More than any other digital asset, stablecoins have long attracted the eyes of regulators and policymakers alike as the targets for potential regulation. In the aftermath of the FTX crash, this regulatory pressure is unlikely to wane anytime soon.
As a reflection of that, on the eve of his retirement, out-going Senator Pat Toomey has released a bill entitled the Stablecoin Transparency of Reserves and Uniform Safe Transactions or Stablecoin TRUST Act which aims to provide a comprehensive regulatory framework for stablecoin issuers. While imposing a host of obligations on stablecoin issuers, the bill’s specific clarification of the securities law status of stablecoins is welcome news to stable coin issuers and the crypto community alike.
The most important provision of the bill clarifies that centralized stablecoins are not securities. While this ought to be stating the obvious, the SEC has taken the view that stablecoins might constitute securities.
By way of background, the dominant framework used to determine whether a sale of a digital asset is a so-called investment contract and thus a security, subject to SEC registration requirements, is the Howey test.
The Howey test consists of four elements:
An investment of money: There must be an investment of money, or something of value, in the transaction.
A common enterprise: There must be a common enterprise, meaning that the investors are pooling their resources or relying on the efforts of others to make a profit.
An expectation of profits: The investors must have an expectation of profits, either through the appreciation of the investment or through the efforts of others.
A profit derived from the efforts of others: The profit must be derived from the efforts of others, such as the promoter or manager of the enterprise.
If all four elements are present, then the transaction is considered an investment contract and is subject to securities regulations. If any of the elements are absent, then the transaction is not an investment contract. Since stablecoins are by definition pegged to some fiat currency, almost always the very currency used to buy the said stablecoin, one is clearly not purchasing a stablecoin in the expectation of profit.
The other alternative test that has been proposed as a means to justify treating stablecoins as securities is the Reves test, which states that notes with a maturity of more than 9 months are presumptively securities unless they bear a resemblance to one of the following seven instruments: a note delivered in consumer financing; a note secured by a mortgage on a home; a short-term note secured by a lien on a small business or its assets; a note evidencing a character loan to a bank customer; a short-term note secured by the assignment of accounts receivable; a note that formalizes an open-account debt incurred in the ordinary course of business; a note evidencing loans by commercial banks for current operations. However, the Court explained that this list was not set in stone and that more general principles would dictate whether a note bore a “family resemblance” to the aforementioned instruments, formulating a four-factor balancing test that includes: (1) the motivations of the buyer and seller, where “[i]f 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.’”; (2) the distribution plan, where “an instrument in which there is common trading for speculation or investment,” is more likely to be a security; (3) “the reasonable expectations of the investing public;” and (4) if there is some kind of alternative regulatory regime other than the securities laws which adequately protects investors.
As is the case in the Howey test analysis of stablecoins, the fundamental problem with treating stablecoins as securities is that there is no speculation or investment in non-interest-bearing stablecoins and the investing public would not expect them to be securities precisely because, by definition, there are no returns on investment, such that considering them to be investment instruments rather than a means of purchasing other digital assets is misguided at best. Nonetheless, the SEC has opaquely taken the view that stablecoins may well be securities, with very little clarification as to what legal authority supports such a view.
While clarifying that the SEC would not have the authority to regulate stablecoins, the bill gives stablecoin issuers three possible routes to regulatory compliance. The first is the most regulatorily burdensome, becoming a depository institution—including federally or state-chartered banks, credit unions, and savings associations—or a national trust bank. This option is unlikely to be attractive to the vast majority of stablecoin issuers.
The second option is to choose between the “lighter touch” existing regulatory frameworks, namely becoming a: money service business, a non-depository trust company, or any other person authorized by a state banking supervisor to issue stablecoins. Since under the existing guidance of the Financial Crimes Enforcement Network (FinCEN), centralized stablecoin issuers already constitute money services businesses engaged in money transmission, this option would be advantageous to those stablecoin issuers already in compliance with FinCEN requirements. Additionally, it would empower states to set their own, less onerous regulatory requirements for stablecoin issuers, which would be recognized at the federal level.
Finally, the bill proposes a wholly new license which would be known as the National Limited Payment Stablecoin Issuer License to be granted by the Comptroller of the Currency. This license would grant stablecoin issuers the right to issue and redeem their stablecoin, function as a market maker in their stablecoin, and hold and manage the reserve assets of the stablecoin, but would disallow any other activity, such as extending credit. The Comptroller of Currency may grant or refuse such license depending on: “the financial condition and business plan of the applicant; the general character and fitness of the management of the applicant; and the risks presented and the potential benefits that could be delivered to consumers.”
Irrespective of the regulatory avenue the stablecoin issuer elects, the bill imposes some disclosure requirements applicable to all issuers. The issuer must “publicly disclose the assets backing the payment stablecoin on a monthly basis; adopt and publicly disclose policies for redeeming the payment stablecoin, including whether redemption requests will be met on demand or with a time lag; undergo quarterly attestations by a registered public accounting firm and publicly disclose the results; and attest that the assets backing the payment stablecoin do not materially diverge from those disclosed” and must file any required disclosure with the Secretary of Treasury. Moreover, the bill requires that stablecoins be at least 100% backed with a limited set of highly liquid assets such as bank deposits, US Treasuries, and the bonds of certain low-risk institutions such as the European Community or European Central Bank.
It is important to bear in mind what the bill does not purport to regulate, namely interest-bearing stablecoins and decentralized stablecoins like DAI. While the decision to exempt decentralized stablecoins from the obligations of the bill is wise and eschews the errors of attempts by regulators to shoehorn DeFi into the existing financial regulatory system, it does leave decentralized stablecoins vulnerable to being categorized as securities by the SEC, highlighting the need for complementary regulation if this bill or its provisions should ever become law.