Interpreting the FIT21 Act: Impact on the Next Decade of the Crypto World

Author: Chen Mo cmDeFi

This article mainly interprets how digital assets are defined in the regulatory framework proposed by FIT21, as well as the boundaries between commodities and securities. On May 22, 2024, the FIT21 bill passed in the House of Representatives with 279 votes in favor and 136 against. This bill establishes a regulatory framework for digital assets and may become one of the most far-reaching pieces of legislation affecting Crypto to date.

FIT21, fully known as the 21st Century Financial Innovation and Technology Act. The key point of this bill coincides with the approval of the ETH spot ETF application (Form 19b-4), regulating the framework for digital asset oversight and providing guidance for future applications of more crypto assets for spot ETFs and compliance pathways. It can almost be declared that the gray era of Crypto, which has lasted for over a decade, has officially ended, entering a new world.

1/9 · Registration and Regulatory Responsibility

Digital assets have two definitional directions: digital commodities and securities. The bill stipulates that, depending on the definitional direction, the regulation of digital assets is jointly overseen by two main agencies:

Commodity Futures Trading Commission (CFTC): Responsible for regulating the trading of digital commodities and related market participants.

Securities and Exchange Commission (SEC): Responsible for regulating those digital assets deemed as securities and their trading platforms.

2/9 · Definition of Digital Assets

The bill defines "digital assets" as a form of transferable digital representation that can be transferred from person to person without relying on intermediaries and is recorded on a cryptographically protected public distributed ledger. This definition encompasses a wide range of digital forms, from cryptocurrencies to tokenized physical assets.

3/9 · Classification of Digital Assets (Commodities or Securities)

The bill proposes several key elements to distinguish whether a digital asset is classified as a security or a commodity:

Investment Contract (The Howey Test): If the purchase of a digital asset is considered an investment, and investors expect to earn profits through the efforts of an entrepreneur or third party, the asset is typically regarded as a security. This is based on the standard established by the U.S. Supreme Court in the SEC v. W.J. Howey Co. case, commonly referred to as the Howey Test.

Use and Consumption: If a digital asset is primarily used as a medium for goods or services, such as tokens that can be used to purchase specific services or products, it may not be classified as a security but rather as a commodity or other non-security asset.

Degree of Decentralization: The bill particularly emphasizes the degree of decentralization of the blockchain network. If a digital asset's underlying network is highly decentralized, with no central authority controlling the network or the asset, this asset may be more likely to be viewed as a commodity.

Functional and Technical Characteristics: The technical construction and functional implementation of digital assets are also criteria for classification.

Market Activity: How the asset is marketed and sold in the market is also an important factor. If the asset is primarily marketed based on expected investment returns, it may be viewed as a security.

The content here is extremely important because its significance lies in regulating the framework for digital asset oversight, which will influence what the next digital asset potentially through spot ETFs might be.

4/9 · Standard 1: Use and Consumption, Rather Than Expecting Capital Appreciation as Investment

From the current perspective, public chains, PoW tokens, and functional tokens are more aligned with this standard. (Note that this is merely an example from the perspective of use and consumption; defining securities/commodities requires multidimensional consideration and does not imply that these types of assets fully meet the standard.)

The common characteristic of these digital assets is that they are primarily used as trading mediums or payment methods, rather than as investments expecting capital appreciation. Although in the actual market, these assets may also be subject to speculative purchases and holdings, from the design and primary use perspective, they are more likely to be viewed as commodities.

5/9 · Standard 2: Definition of Degree of Decentralization

Control and Influence: In the past 12 months, no individual or entity has had unilateral power, directly or through contracts, arrangements, or other means, to control or materially alter the functionality or operation of the blockchain system.

Ownership Distribution: In the past 12 months, no individual or entity associated with the digital asset issuer has owned more than 20% of the total issuance of the digital asset.

Voting Rights and Governance: In the past 12 months, no individual or entity associated with the digital asset issuer has been able to unilaterally guide or influence more than 20% of the voting rights of the digital asset or related decentralized governance system.

Code Contributions and Modifications: In the past 3 months, the digital asset issuer or related personnel have not made substantial, unilateral modifications to the source code of the blockchain system, unless these modifications were made to address security vulnerabilities, maintain routine operations, prevent cybersecurity risks, or for other technical improvements.

Marketing and Promotion: In the past 3 months, the digital asset issuer and its affiliates have not marketed the digital asset to the public as an investment.

Among these defining standards, the more rigid standards are ownership distribution and governance rights, with the 20% threshold being significant for defining digital assets as securities or commodities. Additionally, due to the public transparency, traceability, and immutability characteristics of blockchain, the quantification of this defining standard will become clearer and fairer.

6/9 · Standard 3: Functional and Technical Characteristics

The definition of digital assets in the bill and how they connect to the underlying blockchain technology is the foundation for determining how these assets will be regulated. We have already discussed the definition of digital assets above; here we specifically address how their connection to the underlying blockchain technology within the scope of the digital asset definition determines the regulatory direction. This connection typically includes how assets are created, issued, traded, and managed:

Asset Issuance: Many digital assets are issued through programmatic mechanisms on the blockchain, meaning their creation and distribution are based on preset algorithms and rules rather than human intervention.

Transaction Verification: Transactions of digital assets need to be verified and recorded through the consensus mechanism within the blockchain network, ensuring the correctness and immutability of each transaction.

Decentralized Governance: Some digital asset projects have implemented decentralized governance, allowing users holding specific tokens to participate in the decision-making process of the project, such as voting on the future direction of the project.

These characteristics directly influence how assets are regulated. Specifically:

If digital assets primarily provide economic returns or allow voting participation in governance through automated blockchain programs, they may be viewed as securities, as this indicates that investors expect to gain benefits through management or entrepreneurial efforts.

If the primary function of digital assets is as a medium of exchange or directly used for acquiring goods or services, they may be more likely classified as commodities.

7/9 · Key Issue 1: Programmatic Issuance Characteristics of Assets Tend to Define as Commodities

This section discusses how to determine whether certain digital assets issued through blockchain technology, particularly through smart contracts or decentralized applications (DApps), constitute securities.

In the traditional sense, securities typically involve investors investing funds with the expectation of earning profits through the efforts of an enterprise or third party. However, in the world of blockchain and cryptocurrencies, many assets are issued and managed through automated programs or algorithms, and the characteristics and purposes of these assets may differ from traditional securities.

According to the bill, even if a digital asset is sold or transferred under the terms of an investment contract, if these assets are automatically issued through a programmatic blockchain system, they do not automatically become securities. This is because:

Programmatic Operation: Blockchain technology allows for the issuance and management of assets to be executed automatically through code, without relying on traditional corporate structures or external managers' intervention. This automation reduces direct control by individuals or groups over the operation of the asset.

Decentralized Characteristics: Many blockchain-based asset issuances leverage decentralized characteristics, such as smart contracts and DApps. These tools ensure that the operation and management of the assets follow preset rules rather than the decisions of a single managing entity.

Programming Transparency: Assets issued through smart contracts and other means typically have publicly accessible rules and logic, allowing investors to directly access these rules and make investment decisions based on this programmatic logic.

8/9 · Key Issue 2: How to Handle Digital Assets with Governance and Voting Functions

The bill mentions that if no relevant personnel have individually owned or controlled more than 20% of the voting rights of a digital asset or its associated decentralized governance system in the past 12 months, this may indicate that the asset has decentralized characteristics. However, it also states that if digital assets primarily provide economic returns or allow voting participation in governance through automated blockchain programs, they may be viewed as securities, as this indicates that investors expect to gain benefits through management or entrepreneurial efforts.

Here lies a contradiction: if a digital asset has voting rights and no relevant personnel have individually owned or controlled more than 20% of the voting rights in the past 12 months, is this asset more likely to be defined as a commodity or a security?

This touches on a complex area of digital asset regulation, namely how to handle assets with governance and voting functions. Understanding this requires clarifying two key concepts: the degree of decentralization of the asset and the control or economic benefit expectations provided to investors.

(1) Decentralization and Voting Rights

The bill states that if no relevant personnel have individually owned or controlled more than 20% of the voting rights in the past 12 months, this indicates a higher degree of decentralization for the digital asset. This usually means that no single entity or small group can control the operation or decision-making of the asset. From this perspective, a high degree of decentralization is a factor that drives the asset to be viewed as a commodity, as it reduces the control of a single entity over the asset's value and operation, aligning with the characteristics of commodities, which are primarily used for exchange or consumption rather than for investment returns.

(2) Voting Rights and Securities Attributes

On the other hand, if digital assets allow holders to participate in governance through voting rights, especially in governance that significantly impacts economic decisions, this may lead to the asset being viewed as a security. This is because voting rights and governance participation typically imply that holders expect to gain benefits through management or entrepreneurial efforts (including the efforts of other holders), which aligns with the basic definition of securities.

(3) Understanding the Contradiction

The potential contradiction here is that, on one hand, a high degree of decentralization typically aligns with commodity attributes, while on the other hand, the governance and voting rights functions of the asset may lead it to be viewed as a security. The key to resolving this contradiction lies in assessing:

The Substantive Impact of Voting Rights: Does voting have a substantive direct impact on the asset's value and operation? If voting primarily affects technical settings or non-core economic decisions, the asset may still trend toward being a commodity.

Expectations of Economic Returns: Is the primary purpose for holders to obtain economic returns (e.g., through asset appreciation or dividends), or is it to use the asset for transactions and other activities on the platform or network?

In the context of the approval of the ETH spot ETF application (Form 19b-4), the definition of ETH leans more towards functional use, with its staking and governance nature primarily aimed at maintaining network operation rather than economic returns. Therefore, in the future, digital assets similar to ETH, under the preconditions of meeting decentralization levels, can theoretically rely on this approval as a template.

From this perspective, DeFi protocols governed by DAOs, if their governance direction trends more towards obtaining economic returns or dividends, are more likely to be defined as securities. Conversely, if the governance direction leans towards functionality, technical upgrades, etc., the probability of being defined as commodities is greater.

9/9 · Technical and Innovation Support

The bill proposes to solidify and expand the SEC's Innovation and Financial Technology Strategic Center (FinHub) and the CFTC's LabCFTC. Their mission is to promote policy development related to financial technology and provide guidance and resources regarding emerging technologies to market participants.

Establish a joint advisory committee between the CFTC and SEC, specifically focusing on issues related to digital assets. The goal of this committee is to promote cooperation and information sharing between the two regulatory agencies in the oversight of digital assets.

Research on Decentralized Finance (DeFi): The SEC and CFTC are required to study the development of decentralized finance, assess its impact on traditional financial markets, and explore potential regulatory strategies.

Research on Non-Fungible Tokens (NFTs): Explore NFTs and their roles and regulatory needs in financial markets.

This section fundamentally establishes the attitude towards the compliance of Crypto, with a relatively clear direction being the research on DeFi and NFTs, indicating that DeFi and NFTs may also welcome gradually clearer regulatory strategies in the future.