Regulation
Greater clarity on digital assets must precede unified regulation
Why are so many federal agencies tasked with regulating financial services? Other countries with a strong financial sector (the United Kingdom, for example) mandate a unified regulator to oversee financial markets. Are we doing something inefficient at best and, at worst, fueling the uncertainty that characterizes the federal approach to regulating digital assets?
Our fragmented view of financial services regulation means that jurisdictional disputes between agencies are as inevitable as scratches on a tennis ball in the dog park. The Securities and Exchange Commission won’t stop until it gets the ball rolling: witness the agency’s struggles with the Commodity Futures Trading Commission over how to regulate single-stock futures in the late 1970s, or with banking regulators in the early 2000s over who would oversee the brokerage business of large banks. In both cases, acts of Congress were needed to resolve jurisdictional battles and establish lines of authority.
But what seems like a bug is actually a feature of our infinitely dynamic economy. There are always bad and negligent actors in financial services. Regulatory competition, with each authority seeking to maximize jurisdiction, makes emerging products, services and businesses less likely to slip through bureaucratic cracks and bypass market and consumer guardrails.
The downside, seen in the cryptocurrency industry today, is that in its zeal to protect turf, the SEC will insert new round pegs (digital assets) into old square holes (the Depression-era securities framework) to demonstrate its jurisdiction .
Which brings us to the bipartisan Financial Innovation and Technology for the 21st Century Act (FIT21) past in the House on May 22 and now headed to the Senate. This much-needed legislation would give the CFTC primary regulatory authority for digital assets. The not-so-subtle intent is to position most digital asset activity away from the SEC, which has claimed broad jurisdiction over the industry while refusing to write workable rules or offer comprehensible guidance.
But a fundamental problem with FIT21 is that the fine print sneaks in outdated concepts like “investment contract” in ways that would give the SEC the freedom to claim that nearly all digital assets are securities and therefore not subject to the bespoke solution of the law. Other aspects of FIT21 may require refinement: the idea that digital assets can exist simultaneously as both commodities and securities would introduce metaphysical confusion. However, Congress must address a basic definitional problem before it can resolve the rest.
An “investment contract” is a security, the meaning of which was established nearly a century ago by the Supreme Court with a complex multifactor analysis affectionately called the Howey test. Even a “note” is a security, but there are many securities – like mortgages – that obviously shouldn’t be regulated as securities, and so the court gave us the Reves test four decades ago to decide which securities are securities and which I’m not. T.
Title II of FIT21, “Clarity on Assets Offered as Part of an Investment Contract,” states that an “investment contractual asset” or digital asset sold under an investment contract is not itself a security. This is similar to an approach proposed by Senator Cynthia Lummis (R-WY) and Senator Kirsten Gillibrand (D-NY).
But the definition of investment contract asset in FIT21 expressly excludes any digital asset that otherwise falls under the definition of security, which in turn states that both investment contracts and notes are securities. This loophole would allow – or even encourage – the SEC to make the same arguments it makes today: Nearly all digital assets are securities because Howey says they are investment contracts that offer the buyer the chance to profit from someone else’s efforts. The SEC would also say that many crypto tokens, those that can be staked or otherwise generate returns, are not subject to FIT21 because, according to Reves, they are known to be securities.
The solution to this definitional problem is simple. Because lawmakers write on a clean slate, FIT21 can use plain English to define what Congress means by a non-security digital asset. Presumably this is something like a code that does not represent a legal or contractual claim against the assets, revenues or profits of a company or other entity.
There is little reason to place liability on the SEC for a digital asset that does not represent a claim against an economic enterprise, regardless of the degree of “decentralization” of the associated blockchain, another potentially problematic concept in the bill. Decentralization may be important for network security and resilience, but it is probably too amorphous to be used as a reliable jurisdictional partition. And, of course, the SEC fails to regulate Apple on the basis that it sells the iPhone, which it certainly operates in a centralized ecosystem, but because the company issues common stock.
Defining “digital asset” in a functional way, without using concepts encrusted with decades of case law, would go a long way in providing the predictability that consumers and businesses need. It would also help Congress come up with a workable solution to cryptocurrency regulation that has so far eluded us.
This article does not necessarily reflect the views of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
About the author
Giuseppe Sala is a partner in Davis Polk’s Capital Markets group and head of the interdisciplinary ESG risk practice.
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