The long-awaited and highly-anticipated crypto bill, the Responsible Financial Innovation Act championed by U.S. Senator Cynthia Lummis (R-WY), was recently introduced as a bipartisan proposal co-sponsored by U.S. Senator Kirsten Gillibrand (D-NY). The ambitious and comprehensive bill contains several key pillars — including regulatory oversight, clarification of definitions, taxation, banking and payment stablecoins — that, if passed into law, could reshape the world of crypto well beyond American borders
The main focus of the bill is squarely on centralized service providers and fitting them into existing regulatory constructs. The sole proposal related to decentralized finance providers is consumer protection and proper disclosures. This is a practical starting point because users of centralized exchanges and platforms far outnumber users of DeFi at this moment.
We are reaching dangerous territory, as some crypto platforms abstract away risk with clever marketing and beautiful aesthetic design and user experience. Some are even bordering on misrepresenting digital assets as savings accounts equivalent to the U.S. dollar. Today, users are being exposed to opaque risks in a tumultuous environment triggered by BlockFi, Celsius and other troubled CeFi players.
The importance and value of regulatory oversight and consumer protection cannot be understated. In an unregulated landscape, consumers have limited information regarding the crypto exchanges or platforms where funds are being sent and stored. Without rules and regulations, there is no baseline for safe and sound operations and proper governance and management of a crypto exchange or platform.
With regulation in place, consumers will better understand that holding digital assets at a registered digital asset exchange is not equivalent to depositing digital assets into a crypto lending platform registered off-shore. Second, consumers will better understand that each digital asset exchange or platform has differentiated capabilities in operational and cybersecurity risk management. Third, consumers will better understand how their funds are stored and protected and what legal claims they have to those funds under normal as well as exceptional circumstances, such as when the exchange or platform goes bankrupt.
This article highlights key components of this bill and opines on the potential benefits of regulation against the backdrop of the recent lurking dangers of the crypto industry. Regulation cannot eliminate risk but it can temper much of it by creating a trusted environment for the majority of risk-averse users.
Clarifying definitions and taxation
The most foundational element of the Lummis-Gillibrand bill is to nail down common definitions for the crypto industry and its ecosystem participants. It will be a defining moment for the crypto industry when we witness definitions such as “digital asset” and “payment stablecoin” being amended into the United States Code, the literal books of the law.
We’ve seen in the past how poorly constructed definitions can cause confusion and uncertainty. Sen. Lummis previously spearheaded the fight on the overly broad definition of “broker” under the Infrastructure Investment and Jobs Act enacted in 2021. The law ambiguously sweeps in digital asset miners and stakers, hardware and software wallet providers, and protocol developers as “brokers” subject to Internal Revenue Service (IRS) tax reporting requirements. The new crypto bill seeks to amend the “broker” definition.
Recognition of crypto as an asset class, when combined with clarity on taxation and accounting treatment are necessary building blocks for broader institutional and corporate adoption.
Central to the Lummis-Gillibrand bill is the expansion of the regulatory perimeter to encompass digital assets and introduce much-needed consumer protection. Regulatory oversight is granted to existing regulatory agencies, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). The premise for determining who has regulatory authority rests upon a novel and somewhat ambiguous definition of an “ancillary asset.” In reaction to the draft bill, industry participants are hopeful that most of the top cryptocurrencies by market capitalization will indeed fall into the ancillary assets category under CFTC oversight.
The CFTC purview further expands to regulatory oversight of digital asset exchanges, which would be required to register with the commission and be subject to rules and standards related to custody, segregation of customer funds, market integrity, margin trading, regulatory reporting, governance, compliance and risk management. It is frankly surprising that the industry, particularly crypto exchanges, have grown this large without the kind of rules and standards applicable to traditional financial institutions that safekeep our money or assets.
The consumer protection component of the bill mainly focuses on proper disclosures by persons or protocols that provide digital asset services. Disclosures about products and services, risks, fees, interest rate calculations and rehypothecation policies are commonplace for traditional financial services and should also be necessary for the crypto industry.
Banking and payments
The Lummis-Gillibrand bill lays the groundwork for depository institutions to issue “payment stablecoins,” formally defined as “redeemable, on demand, on a one-to-one basis for instruments denominated in United States dollars.” Payment stablecoins need to be fully reserved and 100% backed by high-quality liquid assets as defined by the bill or determined by banking regulators. Issuers are required to disclose assets monthly and are subject to examination and verification by appropriate banking regulators.
The proposal for payment stablecoin is mostly congruent with the recommendations from the President’s Working Group report on stablecoins issued in 2021. One of the often-cited reasons against the PWG’s recommendation is that onerous regulatory compliance requirements would impede progress and innovation. The bill addresses this criticism by outlining a tailored supervisory approach for monoline depository institutions that are exclusively in the business of issuing payment stablecoins. The tailoring calls for a simplified regulatory capital framework and a custom plan to resume or wind-down operations under stress.
Qualified stablecoins issued by regulated depository institutions offer users the choice of operating within a trusted and whitelisted environment. Importantly, the Lummis-Gillibrand bill does not preclude the issuance of stablecoins by non-depository institutions nor does it prevent builders from creating stablecoins that are not fully collateralized. The bill will, however, allow users to better distinguish safe and sound stablecoins (fully integrated into traditional banking and compliant with regulatory requirements) from more experimental stablecoins.
Due to the laser focus of Sen. Lummis and other lawmakers, we are witnessing real traction on a comprehensive regulatory framework for crypto in the United States. Being a global leader means that the U.S. framework will serve as a template or guide for other countries and smaller markets around the world. It is critical that U.S. lawmakers and regulators take a clear and reasonable approach, and the Lummis-Gillibrand bill appears to do just that.
The next downturn for the crypto markets will be an order of magnitude more impactful than the last. Millions of retail accounts are at risk of suffering losses due to an inability to distinguish between the risks of one centralized service provider and the next. Many investors have already suffered staggering losses due to an inability to distinguish between the risks of one stablecoin from the other. For these users, regulation is crucial and cannot come soon enough.