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On May 22, 2024, the U.S. House of Representatives passed the Financial Innovation and Technology for the 21st Century Act (FIT21) with a vote of 279 to 136. This bill, spearheaded by the Republican Party, aims to amend existing securities and commodities regulations to establish a regulatory framework for digital assets, promoting the development of the crypto industry. Once enacted, the FIT21 Bill will become a significant milestone in the federal regulation of digital assets in the United States. This article will analyze the FIT21 Bill in terms of its legislative background, content, and potential impact.

1. Legislative Background of the FIT21 Bill

Since the genesis block of Bitcoin was mined, crypto digital assets have existed and developed for fifteen years, currently entering a vibrant and increasingly mature stage. However, neither the United States nor other countries have yet established a comprehensive regulatory framework for digital assets, only conducting fragmented and partial regulation. This not only fails to create a stable and predictable legal environment for the crypto industry but also fills the crypto digital sector with various illegal and criminal activities, severely hindering its innovation and progress. Critics argue that under the existing U.S. crypto regulatory framework, crypto startups suffer from “enforcement-based regulation,” leading these companies to operate in other countries, which is detrimental to both U.S. technological innovation and the overall economic development. Therefore, the U.S. urgently needs to legislate to create an innovation-friendly environment, fully exploring the future potential of the crypto industry while avoiding the market monopoly by a few large tech companies as seen 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 formulate specific rules regulating digital assets. The legal draft of FIT21 can be directly traced back to March 2023 when the Digital Assets, Financial Technology, and Inclusion Subcommittee, led by Representative French Hill, planned to work with the House Agriculture Committee to develop a regulatory framework for digital assets. In July of the same year, the House Financial Services Committee and the House Agriculture Committee successively passed the FIT21 Bill. It was not until May 2024 that the House completed the voting process for the bill. The FIT21 Bill will soon be submitted to the Senate for a vote and, after passing the Senate, will be signed by the President and officially enacted.

Recent developments in SAB 121 (Staff Accounting Bulletin No.121) have also raised hopes among the Senate, House, and the crypto industry for the FIT21 Bill. The SEC issued SAB 121 in 2022, requiring digital asset custodians to treat digital assets as liabilities and hold them at fair value on their balance sheets. Consequently, banks wishing to hold digital assets must have cash equal to the fair value of those assets, a provision seen as excessive SEC intervention in banking and digital assets, effectively excluding banks from the crypto industry. In mid-May 2024, just before the SEC’s shift in stance on ETH spot ETFs, the Senate and House preemptively passed a bill to overturn SAB 121. However, this was short-lived as President Biden ultimately vetoed the bill on May 31, leaving the Senate, House, and the crypto industry disappointed, thus placing more hope on the FIT21 Bill pending Senate approval and presidential signing.

2. Contents Overview of the FIT21 Bill

The FIT21 Bill consists of multiple chapters, each of which involves different aspects of the digital asset supervision and innovation system. This section will provide a classified overview of the contents of each chapter of the FIT21 Bill and summarize the main regulatory framework established by it.

2.1 Chapters Overview of the FIT21 bill

The first chapter of the FIT21 Bill 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 bill.

Chapter 2 mainly clarifies the digital assets as part of the investment contract. Article 202 of this chapter describes digital assets as part of investment contracts, defining them as fungible digital representations of value, setting out how they should be classified and regulated, and distinguishing them from traditional securities.

Chapter 3 primarily outlines the regulations on the offering and sale of digital assets. Specifically, Article 301 provides exemptions for certain transactions involving digital assets, Article 302 stipulates specific requirements for the offering and sale of certain digital assets, and Article 303 mandates enhanced disclosure requirements for any digital asset and its related blockchain systems.

Chapters 4 and 5 address the registration requirements for digital asset intermediaries under the jurisdiction of the SEC and CFTC. These intermediaries include digital asset exchanges, digital asset brokers, digital asset dealers, and digital asset custodians. The relevant regulations cover business requirements such as transaction certification and licensing, general and specific conditions for different registrants, registration methods and exemptions, as well as conflict of interest rules.

Chapter 6, titled “Innovation and Technology Improvements,” serves both as a title and a conclusion, reflecting the drafters’ and Congress’s assessment of crypto technology. Related to this, the SEC will establish the Innovation and Financial Technology Strategic Hub (FinHub), and the CFTC will establish LabCFTC. According to FIT21, the primary internal functions of these centers are to shape how the SEC and CFTC inspect fintech innovations and analyze the regulatory impact on fintech companies. Although both research centers engage with stakeholders and provide information on rules and regulations for those working with emerging technologies, the wording of FIT21 suggests that Congress does not view them as proactive regulatory sandboxes, as the SEC and CFTC are not granted specific discretionary powers in regulation.

2.2 Regulatory Framework Overview in the FIT21 Bill

Overall, FIT21 aims to establish a federal regulatory framework for digital assets by clarifying the SEC’s and CFTC’s regulatory responsibilities over digital assets and transactions and updating existing securities and commodities laws to cover various blockchain technologies, including decentralized protocols. Some believe that the protective measures for technology and innovation in FIT21 are somewhat similar to those implemented in the U.S. after the Great Depression in the 1920s, which subsequently led to an unprecedented era of economic growth and innovation.

The regulatory framework established by the FIT21 Bill for U.S. digital assets includes the following four aspects:

The CFTC must regulate digital assets as commodities, provided that the blockchain or cryptographic digital ledger on which they operate is functional and decentralized. Additionally, the act grants the CFTC exclusive regulatory authority over crypto commodities and spot markets.

In cases where the relevant blockchain is functional but not decentralized, the SEC must regulate digital assets as securities. FIT21 stipulates certain exceptions to SEC regulation of digital assets, involving annual sales thresholds, accredited investors, and requirements for primary and secondary market transactions.

The CFTC and SEC must jointly issue rules to formulate relevant provisions and avoid overlapping regulatory rules for exchanges.

The bill excludes approved stablecoins from CFTC and SEC regulation, except for specific transactions related to anti-fraud agencies and registered entities.

3. Interpretation of Articles 101 and 103 of the FIT21 Bill

Clear identification of the subjects is a prerequisite for action. Articles 101 and 103 of the FIT21 Bill provide detailed definitions and specific criteria for restricted digital assets (securities), digital commodities, and permitted payment stablecoins. This enables the SEC and CFTC to clarify their respective jurisdictions and specifically regulate restricted digital assets and digital commodities, while permitted payment stablecoins are excluded from their jurisdiction. This constitutes the premise for subsequent regulatory and guidance measures, allowing the crypto industry to develop within a more orderly regulatory framework and stable development space. Overall, the FIT21 Bill categorizes digital assets into three major categories: restricted digital assets, digital commodities, and permitted payment stablecoins. The relationship among these is that digital assets are generally restricted digital assets unless they self-certify as digital commodities or meet the definition of permitted payment stablecoins.

3.1 Digital Assets

Section 101, Item 26, first defines digital assets and lists exclusions. It states that a digital asset “refers to any fungible digital representation of value that can be fully owned and transferred by individuals without relying on intermediaries and is recorded on a cryptographically secure public distributed ledger.” However, digital assets do not include any note, stock, treasury stock, security futures, security swaps, bonds, debentures… any put, call, straddle, option, privilege, or any asset equivalent to options, futures, or swaps.

Notably, Section 101 emphasizes two points:

“Nothing in this paragraph shall be construed to presume that a digital asset is representative of any type of security not excluded from the definition of a digital asset.” This indicates that FIT21 insists on a strict definition of digital assets, clearly distinguishing them from other types of securities.

“A digital asset offered or sold or intended to be offered or sold pursuant to an investment contract is not and will not become a security due to being sold or otherwise transferred pursuant to such investment contract.” To understand this, one must first understand the Howey Test. The concept of securities in U.S. law originally evolved from the term “investment contract” in the Howey Test, one of whose four conditions is that profits come solely from the efforts of others. Under this criterion, the efforts of the project team and related parties are crucial for investors to gain profits, while investors only need to pay the specified fees and costs and do not actually participate in the project’s operation and management. However, the issuance and management of digital assets often rely on smart contracts and other automated programs, where there are no traditional efforts by the project team and related parties. The relevant provisions of the FIT21 Bill exclude digital assets from being classified as securities primarily to promote technological innovation while also considering investor protection.

3.2 Restricted Digital Assets

Item 34 defines “restricted digital assets” and proposes three criteria for identifying such assets: (1) the degree of decentralization and functionality of the underlying blockchain system; (2) the method by which users ultimately acquire the digital asset; and (3) the identity of the parties 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 “restricted digital assets” here essentially refer to digital assets that have characteristics similar to “securities,” although the term “security” is not used by the legislators. For example, Article 405 explicitly states that securities include restricted digital assets.

According to Item 25, the judgment of the degree of decentralization and functionality includes the following aspects:

(1) Regarding control and influence, in the past 12 months, no individual or entity has had unilateral power, directly or indirectly, to control or substantially alter the functionality or operation of the blockchain system.

(2) Regarding the distribution of digital asset ownership and governance rights, in the past 12 months, no digital asset issuer and related parties collectively held over 20% of the total issued digital assets, nor did they control 20% or more of the circulating voting rights of the digital asset or the related decentralized governance system.

(3) Regarding code modification, in the past 3 months, no digital asset issuer and related parties have substantially or unilaterally modified the blockchain system’s source code in a way that materially changes the system’s functionality or operation, unless such modifications were made to address bugs and misalignments, conduct regular maintenance, prevent cybersecurity risks, or improve blockchain technology.

(4) Regarding marketing, in the past 3 months, no digital asset issuer or related parties have marketed the digital asset to the public as an investment.

(5) The units of the digital asset issued through the blockchain system’s programmatic functions are end user distribution.

According to Item 30, “end user distribution” refers to a broad, fair, non-discretionary distribution accessible to any participant in the blockchain, typical examples being mining and staking rewards for blockchain users.

Among these standards, the “12 months” and “20%” criteria are particularly important. The 12-month period is a longitudinal standard for assessing decentralization, while the 20% threshold is a latitudinal standard. Whether it’s 12 months or 15 months, 20% or 30%, the specific values themselves are not the most important aspect; the key point is that they provide clear, quantifiable standards that make the assessment of decentralization more objective.

For the method by which users acquire digital assets, the provision requires that restricted digital assets are issued to users in a manner other than end user distribution or acquired by users on non-digital commodity exchanges.

For the final criterion, restricted digital assets must be those held entirely by the issuer and related parties during periods when the blockchain system is not functional or has not become decentralized. Additionally, permitted payment stablecoins are exempt from being classified as restricted digital assets.

3.3 Permitted Payment Stablecoin

Section 101, item 32 of FIT21 defines Permitted Payment Stablecoin. It specifies that a Permitted Payment Stablecoin is used or designed for use as a means of payment or settlement. Its issuer is obligated to convert, redeem, or repurchase to obtain a fixed amount of currency value, or represents it will maintain or reasonably expect to maintain stable value relative to a fixed amount of currency value. Additionally, its issuer is regulated by authorized federal or state regulatory agencies, and the stablecoin is not a national currency or security. The aforementioned currency value refers to the national currency, deposits, or equivalent instruments denominated in the national currency. This definition underscores FIT21’s emphasis on the significance of licensing for payment stablecoins, while excluding algorithmic stablecoins from the scope of licensing.

3.4 Digital Commodities

Section 103, item 55 of FIT21 defines “Digital Commodities.” This category covers three scenarios: firstly, any digital asset unit held by individuals other than the digital asset issuer or affiliates before the blockchain system becomes functional and is certified as a decentralized system, obtained through final issuance or on digital commodity exchanges; secondly, any digital asset unit held by individuals other than the digital asset issuer or affiliates after the blockchain system becomes functional and is certified as a decentralized system; thirdly, any digital asset unit held by affiliates during the period when the blockchain system becomes functional and is certified as a decentralized system. Digital commodities similarly do not include permitted payment stablecoins. A specific provision states that if a federal court has ruled a digital asset is not a security before the enactment of FIT21, and the ruling remains valid, that digital asset should be classified as a digital commodity. This special provision reflects FIT21’s approach to distinguishing between securities and commodities, particularly after excluding permitted payment stablecoins.

4. Potential Impacts of the FIT21 Bill

4.1 Impact of the FIT21 Bill on Crypto Taxation

According to IRS Notice 2014-21, all cryptocurrencies are treated as property rather than currency, thus subject to general tax principles applicable to property transactions. However, the IRS defines cryptocurrencies broadly as “a digital representation of value that is recorded on a distributed ledger or any similar technology.” The FIT21 Bill provides detailed criteria and standards for the IRS to determine the scope of cryptocurrencies, whether they qualify as digital commodities or securities. This will aid the IRS in taxing cryptocurrency holders based on distinguishing between ordinary income and capital gains.

It is important to note that throughout the FIT21 Bill, the term “securities” is not used to refer to restricted digital assets that resemble securities. Therefore, some strict tax rules applicable to securities do not apply to restricted digital assets. For instance, while US tax law allows for tax loss harvesting, it strictly prohibits wash sales, which involves selling an asset at a loss and repurchasing it within a short period. Securities subject to these rules include stocks, bonds, mutual funds, ETFs, options, futures, and warrants, whereas “restricted digital assets” continue to be exempt from wash sale rules.

4.2 Impact of the FIT21 Bill on Crypto Regulation

In terms of regulatory bodies and subjects, the FIT21 Bill aims to establish clear regulatory targets and scopes for the two main regulatory bodies, SEC and CFTC, by distinguishing between restricted digital assets, digital commodities, and exempting permitted payment stablecoins. This ensures orderly regulation of digital assets, preventing negative impacts from regulatory ambiguity and conflicts.

Regarding regulatory content, the FIT21 Bill not only mandates SEC and CFTC to oversee the registration of digital assets but also enhances disclosure requirements for digital assets. It requires SEC and CFTC to implement anti-money laundering (AML) systems and anti-fraud mechanisms, further enriching regulatory content for cryptocurrencies.

In terms of regulatory style, overall, the FIT21 Bill adopts a flexible and inclusive regulatory policy while emphasizing protection for small and medium-sized investors and consumers. This framework provides an orderly and sufficient space for innovation and development of the crypto industry in the United States, attracting more crypto talent and businesses. This will stimulate vitality in the US crypto industry and enhance the country’s financial competitiveness globally.

5. Conclusion

Although the final passage of the FIT21 Bill remains uncertain, its approval by the US House of Representatives alone indicates a friendlier stance of lawmakers towards cryptocurrencies. Friendliness does not imply leniency; rather, the US aims to create a stable and effective regulatory environment for the benign growth of the crypto asset market through the FIT21 Bill. In the future, SEC and CFTC will collaborate to further explore the integration of DeFi with financial markets, NFTs with traditional markets, enhance financial literacy among cryptocurrency investors, strengthen infrastructure for blockchain financial markets, and maximize the role of crypto assets and blockchain technology in economic development, all while safeguarding investor rights.

References

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[2].Helms, K. (2024, June 13). Senate urged to pass landmark crypto bill after Biden vetoes resolution to overturn SEC rules. Bitcoin News. https://news.bitcoin.com/senate-urged-to-pass-landmark-crypto-bill-after-biden-vetoes-resolution-to-overturn-sec-rules/

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