California Enacts Digital Financial Assets Law

On October 13, 2023, California enacted the Digital Financial Assets law. This law is California’s first comprehensive framework for regulation of digital asset markets, and some of its provisions may sound familiar to those versed in the state’s money transmitter licensing requirements. Under this new law, on and after July 2025, crypto companies and everyone else will need, in addition to other criteria, a license to operate or hold themselves out as being able to operate digital financial asset business activity, with or on behalf of California residents.

The following editorial was written by guest authors Wyatt Noble and Michael Handelsman for Kelman.Law

Key Definitions

Before diving into the key provisions of the Digital Financial Assets law, it’s important to understand exactly what some of its key terms mean, what they cover, and what they don’t. Under the law, “digital financial asset” means digital mediums of exchange, units of account, or stores of value. However, “digital financial asset” “does not include any of the following: (A) [a] transaction in which a merchant grants, as part of an affinity or rewards program, value that cannot be taken from or exchanged with the merchant for legal tender, bank or credit union credit, or a digital financial asset[;] (B) [a] digital representation of value issued by or on behalf of a publisher and used solely within an online game, game platform, or family of games sold by the same publisher or offered on the same game platform[;] (C) [a] security registered with or exempt from registration with the United States Securities and Exchange Commission or a security qualified with or exempt from qualifications with the department.”

The term “digital financial asset business activity” can be understood to mean those activities that trigger the law’s licensing requirement. Specifically, “digital financial assets business activity is defined as: “(1) [e]xchanging, transferring, or storing a digital financial asset or engaging in digital financial asset administration, whether directly or through an agreement with a digital financial asset control services vendor[;] (2) [h]olding 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[;] (3) [e]xchanging 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) [a] digital financial asset offered by or on behalf of the same publisher from which the original digital representation of value was received [or] (B) [l]egal 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.”

Stablecoins are defined as “a digital financial asset that is pegged to the United States dollar or another national currency and is marketed in a manner that intends to establish a reasonable expectation or belief among the general public that the instrument will retain a nominal value that is so stable as to render the nominal value effectively fixed.”

Who Will Handle Regulation and Enforcement?

The new law grants the California Department of Financial Protection and Innovation (DFPI) broad enforcement power. Now, the DFPI may bring enforcement actions against those that are “engaged, [are] engaging, or [are] about to engage in digital financial business activity.” If this seems a bit broad and vague, that’s because it is, but further changes narrowing the DFPI’s reach may be coming. California Governor Gavin Newsom has already called for the DFPI to clarify ambiguities in the law, and he is likely not the only California resident who will push for greater clarity.

How are Exchanges Impacted?

Among other requirements, exchanges must identify the probability that digital financial assets listed on their platforms “would be deemed a security by federal or California regulators.” However, the law provides no guidance as to how exchanges should make such an assessment. Exchanges must also provide “full and fair disclosure of all material facts relating to conflicts of interest that are associated with” assets on their platforms. Additionally, exchanges must conduct “comprehensive risk assessment designed to ensure consumers are adequately protected from cybersecurity risk, risk of malfeasance, including theft, risks related to code or protocol defects, or market-related risks, including price manipulation and fraud.” Further, exchanges must establish “policies and procedures to reevaluate the appropriateness of the continued listing or offering of the digital financial asset, including an evaluation of whether material changes have occurred,” and conversely must also establish “policies and procedures to cease listing or offering the digital financial asset, including notification to affected consumers and counterparties.” Finally, exchanges are also required to “use reasonable diligence” to ensure that exchange rates between assets are as “favorable as possible” to consumers “under prevailing market conditions.”

How Are Stablecoins Affected?

The law grants the DFPI discretion in deciding which stablecoins are approved for exchange, transfer, or storage. In so doing, the DFPI will look to the “amount, nature, and quality of assets owned or held by the issuer of the stablecoin that may be used to fund any redemption requests from residents.” Additionally, the DFPI commissioner may require stablecoin issuers to obtain licenses “to protect the interests of residents who may use the stablecoin as payment for goods or services or as a store of value.” In furtherance of consumer protection, the law also requires that the “issuer of … stablecoin at all times own eligible securities having an aggregate market value computed in accordance with United States generally accepted accounting principles of not less than the aggregate amount of all of its outstanding stablecoins issued or sold.”

Streamlined Licensure for Bitlicense Holders

Those few companies or individuals holding a New York Bitlicense or limited purpose trust company charter with approval to conduct virtual currency business in New York issued on or before 1 January 2023, may be granted conditional licenses provided they have “supplied all fingerprints required” and meet all other requirements for licensure.

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