The passage of the bipartisan Financial Innovation and Technology Act for the 21st Century (FIT21) by the House of Representatives marks a landmark development for the U.S. cryptocurrency industry, undoubtedly putting much-needed regulatory clarity on the horizon. However, despite its best intentions, FIT21 is fundamentally flawed from a market structure perspective and raises issues that could have far-reaching unintended consequences if not addressed in upcoming Senate negotiations.
Joshua Reisman is Deputy General Counsel at GSR.
Note: The views expressed in this column are those of the author and do not necessarily reflect the views of CoinDesk, Inc. or any of its owners or affiliates.
One of the most problematic aspects of the bill is that it creates a bifurcated market for crypto tokens. By distinguishing between “restricted digital assets” and “digital goods” in the parallel trading market, the bill creates a fragmented environment that is unsuited to the inherent globality and fungibility of crypto tokens, and creates unprecedented compliance complexities.
The legislative effort stems from a long-running debate over the application of U.S. federal securities laws to crypto tokens and the distinction between Bitcoin and nearly all other tokens that are considered non-securities. The U.S. Securities and Exchange Commission's (SEC) guidance on whether crypto tokens are securities is generally based on whether the associated blockchain project is “sufficiently decentralized,” and therefore is not an investment contract “security” as defined by the Howey test.
FIT21 attempts to codify this unrealistic test by splitting regulatory oversight of spot cryptocurrency markets between the Commodity Futures Trading Commission (CFTC) and the SEC based on factors such as the degree of decentralization.
While the bill appears to make it clear and straightforward that crypto tokens transferred or sold pursuant to an investment contract do not inherently become securities, it unfortunately contradicts itself by giving the SEC full authority over investment contract assets sold to investors (or issued to developers) for the period until the project reaches decentralized Valhalla. Only airdropped tokens or tokens acquired by end users will initially be “digital goods” under the CFTC’s jurisdiction.
Most confusingly, FIT21 allows restricted digital assets and digital goods to be traded simultaneously under the same token on separate and distinct markets during this period (As shown in the figure belowMany projects I never have Meets the prescribed definition of decentralization in the Bill and therefore trades in the U.S. fragmented market indefinitely.
The bill's proposed bifurcated market for restricted and unrestricted digital assets ignores a fundamental characteristic of crypto tokens: fungibility. By creating categories of restricted and unrestricted assets, the bill would confuse this principle and cause confusion and market fragmentation. This could undermine liquidity, complicate trading and risk management mechanisms such as derivatives, reduce the overall utility of crypto tokens, and ultimately stifle innovation in emerging industries.
Enforcing such a distinction may require making technical changes to crypto tokens to allow purchasers to recognize the type of crypto asset they are receiving so that they can comply with market-specific requirements. Imposing such technical markings on restricted digital assets, even if possible, would create a “US-only” crypto market separate from the global digital asset market, reducing the utility and value of all related projects.
As shown in the diagram above, if a decentralized project were to re-centralize, tokens could potentially bounce back and forth between the SEC and CFTC markets. The complexity and compliance costs created by such a scheme are vastly underestimated for thousands of crypto tokens in the future, and would undermine the credibility and predictability of US financial markets. There are very few instances where a financial product would shift between the jurisdictions of the SEC and CFTC, and most would be tire fires (for exampleIn 2020, the KOSPI 200 futures contract transferred from CFTC jurisdiction to joint CFTC/SEC jurisdiction.
The bill further underestimates the international nature of the crypto token market. Crypto tokens are global assets that trade as the same securities around the world. Any attempt to restrict certain assets within the U.S. would likely lead to regulatory arbitrage, with flow-backs from international markets undermining the intent of the bill and undermining the competitiveness of the U.S. crypto industry.
It is unlikely that developers and investors outside the U.S. would impose similar restrictions on restricted digital assets themselves. Thus, new projects and investors will have an incentive to move their development and investments outside the U.S. to avoid these requirements. This will make it extremely difficult to prevent the U.S. digital goods market from being flooded with non-U.S. tokens that would have become restricted digital assets if they had been “issued” in the U.S.
A final irony is that the bill designed to protect U.S. consumers may ultimately hurt them because of poor market structure. The nascent CFTC-regulated market for end users is populated by a large number of sellers who typically receive tokens for free. This asymmetric market dynamic will likely drive down prices and increase volatility relative to both restricted and international markets, allowing professional arbitrageurs to profit at the expense of U.S. retailers.
The system will be further exploited by insiders and professional investors as arbitrageurs take advantage of discontinuities in pricing and price spikes caused by the transition between centralized and decentralized designations. At best, the US retail market will be a noisy signal of fundamental value, and end users will be the last to receive institutional liquidity.
While FIT21 is an important step in addressing the regulatory challenges posed by crypto tokens, the market structure as currently proposed could have unintended consequences. To protect customers and ensure the smooth functioning of U.S. digital asset markets, lawmakers should revise the bill to bring spot markets for non-securities, fungible crypto tokens into a consistent regulatory framework.
