Tagus Bits 'n Bobs Issue 5: Reassessing Regulation of Digital Assets

21 June 2024

Deep Dive: Reassessing U.S. Regulation of Digital Assets

• Regulatory Balance: US digital asset regulation beginning to strike a balance towards innovation and protection, after gaining bipartisan support

• ETF Approvals: SEC approval of Bitcoin ETF, and apparent U-turn in favour of Ethereum ETFs represent significant milestones for digital assets and wider adoption 

• Bipartisan SAB 121 Repeal: Congress repealing SAB 121, a controversial crypto accounting policy indicates a more pragmatic bipartisan stance towards digital asset regulation

• Biden's Veto: President Biden veto of bill overturning SAB 121, still indicates strict stance by US Administration

• Trump Goes Pro-Crypto: Former President and current Republican Presidential nominee Donald Trump has shifted his stance on crypto regulation, positioning himself as a pro-crypto candidate

• Swing Voter Influence: Digital asset advocacy groups gain influence, resonating with swing U.S. voters and shaping the political landscape ahead of the U.S. elections in November

• SEC vs. Coinbase: The SEC's case against Coinbase focuses on whether its crypto-asset transactions constitute securities under the Howey test. The outcome of the case may shape the future of crypto regulation and set important precedents for the industry

• Global Digital Asset Regulation: European Union's MiCA leads the way, with the US lagging behind due to lack of federal legislation, while UK, Dubai, Hong Kong, Singapore, and Australia have moved forward with their own regulatory frameworks and guidelines for digital-assets and related service providers. There are still significant gaps in harmonised oversight but still fostering innovation. 

• The US political landscape for crypto regulation is shifting in 2024, driven by bipartisan support and the importance of digital assets for swing voters ahead of the U.S. November elections. The approval of spot Bitcoin and Ethereum ETFs paves the way for mainstream adoption, while Congress's repeal of the controversial crypto accounting policy SAB 121 indicates a reassessment of crypto regulation. However, President Biden's veto of the repeal indicates a continued strict stance by the current US administration. That said, the growing influence of digital asset advocacy groups, along with Donald Trump's shift in stance as he positions himself as a pro-crypto candidate, are shaping a more pragmatic political approach towards digital assets, particularly since May 2024. Outstanding questions remain on defining, classifying, and regulating digital assets effectively, and the SEC vs. Coinbase case could impact the industry's future in the US. Regulating Digital Assets: Regulating the digital asset ecosystem requires a delicate balance between preventing harms, protecting users, and promoting innovation. Despite to a certain degree of progress in the United States and in particular in other jurisdictions such as the United Kingdom, Dubai, Singapore and Hong Kong, key questions remain, including: Softening Stance Towards Digital Assets - Political and Regulatory Developments

1. How to define and classify digital assets for harmonised understanding and regulatory coordination?

2. How to address novel legal and policy issues arising from decentralised activities?

3. How to maintain regulatory oversight over institutions to address risks like cybersecurity and market integrity?

4. How to establish a consistent, coordinated, and effective regulatory framework?

Source: Tagus Capital.  

The Repeal of SAB 121 (H. J. Res. 109) is an Important Shift in Crypto Regulation: The US Senate on 16 May, 2024 passed a rare bipartisan resolution (60-38, 12 Democrats and 48 Republicans voted in favour) to overturn the SEC's crypto accounting policy, SAB 121, following the House which on May 8, 2024 passed H.J. Res. 109 also with bipartisan support (228-182 majority, including 207 Republicans and 21 Democrats). This vote marked a milestone as the first standalone crypto legislation.

Below a summary of SAB121:

• SEC's crypto policy: The controversial crypto policy, known as Staff Accounting Bulletin No. 121 (SAB 121), was passed by the Securities and Exchange Commission (SEC) in 2022

• What does SAB 121 do?: SAB 121 requires companies holding digital assets for their customers to report a liability and "corresponding assets" on their balance sheets for all custodied cryptocurrencies

• What does the Congress vote mean?: The Senate and House voting to overturn SAB 121 demonstrates a bipartisan approach to easing overly restrictive digital asset regulations, signaling a growing consensus among lawmakers to balance innovation and oversight

• Why was SAB 121 overturned by Congress?: The SEC's regulation was criticised by industry stakeholders for being excessive and burdensome, potentially stifling innovation and disproportionately affecting smaller firms

• Biden Veto: The resolution did not receive enough votes to be veto-proof and President Joe Biden vetoed the resolution despite the shift in bipartisan support

• What happens next?: Congress has a chance to overturn President Biden's veto, but it will require a two-thirds majority from both the House and Senate

The repeal of SAB 121 is significant and indicates a reassessment in striking a better balance to crypto regulation towards safeguarding investors but fostering innovation in the crypto industry. However, President Biden vetoed the bill after it reached his desk, as he had pledged to do, with the White House stating its strong opposition to any efforts to disrupt the SEC's measures to protect investors and the financial system. The Biden administration faced pressure from various sectors to sign the H.J. Res. 109 bill, which could repeal SAB 121. The American Bankers Association and the crypto community supported the resolution. However, Biden is likely to have resisted due to political considerations, including potential backlash from his own party and the upcoming elections. Congress still has a chance to overturn it if it secures a two thirds majority. Alternatively, the SEC could revoke SAB 121, ending the impasse. SEC Commissioner, Hester Pierce, has also criticised SAB 121.

SEC 180-degree Turn in Ethereum ETF Approval: The SEC's approval of 19b-4 filings of eight Ethereum ETF providers on May 23, 2024 marks a significant milestone in the digital asset industry, driven by bipartisan political support from both Republican and Democratic parties. In an astonishing 180-degree turn in a short period of time, the SEC provisionally approved spot Ethereum ETFs, paving the way for mainstream adoption. Just months ago, the agency seemed uninterested in engaging with the industry, but a sudden change of heart led to this significant step forward. 

The dramatic change in regulatory sentiment and the last minute approval can be mapped by trading in market-based predictive contracts. At the outset of the SEC allowing trading of spot Bitcoin ETFs on Jan. 11, 2024, optimism for approval of spot Ethereum ETFs by May 31, 2024, was high and the odds were at circa 75% according to market-based contracts. However, the lack of SEC engagement with spot Ethereum ETF applicants led to the odds of a US Ethereum ETF approval by May 31, 2024, plummeting to 7-10% on May 20, 2024, before surging to 100% upon SEC approval on May 23, 2024. Meanwhile, the ETH/BTC ratio hit a 2-year low on May 20, 2024, indicating excessive pessimism towards Ethereum, including dim prospects of ETF approval, which Tagus Bytes (May 21, 2024) noted at the time, anticipating a potential rebound, and has since materialised. 

A bipartisan group of lawmakers, in a letter dated May 22, 2024, urged the SEC to approve spot Ethereum ETFs, calling for consistent approval principles for digital asset-backed ETFs, paving the way for broader regulatory acceptance. While the SEC has been cautious, the approval signals a shift in the regulatory environment, indicating a softening of the Biden administration's stringent stance on crypto platforms and the industry's growing political clout. The SEC's speed in approving spot Ethereum ETF trading by finalising S-1 filings will indicate how far its pragmatic regulatory stance has evolved. SEC Chairman Gary Gensler expects final spot Ethereum ETFs to be approved by the end of summer, but Tagus Capital anticipates early approval, potentially in July. After the end of May S-1 form deadline, modest SEC feedback suggests trading approval within weeks. 

Swing in Odds - ETH ETF Approval by May 31         ETH/BTC Ratio

Source: Polymarket, TradingView. 

Ethereum Commodity Classification?: The SEC dropping its investigation into Ethereum's status as a security, according to Consensys, is also a significant victory for the industry. The Enforcement Division closed its probe into Ethereum 2.0, indicating that Ethereum sales won't be treated as securities transactions. While the SEC's approval of spot Ethereum ETFs via 19b-4 forms in May strongly suggested Ethereum's commodity status, this dropping of the case solidifies the win for Ethereum developers and signals a more balanced US regulatory approach to digital assets. Following in Bitcoin's footsteps, with its approved ETF and apparent commodity classification, the question now is: to what extent can this classification be applied to other tokens, also representing commodities, utilities, assets, or contracts as tradable, fungible tokens?

Growing Influence of Digital Asset Advocacy Groups: The digital asset advocacy group “Stand with Crypto” has surpassed one million members, driven by frustration over President Biden's veto of a measure aimed at regulating crypto assets. The group's rapid growth highlights the potential voting power of cryptocurrency users, with 52 million Americans having used cryptocurrencies. The industry is spending tens of millions of dollars in US elections to support crypto-friendly candidates and defeat those pushing for more regulation. Stand with Crypto has targeted voters in swing states, with nearly 24,000 members in Georgia and over 16,000 in Arizona. Brian Armstrong, CEO of Coinbase and a prominent figure in the crypto industry, believes that crypto issues should be bipartisan and that the industry's growth will influence future elections. As the head of one of the largest cryptocurrency trading platforms, Armstrong's views on crypto regulation carry significant weight.

Pendulum of Swing Voters Soften Political Stance: Following intense lobbying and speculation, the preliminary approval of spot Ethereum ETFs also reflects crypto's growing broader bipartisan influence in US politics, with lawmakers like Senator Cynthia Lummis (R-WY) and Senator Kirsten Gillibrand (D-NY) advocating for clearer regulations. This also resonates in particular amongst swing voters ahead of the U.S. elections in November. Digital assets are a significant issue for both “crypto-positive” voters and the general voter population according to a Harris Poll. The poll highlights a strong desire for balanced regulations that protect consumers without hindering innovation. The poll also confirms that digital assets are now a significant issue in the upcoming election, with over 26% of voters considering candidates' stances on digital assets when casting their votes, further solidifying the impact of this issue on the electoral landscape.

Just over two-fifths of crypto-positive swing voters consider it a major issue in the upcoming election, and many pay attention to candidates' stances on digital assets, which influences their voting decisions. Nearly half of all swing voters want candidates to discuss digital currency more, highlighting its importance. Also there is a relatively even split between Republican (45%) and Democrat leanings (42%) among crypto-positive voters, with a slightly higher percentage leaning towards the former in the crypto-positive voter group. As such, digital assets are a crucial bipartisan topic that could impact electoral outcomes and should be addressed by candidates.

Digital Assets a Significant Issue for U.S. Swing Voters

Source: Harris Poll (May 7, 2024). Notes: Total Respondents (n=1201); Crypto-Positive Respondents (n=364). 

SEC vs. Coinbase - Implications for Digital Assets: One pending case that is likely to have wider ramifications for digital assets is the SEC's allegations against Coinbase. The SEC's complaint against Coinbase was filed in the US District Court for the Northern District of California in June 2023. The SEC argues that Coinbase's transactions in thirteen identified crypto-assets meet the requirements of the Howey test, which would make them subject to federal securities laws and the SEC's enforcement authority. The Howey test, developed in 1946, is a legal framework used by the SEC to determine if a transaction is an investment contract and subject to securities regulations. Despite its origins predating the digital asset landscape, the SEC continues to apply the Howey test to evaluate various digital assets, including in the case against Coinbase.

Coinbase has challenged the allegations, contending that its customers' purchases of crypto-assets are not investments in a common enterprise and that their expectations of profits are not predominantly from the efforts of others. Despite facing SEC allegations, US President Joe Biden's campaign team is considering accepting digital asset donations through Coinbase to appeal to the digital asset community. 

The outcome of this case is likely to have significant implications for the digital asset industry. If the court rules in favour of the SEC, it could lead to increased regulatory scrutiny and further enforcement actions against other cryptocurrency exchanges and issuers. This could potentially stifle innovation and growth in the industry. On the other hand, if the court finds that Coinbase's transactions do not meet the Howey test's requirements, it could provide greater clarity and certainty for the industry, potentially spurring further investment and growth. As the case progresses, it will be important to watch for any developments or rulings that could impact the broader digital asset industry. The outcome of this case could set important precedents for the regulation of cryptocurrencies and other digital assets in the U.S., and could shape the future of the industry for years to come. 

Stablecoin Regulation is Lacking: In the United States, there is no federal legislation specifically for crypto-assets, leaving the SEC and CFTC to apply existing laws. Congress has attempted to legislate, but the lack of bipartisan support has hindered progress. The Clarity for Payment Stablecoins Act was proposed back in 2023 and would explicitly distinguish payment stablecoins from securities and subject issuers to regulatory standards drawn from banking. However, it is unclear how far the bill will be able to proceed. More recently US Senators have introduced a bipartisan stablecoin Bill to establish a regulatory framework and is awaiting further progress. There are chances that U.S. lawmakers may finally approve a stablecoin bill by the end of 2024, which is keenly needed by the industry.  

Regulatory distinctions among major stablecoin issuers are also necessary to consider. USDT (Tether) and USDC (USD Coin) are two prominent stablecoins with unique features in the cryptocurrency market. USDT, launched in 2014 by Tether, has a higher market cap and liquidity but faces scrutiny over reserve transparency and regulatory compliance due to its decentralised approach. In contrast, USDC, introduced in 2018 by Circle and Coinbase, offers greater transparency through monthly attestations and adherence to US federal regulations, making it more favourable among regulators. This difference in regulatory standing could lead to increased scrutiny for USDT and wider acceptance for USDC within traditional financial systems, shaping the future of stablecoins and the broader cryptocurrency market.

In contrast, the European Union is already setting a global precedent via MiCA (Markets in Crypto-Assets) regulation and is a top priority for fiat backed stablecoin issuers as the June 30 deadline approaches. The regulations aim to protect consumers, ensure financial stability, and foster innovation in the digital currency space. MiCA will categorise stablecoins into two groups, regulated and unauthorised, with additional restrictions for the latter. Stablecoin issuers and industry players are preparing for the upcoming requirements, which include registering and complying with capital and reserve obligations, affecting their issuance, operation, and oversight within the EU. While some provisions take effect on June 30, others will be phased in by December 2024. Uncertainty remains in the industry, with concerns about the lack of clarity in implementation requirements and potential impacts on users, issuers, and crypto exchanges. Tether's CEO has criticised MiCA's requirements as problematic and potentially risky for EU-licensed stablecoins. This EU regulation on stablecoins may set a precedent and at a time when the US Senate is also trying to pass a bill to regulate stablecoins, requiring issuers to hold full reserves, use only dollar-backed tokens, and maintain transparency, aiming to enhance financial stability and consumer protection.

Global Crytpo Regulation: The European Union's Markets in Crypto-Asset Regulation (MiCA) - see above - has led to a global shift in the regulation of crypto-assets. The new rules for the regulation of issuing, offering, and providing intermediary services for crypto-assets come into effect in two stages in 2024. Legislators and regulators are now focusing on the issuance and trading of crypto-assets, with a distinction between financial instruments represented on blockchain and novel crypto-assets like stablecoins.

The United Kingdom has taken a proactive approach, with HM Treasury consulting on the regulation of digital-assets and adopting the Financial Securities and Markets Act 2023. The Act expands the role of HM Treasury and financial regulators, allowing for the creation of regulatory sandboxes and addressing new requirements like a definition of crypto-assets. Firms operating in the UK's significant fintech ecosystem must register as Virtual Asset Service Providers (VASPs) with the Financial Conduct Authority (FCA). This regulatory oversight aims to maintain the integrity of the financial system while promoting innovation in the digital asset sector. However, the UK's digital asset regulations have shortcomings, including a lack of frameworks for stablecoins and DeFi, and difficulties for fintech companies using crypto to access banking services. Addressing these issues is essential for fostering innovation and ensuring the industry's long-term success. However, secondary legislation to regulate fiat-backed stablecoin issuance, exchange-based trading, and custody is in development.

Dubai has been actively working to establish itself as a hub for digital assets and blockchain technology. The Dubai Multi Commodities Centre (DMCC) launched the DMCC Crypto Centre, which provides a comprehensive ecosystem for cryptocurrencies, blockchain, and related technologies. The Dubai Financial Services Authority (DFSA) has been developing a regulatory framework for digital assets, including security tokens, utility tokens, and cryptocurrencies. The DFSA issued a guidance document on the regulation of security tokens in 2020 and has been exploring the regulation of other types of digital assets. The Dubai government has also been supportive of blockchain technology, launching the Dubai Blockchain Strategy in 2016 and the Dubai Blockchain Cybersecurity Shield. Recently, the DFSA has been working on the regulation of Virtual Asset Service Providers (VASPs) and issued a consultation paper to seek feedback on the proposed regulatory framework for VASPs.

Hong Kong has made it mandatory for virtual asset trading platforms to be licensed by the Securities and Futures Commission (SFC), with a 12-month transitional period. The new requirements are found in amendments to the Anti-Money Laundering and Counter-Terrorist Financing Ordinance, as supplemented by: The Guidelines for Virtual Asset Trading Platform Operators (VATPs). Hong Kong's SFC approved the first spot ETFs for Bitcoin and Ethereum in April 2024, making it one of the pioneering jurisdictions to offer such investment vehicles for the two leading digital assets. This development may attract demand, especially from mainland Chinese investors seeking a legal way to trade cryptocurrencies following China's ban on trading in 2021. The Hong Kong Monetary Authority (HKMA) and the Financial Services and the Treasury Bureau (FSTB) in Hong Kong have proposed a licensing and regulatory framework for fiat-referenced stablecoins. This framework aims to address concerns related to monetary policy, financial stability, and investor protection. The proposal underwent a consultation period, which ended in February 2024.

In Singapore, the provision of Digital Payment Token (DPT) services, which involve cryptocurrencies, is regulated by the Monetary Authority of Singapore (MAS). DPT service providers are required to obtain a license or be exempted from licensing to operate legally in the country. This regulatory framework aims to ensure the security and integrity of cryptocurrency-related activities and protect consumers and investors. MAS has published its response to feedback on the regulation of single-currency stablecoins (SCS), with forthcoming rules expected in 2H 2024. Entities which provide a "Stablecoin Issuance Service" will need to obtain a Major Payment Institution licence and comply with SCS issuer requirements. There are two notable exceptions: non-bank SCS issuers with SCS in circulation not exceeding SGD 5 million in value, who will remain subject to DPT requirements; and banks issuing SCS by tokenising their liabilities.

Australia is consulting on proposals to regulate digital assets platforms based on the existing financial services regime. Platforms that hold more than AUD 1,500 for individuals and AUD 5,000,000 in aggregate will be required to obtain an Australian Financial Services Licence. In addition to the common requirements applicable to licence-holders, the proposed rules will create specific rules for standard form platform contracts, minimum standards for holding tokens, standards for custody software, and standards when transacting in tokens. New rules would also apply to trading, staking, tokenisation, and fundraising. The Australian Treasury has flagged further consultation on exposure draft legislation in 2024, which will then be followed by a 12-month transitional period once the legislation becomes law.

Global regulation and oversight remain fragmented across jurisdictions, stifling innovation and growth. While clear regulations could boost adoption and legitimacy, inconsistent rules create uncertainty and challenges for businesses operating globally. Harmonised standards and cooperation among regulators are essential for a cohesive and sustainable digital asset market.

Shifting Regulatory Landscape in Favour of Digital Assets: The recent developments in crypto regulation and approval of digital asset ETFs in the US indicate a shift towards a more balanced approach, weighing innovation against customer protection. Despite President Biden's veto of the bill overturning SAB 121 and his administration's strict stance, the SEC's approval of spot Ethereum ETFs and Congress's repeal of SAB 121 reflect a bipartisan effort to promote financial innovation while addressing concerns. As the regulatory environment evolves, a consistent framework will be crucial, and the growing influence of digital asset advocacy groups and the importance of this issue for US swing voters will likely shape the political landscape, especially ahead of the US elections in November. The outcome of the SEC vs. Coinbase case could significantly impact the digital asset industry, either increasing regulatory scrutiny and potentially stifling growth or providing clarity and spurring investment, ultimately shaping the future of digital asset regulation in both the U.S. and globally. 

References

Executive Office of the President, Office of Management and Budget. (May 82024, May 8). Statement of Administration Policy: H.J. Res. 109 - Congressional Disapproval of "Staff Accounting Bulletin No. 121" Issued by the Securities and Exchange Commission. Available:https://www.whitehouse.gov/wp-content/uploads/2024/05/SAP-HJRes109.pdf (Accessed: May 25, 2024). 

The Blockchain Association (2024) Crypto Attitudes in Swing States. Harris Poll Insights. Available: https://theblockchainassociation.org/wp-content/uploads/2024/05/DCG_HarrisPoll-Research-Report.pdf (Accessed: June 4, 2024). 

Securities and Exchange Commission v. Howey Co. (1946) 328 U.S. 293. Available: https://supreme.justia.com/cases/federal/us/328/293 (Accessed: May 26, 2024).