While there is general agreement that there is a need for greater oversight and regulation of the digital asset space in the U.S., regulatory reform is slow moving. In a DerivSource Q&A, Gabriel Rosenberg, Partner at Davis Polk*, offers his quick view on the status of regulatory developments and the key market trends that will influence the areas of digital asset trading, stablecoins, decentralised finance (DeFi) and central bank digital currency (CBDC).
Where are we now?
In 2021, we saw more and different types of market participants entering or exploring crypto markets, including large financial institutions. At the same time, we saw little development in terms of regulation; instead, regulators seem in many cases to be calling on Congress for action. For example, in early February, CFTC Chair Benham asked Congress for additional authority to regulate crypto markets and trading, including in spot markets. However, while legislative proposals may be introduced, we think that legislation is unlikely to move this year given that it is a mid-term election year. It is therefore likely that the main questions—how should digital asset trading be regulated, how should stablecoins be regulated, do DeFi protocols fit within existing regulatory constructs—will not be answered in 2022. In the absence of congressional action, we will continue to see enforcement actions by regulators. On the margins, this may provide some clarity to the industry.
Trends and developments likely to shape the industry in 2022
- Regulated trading activities. One interesting trend we’ve seen is the movement of crypto exchanges into regulated derivatives markets – for example, large U.S. crypto exchanges that have announced acquisitions of futures exchanges and clearinghouses or have established FCMs. The other interesting trend we’ve seen is an increase in crypto swaps – there will be a number of issues for these firms to grapple with as they become registered swap dealers in the United States, including but not limited to margin requirements.
- Stablecoins. Of all digital assets, stablecoins have received the most attention from Congress and prudential regulators worried about potential risks to the wider economy. Congress is likely to see a myriad of proposed bills to regulate stablecoins, but we don’t expect any legislation to be adopted in the near term given the controversy surrounding the appropriate regime for stablecoins. U.S. regulators have floated a number of ideas to regulate stablecoins, including using their power to designate systemically important payment, clearing and settlement systems. However, it appears that regulators would prefer for Congress to determine the overall policy direction for stablecoin regulation.
- DeFi. DeFi is the next frontier. The DeFi ecosystem has grown dramatically over the past year, from $20 billion at the end of 2020 to $300 billion at the end of 2021. All indications are that there will be continued growth in the coming years. DeFi raises many novel regulatory questions, such as if and how decentralized protocols can be regulated. Here too we’ve seen, and will likely continue to see, a focus on enforcement activity.
- Banks: power and authorities. The end of 2020 saw a flurry of guidance from the OCC on bank cryptocurrency activities and, over the last year, we’ve seen the OCC, under a new administration, weigh in again; the Presidents Working Group and the FDIC and OCC propose a regulatory path for stablecoins that requires them to be issued by insured banks; and the Basel Committee weigh in on bank capital requirements for crypto assets. As a practical matter, banks are only slowly moving into crypto activities, including because navigating which activities are permissible for different types of banks can be challenging. As institutional participation in crypto increases, we would expect to see banks engage with regulators on their ability to engage in crypto activities.
- CBDC. The discussion and debate around development of a U.S. CBDC has just begun. The CBDC paper that the Federal Reserve released in January, asking for input on the pros and cons of a U.S. central bank digital currency, is meant to add to these discussions. All indications are that the Federal Reserve plans to move slowly and deliberately, and the paper states that the Federal Reserve does not intend to develop a U.S. CBDC without encouragement or legislation from the executive branch and Congress. So don’t expect a U.S. CBDC anytime soon. Various market participants have different views on the costs and benefits of a U.S. CBDC, and we expect to see a vigorous debate on market including as part of the comment process that ends in May.
Gabriel Rosenberg is a partner in Davis Polk and Wardwell LLP’s Financial Institutions practice. Davis Polk is an elite global law firm with world-class practices across the board. The firm advises financial institutions, fintechs, technology companies and asset managers on regulatory, product structuring and transactional matters related to blockchain, cryptocurrency and digital asset activities. To receive updates from Davis Polk, click here.
