Insights < BACK TO ALL INSIGHTS
Responsible Financial Innovation Act Proposal To Bolster CFTC Authority Over Crypto-Industry
Responsible Financial Innovation Act Proposal To Bolster CFTC Authority Over Crypto-Industry
By: Jake Gray
Bipartisan legislation introduced in the Senate last month would mark the federal government’s first foray into cryptocurrency regulation, and it could be a welcome development as the industry navigates a period of regulatory and commercial uncertainty.
On June 7, 2022, Senators Kirsten Gillibrand (D-NY) and Cynthia Lummis (R-WY) introduced the Responsible Financial Innovation Act (“RFIA”) in the Senate, which aims to establish a comprehensive regulatory framework for digital assets. In a joint press release, Senator Lummis said that the proposal “creates regulatory clarity for agencies charged with supervising digital asset markets, provides a strong, tailored regulatory framework for stablecoins, and integrates digital assets into our existing tax and banking laws.” [1] While unlikely to become law before the congressional session adjourns on January 3, 2023, the RFIA represents long-anticipated, pivotal regulatory initiatives to address the cryptocurrency and broader blockchain industries.
As the most comprehensive crypto-related Congressional legislative proposal to date, the bill’s provisions are wide-ranging, addressing banking and payments, taxation, and consumer protection, as well as securities and commodities laws. The bill’s jurisdictional provisions are likely most important, as they would assign regulatory authority over digital assets and digital asset spot markets to the Commodity Futures Trading Commission (“CFTC”), and they would establish a clear standard for determining which digital assets are commodities and which are securities. Other key components of the bill would create requirements that apply to stablecoins with an eye toward protecting consumers and markets, develop a taxation structure for digital assets, and provide clear definitions for key terms relating to digital assets, among other things. [2]
Ancillary Assets, the CFTC, and the SEC
As we’ve noted previously, many digital asset products—such as certain types of utility NFTs and fungible tokens—raise novel securities questions in regard to the particular rights and benefits conveyed to their owners. Over the last few years, such questions have increasingly generated pressure from businesses and consumers for guidance from the federal government. For instance, much confusion has been generated by the lack of clear digital asset classification, which has left an ambiguous jurisdictional boundary between the unobtrusive CFTC, which has authority over commodities and derivative contracts, and the more assertive Securities and Exchange Commission (“SEC”), which regulates securities. Products under the SEC’s jurisdiction face more onerous registration and disclosure requirements, while the CFTC’s oversight tools are less expansive.
In an attempt to address the issue, the RFIA provides a standard to determine when a digital asset is being offered as a security or commodity. As a means of doing so, the RFIA introduces a new category of digital assets called “ancillary assets” to the Securities Exchange Act. Under the RFIA, ancillary assets would generally be treated as “commodities” under the Commodity Exchange Act (“CEA”) and thus subject to the regulatory authority of the CFTC. Title III of the RFIA defines an ‘ancillary asset’ as:
an intangible, fungible asset that is offered, sold, or otherwise provided to a person in connection with the purchase and sale of a security through an arrangement or scheme that constitutes an investment contract, as that term is used in section 2(a)(1) of the Securities Act of 1933 (15 U.S.C. 77b(a)(1)). [3]
This definition encompasses many cryptocurrencies, although interpretive guidance would still be required for non-fungible tokens (“NFTs”) that exhibit the characteristics of investment contracts.
The new regulatory category would reel in the SEC’s attempts to establish regulatory authority over the cryptocurrency industry, which has historically focused on the ways in which various crypto products function like securities. Under the RFIA, this new class of asset would generally be presumed to be a commodity and therefore under the exclusive jurisdiction of the CFTC. (Notably, that presumption is rebuttable in court.)
Importantly, the new category expressly excludes digital assets that provide holders with the following rights in a business entity: (1) a debt or equity interest in a business entity; (2) liquidation rights; (3) an entitlement to an interest or dividend payment; (4) a profit or revenue share in that entity solely from the entrepreneurial or managerial efforts of others; and (5) any other financial interest in that entity. Such features are distinctive of securities, so any digital asset with any of these characteristics would continue to fall under the regulatory purview of the SEC. And under the RFIA, issuers of ancillary assets may still be required to furnish limited semi-annual disclosures with the SEC – although the law’s requirements would generally not be as onerous as the typical SEC securities disclosure requirements.
To put the matter briefly, an ancillary asset is a fungible digital asset that is provided to a person under an investment contract but does not constitute a security because the asset does not convey rights typically associated with a securities provision. [4]
Title IV – Responsible Commodities Innovation
Beyond new digital asset categorizations, Title IV also expands the CFTC’s jurisdiction in a few important ways.
First, the RFIA grants the CFTC exclusive jurisdiction over all fungible digital assets which are not securities, including ancillary assets, although carve-outs still remain for the SEC’s aforementioned disclosure requirements.
Relatedly, the RFIA requires that the CFTC’s exclusive digital asset spot market jurisdiction only be exercised over fungible digital asset transactions — an apparent effort to restrict the CFTC’s regulatory authority over NFTs, which are most often associated with art and unique digital game items. Lacking from the RFIA, however, is a definition of “fungibility” that is sufficiently clear to address questions regarding the classification of NFTs that involve rights conveyed to owners in a manner similar to securities or investment contracts. [5] Indeed, many NFT offerings advertise “utility” for purchasers, generally in the form of a return on investment or some other profit derived from the managerial efforts of the project owners. [6] In most cases, these rights are substantiated by revenue share, ownership rights, and other perks. Generally speaking, such “utility” meets the definition of an “investment contract” under the Howey test, which would then qualify the asset as a security.
Without proper legislative action or regulatory guidance for businesses and consumers, this issue is increasingly critical as a matter of consumer protection. The rapid proliferation of utility NFT offerings has popularized financial incentives and profit for NFT owners looking to earn money in the cryptocurrency space. And because NFTs are nominally non-fungible, many businesses and consumers may mistakenly believe that such offerings are in compliance with federal securities laws, because securities are typically fungible. While a non-fungible token is unique with respect to its identity as such on the blockchain, the owner’s entitlements may be considered fungible in a way that invokes securities laws (or commodities laws in the future such as the RFIA). The art representing the NFT may not be fungible, while all its other qualities are.
Second, the RFIA proposes “digital asset exchanges” as a new category of registered entity: any trading facility that offers or seeks to offer a market in digital assets may register with the CFTC under this category. This permissive approach is noteworthy, as the RFIA would not make it unlawful to operate a digital asset exchange activity without registration (although registering would come with certain regulatory benefits in addition to increased consumer and market confidence). Additionally, the law would permit existing entities registered with the CFTC as swap execution facilities or designated contract markets to elect to be considered registered digital asset exchanges as long as they meet certain requirements.
Along these lines, digital asset exchanges are required to comply with the RFIA’s “core principles,” although the exchanges would have reasonable discretion in this regard. Among other things, the core principles require digital asset exchanges to develop standards and procedures to protect and ensure the safety of customer money, assets, and property as well as requiring them to ensure that they permit trading only in assets that are not readily susceptible to manipulation. [7] Such regulatory measures, if passed and complied with widely, could bolster consumer and market confidence in the cryptocurrency industry, which is often criticized for the various security and hacking scandals that occur because of malevolent actors taking advantage of unsuspecting consumers in the nascent industry.
If primarily subject to the regulatory authority of the CFTC rather than the SEC, the cryptocurrency industry would face far less scrutiny. While this could result in greater innovation and growth, the arrangement could also come at the expense of greater consumer protections that would be installed if the SEC was given control. The SEC’s regulatory approach is generally more aggressive than the CFTC, which has no investor protection mandate and fewer resources than the former, and further, the SEC’s stance toward cryptocurrency and blockchain-related products is historically an adversarial one. For instance, among various enforcement actions such as against companies like cryptocurrency exchange Binance and crypto-financial services provider Ripple, SEC Chairman Gary Gensler has repeatedly indicated his intention to rein in the cryptocurrency industry to the full extent of the SEC’s authority, even going as far as to characterize the industry as the “Wild West.” [8]
With this in mind, it is no shock that Gensler publicly expressed concern that the RFIA might weaken consumer protections, especially when it comes to investment contracts: “If you’re raising money from the public, the public’s anticipating a profit based on your entrepreneurial or other efforts. You’ve got to make basic disclosures and not mislead them.” [9] On the other hand, Rostin Behnam, Chairman of the CFTC, praised the RFIA, stating that the proposal “does a very good job” in giving the CFTC the authority it needs to “write rules and regulate these stakeholders within the financial ecosystem.” [10]
For cryptocurrency businesses, passage of the RFIA could mean more leeway in offering new cryptocurrency and blockchain products, although businesses would still need to be aware of federal and state securities laws. Nevertheless, the RFIA’s various opt-in opportunities provide an avenue for exchanges to register and earn consumers’ trust, although doing so is not mandatory. Consumers will need to wait and see how the bill’s permissive standards play out in practice if, or when, the bill passes.
Other Provisions of Note
- Codifies a person’s right to the individual management of digital assets: “No person shall be required to use an intermediary for the safekeeping of digital assets legally owned, and possessed or controlled, by that person.” [11]
- Amends and clarifies the definition of “broker” for purposes of the new reporting requirements imposed by the Infrastructure Investment and Jobs Act. It defines the term as “ any person who (for consideration) stands ready in the ordinary course of a trade or business to effect sales of digital assets at the direction of their customers.” [12]
- Amends the Internal Revenue Code to allow taxpayers to exclude gains and losses from gross income that result from the disposition of a virtual currency in a personal transaction of $200 or less. Starting in 2023, the $200 de minimis exclusion may increase based on annual cost-of-living adjustments. [13]
- Provides the following definitions for digital asset related terms, among others:
- Decentralized Autonomous Organization (“DAO”): an organization which utilizes smart contracts to effectuate collective action for a business, commercial, charitable, or similar entity, governance of which is achieved primarily on a distributed basis, and which is properly incorporated or organized under the laws of a State or foreign jurisdiction as a decentralized autonomous organization, cooperative, foundation or any similar entity.
- Digital Asset: a natively electronic asset that confers economic, proprietary, or access rights or powers; and is recorded using cryptographically secured distributed ledger technology, or any similar analogue, and includes virtual currencies, ancillary assets, payment stablecoins, and other securities and commodities.
- Distributed Ledger Technology: technology that enables the operation and use of a ledger that is shared across a set of distributed nodes that participate in a network and store a complete or partial replica of the ledger, is synchronized between the nodes, has data appended to the ledger by following the specified coonsensus mechanism of the ledger, may be accessible to anyone or restricted to a subset of participants, may require participants to have authorization to perform certain actions or require no authorization.
- Smart Contract: computer code deployed to a distributed ledger technology network that executes an instruction based on the occurrence or nonoccurrence of specified conditions, or any similar analogue, and may include taking possession or control of a digital asset and transferring the asset or issuing executable instructions for these actions.
- Virtual Currency: a digital asset that is used primarily as a medium of exchange, unit of account, store of value, or any combination of such functions, is not legal tender, as described in section 5103, and does not derive value from or is backed by an underlying financial asset (except digital assets), and includes a digital asset that is accompanied by a statement from the issuer that a denominated value will be maintained and be available upon redemption, based solely on a smart contract.
Track the RFIA’s progress through the legislative process here.
[2] A few other provisions of the RFIA include the following, per the Lummis-Gillibrand joint press release: creates an advisory committee to develop guiding principles, empower regulatory agencies and advise lawmakers on fast-developing technology; imposes disclosure requirements on digital asset service providers to ensure that consumers understand the product and can make informed decisions when engaging with digital assets; requires a study on digital asset energy consumption; and provides a regulatory sandbox for state and federal regulators to collaborate on innovative financial technologies.
[3] §301; Proposed § 41(a)(1)(A).
[4] Stablecoins issued by a depository institution would not be regulated as either a commodity or a security.
[5] The proposed “ancillary asset” category definition only addresses fungible digital assets.
[6] This notion excludes mere appreciation from supply and demand.
[7] §404.
[8] Generally speaking, the SEC’s enforcement actions involve cryptocurrencies being alleged unregistered securities offerings. Such is the case with Binance and Ripple’s investigations by the SEC. https://www.sec.gov/news/public-statement/gensler-aspen-security-forum-2021-08-03
[9] https://decrypt.co/102972/sec-chair-gensler-crypto-bill-could-undermine-existing-protections
[11] §505(a).
[12] §202(a).
[13] §201.
