2 months ago

    The US Regulatory Developments Involving The Tokenization of The Banking Industry

    Table of contents

      There is a coordinated global effort being made by the International Monetary Fund (IMF), the World Bank , The Federal Reserve Bank, Switzerland’s central bank (SNB), Monetary Authority of Singapore’s (MAS) Project Guardian, the BRICS New Development Bank’s (NDB) New Unit, the Bank for International Settlements (BIS) Project Agorá with a consortium of central banks, and the Institute of International Finance (IIF) which invited the private financial sector to join its exploration of how tokenization can enhance the functioning of wholesale cross-border payments and the Basel Committee, the global standard setter for regulating banks which pushed back the implementation of the Basel rules for digital assets by a year to January 2026.  These institutions are leveraging tokenization technology to streamline financial processes in banking and enhance global economic development. 

      The Role of International Organizations in Tokenization

      Afterall, asset tokenization allows two broad asset classes that are represented by digital tokens on a blockchain– an immutable ledger– by conferring ownership of and legal rights to an asset (Token) on the Token holder. 

      1. Fungible assets such as stocks, bonds and funds that are both divisible and interchangeable, such that each token unit has the same value and market properties and can be divided into as many sub-divisions as desired when issued; 
      2. Non-fungible assets (NFT) such as commodities, art, intellectual property,  trees, land and real estate.  Non fungible tokens are unique, such that each one has its own value and market properties and thus cannot be replaced by other tokens.  

      William Quigley Co-founder of Tether stablecoin and Wax Blockchain explained tokenization  “Money and payments have been evolving for as long as they have existed.  The methods that society has used to store and transfer value during my life time have changed first by digitizing and now tokenizing.  Each major upgrade to the global monetary architecture has introduced both new benefits and new risks over the past several decades.  With digitization, the vast majority of what people generally think of as “money” is in reality ledger balances sitting on databases maintained by commercial banks.   As a general rule, banks use relational databases primarily, but not exclusively running on UNIX and UNIX-like operating systems which was first developed in the 1960s. 

      Tokenization of the global financial system is still in the early stages but may have a transformative impact on the way ownership of commercial bank deposits, payments, government and corporate bonds, money market fund shares, gold and other commodities, real estate and other assets and liabilities are recorded on blockchains and other distributed ledgers,  enabling far-reaching new functions. 

      As detailed in Coincub.com’s Crypto Banking Report, a number of financial institutions around the world have been actively exploring the possibility of tokenizing assets to improve the way we transfer value using blockchain technology to facilitate fast, secure, low-cost international payment processing services (and other transactions) through the use of encrypted distributed ledgers that provide trusted real-time verification of transactions without the need for intermediaries such as correspondent banks and clearing houses.  Because notwithstanding recent advancements in digitization, our banking payment and settlement systems remain slow and inefficient for many users, with delayed settlements for large classes of transactions and numerous intermediaries, each adding  layers and layers of costs. 

      Tokenization and distributed ledgers have the potential to overcome many of these obstacles by globally operating around the clock and introducing settlement finality in real time. Because tokenization offers:

      • Programmability which will may make it easier for the bank and bank customers to automatically remove funds, to respond to liquidity stresses immediately and automatically, move liquidity when and where it is needed.
      • Instant settlement — which will provide the ability to hard-wire on the ledger future transfers of value that automatically self-execute based on the occurrence of future conditions thereby increasing the speed and intensity of bank settlements.  
      • Atomic settlement – which will reduce the risk of loss in the time between payment and delivery or the simultaneous exchange and settlement of payment and delivery, including among multiple parties.   
      • Immutability of the shared ledger – which will serve as a transaction record and reliable audit trail.  Blockchain based IT infrastructure can significantly reduce payment errors, cut down on account reconciliation time.  The transparency and immutability of the ledger can help regulators and law enforcement agencies obtain accurate and verifiable data on token transactions and seize assets from criminals.

      While tokenization of the global financial system will face challenges and risks as financial institutions, developers, regulators, and other stakeholders continue developing the technology, we are already seeing examples of how tokenization is beginning to deliver tangible benefits in the global banking industry.”

      The bankruptcy of FTX which was one of the biggest financial frauds and a watershed moment, whose knock-on effects—included a digital asset market slump, a crypto banking crisis in 2023 with 5 U.S. bank failures, regulatory backlash, and further bankruptcies. On April 26, U.S. regulators closed Philadelphia-based Republic First Bank, marking the nation’s first banking failure of 2024 due to “material weaknesses in internal control over financial reporting.”  But this may only be the beginning of more U.S. bank failures as Consulting firm Klaros Group analyzed about 4,000 U.S. banks and identified 282 smaller banks that face potential losses tied to higher interest rates.  These unfavorable developments in the US have triggered increasing scrutiny and widespread calls for regulation of the digital asset industry which is regulated by  the US Securities and Exchange Commission (SEC); the Commodity Futures Trading Commission (CFTC); Financial Crimes Enforcement Network (FINCEN);  Office of Foreign Assets Control (OFAC) and the Internal Revenue Service (IRS).

      How are the US regulators, legislators  responding to the Tokenization of the Banking Industry?

      Banks involvement with digital assets occurs through the following banking services:

      Crypto Trading Desks/ Wealth Management Services: Many large banks have launched crypto trading desks and wealth management departments with digital assets groups to help banking customers invest in cryptocurrencies, stablecoins, NFTs and Central Bank Digital Currencies (CBDCs) through their banking accounts, investment and retirement funds.  

      SEC:  The SEC  has indicated through  enforcement actions, lawsuits and the statements of its chair, Gary Gensler, that it believes most digital assets are classified as securities.  

      On March 27, in the ongoing case  SEC v. Coinbase, Inc., No. 1:23-cv-04738-KPF (S.D.N.Y. Mar. 27, 2024) (Katherine Polk Failla, J.) the court held that the SEC’s allegations about Coinbase’s digital asset transactions were sufficient for them to “suffice to constitute ‘investment contracts’ under the three-pronged Howey test” and thus be subject to the federal securities laws and the SEC’s enforcement authority.  On May 10, the SEC’s court filing  in  response to Coinbase’s accusation, termed a “power grab,” emphasized that the regulatory body retains the discretion to set its own priorities and that rewriting rules entirely for the crypto industry is unnecessary. 

      IRS:  The IRS recently issued the draft Form 1099-DA which will be used by brokers to report digital asset transactions next year.  Jonathan Cutler, Senior Manager in Deloitte’s Washington National Tax team advising on information reporting of digital assets said, “Under the August 2023 proposed digital asset reporting regulations, an NFT is included as reportable when it is a “digital representation of value that is recorded on a cryptographically secured distributed ledger (or any similar technology).” In April, the draft form on which an NFT or  digital asset might be reported—the Form 1099-DA—was published by the IRS. Importantly, the cover page notes that this early draft release is based only on the proposed regulations and subject to change based on the public comments, the volume of which appears to be significant. Until those comments are digested by the IRS and Treasury, it’s difficult to glean meaningful information, whether from this draft form or otherwise, on the final scope of the definition of “digital asset” for reporting purposes.”  It should be noted that gains from collectible NFTs are being taxed at a 28% rate, which is higher than current capital gains rates.

      The IRS  also announced a “new effort” in February 2024 to focus tax audits since the it has increased funding for collection and enforcement, on high income non-filers, digital assets and FBARs.

      DOJ & IRS:  The Department of Justice (DOJ) and the IRS also recently pursued a first-of-its-kind  indictment that was made public on February 7, wherein a Texan taxpayer, Frank Ahlgren III, was accused of inflating his cost basis in bitcoin and underreporting capital gains of approximately $4 million for tax purposes. In addition, Ahlgren was accused of structuring bank deposits by splitting large portions of his bitcoin earnings into smaller deposits to avoid drawing the attention of law enforcement and of failing to report the capital gains from these transactions thereby not accurately reporting his  cryptocurrency proceeds from otherwise legitimate transactions. 

      Digital Asset Wallets/Custody:  Many banks support digital asset custody services and  have received regulatory approval for their digital asset wallets  that includes payment processing, electronic transfer and exchange of digital assets.  

      SEC:  On April 10, Consensys which developed the Metamask digital asset wallet used by various banks including Revolut, a neobank valued at more than $33 billion, got a Wells notice of impending enforcement action from the SEC which thinks Consensys is operating as an unregistered broker-dealer by making money on the MetaMask Swaps and MetaMask Staking products.  

      DOJ:  Tornado Cash and (TORN) wallet was blacklisted by the U.S government in 2022.  On August 10, 2023  Tornado Cash and (TORN) wallet developers Roman Storm and Roman Semenov were charged with money laundering and sanctions violations in the U.S. by the DOJ.  Storm will go to trial this September for helping bad actors launder over $1 billion in stolen digital assets, but Semenov has not yet been arrested.  

      Separately, Tornado Cash and (TORN) wallet developer Alexey Pertsev was sentenced to 64 months in jail for money laundering in Netherlands. And the U.N. Security Council sanctions committee found that North Korea used Tornado Cash to launder $147.5 million worth of stolen crypto assets earlier this year.

      On April 24, the DOJ criminally charged privacy focused Samourai Wallet developers for unlicensed money transmission. The DOJ arrested the founders  Keonne Rodriguez and William Lonergan Hill and  charged them with operating Samourai Wallet, an unlicensed money Transmitting Business that executed over $2 Billion in unlawful transactions and laundered over $100 Million in criminal proceeds.

      House of Representatives:

      On May 7, a bill titled “the Blockchain Integrity Act” was introduced in the United States House of Representatives to ban cryptocurrency mixers for two years that imposes a fine of up to $100,000 for handling funds from mixers.

      On May 8, the United States House of Representatives voted to  pass a bill titled H.J. Res 109, overturning the SEC’s Special Accounting Bulletin 121 (SAB 121) requiring banks to hold their customers’ crypto assets on their balance sheets, which is not the case for traditional assets such as securities.  SAB 121 guidance prevents banks from owning digital assets. 

      Senate: On May 9, Cynthia Lummis (R ) and Ron Wyden (D),  sent a letter to Attorney General Merrick Garland questioning the use of money-transmitter laws against digital asset mixers like Samurai Wallet and Tornado Cash which can impede tax collection, sanctions compliance and anti-money laundering practices.  

      On May 16 the US Senate passed measure withdrawing SEC SAB 121.  However, this  resolution will likely be vetoed when it reaches President Joe Biden’s desk. 

      Because the resolution was met with disapproval from The American Bankers Association and three banking associations.  As well as the U.S. President Joe Biden’s office which  issued a statement informing lawmakers and the public that his administration plans to veto a joint resolution affecting digital asset policy at the SEC if it comes to his desk.  

      Statement of admission

      Tokenized Cross Border Payments:  A settlement token can be seen as a bridge between other digital assets and fiat currencies, linking the digital asset economy with the banking world and increasing transaction ease and efficiency. Mastercard, JPMorgan, and some of the top banks in the United States are testing shared-ledger technology for tokenized asset settlements. 

      IRS:  With Tokenized cross border payments, U.S. taxpayers should report gains on cross border transactions with digital assets on their tax return since income from digital assets is taxable.   U.S. taxpayers with digital assets held in foreign exchanges or wallets that exceed certain thresholds may be subject to further FinCEN reporting, including filing FinCEN Form 114 (FBAR) or FATCA Form 8938 (Statement of Specified Foreign Financial Assets) to report these assets as well.

      Credit Cards/Payment Services  Credit Card companies such as Mastercard, Visa and American Express, Discover Card  and Payment Services such as Paypal, Venmo, Cash App have a number of partnerships with digital asset companies, allowing banks and merchants in their network to offer crypto-related services and crypto reward cards to banking customers.  

      FINCEN & OFAC:  Whistle blowers have informed the FINCEN about the yearslong widespread compliance lapses at  Block, and the company’s two main units, Square and Cash App which are financial technology firms launched by Twitter co-founder Jack Dorsey.   According to these whistleblowers, Square processed thousands of transactions involving countries subject to economic sanctions in countries like Cuba, Iran, Russia and Venezuela and Block processed multiple digital asset transactions for terrorist groups involving credit card transactions, dollar transfers and Bitcoin, which were not reported to the government as required.

      Digital Asset ATMs:  Digital Asset ATMs are owned and operated by third-party companies — largest networks are Bitcoin Depot, Coinhub and Coinme. To use a Digital Asset ATM, customers can simply insert cash or a Bank issued credit or debit card to exchange their traditional currency for Digital Assets. According to data presented by AltIndex.com, the number of Bitcoin ATMs has been continually growing over the past ten months, with more than 5,600 new devices installed since July 2023.

      CA:  To combat money laundering at Digital Asset ATMs new state-specific licenses for Digital Asset ATMs are emerging – such as California’s AB39 bill, which was recently signed into law. 

      Stablecoins:  Tokenizing fiat currencies is the greatest innovation that will enable new mechanisms in global finance with stablecoins like Tether offering interest yields, in the coming years said William Quigley who co-founded the first ever fiat backed stablecoin Tether which is world’s most traded digital asset.   “Tether is the largest cryptocurrency in terms of trading volume, commanding 64% of the market share among stablecoins.   Having surpassed Bitcoin in 2019, Tether USDT became the most traded digital asset in the world.  As of May 4, 2024, Tether had over $110 billion” added William Quigley.  

      “Tether has been cooperating with law enforcement and  regulatory agencies by introducing a voluntary wallet-freezing policy, since December 1, 2023 .   Tether is offering secondary market controls to freeze transactions associated with individuals listed on the OFAC Specially Designated Nationals (SDN) List. This list includes companies and individuals controlled or owned by sanctioned countries.

      Recently Tether has also announced  its partnership  with blockchain surveillance company Chainalysis to monitor transactions with its tokens on secondary markets.  The monitoring system will help Tether identify risky crypto addresses/wallets that could be used for bypassing sanctions or illicit activities like terrorist financing, and illicit transfers” said William Quigley.

      SEC:  The SEC Chair Gary Gensler says stablecoins have similar traits to money market funds and has long called for greater regulation of the $160 billion stablecoin market.   

      Bloomberg reported that a report by Visa and data platform Allium Labs states that less than 10% of stablecoin transaction volumes come from real people.   And New research study from Deutsche Bank indicates that a majority of  stablecoins are destined to “fail.”  

      On June 5, 2023 in SEC vs Binance, the SEC’s claimed that BUSD stablecoins are securities. 

      On November 2, 2023 the SEC  subpoenaed Paypal over its U.S. dollar stablecoin.

      On May 7, the SEC  targeted Ripple’s proposed stablecoin which it referred to as an “unregistered crypto asset”  in its latest court brief, against the digital asset company.

      CFTC:  On March 7, CFTC advisory committee voted to advance pioneering digital assets taxonomy for agency review with the aim to have consistent language for terms including digital assets, central bank digital currencies, stablecoins, among others. 

      House of Representatives:  During the last week of May, the U.S. House of representatives are gearing up for a vote on: (1) The Financial Innovation and Technology (FIT) for the 21st Century Act  (HR 4763) which suggests splitting digital asset oversight duties between the SEC and  the CFTC.  The bill also includes provisions for the regulation of stablecoin and protection for whistleblowers.

      CBDC:  134 countries & currency unions, representing 98% of global GDP, are exploring a CBDC which will tokenize the global financial/banking system by removing the need to use the correspondent banking system, which adds costs and delays to payments.   So far, 3 countries have fully launched a CBDC—the Bahamas, Jamaica and Nigeria.   

      House of Representatives:  During the last week of May, the U.S. House of representatives are gearing up for a vote on: (2) an anti-Central Bank Digital Currency  (anti-CBDC bill) ( HR 1122) which seeks to prohibit the Federal Reserve from issuing a digital currency to consumers.

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