The Digital Market Clarity Act is pending in the U.S. Congress. The bill’s primary goal is to integrate digital assets more fully into the financial system. The Senate is scheduled for a cloture vote on the bill on Tuesday, September 15. Whether the bill’s overall approach is the right one, I do not know.
What I do know is that the bill’s expansion of the so-called bankruptcy safe harbors is not a great idea. Generally speaking, these safe harbors insulate financial derivative contracts from the normal bankruptcy rules. The argument always has been these financial markets need liquidity and cannot suffer the effects of frozen contract positions that the normal bankruptcy rules require through the imposition of the automatic stay. That position is empirically dubious. I’d refer people to Stephen Lubben’s work on the topic. In the financial crisis of 2007, the safe harbors likely exacerbated the fallout from the Lehman Brothers bankruptcy as investors made a “run on the bank.” In contrast, spillover effects did not happen where the safe harbors did not apply such as in the chapter 11 bankruptcy of FTX or under the FDIC’s resolution authority with Silicon Valley Bank. The safe harbors need to be cut back if not altogether repealed.
The Clarity Act goes in the opposite direction. It would add “digital commodities” to the list of transactions protected by the safe harbors. I signed a letter along with other bankruptcy and banking professors (including Credit Slip bloggers Pamela Foohey and Anna Gelpern) urging Congress to remove the safe-harbor expansion from the Clarity Act. Given the size and volatility of the crypto-markets, now is especially not the time to be experimenting with expanding an already overbroad provision. The letter explains a lot more. For the bankruptcy mavens, one particularly problematic point is the inclusion of “digital commodities” in section 546(e), which provides a defense against fraudulent transfers and preferences. The provision could be read to mean that even partially denominating the payment of a corporate buyout, for example, would insulate the transaction from scrutiny in a later bankruptcy case.
The Clarity Act aims to put digital commodities on an equal footing with similar transactions. The bankruptcy sections of the bill that would treat them the same as traditional assets in stockbroker or commodity broker liquidations do just that. Digital commodities should not be given a leg up, however, by insulating them from the same bankruptcy provisions that apply to everybody else. The safe-harbor expansion should go.