Hot Topics in International Trade – June 2024 – Latest Developments in Digital Asset Policy

(co-author: Justin Holbein)

ENTRY

Digital assets, including blockchain and cryptocurrency protocols and companies, were on the defensive for much of 2022, 2023, and 2024. The collapse of cryptocurrency exchange FTX and multiple enforcement actions by the Securities Exchange Commission (SEC) and the Futures Trading Commission Commodities (CFTC) have forced the sector to reduce and improve its capacity to meet the higher standards of securities regulation. In January, courts forced the SEC to approve spot Bitcoin Exchange Traded Funds (ETFs). On May 22, the House passed important legislation, the Financial Innovation and Technology for the 21st Century Act (FIT21), to provide clear rules for the digital assets sector. In a surprise ruling, the SEC also approved spot Ethereum ETFs on May 23. This article examines the ETF and FIT21 approvals as steps towards providing a clear regulatory framework in the US that can help advance legitimate business applications of digital asset technologies.

Bitcoin and Ethereum ETFs

The SEC approved the sale of Bitcoin ETFs in January 2024 following the court’s ruling in the Grayscale Investments case. The approval of the Bitcoin ETF represented a major shift in the SEC’s stance regarding the potential for market manipulation and the lack of investor protection posed by cryptocurrencies in general and Bitcoin in particular. Incorporating cryptocurrency-based assets into an already existing brokerage system is likely to improve market surveillance and enhance fraud prevention capabilities. This increases the likelihood that digital assets, especially Bitcoin-based products, will become more widely accepted in financial markets. Since approval, nearly $10 billion in investment has flowed into Bitcoin ETFs.

In a surprise move, on May 23, the SEC also approved the sale of spot Ethereum ETFs. The approval of the Ethereum ETF was announced in a 23-page decision that included a rationale based on data collected and analyzed by the SEC regarding the ability of self-regulatory organizations (SROs) to monitor markets and sell Ethereum-based products. These developments may well foster increased acceptance of digital assets traded through existing SROs, including the Chicago Mercantile Exchange, which can provide sufficient oversight and reporting to protect investors and markets from fraud that has plagued the cryptocurrency sector since its inception. Ethereum ETF approval protects investors from fraud by allowing investors to gain exposure to cryptocurrency markets without having to directly use a wallet or directly interface with cryptocurrencies, reducing the chance of investors losing money to hacks or fraud. It also provides an opportunity for traditional capital markets to benefit from cryptocurrency innovations and paves the way for other ETFs for investors based on other cryptocurrency platforms such as Solana.

FIT21

The FIT21 bill aims to establish a clear regulatory framework for digital assets. Cryptocurrency industry advocates have long objected to a perceived lack of clarity in the SEC’s regulation of cryptocurrency assets. The FIT21 bill seeks to provide a clear framework by dividing the regulatory authorities as follows:

The Commodity Futures Trading Commission (CFTC) must regulate digital assets as a commodity if the blockchain, the digital ledger on which they operate, is functional and decentralized. The bill classifies a blockchain as decentralized if, among other things, no person has unilateral authority to control the blockchain or its use, and no issuer or related person has control over 20% or more of the digital asset or voting rights in the digital asset. Additionally, the bill provides the CFTC with exclusive regulatory authority over the spot or cash markets for digital goods.

The Securities and Exchange Commission (SEC) must regulate a digital asset as a security if its associated blockchain is functional but not decentralized. However, the bill establishes certain exceptions to the SEC’s digital asset rules that limit annual sales, restrict access by unaccredited investors, and meet disclosure and compliance requirements. The bill also specifies requirements for transactions on the primary and secondary markets. The CFTC and SEC must jointly issue regulations that define the terms and exempt dual-registered exchanges from duplicative regulations. (Bill summary at https://www.congress.gov/bill/118th-congress/house-bill/4763/text?s=1&r=1&q=%7B%22search%22%3A%5B%22Financial+Innovation+ and +Technology+for+21+century+Act.%22%5D%7D)

Supporters of the legislation in the industry and policy arenas support regulatory clarity shared between the CFTC and SEC, significant improvements in consumer and investor protections, improved market stability, and the assumption that the United States will take a leading role in global innovation, competition and development of the digital asset sector.

Concerns were raised about regulatory gaps, potential market instability resulting from the bill’s self-certification processes, the weakening of safeguards due to the move away from the Howey Test on what constitutes a security, and the exclusion of cryptocurrency trading platforms from the definition of exchange. These concerns can be raised in the Senate to strengthen the solid foundation that the FIT21 bill seeks to build to regulate digital assets.

Provisions of the bill that increase the security of digital assets under the custody of exchanges or other intermediaries include:

Separation of assets: FIT21 requires institutions serving customers, such as exchanges, to separate customer funds from their own funds. This measure solves one of the main drawbacks of the FTX exchange and also minimizes losses caused by hacking attempts.
Security protocols: The Act requires robust security measures to protect against hacking and safeguard customer wallets and funds.
Enhanced operational security requirements.
Disclosure and Transparency: Institutions must provide detailed disclosures about their security measures and the risks associated with transactions in digital assets.
CFTC and SEC supervision: Both agencies will have clear rules for enforcing security standards and taking action when customer assets are not adequately protected.
Operational independence: FIT21 ensures that exchanges and intermediaries prioritize the security of client assets and follow cybersecurity best practices.

Legislative and regulatory purposes

Issues not regulated in the regulations include:

Utility tokens provide access to a product or service on a blockchain-based platform. They are generally not considered securities and are unlikely to be traded on exchanges, so there may be no need to explain or define them. However, agencies should have sufficient powers to provide regulatory guidance on their application.
NFT ownership regulations or proof of authenticity may include verification of origin, intellectual property rights and classification as securities. These potential deficiencies could be addressed during a Senate legislative review.
Stablecoin regulations on reserve management, disclosure practices and the treatment of some exchanges like banks could help improve transparency and efficiency in capital markets. Tether is disclosing limited information daily in connection with its settlement with the CFTC. The sector is regulated, but the Senate should clarify the parameters for regulating stablecoins to increase stability in the markets.
DAO work through smart contracts on the blockchain, enabling collective and automated decision-making. Regulations may register them as securities to address governance and liability issues. However, DAOs can also be regulated cooperatives or nonprofits, if desired, so that capital injections or other assets are not securities. Since much of the trade may be conducted through DAOs, the Senate could expand the scope of the bill to clarify the regulatory framework for digital asset organizations, especially DAOs. Otherwise, state governments will provide regulatory frameworks such as Wyoming’s DAO laws and New York’s digital assets laws.

Summary and Conclusions

The approval of spot and Ethereum bitcoin ETFs are important milestones in the acceptance of the digital asset sector. The FIT21 legislation is a sensible and comprehensive attempt to bring greater transparency, rigor and security to the digital asset sector and improve access to cryptocurrency markets for investors who do not already use cryptocurrency wallets. This can help protect investors by reducing incidents of fraud and hacking. It also moves access to crypto products much closer to the existing centralized system that is trusted by most market participants. To capitalize on this momentum, the digital assets sector can leverage the now clear regulatory framework to help integrate the technology into everyday life so that it can be widely used. For many average users, using a wallet, using an exchange, using a debit or credit card for cryptocurrencies, or easily performing basic transactions is too complicated. With the increased security, asset custody and oversight that the Act may introduce, digital asset companies must meet requirements to ensure the security of the technology, simplify normal transactions for users and demonstrate why digital assets are superior to existing digital approaches to settlement and payments and show how blockchain records are superior to existing record-keeping systems. By working with Congress, regulatory agencies, responsible business organizations, consumer and investor regulators, and other stakeholders, this technology can become as ubiquitous and accepted as current debit card technology, but with a much broader reach and economic impact.