The Financial Innovation and Technology for the 21st Century Act: A Template for Future Crypto Market Legislation?

Last year, the House passed the Financial Innovation and Technology for the 21st Century Act (FIT 21) to close gaps created by current laws that did not anticipate the emergence of digital assets. FIT 21 seeks to divide digital asset jurisdiction between the Securities & Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) by identifying which digital asset transactions are subject to SEC jurisdiction and granting the CFTC authority to regulate secondary transactions in digital commodities. With the recent change in administration, we expect FIT 21 will serve as the template for any future crypto market bill. The following gives a refresher on FIT 21 and issues it leaves open.

Overview of Key Provisions

At a high level, FIT 21 would allocate jurisdiction of digital assets between the SEC and the CFTC on the basis of whether a digital asset is decentralized. The SEC would generally have oversight over “restricted digital assets,” those which are not part of a “functional system” or are not decentralized. The CFTC would then generally regulate “digital commodities,” those which are part of decentralized and functional blockchain systems. With the dividing line of decentralization, FIT 21 would aim to provide regulatory clarity and seek to pair consumer protection with a regulatory framework tailored to the nuances of blockchain technology.

1. Assets Offered as Part of an Investment Contract

The federal securities laws define “security” as a list of financial instruments, including investment contracts.[1] In SEC v. Howey,[2] the Supreme Court defined “investment contract” to mean any “contract, transaction or scheme whereby a person [1] invests money [2] in a common enterprise and [3] is led to expect profits [4] solely from the efforts of the promoter or a third party.” Howey involved the sale of orange grove parcels coupled with services contracts that would pass profits from the sale of oranges to purchasers. The Supreme Court applied its definition of investment contract to find that the scheme as a whole constituted a security.

In recent years, the SEC has relied on Howey to allege that virtually all digital assets are securities, effectively arguing that the oranges in Howey are securities. FIT 21 seeks to resolve this by revising the definition of “security” to exclude “investment contract assets.” It then defines investment contract asset to mean “a fungible digital representation of value that can be exclusively possessed and transferred, person to person, without necessary reliance on an intermediary, and is recorded on a cryptographically secured public distributed ledger; sold or otherwise transferred, or intended to be sold or otherwise transferred, pursuant to an investment contract; and that is not otherwise a security”

2. Offers and Sales of Digital Assets

In general, the Securities Act of 1933 (33 Act) governs distributions of securities to the public, while the Securities Exchange Act of 1934 (34 Act) governs how securities are traded in secondary markets. The 33 Act generally requires public offerings of securities to be registered with the SEC. This process includes the costly production of disclosures about the issuer’s business operations, management, finances and risks. Under the 34 Act, these disclosures must generally be updated and filed with the SEC quarterly.

These disclosures assume the securities offered are equity or debt interests in a company and therefore are ill-suited to digital assets which may not have a clear issuer and often do not provide an ownership interest in a legal entity or business. They also fail to require disclosures that would be relevant to digital asset purchasers such as how code changes can be authorized, what consensus mechanism will be used and how new tokens may be created (e.g., through staking).

FIT 21 seeks to address these issues by creating tailored issuance and disclosure requirements for digital assets. In particular, issuers of digital assets would be exempted from federal and state securities regulation when offering or selling a digital asset if:

• The aggregate amount sold over a 12-month period is $75 million or less (adjusted annually for inflation);
• A single purchaser does not own more than 10% of the total assets sold;
• Purchases made by unaccredited investors do not exceed 10% of their annual income or net worth;
• The transaction does not include digital assets not offered as part of the investment contract; and
• The issuer is organized under U.S. laws, isn’t an investment company and has a specific business plan or purpose.

Despite being exempted from the rules applicable to traditional securities offerings, issuers of digital assets satisfying the above criteria would still be required to disclose certain information, including:

• The source code of the blockchain related to the digital asset;
• A description of the steps required to access, search and verify the transaction history of the blockchain system related to the digital asset;
• The digital asset economics, including the total number of digital assets to be issued, the method for validating transactions and mining digital assets, governance mechanisms for implementing changes to the system and information to help a third party verify the asset’s transaction history;
• All affiliates who have been issued digital assets;
• The development timeline of the digital asset; and
• Material risks of owning the digital asset.

Following issuance, digital asset issuers would be required to file semiannual reports with the SEC on the amount of money raised and the state of development of the digital asset’s blockchain, including when the system intends to become functional and decentralized. These reporting requirements would continue until 180 days after the end of the fiscal year in which the blockchain system to which a digital asset relates is certified as functional and decentralized.

3. Decentralization

FIT 21 treats digital assets obtained pursuant to the new exemption related to blockchain networks that are not functional and decentralized as “restricted digital assets” subject to SEC jurisdiction. FIT 21 treats a digital asset as “decentralized” when in the previous 12 months:

• No one person had unilateral control over the functionality of the blockchain system;
• The issuer or its affiliated persons have not controlled 20 percent or more of the asset;
• Any distributions were directly to end users rather than as part of an investment;
• In the prior three months, neither the issuer or its affiliates have materially contributed to the development of the network; and
• In the prior three months, neither the issuer nor its affiliated persons have marketed the digital asset to the public as an investment.

FIT 21 then allows any person to file a certification with the SEC to demonstrate an asset’s decentralization and creates a process for the SEC to review and decide whether it agrees. If the SEC agrees, the asset becomes a digital commodity subject to CFTC jurisdiction. If not, the filer has recourse to appeal to the D.C. District Court.

4. Intermediaries to Register With the SEC

The 34 Act requires those who intermediate securities transactions to register with the SEC based on their activities. For example, those in the business of effecting securities transactions for the account of others or who engage in the business of buying and selling securities for their own account must register as “broker-dealers,” those who provide facilities for bringing together purchasers and sellers of securities must register as “national securities exchanges” or “alternative trading systems,” and those who act as intermediaries in making payments or deliveries or both in connection with transactions in securities must register as “clearing agencies.” These registration categories, together with the obligations of these intermediaries under the 34 Act, create the “market structure” for securities markets.

FIT 21 creates new SEC registration categories for intermediaries of restricted digital assets. Specifically, FIT 21 generally requires registration as a “digital asset trading system” for marketplaces bringing together purchasers and sellers of restricted digital assets. Digital asset trading systems would also be prohibited from custodying customer money, assets or property “in their role as a digital asset trading system” but could custody such assets under a separate registration qualifying as a “qualified digital asset custodian.” Digital asset brokers and dealers would also generally be required to register with the SEC to transact in restricted digital assets. Digital asset brokers and dealers would further be subject to additional requirements relating to the segregation of customer assets, maintaining of minimum capital requirements and reporting and recordkeeping requirements, among others.

5. Intermediaries to Register With the CFTC

Similar to the 34 Act, the Commodity Exchange Act (CEA) requires those who intermediate transactions in “commodity interests” (i.e., most derivatives) to register with the CFTC. Those who “solicit and accept orders” in derivatives must register as “introducing brokers” or “futures commission merchants,” those acting as organized derivatives exchanges or trading facilities to become “designated contract markets” (the derivatives equivalent of exchanges) and those providing clearing services to register as “derivatives clearing organizations.”

The CEA is focused on derivatives markets and not spot commodity trading. Thus, while it prohibits the manipulation and commodity prices, it does not require the registration of those intermediating most commodity transactions. This has created a gap in the law where even if a digital asset is initially offered as part of a securities transaction that should be registered with the SEC, secondary market transactions in digital assets that do not qualify as securities become unregulated at the federal level. States have generally filled this void with money transmission rules, and in some cases, such as New York, Louisiana and soon to be California, bespoke virtual currency regulations.

Like derivatives contracts presently, FIT 21 would require digital commodities to be certified with CFTC-registered exchanges before they could be traded. It then provides for digital-asset-specific intermediary registrations and prohibits those intermediaries from effecting trades in uncertified assets. Trading facilities that offer or seek to offer a cash or spot market in at least one digital commodity would be required to register as digital commodity exchanges. Digital commodity exchanges would be subject to certain requirements, including restrictions on proprietary trading, requirements to comply with CEA core principles similar to those of designated contract markets now and ongoing reporting and recordkeeping requirements. Digital commodity brokers and digital commodity dealers would also be required to register and be subject to requirements such as standards relating to business conduct, minimum capital requirements and reporting and recordkeeping obligations.

Open Issues

FIT 21 leaves a number of issues unanswered for digital asset firms. First, FIT 21’s definition of “decentralized” leaves open the possibility that an asset that was once decentralized could cease to be decentralized, for example if a large, centralized custodial exchange controlled a majority of the validator nodes (similar to how index funds control a disproportionate percentage of public securities). If not addressed in future drafts, this could leave open the possibility that digital commodities revert to being restricted digital assets, causing regulatory confusion about which rules apply. FIT 21 also excludes numerous decentralized finance (DeFi) activities, making it unclear what their status and related rules would be.

Additionally, unlike in traditional finance, the distinction between infrastructure and software providers on the one hand and financial institutions on the other is not as clear for Web3 firms. FIT 21 is largely silent on when one is providing infrastructure and when one is engaging in regulated financial activities. Thus, it may capture firms that do not view themselves as financial institutions or customer facing. Finally, FIT 21 does not appear to address the status of staking activities, which are separate from the assets themselves. Many states have alleged staking activities qualify as securities under state blue sky laws and could continue to do so were FIT 21 passed.

Looking Forward

As Congress weighs market-structure legislation tailored to digital assets, Paul Hastings Fintech attorneys stand ready to guide you through the shifting regulatory landscape. If you have any questions about how new legislation and regulations may affect your business, please do not hesitate to contact us.