The FIT21 Act, once formally promulgated, will become an important milestone in the federal digital asset regulatory system in the United States.

By Ray, TaxDAO

On May 22, 2024, the U.S. House of Representatives passed the Financial Innovation and Technology for the 21st Century Act (FIT21) with a vote of 279 to 136. The act, led by the Republican Party, aims to amend existing securities and commodity regulations to establish a regulatory framework for digital assets, in order to promote the development of the crypto industry. Once the FIT21 Act is formally promulgated, it will become an important milestone in the federal digital asset regulatory system in the United States. This article will interpret the FIT21 Act from the legislative background, the content of the act, and its potential impact.

1. Legislative Background of the FIT21 Act

Since the genesis block of Bitcoin was mined, digital assets have existed and developed for fifteen years, and are currently in a dynamic and increasingly mature stage. However, whether in the United States or other countries, comprehensive regulatory frameworks for digital assets have yet to be established, and only scattered and one-sided regulations have been implemented. This not only fails to create a stable and predictable legal environment for the crypto industry, but also leads to various illegal and criminal activities in the crypto industry, seriously hindering the innovation and progress of the crypto industry. Critics argue that under the existing crypto regulatory framework in the United States, startups in the crypto industry are subject to "enforcement-based regulation," which may lead these companies to conduct their operations in other countries. This is not conducive to technological innovation in the United States, nor is it conducive to the overall development of the U.S. economy. Therefore, the United States urgently needs to create a legislative environment that supports innovation, fully tap into the future potential of the crypto industry, and avoid the emergence of a situation where a few large tech companies dominate the market in the Web 2.0 era.

In September 2022, the White House released the "First-Ever Comprehensive Framework for Responsible Development of Digital Assets" and urged the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) to develop specific rules for regulating digital assets. The legal draft of FIT21 can be traced back to March 2023, when the Digital Assets, Financial Technology, and Inclusiveness Subcommittee led by U.S. Representative French Hill had planned to work with the House Agriculture Committee to develop a regulatory framework for digital assets. In July of the same year, the House Financial Services Committee and the House Agriculture Committee successively passed the FIT21 Act, and it was not until May 2024 that the House completed the voting process for the act. The FIT21 Act will soon be submitted to the Senate for a vote, and after passing the Senate, it will be signed by the President and formally promulgated.

Recent developments in Staff Accounting Bulletin No. 121 (SAB 121) have also raised high hopes for the FIT21 Act from both the House and the crypto industry. In 2022, the SEC issued SAB 121, which requires digital asset custodians to treat digital assets as liabilities and hold them at fair value on their balance sheets. Based on this, if banks want to hold digital assets, they must hold cash in their accounts equal to the fair value of the asset. This provision is considered by some to be excessive intervention by the SEC in the banking industry and digital assets, as it effectively excludes banks from the crypto industry. In the early to mid-May of 2024, before the SEC changed its stance on ETH spot ETFs, both houses of Congress took action to overturn SAB 121, but the good times did not last long. President Biden ultimately vetoed the bill to overturn SAB 121 on May 31, leaving both houses of Congress and the crypto industry disappointed, and turning their hopes to the pending Senate vote and the President's signing of the FIT121 Act.

2. Overview of the Content of the FIT21 Act

The FIT21 Act consists of multiple chapters, each covering different aspects of the regulatory and innovation system for digital assets. This section will provide a categorized overview of the content of each chapter of the FIT21 Act and summarize the main regulatory framework it establishes.

2.1 Overview of the Chapter Content of the FIT21 Act

The first chapter of the FIT21 Act is titled "Definitions; Rulemaking; Notice of Intent to Register." This section defines key terms under various laws, including the Securities Act of 1933, the Securities Exchange Act of 1934, and the Commodity Exchange Act. These definitions cover terms such as "digital assets," "blockchain," and "decentralized systems," clarifying the scope of application of the act.

The second chapter mainly clarifies digital assets as part of investment contracts. Section 202 of this chapter describes digital assets as part of investment contracts, defining them as digitally represented, fungible representations of value, and specifies how they should be classified and regulated, distinguishing them from traditional securities.

The third chapter specifies how the offering and sale of digital assets should be regulated. Specifically, Section 301 provides exemptions for the trading of digital assets, Section 302 sets out specific requirements for the offering and sale of certain digital assets, and Section 303 requires enhanced disclosure requirements for any digital assets and their related blockchain systems.

The fourth and fifth chapters provide regulations for the registration of digital asset intermediaries under the jurisdiction of the SEC and CFTC. These digital asset intermediaries include digital asset exchanges, digital asset brokers, digital asset dealers, and digital asset custodians. The regulations involve business requirements such as trading certification and licensing, general and specific conditions, methods and exemptions for registration, and conflict of interest rules.

The sixth chapter is titled "Innovation and Technology Improvements," which serves as both a title and a conclusion, indicating the judgment of the drafters of the act and Congress on crypto technology. In connection with this, the SEC will establish the Strategic Hub for Innovation and Financial Technology (FinHub), and the CFTC will establish LabCFTC. According to FIT21, the primary internal functions of these two centers are to shape the way the SEC and CFTC examine financial technology innovation, analyze the impact of regulations on financial technology companies, and so on. Despite both of these research centers having contact with stakeholders and providing information on rules and regulations for those engaged in emerging technologies, given the wording of FIT21, the U.S. Congress does not seem to believe that they will become active regulatory sandboxes, as neither the SEC nor the CFTC has been granted specific discretionary powers in regulation.

2.2 Overview of the Regulatory Framework of the FIT21 Act

Overall, FIT21 will establish a federal digital asset regulatory framework by clarifying the regulatory responsibilities of the SEC and CFTC for digital assets and trading, and updating existing securities and commodity laws to regulate various blockchain technologies, including decentralized protocols. Some believe that the protective measures for technology and innovation in FIT21 are somewhat similar to the protective measures implemented by the United States after the economic depression of the 1920s, which led to unprecedented economic growth and an era of innovation.

The regulatory framework established by the FIT21 Act for digital assets in the United States mainly includes the following four aspects. First, the CFTC must regulate digital assets as commodities, provided that their underlying blockchain or encrypted digital ledger is functional and decentralized. Additionally, the act grants exclusive regulatory authority to the CFTC for crypto commodities and spot markets. Second, in cases where the related blockchain is functional but not decentralized, the SEC must regulate digital assets as securities. The FIT21 Act provides some exceptions for SEC regulation of digital assets, involving matters such as annual sales and accredited investors, and sets requirements for primary and secondary market trading. Third, the CFTC and SEC must jointly issue rules to establish related provisions and avoid duplicate regulatory rules for exchanges. Fourth, the act excludes approved stablecoins from the regulatory oversight of the CFTC and SEC, with specific exceptions for certain transactions involving anti-fraud agencies and registered entities.

3. Interpretation of Sections 101 and 103 of the FIT21 Act

In order to take action, the FIT21 Act's Sections 101 and 103 provide detailed definitions and specific criteria for restricted digital assets (securities), digital commodities, and licensed payment stablecoins. This allows the SEC and CFTC to clarify their respective regulatory responsibilities, targeting restricted digital assets and digital commodities, while licensed payment stablecoins fall outside the jurisdiction of both. This forms the basis for subsequent regulatory and guiding measures, providing the crypto industry with a more orderly regulatory framework and a more stable development space. Overall, the FIT21 Act categorizes digital assets into three main types: restricted digital assets, digital commodities, and licensed payment stablecoins. The relationship between the three is that digital assets are generally restricted digital assets, unless they self-certify as digital commodities or meet the definition of licensed payment stablecoins.

3.1 Digital Assets

Section 101, item 26, first defines digital assets and lists exclusions. It defines digital assets as "any digitally represented, fungible representation of value that can be fully owned and transferred by individuals without reliance on intermediaries, and recorded on a cryptographically secure public distributed ledger." However, digital assets do not include any notes, stocks, shares, securities futures, security swaps, bonds, debt instruments… any put, call, spread, straddle, option, privilege, or any asset equivalent to options, futures, swaps, etc.

It is important to note that Section 101 also emphasizes two points: first, "nothing in this paragraph shall be construed to imply that digital assets represent any type of security not excluded from the definition of digital assets," indicating that FIT21 adheres to a strict definition of digital assets, clearly distinguishing them from other types of securities. Second, "digital assets offered, sold, or intended to be offered or sold pursuant to an investment contract are not and will not become securities by virtue of being offered or transferred in accordance with such investment contract," which refers to the Howey Test. The concept of securities in U.S. law originally developed from the term "investment contract" in the Howey Test, and one of the four test conditions of the Howey Test is that the profits come solely from the efforts of others. Under this condition, the efforts of the project team and related parties are key to investors' profits, while investors themselves only need to pay specified fees and costs, without actually participating in the operation and management of the project. However, the issuance and management of digital assets often rely on smart contracts and other automated programs, and there are no traditional efforts of the project team and related parties. The main reason for the relevant provisions of the FIT21 Act to exclude digital assets from securities is to promote technological innovation while also protecting investors.

3.2 Restricted Digital Assets

Item 34 defines "restricted digital assets" and sets three criteria for identifying them: (1) the degree of decentralization and functionality of the underlying blockchain system of the digital asset; (2) the method by which users ultimately obtain the digital asset; and (3) the identity of the party holding the digital asset. Clarifying the specific meanings of these criteria will help distinguish restricted digital assets from other digital assets. It should be noted that "restricted digital assets" here actually refer to digital assets with characteristics similar to "securities," but the legislators did not use the term "security." For example, Section 405 specifically states that securities include restricted digital assets.

According to item 25, the assessment of the degree of decentralization and functionality includes several aspects: (1) in terms of control and influence, no individual or entity has had unilateral power in the past 12 months to control or substantially alter the functionality or operation of the blockchain system; (2) in terms of ownership and governance distribution of the digital asset, in the past 12 months, no issuer or related party collectively actually owns more than 20% of the total issuance of the digital asset, or no issuer or related party controls 20% or more of the circulating voting rights of the digital asset or related decentralized governance system; (3) in terms of code modifications, in the past 3 months, no issuer or related party has substantially or unilaterally modified the source code of the blockchain system, thereby substantially altering the functionality or operation of the blockchain system, unless these modifications are for bug fixes, regular maintenance, prevention of network security risks, or improvement of blockchain technology; (4) in terms of marketing, in the past 3 months, no issuer or related party has promoted the digital asset as an investment to the public; (5) the units of the digital asset issued through the programmatic function of the blockchain system are distributed to end users. It should be noted that according to the provisions of item 30, the so-called distribution to end users refers to a wide, fair, and non-discretionary distribution that does not involve asset exchange and is accessible to any participant in the blockchain, typical examples being mining and staking rewards for blockchain users.

In the above criteria, the important criteria are "12 months" and "20%." The 12 months is the longitudinal assessment standard for the degree of decentralization, and the 20% is the horizontal assessment standard for the degree of decentralization. Whether it is 12 months or 15 months, 20% or 30%, the specific numerical value itself is not the most important, but the most important thing is that it provides specific, quantifiable standards, making the assessment of the degree of decentralization more objective.

For the method by which users obtain the digital asset, the item requires that restricted digital assets are issued to users in a non-end user distribution manner, or obtained by users in non-digital commodity exchanges.

For the last criterion, restricted digital assets must be held by the issuer and related parties during the period when the blockchain system is not functional or has not become a decentralized system. In addition, licensed payment stablecoins are exempted from restricted digital assets.

3.3 Licensed Payment Stablecoins

Item 32 of Section 101 defines licensed payment stablecoins. It states that a licensed payment stablecoin is used or designed for use as a means of payment or settlement, and its issuer is obligated to convert, redeem, or repurchase to obtain a fixed amount of currency value, or to maintain or reasonably expect to maintain a stable value relative to the fixed amount of currency value, while being regulated by authorized federal or state regulatory agencies, and the stablecoin is not a national currency or security. The currency value referred to here is the national currency, deposits, or equivalent notes denominated in the national currency. From this definition, it can be seen that the FIT21 Act emphasizes the significance of a licensing system for payment stablecoins, and also indicates that only fiat-backed or note-backed stablecoins have the opportunity to be licensed, while algorithmic stablecoins are excluded from the licensing scope.

3.4 Digital Commodities

Section 3. FIT21 Act Sections 101 and 103 Interpretation

Section 103, item 55, defines "digital commodities." This category also involves three situations. First, it includes any digital asset units held by individuals other than the digital asset issuer or related parties before the related blockchain system becomes a functional system and is certified as a decentralized system, and the digital asset units are obtained through final issuance or on digital commodity exchanges. Second, it encompasses any digital asset units held by individuals other than the digital asset issuer or related parties after the related blockchain system becomes a functional system and is certified as a decentralized system. Third, it covers any digital asset units held by related parties during the period when the related blockchain system becomes a functional system and is certified as a decentralized system. Digital commodities also do not include licensed payment stablecoins. There is a special provision that states that if a federal court has ruled that a digital asset is not a security before the enactment of the FIT21 Act, then in the case of a valid ruling, the digital asset should be considered a digital commodity. This special provision reflects the FIT21 Act's approach of essentially dividing digital assets into securities and commodities after excluding licensed payment stablecoins.

Section 4. Potential Impact of the FIT21 Act

4.1 Impact of the FIT21 Act on Crypto Taxation

According to IRS Notice 2014-21, all crypto assets are considered property rather than currency, and are therefore subject to general tax principles for property transactions. However, the IRS has a broad definition of crypto assets, considering any digitally represented value recorded on a cryptographically secure distributed ledger or any similar technology as crypto assets. The FIT21 Act provides detailed criteria and standards for the IRS to determine the scope of crypto assets and whether specific crypto assets belong to digital commodities or securities. This will help the IRS tax crypto asset holders based on distinguishing between general investment income and capital gains.

It is important to note that the FIT21 Act never uses the term "securities" to refer to restricted digital assets that are similar to securities. Therefore, some strict tax rules applicable to specific objects still do not apply to restricted digital assets. For example, U.S. tax law allows for investment loss deductions but strictly prohibits wash sales, meaning investors cannot sell an asset at a loss and then repurchase the same or similar security within a short period. The term "restricted digital assets" excludes crypto assets from wash sale rules.

4.2 Impact of the FIT21 Act on Crypto Regulation

In terms of regulatory authorities and subjects, the FIT21 Act attempts to delineate clear regulatory objects and scopes for the two major regulatory agencies, the SEC and CFTC, by distinguishing restricted digital assets and digital commodities and exempting licensed payment stablecoins. This ensures the orderly regulation of crypto assets and prevents negative impacts caused by unclear regulatory powers and conflicts.

In terms of regulatory content, the FIT21 Act not only requires the SEC and CFTC to be responsible for the registration and management of crypto assets, but also enhances the information disclosure requirements for crypto assets. It also requires the SEC and CFTC to implement anti-money laundering (AML) systems and anti-fraud mechanisms, further enriching the regulatory content for crypto assets.

In terms of regulatory style, overall, the FIT21 Act adopts a flexible and inclusive regulatory policy while emphasizing the protection of small and medium investors and consumers. It provides an orderly and ample space for the innovation and development of the crypto industry in the United States, attracting more crypto talents and businesses to the U.S. and further stimulating the vitality of the U.S. crypto industry, ultimately enhancing the U.S.'s global financial competitiveness.

Section 5. Conclusion

While the final passage of the FIT21 Act remains uncertain, the fact that the U.S. House of Representatives passed the FTI21 Act itself indicates a more favorable attitude of legislators towards crypto assets. Friendliness does not mean laxity; on the contrary, the U.S. hopes to create a stable and effective regulatory environment for the benign growth of the crypto asset market through the FIT21 Act. In the future, the SEC and CFTC will further focus on the integration of DeFi with financial markets, NFTs with traditional markets, and enhance the financial literacy of crypto asset investors, strengthen the infrastructure of blockchain financial markets, and maximize the role of crypto assets and blockchain technology in promoting economic development while protecting investor rights.

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