Reshaping the Crypto Landscape: U.S. Seeks Dominance through New Legislation

The US government's stance on cryptocurrencies remains rather enigmatic. On one hand, regulatory authorities are stepping up their enforcement actions, closely pursuing cryptocurrency institutions. Just in 2023 H1 alone, the SEC has taken legal actions against institutions including Genesis, Kraken, Binance, and Coinbase. On the other hand, the US government is the government that holds the largest Bitcoin. According to Glassnode, as of July 27th, the US government held approximately 194,188 BTCs, roughly 1% of the total Bitcoin supply, valued at about $5.68 billion. Although these Bitcoins have been confiscated from lawbreakers without any cost, unlike other governments, the US hasn't been in a rush to convert them into cash and has opted to retain ownership.

Since the inception of Bitcoin in 2008, the crypto market has seen explosive growth, reaching a market cap of $1.1 trillion. During the COVID-19 pandemic, the US government contemplated using the digital asset industry as a tool to stimulate economic growth and boost employment rates. However, regulatory gaps have paved the way for a surge in illicit activities tied to cryptocurrencies, encompassing fraudulent schemes, money laundering endeavors, and cyberattacks of various magnitudes. Major institutions' failures, especially those of Terra and FTX, have amplified the market's call for more stringent regulations. Recently, both the European Union and the UK have rolled out their regulatory frameworks for cryptocurrencies. In order to build its dominance in the worldwide crypto arena and retain industry enterprises for preventing capital flight, the US has been compelled to expedite its policy initiatives.

In September 2022, the Biden administration released its first regulatory framework targeted at cryptocurrencies and urged entities like the CFTC and SEC to draft rules for digital assets. In 2022 alone, over 50 bills related to digital assets were proposed in Congress. The recently approved House Committee's "Financial Innovation and Technology for the 21st Century Act" is considered a landmark in US crypto regulation. Meanwhile, the "Responsible Financial Innovation Act" proposed by the Senate is seen as a formidable contender. Both bills are believed to help build a viable crypto regulatory system in the US.

This article will delve deep into the reasons influencing the US's regulatory stance on cryptocurrencies, how these two bills might shape the US crypto regulatory scene, and assess the potential market impact of these changes.

The US Crypto Regulatory Dilemma: Who Should Govern Cryptocurrencies?

Is cryptocurrency regulated in the US? Definitely yes.

• In 2013, the US Department of the Treasury classified Bitcoin as a virtual currency. Cryptocurrency exchanges and custodians were categorized as Money Services Businesses (MSB), mandating them to comply with FinCEN's anti-money laundering regulations.
• In 2014, the US Internal Revenue Service (IRS) treated cryptocurrencies as property, subjecting them to taxation.
• In 2015, the Commodity Futures Trading Commission (CFTC) designated Bitcoin and Ethereum as commodities, placing their trade under regulatory oversight.
• In 2017, the US Securities and Exchange Commission (SEC) stated that ICOs are securities offerings and should register with the SEC, adhering to anti-fraud regulations.
• In 2021, an Infrastructure Bill defined digital assets as cash.

As we can see, in the US, various regulatory bodies have different definitions for cryptocurrencies/digital assets. This discrepancy is one of the significant reasons why the US government has yet to establish a reasonable regulatory system: the agencies cannot agree on what cryptocurrency is and who should regulate it.

Cryptocurrencies defy the existence asset categorization. If a traditional financial asset is a commodity (like gold or coffee), it should fall under the jurisdiction of the CFTC. If it's a security (like stocks or bonds), then the SEC should oversee it. If it's considered a currency, the situation becomes more complex, with oversight coming from a combination of authorities. However, a cryptocurrency can exhibit characteristics of one or multiple asset classes. Take ETH, for instance. ETH can be traded on exchanges, giving it a commodity-like nature. Simultaneously, it can act as a medium of exchange for various goods and services on the Ethereum network, imbuing it with currency attributes. Furthermore, Ethereum's ICO resembled traditional securities offerings, making it appear as a security.

The Conflict between SEC and CFTC

Due to the ambiguous nature of cryptocurrencies, there's a lack of clarity in the division of regulatory responsibilities, leading to a regulatory system riddled with overlapping and gray areas. The conflict between the CFTC and SEC is particularly significant in this respect.

First, the boundary between securities and commodities in US law remains blurred. According to federal securities laws, an 'investment contract' is a type of security where one party invests in another, expecting to profit from the efforts of others. Based on this definition, SEC Chairman, Gary Gensler, asserts that most cryptocurrencies are securities and therefore come under the purview of the SEC.

For more on Gary Gensler's stance, refer to: "Gary Gensler — What Else Can the Man Bring to the Table"

However, in the Commodity Exchange Act (CEA), the term "commodity" encompasses nearly all goods and services, including Bitcoin and other cryptocurrencies. (Indeed, even securities can be viewed as a type of commodity.) The overlap in the concepts of "commodity" and "security" has led to persistent disputes about cryptocurrencies between the SEC and CFTC over the years.

Yet, the main focus of the CFTC is on regulating commodities' derivative tradings, and its authority over spot market transactions is limited. The agency can only bring charges in cases where fraudulent and manipulative activities are detected in the spot market.

This situation poses a challenge: when a cryptocurrency fails to be classified as a security and is not involved in derivative trading, neither the SEC nor the CFTC possesses the authority to oversee its regulation. Such occurrences are quite common. For example, within a DAO, the token investors are also the managers of the protocol, it doesn't fall under the SEC's jurisdiction (because it doesn't meet the criteria of investors benefiting from the efforts of others). The regulatory gap allows many crypto projects to evade institutional oversight.

Two Bills That Could Change the Landscape of Cryptocurrency Regulation in the U.S.

Recently, two bills proposed in the U.S. Congress titled the "Financial Innovation and Technology for the 21st Century Act" and the "Responsible Financial Innovation Act", might offer solutions to the longstanding issues between the CFTC and SEC.

TL;DR

• Both bills aim to establish a viable regulatory framework for digital assets, clarifying the definition of digital assets and distinguishing the regulatory responsibilities between the CFTC and SEC.
• Both bills grant greater powers to the CFTC.
• Both are committed to safeguarding the rights and interests of consumers/investors, requiring digital asset-related entities to disclose more information for regulatory oversight.
• Both strive to secure the U.S.'s leadership position in the crypto sector through legislation.
• Neither of the two bills address the regulation of NFTs.
• Compared to the Financial Innovation and Technology for the 21st Century Act, the Responsible Financial Innovation Act has a broader scope. The latter not only covers the above points but also touches on the issuance of stablecoins, combating financial crimes, digital asset taxation, and institutional appropriations.

Financial Innovation and Technology for the 21st Century Act

The Financial Innovation and Technology for the 21st Century Act (shortened as FIT21) was proposed by Republican members of the House Financial Services Committee and the Agriculture Committee on July 20, 2023. It passed the votes of the two House committees on July 26 and 27, respectively. The bill will be forwarded to the House, with an expected vote after the recess ends on September 12.

FIT21 aims to establish a regulatory framework for the digital asset market in the U.S., providing clear rules for market participants and protecting investors and consumers.

Clarifying the Jurisdiction of CFTC and SEC

The bill proposes that digital assets be jointly managed by the CFTC and SEC, with the CFTC taking the lead and the SEC playing a secondary role. The bill categorizes digital assets into digital commodities, restricted digital assets, and payment stablecoins. Digital commodities are under CFTC's jurisdiction, while restricted digital assets are under SEC's. Payment stablecoins can be traded on both SEC and CFTC regulated venues, but neither has the right to regulate stablecoins or their issuers.

What are digital commodities? The bill stipulates that when a digital asset's related blockchain network meets two conditions, it is considered a digital commodity: 1) A functional network, and 2) Decentralization. A functional network means that digital assets can be used on the network for value transfer and storage, participation in services or applications, and governance. Decentralization means no individual or entity can unilaterally control the blockchain. If a digital asset doesn't meet these conditions, it's deemed a restricted digital asset.

Similarly, the bill differentiates intermediaries into digital commodity intermediaries and digital asset intermediaries. The former needs to register with the CFTC and be subject to its regulation, while the latter must register with the SEC.

Disclosure and Consumer Protection

For digital assets and their related blockchain systems, the bill mandates the disclosure of source code, transaction records, economic models, development plans, associated entities and personnel, and risk factors.

Intermediaries must prove to the CFTC that they are not involved in market manipulation before offering their services and must register with a specific futures association. Once registered, intermediaries must meet various requirements set out by the bill, such as adhering to business conduct standards, meeting minimum capital requirements, ensuring fair trading, segregating client assets, disclosing operational details, books and records, conflicts of interest, etc.

No Registration Required for Ancillary Activities

The bill explicitly states that individuals involved in ancillary blockchain operations, such as network validation, node management, providing API/RPC services, developing, maintaining, or managing blockchain systems, do not need to register with regulatory bodies. Violations can be punished by the regulator.

Perspectives on the Bill

Prominent backers of the FIT21 include the Chairman of the House Agriculture Committee (Glenn “GT” Thompson) and the Chairman of the House Financial Services Committee (Patrick McHenry). The bill has received support from Republicans and cryptocurrency enthusiasts. Patrick McHenry publicly stated that it was the first time a committee was marking up crypto-specific legislation and affirming that legislation is necessary to prevent the U.S. from “falling behind” other countries in regulating crypto. CoinBase CEO, Brian Armstrong, also supported the bill before the vote. Brian sees this as a vote to protect cryptocurrency, U.S. innovation, and security.

However, most Democrats agree with Gary Gensler's perspective, believing that most cryptocurrencies are securities. They argue that the primary regulatory power shouldn't be handed over to the CFTC, especially since significant figures in the crypto industry like SBF had requested CFTC to oversee the sector, potentially leading to more fraudulent activities in the future. Democratic Congressman Stephen Lynch once stated, "I’ve been on this committee for 20 years and I can say unequivocally that this is the worst piece of legislation that has been presented for markup in that 20 years,".

Responsible Financial Innovation Act

The Responsible Financial Innovation Act (shortened as RFIA) was first proposed by Republican and Democratic Senators on June 7, 2022, with its updated version being released on July 12, 2023. Its main objective is to establish a regulatory framework for digital assets, clarify the jurisdiction of CFTC and SEC, address stablecoin issuance, digital asset taxation, and protect consumers, providing the industry with certainty and clarity.

Clarifying the Jurisdiction of CFTC and SEC

The bill contends that most digital assets, including BTC and ETH, are commodities, not securities, and fall under the jurisdiction of the CFTC. However, if a digital asset exhibits characteristics of debt or equity, it's considered a security and is regulated by the SEC. A digital asset is deemed a security if it meets any of the following criteria:

1. A debt or equity interest,
2. Liquidation rights,
3. Right to interest or dividends,
4. Profits or income derived solely from the efforts of others,
5. Any other economic benefit within the enterprise.

Under this bill, a digital asset doesn't need to be fully decentralized to be classified as a commodity.

Disclosure and Consumer Protection

In the aftermath of major incidents involving Terra, FTX, and others, the Responsible Financial Act emphasizes consumer protection, setting requirements for information disclosure, proof of reserves, advertising standards, and loan limitations.

• Digital (Crypto) asset exchanges must register with the CFTC and adhere to disclosure mandates.
• Issuers of digital assets need to periodically disclose information to the SEC to prove the commodity nature of the asset.
• Intermediaries must disclose significant changes and its operations details, including asset custody, bankruptcy handling, fee structures, and dispute resolution.

Stablecoin Issuance Policies

The bill puts forth strict requirements for the issuance of stablecoins, allowing only federal/state depository institutions to issue them and subjecting them to federal/state regulatory oversight. Moreover, issuers are required to maintain a 100% reserve of high-quality assets and must publicly disclose the reserve assets backing the stablecoin and their value. Additionally, the bill proposes that algorithmic stablecoins should be regulated by the CFTC.

Adjustments to Digital Currency Taxation

The act delineates digital asset taxation policies and offers minor tax breaks for cryptocurrency holders. Moreover, it proposes facilitative tax measures for non-US entities offering crypto services in the US.

Perspectives on the Bill

The Responsible Financial Innovation Act was first introduced after the Terra collapse, emphasizing stablecoin regulation. However, it didn't gain much traction at the time. After the FTX incident, sponsors Cynthia Lummis and Kirsten Gillibrand significantly adjusted the bill. The adjusted bill leans more towards consumer protection, asserting the superiority of CFTC over SEC.

For more on FTX and SBF's story, read: "Who is SBF - from mansions and yachts to silver bracelets and iron bars in five years".

Notably, unlike the Financial Innovation and Technology for the 21st Century Act, this bill was jointly introduced by bipartisan members. Nevertheless, it faces scrutiny from some SEC proponents. While it falls under the jurisdiction of the Senate Banking Committee and Agriculture Committee, Senate Banking Committee Chair Sen. Sherrod Brown (D-Ohio) (Democrat) has openly stated his lack of support for the bill.

However, some argue that given its wide coverage, the bill doesn't necessarily have to pass as legislation. Its components can be divided and profoundly influence other more specific proposals.

How the New Bills Will Impact the Market

After the introduction of the aforementioned two bills, which attracted considerable market attention, it's important to highlight that there is still a lengthy process before these proposals can evolve into actual laws. This includes stages from introduction, Committee Pass, House Pass, Senate Pass, To President, and Became Law. Currently, the FIT21 has just passed the House committees, while the RFIA was recently introduced. It's noteworthy that the FIT21 is expected to be voted after the House returns from recess on September 12th. If passed, the market is expected to usher in a short-term correction.

Overall, the primary intention behind the new crypto regulatory framework is to delineate the responsibilities of regulatory bodies, aiming to protect consumers through enhanced information disclosure. Both bills, while being drafted, took into consideration the unique attributes of the digital asset, such as decentralization, without aiming to suppress its growth. A clear regulatory framework will help dispel market uncertainties, offering stakeholders a more transparent operating environment, which can attract more institutional and individual investors to the market, further fostering its maturity and stability.

However, like any transformation, there will be fluctuations during its initial phase. The enactment of these regulatory policies will inevitably shine a light on the current gray areas of the crypto market, potentially causing short-term market turbulence. The requirements for information disclosure might also clash with the vision of some market participants who seek decentralization and regulation-free. Nevertheless, both bills endorse the CFTC as the overseer of the cryptocurrency sector. Compared to the SEC, the CFTC has consistently shown a more favorable stance towards the industry and has even garnered the endorsement of leading crypto figures. Hence, the CFTC emerging as the ultimate regulator aligns more with the crypto community's hopes, which is a positive sign.

In the long run, the introduction of these new regulatory policies will aid in safeguarding consumers' interests, bringing greater transparency and trust to the cryptocurrency market.

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