Summary

On June 7, Senators Cynthia Lummis (R-WY) and Kirsten Gillibrand (D-NY) introduced S. 4356, the Responsible Financial Innovation Act (Lummis-Gillibrand Bill).[1] If enacted, the legislation would create a regulatory framework for federal oversight of digital assets. In a jointly authored blog post published in conjunction with the introduced bill, Senators Lummis and Gillibrand warned that continued consumer adoption of digital assets in an unregulated market creates significant risk of financial harm to market participants and predicted that absent adequate regulatory oversight, U.S.-based digital asset innovation will languish. The bill’s main goals include protecting consumers and encouraging innovation, which the draft seeks to accomplish by developing clear standards and defining clearer jurisdictional boundaries among regulators.[2]

Key Takeaways

If enacted into law, recent crypto-focused legislation introduced by Senators Cynthia Lummis and Kirsten Gillibrand would:

• Provide a comprehensive regulatory structure for digital assets, differentiating between digital assets that are securities and those that are commodities.
• Provide the Commodity Futures Trading Commission (CFTC) with new oversight of digital assets that qualify as commodities and digital asset spot markets.
• Create a new asset regulated by the Securities and Exchange Commission (SEC), termed “ancillary assets,” the existence of which would trigger biannual SEC disclosures.
• Provide uniform definitions of native cryptocurrency and blockchain ecosystem terms, including “digital asset,” “virtual currency,” “smart contract” and “decentralized autonomous organization.” The proposed definition of “virtual asset” includes algorithmic and crypto-backed stablecoins but not stablecoins backed by real-world assets or fiat, which qualify instead as “payment stablecoins.”
• Address digital assets’ environmental impact and critics’ comments that proof-of-work mining (e.g., Bitcoin mining) is a significant contributor to climate change due to its energy consumption. Rather than regulate the industry, however, the bill calls for studies to explore the environmental impact of digital assets and the role of renewables in its ecosystem.
• Require stablecoin issuers to keep 100 percent reserves and to provide detailed disclosures. An optional framework would be created to facilitate payment stablecoin issuance by banks and credit unions.
• Clarify U.S. federal income tax treatment of virtual currency and digital assets and modify the recently enacted digital asset broker information reporting rules.

Proposal for a Defined Regulatory Landscape in the Crypto Ecosystem

The bill would amend United States Code Title 31 by providing definitions for numerous terms native to the cryptocurrency ecosystem. The definitions operate as ground rules that unify the proposed statutory updates, which span multiple bodies of law. While not declared, many of the terms selected for definition (e.g., “digital currency,” “virtual currency”) appear to suggest more unification is needed among regulatory stakeholders regarding how to define certain terms that are foundational to the digital asset ecosystem, since such definitions operate as initial thresholds for determining whether a given activity may be subject to regulation and enforcement.

For example, “digital asset” is defined by the bill as “a natively electronic asset” that “confers economic, proprietary, or access rights or powers” and “is recorded using cryptographically secured distributed ledger technology, or any similar analogue.”[3] This proposed definition only loosely tracks the definition included in President Joe Biden’s 2022 Executive Order on Ensuring Responsible Development of Digital Assets, which defines the term in relevant part as “representations of value” used to make payments or investments or to transmit funds that are “issued or represented in digital form through the use of distributed ledger technology.”[4]

Under the bill, “digital asset” is cross-referenced through proposed amendments to the Internal Revenue Code (Code) and the Commodity Exchange Act and would replace the definition of “digital asset” currently provided in Section 6045(g)(3)(B) of the Code (as modified by the Infrastructure Investment and Jobs Act of 2021 (Infrastructure Act)).[5] The legislation’s proposed amendments to the U.S. securities laws do not reference “digital asset” but create a new term, “ancillary asset,” which means “an intangible, fungible asset” that is offered or sold through an investment contract but excludes “an asset that provides the holder of the asset with any of the following rights in a business entity: (i) A debt or equity interest in that entity[;] (ii) Liquidation rights with respect to that entity[;] (iii) An entitlement to an interest or dividend payment from that entity[;] (iv) A profit or revenue share in that entity derived solely from the entrepreneurial or managerial efforts of others[;] (v) Any other financial interest in that entity.”[6] An investment contract is a type of security and is defined by the Howey test.[7] Under certain circumstances, the issuer of ancillary assets is subject to periodic disclosure requirements. The proposed bill appears to limit the types of digital assets that would be regarded as securities; require light disclosure requirements for digital assets that currently may require full registration or must be offered and sold pursuant to an exemption to registration; and provide a path for digital assets to qualify as non-securities.

The bill also defines “virtual currency,” which has been defined inconsistently across regulatory agencies. The Financial Crimes Enforcement Network (FinCEN) guidance defines “virtual currency” as “a medium of exchange that can operate like currency but does not have all the attributes of ‘real’ currency.”[8] The definition promulgated by both IRS and CFTC guidance is similar but slightly different, with “virtual currency” meaning a “digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value” that does not have legal tender status in the U.S.[9]

The bill expands definitions of “virtual currency” provided by IRS and CFTC guidance to clarify that virtual currency “does not derive value from” and is not “backed by an underlying financial asset (except other digital assets)” and includes digital assets that are “accompanied by a statement from the issuer that a denominated or pegged value will be maintained and be available upon redemption from the issuer or other identified person, based solely on a smart contract.”[10] Thus, under the bill, algorithmic and crypto-backed stablecoins would qualify as virtual currency while stablecoins backed by real-world assets or fiat would qualify instead as payment stablecoins.[11] Further, to qualify as a virtual currency under the bill, a digital asset must be “used primarily” as a medium of exchange, unit of account and/or store of value, which the IRS and CFTC guidance does not require.[12] Other defined terms in the proposed bill include “digital asset intermediary,” “distributed ledger technology,” “smart contract” and “decentralized autonomous organization.”[13]

Notable Provisions from the Responsible Financial Innovation Act

Other notable provisions included in the legislation seek to accomplish the following objectives:

Clarify when digital assets are securities or commodities. The bill creates statutory standards for determining which digital assets are commodities and which are securities by looking at (1) the purpose of the asset and (2) the rights or powers it conveys to consumers. This would provide regulators with a clear path to enforcement, and crypto-industry participants craving certainty about whether their activities are compliant with one or more U.S.-based legal and regulatory frameworks would benefit from more clarity concerning digital asset classification standards.[14] How the legislation, if enacted, would comport with the SEC’s recent ramp-up in crypto-enforcement by nearly doubling its crypto assets cyber unit staff is unclear.

Grant the CFTC specific oversight of certain digital assets and related markets. If enacted, the bill provides the CFTC with oversight of (1) digital assets that qualify as commodities and (2) certain digital asset spot markets. The senators’ joint press release accompanying the legislation noted that “most digital assets” are more similar to commodities than securities and that both bitcoin and ether are commodities.[15]

Regulate stablecoin issuers. Under this bill, stablecoin issuers would be required to keep 100 percent reserves and to provide detailed disclosures. An optional framework would be created to facilitate payment stablecoin issuance by banks and credit unions, but the legislation would not require all payment stablecoin issuers to become depository institutions.[16]

Create and implement an advisory board. The bill creates an advisory board to be comprised of experts in consumer protection and education and financial inclusion and literacy. The board’s objective would be to ideate recommendations based on industry changes to ensure regulatory frameworks formed by the proposed bill remain effective and relevant.[17]

Mandate a digital asset energy consumption study. The proposed bill requires annual review and analysis of the amount and impact of energy consumed by blockchain or comparable technologies, including the impact of energy-intensive activities such as mining and staking.[18]

Mandate creation of a digital asset self-regulatory agency by the CFTC and SEC. Within six months of the bill passing, the CFTC and the SEC would be required to collaborate with digital asset intermediaries and certain standard-setting associations to launch a study and issue a report to certain committees “setting forth principles for self-regulation for digital asset markets and a proposal for the establishment of a self-regulatory organization for digital asset markets.”[19]

Direct certain agencies to collaboratively develop rules-based cybersecurity guidance related to digital asset intermediaries. This provision of the bill requires the SEC and CFTC to consult with the Treasury and the National Institute of Standards and Technology to engage in a study of risks concerning digital assets and money laundering, sanctions avoidance and terrorist financing, and to develop rules around auditing and penetration testing, cybersecurity standards, security operations, and threat identification and mitigation.[20]

Facilitate regulatory sandbox. The bill enables state and federal regulators to innovate with financial technology companies to encourage market entry of unique and innovative financial technology services and products.[21]

Implement de minimus tax exclusion. Currently, taxpayers are required to recognize gain or loss each time they use a virtual currency to pay for a good or service. The bill would create a de minimus exclusion from gross income of up to $200 (per transaction) when virtual currency is used by taxpayers to pay for goods or services.[22]

Modifications to digital assets and broker rules. The Infrastructure Act expanded the information reporting rules that apply to brokers of traditional financial assets (i.e., stock, debt, commodities etc.) to brokers of digital assets and modified the definition of “broker” to include “any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.”[23] The proposed bill narrows this definition of “broker” to mean “any person who (for consideration) stands ready in the ordinary course of a trade or business to effect sales of digital assets at the direction of their customers.” The amended definition is intended (in part) to protect miners and validators from being considered brokers for purposes of the tax information reporting rules. The bill also delays the implementation date of the tax information reporting rules for digital asset brokers to Jan. 1, 2025.[24]

Trading safe harbors. Current law provides safe harbors for certain non-U.S. persons who trade securities or commodities through a U.S.-based broker or commission agent or who are trading on their own account from being considered to be engaged in a U.S. trade or business.[25] The bill would extend these safe harbors to non-U.S. persons who use a U.S. financial institution to conduct digital asset trading activities.[26]

Digital asset lending. The bill would treat digital asset lending transactions similar to securities lending transactions by providing that a digital asset lending transaction is generally not a taxable event.[27]

Mining and staking. The bill provides that digital assets obtained from mining or staking activities are not included in a taxpayer’s gross income when received. Instead, income is recognized when the reward is disposed of.[28]

Mandate a risk/benefit analysis of digital asset and retirement investment accounts. This bill would require the U.S. comptroller general to launch a study and draft a corresponding report concerning digital asset investing through retirement accounts.[29]

Mandate a security study on China’s digital yuan. Under this bill, the Office of Management and Budget, in conjunction with the Cybersecurity and Infrastructure Security Agency, the director of National Intelligence, and the secretary of Defense, would be required to develop adequate security measures and processes and procedures for use by executive agencies that may use the digital yuan on government devices.[30]

Conclusion

The Lummis-Gillibrand Bill is the most comprehensive digital asset-focused bill to be proposed in the U.S. and has garnered support across the digital asset ecosystem, including from major trade and policy associates and most major U.S. cryptocurrency exchanges. Consumer and investor advocates, however, do not concur.[31]

The legislation is unlikely to advance in Congress this year. Instead, its supporters will try to leverage the congressional calendar to educate lawmakers on the underlying policy, gain support from external stakeholders and build a foundation for future legislative action.

The introduction of the Lummis-Gillibrand Bill is the beginning of a legislative conversation about federal digital asset policy. For those seeking legal certainty about the regulation, jurisdiction and treatment of digital assets, the Lummis-Gillibrand Bill is an opening salvo. Members of Congress, the Biden administration, regulators and stakeholders will all have a say in the final product.

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