Current Developments in Digital Assets: January 12, 2021

Practical Law Legal Update w-029-1817 (Approx. 10 pages)

Current Developments in Digital Assets: January 12, 2021

by Practical Law Finance

OCC Clarifies Authority of Banks to Use Stablecoins to Conduct Payment Activities and Other Banking Functions

On January 4, 2021, the Office of the Comptroller of the Currency (OCC) published Interpretive Letter 1174, clarifying the authority of national banks and federal savings associations (FSAs) to participate in independent node verification networks (INVN) and use stablecoins to conduct payment activities and other bank-permissible functions. The letter is intended to remove any legal uncertainty about the authority of banks to connect to blockchains as validator nodes and thereby transact stablecoin payments on behalf of customers.

The letter states that a national bank or federal savings association may validate, store, and record payments transactions by serving as a node on an INVN. Likewise, a bank may use INVNs and related stablecoins to carry out other permissible payment activities. The OCC notes that in deploying these technologies, a bank must comply with applicable law and safe, sound, and fair banking practices. For further information, see Legal Update, OCC Clarifies Authority of Banks to Use Stablecoins to Conduct Payment Activities and Other Banking Functions.

OFAC Settles with BitGo in First Ever Digital Asset Enforcement Action

On December 30, 2020, the US Office of Foreign Assets Control (OFAC) issued an enforcement release announcing that BitGo, Inc., a technology company based in Palo Alto, CA, which implements security and scalability platforms for digital assets and offers non-custodial secure digital wallet management services, has agreed to remit $98,830 to settle its potential civil liability for 183 apparent violations of multiple sanctions programs.

According to OFAC, as a result of deficiencies related to BitGo’s sanctions compliance procedures, BitGo failed to prevent persons located in the Crimea region of Ukraine, Cuba, Iran, Sudan, and Syria from using its non-custodial secure digital wallet management service and had reason to know that these users were located in sanctioned jurisdictions based on Internet Protocol (IP) address data associated with devices used to log into the BitGo platform. According to OFAC, at the time of the transactions, BitGo had failed to implement controls designed to prevent such users from accessing its services. OFAC also determined that BitGo did not voluntarily self-disclose the apparent violations.

NYDFS Grants Trust Charter Enabling GMO-Z.com to Issue Japanese Yen- and US Dollar-Pegged Stablecoins in New York State

On December 29, 2020, NYDFS Superintendent of Financial Services Linda Lacewell announced that the New York State Department of Financial Services (NYDFS) granted a charter under New York Banking Law to GMO-Z.com Trust Company Inc., to operate as a limited liability trust company. With DFS approval, GMO is authorized to issue, administer, and redeem Japanese Yen and US Dollar-pegged stablecoins in New York. The Japanese Yen stablecoin will be the first of its kind available to the public. Including the charter granted to GMO, to date DFS has approved 27 charters and licenses for companies engaged in virtual currency business activity. Additional information regarding DFS’s regulation of New York’s virtual currency marketplace can be found on the DFS website.

SEC Issues Cease-and-Desist Order Against Blockchain Developer Tierion, Inc., for Unregistered Securities Offering

On December 23, 2020, the SEC issued a cease-and-desist order under Section 8A of the Securities Act of 1933 (Securities Act) against Tierion, Inc., a startup blockchain technology company then based in California. According to the order, Tierion raised approximately $25 million by selling 350 million digital tokens (Tierion Network Tokens or TNT) via a token sale in July 2017. Tierion and its promoters told investors that Tierion would continue its development of the Tierion network, a distributed network that allowed users to create blockchain receipts using Tierion’s existing technology protocol, Chainpoint, to verify the existence and integrity of digital data, checked against a contemporaneous recording on the Bitcoin blockchain, as well as other applications to be developed in the future.

According to the order, Tierion told investors that it planned that TNT would be used as a medium of exchange to access Chainpoint and in those future applications. In promoting its Token Sale, Tierion touted its founders’ and early investors’ backgrounds and experience in the blockchain industry, and publicized its past history of partnerships with prominent companies. Tierion took steps to ensure that TNT would be made available to trade on secondary markets, and touted TNT to digital asset enthusiasts and other members of the general public.

Accordingly, the SEC concluded that Tierion sold as investment contracts, and therefore securities, under SEC v. W.J. Howey Co., 328 U.S. 293 (1946) and its progeny, including the cases discussed by the SEC in its Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (Exchange Act Rel. No. 81207) (July 25, 2017) – the DAO report.

In the SEC's view, a purchaser in the Tierion token sale would have had a reasonable expectation of obtaining a future profit based on Tierion’s statements that it would use the funds raised to continue to develop the Tierion network by adding partners, infrastructure, and services. The SEC found that Tierion violated Sections 5(a) and 5(c) of the Securities Act by offering and selling these securities without having a registration statement filed or in effect with the SEC or qualifying for exemption from registration.

The order requires Tierion to notify the general public that it is required to repurchase TNT for the $USD value of TNT purchased minus any proceeds of sale. Node operators that received TNT from Tierion as reward for operating a TNT node may receive $.01 USD per token currently held (minus any proceeds of sale). Tierion must submit monthly reports to the SEC regarding this claims process.

SEC Issues Statement and Requests Comment on Broker-Dealer Custody of Digital Asset Securities

On December 23, 2020, the SEC issued a statement and is requesting comment regarding the custody of digital asset securities by broker-dealers. In its statement, the SEC provides a five-year no-action position in which broker-dealers that limit their business to digital asset securities and operate under certain other circumstances can deem themselves to have obtained and maintained physical possession or control of digital asset securities for purposes of Exchange Act Rule 15c3-3 (the Customer Protection Rule). For further details, see Legal Update SEC Issues Statement and Requests Comment on Broker-Dealer Custody of Digital Asset Securities.

SEC Charges Ripple and Two Executives with Conducting $1.3 Billion Unregistered Securities Offering

On December 22, 2020, the SEC announced that it filed an action against Ripple Labs, Inc. and two of its executives, who are also significant security holders, alleging that they raised over $1.3 billion through an unregistered, ongoing digital asset securities offering. The complaint alleges that Ripple raised funds, beginning in 2013, through the sale of digital assets known as XRP in an unregistered securities offering to investors in the US and worldwide. Ripple also allegedly distributed billions of XRP in exchange for non-cash consideration, such as labor and market-making services.

According to the complaint, in addition to structuring and promoting the XRP sales used to finance the company's business, the defendants also effected personal unregistered sales of XRP totaling approximately $600 million. The complaint alleges that the defendants failed to register their offers and sales of XRP or satisfy any exemption from registration, in violation of the registration provisions of the federal securities laws. The SEC's complaint, filed in federal district court in Manhattan, charges defendants with violating the registration provisions of the Securities Act of 1933, and seeks injunctive relief, disgorgement with prejudgment interest, and civil penalties.

According to a Reuters report, California-based cryptocurrency exchange Coinbase said it would suspend trading in XRP after the filing of the SEC charges. Ripple has asserted that XRP is a currency and does not need to be registered as an investment contract.

FinCEN Proposes Regulatory Framework for Certain Convertible Virtual Currency and Digital Asset Transactions

On December 18, 2020, the Financial Crimes Enforcement Network (FinCEN) issued a request for public comment on a proposed rule that would require banks and money services businesses (MSBs) to verify the identity of customers and to collect and report information in connection with certain transactions involving convertible virtual currencies (CVCs) or digital assets with legal tender status (LTDAs). Under the proposed rule, banks and money services businesses (MSBs) would be required to submit reports, keep records, and verify the identity of customers in relation to transactions above certain thresholds involving CVC/LTDA wallets that are:

Not hosted by a financial institution (also known as unhosted wallets); or
Hosted by a financial institution in certain jurisdictions identified by FinCEN. FinCEN is proposing that the list of certain foreign jurisdictions, which would be maintained on FinCEN's website, include those designated by FinCEN as having primary money laundering concerns.

For further details, see Legal Update, FinCEN Proposes Regulatory Framework for Certain Convertible Virtual Currency and Digital Asset Transactions.

SEC Issues No-Action Relief from Registration Requirements to Ethereum-Based Digital Coin

On November 19, 2020, the SEC Division of Corporate Finance issued a no-action letter in response to a request from IMVU, Inc. The letter stated that the SEC will not recommend enforcement action if, based on the representations in its request letter, IMVU offers and sells VCOIN, which is transferable both on and off of IMVU’s platform, without registration under Section 5 of the Securities Act and does not register VCOIN as a class of equity securities under Section 12(g) of the Exchange Act, in reliance on IMVU's "opinion as counsel" that VCOIN is not a security. For further details, see Legal Update, SEC Issues No-Action Relief from Registration Requirements to Ethereum-Based Digital Coin.

SEC Issues Statement on Wyoming No-Action Letter Regarding Custody of Digital Assets

On November 9, 2020, the SEC, in consultation with FinHub (the SEC's strategic hub for innovation and financial technology), issued a statement and request for feedback following the publication of a recent no-action letter by the Wyoming Division of Banking (WDB no-action letter), which stated the view of the Wyoming Division of Banking (WDB) that a Wyoming-chartered public trust company may provide custodial services for digital assets under Wyoming state law (Wyoming Statute 34-29-104(o)).

On October 23, 2020, the WDB issued the WDB no-action letter in response to a request from a Wyoming-chartered public trust company seeking guidance on whether it is permitted to:

Provide custodial services for digital and traditional assets under Wyoming law.
Act as a "qualified custodian" to investment advisers under the Investment Advisors Act of 1940 (Advisers Act) and the SEC Custody Rule (17 C.F.R. § 275.206(4)-2). Under the SEC Custody Rule, investment advisers are required to store customer assets with a "qualified custodian," which includes banks, as defined under the Advisers Act.

In response to the WDB no-action letter, the SEC issued a statement and request for feedback encouraging interested parties to engage with the SEC directly on the application of the Custody Rule to digital assets and what is considered a "qualified custodian."

For further detail, see Legal Update, SEC Issues Statement on Wyoming No-Action Letter Regarding Custody of Digital Assets.

Focus on Stablecoin and CBDC Activity Escalates

With the potential for stablecoins and central bank digital currency (CBDC) to create financial market efficiencies now in focus, regulators globally are devoting increased attention, and stablecoin and CBDC activity continues to mushroom. In addition to the OCC release discussed above (see OCC Clarifies Authority of Banks to Use Stablecoins to Conduct Payment Activities and Other Banking Functions), this includes the following recent noteworthy developments:

Facebook Libra digital currency renamed Diem in attempt to gain regulatory approval. As reported by Reuters, Facebook-backed cryptocurrency Libra has been rebranded "Diem" in a renewed effort to gain regulatory approval by stressing the project’s independence. Plans for Libra were scaled down in April after regulators and central banks raised concerns it could upend financial stability, erode control over monetary policy and threaten privacy. Diem, which means "day" in Latin, now aims to initially launch a single dollar-backed digital coin, which is reportedly scheduled to proceed after approval by Swiss regulators. Facebook, which changed the name of its payments unit Calibra to Novi Financial in May, remains one of 27 members of the Diem Association, formerly the Libra Association. The project has said it would develop policies on anti-money laundering, terrorist financing and sanctions compliance.
Project Helvetia: settling assets in tokenized central bank money. An experiment between the Bank for International Settlements (BIS) Innovation Hub Swiss Centre, the Swiss National Bank (SNB), and the financial market infrastructure operator SIX, Project Helvetia purports to demonstrate the functional feasibility and legal robustness of settling tokenized assets with a wholesale CBDC (PoC1) and with linking a DLT platform to existing payment systems (PoC2) in a near-live setup.
IMF study identifies CBDC challenges. The International Monetary Fund (IMF) published Legal Aspects of Central Bank Digital Currency: Central Bank and Monetary Law Considerations, which analyzes the legal foundations of CBDC under central bank and monetary law. The IMF concludes that absent strong legal foundations, the issuance of CBDC poses legal, financial and reputational risks for central banks. While the appropriate design of the legal framework will up to a degree depend on the design features of the CBDC, some general conclusions can be made. First, most central bank laws do not currently authorize the issuance of CBDC to the general public. Second, from a monetary law perspective, it is not evident that "currency" status can be attributed to CBDC. While the central bank law issue can be solved through rather straightforward law reform, the monetary law issue poses fundamental legal policy challenges.
BIS study highlights benefits of CBDC over stablecoin. BIS published Stablecoins: risks, potential and regulation, which it asserts shows a dichotomy between existing stablecoins and planned global stablecoins. According to BIS, existing stablecoins aim to serve as a means of settlement for automated financial products, whereas global stablecoin proposals like Libra claim that they will make possible new forms of online exchange through their 24/7 availability, borderless nature, fractionalization, and integration with non-financial services. BIS argues that the regulatory responses to global stablecoins should take into account this difference. BIS also emphasizes that the response to global stablecoins should address the potential for other stablecoin uses, such as embedding a robust monetary instrument into digital environments, particularly in the context of decentralized systems. In such cases, stablecoins may allow for embedded supervision. However, BIS suggests that many of these benefits may be achieved with CBDCs and other payment systems.
US and EU stablecoin legislation proposed. As noted recently by Dr. Iwa Salami of Thomson Reuters Regulatory Intelligence, both the US and EU have proposed legislation that could potentially ban the operation of stablecoins issued without regulatory approval: the Markets in Crypto-Assets (MiCA) Regulation, proposed by the EU in September 2020, and the US Stable Bill, proposed in December 2020.
President's working group issues statement on stablecoins. The President’s Working Group on Financial Markets published a Statement on Key Regulatory and Supervisory Issues Relevant to Certain Stablecoins, which provides an initial assessment from the working group, established in 1988, on certain key regulatory and supervisory considerations for participants in significant digital asset arrangements that are designed to maintain a stable value relative to an identified fiat currency, have a US nexus, and are intended primarily for retail payments use.

Further Information on Digital Asset Regulation

For information on regulation of digital assets, see Practice Notes:

See also Practical Law's Blockchain Toolkit and Update Tracker.

Current Developments in Digital Assets: January 12, 2021 | Practical Law