There’s been a lot of coverage about the Financial Innovation and Technology for the 21st Century Act (FIT 21), which should receive a Congressional vote today. However, there’s been little reporting about the details of the Act. While it’s a bipartisan Bill, some Democrats, the White House and the SEC oppose it. The Bill’s major progress is recognizing that some digital assets shouldn’t be regulated as securities. At the same time, it has several flaws and may need more work.
Update: as expected, a significant number of Democrats (71) voted in favor of the Bill, so it was approved with 279 votes in favor and 136 opposed.
Today the White House issued a statement saying, “The Administration is eager to work with Congress to ensure a comprehensive and balanced regulatory framework for digital assets, building on existing authorities, which will promote the responsible development of digital assets and payment innovation and help reinforce United States leadership in the global financial system.”
It added that it doesn’t see the Bill providing sufficient investment protections.
Meanwhile, the Bill is not expected to be heard in the Senate soon, so there may be time to implement fixes.
To examine some of the flaws, we first need some context.
FIT 21: Clarifying decentralization
The Bill splits supervision of digital assets between the CFTC for digital commodities and the SEC for restricted digital assets. A key requirement to be classified as a digital commodity is some degree of decentralization. That includes the issuer not controlling the blockchain or protocol and not owning or influencing more than 20% of the digital commodity tokens or its votes, amongst other requirements.
The SEC would oversee the issuance of restricted digital assets. FIT 21 imposes disclosure rules similar to crowdfunding for token offerings of up to $75 million. Retail investors can participate, provided the investment doesn’t amount to more than 10% of their income or assets.
While the Act attempts to draw lines between the CFTC and the SEC’s purview, it doesn’t entirely succeed, and it’s messy.
Flaws in the CFTC – SEC divide
For example, to be classified as a digital commodity, the digital asset issuer must inform the SEC that it considers the digital asset to be decentralized and provide reasons. The SEC has 60 days to respond.
Today SEC Chair Gary Gensler gave his critique of the Bill. He has a point that there are rather a lot of digital assets. If hundreds or thousands of token issuers simultaneously made a decentralized declaration, the SEC wouldn’t have the resources to review them all, so they automatically become digital commodities.
That could be problematic because digital commodities don’t require reporting, whereas restricted digital assets require investor disclosures twice a year. Also, if a decentralized protocol is able to coordinate governance, why shouldn’t it also coordinate disclosures?
Congresswoman Maxime Waters was also vocal in her criticism. She highlighted that the CFTC was never designed to oversee retail investments. Does it have the resources with 700 staff compared to the SEC’s roughly 5,000? Once a digital asset is classified as a digital commodity, the degree of oversight becomes rather limited, which might lighten the supervision load. Additionally, once the digital asset becomes decentralized, instead of transferring the investor disclosure requirements to the governance system, they fall away.
FIT 21 fails in goal of sidestepping Howey
While a key goal of the legislation is to sidestep the Howey Test under which the SEC classifies most digital assets as securities, lawyers Davis Polk aren’t convinced it succeeds. They believe the legislation leaves a ‘backdoor’ for the SEC to continue to assert the Howey Test. That’s because of the way that FIT 21 defines an “investment contract asset”.
Additionally, the SEC is known to now consider Ether as a security because of its use in staking. Davis Polk also highlights that the Bill’s definition of a ‘digital asset’ excludes ‘any note’. Hence, the SEC could claim staked assets are ‘notes’ (securities) rather than digital assets or digital commodities.
The same digital asset could simultaneously be considered a digital commodity and a restricted digital asset, depending on who owns it. Now that seems messy. “The result is that two identical and otherwise fungible assets could be required to be traded on different systems and with different disclosure and other requirements,” wrote Davis Polk.
All in all, FIT 21 seems like a step in the right direction. At the same time, it still needs a fair bit of work.
