Reading between the lines: SEC's Guidance on "Covered Stablecoins"

What Happened?

New Guidance

Yesterday, the SEC’s Division of Corporation Finance (“CorpFin”) issued its Statement on Stablecoins. To summarize, CorpFin guided that “persons involved in the process of ‘minting’ (or creating) and redeeming Covered Stablecoins do not need to register those transactions with the Commission under the Securities Act or fall within one of the Securities Act’s exemptions from registration.”

CorpFin loosely defined Covered Stablecoins as stablecoins:

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• that are pegged to USD;
• are 1:1 backed;
• with reserves comprised of “low risk” and readily liquid assets (which FN 6 of the Guidance further details as “USD cash equivalents, demand deposits with banks or other financial institutions, U.S. Treasury securities, and/or money market funds registered under Section 8(a) of the Investment Company Act of 1940, and do not include precious metals or other crypto assets.”); and
• are “always” subject to “ready” redemption by an issuer for one USD (or the relevant fraction).

Crenshaw Dissent

Commissioner Crenshaw issued a lone dissent, “Stable” Coins or Risky Business?

The dissent aptly points out that, while Staff describe Covered Stablecoins as being readily redeemable by the issuer, stablecoins are, in practice, virtually never so (at least with respect to retail holders).

Commissioner Crenshaw stretches this singular valid point to failure (in my opinion) by arguing that the lack of a contractual retail redemption right, alone, renders stablecoins securities (or potentially so) due to the absence of risk-reducing factors per Reves. Unlike Howey, however, Reves is a “holistic” assessment requiring the balancing of four factors. The dissent focuses on one (the absence or existence of risk reducing frameworks) and ignores the other three, all of which militate in favor of non-security status. The dissent also fails to address the applicability of Howey.

Impact of Guidance on our approach to advising issuers of US stablecoins

The Good

Bright lines are nice. Especially for crypto lawyers who historically have not had the luxury of trading in bright-lined advice. Practically speaking, however, this Guidance is neither likely to surprise practiced counsel, nor move the advisory needle much. Most have long-considered that a well-designed, fiat-backed stable offering presents very strong non-security arguments under both Howey and Reves.

I suspect this Guidance provides more capital to political and policy folks than it does to front-line practitioners. Nonetheless, I won’t look a gift horse in the mouth.

The Not-So-Good

Credit to Crenshaw- her position on retail user redemption rights vis-a-vis stablecoin issuers is generally correct. A literal reading of the Guidance, therefore, and its qualification that “Covered” stables are those that are always readily redeemable by its issuer arguably results in a construction of the Guidance that excludes most real world stablecoins from the definition of a “Covered Stablecoin.”

Additionally, it is interesting (to me at least) that CorpFin assessed Covered Stablecoins under both Howey and Reves. While one may read this as a positive, in that Covered Stablecoins have been addressed under both tests, I would have preferred the SEC to take a stand and guide that an issuer’s promise to redeem stables 1:1 (token:USD) is fundamentally analyzed as a note and not an investment contract (but of course facts/circumstances dictate). As it stands, on projects that are close calls, we are still left to advise against two tests that can, at times, result in drastically different outcomes.

Final arguments (maybe [but probably not]) as to why the SEC should not be regulating YBS

Protecting Banks and Separation of Concerns is not the way

The arguments I continue to see against governing yield-bearing stables (“YBS”) under the Genius /Stable Acts (and thus not under the 33, 34, and 40 Acts) fall into two general categories: (i) allowing the broad-based US distribution of YBS would undermine the US banking system (if holders move their bank deposits to onchain YBS, there will be no one left to issue mortgages and car loans); and (ii) YBS does not need its own regulatory treatment because we already have frameworks to govern the two component elements- specifically, non-YBS can be regulated as commodities presently or Payment Stablecoins under Genius/Stable and YBS can be separately regulated as the product of money market funds subject to the 33 and 40 Acts.

The bank-protectionist argument has already been expertly addressed and dismissed by many who are much more qualified in monetary, fiscal and banking policy than am I. So I will instead focus on the arguments touting divergent regulatory frameworks. Rather than rehash arguments regarding heightened consumer protection and elimination of information asymmetries made in prior posts, I will distill my argument to the most basic, practical, level: I cannot pay for produce at a local farmer’s market with a money market fund share or a T-bill. In fact, my farmer’s market won’t even accept negotiable instruments against demand deposits (bank checks). But stablecoin payments, via numerous apps, are accepted and YBS, if governed as a non-security, would be no different, as a digital payment instrument, from any other stable.

For those who say just register your YBS as a security and be on with it, how will payment processors process securities as means of payment.? Assuming issuers, for some reason, do begin registering securities that are intended to be used as a method of exchange, merchants who accept such securities as payment for goods and services would begin to risk crossing over into being deemed “inadvertent investment companies” subject to the 40 Act as a result of holding securities on their balance sheets.

YBS is first, and foremost, a fungible payment instrument. In fact, I would posit that YBS are stables in their purest form. If yield were freely distributable without regard to the 33 and 40 Acts, but subject to prudential regulation, whether US-based (Genius/Stable Act) or some other non-US prudential framework such that risk reducing factor were satisfied (ala Wolf v Banco Nacional de Mexico [admittedly, pre-Reves, but conceptually sound]) YBS would very likely be the default variant, worldwide. Issuers would be required to compete for market share by delivering additional value to end users and any issuer hording yield for itself would likely be made a market relic.

As an aside, those who argue separation of concerns with respect to regulation of YBS and do so from a well-intentioned place may not recognize the extent to which divergent regulatory treatment would stymie innovation. The elegance, utility and transformational potential surrounding YBS necessarily depend on its unification of disparate purposes (all without net-additional risk to the holder).

The Guidance itself hints at why the SEC is not the appropriate regulator

Under a literal reading of the Guidance, a YBS that is 1:1 backed in appropriate reserves is arguably not a security in the US if the issuer does not promise, nor market the fact, that the token is yield-bearing. The resulting logical absurdity is that if an issuer deceives the public in presenting the token as non-yield-bearing but then “surprises” the user with yield, the asset is not a security. If, on the other hand, the issuer issues the exact same asset and promotes it accurately, it is foreclosed from the US market.

Additionally, in FN 6 of the Guidance, the Staff inadvertently concedes that the asset backing structures of virtually all prudentially regulated YBS are identical to the asset backing structure of non-security Covered Stablecoins. Given that the first three factors of Reves result in a split decision (due to the payment instrument/investment duality of YBS) and the final (most weighty, according to Crenshaw) factor acknowledges the existence of a risk-reducing framework outside of the Securities Acts, prudentially-regulated YBS treatment should be in-line with Covered Stablecoins.

While this news has been generally accepted by the industry as a win for stables, I would humbly suggest that, when you read between the lines, the Guidance further implicitly supports prior arguments I have made in favor of affirmatively regulating YBS under Genius/Stable rather than the Securities Acts.