The Unintended Consequences of FIT21’s Crypto Market Structure Bill

There is no doubt that the bipartisan passage of the Financial Innovation and Technology for the 21st Century Act (FIT21) by the House of Representatives is a tremendous development that brings visible much-needed regulatory clarity for the US crypto industry. However, despite its good intentions, FIT21 is fundamentally flawed in terms of market structure and raises issues that could have far-reaching unintended consequences if not addressed in future Senate debates.

Joshua Riezman is deputy general counsel at GSR.

Note: The opinions expressed in this column are those of the author and do not necessarily reflect the views of CoinDesk, Inc. or its owners and affiliates.

One of the most problematic aspects of the bill is that it creates a forked market for crypto tokens. The bill creates firsts by distinguishing between “restricted digital assets” and “digital commodities” in parallel trading markets, paving the way for a fragmented landscape that is ill-suited to the inherently global and fungible nature of crypto tokens. species adaptation complications.

This legislative initiative stems from long-running debates over the application of U.S. federal securities laws to crypto tokens and the differences between Bitcoin and nearly all other tokens that are considered non-securities. The U.S. Securities and Exchange Commission’s (SEC) guidance on whether a crypto token is a security is generally based on whether the relevant blockchain project is “sufficiently decentralized” and therefore an investment contract “security” as defined by the Howey test.

FIT21 attempts to codify this impractical test by splitting regulatory oversight over spot crypto markets between the Commodity Futures Trading Commission (CFTC) and the SEC depending on, among other things, the degree of decentralization.

While the bill appears to helpfully clarify that crypto tokens transferred or sold pursuant to an investment contract do not inherently become securities, it unfortunately does so by giving the SEC general assembly jurisdiction over such investment contract assets sold to investors (or given to developers). contradicts itself. ) during the time before a project reaches decentralized Valhalla. Tokens airdropped or earned solely by end users are “digital commodities” that are initially subject to CFTC jurisdiction.

Most confusingly, FIT21 allowed simultaneous trading in restricted digital assets and digital commodities for the same token in separate and distinct markets during this period (as shown in the chart below). It is likely that many projects will never meet the prescriptive definition of decentralization in the bill and thus trade indefinitely in discrete markets in the United States.

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The bill’s proposed forked market for restricted and unrestricted digital assets ignores fungibility, a key feature of crypto tokens. The bill subverts this principle by creating restricted and unrestricted asset categories, leading to confusion and market fragmentation. This can harm liquidity, complicate transactions and risk management mechanisms such as derivatives, reduce the overall utility of crypto tokens, and ultimately hinder innovation in a nascent industry.

See also: Financial Innovation and Technology Act for the 21st Century is a Milestone | Idea

Implementing such distinctions would likely require technological changes to crypto tokens to ensure buyers know what type of crypto asset they are purchasing so that they can comply with market-specific requirements. Even if possible, applying such technological marking to restricted digital assets would create an “America-only” crypto market separate from global digital asset markets, reducing the utility and value of each project involved.

To protect customers and ensure the well-functioning of U.S. digital asset markets, lawmakers need to pass legislation that would unify spot markets.

As shown in the chart above, tokens can move back and forth between the SEC and CFTC markets if decentralized projects are recentralized. The complexity and compliance costs created by such a scheme applied to thousands of future crypto tokens are dramatically underestimated and would undermine the reliability and predictability of US financial markets. There are precious few examples of financial products switching between SEC and CFTC jurisdiction, and it’s almost always a tire fire (e.g., the migration of KOSPI 200 futures contracts from CFTC jurisdiction to joint CFTC/SEC jurisdiction in 2020).

The bill further downplays the international nature of crypto token markets. Crypto tokens are global assets that are traded globally with the same instrument. Trying to restrict certain assets within the US would likely lead to regulatory arbitrages and backflow from international markets would undermine the bill’s intent while also weakening the competitiveness of the US crypto industry.

Developers and investors outside the US are unlikely to impose similar restrictions on restricted digital assets on their own. Therefore, to avoid these requirements, new projects and investors will be encouraged to move their development and investments outside the United States. This will make it extremely difficult to prevent the US digital commodity market from being flooded with non-US tokens that would be limited to digital assets if they were “issued” in the US.

Finally, and ironically, the bill designed to protect US consumers could harm them due to weak market structure. The first CFTC-regulated markets for end users will be filled with sellers receiving tokens, often for free. This unbalanced market dynamic will likely lead to declining prices and increased volatility compared to both limited and international markets, with professional arbitrageurs benefiting to the detriment of the U.S. retail market.

See also: Is Parliament’s FIT21 Bill Really the Legislation Crypto Needs? | Idea

This system will also be gamed by insiders and professional investors as arbitrageurs take advantage of the discrete pricing and disruptions in price increases caused by the shift between centralized and decentralized assignments. At best, US retail markets will be a noisy signal of fundamental value and end users will be the last to receive institutional liquidity.

While FIT21 is an important step towards resolving the regulatory challenges posed by crypto tokens, the current proposed market structure may lead to unintended consequences. To protect customers and ensure the well-functioning of U.S. digital asset markets, lawmakers need to refine the bill to unify spot markets into a coherent regulatory framework for fungible crypto tokens that are not otherwise securities.