The U.S. Secretary of the Treasury Offers Insights into the Future of Digital Assets: Is Functional Regulation on the Horizon?

U.S. Secretary of the Treasury Janet L. Yellen offered new insights into the U.S. Administration’s view of the future the regulatory framework for digital assets in the first landmark speech following issuance of President Biden’s Executive Order on Ensuring Responsible Development of Digital Assets.

Emphasizing both the importance of innovation and the need to reduce the risks that digital assets technologies may present to the financial system, Secretary Yellen called for a technology neutral regulatory framework, under which companies that provide similar services would be regulated similarly, regardless of the technology underlying those services. This vision of functional regulation of digital assets, based on activities and risks, rests upon the view that, “Digital assets may be new, but many of the issues they present are not.”

As with the evolution of other innovative financial products and services, Secretary Yellen focused on the potential risks of digital assets to investors, businesses and consumers. Just as the government addressed the risks of earlier innovative financial products and services through appropriate regulation, the Secretary explained that appropriate government oversight is necessary to mitigate the risks arising from the explosive growth of digital assets. In the Secretary’s view, it will be critical to account for these risks in constructing a new regulatory framework, as banks and traditional financial companies become more involved in the digital assets markets.

Public-private dialogue is a key component of the Biden Administration’s approach to digital assets while the Department of the Treasury (“Treasury”) and other government agencies conduct the reviews mandated by the Executive Order on digital assets. Secretary Yellen emphasized the need for international collaboration and offered an approach to technology-driven financial innovation that is “inherently cross-border and requires international cooperation.

The Treasury Secretary’s speech offered five lessons, drawn from financial services’ history and the Biden Administration’s policy positions, for navigating the opportunities and challenges that digital assets technologies present. Altogether, the five lessons Secretary Yellen described paint a clearer picture of the ultimate U.S. legal regulatory approach to digital assets and the Administration’s key policy and regulatory benchmarks for the reports and recommendations in the Executive Order. This Reed Smith commentary describes each of these lessons in the order in which they are presented in the Treasury Secretary’s remarks.

Five Lessons for Navigating Opportunities and Challenges Posed by Digital Assets

The five lessons, described by Secretary Yellen, that apply to navigating the opportunities and challenges posed by digital assets cover the nature of responsible innovation, the structure of appropriate regulatory and risk guardrails, the fundamentals of the financial system, the U.S. role in the global economy, and the value of domestic and international collaboration. These lessons are based upon the history of financial services and the policy positions of the Administration, recognizing that the “growth in digital services has opened a world of possibilities and risks that would have seemed fantastical only a few decades ago.”

Lesson One: “Our financial system benefits from responsible innovation”

The Treasury Secretary indicated that innovation should be embraced when it improves lives while appropriately managing risks, “but we must also be mindful that ‘financial innovation’ of the past has too often not benefited working families, and has sometimes exacerbated inequality, given rise to illicit finance risks, and increased systemic financial risk.” The Secretary explained that many of today’s domestic and international financial transactions involve inefficiencies that are not shared equally, but rather are predominantly borne by lower-income persons. For this reason, Secretary Yellen concluded that processing times, cost, and technological access issues will need to be overcome to produce a more efficient, low-cost and faster payments system.

Her remarks note that a central bank digital currency (“CBDC”) can contribute to a more efficient payments system by becoming a form of trusted money with some of the potential benefits of digital assets. The Executive Order on digital assets urges the Board of Governors of the Federal Reserve System to explore whether the central bank should create its own digital currency and directs the Treasury and other government agencies to study the impacts of cryptocurrency on financial stability and national security.Lesson Two: “When regulation fails to keep pace with innovation, vulnerable people often suffer the greatest harm”

A regulatory imperative described in the Secretary’s remarks is the need to ensure that the growth of digital assets does not allow risks to emerge or lead to disproportionate impacts to vulnerable communities, similar to those that occurred during the Global Financial Crisis when household net worth decreased precipitously, particularly for people of color. In this regard with respect to stablecoins, which are a type of cryptocurrency intended to maintain a consistent equivalence with a fiat currency like the US dollar, the Secretary remarked that the Treasury is now working with the U.S. Congress to advance legislation to help ensure that stablecoins are resilient to risks that could endanger consumers or the broader financial system.

Secretary Yellen advocated for appropriate oversight of digital asset exchanges and digital native and new types of intermediaries, and similarly, that the regulatory framework for banks and other traditional financial firms that become more involved in digital asset markets will need to appropriately reflect the risks of digital asset activities. The Secretary noted that the Treasury must also be prepared for possible changes in the structure of financial markets and looking forward, that the Department of the Treasury, Financial Stability Oversight Council will identify financial stability risks and regulatory gaps posed by digital assets and make recommendations to address them.Lesson Three: “Regulation should be based on risks and activities, not specific technologies”

The main principle of regulation advanced by the Treasury Secretary is technology neutrality. As a general proposition, the Secretary’s remarks provide that when new technologies power new activities, products, and services, financial regulation should be guided by the risks associated with the services provided to businesses and consumers, and not by the underlying technology. Consistent with the level playing field principle adopted in the Executive Order on digital assets - “same business, same risks, same rules” – Secretary Yellen indicated that regulatory frameworks “should be designed to support responsible innovation while managing risks – especially those that could disrupt the financial system and economy.” The regulatory principle of technology neutrality applies to concerns related to tax evasion, illicit finance, and national security. The Treasury recognizes and supports regulators’ use of existing authorities to address these risk-based concerns. The Secretary’s remarks state that the Treasury will work to make sure investors, businesses and consumers have adequate protections against fraud, privacy and data breaches, and unfair, deceptive, or abusive acts or practices and “will make policy recommendations, including assessment of potential regulatory actions and legislative changes” where there are gaps.

Lesson Four: “Sovereign money is the core of a well-functioning financial system and the US benefits from the central role the dollar and US financial institutions play in global finance”

Secretary Yellen indicated that the approach to digital assets must be guided by an appreciation of the benefits, such as economic growth and stability, brought about by monetary sovereignty and a uniform currency. The Secretary noted the benefits the U.S. derives from the international prominence of the U.S. dollar in the global economy. While confirming that Treasury will address CBDC with urgency, she noted “we must be clear that issuing a CBDC would likely present a major design and engineering challenge that would require years of development, not months.”

The Secretary expressed a strong interest in ensuring that digital innovation does not lead to fragmented international payment architectures, noting that technology-driven financial innovation is “inherently cross-border and requires international cooperation.”

Lesson Five: “We need to work together to ensure responsible innovation”

The final lesson in the Secretary’s remarks addresses the role of government in ensuring responsible innovation, reflecting the view that thoughtful public-private discourse is necessary and should take into consideration the financial history lessons learned throughout history. In the Secretary’s view, the government’s role should be to ensure responsible innovation that “works for all Americans, protects our national security interests and our planet, and contributes to our economic competitiveness and growth.”

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