A Yield-Ban Loophole?

The Structural Choice and the GENIUS Act Companion

§404 sits alongside §4(a)(11) of the GENIUS Act, 12 U.S.C. 5903(a)(11), which prohibits permitted payment stablecoin issuers and registered foreign issuers from paying interest or yield on the stablecoins they issue. The GENIUS Act prohibition runs against the issuer. The §404 prohibition runs against everyone downstream of the issuer in the distribution chain, with the limited exception of foreign-issued stablecoins from non-U.S. issuers operating outside the registered-foreign-issuer framework. The two together cover the spectrum: an issuer cannot pay interest on the stablecoin it issues, and a downstream service provider cannot pay interest on the stablecoin balance the customer holds.

The drafting move is functionally similar to the historical Regulation Q prohibition on interest on demand deposits, 12 C.F.R. pt. 217, which prevented commercial banks from competing for transaction-account deposits on interest-rate terms. Reg Q was eliminated by the Dodd-Frank Act of 2010, but the underlying policy concern (interest-rate competition for transactional liquidity drives bank funding costs up and reduces credit availability) carries through to the §404 stablecoin context. The §404(b) sense-of-Congress provision is explicit about the banking-primacy framing: depository institutions provide financial services integral to the U.S. economy, and the payment of consideration by digital-asset service providers based on payment-stablecoin balances “in a manner that is economically or functionally equivalent to the payment of interest or yield on an interest-bearing bank deposit may inhibit depository institutions’ key functions in the economy of the United States.”

The sense-of-Congress provision also makes the contrary point. Payment stablecoins represent a significant innovation in financial infrastructure that can strengthen the U.S. payments system and the primacy of the U.S. dollar, and activity-based rewards and incentives tied to the use of payment stablecoins and participation in distributed ledger systems are critical to enabling innovation, competition, and consumer adoption. The §404 architecture is structured to permit the latter while prohibiting the former, with the joint rulemaking under §404(c)(3) tasked with drawing the line.

The “Economically or Functionally Equivalent” Standard

§404(c)(1) is the operative prohibition. A covered party shall not, directly or indirectly, pay any form of interest or yield (whether in cash, tokens, or other consideration) to a restricted recipient (a U.S. person who is a customer or user of the covered party) (A) solely in connection with the holding of the recipient’s payment stablecoins, or (B) on a payment-stablecoin balance in a manner that is economically or functionally equivalent to the payment of interest or yield on an interest-bearing bank deposit.

Two formulations, with different substantive content. (A) is the cleanest case: a covered party that pays consideration solely in connection with the holder’s holding of stablecoins, with no other activity required, is paying deposit-equivalent yield. That is the In re BlockFi Lending LLC fact pattern (SEC consent order, $100M, February 2022), the Coinbase Earn fact pattern as alleged in SEC v. Coinbase, Inc., and the Celsius Earn fact pattern. A customer deposits stablecoins; the platform pays the customer a fixed rate based on the balance and duration. (A) prohibits exactly that, and the prohibition is categorical: no rulemaking required, no activity-based exception applies.

(B) is the more interesting formulation. It prohibits payments on a stablecoin balance “in a manner that is economically or functionally equivalent” to deposit interest. The qualifier “economically or functionally equivalent” is the legal standard. The qualifier “in a manner” provides the doctrinal hook. Two structural elements drive the analysis. The economic-equivalence test asks whether the payment produces, in substance, the same economic result as deposit interest: a predictable return on a balance over time, without meaningful additional activity by the holder, with downside protection on principal. The functional-equivalence test asks whether the payment serves the same functional role in the customer’s financial life as deposit interest: a yield on cash held in a transaction account.

The categorical (A) prohibition catches the simple cases. The “economically or functionally equivalent” (B) standard catches the structured cases: products designed to deliver yield-equivalent outcomes through formal compliance with activity-based requirements while economically functioning as deposit substitutes. The joint rulemaking will need to identify the specific operational features that distinguish the two.

The Activity-Based Exception

§404(c)(2)(A) exempts “rewards or incentives based on bona fide activities or bona fide transactions that are not economically or functionally equivalent to the payment of interest or yield on an interest-bearing bank deposit pursuant to the regulations promulgated under paragraph (3).” The exception is conditional on the joint rulemaking, but the exception’s structural breadth is established by the statute.

§404(c)(3)(A) directs the SEC, CFTC, and Treasury, no later than one year after enactment, to jointly promulgate regulations to clarify the circumstances under which the §404(c)(1) prohibition and the §404(c)(2) permissible-rewards exception apply. The rulemaking is required to include a non-exhaustive list of permissible activity-based or transaction-based rewards or incentives, including payments to restricted recipients in connection with or in compensation for any of three categories:

(i) Transaction, payment, transfer, conversion, remittance, or settlement activity, including rebates or incentives provided in connection with the acceptance or use of a payment stablecoin. This is the merchant-acceptance and payment-rewards category. A stablecoin issuer or service provider that pays a rebate on stablecoin payments to merchants, or that pays a cashback equivalent on consumer payments made with stablecoins, is within this category. The structural analogy is credit-card cashback programs and merchant interchange rebates.

(ii) Providing liquidity for market-making activity, posting of collateral in connection with trading, or otherwise putting assets at credit or investment risk. This is the DeFi-and-trading category. A market-making protocol that pays rewards to liquidity providers, a perpetuals exchange that pays rewards to collateral posters, or a lending protocol that pays rewards to depositors who accept credit risk on borrower defaults is within this category. The structural test is whether the holder is putting assets at credit or investment risk. Static cash-equivalent holding is not in. Active liquidity provision with skin in the game is.

(iii) The use of any product or service, including participation in governance, validation, staking, or a loyalty, promotional, subscription, or incentive program. This is the broadest of the three categories and is the one that will determine whether the §404 yield ban has substantive bite. Loyalty programs, subscription-based rewards, governance-participation rewards, and validation-based rewards all sit within this category. The question is what counts as “use of a product or service” and what counts as mere holding.

§404(c)(3)(B) is the structural payoff. It clarifies that payments to restricted recipients of consideration, rewards, or benefits that are permissible under §404(c)(2) and §404(c)(3)(A) “may be calculated by reference to a balance, duration, tenure, or any combination of the foregoing.” This is the critical drafting choice. Activity-based rewards may be measured by balance, duration, or tenure metrics, provided the rewards are tied to qualifying activity. A loyalty program that pays cashback on stablecoin transactions, with the cashback rate increasing based on the customer’s balance, duration of platform tenure, or transaction tenure, is permissible if the underlying activity is qualifying.

The breadth of §404(c)(3)(B) is the structural concession to the crypto-industry position. Activity-based rewards do not have to be flat-rate or transaction-by-transaction. They can be balance-weighted, duration-weighted, or tenure-weighted, provided they are activity-based at the foundation. The economic substance of a balance-weighted activity reward is approximately the same as deposit interest for a customer who engages in any meaningful activity. A 4% annualized cashback rate on stablecoin payments, with the rate paid on the customer’s total balance rather than on transaction volume, looks substantially like 4% deposit interest with a use-it-or-lose-it cliff. The joint rulemaking will need to draw the line, but §404(c)(3)(B) substantially constrains how restrictively that line can be drawn.

§404(c)(4) Anti-Evasion

§404(c)(4) provides the anti-evasion authority. A covered party may not circumvent or evade the §404(c)(1) prohibition or the §404(c)(3) rules. The SEC, CFTC, and Treasury may jointly issue such rules as may be necessary or appropriate to prevent circumvention or evasion.

The anti-evasion language operates as a backstop to the activity-based exception. A program that complies with the literal terms of the §404(c)(2) exception but that, in economic substance, is designed to deliver deposit-equivalent yield to a holder who engages in nominal qualifying activity, is subject to the anti-evasion authority. The joint rulemaking will have to translate evasion into operational terms: what activity threshold is required, what proportionality is required between the activity and the reward, what minimum holding periods or active-use requirements apply.

The principal anti-evasion concern is “rake-back” or “phantom activity” structures: a service provider that pays rewards calculated as percentage of balance to a customer who engages in a single low-friction qualifying transaction per period (a single token swap, a single governance vote) is functionally paying yield on the balance while complying with the literal terms of activity-based reward. The rulemaking will have to confront this structure directly. The likely approach is a proportionality test: the reward must be proportionate to the qualifying activity, not a thin layer of activity supporting a balance-weighted reward.

§404(c)(5) Good-Faith Reliance

§404(c)(5) provides a good-faith reliance safe harbor. A covered party that structures a program in good-faith reliance on §404(c)(2) and §404(c)(3) is not subject to penalties if a subsequent rulemaking or adjudication determines the program falls outside the exception, provided the covered party comes into compliance within 90 days and the violation is not substantially similar to a past violation by the covered party.

The 90-day cure window is operationally meaningful. It permits aggressive program design at the front edge of the §404(c)(2) line, with the protection that the worst-case downside is a 90-day cure rather than penalty exposure. The anti-recidivism limitation prevents repeat offenders from claiming the safe harbor for each new variant of an essentially similar program.

§404(d) Marketing-Representation Prohibition

§404(d) addresses the marketing side of stablecoin yield programs. §404(d)(1)(A) prohibits a covered party from representing that payment stablecoins are investment products, deposits, backed by the full faith and credit of the United States, guaranteed by the U.S. government, subject to FDIC deposit insurance, or subject to NCUA share insurance. §404(d)(1)(B) prohibits representing that compensation paid to a restricted recipient in connection with stablecoin holding, use, or retention is paid or generated by the payment stablecoin itself or the issuer, is risk-free or comparable to deposit interest, or is offered, administered, or paid by a person other than the covered party.

§404(d)(2) prohibits misleading omission of material information necessary to prevent the marketing, promotion, or description from being misleading. The §404(d) prohibitions are structured as marketing-conduct rules rather than as substantive prohibitions on the underlying programs. A program can be lawful under §404(c)(2) and yet be marketed unlawfully under §404(d). The marketing rules are independently enforceable.

§404(e) imposes joint disclosure-rulemaking authority on the agencies, with required disclosures presented in plain English, identifying the circumstances under which compensation is paid, identifying the responsible persons and any affiliations with the issuer, outlining all material terms, and including a statement that payment stablecoins are not investment products, deposits, or government-backed obligations. §404(e)(4) provides that a covered party that provides the required disclosures is deemed not to have made a prohibited representation under §404(d), provided the marketing does not contradict the disclosures and the disclosures are presented in plain English and in a clear and conspicuous manner.

§404(f) Penalties and §404(g) Referral

§404(f) provides civil monetary penalties up to $5,000,000 per violation for knowing and willful participation in a §404(c)(1), (d)(1), (d)(2), or (e)(3) violation. §404(f)(2) provides that separate acts of noncompliance with a common originating cause or arising from the same statement or publication count as a single violation, which limits the multiplication of penalties for systematic compliance failures.

§404(g) directs the SEC and CFTC to refer suspected violations to Treasury, which is the primary enforcement authority under the GENIUS Act framework. The structural choice is to consolidate stablecoin yield enforcement in Treasury rather than to spread it across the three agencies. The SEC and CFTC retain their conduct-rule authority over digital asset service providers, but the §404 enforcement runs through Treasury.

§404(i) Third-Party Payments

§404(i) addresses third-party payment structures. A covered party is not deemed to violate the §404(c)(1) prohibition solely because an unaffiliated third party independently makes a payment with respect to a payment stablecoin, unless the covered party directs or maintains significant influence over the offering of the consideration and the offering would otherwise violate §404(c).

The clarification is operationally important. A merchant that independently pays a customer a discount for paying with stablecoins is not subject to the §404 prohibition, and the stablecoin service provider that facilitates the payment is not deemed to have made the payment. The structural choice is to permit unaffiliated-third-party payments to flow through the stablecoin without the service provider’s involvement being deemed a payment by the service provider. The §404(i) “directs or maintains significant influence” qualifier means that a covered party cannot orchestrate a third-party-payment structure to evade the prohibition.

The Political Economy and the Comment-Letter Fight

If CLARITY is enacted, the joint SEC-CFTC-Treasury rulemaking under §404(c)(3) is going to be the most contested administrative proceeding of the cycle. The banking-lobby comment will press for narrow construction of the activity-based exception, with particular attention to two issues. First, the proportionality between activity and reward: how much qualifying activity is required to support how much reward? A high proportionality requirement (substantial activity required for substantial reward) prevents activity-based programs from functioning as yield substitutes. A low proportionality requirement (nominal activity sufficient for substantial reward) permits activity-based programs to operate as economic equivalents of deposit interest. Second, the calculation-by-reference issue: under what circumstances can rewards be balance-weighted versus transaction-volume-weighted? The banking position will be that balance-weighted rewards are the principal vector for evasion and should be limited.

The crypto-industry comment will press for broad construction of the exception, with corresponding attention to the same two issues from the opposite direction. The proportionality test should be permissive: activity should qualify if it is bona fide, with the agencies declining to inquire into the proportionality of the resulting reward. The calculation-by-reference allowance under §404(c)(3)(B) should be implemented fully: rewards should be calculable on balance, duration, or tenure metrics provided the underlying activity qualifies.

The Treasury position is the swing vote. Treasury’s policy posture on stablecoins, articulated through the GENIUS Act framework and the §404 sense-of-Congress provisions, is supportive of dollar-denominated stablecoin growth as a vehicle for U.S. dollar primacy in global trade and payments. A restrictive §404 rulemaking that suppresses activity-based reward programs would be in tension with that policy. A permissive §404 rulemaking that allows activity-based programs to function as yield substitutes would be in tension with the banking-primacy framing in §404(b)(1). The likely Treasury position is somewhere in the middle: substantive activity required, but not at a level that prevents activity-based programs from operating commercially.

Program Design Under §404

Four structuring consequences follow.

• First, the §404 prohibition is real but narrow. Pure deposit-equivalent yield is out. Activity-based rewards with bona fide qualifying activity are in. The structuring work is in designing programs that satisfy the activity-based exception while delivering the reward economics customers want.
• Second, the proportionality of activity to reward is the principal regulatory risk. Programs that pay substantial balance-weighted rewards on nominal activity will face anti-evasion scrutiny. Programs that scale rewards with activity are structurally safer. The joint rulemaking will draw the line, but the conservative design approach pre-rulemaking is to keep activity-to-reward proportionality reasonable.
• Third, marketing and disclosure are independently enforceable. A program can be substantively lawful under §404(c) and yet generate liability under §404(d) and (e). Plain-English disclosure of the program’s mechanics, identification of the responsible parties, and the boilerplate non-deposit non-investment disclosures are required. The disclosure safe harbor under §404(e)(4) is the operational protection.
• Fourth, the 90-day cure under §404(c)(5) is the front-edge protection. Aggressive program design in the period before the joint rulemaking is final, in good-faith reliance on §404(c)(2) and the published interim positions, is protected if compliance is achieved within 90 days of a later determination. The defensible posture is aggressive design backed by documented good-faith reliance, with cure protocols ready.

The §404 framework is, in the aggregate, more permissive than the banking lobby wanted and less permissive than the crypto industry wanted. The exception swallows much of the rule, but the rule retains meaningful bite for the simple deposit-equivalent programs that drew the most regulatory attention pre-CLARITY. The joint rulemaking will define the operational scope. If the bill is signed, the political economy of stablecoin rewards becomes a regulatory question rather than a legislative one.