Coinbase's proposal is one of a number of approaches to digital asset regulation intended to address the exponential growth in the digital asset markets (see, e.g., the Token Taxonomy Act of 2021, the Digital Asset Market Structure and Investor Protection Act, and the Digital Commodity Exchange Act of 2020). While the likelihood of the proposal becoming law is quite slim, elements of the Coinbase approach may be useful to incorporate into the existing financial regulatory structure, and may serve to clear up the regulatory uncertainty that currently exists regarding digital assets.

That said, the proposal raises a number of important regulatory questions. For example, the proposal asserts that "digital asset markets operate differently from traditional financial markets," yet it argues that the new framework "should incorporate the principles and best practices from regulations that govern traditional financial assets where the characteristics of particular digital assets merit doing so" (pages 11-12). If digital asset markets operate differently from traditional financial markets, where exactly do the characteristics of digital assets merit the application of traditional regulatory principles and best practices? The proposal does not attempt to answer this important question.

The proposal recommends that "Congress should recognize in law that all digital assets, including digitally native versions of traditional financial assets, should be subject to a new regulatory regime for digital assets" (page 12) (emphasis added). The proposal does not appear to explain what exactly distinguishes digitally native versions of traditional financial assets from non-digital versions of such assets. Why should the regulatory framework to which an asset is subject be different solely due to the digital or non-digital nature of the asset? The proposal does not say.

Fundamentally, the proposal appears to be based on a common refrain heard from advocates of digital assets - that the decentralization and disintermediation offered by the blockchain and distributed ledger technology underlying digital assets will offer investors more efficient and accessible financial markets, and reduce transactions costs and related legal fees. To some extent, the efficiencies and cost-reductions offered by such technologies are evident. However, proper financial regulation should take into account more than cost efficiencies offered to investors. The scope of what constitutes "investor protection," particularly with respect to speculative instruments such as digital assets, should also include considerations of (i) the current role of financial intermediaries and (ii) the risks of market power. Too intense a focus on disintermediation and decentralization can serve to underemphasize (or even overlook) the degree to which (i) financial intermediaries are, in effect, deputized within the existing regulatory framework to act as regulatory agents that serve to impede the potential for market abuses, and (ii) the number and range of financial intermediaries serves to actually decentralize financial markets and reduce regulatory costs for market participants.

While the proposal puts forth some important investor protection measures through disclosure requirements, as well as anti-fraud and anti-manipulation provisions, its promotion of "housing all digital asset activities under a regulated MDA" raises critical policy questions involving the centralization of various financial intermediary functions in a single entity, including how to mitigate the potential for conflicts of interest.

Commentary

The government is not going to create a regulatory structure that is based upon the technology used to represent or transfer an asset. Nor should it. Proper regulation should be focused on (i) the purpose of an asset and (ii) its users, not on its technology or form. There are ways in which certain digital assets are unique; i.e., those digital assets that split the difference between being utility tokens and investment assets. Attention to SEC Commissioner Hester M. Peirce's proposal, which would provide a safe harbor under the securities laws for digital tokens, is in order. While her proposal is not nearly as far-reaching in scope as the proposal made by Coinbase, it would build in a practical manner on the existing regulatory structure.

Commentary

Coinbase's proposal is one of a number of approaches to digital asset regulation intended to address the exponential growth in the digital asset markets (seee.g., the Token Taxonomy Act of 2021, the Digital Asset Market Structure and Investor Protection Act, and the Digital Commodity Exchange Act of 2020). While the likelihood of the proposal becoming law is quite slim, elements of the Coinbase approach may be useful to incorporate into the existing financial regulatory structure, and may serve to clear up the regulatory uncertainty that currently exists regarding digital assets.

That said, the proposal raises a number of important regulatory questions. For example, the proposal asserts that "digital asset markets operate differently from traditional financial markets," yet it argues that the new framework "should incorporate the principles and best practices from regulations that govern traditional financial assets where the characteristics of particular digital assets merit doing so" (pages 11-12). If digital asset markets operate differently from traditional financial markets, where exactly do the characteristics of digital assets merit the application of traditional regulatory principles and best practices? The proposal does not attempt to answer this important question.

The proposal recommends that "Congress should recognize in law that all digital assets, including digitally native versions of traditional financial assets, should be subject to a new regulatory regime for digital assets" (page 12) (emphasis added). The proposal does not appear to explain what exactly distinguishes digitally native versions of traditional financial assets from non-digital versions of such assets. Why should the regulatory framework to which an asset is subject be different solely due to the digital or non-digital nature of the asset? The proposal does not say.

Fundamentally, the proposal appears to be based on a common refrain heard from advocates of digital assets - that the decentralization and disintermediation offered by the blockchain and distributed ledger technology underlying digital assets will offer investors more efficient and accessible financial markets, and reduce transactions costs and related legal fees. To some extent, the efficiencies and cost-reductions offered by such technologies are evident. However, proper financial regulation should take into account more than cost efficiencies offered to investors. The scope of what constitutes "investor protection," particularly with respect to speculative instruments such as digital assets, should also include considerations of (i) the current role of financial intermediaries and (ii) the risks of market power. Too intense a focus on disintermediation and decentralization can serve to underemphasize (or even overlook) the degree to which (i) financial intermediaries are, in effect, deputized within the existing regulatory framework to act as regulatory agents that serve to impede the potential for market abuses, and (ii) the number and range of financial intermediaries serves to actually decentralize financial markets and reduce regulatory costs for market participants.

While the proposal puts forth some important investor protection measures through disclosure requirements, as well as anti-fraud and anti-manipulation provisions, its promotion of "housing all digital asset activities under a regulated MDA" raises critical policy questions involving the centralization of various financial intermediary functions in a single entity, including how to mitigate the potential for conflicts of interest.