February 2, 2021 | Jon Hautamäki
#12 Legal Analysis of USD Coin (USDC)
We start off this new year with a bang! As the worldwide interest towards cryptocurrencies is ever-growing, we will launch a new 12-part article series on the top 12 cryptocurrencies and their legal framework within the EU and the US.
The top 12 cryptocurrencies have been determined by Binance’s market cap top list as of 29 January 2021, whereby the article series will cover the following cryptocurrencies:
1. Bitcoin / BTC
2. Ethereum / ETH
3. Tether / USDT
4. XRP / XRP
5. Polkadot /DOT
6. Litecoin /LTC
7. Cardano / ADA
8. Bitcoin Cash / BCH
9. Stellar / XLM
10. Chainlink /LINK
11. Binance Coin / BNB
12. USD Coin / USDC
The article series will cover one cryptocurrency each month starting off with USD Coin (USDC) and culminating in the undisputed crypto giant Bitcoin as the last article of the series (perhaps just in time for the annual December bull run).
USD Coin in a Legal Nutshell
USD Coin is a stablecoin connected to the value of the US dollar. USDC is developed by the Centre consortium that is a collaboration between Coinbase and Circle, which in turn is a peer-to-peer payments technology company. Circle is an official money transmitter, and thus, as a US money service business it must comply with the US federal laws and regulations.
In short, the USD Coin is a service to tokenize US dollars by sending a US dollar to the token issuer’s bank account. Then the issuer uses a USDC smart contract to create a USDC. The USDC is delivered to the user while the substituted US dollar is held in reserve. Redeeming USDC for US dollars is the same process reversed. USDC was originally issued only on the Ethereum blockchain, but currently it is available on Ethereum, Algorand and Solana blockchains.
U.S. Regulation of USDC
Financial Crimes Enforcement Network (FinCEN) has stated that based on their interpretation the Bank Secrecy Act applies to cryptocurrencies. This also means that FinCEN has interpreted that its money services business regulations apply to cryptocurrency exchanges and administrators. Thus, these regulations apply to Centre as the administrator of USDC.
Each U.S. state has its own regulation regime for cryptocurrencies, but as stablecoins are defined as cryptocurrencies or money or monetary value in the absence of an explicitly limiting definition, the activities involving stablecoins are deemed as money transmission in several U.S. states. Thus, in most U.S. states the cryptocurrency exchanges and administrators are obligated to follow the money transmission regulations. In addition, New York and Louisiana have their own cryptocurrency licences which form a stricter way of regulating cryptocurrency exchange activities.
In addition to the state-specific regulation, also the national authorities have varying views of the legal nature of cryptocurrencies.
The Office of the Comptroller of the Currency (OCC) has stated that national banks and federal savings associations supervised by the OCC are authorized to receive deposits from stablecoin issuers, including deposits that are considered stablecoin reserves, and may engage in activities that are incidental to accepting deposits from stablecoin issuers. The OCC has emphasized that the banks and federal savings associations must be vigilant with anti-money laundering regulations and Know-Your-Customer procedures prescribed under the Banking Secrecy Act and other federal banking laws. This OCC statement is, however, limited to stablecoins associated with one fiat-currency and redeemable by the holder with a 1:1 ratio, whereby it applies to USDC among others.
The Securities and Exchange Commission (SEC) has stated that stablecoins may be characterized as securities depending on the facts and characteristics of the stablecoin and whether market participants may structure and sell a digital asset in a way that it does not constitute a security. SEC mainly determines assets as securities if they fulfil the so-called Howey conditions which determine whether a transaction represents an investment contract, whereby such transactions are also considered as securities subject to applicable securities regulation. Under the Howey test, the following questions determine the legal nature of a transaction:
1. Did purchasers of a financial instrument contribute money (or valuable goods or services)?
2. Did purchasers invest in a common enterprise?
3. Were purchasers reasonably expecting to earn profits through that enterprise?
4. Were the expected profits derived from the efforts of others (e.g. a third party)?
Based on the above criteria, it is evident that the Howey test has been constructed around centralized activities, whereby its overall applicability regarding decentralized cryptocurrencies can be questioned from a legal perspective.
Stablecoins may also fail the expectation of profit as the purchasers are also motivated by a desire to use or consume the item purchased. In the end, the Howey test is based on a fact-specific analysis and therefore it remains unclear how it may apply to any particular stablecoin – or any cryptocurrency – project including USDC.
Finally, the Commodity Futures Trading Commission (CFTC) states that cryptocurrencies and presumably stablecoins are commodities for purposes of the Commodity Exchange Act. To the extent that stablecoins are deemed to be commodities, the CFTC would have jurisdiction over margined, leveraged or financed transactions in stablecoins that involve investors that do not qualify as “eligible contract participants,” as defined in Section 1a (18) of the CEA (meaning so-called “retail” investors). In addition, by virtue of being deemed as commodity transactions, stablecoin transactions would enable the CFTC to also act as the anti-fraud and anti-manipulation authority. Thereby, to the extent stablecoins are considered as commodities by the CFTC, also USDC is obligated to comply with the applicable regulation.
EU Regulation of USDC
In the EU, the regulation is somewhat more straightforward. Stablecoins are cryptocurrencies as determined in the Fifth Money Laundering Directive (5AMLD, EU 2018/843) and are defined as a digital representation of value that i) is not issued or guaranteed by a central bank or a public authority, ii) is not necessarily attached to a legally established currency and does not possess a legal status of currency or money but is accepted by natural or legal persons as a means of exchange and iii) which can be transferred, stored and traded electronically. Thus, the EU’s anti money laundering regulations including customer due diligence, risk assessments, fitness and properness test for managers and other regulations apply to cryptocurrency exchange operators and custodian wallet providers.
Some EU Member States e.g. Finland, Malta, Netherlands and Austria have also established a cryptocurrency license system that imposes stricter regulations to the cryptocurrency exchanges, custodian wallet providers and other cryptocurrency service providers. These can include capital requirements, customer protection schemes and stricter data security obligations.
In short, USDC is considered as a cryptocurrency and not a security. Entities trading USDC are obligated by the Member State’s implementation of 5AMLD and thereto related other national regulation. However, new EU-wide regulation is in the works, which will change the definition and regulation of, inter alia, stablecoins and thus also the legal interpretation of USDC may be impacted. You can read more of the proposed EU-wide regulation from our previous article.
Our Associate Trainee Johannes Lottonen took part in writing of this article.