The proposed bill sets forth a comprehensive framework for the digital asset ecosystem by bridging regulatory gaps, promoting innovation, and protecting consumers.
On June 2, 2023, Patrick McHenry, Chairman of the House Financial Services Committee, and Glenn Thompson, Chairman of the House Committee on Agriculture, published a discussion draft of legislation (the Proposed Bill) that seeks to close regulatory gaps and provide a “functional framework” for digital asset regulation in the US. Unlike several other proposed crypto-focused laws around the world, most notably MiCA in the EU, this Proposed Bill largely draws on existing legal frameworks and standards rather than creating an entirely new regime specifically for regulating cryptoassets.
The Proposed Bill grants regulatory authority to the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) and clarifies the jurisdictional scope between the two agencies. The CFTC would be granted explicit authority over spot market digital asset commodities, while the SEC would maintain authority over digital assets offered as part of an investment contract (i.e., securities). And while the Proposed Bill would exclude payment stablecoins from the definition of digital commodity under the Commodity Exchange Act (CEA), the CFTC would still be granted jurisdiction over transactions in payment stablecoins “as if” they were digital commodities when transacted on a CFTC-registered entity.
Representatives McHenry and Thompson have stated that their goal in publishing the Proposed Bill is “to strike the appropriate balance between consumer protection and encouraging responsible innovation.” They have also indicated their intention to formally introduce the Proposed Bill on the House floor in early July 2023.
Key Provisions of the Proposed Bill
CFTC and Commodities
- Jurisdiction: The CFTC would receive exclusive regulatory jurisdiction over digital commodity spot markets, requiring that market participants and trading venues register with the CFTC. The Proposed Bill creates numerous new registrant categories, including digital commodity exchanges, digital commodity brokers, and digital commodity dealers. The CFTC’s jurisdiction would be preemptive, although the scope of that preemption is unclear.
- Decentralization: A token issuer may petition for its restricted digital assets to be considered a commodity as long as the issuer certifies that the network is functional and decentralized[i] and the SEC does not object.
- New CFTC Registrants: A Digital Commodity Exchange (DCE) regulatory regime would be established for the trading of digital asset commodities. The newly registered exchanges would be subject to core principles analogous to those imposed upon existing Designated Contract Markets and Swap Execution Facilities. Further, the CEA proposes a Digital Commodity Broker (DCB) and a Digital Commodity Dealer (DCD) framework. DCBs and DCDs would be required to register with a registered futures association and meet prescriptive business conduct requirements related to:
- anti-fraud, manipulation, and other abusive practices;
- conflicts of interest; and
- segregation of customer assets.
These requirements also follow in suit with the existing CFTC regulatory requirements for swap dealers and intermediaries in the derivatives markets.
- Secondary Sales: Digital asset commodities would be permitted to be traded in secondary sales even after initially being sold as investment contracts, if certain conditions are met (such as certified and publicly available enhanced disclosure requirements related to the digital asset’s blockchain network). A self-certification regime would apply for the listing of digital commodities on DCEs reminiscent of the futures self-certification regime. However, both the CFTC and the SEC can file notices indicating disagreement with the self-certification, which may require delisting from the DCE and could impact the effectiveness of this self-certification regime.
- Stablecoins: Payment stablecoins are expressly excluded from the definition of digital commodity, however, DCEs would be permitted to list them and DCBs and DCDs would be permitted to trade them. If transactions in payment stablecoins were conducted by or on a CFTC-registered entity, they would be regulated as if they were digital commodities. The SEC would have anti-fraud and anti-manipulation authority over transactions in payment stablecoins that are brokered, traded, or custodied by a broker or dealer or through an alternative trading system (ATS).
- Anti-Fraud and Anti-Manipulation Authority: The CFTC’s existing anti-fraud and anti-manipulation authority in spot commodity markets would extend to digital commodities.
- Consumer Protection: Customer protection obligations would be imposed on all entities that register with the CFTC.
SEC and Securities
- Jurisdiction: The SEC would receive jurisdiction over digital assets offered as part of an investment contract (i.e., securities).
- Securities: The SEC would be able to object to a digital asset being self-certified as a digital commodity, but any rebuttal must include a detailed analysis of its decision. Importantly, such self-certification would require the relevant network to meet the definition of “decentralized network,” which leaves significant room for interpretation.
- Exemption: An issuer’s sale of digital assets would be exempted from registration under the securities laws if the following conditions were met:
- the issuer’s total sales of the digital asset over the prior 12 months does not exceed US$75 million;
- a non-accredited investor’s purchases of the digital asset from the issuer over the prior 12 months are less than the greater of 5% of the purchaser’s annual income or 5% of their net worth;
- the purchaser does not own more than 10% of the units of the digital asset after the completion of the transaction; and
- the transaction does not involve equity or debt securities.
- ATS: Digital asset trading platforms would be permitted to register as ATS. The SEC would be prohibited from preventing an ATS from operating pursuant a covered exemption (i.e., an exemption from the requirement to register as a national securities exchange) on the basis that the platform enables trading of digital asset securities, digital commodities, or payment stablecoins.
- Custody: The SEC would be required to revise its rules to allow broker-dealers to offer custody and safekeeping of digital assets if they meet certain requirements.
- Stablecoins: Transactions in payment stablecoins would fall under the SEC’s anti-fraud or anti-manipulation enforcement authority if such transactions occur on or with a SEC-registered entity, although payment stablecoins themselves would not be regulated as securities.
- Consumer Protection: Customer protection obligations would be imposed on all entities that register with the SEC. Specifically, the SEC would be required to revise the Customer Protection Rule to provide that a registered broker-dealer is considered to have control of digital assets under certain circumstances (including provisions for self-custody of private keys).
Provisions Affecting Both the CFTC and the SEC
- Regulatory Transition: Entities under the purview of the CFTC or the SEC would be permitted to file a provisional registration statement with either agency while the agencies are developing and finalizing their rules. Such a registration would subject the entity to certain filing, disclosure, and customer asset segregation requirements, as well as inspection and examination. However, the registration would also provide limited relief from many of the requirements of the Proposed Bill, including from agency enforcement action.
- Dual Registration: Certain entities would be permitted to dually register with the CFTC and the SEC to facilitate transactions in multiple types of digital assets.
- Joint Rulemaking: The SEC and the CFTC would have to engage in joint rulemakings that further define key terms related to digital asset commodities and securities, and support the oversight of dually registered exchanges.
- Joint Advisory Committee: The SEC and the CFTC would have to establish a joint Advisory Committee on Digital Assets, composed of at least 20 digital asset market participants, designated to provide feedback and advice to the agencies on topics related to digital assets.
- Joint Studies on DeFi and NFTs: The SEC and the CFTC would have to conduct joint studies on decentralized finance (DeFi) and non-fungible tokens (NFTs), addressing:
- their respective size, scope, role, nature, and use;
- general benefits and risks;
- risks of integration into traditional markets; and
- the levels and types of illicit activities in these markets.
- Agency Fintech Hubs: The SEC’s Strategic Hub for Innovation and Financial Technology (FinHub) and the CFTC’s LabCFTC are formally codified, serving as resources to both the agencies and market participants.
What’s Missing? / Concerns
- DeFi and NFTs: The Proposed Bill does not address the status or role of DeFi or NFTs,[ii] except to require further joint study by the CFTC and the SEC.
- Disclosure on ESG Factors: The Proposed Bill does not address or mandate disclosures regarding ESG issues, such as energy use, climate impact of mining activity, or board diversity.
- Significant SEC Discretion: As previewed, the Proposed Bill would provide significant discretion to the SEC to determine whether a network is decentralized. We would hope that some reasonable parameters can be established in future drafts to avoid a potential bottleneck for such approvals.
- Appropriations: The Proposed Bill does not include any allocation of new funding for the CFTC, despite the certain increase in demands on the agency were the Proposed Bill to be enacted. CFTC Chairman Rostin Behnam has publicly stated that if enacted, the CFTC would ideally need US$120 million over three years to “appropriately or impactfully implement the law,” such as through building teams for rule implementation and securing IT and cybersecurity resources.
Bipartisan Mixed Messages
According to a statement published by Representatives McHenry and Thompson, the House Financial Services Committee and the House Committee on Agriculture engaged for months on a “historic joint effort” to close regulatory gaps and “bolster U.S. leadership in financial and technological innovation.”
However, at the June 6, 2023, House of Representatives Agricultural Committee’s hearing on the Proposed Bill (“The Future of Digital Assets: Providing Clarity for Digital Asset Spot Markets”), certain Representatives noted that the discussion draft was not shared with Democratic lawmakers on the Committee before its release. One lawmaker expressed “concern for the process that produced the draft” and went so far as to say that “one hand does not seem to know what the other is doing.”
At the June 13, 2023, House Financial Services Committee hearing titled “The Future of Digital Assets: Providing Clarity for the Digital Asset Ecosystem,” Ranking Member Maxine Waters objected to the Proposed Bill’s provisional registration allowance (and related relief from enforcement), stating that it could “allow crypto firms that are currently being sued for violating our securities laws to continue doing business.”
At the same hearing, Representative McHenry signaled his intent to move quickly on the Proposed Bill: “There’s plenty of time for us members to find common ground on how we legislate here, but be advised I intend for this committee to markup some form of this legislation when we return from the July 4 recess.”[iii]
On June 26, 2023, Representative Waters sent letters to Secretary of the Treasury Janet Yellen and SEC Chairman Gary Gensler, urging the two agencies they lead to share their analysis and recommendations on the Proposed Bill. She specifically sought feedback on the effects the Proposed Bill may have on financial stability, consumer and investor protection, and digital assets ecosystem oversight.
Given the apparent discontent over the manner in which the Proposed Bill was publicized and the fact that it seems likely to face pushback on various contentious provisions, uncertainty remains around whether Representative McHenry’s intentions to go to vote quickly on the current text will ultimately prove successful.
While the Proposed Bill is certainly the most detailed proposal on digital assets to date, the authors acknowledge that it is a “first step” and encourage stakeholders and market participants to provide feedback and help refine the draft before it is formally introduced in the House of Representatives. Before that happens, however, intense negotiation with the Democratic members of the House Financial Services Committee and the House Committee on Agriculture will likely produce any number of revisions. Consideration as to how the Proposed Bill will be complemented by a much-needed bill dedicated to the regulation of stablecoins (also a recent point of contention in the House Financial Services Committee) must also be resolved.
Latham & Watkins will continue to monitor and report on developments related to the Proposed Bill.
[i] A decentralized network is defined in the Proposed Bill as one for which all the following conditions are met:
(A) During the previous 12-month period, no person, acting on the person’s own, excluding any decentralized organization (i) had the unilateral authority, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise, to control or materially alter the functionality or operation of the blockchain network; or (ii) had the unilateral authority to restrict or prohibit any person who is not a related person or an affiliated person from (I) using, earning, or transmitting the digital asset; (II) deploying software that uses or integrates with the blockchain network; (III) participating in on-chain governance decisions with respect to the blockchain network; or (IV) operating a node, validator, or other form of computational infrastructure with respect to the blockchain network.
(B) During the previous 12-month period neither any digital asset issuer nor any affiliated person, excluding any decentralized organization (i) beneficially owned units of such digital asset that represented at any time 20% or more units of such digital asset that are then outstanding; and (ii) had the unilateral authority to direct the voting of units of such digital asset that represented at any time 20% or more of the outstanding voting power of such digital assets.
(C) During the previous three-month period, the digital asset issuer, any affiliated person, or any related person has not implemented or contributed any intellectual property to the software code of the blockchain network that materially alters the functionality or operation of the blockchain network.
(D) During the previous three-month period, neither any digital asset issuer nor any affiliated person (i) has marketed to the public the digital assets or the blockchain network; or (ii) issued a unit of the digital asset.
(E) During the previous 12-month period, all issuances of units of the digital asset through the programmatic functioning of the blockchain network were end-user distributions.
[ii] Indeed, digital asset is defined in the Proposed Bill as any fungible digital representation of value that can be exclusively possessed and transferred, person to person, without necessary reliance on an intermediary, and is recorded on a cryptographically secured public distributed ledger.