On October 3, 2022, the Financial Stability Oversight Council (“FSOC”) released a report and accompanying Fact Sheet on Digital Asset Financial Stability Risks and Regulation (the “Report”). The Report comes in response to Executive Order 14067, which outlined a “whole-of-government” approach to crypto-asset policy and directed FSOC “to produce a report outlining the specific financial stability risks and regulatory gaps posed by various types of digital assets.”[1] (For more information, see our post on the Executive Order.) Release of the Report reflects the federal government’s broadening focus on digital assets from a primarily national security perspective to a financial regulatory perspective.  The Report also makes several policy recommendations, many of which would require Congress to pass legislation.  Although, as discussed further below, there are several legislative proposals already pending in Congress relating to crypto-assets, we expect any action on these proposals will be limited until after the upcoming midterm elections.

I. Key Findings from the FSOC Report

In assessing the financial stability risk of digital assets, the Report separately considers risk resulting from interconnections between digital assets and the traditional financial system, and the risk resulting from interconnections within the digital asset system.

  • Interconnections between digital assets and the traditional financial system. The Report notes that interconnections between digital assets and the traditional financial system are “currently somewhat limited” but “have been increasing and could rapidly increase further.” Consistent with other reports and speeches from regulators, the Report describes a run on stablecoins “lead[ing] to fire sales of traditional assets backing the stablecoins,” as an example of risks associated with digital assets spilling over into the traditional financial system.
  • Interconnections within the digital asset system. In discussing the interconnections within digital asset markets, the Report describes how the collapse of the Terra stablecoin rippled through the digital asset ecosystem, leading to liquidations and bankruptcies at other digital asset market participants, such as Three Arrows (3AC), a digital assets hedge fund, and Voyager, a platform allowing retail customers to trade digital assets. For more information, please refer to our earlier blog posts on Terra and on 3AC and Voyager.

II. FSOC’s Recommendations

The Report concludes with a series of 10 recommendations for regulators and Congress. Consistent with prior statements from the administration and financial regulators, the recommendations suggest that regulators be guided by a set of principles that include regulating similar activities and risks, across technologies, in a similar manner, and promoting transparency in digital asset markets. The Report further recommends regulators gather and analyze appropriate data, as well as build regulatory capacity around digital assets.

The Report also provides a number of recommendations to prevent regulatory arbitrage, such as encouraging coordination between regulators and recommending Congress pass legislation providing for comprehensive federal regulation of stablecoins and other digital assets that are not considered securities. It further recommends Congress provide for consolidated supervision of digital asset firms, which would allow one regulator to supervise all of a digital asset firm’s affiliates and subsidiaries. Many of the Report’s recommendations echo previous regulators’ speeches and reports, and regulators likely are already working on implementing the Report’s recommendations. For example, Acting Comptroller of the Currency Michael Hsu has previously suggested requiring consolidated supervision of digital asset firms, and the President’s Working Group on Financial Markets similarly recommended Congress pass comprehensive stablecoin legislation.[2] For more information, refer to our previous blog post on the President’s Working Group report.

Finally, the Report is concerned with risks related to vertically integrated firms providing retail investors direct access to digital asset markets. These vertically integrated firms may provide retail investors with access to products such as margin loans or digital asset derivatives, and the firms may automatically liquidate investor positions in case of a change in digital asset prices. The Report recommends that agencies consider whether these firms “can or should be accommodated under existing laws and regulations.”

III. An overview of crypto proposals in Congress

We note that, in addition to the pending regulatory initiatives recommended in the FSOC report described above, there are several legislative proposals pending in Congress relating to crypto-assets. We expect any action on these proposals will be limited until after the upcoming midterm elections. Some of the pending proposals include:

  • Waters-McHenry bill. Press reports have discussed a bill being negotiated by House Financial Services Committee Chairwoman Maxine Waters (D-CA) and Ranking Member Patrick McHenry (R-NC). While the text of this bill has not yet been released, press reports suggest the bill would require stablecoin issuers to (a) seek approval from federal and state bank regulators and (b) back their stablecoins 100% with reserves.[3]
  • Lummis-Gillibrand bill (S. 4356, Responsible Financial Innovation Act). This bill, introduced by Sen. Cynthia Lummis (R-WY) and Kirsten Gillibrand (D-NY), addresses the digital asset marketplace more broadly than the Waters-McHenry bill, which focuses on stablecoins. In addition to requiring stablecoin issuers to hold assets backing 100% of their stablecoins in high quality reserves, the Lummis-Gillibrand bill gives regulatory authority over non-security digital assets to the Commodity Trading Futures Commission (“CFTC”) and addresses issues such as the taxation of digital assets.[4] Although the Lummis-Gillibrand bill had been discussed at two prior Senate Banking Committee hearings, it appears to be controversial among certain key Democrats. For more information, refer to our previous blog post on the Lummis-Gillibrand bill and to our webcast with members of Senators Lummis and Gillibrand’s staff.
  • Stabenow-Boozman bill (S. 4760, Digital Commodities Consumer Protection Act). Senate Agriculture Committee Chairwoman Debbie Stabenow (D-MI) and Ranking Member John Boozman (R-AR) released a bill in August 2022 giving the CFTC broad regulatory power over certain digital assets; however, the bill does not address stablecoins.[5] Of the crypto-asset bills introduced so far, the Stabenow-Boozman bill may be the most likely to move forward, given its narrow scope and lack of controversy relative to the Lummis-Gillibrand bill.
  • Gottheimer bill (Stablecoin Innovation and Protection Act). In February 2022, Rep. Josh Gottheimer (D-NJ) released a draft of a bill to regulate stablecoins by limiting their issuance to banks or non-banks with approval of the Office of the Comptroller of the Currency. The bill, which has not yet been formally introduced, would also require the Federal Deposit Insurance Corporation to create a deposit insurance fund to backstop non-bank stablecoin issuers. Like other bills, the Gottheimer bill would require stablecoin issuers to hold high quality liquid assets to back 100% of their issued stablecoins.[6] For more information, refer to our previous blog post on the Gottheimer bill.
  • Hagerty bill (S. 5030, Digital Trading Clarity Act of 2022). In September 2022, Sen. Bill Hagerty (R-TN) released a bill that would provide a safe harbor to digital asset exchanges from enforcement actions by the Securities and Exchange Commission.[7] The bill is still in its early stages. Rep. Trey Hollingsworth (R-IN) is partnering with Sen. Hagerty on this bill.

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We would like to give a special thanks to Debevoise law clerk Tejas Dave for his contributions to this post.

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[1] 87 Fed. Reg. 14143, 14148–49, available here.

[2] Michael J. Hsu, Remarks before the American Fintech Council (November 3, 2021) at 9–11, available here; PWG Stablecoin Report at 16–17.

[3] Allyson Versprille, “House Stablecoin Bill Would Put Two-Year Bank on Terra-Like Coins,” Bloomberg (September 20, 2022, 5:53 pm), available here; Allyson Versprille & Evan Weinberger, “Stablecoins Face US Scrutiny as House Lawmakers Craft Rules,” Bloomberg (July 20, 2022, 1:16 pm), available here.

[4] S. 4356.

[5] S. 4760; Press Release, Boozman, Stabenow, Booker and Thune Introduce Legislation to Regulate Digital Commodities (August 3, 2022), available here.

[6] Press Release, Gottheimer Announces “Stablecoin Innovation and Protection Act,” Critical New Cryptocurrency Legislation (February 15, 2022), available here.

[7] S. 5030; Press Release, Hagerty Introduces Legislation to Provide Crucial Regulatory Clarity for Digital Assets (September 29, 2022), available here.

Author

Caroline Swett is a partner and a member of Debevoise’s Financial Institutions and Banking Groups. She can be reached at cnswett@debevoise.com.

Author

Carter Burwell is a litigation counsel and a member of Debevoise's White Collar & Regulatory Defense Group. He formerly served as a senior counsel at the Treasury Department and on the Senate Judiciary Committee and can be reached at cburwell@debevoise.com.

Author

Alison M. Hashmall is a counsel in the firm’s New York office and a member of Debevoise's Banking Group. Ms. Hashmall’s practice focuses on advising domestic and non-U.S. banking organizations and other financial institutions on a wide range of bank regulatory, policy, and transactional matters and cryptocurrency-related issues. She can be reached at ahashmall@debevoise.com.

Author

Lily D. Vo is a corporate associate and a member of Debevoise's Financial Institutions Group. She formerly served as an attorney at the Treasury Department, a senior counsel at the Securities and Exchange Commission, and a congressional fellow for U.S. Sen. Sherrod Brown, and she can be reached at ldvo@debevoise.com.

Author

Taylor Richards is a corporate associate and a member of Debevoise's Banking Group. She can be reached at tmrichards@debevoise.com.

Author

Ezra Newman a corporate associate and a member of Debevoise's Financial Institutions Group. He can be reached at enewman@debevoise.com.