About FIT21 Act: Background, Content and Impact

Author: TaxDAO-Ray

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

1. Legislative background of FIT21 Act 

Since the creation block of Bitcoin was mined, crypto assets have existed and developed for fifteen years and are now in a vibrant and increasingly mature stage. However, neither the United States nor other countries have yet established a comprehensive regulatory framework for digital assets, but only conduct fragmented and one-sided supervision, which not only fails to create a stable and predictable legal environment for the crypto industry, but also makes the crypto industry full of various illegal and criminal activities, seriously hindering the innovation and progress of the crypto industry. Critics believe that under the existing crypto regulatory framework in the United States, start-ups in the crypto industry are subject to "enforcement-based supervision", which will cause related companies to conduct business activities in other countries, which is not conducive to the technological innovation of the United States, nor to the overall development of the US economy. Therefore, the United States urgently needs to create an environment that supports innovation through legislation to fully explore the future potential of the encryption industry while avoiding the situation in which a few large technology companies in the Web 2.0 era monopolize the market. In September 2022, the White House issued 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 to regulate digital assets. The draft law of FIT21 can be traced back to March 2023, when the Digital Assets, Financial Technology and Inclusion 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 U.S. House of Representatives Financial Services Committee and the House of Representatives Agriculture Committee successively passed the FIT21 Act, and it was not until May 2024 that the House of Representatives completed the voting process for the bill. The FIT21 Act will be submitted to the Senate for a vote soon, and after the Senate passes it, it will be signed by the President and officially released. The recent developments of SAB 121 (Staff Accounting Bulletin No.121) have also made the Senate and the crypto industry have high hopes for the FIT21 Act. The SEC issued SAB 121 in 2022, 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 that is consistent with the fair value of the assets. This regulation is considered to be the SEC's excessive intervention in the banking industry and digital assets, because it will actually exclude banks from the crypto industry. In mid-to-early May 2024, before the SEC changed its attitude towards the ETH spot ETF, the Senate and the House of Representatives took action to pass a bill to overturn SAB 121, but the good times did not last long. President Biden finally vetoed the bill to overturn SAB 121 on May 31, which disappointed the Senate, the House of Representatives and the crypto industry, and instead placed more hope on the FIT121 bill, which is awaiting a vote by the Senate and the signature of the President.   

2. Overview of the contents of the FIT21 Act 

The FIT21 Act consists of multiple chapters, each of which involves different aspects of digital asset regulation and innovation systems. This section will provide an overview of the contents of each chapter of the FIT21 Act and summarize the main regulatory framework it has established.  

2.1 Overview of the Chapters 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 system", clarifying the scope of application of the Act.  

Chapter II mainly clarifies digital assets as part of an investment contract. Article 202 of this chapter describes digital assets as part of an investment contract, defining them as fungible digital representations of value, and also specifies how they should be classified and regulated, distinguishing them from traditional securities.  

Chapter III mainly specifies how to regulate the provision and sale of digital assets. Specifically, Article 301 provides for exemptions for digital asset transactions, Article 302 provides for specific requirements for the provision and sale of certain digital assets, and Article 303 requires enhanced disclosure requirements for any digital asset and its related blockchain system. Chapters 4 and 5 provide for registration matters for digital asset intermediaries under the jurisdiction of the SEC and CFTC. Digital asset intermediaries here include digital asset exchanges, digital asset brokers, digital asset traders, and digital asset custodians. The relevant regulations involve business requirements such as transaction certification and licensing, registration requirements such as general and special conditions, methods and exemptions for different registered entities, and specific content such as conflict of interest rules.  

Chapter VI is titled "INNOVATION AND TECHNOLOGY IMPROVEMENTS", which is both the title and the conclusion, indicating the judgment of the drafters of the bill and Congress on crypto technology. Related to this, the SEC will establish the Strategic Center for Innovation and Financial Technology (FinHub) and the CFTC will establish LabCFTC. According to FIT21, the main internal functions of the two centers are to shape the way the SEC and CFTC examine fintech innovations, analyze the impact of regulations on fintech companies, and so on. Although both research centers engage with stakeholders and provide information about rules and regulations to those working in emerging technologies, given the wording of FIT21, the U.S. Congress does not seem to think that they will become active regulatory sandboxes, as neither the SEC nor the CFTC has been granted specific discretion in terms of regulation.  

2.2 Overview of the Regulatory Framework of FIT21 Act 

In general, FIT21 will establish a federal digital asset regulatory framework to regulate various blockchain technologies, including decentralized protocols, by clarifying the regulatory responsibilities of the SEC and CFTC for digital assets and transactions, and updating existing securities and commodity laws. Some people believe that FIT21's protection measures for technology and innovation are somewhat similar to the protection measures implemented by the United States after the Great Depression in the 1920s, and after the implementation of the latter, the United States ushered in an unprecedented era of economic growth and 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 the blockchain or encrypted digital ledger on which it operates is functional and decentralized. In addition, the bill also gives the CFTC exclusive regulatory power over encrypted commodities and spot markets. Second, the SEC must regulate digital assets as securities when the relevant blockchain functions normally but is not decentralized. The FIT21 Act provides some exceptions to the SEC's regulation of digital assets, involving matters such as annual sales, qualified investors, and stipulates requirements for primary and secondary market transactions. Third, the CFTC and the SEC must jointly issue rules to formulate relevant terms and avoid duplicate regulatory rules faced by exchanges. Fourth, the bill excludes approved stablecoins from the supervision of the CFTC and SEC, except for specific transactions with anti-fraud agencies and registered entities.   

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

Clearing the target is the premise for taking action. Sections 101 and 103 of the FIT21 Act provide detailed definitions of restricted digital assets (securities), digital commodities and licensed payment stablecoins, and provide specific judgment criteria. Thanks to this, the SEC and CFTC can clarify the scope of their responsibilities and regulate restricted digital assets and digital commodities respectively, while licensed payment stablecoins are not within the jurisdiction of the two. This constitutes the premise for subsequent regulation and guidance measures, and the crypto industry will therefore obtain a more orderly regulatory framework and a more stable development space. In general, the FIT21 Act divides digital assets into three categories: restricted digital assets, digital commodities, and permitted payment stablecoins. The relationship between the three is that digital assets are generally restricted digital assets unless they are self-certified as digital commodities or meet the definition of permitted payment stablecoins.  

3.1 Digital Assets 

Article 101, Item 26, first defines digital assets and lists the exclusions. The article states that digital assets "refer to any fungible digital representation of value that can be fully owned and transferred by an individual without relying on an intermediary and is recorded on a cryptographically secure public distributed ledger." However, digital assets do not include any notes, stocks, treasury stocks, securities futures, securities swaps, bonds, debt certificates, debt certificates... any puts, calls, spreads, options, privileges" and assets equivalent to options, futures, swaps, etc. It is important to note that Article 101 also emphasizes two points: First, "nothing in this paragraph shall be interpreted as presuming that digital assets are representatives of any type of securities that are not excluded from the definition of digital assets", which shows that FIT21 insists on a strict definition of digital assets and clearly distinguishes other types of securities from digital assets. Second, "digital assets offered or sold or intended to be offered or sold under an investment contract are not and will not become securities because they are sold or otherwise transferred under the investment contract". To understand this, you must first understand the Howey Test. Test). The concept of securities in American law was first developed from the term "investment contract" in the Howey Test, and one of the four test conditions of the Howey Test is that the benefits come only from the efforts of others (Efforts of Others). Under this requirement, the efforts of the project party and related parties are the key to investors' gains, and the investors themselves only need to pay the specified fees and costs, and do not actually participate in the operation and management of the project. However, the issuance and management of digital assets often rely on smart contracts and other automatic programs, and there is no effort from the project party and related parties in the traditional sense. The relevant provisions of the FIT21 Act exclude digital assets from securities mainly to promote technological innovation while taking into account the protection of investors.  

3.2 Restricted digital assets 

Item 34 defines "restricted digital assets" and proposes three criteria for identifying "restricted digital assets": (1) the degree of decentralization and functionality of the blockchain system underlying 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 meaning of these criteria will help distinguish restricted digital assets from other digital assets. It should be noted in advance that the "restricted digital assets" here actually refer to digital assets that have a nature similar to "securities", but the legislator did not use the word "security". For example, Section 405 clearly stipulates that securities include restricted digital assets.  

Among the above standards, the more important ones are "12 months" and "20%". 12 months is the vertical judgment standard for the degree of decentralization, and 20% is the horizontal judgment standard for the degree of decentralization. Whether it is 12 months or 15 months, 20% or 30%, the specific value itself is not the most important. The most important thing is that it provides an exact and quantifiable standard, making the judgment of the degree of decentralization more objective.  

For the method of users obtaining digital assets, this provision requires that the restricted digital assets are issued to users in a non-end-user manner, or obtained by users in non-digital commodity exchanges.  

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

3.3 Licensed Payment Stablecoins 

Article 101, paragraph 32, defines licensed payment stablecoins. This article stipulates that a licensed payment stablecoin is one that is used or designed to be used as a means of payment or settlement, and its issuer is obliged to convert, redeem or repurchase to obtain a fixed amount of monetary value, or to indicate that it will maintain or reasonably expect to maintain a stable value relative to a fixed amount of monetary value, and its issuer is regulated by competent federal or state regulators, and the stablecoin is not a national currency or security. The aforementioned monetary value refers to national currency, deposits, or equivalent bills denominated in national currency. From this definition, it can be seen that the FIT21 Act emphasizes the significance of the licensing system for payment stablecoins on the one hand, and on the other hand, it shows that only legal currency or bill-collateralized stablecoins have the opportunity to be licensed, while excluding algorithmic stablecoins from the scope of the license.  

3.4 Digital Goods 

Article 103, Item 55, defines "digital goods". Digital goods here also involve three situations. First, before the relevant blockchain system becomes a functional system and is certified as a decentralized system, any digital asset unit held by an individual other than the digital asset issuer or associated person, and the digital asset unit is obtained through final issuance or in a digital commodity exchange; second, after the relevant blockchain system becomes a functional system and is certified as a decentralized system, any digital asset unit held by a person other than the digital asset issuer or associated person; third, during the period when the relevant blockchain system becomes a functional system and is certified as a decentralized system, any digital asset unit held by any associated person. Digital goods also do not include licensed payment stablecoins. There is also a special provision here, that is, before the FIT21 Act is enacted, if the federal court has ruled that a digital asset is not a security, then if the ruling is valid, the digital asset should be deemed a digital commodity. This special provision reflects the FIT21 Act's attitude of essentially dividing digital assets into securities and commodities after excluding licensed payment stablecoins.  

4. Potential impact after the passage of the FIT21 Act 

4.1 The impact of the FIT21 Act on crypto taxation 

According to IRS Notice 2014-21, all crypto assets are regarded as property rather than currency, and therefore are subject to the general tax principles of property transactions. However, the IRS defines crypto assets broadly, and believes that "digital representations of value recorded on a cryptographically secure distributed ledger or any similar technology" are all crypto assets. The FIT21 Act provides detailed basis and standards for the IRS to determine the scope of crypto assets and whether specific crypto assets are digital commodities or securities, which will help the IRS to tax crypto asset holders on the basis of distinguishing general investment income from capital gains. At the same time, it should be emphasized that the FIT21 Act has never used the term "securities" to refer to restricted digital assets similar to securities. Therefore, some tax rules that strictly restrict applicable objects still do not apply to restricted digital assets. For example, the US tax law allows investment losses to be deducted, but strictly prohibits wash sales, that is, investors are not allowed to sell an asset at a loss first and then buy the same or similar securities in the near future. Securities here include stocks, bonds, mutual funds, ETFs, options, futures and warrants, and the term "restricted digital assets" continues to exclude crypto assets from wash sale rules. 4.2 Impact of FIT21 on Crypto Regulation In terms of regulatory subjects and objects, FIT21 attempts to distinguish restricted digital assets and digital commodities, and exempt licensed payment stablecoins, to define clear regulatory objects and scopes for the two major regulatory agencies, SEC and CFTC, to ensure the orderliness of digital asset regulation and prevent the negative impact 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 digital assets, but also strengthens the information disclosure requirements for digital assets. It also requires the SEC and CFTC to implement anti-money laundering (AML) systems and anti-fraud mechanisms, which will help further enrich the regulatory content of crypto assets.  

In terms of regulatory style, overall, the FIT21 Act adopts a flexible and inclusive regulatory policy, while paying attention to the protection of small and medium-sized investors and consumers, providing an orderly and sufficient space for the innovation and development of the encryption industry in the United States. This will attract more encryption talents and enterprises to the United States, further stimulate the vitality of the U.S. encryption industry, and ultimately further enhance the United States' global financial competitiveness.  

5. Conclusion 

Although there is still some uncertainty as to whether the FIT21 bill can be finally passed, the fact that the U.S. House of Representatives passed the FTI21 bill itself is enough to show that legislators have become more friendly to crypto assets. Friendliness does not mean laissez-faire. On the contrary, the United States hopes to create a stable and effective regulatory environment for the healthy growth of the crypto asset market through the FIT21 bill. In the future, the SEC and CFTC will work together to pay more attention to the integration of Defi and financial markets, NFT and traditional markets, further enhance the financial literacy of crypto asset investors, strengthen the infrastructure construction of blockchain financial markets, and maximize the role of crypto assets and blockchain technology in promoting economic development while protecting the rights and interests of investors.  

References

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