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Interpreting the FIT21 Act: Is the gray era of Crypto over?

BlockBeats2024/05/27 04:24
By:BlockBeats
Original author: Chen Mo cmDeFi, founder of BV DAO


This article mainly explains how to define digital assets in the regulatory framework proposed by FIT21, and how to divide the boundaries between commodities and securities. On May 22, 2024, the FIT21 bill was passed by the House of Representatives with 279 votes to 136. The bill established a regulatory framework for digital assets and may become one of the most far-reaching bills on Crypto at present.



FIT21, the full name is - 21st Century Financial Innovation and Technology Act. The key point of this bill is that it coincides with the approval of the ETH spot ETF application (Form 19b-4), standardizes the regulatory framework for digital assets, and provides guidance for more crypto assets to apply for spot ETFs in the future, as well as the road to compliance. It can almost be announced that the gray era of more than ten years since the birth of Crypto has ended and officially entered a new world.


1/9 · Registration and Regulatory Responsibilities


There are two definitions of digital assets, digital commodities and securities. The bill stipulates that the regulation of digital assets is jointly responsible by two main agencies according to the different definitions:


Commodity Futures Trading Commission (CFTC): responsible for regulating digital commodity transactions and related market participants.


Securities and Exchange Commission (SEC): responsible for regulating digital assets that are considered securities and their trading platforms.


2/9 · Definition of Digital Assets


The bill defines "digital assets" as an exchangeable digital representation that can be transferred from person to person without relying on an intermediary and is recorded on a cryptographically protected public distributed ledger. This definition includes a wide range of digital forms, from cryptocurrencies to tokenized physical assets.


3/9 · Commodity or Security (Classification of Digital Assets)


The bill proposes several key elements to distinguish whether a digital asset is a security or a commodity:


Investment Contract (The Howey Test): If the purchase of a digital asset is considered an investment and the investor expects to make a profit through the efforts of an entrepreneur or a third party, the asset is generally considered a security. This is based on the standard established by the U.S. Supreme Court in SEC v. W.J. Howey Co., commonly known as the Howey Test.


Use and consumption: If a digital asset is primarily used as a medium for consumer goods or services, such as tokens that can be used to purchase specific services or products, it may not be classified as a security, but rather as a commodity or other non-security asset.


Degree of decentralization: The bill places particular emphasis on the degree of decentralization of the blockchain network. If the network behind a digital asset is highly decentralized and there is no central authority controlling the functions of the network or asset, such an asset may be more likely to be considered a commodity.


Functionality and technical characteristics: The technical construction and functional implementation of digital assets are also the basis for classification.


Market activities: How an asset is promoted and sold in the market is also an important factor. If an asset is primarily marketed through the expected return on investment, it may be considered a security.


The content here is extremely important because it is significant in regulating the regulatory framework for digital assets and will affect what the next digital asset that may be available through spot ETFs is.


4/9 · Standard 1: Use and consumption, rather than as an investment to expect capital appreciation


From this perspective, public chains, PoW tokens, and functional tokens are more in line with the standard. (Note that this is only an example from the perspective of use and consumption. The definition of securities/commodities needs to be considered from multiple dimensions, and it does not mean that such assets fully meet the standard)


The common feature of these digital assets is that they are mainly used as a medium of exchange or payment method, rather than as an investment to expect capital appreciation. Although in the actual market, these assets may also be purchased and held speculatively, from the perspective of design and main use, they are more likely to be regarded as commodities.


5/9 · Standard 2: Definition of the degree of decentralization


Control and influence: In the past 12 months, no individual or entity has the unilateral power to control or substantially change the function or operation of the blockchain system directly or through contracts, arrangements or other means.


Ownership Distribution: In the past 12 months, no individual or entity associated with the digital asset issuer has owned more than 20% of the total digital asset issuance in total.


Voting Rights and Governance: In the past 12 months, no individual or entity associated with the digital asset issuer has been able to unilaterally direct or influence more than 20% of the voting rights of the digital assets or related decentralized governance systems.


Code Contributions and Modifications: In the past 3 months, the digital asset issuer or related personnel have not made substantial, unilateral modifications to the source code of the blockchain system, unless these modifications are to address security vulnerabilities, maintain routines, prevent network security risks or other technical improvements.


Marketing and Promotion: In the past 3 months, the digital asset issuer and its affiliates have not marketed the digital asset to the public as an investment.


Among these definition criteria, the more rigid criteria are ownership distribution and governance rights. The 20% boundary line is of great significance for the definition of digital assets as securities or commodities. At the same time, because of the open, transparent, traceable and tamper-proof characteristics of blockchain, the quantification of this definition standard will become clearer and fairer.


6/9 · Standard 3: Functional and Technical Characteristics


The definition of digital assets in the bill and how to connect them to the underlying blockchain technology are the basis for determining how these assets are regulated. We have already explained the definition of digital assets above. Here we will specifically talk about how their connection with the underlying blockchain technology determines the direction of regulation within the scope of the definition of digital assets. This connection usually includes how assets are created, issued, traded and managed:


Asset issuance: Many digital assets are issued through the programmatic mechanism of the blockchain, which means that their creation and allocation are based on preset algorithms and rules rather than human intervention.


Transaction verification: Transactions of digital assets need to be verified and recorded through the consensus mechanism in the blockchain network to ensure the correctness and immutability of each transaction.


Decentralized governance: Some digital asset projects have implemented decentralized governance, and users holding specific tokens can participate in the decision-making process of the project, such as voting on the future development direction of the project.


These characteristics directly affect how assets are regulated. Specifically:


If digital assets primarily provide economic returns or allow voting to participate in governance through automated programs on the blockchain, they may be considered securities because it indicates that investors are expecting to receive benefits through the efforts of management or enterprises.


If digital assets function primarily as a medium of exchange or are used directly to obtain goods or services, they may be more inclined to be classified as commodities.


7/9 · Key Question 1: The programmatic issuance characteristics of assets tend to be defined as commodities


This section provides important guidance on how to define whether certain digital assets issued through blockchain technology, especially through smart contracts or decentralized applications (DApps), constitute securities.


In the traditional sense, securities generally involve investors investing money in the expectation of receiving benefits through the efforts of enterprises or third parties. However, in the world of blockchain and cryptocurrency, many assets are issued and managed through automated programs or algorithms, and the characteristics and purposes of these assets may be different from traditional securities.


According to the bill, even if a digital asset is sold or transferred in accordance with the terms of an investment contract, if these assets are automatically issued through a programmatic blockchain system, they do not automatically become securities. This is because:


Programmed operation: Blockchain technology allows the issuance and management of assets to be automatically executed through code without relying on traditional corporate structures or intervention by external managers. This automation reduces the direct control of individuals or groups over the operation of assets.


Decentralized characteristics: Many blockchain-based asset issuances utilize decentralized characteristics, such as smart contracts and DApps. These tools ensure that the operation and management of assets follow preset rules rather than the decisions of a single management entity.


Programmed transparency: The rules and logic of assets issued through smart contracts and other means are usually open and transparent, and investors can directly access these rules and make investment decisions based on these programmatic logic.


8/9 · Key Question 2: How to deal with digital assets with governance and voting functions


The bill mentions that if a digital asset or a decentralized governance system related to it has no relevant person who alone owns or controls more than 20% of the voting rights through relevant persons in the past 12 months, this may indicate that the asset has decentralized characteristics, but in the relationship between digital assets and blockchain systems, it is mentioned that if digital assets mainly provide economic returns or allow voting to participate in governance through automated procedures of blockchain, they may be regarded as securities, because this indicates that investors are looking forward to gaining benefits through management or corporate efforts.


There is a contradiction here. If a digital asset has voting rights and no relevant person has alone owned or controlled more than 20% of the voting rights through relevant persons in the past 12 months, is this asset more likely to be defined as a commodity or a security?


It touches on a complex area in digital asset regulation, namely how to deal with assets with governance and voting functions. Understanding this requires distinguishing two key concepts: the degree of decentralization of an asset and the control or economic benefit expectations that the asset provides to investors.


(1) Decentralization and Voting Rights


The bill states that if no relevant person has owned or controlled more than 20% of the voting rights in the past 12 months, this indicates that the digital asset has a high degree of decentralization. This generally means that no single entity or small group can control the operation or decision-making of the asset. From this perspective, a high degree of decentralization is a factor that drives assets to be considered commodities because it reduces the control of a single entity over the value and operation of the asset, which is consistent with the characteristics of commodities, that is, they are primarily used for exchange or use rather than for investment returns.


(2) Voting Rights and Securities Attributes


On the other hand, if a digital asset allows holders to participate in governance through voting rights, especially governance that has a significant impact on economic decisions, this may cause the asset to be considered a security. This is because voting rights and governance participation generally mean that holders expect to gain benefits through management or corporate efforts (including the efforts of other holders), which meets the basic definition of a security.


(3) Understanding the Contradiction


The potential contradiction here is that on the one hand, the high degree of decentralization of an asset is generally consistent with commodity attributes, while on the other hand, the governance and voting rights functions of an asset may cause it to be considered a security. The key to resolving this contradiction lies in assessing:


The substantive impact of voting rights: Does the vote have a substantive and direct impact on the value and operation of the asset? If the vote mainly affects technical settings or non-core economic decisions, the asset may still tend to be a commodity.


Expectation of economic returns: Is the main purpose of the holder holding the asset to obtain economic returns (for example, through asset appreciation or dividends), or to use the asset for transactions and other activities on the platform or network?


In the context of the approval of the ETH spot ETF application (Form 19b-4), the definition of ETH is more inclined to functional use. Its pledge and governance nature are more to maintain network operation rather than economic returns. Therefore, digital assets similar to ETH in the future can theoretically rely on this approval as a model if they meet the preconditions such as the degree of decentralization.


From this perspective, if the DeFi protocol governed by DAO is closer to obtaining economic returns or dividends in terms of governance, its positioning is more likely to be defined as a security. If the governance direction tends to be functional, technological upgrades, etc., it is more likely to be defined as a commodity.


9/9 · Technology and Innovation Support


The bill proposes to solidify and expand the SEC's Strategic Center for Innovation and Fintech (FinHub) and the CFTC's laboratory (LabCFTC). Its mission is to promote policy development related to fintech and provide guidance and resources to market participants on emerging technologies.


Establish a joint advisory committee between the CFTC and the SEC to focus specifically on digital assets. The goal of this committee is to promote cooperation and information sharing between the two major regulatory agencies on digital asset regulation.


Study Decentralized Finance (DeFi): Requires the SEC and CFTC to study the development of decentralized finance and assess its impact on traditional financial markets and potential regulatory strategies.


Research on non-fungible tokens (NFTs): Exploring NFTs and their role in the financial market and regulatory needs.


In this part, the attitude towards Crypto compliance is basically established. The clearer direction is the research on DeFi and NFTs, which means that DeFi and NFTs may also usher in gradually clear regulatory strategies in the future.


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Disclaimer: The content of this article solely reflects the author's opinion and does not represent the platform in any capacity. This article is not intended to serve as a reference for making investment decisions.

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