As the influence of blockchain digital assets in mainstream financial markets grows, their unique decentralized nature also presents challenges to the financial regulatory systems of various countries. How can traditional financial regulatory frameworks adapt to the uniqueness of blockchain digital assets? How can risks be reduced? The focus of the controversy is also different.

Data from the Financial Action Task Force (FATF), an international anti-money laundering regulatory agency, shows that out of 130 jurisdictions worldwide, 88 jurisdictions allow virtual asset service providers to operate, while 20 jurisdictions explicitly prohibit virtual asset services.

Digital Assets as Securities

The United States is a jurisdiction that allows the provision of virtual asset services (including blockchain digital assets) and explicitly states that virtual assets are not real currency. It adopts a joint regulatory model, where different businesses may be subject to regulation by different regulatory agencies. In the United States, the blockchain digital asset industry covers a variety of businesses, such as wallet services, digital asset exchanges, ICOs, mining, smart contracts, staking/re-staking services, NFTs, and more.

As a result, due to jurisdictional disputes, the regulatory authority for a group of blockchain digital assets, represented by ETH, which includes staking services, remains in dispute. The focus of the dispute is whether such digital assets, represented by ETH, are commodities or securities. Regulatory agencies such as the U.S. Securities and Exchange Commission (SEC) and the U.S. Commodity Futures Trading Commission (CFTC) have been actively involved in assessing the applicability of existing regulations, such as using the Howey Test to determine whether digital assets fall under the regulation of "investment contracts."

The Howey Test originated from the 1946 case of SEC v. W.J. Howey Co., which established a clear framework for the SEC to examine whether subsequent investment contracts should be regulated based on specified standards.

If an investment contract passes the Howey Test, it is considered a security. Taking ETH as an example, the key points of the test include:

• Does ETH involve a capital investment?
• Do users have an expectation of profits?
• Is there a common enterprise involved?
• Are profits expected to be derived solely from the efforts of the promoter or a third party?

The U.S. Securities and Exchange Commission's "Framework for 'Investment Contract' Analysis of Digital Assets," released on April 3, 2019, states that if considering conducting an ICO or participating in the issuance, sale, or distribution of digital assets in other ways, one needs to consider whether the U.S. federal securities laws apply. Digital assets should be analyzed to determine whether they exhibit characteristics of any product that meets the definition of "security" under federal securities laws. The term "security" includes "investment contracts," stocks, bonds, and other instruments.

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For more details on the U.S. Securities and Exchange Commission's "Framework for 'Investment Contract' Analysis of Digital Assets," please refer to:

https://www.sec.gov/about/divisions-offices/division-corporation-finance/framework-investment-contract-analysis-digital-assets

Consequences of Digital Assets Being Classified as Securities

The U.S. Securities and Exchange Commission has jurisdiction over such digital assets. If regulatory requirements are violated, the SEC commonly enforces administrative actions through:

• Civil lawsuits brought by the SEC against companies, founders, and executives providing blockchain digital asset-related businesses, based on violations of U.S. securities laws (such as illegal sales of unregistered securities, failure to disclose key information to the public, etc.), with jurisdiction determined by court rulings.
• Administrative penalties imposed by the SEC on companies, founders, and executives providing blockchain digital asset-related businesses, based on violations of U.S. securities laws (such as illegal sales of unregistered securities, failure to disclose key information to the public, etc.).

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SEC's Lawsuit Against Ripple

In December 2020, the U.S. Securities and Exchange Commission filed a lawsuit against Ripple and its founders, alleging that since 2013, Ripple and its founders had issued and sold Ripple's digital asset XRP through various means in exchange for over $1 billion. However, Ripple and its founders did not register the issuance of XRP with the SEC, nor did they meet the conditions for exemption from registration, violating relevant provisions of U.S. securities laws.

In the initial judgment, the court ruled on the economic substance of the transactions to determine whether the sale of XRP assets in different ways constituted the sale of "securities" in substance. Ultimately, the court ruled that XRP's private placement round targeting institutional professional investors met the Howey Test's detection standards, constituting the sale of "securities," while the sale of XRP on exchanges and through other channels did not constitute the sale of "securities." However, the SEC subsequently filed an appeal, and the aforementioned court ruling is not yet final.

Digital Assets as Commodities

In the United States, commodities are generally defined as basic goods used in commerce that are interchangeable with other similar goods. Common commodities include gold, oil, and agricultural products. The U.S. Commodity Futures Trading Commission is responsible for regulating commodity trading, with a focus on ensuring market stability and preventing fraud.

Although blockchain digital assets have not been explicitly defined as commodities under the "Commodity Exchange Act" in the United States, the U.S. Commodity Futures Trading Commission, in a 2015 enforcement action, for the first time stated that BTC and other digital assets are commodities within its enforcement jurisdiction. Subsequently, the U.S. Commodity Futures Trading Commission expanded this classification to include other digital assets such as ETH, recognizing digital assets as "commodities" – they possess characteristics such as interchangeability, market tradability, and a certain level of scarcity.

Restricted Digital Assets vs. Digital Commodities

On May 22, 2024, the U.S. House of Representatives passed H.R. 4763, the "Financial Innovation and Technology Act of the 21st Century" (hereinafter referred to as the "FIT21 Act").

Patrick McHenry, Chairman of the House Financial Services Committee, stated that the FIT21 Act provides necessary regulatory clarity and strong consumer protection measures for the flourishing development of the digital asset ecosystem in the United States.

Regarding the classification of digital assets, the FIT21 Act divides digital assets into the following two types and specifies regulatory responsibilities:

• "Restricted digital assets" regulated by the U.S. Securities and Exchange Commission.
• "Digital commodities" regulated by the U.S. Commodity Futures Trading Commission.

The determination of the type of digital asset is influenced by three factors:

• Whether the underlying blockchain of the digital asset has been certified as a "decentralized system"?
• How the asset was acquired?
• Whether the asset holder is an affiliate of the issuer or is associated with the issuer?

In addition, the FIT21 Act also requires certain participants in the digital asset field to comply with registration and disclosure requirements related to the blockchain system where the digital assets are located.

Impact of the Classification of Digital Assets

Taking ETH as an example, if ETH is classified as a security, it will fall under the regulatory purview of the U.S. Securities and Exchange Commission. In addition to requiring registration for issuance, service providers and asset management companies may also need to comply with strict disclosure obligations, registration obligations, and investor protection measures, leading to a significant increase in compliance costs or potentially causing loss of investment opportunities for retail investors, thereby suppressing market sentiment.

If ETH is classified as a commodity, it will be subject to regulation by the U.S. Commodity Futures Trading Commission. This classification will not lead to a significant increase in compliance costs and will be conducive to the development of the ETH derivatives market, but it will not reflect the unique properties of decentralized digital assets.

Furthermore, the regulatory game between regulatory agencies such as the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission may lead to regulatory arbitrage, making the regulatory environment for Ethereum and other market participants more complex.

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