House Passes FIT 21 Act: A New Era for Cryptocurrency Regulation
Merkle Science
The US House of Representatives recently passed bill HR 4763, titled the “Financial Innovation and Technology for the 21st Century Act,” also known as “FIT 21.” FIT 21 is designed to provide an infrastructure for the tokens and coins that power blockchain transactions (“cryptocurrency” or “crypto”).
Passage of the FIT 21 Act
This bill has been in various committees and on the floor of the House since last year. Although the committee and voting process was inundated with political byplay and rumors of high-level attempts at manipulation, it passed easily and with bipartisan support. However, there is currently no Senate companion bill. Securities and Exchange Commission (“SEC”) Chairperson Gensler has repeatedly disparaged the bill,[1] and President Biden has indicated his dissatisfaction with the bill, though he stops short of saying he will veto it, should it pass the Senate.[2]
Definition and Regulation of Digital Assets
The FIT 21 bill has evolved quite a bit over time, and generally defines all cryptocurrency that is a “fungible representation of value that can be exclusively possessed and transferred” on a public, open-source blockchain as a digital asset.[3] Regulation is based on the concept that all digital assets that are not on a functional,[4] decentralized[5] system (as those terms are defined in the bill) must be offered through registered, regulated parties and exchanges, with regular reporting requirements, except for the noted exceptions.
Exclusions from Digital Assets
Digital assets do not include securities, commodities, or payment stablecoins. They also do not include things like NFTs (non fungible tokens) and securitizations.
Understanding Digital Commodities
Digital commodities, on the other hand, are a subset of digital assets that are held by anyone other than the issuer, an affiliated or related party, before the blockchain system it relates to is functional and certified decentralized and is offered on digital asset exchange or through an “end user distribution.”[6] End user distributions[7] are a loophole of permitted direct distribution, involving transferring digital assets for nominal value (e.g., an airdrop), as non-discretionary, incentive based rewards (e.g., a faucet for early developers), for active maintenance and security of the system (e.g., mining and validation), or to all holders pro rata (e.g., a type of dividend). Digital commodities are governed by the Commodities Futures Trading Commission (CFTC).
Investment Contracts and Securities
In addition to the broad definition of digital commodity, the bill also specifically states that digital assets sold pursuant to an investment contract will not become securities.[8] A second section, Title II, or the “Securities Clarity Act of 2024,” excludes “fungible digital representations of value. . . that can be exclusively possessed and transferred [on a public, open-source blockchain, that is purchased, sold, or intended to be purchased or sold] pursuant to an investment contract.” It calls representations of value “investment contract assets,” and its definition in full form is nearly identical to the previously defined “digital asset.”[9]
These two sections seem expressly designed to undermine one of the SEC’s biggest weapons against crypto: investment contracts. Creating securities via unintended investment contract is the primary source of nearly all claims filed by the SEC against crypto projects, including several currently in the court system.[10] The bill does not clarify what will happen to relevant crypto cases currently pending in the court system should this bill pass, or those declared securities previously.
Regulation of Payment Stablecoins
Payment stablecoins are required to be issued by (1) registered and regulated banks or (2) credit unions and must be convertible on demand into fiat.[11] This is directly from a prior bill regarding stablecoins, but it no longer permits stablecoins that are created by entities or protocols other than banks and credit unions. This will exclude all stablecoins created within the blockchain industry, as well as those backed by items other than fiat or stabilized in other manners. The only permitted stablecoins are fiat duplicates.
Investment Opportunities for Unaccredited Investors
There are several other noteworthy aspects of this bill. For example, Title III permits unaccredited investors to invest in digital assets provided, in part, that (1) the amount sold by the issuer in the 12 month period preceding and including the offering does not exceed $75 million, (2) the unaccredited investors have each not purchased digital assets in the last 12 months, including the current offering, in an amount exceeding the greater of 10% of net worth or 10% of annual income.[12] The issuer may rely on the investor’s declaration that they have not exceeded the total permitted purchase amount unless there is “reason to question” the investor’s statement.[13]
Benefits and Requirements for Issuers
Other benefits include the ability to solicit interest or discuss the offering of digital assets with unaccredited investors prior to the offering, and accepting indications of interest with specific investor information.[14] However, there is a requirement that all transactions be conducted through an intermediary, such as a broker, dealer, or trading system.[15]
Reporting and Disclosure Requirements
There are a number of reporting requirements,[16]and the disclosure includes items like material risk factors, the plan of distribution, method of governance, and the timeline for moving to decentralization and functionality. If restricted digital assets are sold, such as those held by the issuer, affiliated parties, or related parties, additional disclosure is required, such as a method of accessing the transactions on the blockchain. Curiously, there is no requirement for financial statements, audited or otherwise.
Certification of Decentralization
Certification of decentralization is based on an analysis of several factors by the appropriate commission.[17] These factors include (1) the ability to prevent any one person from controlling or altering the blockchain or protocol, (2) the ability to prevent any one person from excluding anyone from participation in the application or protocol or its governance, (3) the distribution of ownership, (4) the number and type of recent changes to the source code, and (5) the marketing of the related digital asset.
Custody Requirements and Recent Changes
Digital asset trading systems, brokers, and dealers, whether governed by the SEC or CFTC, are required to have third party custodians, with traditional custodian requirements. It also reiterates the recent overturning of the SEC’s curious accounting treatment for digital assets. SAB 121[18] required, among other things, for custodians to include custodied assets as though they are held by the custodian entity for purposes of assessing risk and liability accounting.[19] This highly unusual treatment was recently overturned by Congress, and is removed in the discussion of custody in FIT 21.
Exclusion of Decentralized Finance from Regulation
Decentralized finance is expressly excluded from regulation pursuant to the bill,[20] although operators of commodity pools are required to register,[21] and it is possible these may fall within decentralized finance operations.
Prohibition on Restricting Self-Custody
Another noteworthy section prohibits the Financial Crimes Enforcement Network (FinCEN) from issuing any rules that prohibit self-custody of digital assets via hard wallet (e.g., Ledger) or self-custodying internet wallet (e.g., Metamask).[22] However, it has language that could be interpreted to prohibit FinCEN from requiring or enforcing “Know Your Customer” and “Anti-Money Laundering” regulations. This would not only be surprising, considering the primacy of the Bank Secrecy Act in financial and securities transactions, but also their requirements in international regulations to which the US is a party.
Core Flaws in the FIT 21 Act
While this may seem like a helpful bill, it has the same core flaw as all prior attempts: it displays a fundamental lack of understanding of how blockchain actually works. All of the industries incorporated in the bill (securities, commodities, currency, etc) are all static industries. A share of Apple stock remains a share of Apple stock from its issuance until it is liquidated. A dollar bill remains a dollar from minting until destruction.
But cryptocurrency is different. One token or coin (collectively, “Token”) can simultaneously:
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Represent a fungible holder of value (commodity)
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Secure a chain through gas fees (transaction provider)
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Purchase a digital product (currency)
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Sell for speculative value or fractionalize value (securities)
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Vote (governance)
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Represent a nonfungible package of specific rights and/or intellectual property (bundle of rights)
The Complexity of Cryptocurrency Transactions
Not only can one Token (or part of a Token) represent different things throughout its life, but it can also shift between holders. One holder can sell a Token on an exchange (using it as a security), and the buyer can use the same Token to purchase a product (currency) and pay gas fees (transaction provider). It is nearly impossible to tell what any one transaction a Token has engaged in until after the fact, and often an accounting treatment is required.
Dealing with bad actors and illegal activity is necessary, but it cannot be undertaken without a full understanding of the technology itself. Without that, any regulation, however well-intended, becomes unenforceable and meaningless.
[1] https://www.coindesk.com/policy/2024/05/22/secs-gensler-says-house-bill-would-undermine-regulators-crypto-capital-markets-oversight/
[2] https://www.coindesk.com/policy/2024/05/22/secs-gensler-says-house-bill-would-undermine-regulators-crypto-capital-markets-oversight/
[3] “Financial Innovation and Technology for the 21st Century Act,” H.R. 4763, 118th Cong. (2024). https://www.congress.gov/118/bills/hr4763/BILLS-118hr4763eh.pdf Section 101.
[4] Ibid.
[5] Ibid.
[6] Ibid., Section 103.
[7] Ibid., Section 101.
[8] Ibid.
[9] Ibid., Sections 201-202.
[10] See, e.g., SEC v. Coinbase, Inc. and Coinbase Glob., Inc. (collectively d/b/a Coinbase), No. 1:23-cv-04738 (S.D.N.Y. June 6, 2023), https://www.sec.gov/files/litigation/ complaints/ 2023/comp-pr2023-102.pdf, SEC v. Ripple Labs, Inc., Bradley Garlinghouse, and Christian A. Larsen (collectively d/b/a Ripple), No. 1:20-cv-10832 (S.D.N.Y. Jan. 29, 2021), SEC v. Wahi, No. 2:22-cv-01009 (W.D. Wash. Mar. 1, 2024), , SEC v. Terraform Labs PTE Ltd and Do Hyeong Kwon (collectively d/b/a Terraform), No. 1:23-cv-01346 (S.D.N.Y. Feb. 16, 2023), https://www.sec.gov/files/ litigation/complaints/2023/comp-pr2023-32.pdf, and SEC v. Binance Holdings Ltd., BAM Trading Servs. Inc., BAM Mgmt. US Holdings Inc., and Changpeng Zhao (collectively d/b/a Binance), No. 1:23-cv-01599 (D.D.C. June 5, 2023), https://www.sec.gov/files/litigation/ complaints/2023/comp-pr2023-101.pdf.
[11] “Financial Innovation and Technology for the 21st Century Act,” H.R. 4763, 118th Cong. (2024). https://www.congress.gov/118/bills/hr4763/BILLS-118hr4763eh.pdf Sections 101 and 402.
[12] Ibid., Section 301.
[13] Ibid.
[14] Ibid.
[15] Ibid.
[16] Ibid., Sections 301-303.
[17] Ibid., Section 304.
[18] https://www.sec.gov/oca/staff-accounting-bulletin-121
[19] “Financial Innovation and Technology for the 21st Century Act,” H.R. 4763, 118th Cong. (2024). https://www.congress.gov/118/bills/hr4763/BILLS-118hr4763eh.pdf Sections 501-508.
[20] Ibid., Section 509.
[21] Ibid., Section 508.
[22] Ibid., Section 105.