How does the United States regulate stablecoins? A study based on the FIT21 Act and state legislation

Author: TaxDAO-Athena

1. Definition of Stablecoin

1.1. Theoretical Definition

The Bank for International Settlements believes that digital stablecoins can be defined as a type of encrypted digital currency whose purpose is to maintain a stable value relative to a specific asset or a basket of assets. Stablecoins are token-based; their validity is verified based on the token itself, rather than the identity of the counterparty, that is, account-based payments.

There are two types of price stabilization mechanisms for digital stablecoins: one is based on algorithms; the other is based on collateral. Algorithm-based digital stablecoins do not have any assets as endorsements, but only use algorithms to adjust the supply and demand balance according to the current price of stablecoins, thereby maintaining the stability of the exchange rate of stablecoins, such as Basis benchmarking 1 US dollar to adjust supply and demand. The second is a digital stablecoin based on collateral, with assets such as legal currency, gold, and digital assets as collateral for the stabilization mechanism, and its stabilization mechanism has a higher degree of certainty than the former.

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

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

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

(B) is

(i) denominated in or pegged to the U.S. dollar;

or

(ii) denominated in or pegged to another country or state currency; and

(C) at the time of issuance

(i) has a fixed nominal redemption value;

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

(iii) regardless of the intent, has the effect of causing the public to reasonably expect or believe that the instrument will maintain a stable redemption value so that the redemption amount is effectively fixed.

(2) Notional Redemption Value

(A) With respect to stablecoins generally, “notional redemption value” means the value of a stablecoin that is readily convertible upon demand into U.S. dollars or any other national or state currency or functional currency equivalent at the time of issuance, or that is otherwise accepted in payment or satisfaction of an obligation denominated in U.S. dollars or any other national or state currency.

(B) Treatment of U.S. dollar-pegged instruments. For purposes of subparagraph (A), the value of a stablecoin that is convertible upon demand into U.S. dollars at the time of issuance shall be calculated using the express or implied exchange rate for such conversion at the time of issuance.

(C) Treatment of Instruments Denominated in or Pegged to the Currency of Another National or State Currency.

For purposes of subparagraph (A), the value of a stablecoin that is denominated in or Pegged to the Currency of Another National or State Currency or functional currency equivalent at the time of issuance shall be calculated using the express or implied exchange rate for such conversion at the time of issuance.

(D) Definition of “functional currency equivalent.”

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

(ii) electronic money and money transmitter balances;

(iii) other stablecoins;

(iv) any other financial instrument issued for the purpose of circulating as money, paying, or satisfying obligations denominated in the U.S. dollar or any other national or state currency.

H.R. 8827 defines a stablecoin as any cryptocurrency or privately issued digital financial instrument that is distributed directly or indirectly to the public and is pegged to or denominated in the U.S. dollar or any other national or state currency and that has a fixed nominal redemption value at the time of issuance or that is designed and effects such that the public reasonably believes that its redemption value is stable.

2. Federal Regulatory Framework

Currently, 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 characteristics of stablecoin regulation in the United States 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 said that crypto products are "subject to securities laws and must operate within our securities regime," while the CFTC has declared that "Bitcoin and other virtual currencies" are commodities. This turf war has extended to stablecoins, with Gensler saying that many stablecoins are similar to money market mutual funds and therefore may fall under the jurisdiction of the SEC.

Both the SEC and the CFTC believe that stablecoins need to be regulated to minimize risks to the financial system. The CFTC has gone a step further and has taken enforcement actions 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 alleged misrepresentations regarding the reserves backing the stablecoin. The order against Tether requires them to pay a $41 million fine and cease and desist from further violations of the CEA. In addition, the CFTC has rejected any attempt by the SEC to assert exclusive jurisdiction and claimed in a separate lawsuit against Binance that BUSD is a commodity.

A recent proposed bill in the United States: The Financial Innovation and Technology for the 21st Century Act (hereinafter referred to as "FIT 21") provides guidance for future stablecoin regulation. The bill has been passed by the House of Representatives and is about to be voted on by the Senate.

The bill clearly divides the supervision of the SEC and the CFTC: if the stablecoin is centralized, it will be under the jurisdiction of the SEC; if the stablecoin is decentralized, it will be under the jurisdiction of the CFTC.

Centralized cryptocurrencies are considered "securities" because they may involve investors' expectations of the management and operation of centralized organizations, which is consistent with the definition of traditional securities. According to the Howey test, if a transaction meets the following characteristics: capital investment, investment in a common enterprise, and profit solely due to the efforts of the promoter or a third party, then such a transaction may be considered a security. Centralized digital assets usually involve a central organization or entity, and they may have characteristics that are more similar to traditional securities, such as relying on the reputation and expected profits of the issuer. Therefore, the SEC, as a 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 operation, but are based on decentralized technologies such as blockchain and are maintained by network participants. Their value depends mainly on market supply and demand, rather than on the reputation or efforts of a centralized entity. Decentralized cryptocurrencies, which usually do not rely on a single central entity, operate through distributed ledger technology (such as blockchain) and are maintained by network participants. These assets are more similar to commodities because their value depends mainly on market supply and demand, rather than on the reputation of a certain issuing entity. Therefore, the CFTC, as a regulator of the commodity market, is responsible for regulating these decentralized digital assets.

The bill specifically defines decentralization as: among other requirements, if no one has unilateral power to control the blockchain or its use, and no issuer or affiliate has 20% or more of the control of digital assets or voting rights in digital assets. If the bill is passed, it will make stablecoin regulation clearer.

2.1. Possible regulatory orientation of the US SEC

On April 4, 2022, Gary Gensler, Chairman of the US SEC, spoke at the annual meeting of the Capital Market Association of the University of Pennsylvania and raised three policy issues related to stablecoins. First, Gensler pointed out that stablecoins raise public policy considerations in terms of financial stability and monetary policy involved in the US SEC's regulations on money market funds and other securities. These considerations include how stablecoins are supported and the impact that the loss of pegs or the collapse of issuers may have on the broader crypto ecosystem. Second, Gensler pointed out that stablecoins raise questions related to their possible use for illegal activities. Specifically, Gensler expressed concern about whether stablecoins can facilitate those who try to circumvent public policy goals associated with traditional banking and financial systems, such as anti-money laundering, tax compliance, and sanctions. Third, Gensler pointed out issues related to investor protection that could benefit from increased supervision. Gensler expressed concern about potential conflicts of interest and market integrity issues raised by stablecoins owned by cryptocurrency trading and lending platforms because of the counterparty relationship between customers and platforms.

2.2. CFTC’s Possible Regulatory Orientation

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

At the Senate Agriculture Hearing, CFTC Chairman Rostin Behnam was asked by Senator Kirsten Gillibrand about the different views held by the regulator and the SEC after the CFTC reached a settlement with stablecoin issuer Tether in 2021. Behnam responded that "despite the regulatory framework around stablecoins, in my opinion, stablecoins will continue to be commodities." He added: "It is clear to our enforcement team and the Commission that the stablecoin Tether is a commodity." The U.S. CFTC has asserted that certain digital assets such as Ethereum, Bitcoin and Tether are commodities, such as in its lawsuit against FTX founder Sam Bankman-Fried in mid-December 2022.

2.3. Possible regulatory direction of the U.S. Treasury Department

In a report in September 2022, the U.S. Treasury Department pointed out that the impact of stablecoins and their payment systems may be "difficult to predict." TerraUSD's liquidation caught the attention of U.S. Treasury Secretary Janet Yellen, who soon began talking about the possibility of stablecoin regulation. Yellen believes that a regulatory framework is needed to guard against stablecoin risks.

“We have allowed ‘experiments’ like TerraUSD to dominate and develop at a pace far beyond their inherent risks,” said Alex McDougall, CEO of Stablecorp. For a number of reasons, Senator Kirsten Gillibrand (D-NY) and Senator Cynthia Lummis (R-WY) introduced a bipartisan bill to the U.S. Senate in June called the Responsible Financial Innovation Act (RFIA). Among other things, the bill hopes to regulate “payment stablecoins.” “It includes tax requirements for various digital assets, as well as stricter requirements for stablecoins, which, according to Gillibrand, would not allow the use of TerraUSD,” Fedenia said. "The bill also includes provisions on cybersecurity, as well as the possible establishment of a 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 governed by state and federal banking regulators, issued primarily by depository institutions, and are neither commodities nor securities. However, the bill does provide a way for institutions that only seek to issue stablecoins to obtain a limited charter to issue stablecoins from the Office of the Comptroller of the Currency (OCC). Notably, the new bill provides that algorithmic stablecoins will be treated as hybrid instruments and regulated by the U.S. CFTC. In addition, under the updated bill, issuers of algorithmic stablecoins will be prohibited from calling these products "stablecoins."

Stablecoin legislation is also underway in the House of Representatives. House Republicans, led by Rep. Patrick McHenry, have introduced the Clarity for Payment Stablecoins Act. Act, which recently passed the House Financial Services Committee on a largely party-line basis. Non-bank issuers will face bank-like requirements, such as capital, liquidity, and risk management requirements. The bill excludes digital assets created by banks that represent deposits, and will also issue a two-year moratorium on the creation of new algorithmic stablecoins (referred to as "endogenously collateralized stablecoins"), while directing the Treasury Department to study them further.

3. State-Level Regulatory Policies and Legislative Dynamics

Amid this federal uncertainty with the SEC and CFTC in the United States, 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 Act considers stablecoins backed by sovereign currencies to be regulated under its money transmission law, and under Texas law, stablecoins “may be treated as a claim convertible into money and, therefore, fall within the definition of money or monetary value.”

Money Transmission

Stablecoins pegged to sovereign currencies may be treated as a claim convertible into money and, therefore, fall within the definition of money or monetary value under Section 151.301(b)(3) of the Texas Finance Code. If a stablecoin is backed by sovereign currency reserves and the holder of the stablecoin has a right of redemption, then the holder has a claim on the sovereign currency backing the stablecoin because the issuer is obligated to provide the sovereign currency at a later time (upon the holder’s request) in exchange for the stablecoin.

Policy Statement

Sovereign-backed stablecoins may be treated as money or monetary value under the Money Services Act, and therefore receiving stablecoins in exchange for a promise to provide stablecoins at a later time or in a different location may constitute money transmission. The licensing analysis will depend on whether the stablecoin provides holders with a redemption right in sovereign currency, thereby creating a claim convertible into currency or monetary value. This is true regardless of whether the redemption right is expressly granted or implied by the issuer.

3.2. Nebraska Regulatory Policy (Nebraska Revised Statute 8-3024)

The statute states that digital asset custodians are authorized to engage in one or more of the following digital asset business activities:

(1) Provide digital asset and cryptocurrency custody services. Such custodial services may not be provided for a digital asset or cryptocurrency unless the digital asset or cryptocurrency was

(a) first publicly traded more than six months before the date on which the custodial services were provided;

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 doing business in this state;

(2) issues stablecoins and holds deposits with a financial institution insured by the Federal Deposit Insurance Corporation that has its principal charter office in this state, has any branch in this state, or any branch of a financial institution that had its principal charter office in this state before becoming a branch of such financial institution as a reserve for the stablecoin; and

(3) uses an independent node validation network and stablecoins for payment activities.

3.3. Wyoming Stable Token Act

Act Summary:

• A single stablecoin is a virtual currency representation of $1.

• One stable token is redeemable on demand for $1 (unless the U.S. Treasury bill rate falls below zero or the value of the assets held in the trust account falls below $1 per stable token).

• 100% of the nominal value of all tokens in circulation will be deposited into a newly established Wyoming Stable Token Trust Account (although the trust will not create any fiduciary obligations between the state and token holders).

• The trust funds will be invested only in low-risk, short-term U.S. Treasury bills.

• The portion of investment income that exceeds 102% of the value of the tokens in circulation will be deposited into the Wyoming Stable Token Management Account to pay operating costs and fund other state government work.

• The bill establishes the Wyoming Stable Token Commission, which is responsible for issuing and overseeing the program.

• The bill provides that the commission "shall endeavor to issue at least one Wyoming Stable Token by December 31, 2023." The Wyoming State Treasury will provide $500,000 in initial funding for the issuance and management of the tokens, 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 the Treasury (Dep’t Fin. Serv., DFS) issued the Guidance on the Issuance of USD-Backed Stablecoins (“DFS Guidance”), which outlines the general requirements for DFS-regulated issuers to issue USD-backed stablecoins.

Regarding redemption, the DFS Guidance requires, among other things, that stablecoin issuers adopt “clear and conspicuous redemption policies, with prior written approval from DFS” that give holders the right to redeem stablecoins promptly at par. The DFS Guidance defines “prompt” redemption as no more than two business days after the redemption instruction is issued, but exceptions may apply to this requirement if DFS “determines that a timely redemption may jeopardize the asset-backing requirements of the reserve or the orderly liquidation of reserve assets.”

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

As for verification, DFS Guidance requires issuers to publish a monthly report 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 reserves are sufficient to fully support unissued stablecoin units; and (4) whether all DFS conditions for reserves are met. DFS Guidance also requires issuers to obtain a report annually demonstrating management’s assertion of the effectiveness of internal controls, structure, and procedures to comply with the monthly reporting requirement and to file it with DFS within 120 days of the covered period, although issuers are not required to release the report publicly.

4. Main Legal Controversy:Terraform Case - Crypto Asset Securities Fraud

LUNA is the governance token of the Terra Blockchain Network, a delegated proof-of-stake blockchain that operates to issue and maintain a stablecoin, UST, a token designed to trade exactly $1. To incentivize people to hold and use UST for the long term, Terraform Labs (the creator of the Terra Blockchain Network) launched Anchor, a purportedly low-risk, high-yield savings protocol that guarantees an annual yield of 20% on UST deposits.

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

On February 16, 2023, the U.S. SEC sued Terraform Labs and its founder Do Kwon, alleging that they offered and sold UST and LUNA as unregistered securities. (Additional note: There is no clear regulatory policy at this time. The SEC regards both UST and LUNA as securities for regulation. If the case occurs later than the time when FIT 21 is passed, LUNA, as an algorithmic stablecoin, should be subject to the jurisdiction of the CFTC.) On July 31, 2023, the trial court rejected Terraform Labs and Quandou’s motion to dismiss, ruling that their marketing of the anchor protocol as a means of generating income was sufficient to constitute an investment contract and therefore a security. Although the court ruled that BUSD and other stablecoins are not isolated securities because there is no "reasonable expectation of profit" for fixed-price assets themselves, Terra's marketing and sale of equity derivatives (through mirror protocols) and interest-bearing products (through anchor protocols) to encourage UST "deposits" constituted unregistered securities offerings and sales.

5. Conclusion

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 that is pegged to the US dollar or other legal currency and has a fixed nominal redemption value. These acts require stablecoin issuers to meet specific capital, liquidity and risk management requirements and must obtain a charter from the Office of the Comptroller of the Currency (OCC). Federal agencies such as the SEC and CFTC are also actively competing for regulatory power over stablecoins and have proposed their own regulatory orientations. The emergence and advancement of FIT 21 has made the future regulation of stablecoins more clear. In addition, this article also discusses different policy and legislative dynamics of state-level regulation, including specific implementation policies in Wyoming and New York.

FIT 21 and the continued attention of various federal agencies to stablecoins are accelerating the improvement of the United States' stablecoin regulatory agency. In the future, it is expected that the United States will further strengthen regulatory measures for stablecoins to ensure their stability and security in the financial system. Regulators may continue to improve the legal framework to respond to evolving market demands and technological innovations.

References

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

[2]. Tsinghua University PBC School of Finance MBA 2023. (2024). Digital Stablecoin Pricing Analysis and Future Trends - Taking Tether 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. 14px;">[7]. COITELEGRAPH. (2023). Stablecoins and Ether are ’going to be commodities,’ reaffirms CFTC chair.