The Unintended Consequences of FIT21’s Crypto Market Structure Bill

There
is
no
doubt
that
the

bipartisan
passage
of
the
Financial
Innovation
and
Technology
for
the
21st
Century
Act
(FIT21)
by
the
House
is
a
monumental
development
for
the
U.S.
crypto
industry,
bringing
much-needed
regulatory
clarity
within
sight.
However,
despite
its
good
intentions,
FIT21
is
fundamentally
flawed
from
a
market
structure
perspective
and
introduces
issues
that
could
have
far-reaching
unintended
consequences
if
not
addressed
in
future
Senate
negotiations.

Joshua
Riezman
is
deputy
general
counsel
at
GSR.

Note:
The
views
expressed
in
this
column
are
those
of
the
author
and
do
not
necessarily
reflect
those
of
CoinDesk,
Inc.
or
its
owners
and
affiliates.

One
of
the
most
problematic
aspects
of
the
bill
is
its
creation
of
a
bifurcated
market
for
crypto
tokens.
By
distinguishing
between
“restricted
digital
assets”
and
“digital
commodities”
in
parallel
trading
markets,
the
bill
sets
the
stage
for
a
fragmented
landscape
that
is
ill-suited
for
the
inherently
global
and
fungible
nature
of
crypto
tokens
and
creates
first-of-its-kind
compliance
complications.

This
legislative
initiative
stems
from
the
long-running
debates
over
U.S.
federal
securities
laws
application
to
crypto
tokens
and
the
difference
between
bitcoin,
considered
a
non-security,
and
nearly
every
other
token.
The
U.S.
Securities
and
Exchange
Commission’s
(SEC)
guidance
on
whether
a
crypto
token
is
a
security
has
generally
been
based
on
whether
the
associated
blockchain
project
is
“sufficiently
decentralized”
and
thus
not
an
investment
contract
“security”
as
defined
by
the
Howey
test.

FIT21
attempts
to
codify
this
impractical
test
by
dividing
regulatory
oversight
over
spot
crypto
markets
between
the
Commodity
Futures
Trading
Commission
(CFTC)
and
SEC,
based
on,
among
other
things,
the
degree
of
decentralization.

While
the
bill
helpfully
appears
to
clarify
that
crypto
tokens
transferred
or
sold
pursuant
to
an
investment
contract
do
not
inherently
become
securities
themselves,
it
unfortunately
contradicts
itself
by
nonetheless
giving
the
SEC
plenary
authority
over
such
investment
contract
assets
where
sold
to
investors
(or
issued
to
developers)
for
the
time
period
before
a
project
reaches
decentralized
Valhalla.
Only
tokens
airdropped
or
earned
by
end-users
are
initially
“digital
commodities”
subject
to
CFTC
jurisdiction.

Most
confoundingly,
FIT21
allows
for
concurrent
trading
in
restricted
digital
assets
and
digital
commodities
for
the
same
token
in
separate
and
distinct
markets
during
this
period
(as
shown
in
the
graphic
below).
It
is
likely
that
many
projects
would

never
meet
the
prescriptive
definition
of
decentralization
in
the
bill
and
therefore
trade
in
disjointed
markets
in
the
U.S.
indefinitely.

The
bill’s
proposed
bifurcated
market
for
restricted
and
unrestricted
digital
assets
ignores
fungibility
as
a
fundamental
characteristic
of
crypto
tokens.
By
creating
categories
of
restricted
and
unrestricted
assets,
the
bill
disrupts
this
principle,
leading
to
confusion
and
market
fragmentation.
This
could
impair
liquidity,
complicate
transactions
and
risk
management
mechanisms
such
as
derivatives,
reduce
the
overall
utility
of
the
crypto
tokens
and
ultimately
stifle
innovation
in
a
nascent
industry.

See
also:



The
Financial
Innovation
and
Technology
for
the
21st
Century
Act
Is
a
Watershed
Moment


|
Opinion

Implementing
such
distinctions
would
likely
necessitate
technological
modifications
to
crypto
tokens
to
enable
buyers
to
know
which
type
of
crypto
asset
they
are
receiving
such
that
they
may
comply
with
market-specific
requirements.
Imposing
such
technological
marking
on
restricted
digital
assets,
even
if
possible,
would
create
an
“American-only”
crypto
market
separate
from
global
digital
asset
markets,
reducing
the
utility
and
value
of
every
relevant
project.

As
shown
in
the
above
graphic,
tokens
may
transition
back
and
forth
between
the
SEC
and
CFTC
markets
should
decentralized
projects
re-centralize.
The
complexity
and
compliance
costs
created
by
such
a
scheme
applied
to
the
many
thousands
of
future
crypto
tokens
is
dramatically
underestimated
and
would
undermine
the
credibility
and
predictability
of
U.S.
financial
markets.
There
are
precious
few
examples
of
financial
products
transitioning
between
SEC
and
CFTC
jurisdiction
and
it’s
nearly
always
a
tire
fire
(e.g.,
the
2020
transition
of
KOSPI
200
futures
contracts
from
CFTC
jurisdiction
to

joint
CFTC/SEC
jurisdiction).

The
bill
further
underestimates
the
international
nature
of
crypto
token
markets.
Crypto
tokens
are
global
assets
that
trade
as
the
same
instrument
globally.
Attempting
to
restrict
certain
assets
within
the
U.S.
would
likely
lead
to
regulatory
arbitrage,
where
the
flowback
from
international
markets
would
undermine
the
bill’s
intent
while
eroding
the
competitiveness
of
the
U.S.
crypto
industry.

Developers
and
investors
outside
the
U.S.
are
unlikely
to
self-impose
similar
restrictions
on
restricted
digital
assets.
Therefore,
new
projects
and
investors
will
be
incentivized
to
move
development
and
investment
outside
of
the
U.S.
to
avoid
these
requirements.
This
would
make
it
extremely
difficult
to
prevent
the
U.S.
digital
commodities
market
from
being
flooded
with
non-U.S.
tokens
that
would
have
been
restricted
digital
assets
had
they
been
“issued”
in
the
U.S.

Lastly
and
ironically,
the
bill
designed
to
protect
U.S.
consumers
could
end
up
harming
them
due
to
poor
market
structure.
The
initial
CFTC-regulated
markets
for
end
users
will
be
full
of
sellers
that
generally
received
tokens
for
free.
This
unbalanced
market
dynamic
will
most
likely
lead
to
depressed
prices
and
increased
volatility
compared
to
both
the
restricted
and
international
markets,
with
professional
arbitrageurs
benefiting
at
the
expense
of
U.S.
retail.

See
also:



Is
the
House’s
FIT21
Bill
Really
the
Legislation
That
Crypto
Needs?


|
Opinion

This
system
will
further
be
gamed
by
insiders
and
professional
investors
as
arbitrageurs
capitalize
on
disjointed
pricing
and
price
jump
discontinuities
caused
by
the
transition
between
centralized
and
decentralized
designations.
At
best
U.S.
retail
markets
will
be
a
noisy
signal
of
fundamental
value
and
end-users
will
be
the
last
to
receive
institutional
liquidity.

While
FIT21
is
a
crucial
step
towards
addressing
the
regulatory
challenges
posed
by
crypto
tokens,
its
current
proposed
market
structure
could
have
unintended
consequences.
To
protect
customers
and
ensure
well-functioning
U.S.
digital
asset
markets
lawmakers
must
refine
the
bill
to
unify
spot
markets
for
fungible
crypto
tokens
that
are
not
otherwise
securities
in
a
coherent
regulatory
framework.