Why the United States is behind the world in clarifying the regulatory status of digital assets and digital asset custodians

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If it is curious that Germany finds itself ahead of Switzerland and Luxembourg, it is even more curious that it finds itself ahead of the United States. Indeed, the first issue of the Digital Asset Custody Guide (DACG) argued that the United States sets the parameters for institutional custody around the world by virtue of weight of money and longstanding legislative prescriptions embodied in laws such as the Employee Retirement Income Security Act of 1974 (ERISA) and the Investment Company Act of 1940. (1) So it is all the more puzzling that, in the case of digital assets, the United States is a conspicuous laggard.

In most major financial jurisdictions around the world – France, Germany, Japan, Luxembourg, Singapore, Switzerland, the United Kingdom – governments have taken and are taking steps to regulate and domesticate all forms of cryptographic financial instruments, from cryptocurrencies to security tokens. The collapse of FTX, itself the culmination of a series of unfortunate events in the cryptocurrency and algorithmic Stablecoin markets, has accelerated this regulatory work.

Yet the United States, where FTX originated, is the major exception. Superficially, it is hard to explain. The country is host to almost all the leading forces in digital technology, from blockchain, through artificial intelligence (AI) and Machine Learning (ML), to quantum computing. By most measures of progress in blockchain-based developments, including cryptocurrencies and Stablecoins, the United States is a market leader. Yet progress in law and regulation has stalled.

This is partly a function of the way the United States regulatory system works. It has multiple, competing financial regulators, in the shape of the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), the Financial Industry Regulatory Authority (FINRA), the Office of the Comptroller of the Currency (OCC), the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC) and the Consumer Financial Protection Bureau (CFPB). Then there are dozens of separate financial services regulators in every State, of which the New York Department of Financial Services (NYDFS) has the highest profile.

The regulatory culture – like American culture in general – is also highly litigious. As a result, progress is ensnared in slow-moving court processes. The SEC case against Ripple and Ripple executives for allegedly raising money through the sale of an unregistered security in the form of its XRP token, for example, continued for three years before being partially settled. Legal uncertainty continues, with the partial settlement now being challenged in the courts.

Indeed, 14 leading cryptocurrency businesses have, in conjunction with a law firm, created a Crypto Rating Council that has developed a decision tree methodology to review particular digital assets to assess whether they exhibit the characteristics that make it likely the assets will be classified as a security under the federal securities laws of the United States, and under the Howey and Reves Tests in particular. (2) It is an apt measure of the continuing uncertainty.

The Biden administration has in fact brought a noticeably less laisser-faire approach to cryptocurrency and digital asset market issues than its predecessor. The Executive Order on Ensuring Responsible Development of Digital Assets (EO-14067) of 9 March 2022, spawned a string of detailed reports discussing the pros and cons of digital money and digital assets from multiple arms of government – the Treasury, State, Justice and Commerce departments all contributed – as well as the main federal regulatory agencies. Their findings and advice are not yet being translated into law.

Even if they were, the United States is intrinsically slow to agree and pass legislation because it is hard to pass new laws in the United States at all. A bias against legislative solutions to new problems is built into the Constitution, whose framers were distrustful of central government. This structural obstacle is exacerbated in current circumstances by the partisan spirit of American politics and of course by time itself. There is a spatio-temporal limit to how many laws can be processed through the Congressional system (see Box 6).

Box 6: Why it is so hard to pass digital asset legislation through the United States Congress

One reason the United States is lagging other jurisdictions in fostering the digital assets markets is the absence of supportive legislation. This is not by commission or omission. It simply reflects the fact that securing the passage of legislation through the US Congress is extremely difficult – and difficult by design, not accident. 

The architects of the United States Constitution intended to make it difficult to pass laws, to discourage government overreach. In the modern era, the limited amount of time available to agree and pass legislation, especially on top of the recurring workload of both chambers of Congress, makes it challenging to get priority for any piece of legislation.

A basic difficulty is that any Bill has to be passed by both chambers of Congress - the House of Representatives and the Senate - before going to the President to be signed into law, or returned to Congress for further consideration. 

An implication is that neither chamber of Congress can accomplish anything by itself. Either the House or the Senate can pass a Bill, but the other chamber can decline to take it up. On occasion a Bill may be passed by one chamber and approved without amendment by the other (though such agreements usually follow some form of discussion).

While it is not typical, the House of Representatives treatment of Obamacare illustrates what can happen. Between 2011 and 2017 the House voted to repeal all or parts of Obamacare 54 times. The last occasion was the only time in which there was a possibility the Senate would concur with the House decision – and it did not.

If the chambers pass competing Bills or one chamber amends a Bill significantly, Congress then enters a process called Reconciliation. Reconciliation involves teams from both Chambers trying to create a Bill acceptable to both Chambers. If the differences are too large the Bill will be dropped. But the creation of a reconciled Bill does not guarantee passage as each Chamber still has to approve it and Reconciliation negotiators do not always judge correctly what is acceptable to their members.

Historically, this is less of a problem in the House of Representatives, which affords individual members much less power than an individual Senator can acquire and hold. The House traditionally gives the leadership much more control. Votes all require a simple majority. Traditionally, party discipline in the House has been strong though currently this is clearly not the case for the Republicans. 

The Senate, by contrast, affords individual Senators much more autonomy. A complex web of rules and procedures also allows individual Senators to stop business. For example, a single Senator has blocked all promotions in the United States military for more than nine months.

But the greater autonomy of individuals in the Senate also reflects the fact that the 100 Senators enjoy six-year terms and represent an entire State, making them less vulnerable to primary challenges in smaller constituencies. The 435 members of the House of Representatives, by contrast, are considered for reelection every even year - that is to say, every two years. 

In both chambers, legislation is produced by the relevant committee (though jurisdiction between the various commit-tees can be a matter of contention). In the House, appointments to committees are more in the gift of the leadership. Seniority is a major factor in Senate Committees in a way that is not true in the House. Each committee has the capacity to pass a limited amount of legislation only and any proposal must fight for priority in the timetable. 

While the Chairman of a House committee has considerable control over what issues are considered for legislation it is much less absolute than in the Senate. Appointments to Senate committees are less under leadership control and, once on a committee, a Senator is hard to dislodge. Seniority on the committee tends to dictate leadership of Senate commit-tees too, and the chair of a Senate committee has almost total control over what the committee will or will not take up. If there is a topic the Chairman objects to, there is little other legislators can do.

Sherrod Brown (a Democratic senator from Ohio), as Chairman of the Senate, controls whether there will be any legisla-tion governing digital assets originating in the Senate. It is fair to say that Senator Brown is not known to take a particu-larly positive view of cryptocurrencies. 

For the digital assets industry, the House of Representatives Financial Services Committee, traditionally the major source of financial services legislation, is much more enthusiastic. It has produced draft Stablecoins legislation and the outlines of more general “crypto-asset” legislation. 

However, Senator Brown represents a formidable obstacle to progress. The best-known proponents of digital assets in the Senate are Kirsten Gillibrand (a junior Democratic Senator from New York who is on the Committee on Agriculture, Nutrition and Forestry but not the crucial Commodities sub-committee) and Cynthia Lummis (a junior Republican Sena-tor from Wyoming who is on the Banking, Housing and Urban Affairs Committee). They carry little weight in this political calculus.

So the fact that the House Financial Services Committee has agreed digital asset legislation is of limited relevance until a more general consensus in favour emerges across both chambers and the President supports a particular course of action. At that point, Senator Brown would likely facilitate legislation.  But for the time being the attitude of Senator Brown means there is minimal prospect of any digital asset legislation emerging from the Senate prior to the November 2024 elections.

The power structures in Congress create other obstacles to progress. The House Financial Services Committee and the Senate Committee on Banking, Housing, and Urban Affairs, for example, have oversight of the Securities and Exchange Commission (SEC). But supervision of the Commodity Futures Trading Commission (CFTC) resides with the House Agriculture Committee and the Senate Committee on Agriculture, Nutrition and Forestry (a relic of the historic role of agriculture in developing the futures markets). 

As a result, turf wars between Congressional committees reflect and reinforce turf wars between regulators. Digital assets have further exacerbated these rivalries. Most prominently, there is fierce contention over whether specific cryp-tocurrencies or tokens should be treated as securities (the SEC view) or as commodities (the CFTC view). 

It would be misleading to describe the passage of legislation through the United States Congress as a lottery, but it is difficult to get legislation passed. So many pieces must fall into place at a time when there is room in the legislative cal-endar. It takes the most fortuitous coincidences of time, interest and opportunity to get a particular piece of legislation onto the statute book.

The time limit alone makes it a safe bet that no new laws affecting the cryptocurrency and digital asset markets will be agreed, passed and signed into law prior to the results of the 2024 Congressional elections (in which 33 Senate seats and all 435 seats in the House of Representatives are up for election) that will accompany the Presidential Election. A new Congress will not even start work until January 2025.

However, even if new laws are on hold until after the 2024 elections, regulators have scope to act. Indeed, they sometimes view the looming expiry of a Presidential administration as an opportunity to press ahead with innovations and ideas they favour. The decision by the previous leadership of the OCC in late 2020 and early 2021 to grant actual and conditional national trust bank licences to firms custodying cryptocurrencies is a case in point.

So an important question now is the attitude of the incumbent leaders of the two main federal regulators. In the case of both the SEC and the OCC, the leadership is unenthusiastic about rapid adaptation of the regulatory environment to cryptocurrencies and digital assets, indicating that the current broadly negative approach will persist and regulated entities will as consequence proceed cautiously.

Gary Gensler, a former chairman of the CFTC who was appointed chairman of the SEC in April 2021, has pursued an aggressive policy to bring cryptocurrencies and digital assets within the remit of existing regulatory arrangements, including enforcement and court actions. (3) This has dismayed progressive opinion in the securities industry. Regulated custodian banks are far from immune to the consequences of SEC decision-making - custody of securities is, after all, regulated by the SEC - but it is the attitude of officials at the principal regulator of the banking industry that has mattered more, because its decisions affect the cost of capital.

The OCC, which is charged with chartering and regulating national banks, and monitoring their compliance with existing laws and regulations, has been led since May 2021 by Michael J. Hsu as Acting Comptroller of the Currency. Although his authority was mitigated by his status as “acting” head – a role in which he has continued since Cornell Law School Professor Saule Omarova was forced to withdraw her nomination as Head after hostile Senate hearings in November 2021 – Hsu has played a visible role in the reversal of the OCC policy of licensing digital asset custodians. (4)

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(1) See Future of Finance, Digital Asset Custody Guide: The Future Looks Like the Past, Issue 1, pages 22-24.

(2) See https://www.cryptoratingcouncil.com/asset-ratings

(3) See “What is the SEC doing?” in Future of Finance, Digital Asset Custody Guide: The Future Looks Like the Past, Issue 1, pages 24-25.

(4) The OCC approved the application of Anchorage Digital Bank to establish a national trust bank in April 2022 and gave both Paxos (in April 2021) and Protego Trust Company (also in 2021) conditional approval to do the same, but both applications were allowed to lapse in in March and February 2023 respectively. See Future of Finance, Digital Asset Custody Guide: The Future Looks Like the Past, Issue 1, page 26.