This article is taken from GTDT Cryptoassets & Blockchain 2023. Click here for the full guide.
The balladeer Kenny Rogers once warned fans that ‘You’ve gotta know when to hold’em, know when to fold’em, know when to walk away, and know when to run.’[i] Like the young man in Rogers’s ‘The Gambler’, developers of stablecoins are in a high-stakes game of poker with federal regulators, including the US Securities and Exchange Commission (SEC). SEC Chairman, Gary Gensler, has said: ‘These stablecoins are acting almost like poker chips at the casino.’[ii] Gensler’s concerns about stablecoins echo the comments of the Presidential Working Group on stablecoins, which noted in its report that a stablecoin ‘may constitute a security, commodity, and/or derivative . . . subject to the US federal securities laws, or . . . subject to the [Commodity Exchange Act]’.[iii] The Presidential Working Group also noted ‘[t]he federal securities laws and/or the [Commodity Exchange Act] may apply to the stablecoin, the stablecoin arrangement, transactions in, and/or participants involved in, the stablecoin or stablecoin arrangement, and/or derivatives of any of the foregoing instruments.’[iv] The International Organisation of Securities Commissions (IOSCO) has noted ‘so-called ‘stablecoins’ can include features that are typical of regulated securities.’[v]
This chapter will:
- introduce the reader to stablecoins;
- discuss the work of the Presidential Working Group on Stablecoins;
- summarise proposed legislation with respect to stablecoins;
- discuss the Executive Order on Digital Assets;
- discuss the SEC’s position on stablecoins;
- summarise the securities law tests that apply to stablecoins; and
- discuss the regulation of stablecoin trading platforms.
What is a stablecoin?
A stablecoin is a digital asset whose value is pegged, or tied, to a reference asset. The reference asset could be a currency, commodity or other financial instrument. Stablecoins are designed to maintain a stable price over time and provide an alternative to more volatile cryptocurrencies. The first stablecoin was issued in 2014 and, since then, stablecoins have risen in popularity. Stablecoins were primarily used to buy cryptocurrencies on trading platforms that did not offer fiat currency trading pairs. As adoption grew, stablecoins began to be used in several blockchain-based financial services and used to pay for goods and services. According to CoinMarketCap, the total market capitalisation of stablecoins is estimated to be approximately US$152 billion.[vi]
Types of stablecoins
Stablecoins use different mechanisms to maintain their price peg. The two most common methods are maintaining a pool of reserve assets as collateral or using an algorithmic formula to control the supply of a coin.
Collateralised stablecoins
Collateralised stablecoins maintain a pool of collateral to support the coin’s value. The types of collateral could include fiat currency, commodities or other cryptocurrencies. For example, the issuer of a stablecoin pegged to the US dollar would maintain US$1 million in reserve to support 1 million units of the stablecoin. Whenever the holder of the stablecoin wishes to cash out his or her tokens, an equal amount of the collateralising asset is taken from the reserve. Another example is a crypto-backed stablecoin, which can be issued to launch one asset on a different blockchain. For example, Wrapped Bitcoin (WBTC) is a stablecoin pegged to Bitcoin and issued on the Ethereum blockchain.
Algorithmic stablecoins
Algorithmic stablecoins maintain their value by controlling the stablecoin’s supply through an algorithm. Coins are either destroyed (burned) or created (minted) to keep the coin’s value in line with the target price. For example, if the value of a stablecoin drops from the target price of US$1 to US$0.75, the algorithm will automatically burn a tranche of coins to introduce more scarcity, propping up the price of the stablecoin. Alternatively, if the stablecoin’s price exceeds that of the target price, new tokens are issued to bring the stablecoin’s value down.
TerraUSD (UST) is an example of an algorithmic stablecoin whose price is pegged at US$1 via the minting and burning of its sister coin Luna. TerraUSD is not collateralised – its model operates via the algorithmic minting and burning of Luna tokens each time a UST stablecoin is bought or sold. However, in May 2022, TerraUSD suffered the crypto equivalent of a bank run, which resulted in a ‘de-pegging’ of TerraUSD from its US$1 price, sending both the stablecoin and its sister coin close to zero.
Stablecoin use cases
Stablecoins are predominantly used in the United States to facilitate trading, lending and borrowing of other digital assets. Stablecoins also allow users to store and transfer value associated with digital asset trading, lending and borrowing within the distributed ledger environment, thus reducing the need for fiat currencies and traditional financial institutions. In addition to digital asset trading, several stablecoin issuers seek to have the stablecoins they create be widely used by retail users to pay for goods and services and by corporations in the context of supply chain payments and international remittances.
Presidential Working Group
On 1 November 2021, a joint task force consisting of senior regulators from the US Department of Treasury, the Federal Reserve Board (Fed), the SEC, the Commodity Futures Trading Commission (CFTC), the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) (collectively, the Presidential Working Group) issued its Report on Stablecoins, evaluating the risks and regulatory gaps presented by stablecoins and recommending several future legislative and regulatory actions on stablecoins.[vii] The Report on Stablecoins summarised the risks presented by stablecoins and stablecoin-related activity, including loss of confidence in stablecoin value, payment system risks, systemic risk and the concentration of economic power.
In the Report on Stablecoins, the Presidential Working Group noted:
Depending on the facts and circumstances, a stablecoin may constitute a security, commodity, and/or derivative implicating the jurisdiction of the SEC, and be subject to the US federal securities laws, or implicating the jurisdiction of the CFTC, and be subject to the [Commodity Exchange Act]. The federal securities laws and/or the [Commodity Exchange Act] may apply to the stablecoin, the stablecoin arrangement, transactions in, and/or participants involved in, the stablecoin or stablecoin arrangement, and/or derivatives of any of the foregoing instruments.[viii]
To that end, the SEC and CFTC have broad enforcement, rulemaking and oversight authorities over transactions and participants falling within their respective jurisdictions to address investor protection and market integrity risks. To the extent stablecoin-related activity such as trading, lending, borrowing and other activity falls within the jurisdiction of the SEC or CFTC, such activity must be conducted in compliance with applicable provisions of the federal securities laws and the Commodity Exchange Act, as well as applicable regulations. Since the Report on Stablecoins, the chair of the SEC and other SEC commissioners have indicated in numerous articles that stablecoins are or may be securities, are subject to the jurisdiction of the SEC and that regulation of stablecoins is coming.
The Report on Stablecoins concludes ‘legislation is urgently needed to comprehensively address the prudential risks posed by payment stablecoins’ and recommends that Congress ‘act promptly to enact legislation to ensure that payment stablecoins and payment stablecoin arrangements are subject to a federal prudential framework on a consistent and comprehensive basis.’[ix] The Report on Stablecoins also recommends legislation requiring stablecoin issuers be insured depository institutions,[x] which would subject them to supervision and regulation at the depository institution level by a federal banking agency and consolidated supervision and regulation by the Federal Reserve at the holding company level. Stablecoin issuers thus would be subject to capital and liquidity standards designed to address safety and soundness and guard against stablecoin runs. The Report on Stablecoins further recommends legislation requiring all custodial wallet providers and all other entities that perform functional activities within any stablecoin arrangement be subject to federal oversight.
In the absence of legislation, the agencies forming the Presidential Working Group intend to continue to use their existing authorities to address prudential risks falling within each agency’s jurisdiction to the extent possible. In evaluating a charter application, the banking agencies will seek to ensure that applicants address the risks outlined by the Report on Stablecoins, including risks associated with stablecoin issuance and other related services conducted by the banking organisation or third-party service providers. In the context of those stablecoins that are securities, commodities or derivatives, application of the federal securities laws or the Commodity Exchange Act would provide important investor and market protections, as well as transparency benefits. The Department of Justice may consider whether or how the Consumer Financial Protection Bureau (CFPB) and consumer protection laws also provide several safeguards in the payments sector. The Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN) may supervise and enforce federal anti-money laundering and combating the financing of terrorism obligations under the Bank Secrecy Act (BSA) where a stablecoin arrangement also offers money transmission services.
Following the publication of the Report on Stablecoins, members of Congress have proposed legislation to address the lack of clarity with respect to the regulations of stablecoins.
Legislation
Interest in blockchain and digital assets, particularly its regulation, continues to grow at the highest levels of government. In June 2022, Senators Cynthia Lummis (R-WY) and Kirsten Gillibrand (D-NY) introduced the Responsible Financial Innovation Act (the Bill): a bipartisan legislation that proposed a complete regulatory framework for digital assets designed to encourage responsible innovation and consumer protection while integrating digital assets into existing law.[xi] Included within the Bill was proposed framework to define stablecoins and impose requirements on their creation and issuance. Specifically, the Bill defined a ‘payment stablecoin’ to mean a digital asset that is:
- redeemable on demand on a one-to-one basis for instruments denominated in US dollars;
- defined as legal tender under US law or under the laws of a foreign country;
- issued by a business entity;
- accompanied by a statement from the issuer that the payment stablecoin is redeemable upon demand from the issuer;
- backed by one or more financial assets (excluding other digital assets); and
- intended to be used as a medium of exchange.[xii]
Furthermore, the Bill established for depository institutions (as defined under the Federal Reserve Act) to ‘issue, redeem, and conduct all incidental activities’ relating to payment stablecoins and set forth ‘high-quality liquid assets’ that would be eligible to back a payment stablecoin.[xiii] The Bill also established a framework for non-depository institutions to issue payment stablecoins subject to certain requirements related to maintaining high-quality liquid assets and providing appropriate disclosures and even included an optional framework for a special depository institution charter under both state and federal law for payment stablecoin issuance, with tailored capital requirements and regulatory supervision.[xiv]
Presidential action
In March 2022, President Joe Biden issued an Executive Order on Ensuring Responsible Development of Digital Assets (the Executive Order).[xv] The Executive Order called for an interagency effort to formulate policies related to the regulation of digital assets to ensure the safety and soundness of the financial system, to protect consumers, investors and businesses, and to provide broader access to safe and affordable financial services.[xvi] In September 2022, the White House followed the Executive Order with the promulgation of a comprehensive framework for the ‘responsible development of digital assets’.[xvii] Among the key pillars of the framework was fostering financial stability. The White House noted the potentially disruptive runs on digital assets if left unregulated and specifically identified the 2022 crash of TerraUSD that effectively led to the erasure of almost US$600 billion in wealth within a few days.[xviii] Accordingly, the White House has called on the Department of Treasury to work with US financial institutions to bolster their capacity to identify and mitigate cyber-vulnerabilities related to digital assets, including stablecoins, and to engage with other regulatory agencies to identify, track and analyse emerging strategic risks related to digital asset markets.[xix]
Securities and Exchange Commission
In September 2020, the staff of the SEC’s Strategic Hub for Innovation and Financial Technology (FinHub) issued a statement in response to the OCC’s Interpretive Letter 1172 noting that stablecoin reserves could constitute securities and subject issuers of such stablecoins to registration, reporting and other requirements under the federal securities laws.[xx] The FinHub did not provide guidance pertaining to the circumstances where a stablecoin would constitute a security. The FinHub stated that whether a stablecoin reserve constituted a security was an ‘inherently facts and circumstances determination . . . [requiring] a careful analysis of the nature of the instrument, including the rights it purports to convey, and how it is offered and sold’. The FinHub encouraged stablecoin issuers to contact them with any questions to help ensure that such stablecoins are structured, marketed and operated in compliance with the federal securities laws. FinHub’s statement notes that the FinHub staff is prepared to engage with market participants and, depending on the specific facts and circumstances, consider providing a ‘no-action’ position regarding whether activities with respect to a specific stablecoin may involve the application of the federal securities laws.
On 4 April 2022, SEC Chairman Gary Gensler, speaking at the Penn Law Capital Markets Association Annual Conference, raised three policy concerns related to stablecoins.[xxi] First, Gensler noted that stablecoins raise public policy considerations regarding financial stability and monetary policy underlying SEC regulations related to money market funds and other securities. These considerations include how a stablecoin is backed and the effect the loss of a peg or the failure of an issuer could have on the wider crypto ecosystem. Second, Gensler noted that stablecoins raise issues related to their potential use for illicit activity. Specifically, Gensler expressed his concern with a stablecoin’s ability to facilitate those seeking to sidestep public policy goals connected to the traditional banking and financial system, such as anti-money laundering, tax compliance and sanctions. Third, Gensler noted concerns related to investor protection that could benefit from greater oversight. Gensler expressed his concern with potential conflicts of interest and market integrity questions raised by stablecoins owned by crypto trading and lending platforms where customers have a counterparty relationship with the platform. Although Gensler’s views are his own and do not constitute formal SEC guidance or rulemaking, Gensler’s comments provide insight on the SEC’s potential concerns regarding stablecoin regulation.
Regulation of stablecoins as securities
The SEC has not, to date, taken action to regulate stablecoin issuers or platforms that facilitate the trading of stablecoins. SEC Chairman Gary Gensler has said, however, that some stablecoins may qualify as ‘securities’ under federal law—a designation that would subject issuers to registration and reporting requirements. Gensler has not elaborated on the details of this assessment, but stablecoins would qualify as securities under existing law if they represent ‘investment contracts’. In addition, stablecoins may qualify as securities if they represent ‘notes’. Each category has its own legal test.
What is a security?
The definitions of ‘security’ under the Securities Act of 1933 (the Securities Act) and the Securities Exchange Act of 1934 (the Exchange Act) are nearly identical and may be broad enough to cover some stablecoins. Section 2(a)(1) of the Securities Act defines a ‘security’ as:
any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganisation certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, . . . or, in general, any interest or instrument commonly known as a ‘security’.[xxii]
It was the intent of Congress to define a ‘security’ to include the many types of instruments that, in the commercial world, fall within the concept of a security,[xxiii] and courts have interpreted the definition of security broadly.[xxiv] The definition of security is sufficiently expansive to grant the SEC broad authority to regulate a variety of products as securities, including instruments like stocks, bonds and notes, as well as the various collective investment pools and common enterprises devised by persons seeking to generate profits from the efforts and investments of others (ie, investment contracts and instruments commonly known as securities).[xxv]
In determining whether an instrument is a security, courts will look at the economic reality and focus on the substance rather than form.[xxvi] In enforcement actions, the SEC has argued that offerings of digital assets are investment contracts.[xxvii] While the definition of a security is very broad, it does not explicitly include digital assets or stablecoins. However, in certain circumstances, a stablecoin could be deemed an investment contract.
The Howey test
What constitutes an investment contract is determined based on the test articulated by the US Supreme Court in Securities and Exchange Commission v W J Howey Co. Under the Howey test, an investment contract is a contract, transaction, or scheme involving (1) an investment of money, (2) in a common enterprise, (3) with the expectation that profits will be derived from the efforts of the promoter or a third party. The Howey test brings many non-traditional offerings within the scope of the term security.
Investment of money
The SEC has taken the position that the investment does not have to be in the form of ‘money,’ but it can be any ‘specific consideration in return for a separable financial interest with the characteristics of a security’.[xxviii] The first prong of the Howey test typically is satisfied in an offer and sale of a digital asset because the digital asset is purchased or otherwise acquired in exchange for value, whether in the form of fiat currency or another digital asset as consideration.[xxix]
Common enterprise
Courts generally have analysed ‘common enterprise’ as a distinct element of an investment contract. However, there is a split in authority among the federal circuit courts regarding what constitutes a ‘common enterprise’. The courts are divided regarding whether horizontal or vertical commonality is required (and, in the latter case, whether the broad or narrow variety is required) to satisfy the Howey common enterprise requirement.
A majority of the circuit courts require or recognise a showing of ‘horizontal commonality,’ which involves the pooling of assets from multiple investors in such a manner that all investors share in the profits and risks of the enterprise.[xxx] In horizontal commonality, the fortunes of each investor depend upon the profitability of the enterprise as a whole.
Other circuit courts, including the Ninth Circuit that includes California, have held that a ‘common enterprise’ exists by virtue of ‘vertical commonality,’ which focuses on the relationship between the promoter and the body of investors.[xxxi] In this approach, an investor’s fortunes are tied to the promoter’s success rather than to the fortunes of his or her fellow investors. This approach focuses on the community of interest between the individual investor and the manager of the enterprise.[xxxii] In vertical commonality, the investors’ fortunes need not rise and fall together, and a pro rata sharing of profits and losses is not required.[xxxiii] It is also not necessary that the funds of investors be pooled.[xxxiv]
Reasonable expectation of profits derived from the profits of others
Under the Howey test, profits can be either capital appreciation resulting from the development of the initial investment or a participation in earnings resulting from the use of investors’ funds.[xxxv] Profits are income or return that investors seek on their investment, not the profits of the scheme in which they invest.[xxxvi] Profits include, for example, dividends, other periodic payments or the increased value of the investment. The determining factor under this prong of the Howey test is that the investor is ‘attracted solely by the prospects of a return’ on his or her investment.[xxxvii] The investor may not have been motivated by a desire to use or consume the item purchased.[xxxviii] In determining whether an investor was ‘attracted or led’ by the expectation of profits, courts look at whether the promoter induced prospective investors with proposed or promised profits.
While the SEC has not provided guidance on when a stablecoin is a security, the SEC staff have noted:
The main issue in analysing a digital asset under the Howey test is whether a purchaser has a reasonable expectation of profits (or other financial returns) derived from the efforts of others. A purchaser may expect to realise a return through participating in distributions or through other methods of realising appreciation on the asset, such as selling at a gain in a secondary market.[xxxix]
If a stablecoin promises a return on investment from the efforts of others, the stablecoin likely will be deemed a security by the SEC. However, as noted by the SEC staff in its 2019 Framework for ‘Investment Contract’ Analysis of Digital Assets: ‘Price appreciation resulting solely from external market forces (such as general inflationary trends or the economy) impacting the supply and demand for an underlying asset generally is not considered ‘profit’ under the Howey test.’[xl]
The Reves test
Under Reves, all notes are presumptively securities. However, that presumption is rebuttable in two ways. First, the seller of a note can establish that a note bears a ‘family resemblance’ to one of the constituents of a judicially created list of notes that are not securities. Analysing and bringing together the line of lower court opinions, the US Supreme Court in Reves v Ernst & Young adopted the ‘family resemblance’ test to determine whether a note is a security.
Under the family resemblance test, there is a presumption that a note is a security, with the presumption being rebutted if the note bears a resemblance to one of the enumerated categories on a judicially developed list of exceptions.[xli] If the note does not bear resemblance to an item on the list, the analysis continues to determine if a new category should be added to the list. In determining whether a note bears a resemblance to one of the enumerated exceptions to a security, or whether a new exception should be added, the courts consider:
- the motivations and purpose of the buyer and seller in the transaction;
- the issuer’s plan of distribution for the note;
- the reasonable expectations of the investing public; and
- the existence of an alternative regulatory scheme that sufficiently protects investors.
Motivation and purpose
Courts examine the transaction to assess the motivations that would ‘prompt a reasonable seller and buyer to enter into [the transaction]’.[xlii] If the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a ‘security’.[xliii] If the note is exchanged to facilitate the purchase and sale of a minor asset or consumer good, to correct for the seller’s cash-flow difficulties, or to advance some other commercial or consumer purposes, on the other hand, the note is less likely to be a ‘security’.[xliv]
Plan of distribution
The second factor determines whether the instrument is being distributed for investment or speculation. If the note is being offered and sold to a broad segment or the public for investment purposes or for ‘speculation or investment’, the note is likely to be a ‘security’.[xlv]
Reasonable expectations of the investing public
An instrument will be deemed a security where the reasonable expectation of the investing public is that the securities laws (and accompanying anti-fraud provisions) apply to the investment. The courts will consider instruments to be ‘securities’ based on such public expectations, even where an economic analysis of the circumstances of the particular transaction might suggest that the instruments are not ‘securities’ as used in the transaction.[xlvi]
Existence of alternative regulatory scheme
The fourth and final factor is a determination of whether another regulatory scheme ‘significantly reduces the risk of the instrument, thereby rendering the application of the Securities Act unnecessary’. The FDIC and Employee Retirement Income Security Act (ERISA) laws are two such examples.
Application of the Howey and Reves tests
Both the Howey and Reves tests are fact intensive. As a result, the details surrounding specific stablecoin offerings may prove decisive under either inquiry. There is also some ambiguity as to when the tests apply. The Supreme Court has applied the Howey test to evaluate agreements that appear to be notes, leading some commentators to wonder whether the standards are mutually exclusive. Accordingly, it is uncertain whether a court would determine that a given stablecoin is (1) a note governed only by the Reves test, (2) a note governed by both the Reves and Howeytests or (3) another type of instrument governed only by the Howey test.
The Howey and Reves tests evaluate whether the buyer of an instrument is motivated primarily by an expectation of profits. Under the Howey test, such expectations are required for an instrument to be deemed an investment contract. Under the Reves test, profit expectations are one element of a multi-part test.
The ‘expectation of profits’ factor appears to support the argument that stablecoins are not securities. Generally, stablecoins do not pay interest. Stablecoins are designed with the purpose of maintaining a stable value. It is unlikely most stablecoins are acquired because of the prospect of capital appreciation. This argument appears to be consistent with the SEC’s 2019 Framework for ‘Investment Contract’ Analysis of Digital Assets, which notes a digital asset is less likely to be a security under the Howey test if its design ‘provides that its value will remain constant’.[xlvii]
The Reves test also may support the argument that stablecoins are not a security. The Reves test includes a discussion of risk-reducing factors such as alternative regulatory schemes that would render unnecessary the reliance on the securities laws. Supporters of stablecoins will argue the banking regulations are such an alternative regulatory scheme. In Marine Bank v. Weaver, the Supreme Court held that bank-issued certificates of deposit were not securities based in part on the comprehensiveness of federal banking law.[xlviii] The Court has also concluded that interests in federally regulated pension plans do not qualify as securities based on the separate protections afforded by ERISA.[xlix]
The Reves test suggests whether a stablecoin is a security will depend on the regulatory status of the instrument. The facts and circumstances analysis of whether a stablecoin is a security will focus on the level of protection offered by the applicable regulatory scheme, if any, that may apply to the stablecoin.
Regulation of stablecoin platforms
In an April 2021 speech, SEC Chairman Gensler noted:
I’d briefly like to discuss the intersection of security-based swaps and financial technology, including with respect to crypto assets. There are initiatives by a number of platforms to offer crypto tokens or other products that are priced off of the value of securities and operate like derivatives. Make no mistake: It doesn’t matter whether it’s a stock token, a stable value token backed by securities, or any other virtual product that provides synthetic exposure to underlying securities. These platforms – whether in the decentralised or centralised finance space – are implicated by the securities laws and must work within our securities regime.
If a stablecoin is a security, the platform facilitating the sale and secondary trading of the stablecoin may have to register with the SEC as an exchange or a broker-dealer and alternative trading system (ATS).
Securities exchanges
Section 3(a)(1) of the Exchange Act defines an ‘exchange’ as ‘any organisation, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood.’[l] Exchange Act Rule 3b-16(a) provides a functional test to assess whether a trading system meets the definition of exchange. Under Rule 3b-16(a), an organisation, association or group of persons will be deemed to provide ‘a marketplace or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange’, if such organisation, association or group of persons: (1) brings together the orders for securities of multiple buyers and sellers and (2) uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of the trade.
As the SEC noted in the DAO Report, a system that meets the definition of an exchange and is not excluded under Rule 3b-16(b) must register as a national securities exchange or operate pursuant to an appropriate exemption.[li]One frequently used exemption is for ATS’s. Rule 3a1-1(a)(2) exempts from the definition of ‘exchange’ under section 3(a)(1) an ATS that complies with Regulation ATS. An ATS that operates pursuant to the Rule 3a1-1(a)(2) exemption and complies with Regulation ATS would not be subject to the registration requirement of section 5 of the Exchange Act.
If a stablecoin is a security, any platform that brings together multiple buyers and sellers of the stablecoin using non-discretionary methods will likely be deemed an exchange.
Alternative trading systems
In 1998, the SEC adopted Regulation ATS, which allows an ATS to choose whether to register as a national securities exchange or to register as a broker-dealer and comply with additional requirements of Regulation ATS. An ‘ATS’ means any organisation, association, person, group of persons or system that (1) constitutes, maintains or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange within the meaning of Rule 3b-16 under the Exchange Act and (2) does not set rules governing the conduct of subscribers other than the conduct of such subscribers’ trading on such organisation, association, person, group of persons or system; or discipline subscribers other than by exclusion from trading.
A stablecoin platform may be required by the SEC to register as an ATS if it maintains a marketplace or facilities for bringing together purchasers and sellers of digital assets that are deemed securities, and it does not set rules governing the conduct of subscribers other than the conduct of such subscribers’ trading on such platform. If the platform is not required to register as an ATS, the operator of the platform may be required to register as a broker-dealer.
Broker-dealers
Section 15 of the Exchange Act requires registration with the SEC of all broker-dealers using interstate commerce or the facilities of any national securities exchange to effect transactions in securities (other than exempted securities and certain short-term debt instruments). Section 3(a)(4)(A) of the Exchange Act defines a ‘broker’ as ‘any person engaged in the business of effecting transactions in securities for the account of others’. The Exchange Act and the rules thereunder do not define these terms. The SEC and the courts have taken an expansive view of the scope of these terms.[lii] The SEC and the courts apply a ‘facts and circumstances’ analysis in evaluating whether a person has acted as a broker, with no single element being dispositive.[liii]
Depending on the circumstances, the operator of a stablecoin platform may be deemed a broker-dealer if the operator of the platform is deemed to be engaged in the business of effecting transactions in securities for the account of others.
Engaged in the business
Courts have read ‘engaged in the business’ as connoting a certain regularity of participation in purchasing and selling activities rather than a few isolated transactions.[liv] Two factors are important in determining whether there is ‘regularity of business’: the number of transactions and clients and the dollar amount of securities sold, as well as the extent to which advertisement and investor solicitation were used.[lv] Besides ‘regularity of business’, courts and the SEC have identified several other factors that indicate a person is ‘engaged in the business’.[lvi] These factors include (1) receiving transaction-related compensation; (2) holding oneself out as a broker, in executing trades or as assisting others in settling securities transactions and (3) soliciting securities transactions.
The operator of a stablecoin platform could be deemed to be engaged in the business of effecting transactions in securities because it will more than likely receive transaction-related compensation, execute trades for users of the platform and solicit users to engage in such transactions.
For the account of others
A ‘broker’ is a person that effects transactions in securities for others, not itself. A firm that effects transactions solely on its own behalf should not be acting as a ‘broker’.[lvii] Unless the operator of a stablecoin platform is executing all transactions as a principal to the transaction, the platform operator could be deemed to be effecting transactions in securities for others.
Role of compensation in analysis
SEC guidance and enforcement actions have noted the receipt of commissions or other transaction-related compensation is an important factor in deciding whether a person is a ‘broker’ subject to the registration requirements under the Exchange Act.[lviii] Transaction-related compensation refers to compensation based, directly or indirectly, on the size, value or completion of any securities transactions. The SEC will look behind the terms of a compensation arrangement to determine its economic substance, that is, to determine whether it is transaction related. The receipt of transaction-based compensation often indicates that a person is engaged in the business of effecting transactions in securities.[lix]
If the operator of a stablecoin platform receives transaction-related compensation in the sale of a stablecoin that is deemed a security, the platform could be deemed to be acting as a broker-dealer.
Effecting transactions in securities
Courts and the SEC have determined that a person ‘effects transactions in securities’ if the person participates in such transactions ‘at key points in the chain of distribution’.[lx] Participation may include:
- assisting an issuer to structure prospective securities transactions;
- helping an issuer to identify potential purchasers of securities;
- screening potential participants in a transaction for creditworthiness;
- soliciting securities transactions (including advertising);
- negotiating between the issuer and the investor;
- making valuations as to the merits of an investment or giving advice;
- taking, routing or matching orders, or facilitating the execution of a securities transaction;
- handling customer funds or securities; and
- preparing and sending transaction confirmations (other than on behalf of a broker-dealer that executes the trades).
Handling customer funds may also include handling a customer’s digital currencies, such as Bitcoin, in connection with Bitcoin denominated securities transactions.[lxi]
The SEC could deem a platform that is facilitating transactions in digital assets to be effecting securities transactions if it is helping an issuer to identify potential purchasers of securities. A stablecoin platform that solicits securities transactions and facilitates negotiations between the issuer and the investor could be deemed to be effecting securities transactions. The operator of a stablecoin trading platform that takes, routes or matches orders or facilitates the execution of a securities transaction, could be viewed as effecting transactions in securities. Finally, the operator of a stablecoin trading platform that handles customer funds (even if the funds are a digital currency) or securities could be deemed to be effecting transactions.
Even if a stablecoin is not deemed a security, stablecoins could be considered a commodity subject to regulation by the CFTC.
Commodity Futures Trading Commission
In October 2021, the CFTC settled an enforcement action with stablecoin issuer Tether whose stablecoin USDT claimed to be pegged to the US dollar.[lxii] According to the CFTC, at various times between June 2016 and February 2019, Tether made misleading or untrue statements regarding whether it held sufficient US dollar reserves to fully back up UDST. In the settlement order, the CFTC defined a ‘stablecoin’ as a type of virtual currency whose value is derived from a fiat currency. In reaching its decision in the settlement order, the CFTC determined that stablecoins, like USDT, fall within the definition of a ‘commodity’ under the Commodity Exchange Act on the basis that courts have ruled that digital currencies fall within the definition of a commodity.
In the settlement order, the CFTC alleged that since the introduction of USDT in 2014, Tether made numerous public representations that USDT was linked directly to fiat currency. However, according to the settlement order, Tether did not actually hold sufficient fiat currency reserves to back each stablecoin in circulation. For example, between 2 September 2016 and 1 November 2018, the order alleges that USDT was only fully backed by actual fiat currency 27.6 per cent of the time. The order also alleged that Tether relied on unregulated entities and third parties to hold customer funds, commingled reserve funds with the company’s corporate funds and held reserves in non-cash products such as commercial paper and bank repurchase agreements. Additionally, according to the settlement order, at least until 2018, Tether utilised a manual process to track its reserves, which did not capture the real-time status of the reserves. Furthermore, the settlement order noted that Tether’s reserves were not routinely audited. As a result of Tether’s misrepresentations to customers and the market, the CFTC ordered Tether to pay a civil monetary penalty of US$41 million based upon the CFTC’s anti-market manipulation regulations.
Federal banking regulators
The federal banking agencies have long focused on ensuring the safety and soundness of the financial system. As digital assets, particularly stablecoins, continue to garner mainstream attention and consumers increasingly turn to stablecoins to participate in and engage with the financial system, bank regulators seek to understand the risks and benefits of integrating digital assets into the financial system and to enable banks to play a greater role in the digital asset economy.
Office of the Comptroller of the Currency
The OCC has taken a lead role in providing guidance to nationally chartered banks and federal savings associations engaging in digital asset-related activities. In July 2020, the OCC issued an interpretive letter (Interpretive Letter 1170) asserting that national banks were permitted to provide digital asset custody services on behalf of customers.[lxiii]Interpretive Letter 1170 discussed the custody services provided by banks and concluded that banks may provide ‘cryptocurrency custody services, including holding the unique cryptographic keys that permit the control and transfer of the customer’s cryptocurrency, is a modern form of these traditional bank activities.’[lxiv] The OCC also affirmed the agency’s belief in its own power to ‘authorise national banks to perform, provide or deliver through electronic means and facilities any activities that they are otherwise authorised to perform’.[lxv]
Interpretive Letter 1170 laid the groundwork for the OCC’s subsequent interpretive letter (Interpretive Letter 1172), which reaffirmed the OCC’s support of financial technology entities, particularly those entities conducting activities considered ‘core’ activities of banking, such as deposit-taking and custody services, by confirming that national banks and federal savings associations are permitted to take and hold fiat currency deposits that serve as fiat-currency-backed stablecoins associated with hosted digital wallets.[lxvi] In Interpretive Letter 1172, the OCC recognised that ‘some stablecoin issuers may desire to place the cash reserves backing their issued stablecoin with a national bank.’[lxvii] Given the OCC’s prior guidance affirming the ability of national banks to ‘provide permissible banking services to any lawful business they choose,’ the OCC concluded that national banks are permitted to receive deposits associated with a stablecoin issuance and also may engage in any activity incidental to receiving deposits from stablecoin issuers.[lxviii]
The OCC followed up Interpretive Letters 1170 and 1172 with two additional interpretive letters in 2021, further reinforcing national banks’ rights to engage in certain stablecoin-related activities. Specifically, in January 2021, the OCC issued an interpretive letter reaffirming the legal permissibility of national banks to engage in payment-related activities involving stablecoins (Interpretive Letter 1174).[lxix] Specifically, the OCC acknowledged that payment activities (eg, electronic payments message transmission and processing and payments settlement) are within the business of banking and that utilising new and innovative technologies, such as stablecoins, is consistent with the notion that banks may use electronic means to perform core banking functions, such as acting as financial intermediaries.[lxx] The OCC reaffirmed each of Interpretive Letters 1170, 1172, and 1174 in November 2021 by asserting that the activities discussed in each of these interpretive letters were considered bank-permissible activities; however, any such digital asset-related activities could only be conducted after a bank notifies its appropriate supervisory office and receives written notification of the supervisory office’s non-objection.[lxxi] In testimony to the US House of Representatives, Acting Comptroller of the Currency, Michael Hsu, stated:
[W]e – financial regulators – must collectively adapt to the digitalisation of banking and finance. I am concerned that the regulatory community is taking a fragmented agency-by-agency approach to the technology-driven changes taking place today. At the OCC, the focus has been on encouraging responsible innovation. For instance, we updated the framework for chartering national banks and trust companies and interpreted crypto custody services as part of the business of banking. I have asked staff to review these actions. With regards to charters, some are concerned that providing charters to fintechs will convey the benefits of banking without its responsibilities. Others are concerned that refusing to charter fintechs will encourage growth of another shadow banking system outside the reach of regulators. I share these concerns. Recognising the OCC’s unique authority to grant charters, we must find a way to consider how fintechs and payment platforms fit into the banking system, and we must do it in coordination with the FDIC, Federal Reserve, and the states.[lxxii]
The OCC’s support of banks providing core banking services to businesses issuing or heavily involved in digital assets has not been formally mirrored by the other US federal bank regulators such as the Fed and the FDIC. As a result, banks have been slow to provide custody services for cryptocurrencies and other digital assets due to the lack of clarity on the permissibility of custodying of digital assets across all federal bank regulators. However, certain US nationally chartered banks began providing cryptocurrency custody services to consumers in early 2021, with more banks anticipated to do so in the near future by seeking a national bank charter with the OCC. Meanwhile, though some state-charted trust companies have provided cryptocurrency services, most state banks have declined to do so pending greater regulatory certainty.
Federal Deposit Insurance Corporation
As indicated above, the FDIC has taken a slower approach to developing digital asset-related guidance for its regulated institutions. In April 2022, the FDIC issued a notice requiring all FDIC-supervised institutions that intend to engage in, or are engaged in, any activities involving or relating to digital assets to notify the FDIC and provide all necessary information to enable the FDIC to ‘assess the safety and soundness, consumer protection, and financial stability implications’ of the proposed digital asset-related activities.[lxxiii] The FDIC also issued an advisory to FDIC-insured banks regarding misrepresentations about FDIC deposit insurance by certain digital asset-related companies.[lxxiv] The advisory was especially timely in light of the brief collapse of the Terra stablecoin in May 2022. Nevertheless, the FDIC has not moved beyond providing advisories and seeking information from its supervised institutions to providing any prescriptive guidance.
Federal Reserve
Much like the FDIC, the Fed has not issued formal guidance or rulemakings on stablecoins. However, both Vice Chair Lael Brainard and Governor Christopher Waller support prudential regulatory frameworks for digital assets and stablecoins. In a speech given at the 2021 Financial Stability Conference, Governor Waller asserted that stablecoins are a new version of the bank deposit that ‘mimic the safe-asset features of commercial bank money’ by offering fixed exchange rates pegged to a single asset or bundle of assets as well as certain redemption rights.[lxxv] To that end, Governor Waller argued for a robust regulatory and supervisory framework for payment stablecoins that addresses specific risks ‘directly, fully, and narrowly’.[lxxvi] Similarly, in a September 2022 speech given by Vice Chair Brainard, who has championed the development of a US central bank digital currency, asserted the need for digital assets to be subject to clear regulatory guardrails because the digital asset market bears similar risks to traditional finance and, as a result, the digital asset sector should meet the same safety and soundness standards as traditional finance.[lxxvii]
International regulation
Basel Committee on Banking Supervision
In June 2021, the Basel Committee on Banking Supervision (the Basel Committee)[lxxviii] published a consultative document that outlined a proposal to apply traditional Basel capital, liquidity, supervisory and disclosure requirements to cryptoasset exposures. Under the proposal, banks would be subject to risk-weighted capital and liquidity and ongoing monitoring requirements for cryptoassets, including stablecoins, on their balance sheets. The proposal divided cryptoassets into two broad groups. Group 1 consists of tokenised assets and collateralised stablecoins, both of which are susceptible to risk-based capital treatment that is based on the risk weight of underlying assets and counterparties. Group 2 consists of all cryptoassets that do not fit within group 1 and are therefore subject to a more punitive risk weighted capital treatment. By way of example, group 2 cryptoassets would include algorithmic stablecoins, Bitcoin and Ether.
The June 2021 proposal sought to map the regulatory capital requirements for cryptoassets that are redeemable into physical assets to the treatment of those physical assets and to the exposure to any counterparties whose performance is required to effectuate such redemption. The proposal would impose larger capital requirements on ‘group 2’ cryptoassets, like Bitcoin, that neither represent nor are redeemable into underlying physical assets, as well as funds or other entities that derive their value from such other cryptoassets.
A year later, in June 2022, the Basel Committee published a second consultative document building upon the proposals from the June 2021 document. The changes to the June 2022 proposal include a revised stabilisation test for collateralised stablecoins to ensure that they are redeemable and that their price does not deviate too much from par. The proposal also includes additional requirements for managing reserve assets.
For a stablecoin to meet the group 1 designation, and thus be subject to at least equivalent capital requirements as set out in the existing Basel Capital Framework, it must meet two tests:
- the redemption risk test: the stablecoin’s reserve assets must be sufficient to enable it to be redeemable at all times, including during periods of extreme stress, for the peg value. The composition and management of reserve assets also must meet certain conditions; and
- the basis risk test: the holder of a stablecoin must be able to sell it in the market for an amount that closely tracks the peg value.
To pass the basis risk test, banks must calculate a ‘peg-to-market value difference’ expressed in basis points. A stablecoin ‘fully passes’ the basis risk test if the peg-to-market value difference does not exceed 10bp more than three times over the prior 12 months. A stablecoin ‘fails’ the basis risk test if the peg-to-market value difference exceeds 20bp more than 10 times over the prior 12 months. If the stablecoin meets all of the classification conditions for inclusion in group 1, but only narrowly passes the basis risk test, the stablecoin will not be classified in group 2 but will be subject to a risk-weighted assets adjustment. Stablecoins referencing other cryptoassets and algorithmic stablecoins are expressly excluded from group 1. The Basel Committee also is considering an alternative to the redemption risk and basis risk tests that would recognise that banks’ exposures to stablecoins issued by regulated entities, and in particular banks, are generally lower risk than those issued by unregulated entities.
The more stringent eligibility criteria proposed by the Basel Committee may prove to be too burdensome for current stablecoins in circulation to qualify for inclusion in group 1. Nevertheless, banks are more likely than non-bank issuers to be able to issue stablecoins that would be eligible as group 1 cryptoassets due to their diluted eligibility criteria. The Basel Committee has indicated that it plans to finalise the rules by the end of 2022.
Bank for International Settlements and International Organisation of Securities Commissions
On 13 July 2022, the Bank for International Settlements’ Committee on Payments and Market Infrastructures (CPMI) and IOSCO published final guidance on stablecoin arrangements confirming that the Principles for Financial Market Infrastructures (PFMI) apply to systemically important stablecoin arrangements that transfer stablecoins.[lxxix] The PFMI was created in response to the 2008 financial crisis and was published in 2012. The CPMI and IOSCO guidance affirms the ‘same risk, same regulation’ principle by extending the international standards for payment, clearing, and settlement systems to cover systematically important stablecoin arrangements.
In a previous consultative report, the CPMI and IOSCO defined a stablecoin arrangement as ‘an arrangement that combines a range of functions to provide an instrument that purports to be used as a means of payment and/or store of value’.[lxxx] Stablecoin arrangements may present novel features as compared to other financial market infrastructures related to the potential use of settlement assets that are neither central bank money nor commercial bank money and carry additional financial risk, the interdependencies between multiple stablecoin arrangement functions, the degree of decentralisation of operations or governance, and a potentially large-scale deployment of emerging technologies such as distributed ledger technology. Although all standards under the PFMI apply to stablecoin arrangements under the new guidance, the guidance elaborates on aspects related to governance, framework for the comprehensive management of risks, settlement finality and money settlements. The guidance does not create additional standards for stablecoin arrangements beyond those set out in the PFMI and instead aims to provide increased clarity on how systematically important stablecoin arrangements should approach observing certain aspects of the PFMI.
Stablecoins and central bank digital currencies
Globally, the popularity of digital assets, particularly stablecoins, has forced sovereign governments to acknowledge that individuals want a borderless financial world. As stablecoins gain greater traction around the globe, they have the potential to pose significant macroeconomic risks to monetary policy and the overall safety and soundness of the global financial system.[lxxxi] To that end, central banks around the world have, in varying degrees, viewed central bank digital currencies (CBDCs) as the logical evolution of legal tender representing a new form of currency issued digitally by a country’s central bank.[lxxxii]
Given that several stablecoins claim to be backed by or pegged to the US dollar, a question is raised regarding whether the introduction of CBDCs, particularly a US CBDC, renders stablecoins obsolete. A CBDC is a digital payment instrument, denominated in the national unit of account, that is a direct liability of the country’s central bank.[lxxxiii] Assuming that a CBDC could operate on the same payment systems as a stablecoin, it would seem that CBDCs carry a distinct advantage as a payment instrument over stablecoins. In other words, why use a stablecoin issued by a private company when a digital asset exists that is backed by the full faith and credit of a sovereign country? Of course, there are a myriad of other concerns unique to CBDCs, such as financial integrity and government data privacy issues.
Conclusion
Like the Gambler in the ballad by Kenny Rogers, developers of stablecoins are engaged in a high-stakes poker game with federal regulators. Based on the SEC’s enforcement actions against the issuers of digital assets the SEC deems securities and the public comments by Chairman Gensler, there is a risk the SEC will attempt to regulate stablecoins through enforcement actions. Unfortunately for stablecoin proponents, there are several other US regulators at the table including the Fed, the OCC and the CFTC that may also play a role in regulating stablecoins. The authors believe it is likely these regulators and the Presidential Working Group will issue guidance in the future on the regulation of stablecoin issuers and the platforms that facilitate the offering and secondary trading of stablecoins. Finally, stablecoin issuers and trading platforms must also contend with international regulators that are also at the poker table.
The authors encourage stablecoin issuers and trading platforms heed the advice of Kenny Rogers – proceed with caution. We encourage these parties to engage in discussions with the SEC because whether a stablecoin is deemed a security will depend on a facts and circumstances analysis. Such discussions may present the stablecoin issuer or trading platform with the opportunity to seek ‘no-action’ relief from the SEC regarding whether activities with respect to a specific stablecoin may involve the application of the federal securities laws.
