On Friday, June 2, 2023, Representatives McHenry and Thompson released a digital asset market structure draft proposal. The House Financial Services Committee leadership published both text of the discussion draft and a section-by-section summary. This joint effort between the majority members of the House Financial Services and Agriculture Committees is a significant attempt at comprehensive US regulation for digital assets.
The Proposal uses existing securities and commodities laws to regulate digital assets, which works better in some ways than others. It isn’t perfect, but it is an important step towards US regulatory clarity for digital assets, and provides an opportunity for Congressional engagement with hearings in various House Committees to discuss digital assets and the Proposal’s ideas.
What does the Proposal cover?
The Proposal enables issuing, supporting, purchasing, and trading of digital assets, under both the securities and commodities laws. While the SEC remains the default regulator for digital assets, the Proposal:
Defines which assets are digital commodities and gives the CFTC jurisdiction over them
Expands the SEC’s existing exemption for unregistered securities offerings to cover digital assets offered as part of an investment contract
Establishes a process for digital assets that are securities to be regulated instead as digital commodities, and permits secondary market trading of those assets
Sets out SEC and CFTC registration requirements tailored for digital asset exchanges and broker/dealers
Requires the SEC to update its regulations to address digital assets and issue joint rulemaking with the CFTC
Provides a safe harbor for existing digital assets to trade until the SEC and CFTC draft rules and issue a notice to the trading venue identifying which assets may no longer trade as digital commodities
Does the Proposal define which digital assets are securities?
Not expressly—the Proposal regulates digital assets as securities, unless they: (1) relate to a decentralized blockchain network; (2) are issued directly to a functional blockchain network’s end users; or (3) are certain payment-backed stablecoins.
A decentralized network is one where during the previous 12-months:
no single person or entity (other than a decentralized organization) could control or materially change the network, or restrict others from participating in on-chain governance, or operating infrastructure, like a validator node;
no digital asset issuer (other than a decentralized organization) owned or had voting power of 20% or more of the then outstanding digital assets; and
all digital asset issuances were airdropped directly to end users.
And during the previous 3-month period the issuer neither:
contributed code to the network that materially changed its function or operation; nor
marketed nor issued any digital assets on the network.
A functional network allows participants to use the network’s digital asset to: (1) transmit and store value on the network; or (2) access an application running on the network.
Digital assets that are securities are regulated much like TradFi securities, with minor changes to licensing, registration, and disclosure requirements. Digital commodities are exempt from most regulatory requirements. But all digital asset exchanges—whether for securities or commodities or both—must put in place investor and market integrity protections.
Will the Proposal’s requirement to comply with both securities and commodities laws work?
Under the Proposal, digital asset issuers and exchanges are regulated by both the SEC and the CFTC, depending on the digital assets’ characteristics. It is challenging to harmonize two massive bodies of law—including rules by their complementary self-regulatory organizations (FINRA for securities broker/dealers, and the NFA for derivatives). The Proposal tries to address inconsistent or overlapping requirements, but it could be tough for digital asset issuers and exchanges to comply.
For all its empowerment of the CFTC, the Proposal leaves discretion with the SEC that could be used to stifle digital assets, undermining the Proposal’s objectives in two key ways. First, the SEC may determine that a blockchain network is not sufficiently decentralized, keeping its digital assets under the SEC’s jurisdiction. If it rejects a decentralization certification, the SEC must satisfy the Proposal’s requirements for public comment, analysis, and reconsideration by specific deadlines. But those guardrails might not prevent the SEC from blocking the path to decentralization and deregulation for many digital assets.
Second, the SEC may co-opt the rulemaking process. The Proposal sets deadlines only for the SEC to update its rules to address digital assets, but not for joint rulemakings with the CFTC to define key terms like “decentralized network” and “digital asset issuer,” and outline requirements for exchanges that must register with both the CFTC and SEC. Those rules could have significant impact, given the number of exchanges and other stakeholders who need to comply with both rulesets.
Also, embracing both securities and commodities regimes could create fragmented markets for digital assets. Exchanges could face liquidity challenges or other operational difficulties segregating digital assets that are securities from digital commodities.
Will the Proposal change how the SEC and CFTC engage the crypto industry?
The Proposal paves the way for more constructive regulatory engagement. It mandates SEC and CFTC rulemaking for digital assets, and establishes a joint advisory council to both regulators. It also ensures that both the SEC and CFTC maintain innovation hubs that report to the Commission rather than the Chair.
What aspect of the Proposal should be revisited?
Definitions in the Proposal may be too broad or imprecise. For example, the definition of “Decentralized Network” requires that neither the “digital asset issuer” nor any “affiliated person” has contributed to the network’s code for the previous three months. But the definitions of "Digital Asset Issuers" and “Affiliated Persons” could include any software developer who contributes to the network’s source code, not just the network’s founder or software developers employed by the protocol’s foundation. Scoping the decentralization requirements that way could prevent network upgrades to address security issues or add new features, harming the investors that the Proposal aims to protect.
The Proposal also doesn’t include any funding mechanism for the CFTC’s additional oversight.
We need to clarify the Proposal’s impact on DeFi, which is not carved out like NFTs, the use of restricted tokens for staking and governance, and the scope of protections for ancillary activities like validating, compiling, searching, sequencing, or providing access or other incidental services to a blockchain network.
Does compliance with the Proposal satisfy other global regulatory obligations?
No, the Proposal’s requirements don’t currently align well with other prominent digital asset regulations, including the EU’s comprehensive Markets in Crypto Assets (MiCA) law. If founders cannot export or passport their regulatory compliance to or from the US, they might avoid the US entirely.
Is the Proposal likely to become law?
Given the hurdles to Congress passing any legislation, it is unlikely that the Proposal becomes law in the next 12-18 months. Republicans enjoy only a narrow majority in the House, and have not yet collaborated with their Democratic counterparts to get their support to advance the Proposal in the Senate.
But Representatives McHenry and Thompson have made clear that the Proposal is a draft, and they welcome feedback. Now is the time to engage with Republicans and Democrats alike to craft the best possible Proposal. The more Democrats who support the Proposal in the House, the better its chances of passing the Senate. Even if the Proposal stalls out this term, key provisions will be taken up again next Congress when they may have a greater chance of becoming law.
What does the Proposal mean for digital asset developers?
The Proposal is a strong signal that members of Congress want to provide regulatory clarity to enable developers to keep building in the US. That’s why it is incredibly important for founders to make their voices heard in the legislative process. Contact your representatives and the Proposal’s sponsors to provide feedback on the bill, and thank them for engaging on digital asset regulation. Educate lawmakers on the value and utility of blockchain technology now and what it promises for the future. Share why you build digital asset products and services, and why you want to build in the US.
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