House Leaders Propose Comprehensive Digital Asset Regulatory Framework
Commentary by Steven Lofchie
House Financial Services Subcommittee Chair French Hill (R-AR), House Agriculture Committee Chair Glen "GT" Thompson (R-PA) and House Agriculture Subcommittee Chair Dusty Johnson (R-SD) introduced legislation to authorize the SEC and the CFTC to establish a registration framework for digital assets and support further research on emerging technologies.
H.R. 4763, the "Financial Innovation and Technology for the 21st Century Act" addresses the following:
- Registration with the SEC. The proposal would provide the SEC with anti-fraud and anti-manipulation authority over transactions involving payment stablecoins, but does not grant the SEC any control over the "design, structure, issuance, redemption, financial resources, collateral, or any other aspect of a payment stablecoin’s operation." The proposal would create a registration framework for digital asset trading systems and digital asset broker-dealers and would establish measures to address conflicts of interest. Digital asset broker-dealers would also be required to comply with capital, recordkeeping and segregation of customer funds-related requirements. The proposal excludes "digital commodities" and "permitted payment stablecoins" from the definition of a security under securities laws.
- Registration with the CFTC. The proposal would provide the CFTC with "exclusive" regulatory jurisdiction over digital commodity cash or spot markets in connection with entities, such as digital commodity exchanges and digital commodity broker-dealers, that would be required to register under the proposal. Digital commodity exchanges would be required to (i) comply with "core principles," including "listing standards, treatment of customer assets, trade surveillance, capital, conflicts of interest, reporting, and system safeguards" and (ii) only list digital commodities not susceptible to manipulation. Separately, digital commodity broker-dealers would be required to comply with requirements regarding "business conduct standards, fair dealing, customer disclosures, segregation of customer funds, conflicts of interest, minimum capital requirements [and] reporting and recordkeeping." Future commission merchants would be required to hold customers’ digital commodities in a "qualified digital commodity custodian." The proposal would complement the CFTC’s existing anti-fraud and anti-manipulation authority but does not provide authority over the "design, issuance, redemption, structure, or operation" of permitted payment stablecoins.
- Digital Asset Exemptions. The proposal would exempt digital asset issuers from securities laws if (i) from the past 12 months, their total digital assets sales do not exceed $75 million or a non-accredited investor’s purchases of the digital assets are "less than the greater of 10% of the purchaser’s annual income or 10% of their net worth," (ii) the purchaser does not own more than 10 percent of the digital asset units following the transaction or (iii) the "transaction involves the sale of a digital asset as part of an investment contract." The proposal also provides for conditions under which individuals may engage in restricted asset transactions, a new disclosure regime for digital assets and the process for a digital asset blockchain to be certified as "decentralized."
- Innovation and Technology. The proposal would direct the SEC Strategic Hub for Innovation and Financial Technology ("FinHub") to be used for (i) conducting research on technology advancements and examining their impact on capital markets and investors and (ii) coordinating the SEC’s response to emerging technologies in financial, regulatory and supervisory systems. The proposal would direct LabCFTC to act as an information source for the CFTC on FinTech innovation by (i) increasing the CFTC’s accessibility for innovators and (ii) serving as a forum for innovators to understand the CFTC’s regulatory framework. The proposal would direct the SEC and CFTC to form a "Joint CFTC-SEC Advisory Committee on Digital Assets" to provide recommendations to both agencies and would require the SEC and CFTC to publicly respond to any such recommendations. The proposal would also require related studies to be submitted to Congress from (i) the SEC and the CFTC on decentralized finance and (ii) GAO on non-fungible digital assets in comparison to other digital assets, and their associated risks and benefits. Securities laws would be amended to include the word "innovation" to the factors that must be considered by the SEC when issuing a rulemaking.
Virtual Seminar/CLE
On August 2, representatives from Fried Frank, Morrison Cohen and DLx Law will host a complimentary virtual seminar on the legal impact of the Ripple decision for the digital assets industry (see related news). This program has been approved in accordance with the requirements of the New York State CLE Board for a maximum of 1.0 credit hour in Professional Practice.
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Commentary
What a complicated piece of legislation this is! It may be even more complicated than the regulation of swaps and security-based swaps under Title VII of Dodd-Frank. While the definition of "swap" under Dodd-Frank is arguably imprecise and overly broad, at least there was a pre-existing consensus as to what a swap is - and that consensus has largely governed conduct in the market, perhaps more than the definition in Dodd-Frank. In the case of digital assets that may or may not be securities or commodities, there is no such existing consensus that will inform interpretation of the bill should it be adopted.
Ideally, legislation this complicated would be accompanied by a significant report describing the state of the digital asset markets, the types of digital asset products, and perhaps how the drafters imagine that this should all work. Unfortunately, Congress has been left to legislate with very little assistance from the regulatory agencies that should have been most on top of the relevant issues.
However, the SEC has simply refused to engage in the question. (See generally The Securities Law Treatment of Utility Tokens (Or Why It Is Past Time for the SEC to Engage with the Hard Questions.) It would have been good if there were hidden somewhere in the SEC's files a document that would at least describe the markets and products as they exist. But all we have had from the SEC is that "like must be treated as like," and "Howey governs." Except digital assets are not just like oranges, and if Howey governs, then the securities laws don't seem to apply. Which brings us back to the recent Ripple decision.
While there are certainly elements of the Ripple decision that are questionable, on the most important holding, the outcome is fairly persuasive. The Court accepted the SEC's assertion that the Howey decision governs, and concluded that most secondary market transactions in the XRP token did not seem to be related to any "investment contract" and thus the securities laws were inapplicable. On August 2, we will host a complimentary webinar on the implications of the Ripple decision for crypto. (For an incredibly thorough discussion of this issue, see Lewis Cohen's article, "The ineluctable Modality of Securities Law." Note: don't be put off by the title, even if you have to look up what the word "ineluctable" means. A simpler title would be something like, "The Essential Elements of an Investment Contract.")
As a result, there is a clear need for legislation.
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