California Enacts Digital Financial Asset Regulatory Framework

Practical Law Legal Update w-041-2381 (Approx. 6 pages)

California Enacts Digital Financial Asset Regulatory Framework

by Practical Law Finance

Digital Financial Assets Law

Effective July 1, 2025, the DFAL prohibits a person from engaging in digital financial asset business activity or holding itself out as being able to engage in "digital financial asset" business activity with or on behalf of a California resident unless any of the following conditions are met:

The person is licensed by the California Department of Financial Protection and Innovation (DFPI), as set out in Section 3203 of the DFAL.
The person submits an application on or before July 1, 2025 and is awaiting approval or denial of that application.
The person is exempt from licensure under the terms set forth in Section 3103 of the DFAL.

The DFAL defines "digital financial asset" as "a digital representation of value that is used as a medium of exchange, unit or account, or store of value, and that is not legal tender, whether or not denominated in legal tender." Under the DFAL, the following do not constitute digital financial assets:

A transaction in which a merchant grants, as part of an affinity or rewards program, value that cannot be taken from or exchanged with the merchant for legal tender, bank or credit union credit, or another digital financial asset.
A digital representation of value issued by or on behalf of a publisher and used solely within an online game, game platform, or family of games sold by the same publisher or offered on the same game platform.
A security registered with or exempt from registration with the SEC or a security qualified with or exempt from qualifications with the DFPI.

Under the DFAL, a "digital financial asset business activity" is defined as:

Exchanging, transferring, or storing a digital financial asset or engaging in digital financial asset administration, whether directly or through an agreement with a digital financial asset control services vendor.
Holding electronic precious metals or electronic certificates representing interests in precious metals on behalf of another person or issuing shares or electronic certificates representing interests in precious metals.
Exchanging one or more digital representations of value used within one or more online games, game platforms, or family of games for either:
- a digital financial asset offered by or on behalf of the same publisher from which the original digital representation of value was received; or
- legal tender or bank or credit union credit outside the online game, game platform, or family of games offered by or on behalf of the same publisher from which the original digital representation of value was received.

The DFAL exempts activity by certain specified entities and authorizes the Commissioner of Financial Protection and Innovation (commissioner) to further exempt a person or transaction if the commissioner finds that the exemption is in the public interest.

Under the DFAL, a digital financial asset business activity licensee must maintain a surety bond or trust account in US dollars in a form and amount as determined by the DFPI for the protection of California residents that engage in digital financial asset business activity with the licensee. In addition, the licensee must maintain at all times capital and liquidity in an amount and form as the DFPI determines is sufficient to ensure the financial integrity of the licensee and its ongoing operations based on an assessment of the specific risks applicable to the licensee. The DFAL also requires licensees to submit to the DFPI annual reports containing, among other things:

The licensee's most recent reviewed annual financial statement.
A description of any material change in the financial condition of the license.
Any international, federal, state, or local investigation of the licensee, where permitted by law.
Any data security breach or cybersecurity event of the licensee.
The number of digital financial asset business activity transactions with, or on behalf of, residents for the period since the later of the date the license was issued or the date the last annual report was submitted.

The DFAL also specifically addresses stablecoins, stating that unless provided otherwise in the DFAL, a covered person cannot exchange, transfer, or store a digital financial asset that is a stablecoin or engage in digital financial asset administration relating to any stablecoin, whether directly or through an agreement with a digital financial asset control services vendor, unless both of the following are true:

The issuer of the stablecoin is an applicant for a license under the DFAL, is licensed by DFPI under the DFAL, or is a bank or trust company licensed pursuant to DFAL Section 1042, or a national association authorized under federal law to engage in a trust banking business.
The issuer of the stablecoin at all times owns eligible securities having an aggregate market value computed in accordance with US generally accepted accounting principles (GAAP) of not less than the aggregate amount of all of its outstanding stablecoins that have been issued or sold.

Under the DFAL, a covered exchange, prior to listing or offering a digital financial asset that the covered exchange can exchange on behalf of a California resident, must certify on a form provided by the DFPI that the covered exchange has done the following:

Identified the likelihood that the digital financial asset would be deemed a security by federal or California regulators.
Provided, in writing, full and fair disclosure of all material facts relating to conflicts of interest that are associated with the covered exchange and the digital financial asset.
Conducted a comprehensive risk assessment designed to ensure consumers are adequately protected from cybersecurity risk, risk of malfeasance, including theft, risks related to code or protocol defects, or market-related risks, including price manipulation and fraud.
Established policies and procedures designed to reevaluate the appropriateness of the continued listing or offering of the digital financial asset, including an evaluation of whether material changes have occurred.
Established policies and procedures to cease listing or offering the digital financial asset, including notification to affected consumers and counterparties.

Under the DFAL, in a transaction for or with a California resident, a covered exchange cannot interject a third party between the covered exchange and the best market for the digital financial asset in a manner inconsistent with the DFAL.

The DFAL defines a "covered exchange" as "a covered person that exchanges or holds itself out as being able to exchange a digital financial asset for a resident."

Under the DFAL, the commissioner may issue a conditional license to an applicant who already holds or maintains a license to conduct virtual currency business activity in New York (see Practice Note, Virtual Currency Business Regulation (NY State): VCB Activities Requiring a License).

The DFAL also requires licensees to apply to the DFPI before merging or consolidating with another person.

Digital Financial Asset Transaction Kiosks

SB-401 provides for the regulation of digital financial asset transaction kiosks (DFATK), effective January 1, 2025, and prohibits an operator from accepting or dispensing more than $1,000 in a day from or to a customer via a digital financial asset transaction kiosk. An "operator" is defined as a person who owns, operates, or manages a DFATK located in California.

Under this legislation, an operator must do the following before conducting a digital financial asset transaction:

Provide a written disclosure in English and in the same language principally used by the operator to advertise, solicit, or negotiate with a customer containing the terms and conditions of the transaction.
Provide a customer with a receipt for any transaction made at the operator's DFATK, including certain information such as the name of the customer and the date and time of the transaction.
Provide to the DFPI a list of all locations of DFATKs that the operator owns, operates, or manages in California.

For further information on state digital asset regulation, see Practice Note, Cryptocurrency and Virtual Currency Regulatory Tracker: Virtual Currency and Cryptocurrency Regulatory Tracker: State Law.

California Enacts Digital Financial Asset Regulatory Framework | Practical Law