It's Market Structure Week
And what rough beast, its hour come round at last, slouches towards Bethlehem to be born.
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If you’ve been anywhere near X lately, you’re probably aware that it is Market Structure week. The lumbering bill is coming back after a holiday break and a few months of inactivity, and this cycle there are some new issues appended.
The substance of the bill we’ve covered before exhaustively in previous posts. It will create a framework for token issuance and certain transactions using tokens. These transactions, of course, are already effectively legal, since the Trump administration has thus far chosen not to pursue new cases against cryptocurrency firms (other than in cases of fraud) and dismissed most of the otherwise pending matters.
So really the current instantiation of the bill effects two substantive policy goals for the industry. First, it will create a legislative policy scheme that cannot be easily undone by future administrations for the offering and sale of cryptocurrency tokens. This assuages the fears of many that AOC 2028 might wipe out all the progress the industry has made since the Biden administration.
Second, it bakes in a meaningful decentralization requirement. This is important to a select subset of cryptocurrency operators and thinkers who are ideologically wedded to the importance of decentralization. This idea is historically important to cryptocurrency communities that developed out of cypherpunk traditions rooted in notions of privacy and censorship-resistance. For advocates, the arguments around decentralization in policy have almost religious significance because most contemporary projects are not interested in decentralization, and if it loses policy significance, its advocates correctly suspect that crypto as a whole will cease to resemble the systems they pioneered.
One may query whether that is a good or bad thing. And, reportedly, many have, with rumors swirling for months that certain participants in DeFi or in the Solana ecosystem may be furtively opposing the bill’s passage.
But this week, it may finally be happening. Out of nowhere, a sudden powerful push to move the bill forward has emerged in recent weeks, and now, this Thursday the Senate Banking Committee will mark up the bill.
The new bill’s text emerged at midnight ET last night, here, and, in an expected move, includes some controversial language.
Prohibition on Yield
Either you die a yield-bearing stablecoin program or you live long enough for adversarial interests to ban you! Last year we wrote several times about a sustained push by the banking lobby to prohibit yield-bearing stablecoins.
This was a central and highly discussed issue in the drafting process of GENIUS even before it was passed. The law ultimately included Sec. 4(a)(11), which states:
No permitted payment stablecoin issuer or foreign payment stablecoin issuer shall pay the holder of any payment stablecoin any form of interest or yield (whether in cash, tokens, or other consideration) solely in connection with the holding, use, or retention of such payment stablecoin.
At first, it seems, the banking lobby was happy with this. Some say it was because they weren’t paying enough attention, or just because they misunderstood the language, but those close to crypto policy circles immediately recognized that this “prohibition on interest” did no such thing.
Stablecoins have long avoided bearing direct interest out of concern that it would make them a security under the Howey test. But as rates rose in the early 2020s, there was increasing pressure to pass some or all of it on to end users. Stablecoins are highly liquid, and people respond to incentives, so everyone expects flows from deposits of value that do not pay yield and into those that do.
To deal with this, exchanges like Coinbase with market power cut deals with issuers like Circle (which we discussed in depth in our teardown of Circle’s S-1 last year), whereby the token issuers, who hold collateral and earn yield, would pay some of that collateral to exchanges holding their tokens in omnibus wallets on behalf of customers. The exchanges then paid on some or all of that yield to the owners of those tokens through rewards programs.
It’s important to note that this is incredibly fair. The interest is not some windfall profit, in high rate environments it is a representation of the time value of money, and without it stablecoins cannot participate pari passu in the American financial system with assets like deposits that do pay yield, but I digress.
These programs became ubiquitous, and they are probably not covered by Sec. 4(a)(11) of GENIUS because the payment stablecoin issuer, the relevant regulated entity, is not paying yield “solely in connection with the holding, use or retention” thereof. They are paying yield as part of negotiated commercial agreements with institutional counterparties. The exchanges are paying these yields, but they are not covered by this section of GENIUS.
The upside? Yield lives.
Well, after the banking lobby got word of this, so-called “loophole”1, there was a come-to-Jesus moment. Apparently, there is great concern that stablecoins will outcompete deposit accounts if they pay yield. The risk would be that stablecoins are a better product and consumers choose to use them because they improve their lives. The banks couldn’t have this.
They raised some interesting points. If capital flowed from deposit accounts to stables, then state-licensed savings associations and other small banks may not be able to survive. And more concerningly, because stablecoins require 100% collateralization and so cannot support fractional reserve banking models, a flight from deposits to stables will not be a neutral transfer, it will materially reduce the M2 money supply by collapsing fractional reserve money creation. This would be bad, which is why I suggested that 100% collateralization is dumb back in May of last year.
After all that, in this bill they finally did it. Sec. 404 of the new draft law includes a new prohibition on yield, and this time it may actually work. The law would extend Sec. 4(a)(11) to also cover digital asset service providers, stating “A digital asset service provider may not pay any form of interest or yield (whether in cash, tokens, or other consideration) solely in connection with the holding of a payment stablecoin.”
There are carve-outs for rewards, but not rewards for just holding stablecoins, and that, of course, is what deposit accounts are for.
This kind of language is bad, in my view, because it is unfair to consumers and will ultimately handicap the adoption of cryptocurrency modalities. But it is an interesting example of the mixed incentives of those negotiating the bill. Bloomberg has reported that Coinbase threatened to pull support for the bill over it, but the direct effect of a prohibition on yield would be them retaining all of the capital outflows currently distributed through rewards programs themselves.
That’s profit!
In the same vein, there have been rumblings that some big players in the stablecoin game may not mind so much if yield is prohibited. Whether players will put their foot down here or not remains to be seen. But it is not the only issue.
The DeFi Mullet
There have long been rumors that DeFi will revolt on this law. And that may soon come to a head, as this draft bill contains language that affects them directly. Sec. 301 creates a new category “decentralized ledger finance trading protocol.” This means “a distributed ledger system through which multiple participants can execute a financial transaction in accordance with an automated rule or algorithm that is predetermined and non-discretionary, without reliance on a person other than the user to maintain custody or control of any digital assets subject to the financial transaction.” In other words, autonomous, non-custodial, smart contracts.
The definition is further refined by the definition of a “non-decentralized finance trading protocol,” which applies when a person or group of persons “has the authority, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise, to control or materially alter the functionality, operation, or rules of consensus or agreement of the decentralized ledger finance trading protocol.” It also draws in smart contracts that do not operate “based solely on pre-established, transparent rules encoded directly within the source code of the distributed ledger system.” Or when a person or group of persons has control.
301 goes on to say that non-decentralized finance trading protocols should be subject to the securities laws and Bank Secrecy Act (BSA). Bizarrely, however, it does not include any express carve-out of decentralized finance. Indeed, the definition “decentralized ledger finance trading protocol” is made and then never used anywhere else in the draft law. An exemption is implied, but not yet made.
Then, Sec. 302 extends monitoring and compliance requirements to the “distributed ledger application layer,” which essentially means the hosted front-end of a DeFi protocol. It goes to specify criteria for these distributed ledger applications to comply with sanctions law through monitoring and risk-based measures. While these may impose a new burden, I am not sure that they will be unwelcome in the DeFi community, where most professional applications already observe similar measures but with less certainty than this law would provide.
The biggest takeaway from these sections, other than that they do not provide a complete carve-out of decentralized DeFi, is that they leave a significant amount of air for rulemaking. If this were to become law unamended, I think that the rulemaking around DeFi rules may be the single most consequential regulatory process in cryptocurrency’s history. The whole industry will be on trial, and the administration that gets to decide what applies is going to have massive influence on its outcome. While more analysis will come soon, these sections make me nervous.
Ethics
What does ethics in crypto mean? Making whatever Donald Trump is doing illegal.
There was a push last week to include language to that effect in this bill. Of course, Donald Trump will have to sign the bill to make it law, so the “Make Trump Illegal” language will always be a non-starter and is pure political posturing. This draft does not include language to this effect.
Whether the bill will be able to progress, only time will tell, but for the first time ever, I am starting to think there may be sufficient political will to get this passed. The question now, as Keith Calstaldo described for us in November, is timing.
In a midterm election year, the legislative agenda is likely to be frozen early. The prohibition on yield is still lurking as a bogeyman, and it is not clear, even if it weren’t a controversy, whether there would be 60 floor votes to pass this law. This is before the long-rumored rebellion from DeFi emerges, should it do so.
That is why you have to keep reading the newsletter.
Till next week.
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Which is a strange thing to call it, in my view, since this language was a focal point of the bill through drafting. It’s not like it snuck in at the 11th hour.