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Will States Lead Way in Regulating DeFi?

September 15, 2022

Will States Lead Way in Regulating DeFi?

Decentralized finance, or DeFi - financial services like banking, borrowing and lending but provided via blockchain technology instead of a traditional financial institution - has exploded in the past few years. That rapid growth and a steady stream of hacks and other problems have earned DeFi a reputation as the “Wild West of Cryptocurrency” and drawn the attention of government regulators. Those at the state level have already begun to act.

Rise of DeFi

At the end of December 2019 the total value of assets locked in DeFi transactions was $700 million. By the start of this year the total locked value had rocketed to $200 billion, roughly equivalent to the GDP of Greece in 2017, according to Finance Monthly.

That growth was largely driven by DeFi’s eye-popping yield rates. While those with a savings account at a bank were earning a meager 0.5 percent or less in interest on their principal, crypto holders were earning 5 to 15 percent or more by “staking” their assets on a DeFi platform.

Fall of Stablecoin UST

The dramatic growth and spectacular returns of DeFi have been accompanied by numerous hacks, scams and other problems, most notably the recent collapse of stablecoin terraUSD, or UST. Stablecoins are cryptocurrencies designed to maintain a stable value, often pegged to a fiat currency like the U.S. dollar and at least claimed to be fully backed by reserves of real-world assets like government currencies or precious metals. They’ve played a key role in the rise of DeFi by allowing investors to generate yield on a crypto asset that theoretically isn’t subject to the wild price gyrations of other cryptocurrencies like bitcoin.

But when UST - an algorithmic stablecoin that maintained its value via computer code that controlled its supply and demand by creating and destroying UST and its sister token luna - lost its dollar peg in May, investors rushed to get their money out of both UST and luna, sending their combined value, once nearly $60 billion, virtually to $0. The dramatic implosion of two popular cryptocurrencies triggered panic selling in the broader crypto market that wiped out hundreds of billions of dollars in market cap in the span of a week, leading some to call UST’s demise crypto’s Bear Stearns moment, in reference to the major Wall Street bank failure that heralded the 2008 financial crisis. That characterization seemed even more valid a couple of months later when other major players in the DeFi space including crypto hedge fund Three Arrows Capital, crypto lender Celsius and crypto broker Voyager Digital began falling like dominoes.

Federal Action

The turmoil didn’t go unnoticed by federal government officials.

“I think it is likely that we’re going to have regulation happen faster because of the events of recent weeks,” said Securities and Exchange Commissioner Hester Peirce, who noted that federal stablecoin legislation had already been in the works before the UST debacle.

A bill (SB 4356) sponsored by U.S. Sens. Cynthia Lummis (R-WY) and Kirsten Gillibrand (D-NY) would require stablecoins to either be FDIC-insured or be backed over 100 percent by hard assets. The bill would actually do much more than just impose requirements on stablecoins, establishing a regulatory framework for cryptocurrencies in general.

“We’re setting it on top of the current regulatory framework for assets, including the CFTC and the SEC,” Lummis told CNBC. “We’re making sure that the taxation is capital gains and not ordinary income. We’ve dealt with some accounting procedures, some definitions, we’re looking at consumer protection and privacy.”

Lummis’ bill is one of several measures before Congress that address stablecoins, according to State Net’s legislative tracking system.

But Jarrod Loadholt, a partner at Ice Miller Public Affairs Group in Washington, D.C., said on CoinDesk TV’s “First Mover” in June that it was unlikely Congress would pass a law to regulate the industry this year simply because there was too little time left in the legislative calendar to do so. He said it was more likely that the federal government would regulate crypto through enforcement actions for the time being. (In June the Department of Justice brought insider trading charges in connection with digital assets for the first time.)

State Action

Loadholt also said state action was likely to come in the crypto space before regulation or legislation from Washington.

“The reality is that this is still a market that is evolving and most policymakers are still trying to learn it,” he said. “But in terms of who can act faster and who can actually move faster, it’s going to be a state regulator or a state legislator as opposed to Congress or the SEC or the CFTC.”

Specifically, Loadholt said states could enact their own standards for obtaining a license to operate a crypto trading platform, such as liquidity requirements.

Nebraska has actually already done that with regard to stablecoins specifically with its enactment of L 707 in April. The law requires a “digital asset depository” - defined as “a financial institution that securely holds liquid assets when such assets are in the form of controllable electronic records” - to “maintain unencumbered liquid assets denominated in United States dollars valued at not less than one hundred percent of the value of any stablecoin” it issues.

Another bill (L 649) enacted by the state in May of last year authorizes digital asset depositories and provides for their operation and regulation, including allowing them to issue stablecoins.

A bill in California (AB 2269) that would require the issuer of a stablecoin to “own eligible securities having an aggregate market value computed in accordance with United States generally accepted accounting principles of not less than the aggregate amount of all of its outstanding stablecoins issued or sold in the United States” cleared the legislature and is awaiting action from Gov. Gavin Newsom (D).

That requirement is just one provision of a broader bill mandating that anyone “engaging in digital financial asset business activity” be licensed by the state and establishing requirements for such licensure.

There are also bills pending in New York that would establish criminal offenses related to virtual tokens including stablecoins (AB 8820 and SB 8839) and require certain disclosures in advertisements for stablecoins and other virtual tokens (AB 9028 and SB 8838).

While those three states appear to be the only ones that have introduced legislation referring specifically to stablecoins this session, at least 15 states have introduced bills dealing with the licensing of businesses that engage in cryptocurrencies or virtual currencies in general. The measures in most of those states have failed, but they’ve been enacted in two, Florida (HB 273) and Nebraska (L 649 and L 707, the same bills that address stablecoins), and bills are still pending in California, New Jersey, New York, Pennsylvania and Rhode Island. And in the absence of federal action, such legislation is likely to keep coming in the states.

 -- By KOREY CLARK

Please visit our webpage for more information on the bills mentioned in this article, or to speak with a State Net representative about how the State Net legislative and regulatory tracking solution can help you react quickly to relevant legislative and regulatory changes.

States Taking Action on Stablecoins, DeFi

Three states have introduced legislation this session referring specifically to stablecoins, cryptocurrencies that are designed to maintain a stable value, often pegged to the U.S. dollar, and which have been pivotal to the rise of decentralized finance, financial services provided with blockchain technology. One of those states, Nebraska, has enacted two such measures. Fifteen states have also introduced bills dealing with the licensing of businesses that engage in cryptocurrencies or virtual currencies in general. The measures in two of those states - Florida (HB 273) and Nebraska (L 649 and L 707, which also address stablecoins) - have been enacted. 

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