California Advances New Regulatory Framework for Crypto

Last week, the California State Assembly and the state Senate have passed a new bill regulating digital financial assets and related business activities (“Digital Financial Assets Law“). The bill sets new mandatory licensing as well as additional regulatory requirements for a wide range of entities operating in the crypto and other digital assets domain and conducting digital financial asset business activities. The bill also provides additional examination and enforcement powers to the Department of Financial Protection and Innovation of California (“DFPI“). In addition, among others, the bill sets specific rules concerning licensee’s ability to exchange, transfer, store and administer stablecoins. The Digital Financial Assets Law defines “digital financial asset” as a “digital representation of value that is used as medium of exchange, unit of account, or store of value, and that is not legal tender, whether or not denominated in legal tender“. However, the definition exempts types of virtual coins – such as commonly used in the gaming industry, as an in-app mechanism that cannot be cashed-out – from the new law’s applicability. The definition of the “digital financial asset business activity” covered under the Digital Financial Assets Law is broad and includes the following: (i) exchange, transfer, storage of digital financial asset, or engagement in digital financial asset administration, whether directly or through an agreement with digital financial asset control services vendor; (ii) holding electronic precious metals or electronic certificates representing interests in precious metals on behalf of another person or issuing shares or electronic certificates representing interests in precious metals; (iii) exchange of one or more digital representations of value used within one or more online games, game platforms, or family of games for either of the following: (a) digital financial asset offered by or on behalf of the same publisher from which the original digital representation of value was received; (b) legal tender or bank or credit union credit outside the online game, game platform, or family of games offered by or on behalf of the same publisher from which the original digital representation of value was received.  

Below are the key issues covered by the Digital Financial Assets Law:

1. Licensing – under the new law, no person may engage in any digital financial asset business activity, or hold itself out as being able to engage in digital financial asset business activity, with or on behalf of a resident of California, unless it is properly authorized to do so under the newly introduced licensing regime or unless certain exemptions apply. The applicants for the license and licensees are required to prepare and maintain certain policies and procedures, as well as comply with additional regulatory requirements specified in the bill. 2. Examination and Enforcement – the bill provides DFPI with enforcement powers concerning licensees or persons that are not licensees but are engaging in digital financial asset activities in material violation of the bill, associated rule or order, or of another law of the state of California that applies to such activities. Among others, the Digital Financial Assets Law prescribes civil penalties for violations of its provisions. In addition, the bill provides DFPI with powers to conduct examinations of licensees and their compliance with regulatory requirements under the law. 3. Disclosures and Protections –  prior to engaging in digital financial asset business activity with a resident of California, a licensee is required to provide certain disclosures as specified within the bill and further determined by the DFPI. Such disclosures shall include, among others, schedule of fees and charges, insurance coverage, irrevocability of a transfer or exchange and exception to irrevocability, and others. 4. Stablecoins – until 1 January 2028, the engagement in exchange, transfer, storage or administration of stablecoins, whether directly or through an agreement with a digital financial asset control services vendor is prohibited under the Digital Financial Assets Law, unless two cumulative requirements are fulfilled: (i) the issuer of the stablecoin is a bank or entity licensed to conduct such activity by the DFPI; (ii) the issuer owns eligible securities with an aggregate market value of not less than the aggregate amount of all of its outstanding stablecoins issued or sold in the United States. 5. Privacy – the Digital Financial Assets Law applies the requirements of California Financial Information Privacy Act, which regulates disclosure of consumer’s nonpublic personal information in financial sector, to entities holding a license under its provisions and digital financial asset business activities. The new law is still subject to California’s’ Governor’s signature, and if signed as expected, it will enter into force on 1 January 2025. Businesses that conduct crypto and other digital asset-related activities with residents of California, should stay tuned for further updates and prepare a path to compliance with the new regulatory framework before it goes into effect. Feel free to contact us if you have any questions regarding the new law and its potential effects on your company’s compliance efforts.