Crypto Laboratories of Democracy | Brownstein Hyatt Farber Schreck

President Joe Biden’s executive order directing agencies to come up with a federal governmentwide approach to regulating digital assets appropriately garnered widespread attention. But as Justice Louis Brandeis once said¹, states are laboratories of democracy. True to form, states are quietly and methodically taking action in the cryptocurrency space. For example, bipartisan coalitions of state attorneys general are meeting later this month and in April to discuss their regulatory authority in the cryptocurrency space. Legislation has been introduced in California to allow government agencies in California to accept payment via digital currencies. This month, Wyoming updated its robust cryptocurrency statutory scheme by passing the Decentralized Autonomous Organizations Amendments, which essentially clarifies how people join, leave and vote in a decentralized autonomous organization (“DAO”). Indeed, state-level activity in the digital asset space has been steadily afoot for several years. In fact, Nevada has since 2017 accepted a blockchain as an electronic record and recognized the validity of smart contracts. While the federal government’s recent directive to study digital assets is a critical step in the right direction, the states have been consistently marching forward. The digital asset industry will want to consider its state-level approach keeping in mind the areas referenced below.

Representations Made to Consumers

One of the few bipartisan issues of our time involves Democratic and Republican attorneys general asserting their authority to combat practices they believe to be unfair, deceptive or abusive by those who offer financial products or services to consumers. The more consumers are impacted, the more likely it is for a state attorney general to review statements made to consumers. We should expect to see state regulators playing a larger enforcement role as digital assets become more mainstream. Indeed, state-level scrutiny has already begun. For example, New York Attorney General Letitia James obtained a $3 million default judgement against Coinseed (a now-defunct cryptocurrency trading platform) and its CEO for selling securities without registering as a broker-dealer. State prosecutors also accused the CEO of fabricating his experience to market the platform. As digital assets expand, companies would be wise to consider the state-level implications of any public-facing statements made concerning those digital assets.

The Rise of Stablecoins

Stablecoins have the potential to help beginners understand cryptocurrencies. However, not all stablecoins are equal. For example, fiat-collateralized stablecoins have the backing of a fiat currency (e.g., the U.S. dollar). Yet again, state regulators are already scrutinizing these digital assets. For example, in February 2021, Attorney General James entered into a settlement agreement with Tether, a cryptocurrency trading platform. Tether claimed to offer a stablecoin backed by the U.S. dollar. Attorney General James alleged that the cryptocurrency was not fully backed by U.S. dollars. In the settlement agreement, Tether agreed to pay $18.5 million in penalties and cease trading activity with New Yorkers.

In light of the state attorney’s general actions to date, it would be wise to consider how the states would respond to public-facing statements surrounding commodity-backed stablecoins (which are collateralized by various commodities, including gold). Moreover, algorithmic stablecoins (which do not have a collateral backing themselves but instead rely on an algorithm to increase or reduce the circulating supply) possess a heightened level of decentralization. The decentralized nature of these assets poses a unique risk to consumers, and therefore fits into the bipartisan consumer protection efforts of state attorneys general.

Risk Monitoring Procedures

Another area that will increase the mainstream appeal of digital assets is crypto payment processing. These conduits enable the acceptance of digital payments in exchange for fiat currency. This is an exciting and developing area filled with the potential to remove the hesitancy of merchants and consumers. However, yet again, state regulators are already vigilant. For example, the payment processor Stripe paid $120,000 to resolve allegations advanced by the Massachusetts Attorney General Maura Healey that it should have had more robust risk monitoring and fraud prevention processes in place to protect consumers. Several takeaways from the Stripe settlement include the need for payment processors to have monitoring procedures in place to detect and review duplicative accounts with shared bank accounts, identify and escalate requests from law enforcement, investigate consumer complaints about merchant fraud, and train employees on risk monitoring procedures. As cryptocurrency becomes more mainstream, centralized companies offering crypto services would be wise to audit their risk monitoring processes with an eye toward state regulators.

Crypto Lending

If state regulators’ activity surrounding financial lending is a guiding star, crypto lending will garner scrutiny. Here, centralized platforms serve as intermediaries for the execution of the crypto lending process by taking control of the assets of the lenders and collateral for borrowers. Thus, “Know Your Customer” compliance and anti-money laundering assessments will be critical. To the extent a platform uses smart contracts for the execution of lending procedures, state regulators may be interested in the information gathered to execute the contract (e.g., whether off-chain information is used, the source of the information, and accuracy of that information).

Conclusion

Nimble state regulators and legislatures are poised to continue taking action regarding digital assets. States around the country, including Wyoming, California and Nevada, have already passed legislation. State attorneys general are actively and jointly charting the future of their regulatory authority. Companies in the digital asset industry should consider their state-focused approach in conjunction with President Biden’s Executive Order studying the federal government’s approach to regulation.

¹ The actual quote is as follows: “it is one of the happy incidents of the federal system that a single courageous state may, if its citizens choose, serve as a laboratory; and try novel social and economic experiments without risk to the rest of the country.” New State Ice Co. v. Liebmann, 285 U.S. 262, 311 (1932) (Brandeis, J., dissenting).