Benjamin Sauter and Jake Chervinsky of Kobre & Kim LLP are litigators and government enforcement defense attorneys who specialize in disputes and investigations related to digital assets. This article is not intended to provide legal advice.
As we enter the second year of this so-called “crypto winter,” the stablecoin market is hotter than ever.
In recent months, stablecoins – digital assets pegged to the value of fiat currencies like the U.S. dollar – have exploded in size and variety thanks to high-profile offerings from companies like Circle, Paxos and Gemini. Even traditional banks are joining the action, with JP Morgan recently announcing its own stablecoin-like product called JPM Coin.
Thus far, stablecoins have largely avoided public scrutiny and criticism from agencies like the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), which have focused their attention on the many issues arising out of the 2017 initial coin offering bubble instead. Yet, as stablecoins see greater capital inflows and industry adoption, the SEC and CFTC will likely take a harder look at their compliance status.
Unfortunately for stablecoin proponents, agencies like the SEC and CFTC are often quick to assert their jurisdiction over new financial innovations, even if their intervention may not serve the best interests of an emerging industry.
Stablecoins promise many of the same benefits as other cryptocurrencies – like cheap transactions and rapid settlement – without the price volatility typically found in the crypto markets. Through that combination, stablecoins could satisfy the demand for high-quality fiat currencies in parts of the world with limited access to the global financial system, like Iran or Venezuela.
Stablecoins also could be useful for crypto exchanges that want to offer fiat-based trading pairs while reducing their engagement with legacy financial institutions.
To maintain their one-to-one peg with fiat currencies, most stablecoins use either a fiat-collateralized, crypto-collateralized, or algorithmic model. Fiat-collateralized stablecoins are backed by actual fiat currencies held in reserve by the stablecoins’ issuers, whereas crypto-collateralized stablecoins are backed by digital assets locked in smart contracts.
Algorithmic stablecoins, by contrast, aren’t backed by collateral at all. Instead, they use various mechanisms to expand or contract their circulating supply as necessary to maintain a stable value.
It was this type of stablecoin that apparently caught the SEC’s attention last year.
A basis for concern
In April 2018, an algorithmic stablecoin project called Basis made headlines when it raised $133 million from several prominent funds and venture firms. But, only eight months later, Basis shut down unexpectedly and returned its remaining capital to investors. The reason for the shuttering, according to Basis CEO Nader Al-Naji: “We met with the SEC to clarify a lot of our thinking [and] got the impression that we would not be able to avoid securities classification.”
It’s not hard to see why the SEC might view Basis through the lens of a securities offering.
The Basis protocol was designed to maintain stability by auctioning “bond” and “share” tokens to investors who would profit as long as Basis held its peg. Tokens like these could qualify as “investment contracts” under U.S. law, and thus may fall within the definition of a security. Apparently, the Basis team decided that the regulatory requirements imposed by that classification were too onerous to overcome.
Despite Basis’ startling end, there hasn’t been much discussion in the crypto industry about how U.S. securities and commodities laws might apply to stablecoins.
In fact, most industry players seem to take for granted that fiat-collateralized stablecoins are safe from regulatory scrutiny. That assumption may prove dangerous.
Stablecoin regulation under federal law
Most dollar-backed stablecoins are created in roughly the same way: purchasers deposit dollars with a stablecoin issuer, and in exchange, the issuer mints and returns an equivalent amount of the stablecoin. The process also works in reverse: stablecoin-holders can send a stablecoin back to its issuer in exchange for an equivalent amount of dollars.
Given how these stablecoins are redeemed, the SEC might characterize them as “demand notes,” which are traditionally defined as two-party negotiable instruments obligating a debtor to pay the noteholder at any time upon request.
According to the Supreme Court’s 1990 decision in Reves v. Ernst & Young, demand notes are presumed to be securities under Exchange Act Section 3(a)(10) unless an exception or exclusion applies.
For its part, the CFTC might take the position that stablecoins are “swaps” under Commodity Exchange Act Section 1(a)(47)(A). That provision defines swap to include an “option of any kind that is for the purchase or sale, or based on the value, of 1 or more interest or other rates, currencies, commodities, or other financial or economic interests or property of any kind.”
Under that definition, the CFTC might characterize stablecoins as options for the purchase of, or based on the value of, fiat currencies.
Of course, individuals and companies dealing with stablecoins will have good arguments as to why the “demand note” and “swap” classifications shouldn’t apply. For example, issuers could invoke the Reves court’s “family resemblance” test for demand notes, or challenge the CFTC’s jurisdiction over retail foreign currency options, depending on the circumstances. The regulators, however, may take a different view.
What could this mean for stablecoins?
If stablecoins are classified as regulated securities or swaps, there could be serious consequences for a large segment of the crypto industry. For example, stablecoin issuers might have to register their offerings and comply with all the ensuing regulatory requirements. Similarly, a company or fund that conducts or facilitates stablecoin transactions might have to register as a broker-dealer.
Plus, the SEC and CFTC aren’t the only regulators that may take an interest in stablecoins.
Only time will tell how other state and federal entities, such as the New York Department of Financial Services (NYDFS) or the Financial Crimes Enforcement Network (FinCEN), will approach the regulation of stablecoins, particularly if they’re used to evade trade sanctions or other transaction reporting obligations.
For now, it’s clear that anyone who issues or uses stablecoins should give considerable thought to their potential risk under U.S. securities and commodities laws.
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