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On October 3, 2022, the Financial Stability Oversight Council (“FSOC”) – a collaborative body formed under the Dodd-Frank Act composed of state and federal regulators and tasked with identifying risks and responding to emerging threats to financial stability – released its 100+-page Report on Digital Asset Financial Stability Risks and Regulation (the “Report”). In the Report – a response to President Biden’s Executive Order 14067 on digital assets, which, among other things, directed various agencies to promote innovation and R&D while calling for measures to mitigate risks – the FSOC reviewed what it deems to be, “specific financial stability risks and regulatory gaps posed by various types of digital assets.”

At the core, the FSOC Report is a call to arms, with the council citing what it sees as a host of regulatory and industry shortfalls that have not kept up with the rapid growth of digital asset activities.  For example:

  • The FSOC report noted that stablecoins and the lending and borrowing on digital asset trading platforms are now an “important emerging vulnerability.”
  • The Report’s basic thesis is that crypto-asset activities “could pose risks to the stability of the U.S. financial system if their interconnections with the traditional financial system or their overall scale were to grow without being paired with appropriate regulation, including enforcement of the existing regulatory structure.” This point was reiterated in the Federal Reserve’s November 2022 “Financial Stability Report,” which presents the Federal Reserve Board’s current assessment of the stability of the U.S. financial system.
  • The FSOC Report also expresses the position that federal comprehensive digital asset legislation is needed to address complex, systemic economic risks, as, in its opinion, “many crypto-asset platforms are not registered or chartered under regulatory frameworks that would address these risks.”

There have been a number of developments swirling around stablecoins in the past month, including, earlier this week, the recent introduction in the U.S. Senate of a bill (the “Responsible Financial Innovation Act”) that would put in place a regulatory framework for digital assets and enact certain requirements and consumer protections surrounding stablecoins. The topic of stablecoins’ utility and risk has been in the headlines and on the minds of both legislators and state and federal financial regulators. In a timely move, the New York Department of Financial Services (NYDFS), released its “Guidance on the Issuance of U.S. Dollar-Backed Stablecoins” meant to set foundational criteria for USD-backed stablecoins issued by DFS-regulated entities on the issues of redeemability, assets reserves and attestations about such reserves. The NYDFS is the first state regulator to release such guidance. With the fate of Congressional action on stablecoins this year uncertain (and equally uncertain whether federal agencies or banking regulators will step in to offer certain guardrails), it will likely be left to the states (and the industry itself) to establish certain baselines that offer consumer protection and stability without harming innovation. Given NYDFS’s experience in the virtual currency space and its prominence, its latest guidance may be influential to other regulators around the country. 

Back in January, the U.S. Board of Governors of the Federal Reserve (the “Federal Reserve”) released its long-awaited discussion paper, “Money and Payments: The U.S. Dollar in the Age of Digital Transformation” (the “Report”), beginning a public dialogue about central bank digital currencies (“CBDCs”) and weighing the merits of a U.S. CBDC.

For the purposes of the Report, a CBDC is defined as a “digital liability of a central bank that is widely available to the general public” and further, a “digital form of paper money.” In this respect, a CBDC is like a stablecoin because a CBDC also seeks to maintain a stable value and become an alternate payment mechanism that can be used to facilitate trading and lending, lessen the friction surrounding cross-border payments, and help foster more financial inclusion. However, unlike a stablecoin backed by reference assets like a national currency, commodities, or another digital asset, a U.S. CBDC (i.e., a digital dollar) would be backed by the full faith and credit of the United States in the same way as a physical dollar and, as described in the Report, would be digital money that is “free from credit risk and liquidity risk.” Thus, as discussed in our recent post on stablecoins, a CBDC enjoys many of the same benefits as stablecoins and, as described in the Report, “could spur innovation by banks and other actors and would be a safer deposit substitute than many other products, including stablecoins and other types of nonbank money.”  Still, the Report suggests that CBDCs may bring their own risks to the safety and stability of the monetary system, particularly during times of financial stress, and otherwise affect the Fed’s ability to implement monetary policy. Plus, there is the added complexity of harnessing and updating the government’s infrastructure to launch such a digital dollar.  On the whole, the Report cautions that a CBDC “could fundamentally change the structure of the U.S. financial system.”

On March 9, 2022, the President issued an Executive Order (the “E.O.”) that articulates a high-level, wide-ranging national strategy for regulating and fostering innovation in the burgeoning digital assets space.  The strategy is intended to encourage innovation yet still provide adequate oversight to control systemic risks and the attendant investor, business, consumer and environmental concerns.

The E.O. is very broad in scope.  It focuses on the myriad of issues associated with “digital assets,” a term defined in a way to capture a wide variety of existing and emerging “crypto” implementations.  Specifically, the E.O. defines digital assets to include “all central bank digital currencies (CBDCs), regardless of the technology used, and to other representations of value, financial assets and instruments, or claims that are used to make payments or investments, or to transmit or exchange funds or the equivalent thereof, that are issued or represented in digital form through the use of distributed ledger technology.” Significantly, the E.O. does not make an attempt at defining the regulatory status of digital assets and notes a digital asset “may be, among other things, a security, a commodity, a derivative, or other financial product.”

While the E.O. itself doesn’t really set forth any new requirements, it puts into motion a process that may yield specific regulatory approaches to digital assets.  Of course, this process is happening in parallel with other initiatives by the Securities and Exchange Commission (“SEC”) and Congress itself and thus, there is a possibility that the E.O will result in approaches that are in ways inconsistent with other ongoing regulatory developments.  For example, in January 2022 the SEC released a proposal that would enhance investor protections and cybersecurity for alternative trading systems that trade Treasuries and other government securities.  The proposal prompted a dissenting statement from SEC Commissioner Hester Peirce (often referred to as “Crypto Mom” for her advocacy of the industry), who objected to the speed and breadth of the January 2022 proposal.  The E.O. sidesteps some of the controversial issues addressed in the SEC proposal, such as how “exchanges” should be defined, as well as the greater issue of how different digital assets should be classified (and therefore, which financial regulatory agencies have jurisdiction over various digital products and platforms). At the same time, there seems to be some amount of bipartisan interest in Congress to pass its own legislation regulating certain aspects of cryptocurrency and related technologies (e.g., in the stablecoin area), Whether or not that legislation would be consistent with the results of the E.O.-driven processes is also hard to tell.

On December 17, 2021, the Financial Stability Oversight Council (“FSOC”) – a collaborative body formed under the Dodd-Frank Act composed of state and federal regulators and tasked with identifying risks and responding to emerging threats to financial stability – released its 2021 Annual Report (the “Report”). In the Report, the FSOC offered wide-ranging insight into what it perceived to be various vulnerabilities in the financial system and related regulatory concerns on topics ranging from climate-related financial risks, the real estate market, certain financial structures, data challenges, and cybersecurity. Notably, the FSOC additionally dedicated a section of the Report on the specific risks digital assets pose to the financial system, specifically, those involving stablecoins.

Stablecoins are digital assets designed to maintain a stable value by pegging the digital asset to a national currency or another reference asset (i.e., a commodity like gold, silver, or oil). Using reference assets to stabilize price, stablecoins seek to become the alternative payment mechanism to bitcoin and other cryptocurrencies, and have also been used to facilitate trading and lending of other digital assets. However, the FSOC, taking a systemic, wide view, is not without concern.