Policy newsletter

Carta Policy: Regulators outline risks of digital assets

October 7, 2022
The Carta Policy Team

The Topline:

  • Midterm elections are approaching with Republicans likely winning House, while Senate map remains tight
  • SEC advisory committee to discuss building entrepreneurial ecosystems
  • FSOC report highlights risk digital assets pose based on scale and interconnectedness, urging agencies to take enforcement actions based on existing regulations and Congress to act on stablecoins and spot markets
  • President directs agencies to reconsider legal category for cannabis, with potential implications on access to banking services

Macro Matters

Midterm elections

Election day is nearly a month away, with every House seat and 34 Senate seats on the ballot, in addition to 36 gubernatorial races. In recent history, the party in the White House has not fared well in midterm elections, which tend to serve as a referendum on the sitting president—and President Biden’s approval ratings are currently in the low 40s. Economic conditions are likely to be the driving force in election outcomes: Record inflation, rising interest rates, and high gas prices suggest Democrats face an uphill battle to maintain their slim majorities in the House and Senate. 

But Republicans are facing their own struggles, which could lead to a smaller House majority and prevent them from taking the Senate majority. Candidate quality and weak GOP gubernatorial candidates in key battleground states could hurt down-ballot pickup opportunities, and Democrats have a significant cash advantage in several key races. Key national issues like abortion access and climate change may help energize the base for Democrats, though national polling shows economic issues and crime as top priorities.  

House dynamics

On the House side, Republicans are expected to reclaim the majority; the question is the size of that majority. Around 50 Democrat-held seats are considered competitive, compared to around a dozen on the Republican side, which largely stems from a historic number of Democratic retirements and redistricting, in addition to the overall environment. Democrats currently enjoy a six-seat majority in the House—a slim margin that makes control of the House likely to flip. Republicans are currently favored to win at least 10 seats held by Democrats, while at least two dozen other Democrat seats are considered toss-ups. 

Map of the U.S. shows Republicans are expected to reclaim the majority in the 2022 Midterms.

Senate dynamics

Democrats have a better chance of holding their majority in the Senate. While House races are tied more to current public sentiment, individual candidates matter more in Senate races. Republicans seem likely to come up short in potential pickup opportunities, including in Arizona and New Hampshire, though these races have been tightening. Republicans are also on the defensive in several other competitive races, including Wisconsin, Ohio, and North Carolina. As of today, races in three states are most likely to determine Senate control: Georgia, Pennsylvania, and Nevada. If Republicans win two of these three races, they would have a 51-49 majority; if they lose two, the Senate makeup would remain 50-50, with Democrats holding the majority with the vice president’s tie-breaking vote.

Georgia has been viewed as one of the best pickup opportunities for Senate Republicans, though recent allegations against former football player Herschel Walker (R) may tilt the race in Sen. Raphael Warnock’s (D) favor. If neither candidate receives 50% of the vote, a runoff election will be triggered under state law, meaning control of the Senate may not be determined until later in December. In Pennsylvania, Democrats have been favored to pick up a seat, with Lieutenant Governor John Fetterman (D) leading television personality Dr. Mehmet Oz (R) in the polls, though the race is tightening as questions around Fetterman’s health and stance on crime come into focus. Republicans likely have the best chance to pick up a seat in Nevada, where recent polls have former state attorney general Adam Laxalt (R) leading Sen. Catherine Cortez Masto (D). 

What a divided Congress means for Biden’s agenda

If Republicans gain control of at least one chamber of Congress, the Biden administration will need to adopt a more bipartisan posture to pass any noteworthy legislation over the remainder of the president’s first term. With infrastructure checked off the list, this could mean a greater focus on policies to bolster capital formation, promote U.S. competition and innovation, and support small businesses. Democrats will also be motivated to score legislative wins as they head into a tough 2024 Senate map. If Republicans win control of the Senate, Biden will have a hard time confirming nominees for judicial or regulatory posts without the support of Republicans. This may not matter much for regulators like SEC Chair Gary Gensler who are currently in seat, but it could have major implications should key positions become vacant.

With a divided government, Democrats will have to rely on the administrative state to advance some of the more polarizing policy objectives through rulemaking and enforcement, including actions on climate change and and reigning in the private markets. While Republican control in Congress is unlikely to stop regulators from moving forward on their respective agendas, aggressive oversight could slow their reform efforts. For more controversial proposals, such as climate change disclosures or even the private fund adviser proposal—regulators will also have to be mindful of the courts where there has been increased scrutiny on agencies acting without explicit congressional authority. 

Tune in next week for a deep dive on what to expect on the policy front next Congress.

Capital Markets

Lawmakers push for congressional action on outbound investment

Building on a recent Senate Banking Committee hearing, Rep. Patrick McHenry, ranking member of the House Financial Services Committee, urged the administration to work with Congress on outbound investment screening rather than take unilateral action through an executive order (EO). The Biden Administration is considering an EO that may require investors to provide the administration with notifications on investments in China and authorize the president to restrict them. This could have negative impacts on private fund investment into companies with tethers to supply chains or sensitive technology linked to certain regions. A bipartisan, bicameral group of lawmakers wrote to President Biden last week to highlight changes to the National Critical Capabilities Defense Act, a pending bill that would increase transparency and oversight over outbound investments. However, unlike Rep. McHenry, the group also advocated for executive action. 

A few items of note on the SEC front:

  • Court finds SEC violated APA: In an action celebrated by the business community, a Texas court ruled the SEC violated the administrative procedures act by delaying enforcement of the 2020 proxy rule amendments while those rules were being reconsidered by the agency. The court concluded the SEC could not effectively repeal rules by postponing enforcement; it must follow formal notice-and-comment rulemaking, setting a precedent that could constrain how future administrations deal with unfavorable rules from their predecessors. 
  • SEC advisory committee on entrepreneurship: The SEC’s Small Business Capital Formation Advisory Committee is scheduled to meet next week to discuss factors that lead to a vibrant entrepreneurial ecosystem and recommendations to help policymakers support these environments and small business growth. The Committee will also examine how recent economic conditions and other factors—including recent SEC rulemaking proposals—have impacted IPO activity, which has dropped significantly in 2022.
  • SEC open meeting: The SEC will meet next week to consider adopting amendments to update its electronic recordkeeping requirements for broker-dealers to better align with modern electronic recordkeeping systems.

 

Crypto & Digital Assets

FSOC report highlights financial stability risk of crypto activities

The Financial Stability Oversight Council (FSOC) released its Report on Digital Asset Financial Stability Risks and Regulation, which finds digital assets could pose significant risks to the U.S. financial system, if the scale of activities and interconnectedness with the financial system were to grow rapidly. The industry, which once was optimistic on Biden’s digital asset executive order, slammed the report for overstating the risks while not appreciating the opportunities for innovation that crypto networks present. The timing of the report following the market downturn and collapse of TerraUSD and Three Arrows was not ideal in that respect.

To address the risks posed by crypto, FSOC recommended aggressive enforcement of existing regulation, a message the SEC will take to heart (as Kim Kardashian found out this week). Such a directive supports Gensler’s position that crypto can be regulated through the existing securities framework without the need for additional guidance or tailored rulemaking. The report also emphasized the importance of addressing regulatory gaps in crypto asset regulation, including providing authority to financial regulators to regulate the crypto spot markets and creating a regulatory regime for stablecoins. Bipartisan efforts are currently underway in Congress to address both stablecoin regulation and the spot markets, and support from FSOC for congressional action could help push them over the finish line, though it is unlikely to happen until the next Congress.

Court dismisses staking refund suit as moot

A U.S. District Court in Tennessee dismissed Jarrett v. United States as moot, finding that the IRS’ decision to issue the refund in question undercut the case. At issue in the case is whether tokens gained through proof-of-stake should be considered “new property” created by the taxpayer and not income, which would determine whether the tax on the tokens would be applied at the time of disposition or sale instead of creation. The point of taxation is one of many issues that would be addressed by the Responsible Financial Innovation Act, a bipartisan Senate bill that would allow taxes on digital assets to be assessed upon disposition. However, no substantive congressional action is expected on this front before year end. Notably, the IRS’ decision to issue a refund clashes with existing guidance which defines a “transaction involving virtual currency” as one that includes “the receipt of new virtual currency as a result of mining and staking activities,” potentially signaling a policy shift.

Banking & Financial Products

President Biden directs agencies to review the legal categorization of cannabis

The president has asked the Departments of Justice and Health and Human Services to expeditiously review how marijuana is scheduled under federal law. Rescheduling cannabis could have implications for cannabis business ability access banking services. The administration can reschedule cannabis without congressional action, but the process requires a recommendation by HHS, which will then be implemented by the DOJ through rulemaking. Put simply, it will take some time. Importantly, this could push the SAFE Banking Act, which helps provide banking services to cannabis businesses, forward when Congress returns post-election. President Biden also announced he would pardon all prior federal offenses of simple marijuana possession. 

Antitrust, Privacy, & Technology

White House releases privacy shield order

Building on a preliminary agreement announced in March, President Biden signed an executive order (EO) on transatlantic data transfers today. The EO marks the next phase of developing a Privacy Shield between the United States and European Union, enabling the secure transfer of content and information, including financial data, between the two partners. A previous U.S.-EU agreement was struck down by European courts in 2020 over concerns that EU citizens were not adequately protected from U.S. surveillance, but this issue is addressed in the EO and provides the European Commission with a basis to adopt a new adequacy decision. The European Commission will now begin the ratification process, which can stretch up to six months, meaning the final agreement would be released in spring 2023.

Tech office releases blueprint for AI development

The White House Office of Science and Technology Policy (OSTP) published a “Blueprint for an AI Bill of Rights” to guide the development and deployment of automated systems. The blueprint provides five guiding principles for the future of artificial intelligence (AI): (1) safe and effective systems; (2) algorithmic discrimination protections; (3) data privacy; (4) notice and explanation; and (5) human alternatives, consideration, and fallbacks. The blueprint broadly defines critical resources and services and provides an appendix with examples of each covered category, including a range of systems with potential privacy impacts and financial system algorithms. AI is an issue of growing interest in Washington, but its complexity and rapid pace of development have proved challenging to regulate.

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10/11/2022

 

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