The Breakdown - Lummis-Gillibrand Reintroduce Landmark Crypto Legislation

Episode Date: July 13, 2023

Last year the Lummis-Gillibrand Responsible Financial Innovation Act set the template for comprehensive crypto legislation. Now, the act has been reintroduced but there are some changes the community doesn't love. Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribeto the newsletter: https://breakdown.beehiiv.com/ Join the discussion: https://discord.gg/VrKRrfKCz8 Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. What's going on, guys? It is Thursday, July 13th, and today we are talking about the return of some of the most significant crypto legislation from last year. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod.

All right, a quick note before we dive in. This show was all prepped and ready for today. I was about to press record when the news dropped that Alex Machinsky of Celsius had been arrested, alongside being sued by the CFTC and the SEC, but the more significant part is that he had been arrested. This is obviously a huge bit of news. After Sam from FTX and Doquan from Terraluna, Machinsky was probably the person from the 2022 crop of crypto failures

that most had a target on his back from the crypto community. As you listen to this, people are ripping through court documents to see what they can learn. And so tomorrow, of course, we will have a full workup of everything that comes out of that. But for today, we are going to be digging into the reintroduction of the most significant crypto legislation proposed last year. And in many ways, the most significant crypto legislation write up until this year's McHenry Thompson Act. Yesterday, Senator Cynthia Lemmiss of Wyoming wrote, The crypto asset industry is here to stay. Today, Senator Gillibrand and I are reintroducing

landmark legislation to create a federal regulatory framework that allows crypto businesses and investors to prosper here in America while protecting consumers from bad actors. The Bipartisan Responsible Financial Innovation Act was first introduced last June. At the time, it represented a coming together between the two parties in recognition that the crypto industry required new legislation to govern its operation and define clear rules. One of the things that I noted back when this was first introduced was that it didn't shirk away from some of the most complicated issues. Notably, it ran headlong at the question of whether a crypto asset is a security or a commodity, or indeed how it transitions between those two states. And given that potential transition, who should

have regulatory authority over it? Unfortunately, of course, that legislation didn't really. go anywhere last year. And subsequent to that bill being introduced, a lot has happened. The biggest thing is, of course, the collapse of FTCS. The response of many Democrats to that collapse has been that they have been unwilling to deal with crypto legislation in any form. The idea that they've latched onto is that introducing a regulatory framework would grant the industry an error of legitimacy that it does not deserve. However, at the same time, in that same period, we saw the Republicans take control of the House along with the House committees that consider crypto legislation. Since his appointment as chair of the House Financial

Services Committee, Patrick McHenry has pushed forward with multiple pieces of crypto legislation. He's taken up the task of designing functional standalone stable coin legislation, as well as drafting his own comprehensive market structure bill in coordination with Glenn Thompson, his counterpart of the House Financial Services Committee. The McHenry-Thompson bill takes a very different approach to some of the key issues addressed in the Lumas-Gillibrand bill, which means that we now have two competing pieces of legislation with contrasting approaches. Given how much the political discourse from here is likely to be about the difference between those two approaches, let's dig into the contents of the revamped and reintroduced Lumas-Gillibrand

bill. First, how to handle crypto assets. It remains the case that the major question hanging over crypto from a regulatory standpoint is whether tokens should be classified as securities or commodities, or some new thing entirely, or something that transitions between them. The updated Responsible Financial Innovation Act deals with this in a fairly straightforward way. Tokens are securities if they grant the owner's rights over a business entity, including a right to debt repayments or a share of cash flows. If a token doesn't represent any underlying rights to a business entity, then it's considered a commodity. The bill also makes it clear that most tokens are issued via an initial investment contract with an investor, which is governed by

securities law. The tokens which are issued are referred to as ancillary assets and are presumed to be commodities considered separate from the original investment contract. This issue has, of course, been at the heart of every token lawsuit, so it would be an important point of clarity around how the Howie test should be applied to cryptocurrency issuance. In terms of how this fits with other precedent and legal matters happening right now, the Lumas Gillibrand bill goes against the argument being put forward by the SEC in the Coinbase lawsuit, but is fairly aligned with the recent court decision in the LBRY case. Now, the approach in this bill is fundamentally different and much less complicated than the approach taken in the McHenry-Thompson bill. That bill has this sort of

transitional state that I was mentioning a moment ago, in which tokens are to be considered securities upon issuance, but able to reach a certain threshold of decentralization, which would then allow those tokens to be considered commodities at a later date. Now, without having had a ton of time to spend on the details, it strikes me that the McHenry-Thompson approach to this is actually a little bit closer to the original Lumas Gillibrand approach as compared to where they landed this time. Now, one of the reasons this matters so much is that the differing approach would change which regulator has primary authority over crypto markets. If it's all about securities, obviously we have the SECC. If tokens are considered commodities, it's the CFTC. And that, of course,

gets us to regulatory authority. When it comes to oversight of the industry, Lumas Gillibrand would introduce a self-regulatory organization or SRO. These sort of entities are already in use in other parts of the financial services industry. Finra regulates intermediaries and securities markets, and the National Futures Association plays the same role in derivatives markets. This bill establishes an association of crypto asset intermediaries with the power to set rule around customer protection and market integrity. Applications for membership of this organization would be decided by a 13-person committee, including a representative from both the SECC and the CFTC, as well as a representative from the Financial Crimes Enforcement Network FinC,

four presidential appointees, and six representatives from the industry. This structure would give industry some say over membership to the self-regulatory organization, but ultimately leave the deciding power in the hands of government representatives. Now, this idea of an SRO of a self-regulatory organization has been the topic of heated dispute in Washington and splashed across the op-ed pages written by former regulators. The proponents of an industry influenced organization with the authority to set the rules for its members have said this structure would allow the rulebook to be written much faster. They also suggest that this kind of body would be more likely to understand the key issues that need to be addressed and the technical quirks and limitations of the industry. Opponents have, of course,

been primarily concerned that the crypto industry has shown itself to be pretty incapable of self-governance, and so it might require independent oversight to go forward. Again, if we're contrasting the McHenry-Thompson bill, that bill doesn't establish an SRO, but instead just divides authority based on when tokens are securities or when tokens are considered commodities. Next up, the bill contains a significant list of hard and fast rules around what intermediaries like custodians and exchanges can do with customer assets. This is obviously meant to address major issues of investor protection and market integrity that have dogged the industry in the recent years.

One thing that many were excited to see is that proof of reserve audits are written into the bill as a mandatory requirement for all intermediaries. Given how many of the recent corporate failures were made worse by a lack of transparency around reserves, this is something that a lot of people in the industry support. What's more, it's something that's actively showing up in other legislation. Bermuda, Canada, Dubai, and Singapore have all recently issued rules or legislation around the issue, while Texas and Wyoming have both added proof-of-reserve requirements into state legislation in the past few years. Reserves would need to undergo regular financial audits by accredited firms, but of course,

one of the issues with proof-of-reserves has been the lack of codified accounting standards. This has led major accounting firms to refuse to provide proof-of-reserve audits, as well as leaving exchanges to largely decide their own methodology. And given the fact that we have people like Elizabeth Warren writing open letters to people who do proof of reserves, it's not hard to understand why those accounting firms are a little bit gun-shy. This bill would require the public company accounting oversight board to establish standard procedures for proof-of-reserve audits. This would mean hopefully that accounting firms could provide the service in a consistent and clear manner and without that political risk. Crypto lending is addressed extensively. Intermediaries

would be prohibited from re-hypothicating customer assets, restricting firms from using their clients' assets as collateral like we saw so many times in the recent spate of bankruptcies. Lending arrangements are allowed, but subject to common-sense requirements on customer disclosures, consent, and risk management. Crypto intermediaries would also be required to make fairly extensive disclosures around how assets will be treated in bankruptcy, as well as around service fees and customer expectations around withdrawals. CEOs would be required to attest that those disclosures were properly made and would face a criminal penalty attached to any misrepresentations or inaccuracies.

The bill also beefs up the criminal penalties for money laundering offenses related to crypto, increasing the penalty to up to five years in prison. Now, one thing the McHenry-Thompson bill didn't really consider, but which the Lummis-Gillibrand bill does at length is crypto taxation. This is a huge issue, how are airdrops, mining, wash-trading, all these aspects that are common in the industry to be handled under the tax code. With the Lummustillabrand bill, trading would be taxed as capital gains income rather than regular income in the same way as commodities in stock trading. Token sales with a capital gain below $200

aren't taxed, which is a nod to the idea that cryptocurrency should be allowed to be used in everyday transactions without requiring onerous tax accounting for small fluctuations in price. Airdrops are taxed as regular income, but only if some affirmative steps have been taken to claim a token. The goal here would be to put an end to some types of dust attacks. Both airdrops and mining are only taxed when tokens are sold, ensuring that an unpayable tax burden doesn't accrue in the meantime. Wash trading would be subject to the same taxation treatment as applied in the stock market. Now, somehow, the taxation of wash sales has been put forward as a big deal by Democrats. Back in May, during the debt-sealing dispute, you'll remember that President Biden referred to

closing this loophole as having the potential to raise $18 billion in tax revenue. This bill would apportioned that additional tax funding to financial regulators to assist with the cost of bringing the crypto industry into their jurisdiction. Now, this bill is nearly 300 pages long, so obviously I'm not going to be able to get into everything, but touching on a few more topics briefly. When it comes to stablecoins, the bill would require that stablecoins are issued only by banks or credit unions and regulated on either a state or federal level. That said, existing and prospective stable coin issuers would be allowed to obtain licensing under a new type of banking charter that limits their activity to operating a stable coin. It seems to me that the goal here

is to have bank-level regulation and oversight, but to not explicitly prohibit either the existing players, presumably like a circle, or newer players, from having a path to actually be regulated in that way. A special purpose charter that's just for stablecoin seems like potentially an elegant solution to that problem. The defy parts of the bill are probably expectedly pretty murky. Trying to sum up what's there briefly, although this isn't really doing it justice, the bill would roughly require decentralized exchanges to operate under the same set of risk controls as their centralized counterparts. But this all gets us to one of the most noteworthy changes in the revised bill. And this is why it's important to read things in depth. A section from the original

bill, Section 505, was removed. That section had guaranteed the right to individual management of digital assets. It ensured that, quote, no person shall be required to use an intermediary for the safekeeping of digital assets. The revised bill instead would require the SRO to establish rules for self-hosted wallets around money laundering, customer identification, and sanctions compliance. Exchanges would be required to ensure that all of the customer self-hosted wallets they transact with comply with these requirements. Now, this has definitely gotten the most attention of any part of the bill so far. Law professor J.W. Verrett writes, this bill targets self-hosted wallets and requires they implement KYC if they want to accept Bitcoin from a crypto exchange registered with the

CFTC. And another thing, this bill cuts and pace from the Chainalysis drafted Financial Technology Act. That is a clever pseudonym for creating an anti-privacy committee of law enforcement agencies toward a ban on crypto privacy coins and privacy tech. Dave Weisberger, the CEO of Coin Routes, responded to that tweet, no offense, but how is that different from every institution including banks, brokers, and even casinos, requiring KYC to withdraw cash? Once individuals have cash, they can transact privately. If the bill allows subsequent peer-to-peer transactions, what is different? Verrett responds, imposes a K-Y-C obligation on the wallet, not the financial intermediary. That is a world of difference.

And this is really the point, the TLDR here, is that exchanges can't interact with self-hosted wallets that aren't KYC. Full stop. Verrett summed up his feelings when he wrote, Hard know on this bill from Cynthia Lummis and Senator Gillibrand. It's anti-privacy and anti-self-custody. goes against core values and foundations of crypto, betrayal of the crypto community. No other way to describe it. Now, I think as we start to dig into the debate around this act, and as we start to try to reconcile it with the McHenry-Thompson bill, this is going to be one of the biggest issues. To the extent that there's good news, this was always going to be one of the biggest issues. There isn't a good solution or an elegant solution built into this bill, certainly. But it doesn't mean that we can't get there. It sounds silly,

but at least they're not using the language of unhosted wallet, which historically the opponents of crypto have. Now, when it comes to the politics of this, it's pretty interesting. Lois Gillibrand has the benefit that it's coming from the Senate, but McHenry Thompson has the benefit that it's coming from two committee chairs. It is a very rare thing for those two committee chairs, one that oversees the SEC, and one that oversees the CFTC, to come together on that type of landmark legislation. One of the ways to read this then is that Senators Lummiss and Gillibrand and the people who contributed to this bill want to use it as a way to have their voice included as whatever the combined bill ultimately becomes. The most encouraging thing for those of you who are trying to keep score out there

is that when this bill was introduced last year, it was introduced mostly as a way to start conversations. It wasn't that Senators Lummiss and Gillibrand weren't sincere in their efforts, far from that. There just wasn't really a window yet to get this as a legislative priority. Now, it is a legislative priority, both because of the shift to Republican leadership in Congress, but also as a negative reaction to everything that happened after the bill was introduced. That means this time, when we're debating these issues, they actually have a chance of finding their way into a revised version of this thing, that one day actually could see a vote and even become law.

I think it's good for people in the community to call out every single little detail that they find abhorrent, because there are going to be many. We've only noticed this first one around self-hosted wallets, but I guarantee there is more in this bill in these 274 pages that we're going to have issues with, but at least we now get to have the conversation. Until next time, be safe and take care of each other. Peace.