Greater transparency regarding digital assets must precede harmonized regulations

Why do so many federal agencies regulate financial services? Other countries with a strong financial sector (for example, the UK) designate a single regulator to supervise the financial market. Are we doing something ineffective at best and, at worst, fueling the uncertainty that characterizes the federal approach to regulating digital assets?

Our fragmented approach to regulating financial services means that jurisdictional disputes between agencies are as inevitable as fights over a tennis ball at the dog park. The Securities and Exchange Commission won’t rest until it gets the ball: we witness the agency’s struggles with the Commodity Futures Trading Commission in the late 1970s to regulate stock futures, or with banking regulators in the early 2000s. w. regarding who would supervise the brokerage activities of large banks. In both cases, Congress needed acts to settle jurisdictional disputes and establish lines of authority.

But what seems like a mistake is actually a feature of our endlessly dynamic economy. There are always bad and careless actors in the financial services industry. Regulatory competition, in which each authority seeks to maximize its jurisdiction, reduces the likelihood that emerging products, services and activities will suffer bureaucratic fissures and circumvent market and consumer barriers.

The flaw seen in crypto today is that, in its zeal to protect turf, the SEC will push cutting-edge round pegs (digital assets) into old square holes (the crisis-era securities framework) to prove its jurisdiction.

Which brings us to the bipartisan Financial Innovation and Technology for the 21st Century Act (FIT21), passed by the House on May 22 and now headed to the Senate. This much-needed legislation would assign the CFTC the primary regulatory authority for digital assets. The not-so-subtle intention is to place most digital asset activities away from the SEC, which claims broad jurisdiction over the industry while refusing to write enforceable rules or offer comprehensible guidance.

FIT21’s fundamental problem, however, is that the fine print smuggles in outdated terms such as “investment treaty” in a way that would give the SEC leeway to claim that almost all digital assets are securities and therefore not subject to a tailored solution. Other aspects of FIT21 could use refinement – the idea that digital assets can exist simultaneously as commodities and securities would introduce metaphysical confusion. But Congress must deal with a fundamental definitional problem before it can sort out the rest.

An “investment contract” is a security whose meaning was determined by the Supreme Court nearly a hundred years ago based on a complex multi-factor analysis, affectionately known as Hi test. A “bank note” is also a security, but there are many notes – such as mortgages – that obviously should not be regulated as securities, which is why the court gave us Reves conduct a test four decades ago to decide which notes are securities and which are not.

Title II of FIT21 “Transparency of assets offered under an investment treaty” states that “investment treaty assets” or digital assets sold under an investment treaty are not themselves securities. This is a similar approach to that proposed by Senator Cynthia Lummis (R-WY) and Senator Kirsten Gillibrand (D-NY).

However, the definition of investment treaty assets in FIT21 specifically excludes any digital asset that would otherwise fall within the definition of a security, which in turn means that both investment treaties and bonds are securities. This loophole would allow – or even encourage – the SEC to make the same argument as it currently does: almost all digital assets are securities because under Sec. Hi these are investment contracts that offer the buyer the opportunity to profit from the efforts of others. The SEC would also find that many crypto tokens – those that can be staked or that otherwise generate profits – are not subject to FIT21 because, according to Revesthese are banknotes that are securities.

The solution to this definitional problem is simple. Because the legislature writes cleanly, FIT21 can use plain English to define what Congress means when it talks about a digital asset that is not a security. It is likely code that does not constitute a legal or contractual claim against the assets, revenues or profits of the company or other entity.

There is no reason to assign liability to the SEC for digital assets that do not constitute a claim against a business enterprise, regardless of the degree of “decentralization” of the associated blockchain – another potentially problematic concept included 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 division. And of course, the SEC cannot regulate Apple based on iPhone sales, which certainly operate in a centralized ecosystem, but because the company issues common stock.

A functional definition of “digital assets” without using concepts rooted in decades of case law would go a long way to providing the predictability that consumers and businesses need. It would also help Congress develop a workable solution to cryptocurrency regulation that has so far eluded us.

This article does not necessarily reflect the opinions of Bloomberg Industry Group, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.

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Joseph Hall is a partner in Davis Polk’s capital markets group and head of the interdisciplinary ESG risk practice.

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