Jack Solowey and Jennifer J. Schulp
While the Securities and Exchange Commission (SEC) leans into regulating crypto by enforcement, lawmakers in the House are looking to lay a foundation for rationalizing U.S. crypto policy—releasing a Digital Asset Market Structure Discussion Draft last Friday and holding a pair of hearings this past Tuesday and next.
The Discussion Draft, while in early days, gets the big question right: it would determine whether crypto tokens are securities or commodities largely based on whether the networks over which they operate are decentralized. In addition, the Discussion Draft would help provide regulatory clarity to crypto marketplaces through long‐sought pathways for lawfully registering certain crypto exchanges. While the draft would benefit from some modifications—including to the process for certifying network decentralization and the treatment of decentralized marketplaces—this legislative effort would bring much‐needed clarity to U.S. crypto policy by tackling its thorny questions.
In a microcosm of the SEC’s years long effort to use the inexact fit between legacy securities laws and modern crypto markets to declare most U.S. crypto activity unlawful, the SEC on Tuesday filed a complaint alleging that U.S.-based crypto exchange Coinbase operates an unregistered securities exchange. Congressman French Hill (R‑AR) dryly dubbed it “an interesting coincidence” that the complaint was filed on the same day the House Agriculture Committee held a hearing on the Discussion Draft. Coinbase maintains the tokens it lists are not securities and that it would be happy to register with the SEC if only the Commission would let it.
The poor fit between existing rules and reality stems from the challenge of squaring securities laws designed for centralized firms and financial intermediaries with a crypto ecosystem that includes tokens generated by decentralized networks and traded via disintermediated protocols. Compounding this challenge is the fact that centralized crypto projects can decentralize over time.
The Discussion Draft, to its credit, grasps these nettles. Understanding how is a matter of understanding the security versus commodity debate. A classic security is a share of stock—a partial ownership stake in a company and claim on assets and profits. A stock’s value typically depends on how well a company and its managers perform, so securities regulation seeks to make managers share information relevant to that performance. A classic commodity, by contrast, is a piece of produce (like, say, an orange) that’s standardized and interchangeable. Its value typically depends on supply and demand.
Those arguing crypto tokens are securities analogize them to stocks: they can be sold to raise funds to build out projects and also can be viewed as proxies for those projects’ value.
Those arguing crypto tokens are commodities analogize them to produce. In a famous Supreme Court case on the nature of securities—which is tediously but unavoidably recounted in any crypto regulation discussion—the Court assessed whether an orange grove seller’s scheme to contract with land purchasers to manage orange sales and give them a cut constituted a securities arrangement. It was a securities scheme, the Court reasoned, because the seller’s efforts to manage the operation were essential. Those who argue crypto tokens are commodities point out that while certain token sales may resemble the contract in the orange grove case, the tokens themselves are best analogized to the oranges, which remained commodities notwithstanding the securities scheme.
The Discussion Draft enters this fray by identifying that crypto tokens are neither inherently like stocks nor oranges, but rather resemble one or the other depending on whether there are managers—like the executives at a company or citrus enterprise—controlling the token network.
The Discussion Draft does this through a legal test for whether a crypto project’s network is decentralized. At a high level, it defines a decentralized network as one where no person could unilaterally control, materially change, or restrict general users’ use of the network. In addition, the definition requires that within specific lookback periods, certain persons closely related to the network project have not held or controlled over 20 percent of the network’s outstanding tokens or voting power, contributed intellectual property that materially changed network functionality, or marketed the network or its tokens or issued those tokens, and that certain token issuances were nondiscretionary.
Although it’s possible to quibble over certain details—such as the arbitrariness of a 20 percent holdings cut off and who qualifies as a closely related person—the definition incorporates some key decentralization features, namely the absence of: unified and discretionary control, reliance on or susceptibility to closely related parties’ material contributions or changes, and gatekeeping that excludes general users.
Decentralization is key to the regulatory framework proposed in the Discussion Draft because it is a core component (along with a network becoming “functional”) of the definition of a “digital commodity.” Digital commodities, as laid out by the Discussion Draft, do not require the same ongoing disclosures by issuers as other digital assets (though they are subject to listing disclosures on registered digital commodity exchanges) and may generally be offered and sold by any person other than a closely related party. Importantly, such digital commodities are expressly excluded from the definition of securities and are generally subject to the exclusive jurisdiction of the Commodity Futures Trading Commission (CFTC).
While the Discussion Draft framework is complex, this is largely an unavoidable consequence of the existing “byzantine” U.S. capital markets regulatory regime. Moreover, the framework is appropriately premised on the presence, or lack, of core risks that securities laws seek to address: information asymmetries from managerial bodies.
Even with a legal definition of decentralization that gets to the heart of managerial control, though, there’s the challenge of identifying decentralization in the wild. To address this, the Discussion Draft proposes a process where any person can seek to certify to the SEC that a network is decentralized. Certification will occur by default within 30 days unless the SEC issues a stay or rebuttal explaining its decision. Notably, the SEC will be able to reconsider certifications annually and, where appropriate, cancel them. The certifying party may appeal both initial SEC rebuttals, as well as later cancellations.
It’s probably inevitable that the process for certifying decentralization before a regulator is going to be an intellectually unsatisfying exercise in Gordian knot cutting. Helpfully, the certification process would allow “any person” to initiate a certification, which recognizes that in the case of a truly decentralized network, there’s no single party that must be the one to provide relevant information. For that same reason, the proposed appeals process should similarly allow any person—not just the initial certifying party—to appeal an SEC rebuttal or cancellation. This is particularly important in the case of the cancelled certification of a genuinely decentralized network, where the initial certifier may no longer be in a prime, or any, position to appeal.
Another wrinkle is that leaving the process to the SEC assumes crypto projects are properly subject to SEC jurisdiction unless proved otherwise. While some projects would appropriately begin life under SEC jurisdiction, others, like Bitcoin, would not. One way to resolve this would be to involve the SEC only where the network’s digital asset previously was part of a securities transaction, such as a traditional private offering or the novel exempt digital asset offering provided for in the Discussion Draft, and otherwise leave the process to the CFTC.
The Discussion Draft also grapples with the fact that, like tokens themselves, the marketplaces over which they trade also may be decentralized. And similar to how a lack of managers makes applying traditional securities regulation inappropriate, the lack of a financial intermediary in the case of a crypto marketplace makes applying traditional exchange regulations inappropriate as well.
Importantly, the Discussion Draft recognizes that decentralized finance (DeFi) is different from intermediated finance, and, in addition to defining DeFi, provides for the SEC, CFTC, and Government Accountability Office to provide DeFi studies to Congress. Further, the Discussion Draft expressly exempts from both securities and digital commodities exchange requirements certain “ancillary activities” related to operating a blockchain network, including compiling and validating transactions; operating a pool; providing computing and incidental transaction services; providing a user‐interface to interact with a blockchain network; and developing, publishing, and maintaining a blockchain network or digital wallet software or hardware systems.
These provisions could be read to cabin off the activities of decentralized exchanges (DEXs), yet reasonable minds may disagree. For one, while SEC rule revisions under the Discussion Draft must permit disintermediated trading in covered assets, that such rules must be “consistent with what is necessary or appropriate in the public interest or for the protection of investors” suggests that at least disintermediated exchange of digital asset securities would likely face some degree of regulation. In addition, although the ancillary activities are broad enough and incorporate enough DEX‐related concepts to be read to create exemptions for DEX activity, the fact that the definition of DeFi and listed ancillary activities are not coterminous leaves the question open to debate. To head off some of this ambiguity, the DeFi definition could, for example, state that it should not be construed to mean that DeFi is not otherwise covered by ancillary activities.
Finally, residual sources of potential regulatory landgrabs in the Discussion Draft’s framework should continue to be limited and clarified. In particular, there are several points where the framework would give the SEC and CFTC the authority to set standards or impose requirements on any basis that the agencies determine to be in the public interest.
Judging by SEC Chair Gensler’s recent remark that “we don’t need more digital currency,” one such landgrab would seem to be transforming the SEC into the merit regulator it never was meant to be. To borrow a line from House Agriculture Committee Chairman GT Thompson (R‑PA) at Tuesday’s hearing, the SEC’s current approach is no way “to govern a market, adequately protect customers, or promote innovation.” The Discussion Draft offers an opportunity to reverse this course and bring clear thinking to crypto policy.