Taking Steps Toward Federal Blockchain and Cryptocurrency Regulation | Sullivan & Worcester

[co-author: Karly Roux, Summer Associate]

On May 22, 2024, with bi-partisan support, the U.S. House of Representatives passed H.R. 4763, the Financial Innovation and Technology for the 21^st Century Act (“FIT21”), becoming the first major cryptocurrency legislation to pass one of the chambers of Congress.

Brief Summary of FIT21

Broadly, FIT21 aims to provide safeguards, comprehensive customer disclosure, and operational guidelines for digital assets.[1] If enacted, FIT21 would grant the U.S. Securities and Exchange Commission (“SEC”) jurisdiction to regulate restricted digital assets[2] and grant the Commodity Futures Trading Commission (“CFTC”) jurisdiction to regulate digital commodities.[3] Digital commodities are distinguished under the bill from restricted digital assets based on “decentralization” and “functionality.”

Generally, a decentralized blockchain is one in which:

• during the previous 12-month period, no person has had unilateral authority to control the blockchain or its usage, and no issuer or affiliated person owned 20% or more of the digital asset or the voting power of the digital asset, and all issuances of units of the digital asset through the functioning of the blockchain system were to end users, and
• during the previous three-month period, the issuer and affiliated persons have not contributed intellectual property to the source code of the blockchain system that materially altered the functionality or operation of the system other than certain technical fixes or changes that were adopted through the consensus or agreement of a decentralized governance system, and neither the issuer nor affiliated persons have marketed to the public the digital asset as an investment.

The bill defines a functional blockchain system as one that allows network participants to use a corresponding digital asset for an application on the blockchain system, transmission and storage of value, participation in services or participation in the decentralized governance system on the blockchain.

Under the bill, a person may certify to the SEC that a blockchain system to which a digital asset relates is a decentralized system. In connection with this certification, the person would provide detailed information to the SEC to substantiate the determination that the system is decentralized, including, among other things, with respect to functionality, governance, ownership of the digital asset, and recent issuances. The blockchain system will be deemed certified as decentralized 60 days after the certification date unless the SEC provides notice within such period indicating that the person making the certification has provided an inadequate explanation or there are novel or complex issues that require additional time for consideration. The bill also provides for an appeals process if the SEC ultimately determines that a system is not decentralized.

Once a blockchain system to which a digital asset relates is a functional system and is certified as decentralized, the digital asset would fall within the definition of a digital commodity and will be regulated by the CFTC. Excluded from the definition of a digital commodity are digital assets held by the digital asset issuer or owned by related persons[4] and affiliates of the digital asset issuer[5] – these digital assets will be regulated by the SEC.

The bill also proposes amendments to the Securities Act of 1933 (the “Securities Act”), including a new Section 4(a)(8) under the Securities Act, to include processes and procedures for issuers to offer and sell units of digital assets in transactions that are exempt from the full registration requirements of the Securities Act, and also proposes new SEC authority for the registration and regulation of digital asset brokers, digital asset dealers and digital asset trading systems.

Potential Impact of FIT21

If enacted, FIT21 could potentially provide a more clear and stable landscape for the U.S. digital asset market while fostering technological innovation. The bill tries to accomplish this by imposing certain limited disclosure requirements aimed at preventing market manipulation and fraud, thereby increasing investor confidence in these investment opportunities. Consumer protections within FIT21 include requirements for brokers, dealers, and exchanges to register with the SEC or CFTC, disclose information about the assets, segregate customer funds, create lock-up periods for token insiders, and limit the volume of annual sales. Furthermore, by defining the difference between a commodity and a security, the bill helps alleviate some of the regulatory ambiguity that has existed in the crypto industry. Given the efforts of other countries to develop their own regulatory guidelines, FIT21 could solidify the U.S. as a thought leader in the financial technology space.

However, there are a number of critics of FIT21 that feel the bill will not accomplish its goals and could cause more problems than it solves. Whether or not FIT21 is enacted as law, at a minimum, it serves as an essential first step in the Congressional conversation surrounding digital token regulation and as a baseline for future legislative proposals.

Next Steps for FIT21

The Biden Administration released a statement sharing concerns that the bill lacks adequate protections for investors and consumers, but it has nonetheless expressed eagerness to work with Congress on the issue of regulating cryptocurrency market activity, and it did not threaten to veto the bill should it pass the Senate. The Senate now has the opportunity to amend the bill but, as of the end of June 2024, has not yet scheduled a floor vote or a committee hearing to discuss any such changes. In any case, while enacting FIT21 may be an uphill battle, the bill’s passage in the House underscores the growing bipartisan support for clear and comprehensive cryptocurrency legislation.