services for digital assets and cryptocurrencies. No such custody service may be provided for a digital asset or cryptocurrency unless the digital asset or cryptocurrency is

(a) First publicly traded more than six months before the date of provision of custodial services; or

(b) created or issued by any bank, savings bank, savings and loan association, or building and loan association organized under the laws of this State or organized under the laws of the United States and carrying on business in this State;

(2) Issue a stablecoin and hold deposits with a financial institution guaranteed by the Federal Deposit Insurance Corporation that has a principal chartered office in the state and any branch office in the State, Or any branch of a financial institution that has a principal chartered office in the State prior to becoming a branch of that financial institution, as a reserve for stablecoins; and

(3) Use an independent node verification network and stablecoins for payment activities.

3.3. Wyoming Stable Token Act

Summary of the bill:

·A single stablecoin is a virtual currency representative of $1.

·One stable token can be exchanged for $1 upon request (unless the U.S. Treasury bill interest rate falls below zero or the value of the assets held in the trust account falls below $1 per stable token).

·100% of the notional value of all circulating tokens will be deposited into a newly created Wyoming Stable Token Trust account (although the trust will not create any fiduciary liability between the state government and token holders).

·The trust funds will be invested only in low-risk, short-term Treasury securities.

·The portion of the investment income exceeding 102% of the value of the tokens in circulation will be deposited into the Wyoming Stable Token Management Account to cover operating costs and fund other efforts of the state government.

·The act established the Wyoming Stable Token Board to issue and oversee the program.

·The bill states that the commission “shall endeavor to issue at least one Wyoming stable token by December 31, 2023.” Wyoming Treasury will provide $500,000 in initial capital for the offering and administration of the token, but it is expected that these funds will be repaid from expected interest income.

3.4. New York Stablecoin Regulation (DFS Guidance)

On June 8, 2022, the New York Department of Treasury (Dep’t Fin.Serv.,DFS) issued the “DFS Guidance” outlining the general requirements for issuers regulated by DFS to issue dollar-backed stablecoins.

Regarding redeemability, the DFS Guidance requires, among other things, that stablecoin issuers adopt a “clear, visible redemption policy, with prior written approval from DFS,” giving holders the right to redeem stablecoins at face value in a timely manner. The DFS guidance defines a “timely” redemption as no more than two business days after a redemption order is issued, but exceptions to this requirement may apply if the DFS “determines that a timely redemption could jeopardize the asset support requirements of the reserve or the orderly liquidation of the reserve assets.”

As for reserves, DFS Guidance requires that stablecoins must be fully backed by reserve assets, which can only include: (1) Treasury bills; (2) Reverse repurchase agreements with approved counterparties; (3) Government money market funds, subject to DFS approved limits; And (4) a deposit account with a U.S. state or federally chartered depository institution, subject to the DFS-approved limit on the allowable amount held at any particular institution. The DFS also expects issuers to manage liquidity risk so that the market value of the reserve asset is at least equal to the value of the outstanding stablecoin units at the end of each business day.

As for verification, the DFS Guidance requires issuers to publish monthly reports to DFS and the public, conducted by an independent U.S. licensed certified public accountant (" CPA "), detailing: (1) the value and composition of reserves; (2) unissued stablecoin units; (3) whether the reserves are sufficient to fully support unissued stablecoin units; (4) Whether all DFS conditions for the reserve are met. The DFS Guidance also requires issuers to obtain a report annually attesting to management’s claims about the effectiveness of internal controls, structures, and procedures to meet the monthly reporting requirements and submit it to DFS within 120 days of the coverage period, although issuers are not required to publicly release the report.

4. Major legal controversy: Terraform case - crypto asset securities fraud

LUNA is the governance token of the Terra Blockchain Network, a entrusted proof-of-stake blockchain that operates for the purpose of issuing and maintaining a stablecoin, or UST, a token designed for the precise transaction of $1. To motivate people to hold and use UST for the long term, Terraform LABS (creator of the Terra Blockchain network) has launched Anchor, a supposedly low-risk, high-yield savings protocol that guarantees a 20% annual return on UST deposits.

To maintain the UST peg, the agreement uses a mechanism called “seigniorage,” which, at least in theory, incentivizes carry trades, thereby generating upward or downward price pressure. Since UST can always be exchanged for exactly $1 worth of LUNA at the agreement level (regardless of the market price of UST), carry traders are incentivized to buy UST whenever it is below $1 and sell UST whenever it is above $1. This process works until it fails. Once the UST is unpegged in May 2022, it will trigger a bank run that will exchange the UST for LUNA, thereby further decoupling from the peg and eventually leading to a death spiral that will drive the LUNA price to zero.

On February 16, 2023, the SEC sued Terraform Labs and its founder, Do Kwon, for offering and selling UST and LUNA as unregistered securities. (Supplementary note: At this time, there is no clear regulatory policy, and the SEC regards both UST and LUNA as securities for supervision. If the case occurs later than the passing time of FIT 21, LUNA, as an algorithm stablecoin, should fall under the jurisdiction of CFTC.) On July 31, 2023, the trial Court denied Terraform Labs’ and Kuantou’s motions to dismiss, ruling that their marketing of the anchor agreement as a means of generating revenue was sufficient to constitute an investment contract and therefore a security. While the court ruled that BUSD and other stablecoins were not isolated securities because the fixed-price assets themselves did not present a “reasonable expectation of profit,” Terra’s actions in marketing and offering of equity derivatives (through mirroring agreements) and interest-bearing products (through anchor agreements) to encourage UST “deposits” constituted an unregistered offer and sale of securities.

5. Summarize

This article discusses in detail the regulatory framework and definition of stablecoins in the United States. According to the Responsible Financial Innovation Act (RFIA) and the Clarity for Payment Stablecoins Act, stablecoins have a relatively clear definition: Any cryptocurrency and privately issued digital financial instrument linked to the US dollar or other fiat currency with a fixed nominal redemption value. These bills require stablecoin issuers to meet specific capital, liquidity, and risk management requirements and must be licensed by the Office of the Comptroller of the Currency (OCC). Federal agencies such as SEC and CFTC are also actively competing for the regulatory rights of stablecoins, and put forward their own regulatory guidance, and the emergence and promotion of FIT 21 makes the future regulation of stablecoins increasingly clear. In addition, the paper discusses the different policy and legislative dynamics of state-level regulation, including specific implementation policies in Wyoming and New York.

FIT 21 and the continued focus of various federal agencies on stablecoins are accelerating the development of a stablecoin regulatory body in the United States. In the future, the United States is expected to further strengthen the regulatory measures for stablecoins to ensure their stability and security in the financial system. Regulators are likely to continue to improve the legal framework to respond to evolving market demands and technological innovations.

reference

[1]. The House Committee on Financial Services. (2020). H.R.8827-Stablecoin Classification and Regulation Act of 2020.

[2]. Wudaokou School of Finance, Tsinghua University, Level MBA2023. (2024). Pricing analysis and future trend of digital stablecoins – taking Teda USDT as an example.

[3]. GLOBAL LEGAL INSIGHT. (2024). The regulation of stablecoins in the United States.

[4]. TEXAS DEPARTMENT OF BANKING. (2019). Regulatory Treatment of Virtual Currencies Under the Texas Money Services Act.

[5]. LATHAM & WATKINS LLP. (2023). Wyoming Stable Token Act Enacted into Law.

[6]. OFFICIAL NEBRASKA GOVERMENT. (2022). Nebraska Revised Statute 8-3024.

[7]. COITELEGRAPH. (2023). Stablecoins and Ether are ’going to be commodities,’ reaffirms CFTC chair.

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