The Unintended Consequences of FIT21’s Crypto Market Structure Bill

Joshua Riezman is deputy general counsel at GSR.

As a seasoned crypto investor, I’d like to share an alternative perspective on a recent topic. Keep in mind that my personal opinions don’t automatically represent those of CoinDesk or its stakeholders.

One major issue with the proposed legislation is the establishment of separate marketplaces for “restricted digital assets” and “digital commodities” in the crypto token sector. This distinction, made within parallel trading systems, could lead to a fragmented industry that contradicts the fundamental characteristics of crypto tokens – their borderless and interchangeable essence. Consequently, this arrangement would introduce unprecedented regulatory complexities.

The ongoing controversy surrounding the U.S. federal securities laws’ applicability to cryptocurrency tokens hinges on the distinction between bitcoin, classified as a non-security, and almost every other token. The U.S. Securities and Exchange Commission (SEC) has primarily determined whether a crypto token is a security based on the decentralization level of its associated blockchain project. If the project is deemed sufficiently decentralized and therefore not an investment contract “security” as defined by the Howey test, then the token is considered a non-security.

The complex regulation of crypto spot markets undergoes an attempt at clarification through FIT21. This effort sees the CFTC and Securities and Exchange Commission (SEC) assigned distinct supervisory roles, with the level of decentralization being a significant factor in this division.

The bill provides clarity that crypto tokens transferred or sold under the scope of an investment contract do not automatically transform into securities. However, it creates a paradox by granting the SEC extensive control over investment contract assets during the pre-decentralized stage, whether these are sold to investors or issued to developers. In contrast, only digital commodities obtained through airdrops or earned by end-users fall under CFTC jurisdiction initially.

Surprisingly, FIT21 enables simultaneous transactions in restricted digital assets and commodities represented by the same token in separate marketplaces during this time frame, as depicted in the graphic below. Many projects may not satisfy the stringent definition of decentralization outlined in the bill and instead perpetually trade in fragmented U.S. markets.

The bill’s plan for dividing the digital asset market into restricted and unrestricted categories disregards fungibility, which is a key feature of cryptocurrency tokens. This division disturbs the fundamental principle of fungibility, resulting in perplexity and market fragmentation. Consequently, this could negatively impact liquidity, add complexity to transactions and risk management tools like derivatives, decrease the overall value of crypto tokens, and potentially hinder innovation within the emerging crypto industry.

See also: The Financial Innovation and Technology for the 21st Century Act Is a Watershed Moment | Opinion

Making these distinctions a requirement would probably involve making changes to the technology behind cryptocurrencies. This would allow buyers to identify the type of crypto asset they are purchasing, ensuring compliance with various market regulations. However, implementing such technological labels on restricted digital assets could lead to a fragmented crypto market, with an “American-only” sector that operates separately from global markets. This division could limit the usefulness and value of these projects for the entire industry.

From a crypto investor’s perspective, the intricacy and financial burden of having tokens move between SEC and CFTC markets due to potential re-centralization of decentralized projects is greatly underestimated. This situation could potentially harm the trustworthiness and consistency of U.S. financial markets. The number of financial products transitioning between SEC and CFTC jurisdiction is minimal, and history has shown that such transitions rarely go smoothly – an example being the turbulent transition of KOSPI 200 futures contracts from CFTC to a shared CFTC/SEC jurisdiction in 2020.

As a crypto investor, I strongly believe that the proposed legislation underestimates the global nature of the crypto token market. Crypto tokens are not confined to any specific jurisdiction; they trade as a single instrument across various international markets. Consequently, any attempt to restrict certain assets within the U.S. borders may lead to regulatory arbitrage. This could result in unintended consequences, such as the flowback from international markets undermining the legislation’s intent while weakening the competitiveness of the U.S. crypto industry.

As a researcher studying the global digital asset market, I’ve observed that outside the United States, developers and investors are less likely to voluntarily adhere to the same restrictions on restricted digital assets. Consequently, new projects and investment are more likely to emerge in regions outside of the U.S., providing incentives for growth in these areas. This trend could potentially lead to a significant influx of non-U.S. tokens into the U.S. digital commodities market, as some of these tokens would have been classified as restricted digital assets had they originated in the United States. This could make it challenging for the U.S. market to maintain regulatory control and potentially result in a flooded market.

In an unexpected turn of events, a legislative bill intended to safeguard American consumers may inadvertently harm them. The market structure for initial transactions overseen by the Commodity Futures Trading Commission (CFTC) is cause for concern. These markets will be populated predominantly by sellers who have acquired tokens without cost. This imbalance could result in lower prices and heightened volatility compared to both restricted and international markets. Professionals specializing in arbitrage will likely capitalize on these conditions, leaving U.S. retail consumers at a disadvantage.

See also: Is the House’s FIT21 Bill Really the Legislation That Crypto Needs? | Opinion

Insiders and professional investors may exploit this system by taking advantage of price discrepancies and sudden jumps in pricing that occur during the shift from centralized to decentralized market structures. U.S. retail markets could become an unreliable indicator of a security’s true value, with institutional liquidity only trickling down to end-users last.

The FIT21 bill is essential for tackling the regulatory issues surrounding crypto tokens, but its suggested market structure may bring about unwanted outcomes. To safeguard consumers and maintain effective U.S. digital asset markets, legislators need to fine-tune the bill by creating a unified regulatory framework for fungible crypto tokens that don’t qualify as securities. This will help ensure a coherent market structure.