More Clarity About Digital Assets Must Precede Unified Regulation

Why are so many federal agencies charged with regulating financial services? Other countries with a robust financial sector (the UK, for example) task a unified regulator with financial-market oversight. Are we doing something inefficient at best and, at worst, feeding uncertainty that characterizes the federal approach to digital-asset regulation?

Our fractured take on regulating financial services means that jurisdictional disputes among agencies are as inevitable as scrapes over a tennis ball in the dog park. The Securities and Exchange Commission isn’t going to stop until it gets the ball: Witness the agency’s struggles with the Commodity Futures Trading Commission over how to regulate single-stock futures in the late 1970s, or with banking regulators in the early 2000s over who would oversee brokerage activity of big banks. In both cases, it took acts of Congress to resolve jurisdictional battles and establish lines of authority.

But what seems like a bug is actually a feature in our endlessly dynamic economy. There are always bad and careless actors in financial services. Regulatory competition, with each authority looking to maximize jurisdiction, makes it less likely that emerging products, services, and activities will fall through bureaucratic cracks and bypass market and consumer guardrails.

The downside, seen today in crypto, is that in its turf-protecting zeal the SEC will push novel round pegs (digital assets) into old square holes (the Depression-era securities framework) to prove its jurisdiction.

Which brings us to the bipartisan Financial Innovation and Technology for the 21st Century Act (FIT21) passed by the House on May 22 and now headed for the Senate. This much-needed legislation would assign primary regulatory authority for digital assets to the CFTC. The not-so-subtle intent is to position most digital asset activity away from the SEC—which has claimed broad jurisdiction over the industry while declining to write workable rules or offer intelligible guidance.

But a basic problem with FIT21 is that the fine print smuggles in hoary legacy concepts like “investment contract” in ways that would give the SEC latitude to claim that almost all digital assets are securities and therefore not subject to the bill’s tailored solution. Other aspects of FIT21 could use refining—the idea that digital assets can simultaneously exist as both commodities and securities would introduce metaphysical confusion. Yet Congress needs to tackle a basic definitional problem before it can sort out the rest.

An “investment contract” is a security, the meaning of which the Supreme Court established nearly a century ago with a complex multi-factor analysis affectionately called the Howey test. A “note” is also a security, but there are many notes—like mortgages—that obviously shouldn’t be regulated as securities, and so the court gave us the Reves test four decades ago to decide which notes are securities and which aren’t.

Title II of FIT21, “Clarity for assets offered as part of an investment contract,” says that an “investment contract asset,” or a digital asset sold pursuant to an investment contract, isn’t itself a security. This is similar to an approach proposed by Sen. Cynthia Lummis (R-WY) and Sen. Kirsten Gillibrand (D-NY).

But the definition of investment contract asset in FIT21 expressly excludes any digital asset that otherwise falls under the definition of security—which in turn says both investment contracts and notes are securities. This loophole would allow—even encourage—the SEC to make the same argument it does today: Nearly all digital assets are securities because under Howey they are investment contracts offering the purchaser an ability to profit from someone else’s efforts. The SEC would also say many crypto tokens—those that can be staked or that otherwise generate returns—aren’t subject to FIT21 because, per Reves, they are notes that are securities.

The fix to this definitional problem is simple. Since the legislature writes on a clean slate, FIT21 can use plain English to define what Congress means by a non-security digital asset. Presumably this is something such as code that doesn’t represent a legal or contractual claim against assets, revenues, or profits of a business or other entity.

There is little reason to assign responsibility to the SEC for a digital asset that doesn’t represent a claim on an economic enterprise, regardless of the associated blockchain’s degree of “decentralization”—another potentially problematic concept in the bill. Decentralization may be important for network security and resilience but it’s likely too amorphous for use as a reliable jurisdictional partition. And, of course, the SEC doesn’t get to regulate Apple on grounds that it sells the iPhone, which surely operates in a centralized ecosystem, but because the company issues common stock.

Defining “digital asset” functionally, without using concepts encrusted with decades of case law, would go a long way toward providing the predictability that consumers and businesses need. It would also help Congress craft the workable solution to crypto regulation that so far has eluded us.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

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Joseph Hall is partner in Davis Polk’s capital markets group and head of the interdisciplinary ESG risk practice.

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