Congress Offers Potential Cryptocurrency Regulatory Framework

Synthesis

• Regulation of cryptocurrencies (“cryptocurrencies”), digital assets, and related technologies has been hampered by disagreement over the nature of cryptocurrencies and a turf war among financial regulators.
• The House-passed Financial Innovation and Technology for the 21st Century Act (FIT21) would give necessary congressional rubber stamp to cryptocurrency regulation and resolve disputes among regulators by defining a digital asset based on how it is used, not what it is .
• By assigning regulatory roles, FIT21 would provide frameworks within which digital assets overseen by consumers and investors could be regulated.

introduction

Regulation of cryptocurrencies (“cryptocurrencies”), digital assets, and related technologies has been hampered by disagreement over the nature of cryptocurrencies and a turf war between the Commodity Futures Trading Corporation (CFTC) and the Securities and Exchange Commission (SEC ). The House-passed Financial Innovation and Technology for the 21st Century Act (FIT21) would give necessary congressional rubber stamp to cryptocurrency regulation and resolve disputes among regulators by defining a digital asset more by how it is used, and less by what it is.

FIT21 contains three important features. First, Congress needs to establish the regulatory framework for digital assets and assign regulatory responsibilities to the relevant agencies. FIT21 would do this and thus end the turf war between the CFTC and SEC. Second, it would put in place the necessary apparatus for consumer protection regulations, including a mechanism for transferring between digital assets and traditional financial assets – a “stablecoin”. Finally, it would establish a framework to ensure the safety and soundness of digital institutions and the functioning of digital financial markets.

While there is much to evaluate in the bill, there is likely to be light, although it is not yet clear how much, between Congress’ vision for a cryptographic framework and how such a framework would likely be adopted by agencies in practice. Therefore, legislators should be especially vigilant about the logistics of implementing FIT21. Congress should be cautious in ensuring that digital assets are placed on equal footing with traditional assets, an outcome that is not guaranteed solely by the plain language of the bill.

What is encryption and who regulates it?

One of the great challenges for the regulation of cryptocurrencies has been the lack of understanding of them. In other words, it is difficult to answer this question: whatANDcryptocurrency? And, under current law, the answer actually matters. If cryptocurrency is a commodity, it is simple to assign jurisdiction to the CFTC. The CFTCdefines a commodityto include “all goods and articles… and all services, rights and interests… in which contracts for future delivery are now or hereafter dealt with” and is not limited to tangible goods alone.”

Alternatively, perhaps encryption is a security. The SEC defines a security as a “investment contract” and relies onTry Howey, established by a Supreme Court decision nearly a century ago. The test holds that a financial instrument (including, potentially, a digital asset) is considered a security if it is: an investment of money; in a joint venture; with a reasonable expectation of profits; and derived from the entrepreneurial or managerial efforts of others. On the merits it is difficult to make these distinctions.

FIT21 would avoid this conundrum by defining digital assets not based on what they are but how they are used. This would involve a two-step process. First, the law would argue that digital assets are not securities and, therefore, are regulated by the CFTC. A special class of restricted digital assets (RDA) would then be created, identified by the fact that they are used to raise capital.

RDAs would be regulated by the SEC as long as they are meaningfully supervised by a developer and other industry insiders. One challenge, of course, is that a standard that requires significant oversight will require substantial regulation and legal precedent-setting to achieve clarity.

The SEC would also be tasked with creating institutions parallel to traditional financial activities. Specifically, it would be necessary to develop the registration of such RDAs, as well as the regulation of brokers, dealers and exchanges for the exchange of digital assets.

With Congress having its say in allocating resources and tasks, the current regulatory conflict would be largely resolved and those operating in the digital financial world would benefit from greater clarity.

Consumer protection

FIT21 would create a digital goods trading framework similar to existing exchanges under the CFTC, as well as consumer protections for participants. There would be requirements to monitor trading activity, prohibit abusive trading practices, establish minimum capital requirements and require public reporting of trading information, conflicts of interest, governance standards and cybersecurity.

Likewise, digital versions of brokers and intermediaries will be required to register and comply with regulations on minimum capital, fair dealing, risk disclosure, advertising restrictions, conflicts of interest, record keeping and reporting , daily business records and employee fitness standards.

Finally, brokers and dealers would offer payment stablecoins on their platforms and limited digital assets (if the broker or dealer is also registered with the SEC). Stablecoins avoid the risk of high volatility because their value is “pegged” to another asset, usually the US dollar.

Safety and soundness of digital investments

Similar to digital commodity exchanges (above), the SEC would develop a digital asset trading system. Trading would be regulated to include order viewing, fair access, record keeping and reporting, and conflicts of interest.

All digital brokers and retailers should register and comply with minimum capital requirements, client asset protection, risk disclosure, record keeping and reporting, and conflicts of interest. Client funds would be segregated and held with a qualified digital asset custodian.

Finally, the exchange system could offer a payment stablecoin.

Challenges

While FIT21 takes steps in the right direction towards creating a regulatory framework for cryptocurrencies, it is not yet clear how such a framework would be adopted by agencies in practice. Therefore, legislators should be especially vigilant about implementing legislation. Congress should also be cautious in ensuring that digital assets are placed on equal footing with traditional assets.

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