Written by: Ray, TaxDAO
On May 22, 2024, the U.S. House of Representatives passed the Financial Innovation and Technology for the 21st Century Act (FIT21) by a vote of 279 to 136. The bill, led by the Republican Party, aims to amend existing securities and commodity regulations and establish a regulatory framework for digital assets to promote the development of the crypto industry. Once officially enacted, the FIT21 bill will become an important milestone in the U.S. federal digital asset regulatory system. This article will interpret the FIT21 bill from the aspects of legislative background, bill content, and potential impact.
1. Legislative background of FIT21
Since the creation of Bitcoin, crypto assets have existed and developed for fifteen years and are now in a vibrant and increasingly mature stage. However, neither the United States nor other countries have established a comprehensive regulatory framework for digital assets, but only fragmented and one-sided regulation, which not only fails to create a stable and predictable legal environment for the crypto industry, but also makes the crypto industry full of various illegal and criminal activities, which seriously hinders the innovation and progress of the crypto industry. Critics believe that under the existing crypto regulatory framework in the United States, start-ups in the crypto industry are subject to "enforcement-based regulation", which will cause related companies to conduct business activities in other countries, which is not conducive to the technological innovation of the United States, nor to the overall development of the U.S. economy. Therefore, the United States urgently needs to create an environment that supports innovation through legislation to fully explore the future potential of the crypto industry, while avoiding the situation in which a few large technology companies monopolize the market in the Web 2.0 era.
In September 2022, the White House released the First-Ever Comprehensive Framework for Responsible Development of Digital Assets, and urged the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) to develop specific rules to regulate digital assets. The draft law of FIT21 can be traced back to March 2023, when the Digital Assets, Financial Technology, and Inclusion Subcommittee led by U.S. Representative French Hill had planned to work with the House Agriculture Committee to develop a regulatory framework for digital assets. In July of the same year, the U.S. House Financial Services Committee and the House Agriculture Committee successively passed the FIT21 bill, and it was not until May 2024 that the House of Representatives completed the voting process for the bill. The FIT21 bill will be submitted to the Senate for a vote soon, and after the Senate passes it, it will be signed by the President and officially released.
The recent developments of SAB 121 (Staff Accounting Bulletin No. 121) have also made the Senate, the House of Representatives and the crypto industry have high hopes for the FIT21 Act. The SEC issued SAB 121 in 2022, which requires digital asset custodians to treat digital assets as liabilities and hold them at fair value on their balance sheets. Based on this, if a bank wants to hold digital assets, it must hold cash in its account that is consistent with the fair value of the asset. This regulation is considered to be an excessive intervention of the SEC in the banking industry and digital assets, because it will actually exclude banks from the crypto industry. In mid-to-early May 2024, before the SEC changed its attitude towards the ETH spot ETF, the Senate and the House of Representatives took action to pass a bill to overturn SAB 121. However, the good times did not last long. President Biden ultimately vetoed the bill to overturn SAB 121 on May 31, which disappointed the Senate, the House of Representatives and the crypto industry. They instead placed more hope on the FIT121 bill, which is awaiting a vote by the Senate and a signature by the President.
2. Overview of FIT21
The FIT21 Act consists of multiple chapters, each of which covers different aspects of digital asset regulation and innovation systems. This section will provide an overview of the contents of each chapter of the FIT21 Act and summarize the main regulatory framework it has established.
2.1 Overview of the chapters of the FIT21 Act
Chapter 1 of the FIT21 Act is titled "DEFINITIONS; RULEMAKING; NOTICE OF INTENT TO REGISTER." This section defines key terms under various laws, including the Securities Act of 1933, the Securities Exchange Act of 1934, and the Commodity Exchange Act. These definitions cover terms such as "digital assets," "blockchain," and "decentralized systems," clarifying the scope of application of the Act.
Chapter 2 mainly clarifies digital assets as part of an investment contract. Article 202 of this chapter describes digital assets as part of an investment contract, defining them as fungible digital representations of value, and specifies how they should be classified and regulated, distinguishing them from traditional securities.
Chapter 3 mainly stipulates how to regulate the provision and sale of digital assets. Specifically, Article 301 stipulates the exemption of digital asset transactions, Article 302 stipulates the specific requirements for the provision and sale of certain digital assets, and Article 303 requires strengthening the disclosure requirements for any digital assets and their related blockchain systems.
Chapters 4 and 5 are about the registration of digital asset intermediaries under the jurisdiction of the SEC and CFTC. Digital asset intermediaries here include digital asset exchanges, digital asset brokers, digital asset traders, and digital asset custodians. The relevant regulations involve business requirements such as transaction certification and licensing, general and special conditions, methods and exemptions for different registered entities, registration requirements, and conflict of interest rules.
Chapter 6 is titled "INNOVATION AND TECHNOLOGY IMPROVEMENTS", which is both a title and a conclusion, indicating the judgment of the drafters of the bill and Congress on crypto technology. In connection with this, the SEC will establish the Strategic Center for Innovation and Financial Technology (FinHub), and the CFTC will establish LabCFTC. According to FIT21, the main internal functions of the two centers are to shape the way the SEC and CFTC examine fintech innovations, analyze the impact of regulations on fintech companies, and so on. Although both research centers engage with stakeholders and provide information about rules and regulations to those working in emerging technologies, given the wording of FIT21, the U.S. Congress does not seem to think that they will become active regulatory sandboxes, as neither the SEC nor the CFTC has been granted specific discretion in regulation.
2.2 Overview of the regulatory framework of the FIT21 Act
In general, FIT21 will establish a federal digital asset regulatory framework to regulate various blockchain technologies, including decentralized protocols, by clarifying the regulatory responsibilities of the SEC and CFTC for digital assets and transactions, and updating existing securities and commodity laws. Some believe that FIT21's protection measures for technology and innovation are somewhat similar to those implemented by the United States after the Great Depression in the 1920s, after which the United States ushered in an unprecedented era of economic growth and innovation.
The regulatory framework established by the FIT21 Act for digital assets in the United States mainly includes the following four aspects. First, the CFTC must regulate digital assets as commodities, provided that the blockchain or encrypted digital ledger on which it operates is functional and decentralized. In addition, the Act also gives the CFTC exclusive regulatory power over crypto commodities and spot markets. Second, the SEC must regulate digital assets as securities when the relevant blockchain functions normally but is not decentralized. The FIT21 Act provides some exceptions to the SEC's regulation of digital assets, involving matters such as annual sales, qualified investors, and stipulates requirements for primary and secondary market transactions. Third, the CFTC and the SEC must jointly issue rules to formulate relevant terms and avoid duplication of regulatory rules faced by exchanges. Fourth, the Act excludes approved stablecoins from the supervision of the CFTC and the SEC, except for specific transactions with anti-fraud agencies and registered entities.
3. Interpretation of Articles 101 and 103 of FIT21
Clarifying the object is the premise for taking action. Sections 101 and 103 of the FIT21 Act provide detailed definitions of restricted digital assets (securities), digital commodities, and licensed payment stablecoins, and provide specific judgment criteria. Thanks to this, the SEC and CFTC are able to clarify the scope of their responsibilities and regulate restricted digital assets and digital commodities respectively, while licensed payment stablecoins are not within their jurisdiction. This constitutes the premise for subsequent regulation and guidance measures, and the crypto industry will also gain a more orderly regulatory framework and a more stable development space. In general, the FIT21 Act divides digital assets into three categories: restricted digital assets, digital commodities, and permitted payment stablecoins. The relationship between the three is that digital assets are generally restricted digital assets unless they are self-certified as digital commodities or meet the definition of licensed payment stablecoins.
3.1 Digital Assets
Article 101, Item 26, first defines digital assets and lists exclusions. The article states that digital assets "mean any fungible digital representation of value that can be owned and transferred entirely by an individual without reliance on an intermediary and is recorded on a cryptographically secure public distributed ledger." However, digital assets do not include any bills, stocks, treasury stocks, securities futures, securities swaps, bonds, debt certificates, debt certificates... any puts, calls, spreads, options, privileges, and assets equivalent to options, futures, swaps, etc.
It is important to note that Article 101 also emphasizes two points: First, "nothing in this paragraph shall be interpreted as presuming that digital assets are representatives of any type of securities that are not excluded from the definition of digital assets." This shows that FIT21 insists on a strict definition method for digital assets, clearly distinguishing other types of securities from digital assets. Second, "digital assets offered or sold or intended to be offered or sold under an investment contract are not and will not become securities because they are sold or otherwise transferred under the investment contract." To understand this, you must first understand the Howey Test. The concept of securities in American law was first developed from the term "investment contract" in the Howey Test, and one of the four test conditions of the Howey Test is that the benefits come only from the efforts of others. Under this requirement, the efforts of the project party and related parties are the key to investors' gains, and the investors themselves only need to pay the specified fees and costs, and do not actually participate in the operation and management of the project. However, the issuance and management of digital assets often rely on smart contracts and other automatic programs, and there is no effort by the project party and related parties in the traditional sense at this time. The reason why the relevant provisions of the FIT21 Act exclude digital assets from securities is mainly to promote technological innovation while taking into account the protection of investors.
3.2 Restricted Digital Assets
Item 34 defines “restricted digital assets” and proposes three criteria for identifying “restricted digital assets”: (1) the degree of decentralization and functionality of the underlying blockchain system of the digital asset; (2) the method by which the user ultimately obtains the digital asset; and (3) the identity of the party holding the digital asset. Clarifying the specific meaning of these criteria will help distinguish restricted digital assets from other digital assets. It should be noted in advance that the “restricted digital assets” here actually refer to digital assets that have a nature similar to “securities”, but the legislator did not use the word “security”. For example, Section 405 clearly stipulates that securities include restricted digital assets.
According to Item 25, the judgment on the degree of decentralization and functionality includes the following aspects: (1) In terms of control and influence, in the past 12 months, no individual or entity has directly or indirectly had unilateral power to control or substantially change the functions or operations of the blockchain system. (2) In terms of the distribution of digital asset ownership and governance rights, in the past 12 months, no digital asset issuer and affiliates actually owned more than 20% of the total issued digital assets, or no digital asset issuer and affiliates controlled 20% or more of the circulating voting rights of the digital asset or related decentralized governance system. (3) In terms of code modification, in the past 3 months, no digital asset issuer and affiliates substantially or unilaterally modified the source code of the blockchain system, thereby substantially changing the functions or operations of the blockchain system, unless such modifications are to address vulnerabilities and misalignments, regular maintenance, prevent network security risks or improve blockchain technology. (4) In terms of marketing, in the past 3 months, no digital asset issuer and affiliates have promoted digital assets to the public as investments. (5) All digital asset units issued through the programmatic functions of the blockchain system are issued to end users (end users distribution). It should be noted that according to the provisions of Item 30, the so-called end-user distribution refers to a broad, fair, non-discretionary distribution that does not involve asset exchange, but is accessible to any participant in the blockchain. Typical examples include mining and staking income of blockchain users.
Among the above standards, the more important ones are "12 months" and "20%". 12 months is the vertical judgment standard of the degree of decentralization, and 20% is the horizontal judgment standard of the degree of decentralization. Whether it is 12 months or 15 months, 20% or 30%, the specific value itself is not the most important. The most important thing is that it provides an accurate and quantifiable standard, making the judgment of the degree of decentralization more objective.
Regarding the method by which users acquire digital assets, the provision requires that restricted digital assets be issued to users in a manner that is not issued to end users, or be acquired by users in non-digital commodity exchanges.
For the last criterion, the restricted digital assets must be all digital assets held by the issuer and its affiliates during the period when the blockchain system is not functional or decentralized. In addition, permissioned payment stablecoins are exempted from the restricted digital assets.
3.3 Permissioned Payment Stablecoins
Article 101, item 32 defines a licensed payment stablecoin. This article stipulates that a licensed payment stablecoin means a stablecoin that is used or designed to be used as a means of payment or settlement, and its issuer is obliged to convert, redeem or repurchase for a fixed amount of monetary value, or indicates that it will maintain or reasonably expect to maintain a stable value relative to a fixed amount of monetary value, and its issuer is regulated by a competent federal or state regulator, and the stablecoin is not a national currency or security. The aforementioned monetary value refers to national currency, deposits, or equivalent notes denominated in national currency. From this definition, it can be seen that the FIT21 Act emphasizes the significance of the licensing system for payment stablecoins on the one hand, and on the other hand, it shows that only legal currency or bill-collateralized stablecoins have the opportunity to be licensed, while excluding algorithmic stablecoins from the scope of the license.
3.4 Digital Goods
Section 103, Item 55 defines "digital goods". The digital goods here also involve three situations. First, any digital asset unit held by an individual other than the issuer or associated person of the digital asset before the relevant blockchain system becomes a functional system and is certified as a decentralized system, and the digital asset unit is obtained through final issuance or in a digital commodity exchange; second, any digital asset unit held by a person other than the issuer or associated person of the digital asset after the relevant blockchain system becomes a functional system and is certified as a decentralized system; third, any digital asset unit held by any associated person during the period when the relevant blockchain system becomes a functional system and is certified as a decentralized system. Digital goods also do not include licensed payment stablecoins. There is also a special provision here, that is, before the enactment of the FIT21 Act, if the federal court has ruled that a digital asset is not a security, then if the ruling is valid, the digital asset should be deemed a digital commodity. This special provision reflects the attitude of the FIT21 Act to essentially divide digital assets into securities and commodities after excluding licensed payment stablecoins.
4. Potential impact of the FIT21 bill after its passage
4.1 Impact of FIT21 on Crypto Taxation
According to IRS Notice 2014-21, all crypto assets are considered property rather than currency, and therefore are subject to general taxation principles for property transactions. However, the IRS has a broad definition of crypto assets, and considers that "digital representations of value recorded on a cryptographically secure distributed ledger or any similar technology" are all crypto assets. The FIT21 Act provides detailed basis and standards for the IRS to determine the scope of crypto assets and whether specific crypto assets are digital commodities or securities, which will help the IRS to tax crypto asset holders based on the distinction between general investment income and capital gains.
At the same time, it should be emphasized that the FIT21 Act has never used the word "securities" to refer to restricted digital assets similar to securities. Therefore, some tax rules that strictly restrict applicable objects still do not apply to restricted digital assets. For example, US tax law allows investment losses to be deducted from taxes, but wash sales are strictly prohibited, that is, investors are not allowed to sell an asset at a loss and then buy the same or similar securities in the near future. Securities here include stocks, bonds, mutual funds, ETFs, options, futures, and warrants, and the term "restricted digital assets" continues to exclude crypto assets from wash sale rules.
4.2 Impact of FIT21 on Crypto Regulation
In terms of regulatory subjects and objects, the FIT21 Act attempts to define clear regulatory subjects and scope for the two major regulatory agencies, the SEC and the CFTC, by distinguishing between restricted digital assets and digital commodities and exempting licensed payment stablecoins, thereby ensuring the orderliness of digital asset regulation and preventing the negative impact caused by unclear and conflicting regulatory powers.
In terms of regulatory content, the FIT21 Act not only requires the SEC and CFTC to be responsible for the registration and management of digital assets, but also strengthens the information disclosure requirements for digital assets. It also requires the SEC and CFTC to implement anti-money laundering (AML) systems and anti-fraud mechanisms, which will help further enrich the regulatory content of crypto assets.
In terms of regulatory style, overall, the FIT21 Act adopts a flexible and inclusive regulatory policy, while paying attention to the protection of small and medium-sized investors and consumers, providing an orderly and sufficient space for innovation and development of the crypto industry in the United States. This will attract more crypto talents and companies to the United States, further stimulate the vitality of the U.S. crypto industry, and ultimately further enhance the United States' global financial competitiveness.
5 Conclusion
Although there is still some uncertainty as to whether the FIT21 bill can be finally passed, the fact that the U.S. House of Representatives passed the FTI21 bill itself is enough to show that legislators have become more friendly to crypto assets. Friendly does not mean laissez-faire. On the contrary, the United States hopes to create a stable and effective regulatory environment for the healthy growth of the crypto asset market through the FIT21 bill. In the future, the SEC and CFTC will work together to further focus on the integration of Defi and financial markets, NFT and traditional markets, and further enhance the financial literacy of crypto asset investors, strengthen the infrastructure construction of the blockchain financial market, and maximize the role of crypto assets and blockchain technology in promoting economic development while protecting the rights and interests of investors.
