About FIT21: Background, Content and Implications

On May 22, 2024, the US House of Representatives passed the Financial Innovation and Technology for the 21st Century Act (FIT21) with a resounding vote of 279 to 136. The bill, led by Republicans, aims to modify existing securities and commodities regulatory frameworks and establish a regulatory framework for digital assets to promote the development of the cryptocurrency industry. Once officially enacted, FIT21 will be a significant milestone in the US federal digital asset regulatory system. This article will interpret the FIT21 Act from the perspectives of legislative background, bill content, and potential impact.

1. Legislative Background of FIT21 Act

Since the genesis block of Bitcoin was mined, cryptocurrency assets have existed and developed for 15 years, currently being in a vibrant and mature stage. However, neither the US nor other countries have 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 cryptocurrency industry, but also fills the industry with various illegal and criminal activities, seriously hindering the innovation and progress of the cryptocurrency industry. Critics argue that in the existing cryptocurrency regulatory framework in the United States, startups in the cryptocurrency industry are subject to “regulation based on law enforcement,” which can lead to these companies relocating their operations to other countries, which is not only detrimental to the country’s innovation but also to its overall economic development. Therefore, the United States urgently needs to pass legislation to create an environment that supports innovation and fully exploits the potential of the cryptocurrency industry while avoiding the situation where a few large tech companies dominate the market 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 US Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) to develop specific rules for digital assets. The FIT21 legal draft can be traced back to March 2023, when the Digital Assets, Financial Technology, and Inclusion Subcommittee, led by US Representative French Hill, planned to collaborate 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 passed the FIT21 Act, while the House did not complete the voting process until May 2024. The FIT21 bill will soon be submitted for a vote in the Senate and, once passed by the Senate, will be signed by the President and officially released. The recent developments of SAB 121 (Staff Accounting Bulletin No.121) have also made the Senate and House of Representatives, as well as the cryptocurrency industry, hopeful for the passage of the FIT21 bill. The SEC issued SAB 121 in 2022, which requires digital asset custodians to treat digital assets as liabilities and hold them on their balance sheets at fair value. Based on this, banks that want to hold digital assets would have to hold cash on their accounts equal to the asset’s fair value, a provision that was seen as excessive intervention by the SEC in the banking and digital asset industries because it effectively excludes banks from the cryptocurrency industry. In mid-May 2024, before the SEC changed its stance on the ETH spot ETF, the House and Senate took action to pass a bill overturning SAB 121, but the good times were short-lived as President Biden ultimately vetoed the bill on May 31, leaving the House and Senate and the cryptocurrency industry deeply disappointed and turning their hopes to the FIT21 bill pending Senate vote and Presidential signature.

  1. Overview of the FIT21 Bill Content

The FIT21 Act is comprised of several chapters, each covering different aspects of digital asset regulation and innovation. This section provides a categorized overview of the content of each chapter of the FIT21 Act and summarizes the main regulatory framework established by the Act.

2.1 Overview of Chapters in the FIT21 Act

The first chapter of the FIT21 Act is titled "Definitions; Rule-making; Registration Intent Notification (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” and clarify the scope of the bill.

Chapter 2 primarily clarifies digital assets as part of an investment contract. Section 202 of this chapter describes digital assets as a The relevant provisions cover business requirements such as transaction authentication and authorization, general and specific conditions, methods, and exemptions for registration requirements for different registration subjects, as well as specific content such as conflict of interest rules.

Chapter 6 is entitled “Innovation and Technology Improvements (INNOVATION AND TECHNOLOGY IMPROVEMENTS)”, which is not only the title but also the conclusion, indicating the evaluation of cryptographic technology by the bill drafters and the National Congress. Related to this, the SEC will establish the Innovation and Financial Technology Strategy Center (FinHub), while the CFTC will establish LabCFTC. According to FIT21, the main internal functions of these two centers are to shape the way in which SEC and CFTC examine financial technology innovations, analyze the impact of regulations on financial technology companies, and so on. Although both centers interact with stakeholders and provide information on rules and regulations to personnel working on emerging technologies, the wording of FIT21 suggests that the US Congress does not believe that they will become active regulatory sandboxes because SEC and CFTC have not been granted specific discretionary powers in terms of regulation.

2.2 Overview of the Regulatory Framework under FIT21

In summary, FIT21 will establish a federal digital asset regulatory framework by clearly defining the regulatory responsibilities of SEC and CFTC for digital assets and transactions, as well as updating existing securities and commodities laws. There is a view that the protection measures for technology and innovation in FIT21 are similar to those implemented in the United States after the Great Depression of the 1920s, and that after the latter was implemented, the United States experienced unprecedented economic growth and an era of innovation.

The regulatory framework established by FIT21 Act for the digital assets of the United States mainly includes the following four aspects. First, the CFTC must regulate digital assets as commodities, with the prerequisite that the blockchain or encrypted digital ledger on which they operate is functional and decentralized. In addition, the bill grants the CFTC exclusive regulatory authority over cryptocurrency commodities and spot markets. Second, in cases where the relevant blockchain functions are normal but not decentralized, the SEC must regulate digital assets as securities. FIT21 Act has set some exceptions for the SEC’s regulation of digital assets, including annual sales and qualified investors, and stipulates requirements for transactions in the primary and secondary markets. Third, the CFTC and SEC must jointly issue rules to formulate relevant provisions and avoid duplicative regulatory rules faced by exchanges. Fourth, the bill excludes approved stablecoins from the regulatory jurisdiction of the CFTC and SEC, but specific transactions involving fraud prevention agencies and registered entities are excluded.

  1. Interpretation of Articles 101 and 103 of FIT21

Clearly defining the target is a prerequisite for taking action. FIT21 Act’s Article 101 and Article 103 provide detailed definitions of restricted digital assets (securities), digital commodities, and permitted payment stablecoins, and give specific criteria for judgment. Thanks to this, the SEC and CFTC can clarify their scope of responsibilities and targeted regulation of restricted digital assets and digital commodities, while permitted payment stablecoins are not within their jurisdiction. This constitutes the basis for subsequent regulatory and guiding measures, and the cryptocurrency industry will thus receive a more orderly regulatory framework and a more stable development space. In summary, FIT21 Act divides digital assets into three categories: restricted digital assets, digital commodities, and permitted payment stablecoins. The relationships among them are: digital assets are usually restricted digital assets, unless they self-identify as digital commodities or meet the definition of permitted payment stablecoins.

3.1 Digital Assets

Article 101, Paragraph 26, first defines digital assets (digital asset) and lists exclusions. The provision states that digital assets “are any alternative digital value representation that can be fully owned and transferred by individuals without reliance on intermediaries and recorded on a secure, public, distributed ledger.” However, digital assets do not include any bills, stocks, shares, futures on securities, swaps on securities, bonds, debentures, proof of debt… any put, call, forward, option, privilege" and assets equivalent to options, futures, swaps, etc.

It is worth noting that Article 101 also emphasizes two points: First, “any content of this paragraph shall not be construed as implying that the digital asset referred to in this paragraph is a representative of any type of security that is not excluded by the definition of digital assets,” which indicates that FIT21 insists on taking a strict definition approach to digital assets, clearly distinguishing them from other types of securities. Second, “digital assets issued or sold or intended to be issued or sold under an investment contract are not and will not become securities solely because they are sold or otherwise transferred pursuant to the investment contract,” to understand this, it is necessary to first understand the Howey Test. The concept of securities in U.S. law originated from the term “investment contract” in the Howey Test, and one of the four test conditions in the Howey Test is that the profit comes solely from the efforts of others. Under this condition, the efforts of the project side and related parties are the key for investors to obtain returns, while investors only need to pay the designated fees and costs and do not actually participate in the operation and management of the project. However, the issuance and management of digital assets are often based on smart contracts and other automatic programs, in which there is no traditional sense of the efforts of the project side and related parties. The relevant provisions of the FIT21 Act that exclude digital assets from securities are mainly aimed at promoting technological innovation and balancing the protection of investors.

3.2 Restricted Digital Assets

Article 34 defines “restricted digital assets” and proposes three criteria for identifying “restricted digital assets”: (1) the degree of decentralization and functions of the underlying blockchain system; (2) the method by which users ultimately obtain digital assets; and (3) the identity of the party holding digital assets. Being clear about the specific meanings of these criteria will help distinguish restricted digital assets from other digital assets. It should be noted that the “restricted digital assets” referred to here are actually digital assets with similar properties to securities, but the legislator did not use the word “security”, for example, Article 405 explicitly stipulates that securities include restricted digital assets. According to Article 25, the assessment of decentralization and functionality includes the following aspects: (1) In terms of control and influence, no individual or entity has had unilateral power, either directly or indirectly, to control or substantially change the functional operation of the blockchain system within the past 12 months. (2) In terms of distribution of digital asset ownership and governance rights, no digital asset issuer or related party has, within the past 12 months, collectively owned more than 20% of the total digital assets issued, or no digital asset issuer or related party has held more than 20% of the circulating voting rights of the digital asset or related decentralized governance system. (3) In terms of code modification, no digital asset issuer or related party has substantially or unilaterally modified the source code of the blockchain system within the past 3 months, thereby substantially changing the functional operation of the blockchain system, unless such modifications are made to address vulnerabilities and malfunctions, regular maintenance, prevention of network security risks, or improvement of blockchain technology. (4) In terms of marketing, no digital asset issuer or related party has, within the past 3 months, promoted the digital asset to the public as an investment. (5) Digital assets units issued through the programmable function of the blockchain system are all distributed to end users (end users distribution). It should be noted that, according to Article 30, the so-called end users distribution refers to a widely, fair and non-discretionary distribution that can be accessed by any participant in the blockchain, such as mining and pledging income obtained by blockchain users.

In the above standards, the more important standards are “12 months” and “20%”. The “12 months” is a vertical judgment standard for decentralization, and the “20%” is a horizontal judgment standard for decentralization. Whether it is 12 months or 15 months, 20% or 30%, the specific numerical values themselves are not the most important. What is important is that they provide precise and quantifiable standards, making the judgment of decentralization more objective.

For the method by which users obtain digital assets, this regulation requires that restricted digital assets are issued to users in a non-end users distribution manner or obtained by users in non-digital commodity exchanges.

For the last standard, restricted digital assets must be all digital assets held by the issuer and related parties during the period when the blockchain system did not have functionalities or was not a decentralized system. Additionally, licensed payment stablecoins are exempt from the restricted digital assets.

3.3 Licensed Payment Stablecoins

Article 101, Paragraph 32, defines licensed payment stablecoins. The paragraph states that a licensed payment stablecoin is one that is used or designed to be used as a means of payment or settlement, where the issuer has an obligation to convert, redeem, or repurchase it for a fixed monetary value, or to maintain or reasonably expect to maintain a stable value relative to a fixed monetary value, while being subject to regulation by a competent federal or state regulatory authority, and the stablecoin is not a national currency or security. The monetary value referred to here is the currency of the country, deposits, or equivalent notes denominated in the country’s currency. From this definition, it can be seen that the FIT21 Act emphasizes the significance of licensing for payment stablecoins, while indicating that only fiat or collateralized stablecoins have the opportunity to obtain a license, while excluding algorithmic stablecoins from the scope of licensing.

3.4 Digital Commodities

Article 103, subparagraph 55 defines “digital goods”. There are also three cases involved in digital goods here. (1) any digital asset unit held by an individual other than the digital asset issuer or related person before the relevant blockchain system becomes a functional system and is certified as a decentralized system, and the digital asset unit is obtained through final issuance or in a digital commodity exchange; (2) any units of digital assets held by persons other than the issuer or affiliate of the digital asset after the relevant blockchain system becomes a functional system and is certified as a decentralized system; The third is any unit of digital assets held by any related person during the period when the relevant blockchain system becomes a functional system and is certified as a decentralized system. Digital goods likewise do not include licensed payment stablecoins. There is also a special provision here, that is, if a federal court has ruled that a digital asset is not a security before the enactment of FIT21, then if the ruling is valid, the digital asset should be recognized as a digital commodity, which reflects the FIT21 Act’s essentially dichotomy of securities and commodities towards digital assets after excluding licensed payment stablecoins.

4. Potential impact of the passage of FIT21

4.1 Impact of FIT21 on crypto taxation

Under IRS Notice 2014-21, all crypto assets are considered property and not currency, and therefore the general tax principles apply to property transactions. However, the IRS defines cryptoassets broadly, considering them to be “digital representations of value recorded on a cryptographically secure distributed ledger or any similar technology.” FIT21 provides a detailed basis and criteria for the IRS to determine the scope of cryptoassets and determine whether a particular cryptoasset is a digital commodity or a security, which will help the IRS tax cryptoasset holders on the basis of distinguishing general investment income from capital gains.

At the same time, it should be emphasized that FIT21 does not use the term “securities” to refer to restricted digital assets similar to securities from beginning to end, so some tax rules that strictly restrict who can be applied still do not apply to restricted digital assets. For example, U.S. tax law allows for tax deductions for investment losses, but strictly prohibits wash selling, meaning that investors cannot sell an asset at a loss and then buy the same or similar security in the near future. Securities here include stocks, bonds, mutual funds, ETFs, options, futures, as well as warrants, and the term “restricted digital assets” continues to exclude crypto assets from the wash rules.

4.2 Impact of FIT21 on Crypto Regulation

In terms of regulatory subjects and objects, the FIT21 bill attempts to delineate the regulatory objects and regulatory scope for the two major regulators, the SEC and the CFTC, by distinguishing restricted digital assets and digital commodities and exempting licensed payment stablecoins, ensuring the orderly supervision of digital assets and preventing the negative impact caused by unclear regulatory powers and conflicts.

In terms of regulatory content, the FIT21 bill not only requires the SEC and CFTC to be responsible for the registration and management of digital assets, but also enhances the information disclosure requirements for digital assets, and also requires the SEC and CFTC to implement anti-money laundering (AML) systems and anti-fraud mechanisms, which will help further enrich the regulatory content of crypto assets.

In terms of regulatory style, in general, the FIT21 bill adopts flexible and inclusive regulatory policies, while attaching importance to the protection of small and medium-sized investors and consumers, providing an orderly and sufficient space for the innovation and development of the crypto industry in the United States, which will attract more crypto talents and enterprises to the United States, further stimulate the vitality and vitality of the American crypto industry, and ultimately further enhance the global financial competitiveness of the United States.

5. Conclusion

Although the ultimate passage of the FIT21 Act still has some uncertainty, the fact that the US House of Representatives has passed the FIT21 Act itself is enough to show that legislators are becoming more friendly towards cryptocurrencies. Friendliness does not mean tolerance. On the contrary, the United States hopes to create a stable and effective regulatory environment for the healthy growth of the cryptocurrency market through the FIT21 Act. In the future, the SEC and CFTC will jointly pay more attention to the convergence of Defi with financial markets, the fusion of NFTs with traditional markets, and further enhance the financial literacy of cryptocurrency investors, strengthen the infrastructure of the blockchain financial market, protect investor rights while maximizing the promotion of cryptocurrencies and blockchain technology for economic development.

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