Blockchain Update: Lummis-Gillibrand Crypto Regulation Bill Reintroduced Following Tumultuous Year – Financial Services

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Sens. Cynthia Lummis (R. Wyo.) and Kristen Gillibrand (D. N.Y.)
have reintroduced their landmark bipartisan crypto bill known as
the Lummis-Gillibrand Responsible Financial Innovation Act
(“Lummis-Gillibrand Act” or “LG
Act”).1 The original bill,2 introduced
last June, ultimately failed to move forward. The new bill was
introduced on July 12, read and referred to the Senate Finance
Committee for consideration.

The digital asset world has had quite a year following the
so-called “Crypto Winter” of 2022. With the fall of
crypto exchange FTX and Alameda Trading, a wave of crypto-related
bankruptcies, SEC lawsuits against popular crypto trading platforms
for failure to register as a securities exchange, and continuing
litigation against token issuer Ripple, calls for Congress to
clearly structure and delegate crypto oversight gained significant
traction. In response, the Lummis-Gillibrand Act was updated to
include heightened consumer protections and a clearer division of
labor among regulators.

The CFTC’s Role in the Updated Act

While the previous version of the LG Act proposed an expanded
role for the CFTC by defining most digital assets as commodities
and establishing the CFTC as their primary regulator, the updated
version goes a step further by requiring all crypto asset exchanges
(except truly decentralized exchanges) to register with the CFTC.
This would include expanding the CFTC’s oversight of
cryptocurrency spot markets, which, under the Commodities Exchange
Act up until now would not fall under the purview of a regulator
that primarily oversees futures and derivatives trading.

The goal of the LG Act is to establish a principal regulator for
token exchanges that is more tailored to the idiosyncrasies of
token trading than a traditional broker-dealer regulatory overlay
that the SEC is attempting to impose on the large exchanges with
which it has commenced enforcement cases and litigation. Any
cryptocurrency token would be considered in scope under the new
act, not just those that are deemed “securities” under
the 1946 SEC v. S.J. Howey Co.3 Supreme Court
decision. Many decentralized exchanges, or DEXs, are likely in
scope for regulation under this rubric, other than purely
programmatic exchanges. It is unclear how an exchange would be
deemed exempt from this regulation.

SEC Implications

While the CFTC would effectively become crypto’s primary
regulator under the LG Act, SEC Chair Gary Gensler has contended
that the majority of traded crypto tokens are securities. In turn,
the SEC has sought to establish itself as crypto’s primary
regulator and brought significant actions against the world’s
largest crypto exchanges.4, 5

The updated LG Act includes “ancillary assets” that
are defined as containing some characteristics of a security but do
not clearly confer contractual rights to an investor. These assets
may derive their value from the efforts of others but don’t
confer a right to profits nor represent equity or other contractual
rights.

The updates also include the CFTC and the SEC working together
by jointly chartering a customer protection and market integrity
authority that would regulate, supervise and discipline firms. Both
agencies would receive $100 million in funding to implement the LG
Act’s provisions annually through 2027. Nonetheless, the SEC
stands to lose some of its influence over nebulous digital assets
that do not squarely fit within the Howey test for
classification as securities.

Stablecoins

Under the updated Lummis-Gillibrand Act, stablecoins would be
governed by state and federal banking regulators. Stablecoins would
primarily be issued by banks or credit unions, which would need to
provide clear proof of reserves.6 The bill does create a
specific path for firms seeking to issue only stablecoins by
granting the Office of the Comptroller of the Currency the
authority to issue limited charters for the purpose of issuing
stablecoins. This is helpful for some of the largest stablecoins,
such as the USDC coin, that is managed by Circle, which is not a
bank.

Algorithmic stablecoins, made infamous by the collapse of
TerraUSD,7 would be considered hybrid instruments
regulated by the CFTC. Notably, any issuers of these assets would
be prohibited from calling them stablecoins under the updated LG
Act.

Goal to Ensure FTX Never Happens Again

In a joint press release, Sens. Lummis and Gillibrand
highlighted additions to the LG Act designed to prevent FTX-like
disasters from happening again. Among the additions were (1)
imposing mandatory segregation and third-party custody
requirements; (2) giving the CFTC the legal authority to supervise
affiliates, holding companies and other potential conflicts of
interest; and (3) limiting crypto asset lending and banning
rehypothecation (the practice of a financial intermediary using
client collateral for its own purposes). All of these rules, if
followed, will curb the possibility of another platform
meltdown.

Next Steps

With the reintroduction of the bill, the next step in the Senate
is to refer the bill to the appropriate Committees for
consideration. A companion bill will likely be introduced in the
House of Representatives, or it could be joined to other bills
pending in the House. There remain significant hurdles to cross for
this legislation. In an attempt to appease crypto critics and gain
support, the updated Lummis-Gillibrand Act contains sections
designed to prevent illicit finance and includes three provisions
from Sens. Warren (D. Mass.) and Marshall’s (R. Kan.)
“Digital Asset Anti-Money Laundering Act,” which was
recently delayed due to lack of sponsors. House Financial Services
Committee Chair Patrick McHenry (R. N.C.), who is also the
Republican Deputy Whip, has indicated he is in favor of moving
forward with constructive legislation on cryptocurrency, as have
Reps. Waters (D. Cal.), Torres (D. N.Y.), Meeks (D. N.Y.), Emmer
(R. Minn.) and Smith (R. Ark.), the Chair of the House Digital
Assets Subcommittee.

Still, bipartisanship and a clear regulatory framework may not
be enough to get the revised LG Act across the finish line. One
Democrat was anonymously quoted describing the Lummis-Gillibrand
Act as an “effort to muzzle the SEC by the [crypto] industry
in favor of what it sees as an easier regulator in the form of the
CFTC.” Indeed, critics point to support of the former LG Act
and a similar late 2022 bill8 by Sens. John Boozman (R.
Ark.) and Debbie Stabenow (D. Mich.) by disgraced FTC CEO Sam
Bankman-Fried as an indicator that they should be cautious. Beyond
critical response, the Act may still take a back seat to other
Congressional matters and may fall by the wayside as the 2024
presidential election looms.

We appreciate the contribution of Summer Associate Jake
Barroway to this article.

Footnotes

1. https://www.congress.gov/bill/118th-congress/senate-bill/2281?s=1&r=1

2. https://www.congress.gov/bill/117th-congress/senate-bill/4356/text

3. 328 U.S. 293 (1946).

4. See https://www.cnbc.com/2023/06/05/sec-sues-binance-and-ceo-changpeng-zhao-for-us-securities-violations.html

5. See https://unchainedcrypto.com/sec-says-coinbase-understood-that-securities-laws-applied-to-its-business-before-lawsuit/

6. Treasury Secretary Janet Yellen has consistently
called for stablecoin regulation. See Yellen Says US Must Address Vulnerabilities in
‘Shadow Banking’ (pymnts.com)

7. https://www.coindesk.com/learn/the-fall-of-terra-a-timeline-of-the-meteoric-rise-and-crash-of-ust-and-luna/

8. https://www.coindesk.com/policy/2022/11/15/the-sbf-bill-whats-in-the-crypto-legislation-backed-by-ftx-founder/.

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